FAIR VALUE

12 Months Ended

Dec. 31, 2019

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Certain financial instruments and all non-financial instruments are excluded from fair value disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.

The fair value hierarchy distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity's own assumptions about market participant assumptions based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are:

Level 1 – quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access at the measurement date.

Level 2 – significant other observable inputs other than Level 1 prices such as prices for similar assets and liabilities in active markets; quoted prices for identical or similar instruments in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3 – at least one significant unobservable input that reflects a company's own assumptions about the assumptions that market participants would use in pricing an asset or liability.

In instances in which multiple levels of inputs are used to measure fair value, hierarchy classification is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company's assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.

The Company used the following methods and significant assumptions to estimate fair value for instruments measured on a recurring basis:

Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, securities are classified within Level 2 and fair values are estimated by using pricing models, quoted prices of securities with similar characteristics or discounted cash flow. Level 2 securities include U.S. agency securities, mortgage-backed securities, obligations of states and political subdivisions and certain corporate, asset backed and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy. All of the Company’s securities are classified as available for sale.

The Company had no fair value liabilities measured on a recurring basis at December 31, 2019 or 2018.

The following table summarizes assets measured at fair value on a recurring basis at December 31, 2019 or 2018.


	Level 1		Level 2		Level 3		Total Fair Value Measurements
December 31, 2019
AFS Securities:


States and political subdivisions	$	—	$	87,863	$	—	$	87,863


GSE residential CMOs	—		68,154		—		68,154
Non-agency CMOs	—		—		17,087		17,087


Private label commercial CMOs	—		79,437		7,192		86,629
Asset-backed and other	—		230,653		—		230,653
Loans held for sale	—		9,364		—		9,364
Interest rate lock commitments on residential mortgages	—		—		103		103
Totals	$	—	$	475,471	$	24,382	$	499,853
December 31, 2018
AFS Securities:



States and political subdivisions	$	—	$	145,004	$	—	$	145,004


GSE residential CMOs	—		108,064		—		108,064


Private label residential CMOs	—		143		—		143
Private label commercial CMOs	—		67,836		7,209		75,045
Asset-backed and other	—		137,588		—		137,588


Totals	$	—	$	458,635	$	7,209	$	465,844

The Company has CMOs measured at fair value on a recurring basis using significant unobservable inputs (Level 3) at December 31, 2019 and 2018. The Level 3 valuation is based on a non-executable broker quote, which is considered a significant unobservable input. Such quotes are updated as available and may remain constant for a period of time for certain broker-quoted securities that do not move with the market or that are not interest rate sensitive as a result of their structure or overall attributes.

Effective October 1, 2019, the Company’s residential mortgage loans held-for-sale were recorded at fair value utilizing Level 2 measurements. This fair value measurement is determined based upon third party quotes obtained on similar loans. The adoption of this accounting election resulted in an increase of $226 thousand in gain on sale of loans in the consolidated statements of income for the year ended December 31, 2019. For loans held-for-sale for which the fair value option has been elected, the aggregate fair value exceeded the aggregate principal balance by $226 thousand as of December 31, 2019.

As a part of its normal residential mortgage operations, the Company will enter into an interest rate lock commitment with a potential borrower. The Company enters into a corresponding commitment to an investor to sell that loan at a specific price shortly after origination. In accordance with FASB ASC 820, adjustments are recorded through earnings to account for the net change in fair value of these transactions for the held-for-sale pipeline. The determination of the fair value of interest rate lock commitments on residential mortgages is based on agreed upon pricing with the respective investor on each loan and includes a pull through percentage. The pull through percentage represents an estimate of loans in the pipeline to be delivered to an investor versus the total loans committed for delivery. Significant changes in this input could result in a significantly higher or lower fair value measurement. As the pull through percentage is a significant unobservable input, this is deemed a Level 3 valuation input. The pull through percentage, which is based upon historical experience, was 95% as of December 31, 2019. The fair value of interest rate lock commitments was $103 thousand at December 31, 2019 and is included in other assets on the consolidated balance sheets.

The following provides details of the Level 3 fair value measurement activity for the years ended December 31, 2019 or 2018.


CMOs:
	2019		2018
Balance, beginning of year	$	7,209	$	—


Unrealized (loss) gain included in OCI	(17)		37
Purchases	17,619		7,213
Net discount accretion (premium amortization)	7		(41)
Principal payments	(539)		—


Balance, end of year	$	24,279	$	7,209


Interest rate lock commitments on residential mortgages:
	2019
Balance, beginning of year	$	—
Total gains (losses), realized/unrealized:
Included in earnings	103


Balance, end of year	$	103

Certain financial assets are measured at fair value on a nonrecurring basis. Adjustments to the fair value of these assets usually results from the application of lower-of-cost-or-market accounting or write-downs of individual assets. The Company used the following methods and significant assumptions to estimate fair value for these financial assets.

Impaired Loans

Loans are designated as impaired when, in the judgment of management and based on current information and events, it is probable that all amounts due, according to the contractual terms of the loan agreement, will not be collected. The measurement of loss associated with impaired loans for all loan classes can be based on either the observable market price of the loan, the fair value of the collateral, or discounted cash flows using a market rate of interest for performing TDRs. For collateral-dependent loans, fair value is measured based on the value of the collateral securing the loan, less estimated costs to sell. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The value of the real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the collateral is a house or building in the process of construction, or if management adjusts the appraisal value, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal, if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivable collateral are based on financial statement balances or aging reports (Level 3). Impaired loans with an allocation to the ALL are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the consolidated statements of income. Changes in the fair value of impaired loans for those still held at December 31 considered in the determination of the provision for loan losses totaled $77 thousand, $146 thousand and $867 thousand for the years ended December 31, 2019, 2018, and 2017, respectively.

Foreclosed Real Estate

OREO property acquired through foreclosure is initially recorded at the fair value of the property at the transfer date less estimated selling cost. Subsequently, OREO is carried at the lower of its carrying value or the fair value less estimated selling cost. Fair value is usually determined based upon an independent third-party appraisal of the property or occasionally upon a recent sales offer. There were no specific charges to value OREO at the lower of cost or fair value on properties held at December 31, 2019 and 2018. Changes in the fair value of foreclosed real estate for those still held at December 31 charged to OREO totaled $0 for the years ended December 31, 2019, 2018, and 2017.

Mortgage Servicing Rights

The fair value of mortgage servicing rights is estimated to be equal to its carrying value, unless the quarterly valuation model calculates the present value of the estimated net servicing income is less than its carrying value, in which case a lower of cost or fair value charge is taken. At December 31, 2019, a $70 thousand lower of cost or fair value reserve existed on the mortgage servicing right portfolio. In 2019, net impairment charges of $70 thousand were recorded in mortgage banking activities on the consolidated statements of income. No reserve existed at December 31, 2018, and no impairment charges were recorded in 2018.

The following table summarizes assets measured at fair value on a nonrecurring basis at December 31, 2019 and 2018.


	Level 1		Level 2		Level 3		Total Fair Value Measurements
December 31, 2019
Impaired loans
Commercial real estate:
Owner-occupied	$	—	$	—	$	938	$	938

Multi-family	—		—		96		96
Non-owner occupied residential	—		—		103		103



Commercial and industrial	—		—		11		11
Residential mortgage:
First lien	—		—		641		641

Home equity - lines of credit	—		—		400		400
Installment and other loans	—		—		7		7
Total impaired loans	$	—	$	—	$	2,196	$	2,196






Mortgage servicing rights	$	—	$	3,119	$	—	$	3,119

December 31, 2018
Impaired loans
Commercial real estate:
Owner-occupied	$	—	$	—	$	1,087	$	1,087

Multi-family	—		—		131		131
Non-owner occupied residential	—		—		278		278



Commercial and industrial	—		—		25		25
Residential mortgage:
First lien	—		—		1,121		1,121

Home equity - lines of credit	—		—		409		409

Total impaired loans	$	—	$	—	$	3,051	$	3,051

The following table presents additional qualitative information about assets measured on a nonrecurring basis and for which the Company has utilized Level 3 inputs to determine fair value.

Fair Value

Estimate

Valuation Techniques

Unobservable Input

Range

December 31, 2019

Impaired loans

2,196

Appraisal of collateral

Management adjustments on appraisals for property type and recent activity

0% - 20% discount

- Management adjustments for liquidation expenses

6% - 33% discount

Mortgage servicing rights

3,119

Discounted cash flows

Weighted average CPR

11.63%

Discount rate

9.54%

December 31, 2018

Impaired loans

3,051

Appraisal of collateral

Management adjustments on appraisals for property type and recent activity

5% - 75% discount

- Management adjustments for liquidation expenses

6% - 20% discount

Fair values of financial instruments

GAAP requires disclosure of the fair value of financial assets and liabilities, including those that are not measured and reported at fair value on a recurring or nonrecurring basis. The following table presents the carrying amounts and estimated fair values of financial assets and liabilities at December 31, 2019, and 2018.


	Carrying Amount		Fair Value		Level 1		Level 2		Level 3
December 31, 2019
Financial Assets
Cash and due from banks	$	25,969	$	25,969	$	25,969	$	—	$	—
Interest-bearing deposits with banks	30,493		30,493		30,493		—		—

Restricted investments in bank stock	16,184		n/a		n/a		n/a		n/a
AFS securities	490,386		490,386		—		466,107		24,279
Loans held for sale	9,364		9,364		—		9,364		—
Loans, net of allowance for loan losses	1,629,675		1,652,788		—		—		1,652,788
Interest rate lock commitments on residential mortgages	103		103		—		—		103
Accrued interest receivable	6,040		6,040		—		1,863		4,177

Financial Liabilities
Deposits	1,875,522		1,876,555		—		1,876,555		—
Short-term borrowings	154,869		154,869		—		154,869		—
Long-term debt	63,067		63,405		—		63,405		—
Subordinated notes	31,847		33,953		—		33,953		—
Accrued interest payable	879		879		—		879		—

December 31, 2018
Financial Assets
Cash and due from banks	$	26,156	$	26,156	$	26,156	$	—	$	—
Interest-bearing deposits with banks	45,664		45,664		45,664		—		—
Federal funds sold	16,995		16,995		16,995		—		—
Restricted investments in bank stock	10,842		n/a		n/a		n/a		n/a
AFS securities	465,844		465,844		—		458,635		7,209
Loans held for sale	3,340		3,413		—		3,413		—
Loans, net of allowance for loan losses	1,233,643		1,229,645		—		—		1,229,645

Accrued interest receivable	5,927		5,927		—		2,853		3,074

Financial Liabilities
Deposits	1,558,756		1,555,912		—		1,555,912		—
Short-term borrowings	64,069		64,069		—		64,069		—
Long-term debt	83,450		82,951		—		82,951		—
Subordinated notes	31,859		31,256		—		31,256		—
Accrued interest payable	1,301		1,301		—		1,301		—

The methods used to estimate the fair value of financial instruments at December 31, 2019 did not necessarily represent an exit price. In accordance with the Company's adoption of ASU 2016-01, the methods utilized to measure the fair value of financial instruments at December 31, 2019 represents an approximation of exit price; however, an actual exit price may differ.

- Definition

The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information.

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