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 March 31, 2020 and December 31, 2019, respectively:


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

March 31, 2020
Securities available-for-sale:
US government agencies	$	-	$	34,906	$	-	$	34,906
States and political subdivisions		-		3,337		-		3,337
Mortgage-backed securities		-		120,948		-		120,948
Mortgage servicing rights		-		-		485		485

December 31, 2019
Securities available-for-sale:
US government agencies	$	-	$	28,155	$	-	$	28,155
States and political subdivisions		-		3,351		-		3,351
Mortgage-backed securities		-		96,416		-		96,416
Mortgage servicing rights		-		-		555		555

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. MSRs 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 MSRs:


	Three months ended March 31,
(in thousands)	2020		2019
Mortgage servicing rights - January 1	$	555	$	609
Gains/(Losses) included in earnings		(103)		(40)
Additions from loan sales		33		18
Mortgage servicing rights - March 31	$	485	$	587

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


	March 31, 2020		December 31, 2019
Servicing fees	0.25	%	0.25	%
Discount rate	9.00	%	9.00	%
Prepayment rate (CPR)	8.75	%	8.21	%

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 March 31, 2020 and December 31, 2019:



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

March 31, 2020
Collateral dependent impaired loans	$	-	$	-	$	17,263	$	17,263

December 31, 2019
Collateral dependent impaired loans	$	-	$	-	$	15,735	$	15,735

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 special mention or a substandard depending on the amount of the loan, the type of loan and the type of collateral. All impaired commercial loans are graded substandard or worse 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. Collateral dependent impaired loans had a gross value of $18.2 million, with an allowance for loan loss of $0.9 million, at March 31, 2020 compared with $16.0 million and $0.3 million, respectively, at December 31, 2019.

FAIR VALUE OF FINANCIAL INSTRUMENTS

The table below depicts 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.


	March 31, 2020				December 31, 2019
	Carrying		Fair		Carrying		Fair
	Amount		Value		Amount		Value
		(in thousands)				(in thousands)
Financial assets:
Level 1:
Cash and cash equivalents	$	51,968	$	51,968	$	38,857	$	38,857
Level 2:
Available for sale securities		159,191		159,191		127,922		127,922
FHLB and FRB stock		3,549		N/A		3,544		N/A
Level 3:
Held to maturity securities		2,847		2,963		2,386		2,392
Loans, net		1,228,049		1,258,020		1,211,356		1,222,386
Mortgage servicing rights		485		485		555		555

Financial liabilities:
Level 1:
Demand deposits	$	273,623	$	273,623	$	263,717	$	263,717
NOW deposits		159,223		159,223		140,654		140,654
Savings deposits		625,773		625,773		587,142		587,142
Level 2:
Securities sold under agreement to
repurchase		2,572		2,572		2,425		2,425
Other borrowed funds		10,000		10,002		10,000		9,997
Junior subordinated debentures		11,330		11,330		11,330		11,330
Level 3:
Time deposits		268,978		271,259		275,927		277,051