3. FAIR VALUE MEASUREMENT

Fair value is defined in ASC Topic 820 “Fair Value Measurement” as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

There are three levels of inputs to fair value measurement:


			Level 1 inputs are quoted prices for identical instruments in active markets;
			Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly; and
			Level 3 inputs are unobservable inputs.

Observable market data should be used when available.

FINANCIAL INSTRUMENTS MEASURED AT FAIR VALUE ON A RECURRING BASIS

The following table presents, for each of the fair-value hierarchy levels as defined in this footnote, those financial instruments which are measured at fair value on a recurring basis as of September 30, 2017 and December 31, 2016, respectively:



(in thousands)		Level 1		Level 2		Level 3		Fair Value

September 30, 2017
Securities available-for-sale:
U.S. government agencies	$	-	$	28,247	$	-	$	28,247
States and political subdivisions		-		30,388		-		30,388
Mortgage-backed securities		-		89,665		-		89,665
Mortgage servicing rights		-		-		571		571

December 31, 2016
Securities available-for-sale:
U.S. government agencies	$	-	$	12,872	$	-	$	12,872
States and political subdivisions		-		35,142		-		35,142
Mortgage-backed securities		-		47,208		-		47,208
Mortgage servicing rights		-		-		527		527

Securities available for sale

Fair values for securities are determined using independent pricing services and market-participating brokers. The Company’s independent pricing service utilizes evaluated pricing models that vary by asset class and incorporate available trade, bid and other market information for structured securities, cash flow and, when available, loan performance data. Because many fixed income securities do not trade on a daily basis, the evaluated pricing applications apply information as applicable through processes, such as benchmarking of like securities, sector groupings, and matrix pricing, to prepare evaluations. In addition, model processes, such as the Option Adjusted Spread model, are used to assess interest rate impact and develop prepayment scenarios. The models and the process take into account market convention. For each asset class, a team of evaluators gathers information from market sources and integrates relevant credit information, perceived market movements and sector news into the evaluated pricing applications and models. The Company’s service provider may occasionally determine that it does not have sufficient verifiable information to value a particular security. In these cases the Company will utilize valuations from another pricing service.

Management believes that it has a sufficient understanding of the third party service’s valuation models, assumptions and inputs used in determining the fair value of securities to enable management to maintain an appropriate system of internal control. On a quarterly basis, the Company reviews changes in the market value of its security portfolio. Individual changes in valuations are reviewed for consistency with general interest rate movements and any known credit concerns for specific securities. Additionally, on an annual basis, the Company has its entire security portfolio priced by a second pricing service to determine consistency with another market evaluator. If, during the Company’s review or when comparing with another servicer, a material difference between pricing evaluations were to exist, the Company would submit an inquiry to the service provider regarding the data used to value a particular security. If the Company determines it has market information that would support a different valuation than the initial evaluation it can submit a challenge for a change to that security’s valuation.

Securities available for sale are classified as Level 2 in the fair value hierarchy as the valuation provided by the third-party provider uses observable market data.

Mortgage servicing rights

Mortgage servicing rights (“MSRs”) do not trade in an active, open market with readily observable prices. Accordingly, the Company obtains the fair value of the MSRs using a third-party pricing provider. The provider determines the fair value by discounting projected net servicing cash flows of the remaining servicing portfolio. The valuation model used by the provider considers market loan prepayment predictions and other economic factors which management considers to be significant unobservable inputs. The fair value of MSRs is mostly affected by changes in mortgage interest rates since rate changes cause the loan prepayment acceleration factors to increase or decrease. Management has a sufficient understanding of the third party service’s valuation models, assumptions and inputs used in determining the fair value of MSRs to enable management to maintain an appropriate system of internal control. Mortgage servicing rights are classified within Level 3 of the fair value hierarchy as the valuation is model driven and primarily based on unobservable inputs.

The following table summarizes the changes in fair value for mortgage servicing rights during the three and nine month periods ended September 30, 2017 and 2016, respectively:



	Three months ended September 30,
(in thousands)	2017		2016
Mortgage servicing rights - July 1	$	555	$	466
Losses included in earnings		(25)		(22)
Additions from loan sales		41		15
Mortgage servicing rights - September 30	$	571	$	459



	Nine months ended September 30,
(in thousands)	2017		2016
Mortgage servicing rights - January 1	$	527	$	557
Losses included in earnings		(46)		(147)
Additions from loan sales		90		49
Mortgage servicing rights - September 30	$	571	$	459

Quantitative information about the significant unobservable inputs used in the fair value measurement of MSRs at the respective dates is as follows:




	September 30, 2017		December 31, 2016
Servicing fees	0.25	%	0.25	%
Discount rate	9.52	%	9.52	%
Prepayment rate (CPR)	8.78	%	8.12	%

FINANCIAL INSTRUMENTS MEASURED AT FAIR VALUE ON A NONRECURRING BASIS

The Company is required, on a nonrecurring basis, to adjust the carrying value of certain assets or provide valuation allowances related to certain assets using fair value measurements. The following table presents for each of the fair-value hierarchy levels as defined in this footnote, those financial instruments which are measured at fair value on a nonrecurring basis at September 30, 2017 and December 31, 2016:



(in thousands)		Level 1		Level 2		Level 3		Fair Value

September 30, 2017
Collateral dependent impaired loans	$	-	$	-	$	18,639	$	18,639

December 31, 2016
Collateral dependent impaired loans	$	-	$	-	$	13,114	$	13,114

Collateral dependent impaired loans

The Company evaluates and values impaired loans at the time the loan is identified as impaired, and the fair values of such loans are estimated using Level 3 inputs in the fair value hierarchy. Each loan’s collateral has a unique appraisal and management’s discount of the value is based on factors unique to each impaired loan. The significant unobservable input in determining the fair value is management’s subjective discount on appraisals of the collateral securing the loan. Collateral may consist of real estate and/or business assets including equipment, inventory and/or accounts receivable and the value of these assets is determined based on appraisals by qualified licensed appraisers hired by the Company. Appraised and reported values may be discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, estimated costs to sell, and/or management’s expertise and knowledge of the client and the client’s business.

The Company has an appraisal policy in which appraisals are obtained upon a commercial loan being downgraded on the Company’s internal loan rating scale to a 5 (special mention) or a 6 (substandard) depending on the amount of the loan, the type of loan and the type of collateral. All impaired commercial loans are either graded a 6 or 7 on the internal loan rating scale. For consumer loans, the Company obtains appraisals when a loan becomes 90 days past due or is determined to be impaired, whichever occurs first. Subsequent to the downgrade or reaching 90 days past due, if the loan remains outstanding and impaired for at least one year more, management may require another follow-up appraisal. Between receipts of updated appraisals, if necessary, management may perform an internal valuation based on any known changing conditions in the marketplace such as sales of similar properties, a change in the condition of the collateral, or feedback from local appraisers. Impaired loans had a gross value of $20.3 million, with an allowance for loan loss of $1.7 million, at September 30, 2017 compared with $15.1 million and $2.0 million, respectively, at December 31, 2016.

FAIR VALUE OF FINANCIAL INSTRUMENTS

At each of September 30, 2017 and December 31, 2016, the estimated fair values of the Company’s financial instruments, including those that are not measured and reported at fair value on a recurring basis or nonrecurring basis, were as follows:




	September 30, 2017				December 31, 2016
	Carrying		Fair		Carrying		Fair
	Amount		Value		Amount		Value
		(in thousands)				(in thousands)
Financial assets:
Level 1:
Cash and cash equivalents	$	18,055	$	18,055	$	13,084	$	13,084
Level 2:
Available for sale securities		148,300		148,300		95,222		95,222
FHLB and FRB stock		4,312		4,312		3,731		3,731
Level 3:
Held to maturity securities		4,487		4,472		1,983		1,959
Loans, net		983,823		977,975		928,596		945,998
Mortgage servicing rights		571		571		527		527

Financial liabilities:
Level 1:
Demand deposits	$	216,250	$	216,250	$	201,741	$	201,741
NOW deposits		96,741		96,741		88,632		88,632
Savings deposits		552,559		552,559		508,652		508,652
Level 2:
Securities sold under agreement to
repurchase		9,380		9,380		10,159		10,159
Other borrowed funds		33,600		33,558		28,200		28,152
Junior subordinated debentures		11,330		11,330		11,330		11,330
Level 3:
Time deposits		166,769		168,389		140,949		141,758

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practical to estimate that value.

Cash and Cash Equivalents. For these short-term instruments, the carrying amount is a reasonable estimate of fair value. “Cash and Cash Equivalents” includes interest-bearing deposits at other banks.

FHLB and FRB stock. The carrying value of Federal Home Loan Bank (“FHLB”) and Federal Reserve Bank (“FRB”) stock, which are non-marketable equity investments, approximate fair value.

As a member of the FHLB System, the Bank is required to hold stock in FHLBNY. The Company regularly evaluates investments in FHLBNY for impairment, considering liquidity, operating performance, capital position, stock repurchase and dividend history. As of September 30, 2017, the Bank’s investment in FHLBNY stock was not impaired.

The Bank, as a member of the FRB system, is currently required to purchase and hold shares of capital stock in the FRB in an amount equal to 6% of its capital and surplus. Based on the current capital adequacy and liquidity position of the FRB, management believes there is no impairment in the Company’s investment at September 30, 2017.

Securities Held to Maturity. The Company holds certain municipal bonds as held-to-maturity. These bonds are generally small in dollar amount and are issued only by certain local municipalities within the Company’s market area. The original terms are negotiated directly and on an individual basis consistent with our loan and credit guidelines. These bonds are not traded on the open market and management intends to hold the bonds to maturity. The fair value of held-to-maturity securities is estimated by discounting the future cash flows using the current rates at which similar agreements would be made with municipalities with similar credit ratings and for the same remaining maturities.

Loans Receivable. The fair value of fixed rate loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities, net of the appropriate portion of the allowance for loan losses. For variable rate loans, the carrying amount is a reasonable estimate of fair value. This fair value calculation is not necessarily indicative of the exit price, as defined in ASC 820.

Deposits. The fair value of demand deposits, negotiable order of withdrawal (“NOW”) accounts, muni-vest accounts and regular savings accounts is the amount payable on demand at the reporting date. The fair value of time deposits is estimated using the rates currently offered for deposits of similar remaining maturities.

Junior Subordinated Debentures. There is no active market for the Company’s debentures and there have been no issuances of similar instruments in recent years. The Company looked at a market bond index to estimate a discount margin to value the debentures. The discount margin was very similar to the spread to LIBOR established at the issuance of the debentures. As a result, the Company determined that the fair value of the adjustable-rate debentures approximates their face amount.

Securities Sold Under Agreement to Repurchase. The fair value of the securities sold under agreement to repurchase approximates its carrying value as the repurchase agreements are one day agreements.

Other Borrowed Funds. The fair value of the short-term portion of other borrowed funds approximates its carrying value. The fair value of the long-term portion of other borrowed funds is estimated using a discounted cash flow analysis based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.