Fair Value of Financial Instruments

ASC Topic 820 - Fair Value Measurement establishes a framework for measuring fair value and disclosures about fair value measurements. Fair value is defined 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.

In determining fair value, various valuation methods are used including market, income and cost approaches. Assumptions that market participants would use in pricing the asset or liability are utilized in these valuation methods, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs may be readily observable, market corroborated or generally unobservable inputs. Valuation methodologies are employed that maximize the use of observable inputs and minimize the use of unobservable inputs. Based on observability of the inputs used in the valuation methodologies, financial assets and liabilities measured at fair value on a recurring and nonrecurring basis are categorized according to the fair value hierarchy. The fair value hierarchy ranks the quality and reliability of the information used to determine fair values. Financial assets and liabilities that are adjusted to fair value are classified in one of the following three categories:


•	Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.


•	Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.


•	Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

Fair Value on a Recurring Basis

The following methods and assumptions were used for financial instruments measured at fair value:

Investment securities available for sale: The fair values for investment securities available for sale are obtained from an independent pricing service using a market data model. For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using other market indicators. As of December 31, 2015, the Bank has one remaining non-agency CMO which is not validated by an independent pricing service.

Loans held for sale: The fair values for loans held for sale are based on commitments on hand from investors or quoted market prices.

Other assets and liabilities: Other assets and other liabilities include interest rate lock commitments provided to customers to fund mortgage loans intended to be sold, forward sale contracts for future delivery of funded residential mortgages to investors and interest rate swap contracts.

The Company relies on an internal valuation model to estimate the fair value of its interest rate lock commitments, which includes applying an estimated pull-through rate (the percentage of commitments expected to result in a closed loan) based on historical experience; multiplied by quoted investor prices on closed loans for future delivery determined to be reasonably applicable to the loan commitment based on interest rate, terms and rate lock expiration.

The Company also relies on an internal valuation model to estimate the fair value of its forward contracts to sell residential mortgage loans (i.e., an estimate of what the Company would receive or pay to terminate the forward delivery contract) based on market prices for similar financial instruments, which includes matching specific terms and maturities of the forward commitments against applicable investor pricing available.

The Company relies on valuations provided by a third party to value its interest rate swap contracts. These valuations are corroborated by comparison with valuation provided by the counter parties to the contracts.

The table below presents the financial instruments carried at fair value by the valuation hierarchy:



	Level 1		Level 2		Level 3		Total
	(In thousands)
December 31, 2015
Financial assets
Investment securities available for sale:
U.S. government sponsored and federal agency obligations	$	—	$	3,136	$	—	$	3,136
Mortgage backed securities	—		338,384		—		338,384
Other securities	3		—		—		3
Loans held for sale	—		10,323		—		10,323
Other assets:
Interest rate lock commitments	—		189		—		189
Interest rate swap contacts	—		2,081		—		2,081
Total	$	3	$	354,113	$	—	$	354,116
Financial liabilities
Other liabilities:
Interest rate lock commitments	$	—	$	6	$	—	$	6
Forward contracts to sell mortgage loans	—		90		—		90
Interest rate swap contacts	—		2,081		—		2,081
Total	$	—	$	2,177	$	—	$	2,177



	Level 1		Level 2		Level 3		Total
	(In thousands)
December 31, 2014
Financial assets
Investment securities available for sale:
U.S. government sponsored and federal agency obligations	$	—	$	3,261	$	—	$	3,261
Mortgage backed securities	—		291,335		—		291,335
Other securities	3		—		—		3
Loans held for sale	—		6,594		—		6,594
Other assets:
Interest rate lock commitments	—		154		—		154
Forward contracts to sell mortgage loans	—		2		—		2
Total	$	3	$	301,346	$	—	$	301,349
Financial liabilities
Other liabilities:
Interest rate lock commitments	$	—	$	14	$	—	$	14
Forward contracts to sell mortgage loans	—		174		—		174
Total	$	—	$	188	$	—	$	188

The following is a reconciliation of assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3):



	Year Ended December 31, 2014
	(In thousands)
Non-agency CMOs
Beginning balance	$	6,208
Total realized/unrealized gains (losses):
Included in earnings	(37		)
Included in other comprehensive income	212
Included in earnings as unrealized other-than-temporary impairment	(64		)
Included in earnings as realized other-than-temporary impairment	222
Principal repayments	(1,126		)
Sales	(5,388		)
Transfers out of level 3	(27		)
Ending balance	$	—

There were no transfers out of Level 3 to Level 2 for the year ended December 31, 2015. During the year ended December 31, 2014, there was a transfer out of Level 3 to Level 2 of $27,000. The Company’s policy for determining transfers between levels occurs at the end of the reporting period when circumstances in the underlying valuation criteria changes and result in transfers between levels.

Fair Value on a Nonrecurring Basis

Certain assets are measured at fair value on a nonrecurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). Mortgage servicing rights includes only those items that were adjusted to fair value as of the dates indicated.

The following table presents such assets carried on the consolidated balance sheets by caption and by level within the fair value hierarchy:



	Level 1		Level 2		Level 3		Total
	(In thousands)
December 31, 2015
Impaired loans, with an allowance recorded, net	$	—	$	—	$	18,838	$	18,838
Mortgage servicing rights	—		—		5,789		5,789
Other real estate owned	—		—		20,371		20,371
Total assets at fair value	$	—	$	—	$	44,998	$	44,998
December 31, 2014
Impaired loans, with an allowance recorded, net	$	—	$	—	$	32,331	$	32,331
Mortgage servicing rights	—		—		18,918		18,918
Other real estate owned	—		—		35,491		35,491
Total assets at fair value	$	—	$	—	$	86,740	$	86,740

The significant inputs for those assets measured at fair value on a nonrecurring basis are as follows:



	December 31, 2015
	Method	Inputs
Impaired loans, with an allowance recorded, net	Appraised Values	External appraised values- adjustments made to values due to management factors including age of appraisal, age of comparables, known changes in the market and in the collateral and selling and commission cost of 15% to 35%.
Mortgage servicing rights	Discounted Cash Flow	Weighted average prepayment speed 11.31%; weighted average discount rate 11.35%.
Other real estate owned	Appraised Values	External appraised values less selling and commission cost of 15% to 35%.

The Company does not adjust loans held for investment to fair value on a recurring basis. However, some loans are considered impaired and an allowance for loan losses is established. The specific reserves for collateral dependent impaired loans are based on the fair value of the underlying collateral less estimated costs to sell. The fair value of collateral is usually determined based on appraisals. In some cases, adjustments are made to appraised values due to various factors including age of the appraisal, age of comparables included in the appraisal, and known changes in the market and in the collateral. Since adjustments to appraised values are based on unobservable inputs, the resulting fair value measurement is categorized as a Level 3 measurement.

MSRs are recorded as an asset when loans are sold to third parties with servicing rights retained. Mortgage servicing rights are initially recorded at fair value and subsequently amortized in proportion to, and over the period of, estimated net servicing revenues. The carrying value of these assets is reviewed for impairment on a monthly basis using a lower of carrying value or fair value methodology. Mortgage servicing rights are valued monthly by an independent third party valuation service with income adjustments recorded monthly. On an annual basis the valuation is validated by a separate third party valuation service. The fair value of servicing rights is determined by estimating the present value of future net cash flows using a discounted cash flow model, taking into consideration certain critical assumptions, such as market loan prepayment speeds, discount rates, costs to service and other economic factors. For purposes of measuring impairment, the rights are stratified based on predominant risk characteristics of the underlying loans which include product type (i.e., fixed, adjustable or balloon) and interest rate. If the aggregate carrying value of the capitalized mortgage servicing rights for a stratum exceeds its fair value, the difference is recognized in non-interest expense as an impairment loss.

Variations in the assumptions used in the MSR discounted cash flow model could materially affect the estimated fair values. Changes to the assumptions are made when market data indicate that new trends have developed. Current market participant assumptions based on loan product types – fixed rate, adjustable rate and balloon loans – include discount rates in the range of 11.00% to 20.00% as well as portfolio weighted average prepayment speeds of 6.67% to 39.90% annual CPR. Many of these assumptions are subjective and involve a high degree of management judgment. MSR valuation assumptions are reviewed and approved by management on a quarterly basis.

Prepayment speeds may be affected by economic factors such as changes in home prices, market interest rates, the availability of other credit products to borrowers and customer payment patterns. Prepayment speeds include the impact of all borrower prepayments, including full payoffs, additional principal payments and the impact of loans paid off due to foreclosure liquidations. As market interest rates decline, prepayment speeds will generally increase as customers refinance existing mortgages to more favorable interest rate terms. As prepayment speeds increase, anticipated cash flows will generally decline resulting in a potential reduction, or impairment, of the fair value of the capitalized MSRs. Alternatively, an increase in market interest rates may cause a decrease in prepayment speeds and therefore an increase in fair value of MSRs. Annually, external data is obtained to test the values and assumptions that are used for the initial valuations in the discounted cash flow model.

Real estate acquired by foreclosure, real estate acquired by deed in lieu of foreclosure and other repossessed assets (OREO) are held for sale and are initially recorded at fair value less estimated selling expenses at the date of foreclosure. OREO is re-measured at the lower of cost or fair value after initial recognition and reported using a valuation allowance on OREO. Fair value is generally based on third party appraisals subject to discounting and is therefore considered a Level 3 measurement.

Fair Value Summary

ASC Topic 825 Financial Instruments requires disclosure of fair value information about financial instruments, for which it is practicable to estimate that value, whether or not recognized in the Consolidated Balance Sheets, including those financial assets and liabilities that are not measured and reported at fair value on a recurring or nonrecurring basis. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Results from these techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, may not be realized in immediate settlement of the instruments. Certain financial instruments with a fair value that is not practicable to estimate and all non-financial instruments are excluded from the disclosure requirements. Accordingly, the aggregate fair value amounts presented in the table below do not necessarily represent the underlying value of the Company.

The following methods and assumptions were used in estimating the fair value of financial instruments that were not previously disclosed:

Cash and cash equivalents and accrued interest: The carrying amounts reported in the balance sheets approximate the fair values for those assets and liabilities. In accordance with ASC Topic 820, cash and cash equivalents and accrued interest have been categorized as a Level 2 fair value measurement.

Investment securities held to maturity: The fair value of investment securities are determined by an independent pricing service. In accordance with ASC 820, investment securities held to maturity have been categorized as a Level 2 fair value measurement.

Loans held for investment, net: The fair value of loans held for investment are estimated using observable inputs including estimated cash flows, and discount rates based on interest rates currently being offered for loans with similar terms, to borrowers of similar credit quality. In accordance with ASC Topic 820, loans held for investment that are not included with impaired loans in the preceding section titled Fair Value on a Nonrecurring Basis have been categorized as a Level 2 fair value measurement.

Federal Home Loan Bank stock: The carrying amount of FHLB stock approximates its fair value as it can only be redeemed with the FHLB at par value. In accordance with ASC Topic 820, Federal Home Loan Bank stock has been categorized as a Level 2 fair value measurement.

Deposits: The fair value of checking, savings and money market accounts are reported at book value, which is the amount payable on demand. The fair values of fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies current interest rates being offered on certificates of deposit to a schedule of aggregated expected monthly maturities of the outstanding certificates of deposit. In accordance with ASC Topic 820, deposits have been categorized as a Level 2 fair value measurement.

Other borrowed funds: The fair value of FHLB advances and repurchase agreements are estimated using discounted cash flow analysis, based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements. The fair value of the long-term lease obligation is reported at book value, which represents the present value of the cash flows at the time of inception and is indicative of the fair value in the current stable rate environment. In accordance with ASC Topic 820, other borrowed funds have been categorized as a Level 2 fair value measurement.

Off-balance sheet instruments: The fair value of off-balance sheet instruments (held for investment lending commitments and unused lines of credit) are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements, the counterparties’ credit standing and discounted cash flow analyses. The fair value of these off-balance sheet items approximates the recorded amounts of the related fees and is not material at December 31, 2015 and 2014.

The carrying amount and fair value of the Company’s financial instruments consist of the following:



	December 31,
	2015				2014
	Carrying Amount		Fair Value		Carrying Amount		Fair Value
	(In thousands)
Financial assets:
Cash and cash equivalents	$	75,267	$	75,267	$	147,273	$	147,273
Investment securities available for sale	341,523		341,523		294,599		294,599
Investment securities held to maturity	15,492		15,422		—		—
Loans held for sale	10,323		10,323		6,594		6,594
Loans held for investment, net	1,614,953		1,579,582		1,524,439		1,496,791
Mortgage servicing rights	18,942		19,252		19,404		19,590
Federal Home Loan Bank stock	11,940		11,940		11,940		11,940
Accrued interest receivable	7,827		7,827		7,627		7,627
Interest rate lock commitments	189		189		154		154
Unused commitments	—		—		—		—
Forward contracts to sell mortgage loans (1)	—		—		2		2
Interest rate swap contracts	2,081		2,081		—		—
Financial liabilities:
Non-maturity deposits	1,450,404		1,450,404		1,366,958		1,366,958
Deposits with stated maturities	390,320		388,285		447,213		445,938
Borrowed funds	12,562		12,837		13,752		14,077
Accrued interest payable	325		325		316		316
Interest rate lock commitments	6		6		14		14
Unused commitments	—		—		—		—
Forward contracts to sell mortgage loans (1)	90		90		174		174
Interest rate swap contracts	2,081		2,081		—		—


(1)	The Company, as of the quarter ended September 30, 2015, has elected to offset the fair value of individual forward sale contracts and present a net amount on the Consolidated Balance Sheets in accordance with ASC Topic 815-45.