10. FAIR VALUE

Fair value represents 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. There are three levels of inputs that may be used to measure fair values:

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.

The Bank used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:

Available-for-sale debt securities: Except for the Bank’s private label mortgage backed security and its TRUP investment, the fair value of available-for-sale debt securities is typically determined by matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs).

The Bank’s private label mortgage backed security remains illiquid, and as such, the Bank classifies this security as a Level 3 security in accordance with ASC Topic 820, Fair Value Measurement. Based on this determination, the Bank utilized an income valuation model (present value model) approach in determining the fair value of this security.

See in this section of the filing under Footnote 2 “Investment Securities” for additional discussion regarding the Bank’s private label mortgage backed security.

The Company acquired its TRUP investment in 2015 and considered the most recent bid price for the same instrument to approximate market value at March 31, 2019. The Company’s TRUP investment is considered highly illiquid and also valued using Level 3 inputs, as the most recent bid price for this instrument is not always considered generally observable.

Equity securities with readily determinable fair value: Quoted market prices in an active market are available for the Bank’s CRA mutual fund investment and fall within Level 1 of the fair value hierarchy.

The fair value of the Company’s Freddie Mac preferred stock is determined by matrix pricing, as described above (Level 2 inputs).

Mortgage loans held for sale, at fair value: The fair value of mortgage loans held for sale is determined using quoted secondary market prices. Mortgage loans held for sale are classified as Level 2 in the fair value hierarchy.

Consumer loans held for sale, at fair value: From the first quarter of 2016 through the first quarter of 2018, the Bank piloted a consumer installment-loan product across the United States using a third-party marketer/service. As part of the program, the Bank sold 100% of the balances generated through the program back to the third-party marketer/servicer approximately 21 days after origination. The Bank carried all unsold loans under the program as “held for sale” on the its balance sheet. At the initiation of this program in 2016, the Bank elected to carry these loans at fair value under a fair-value option, with the portfolio thereafter marked to market on a monthly basis.

During the second quarter of 2018, the Bank and its third-party marketer/service provider suspended the origination of any new loans, and the subsequent sale of all recently-originated loans under this program, while the two parties evaluate the future offering of this product due to changes in the applicable state law impacting the product. Concurrent with the suspension of this program, the Bank reclassified approximately $2.2 million of these loans from held for sale on the balance sheet into the held for investment category and revalued these loans accordingly.

The fair value for these loans is based on the discounted cash flows of the underlying loans, which are also classified as Level 3 inputs.

Mortgage Banking derivatives: Mortgage Banking derivatives used in the ordinary course of business primarily consist of mandatory forward sales contracts (“forward contracts”) and interest rate lock loan commitments. The fair value of the Bank’s derivative instruments is primarily measured by obtaining pricing from broker-dealers recognized to be market participants. The pricing is derived from market observable inputs that can generally be verified and do not typically involve significant judgment by the Bank. Forward contracts and rate-lock loan commitments are classified as Level 2 in the fair value hierarchy.

Interest rate swap agreements: Interest rate swaps are recorded at fair value on a recurring basis. The Company values its interest rate swaps using a third-party valuation service and classifies such valuations as Level 2. Valuations of these interest rate swaps are also received from the relevant dealer counterparty and validated against the Company’s calculations. The Company has considered counterparty credit risk in the valuation of its interest rate swap assets and has considered its own credit risk in the valuation of its interest rate swap liabilities.

Impaired loans: Collateral-dependent impaired loans generally reflect partial charge-downs to their respective fair value, which is commonly based on recent real estate appraisals or BPOs. These appraisals or BPOs may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the process by the independent experts to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Collateral-dependent loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly.

Premises carried at fair value: Premises and equipment are accounted for at the lower of cost less accumulated depreciation or fair value less estimated costs to sell. The fair value of Bank premises is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches, including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments may be significant and typically result in a Level 3 classification of the inputs for determining fair value.

Mortgage servicing rights: On at least a quarterly basis, MSRs are evaluated for impairment based upon the fair value of the MSRs as compared to carrying amount. If the carrying amount of an individual tranche exceeds fair value, impairment is recorded, and the respective individual tranche is carried at fair value. If the carrying amount of an individual tranche does not exceed fair value, impairment is reversed if previously recognized and the carrying value of the individual tranche is based on the amortization method. The valuation model utilizes assumptions that market participants would use in estimating future net servicing income and can generally be validated against available market data (Level 2). There were no MSR tranches carried at fair value at March 31, 2019 and December 31, 2018.

Assets and liabilities measured at fair value on a recurring basis, including financial assets and liabilities for which the Bank has elected the fair value option, are summarized below:


	Fair Value Measurements at
	March 31, 2019 Using:
	Quoted Prices in		Significant
	Active Markets		Other		Significant
	for Identical		Observable		Unobservable		Total
	Assets		Inputs		Inputs		Fair
(in thousands)	(Level 1)		(Level 2)		(Level 3)		Value
Financial assets:
Available-for-sale debt securities:
U.S. Treasury securities and U.S. Government agencies	$	—	$	178,757	$	—	$	178,757
Private label mortgage backed security		—		—		3,659		3,659
Mortgage backed securities - residential		—		163,068		—		163,068
Collateralized mortgage obligations		—		71,322		—		71,322
Corporate bonds		—		9,694		—		9,694
Trust preferred security		—		—		4,100		4,100
Total available-for-sale debt securities	$	—	$	422,841	$	7,759	$	430,600

Equity securities with readily determinable fair value:
Freddie Mac preferred stock	$	—	$	662	$	—	$	662
Community Reinvestment Act mutual fund		2,433		—		—		2,433
Total equity securities with readily determinable fair value	$	2,433	$	662	$	—	$	3,095

Mortgage loans held for sale	$	—	$	11,313	$	—	$	11,313
Consumer loans held for investment		—		—		1,718		1,718
Rate lock loan commitments		—		843		—		843
Interest rate swap agreements		—		2,260		—		2,260

Financial liabilities:
Mandatory forward contracts	$	—	$	282	$	—	$	282
Interest rate swap agreements		—		2,234		—		2,234


	Fair Value Measurements at
	December 31, 2018 Using:
	Quoted Prices in		Significant
	Active Markets		Other		Significant
	for Identical		Observable		Unobservable		Total
	Assets		Inputs		Inputs		Fair
(in thousands)	(Level 1)		(Level 2)		(Level 3)		Value
Financial assets:
Available-for-sale debt securities:
U.S. Treasury securities and U.S. Government agencies	$	—	$	216,873	$	—	$	216,873
Private label mortgage backed security		—		—		3,712		3,712
Mortgage backed securities - residential		—		169,209		—		169,209
Collateralized mortgage obligations		—		72,811		—		72,811
Corporate bonds		—		9,058		—		9,058
Trust preferred security		—		—		4,075		4,075
Total available-for-sale debt securities	$	—	$	467,951	$	7,787	$	475,738

Equity securities with readily determinable fair value:
Freddie Mac preferred stock	$	—	$	410	$	—	$	410
Community Reinvestment Act mutual fund		2,396		—		—		2,396
Total equity securities with readily determinable fair value	$	2,396	$	410	$	—	$	2,806

Mortgage loans held for sale	$	—	$	8,971	$	—	$	8,971
Consumer loans held for investment		—		—		1,922		1,922
Rate lock loan commitments		—		356		—		356
Interest rate swap agreements		—		1,264		—		1,264

Financial liabilities:
Mandatory forward contracts	$	—	$	262	$	—	$	262
Interest rate swap agreements		—		1,149		—		1,149

All transfers between levels are generally recognized at the end of each quarter. There were no transfers into or out of Level 1, 2 or 3 assets during the three months ended March 31, 2019 and 2018.

Private Label Mortgage Backed Security

The following table presents a reconciliation of the Bank’s private label mortgage backed security measured at fair value on a recurring basis using significant unobservable inputs (Level 3):


	Three Months Ended
	March 31,
(in thousands)	2019		2018

Balance, beginning of period	$	3,712	$	4,449
Total gains or losses included in earnings:
Net change in unrealized gain		(33)		(2)
Recovery of actual losses previously recorded		37		38
Principal paydowns		(57)		(365)
Balance, end of period	$	3,659	$	4,120

The fair value of the Bank’s single private label mortgage backed security is supported by analysis prepared by an independent third party. The third party’s approach to determining fair value involved several steps: 1) detailed collateral analysis of the underlying mortgages, including consideration of geographic location, original loan-to-value and the weighted average FICO score of the borrowers; 2) collateral performance projections for each pool of mortgages underlying the security (probability of default, severity of default, and prepayment probabilities) and 3) discounted cash flow modeling.

The significant unobservable inputs in the fair value measurement of the Bank’s single private label mortgage backed security are prepayment rates, probability of default and loss severity in the event of default. Significant fluctuations in any of those inputs in isolation would result in a significantly different fair value measurement.

Quantitative information about recurring Level 3 fair value measurement inputs for the Bank’s single private label mortgage backed security follows:


	Fair		Valuation
March 31, 2019 (dollars in thousands)	Value		Technique	Unobservable Inputs	Range

Private label mortgage backed security	$	3,659	Discounted cash flow	(1) Constant prepayment rate	4.5% - 5.8%

				(2) Probability of default	1.8% - 5.0%

				(3) Loss severity	50% - 75%


	Fair		Valuation
December 31, 2018 (dollars in thousands)	Value		Technique	Unobservable Inputs	Range

Private label mortgage backed security	$	3,712	Discounted cash flow	(1) Constant prepayment rate	6.5% - 8.9%

				(2) Probability of default	1.8% - 4.7%

				(3) Loss severity	50% - 75%

Trust Preferred Security

The following table presents a reconciliation of the Company’s TRUP measured at fair value on a recurring basis using significant unobservable inputs (Level 3):


	Three Months Ended
	March 31,
(in thousands)	2019		2018

Balance, beginning of period	$	4,075	$	3,600
Total gains or losses included in earnings:
Discount accretion		10		10
Net change in unrealized gain		15		290
Balance, end of period	$	4,100	$	3,900

The fair value of the Company’s TRUP investment is based on the most recent bid price for this instrument, as provided by a third-party broker.

Mortgage Loans Held for Sale

The Bank has elected the fair value option for mortgage loans held for sale. These loans are intended for sale and the Bank believes that the fair value is the best indicator of the resolution of these loans. Interest income is recorded based on the contractual terms of the loans and in accordance with Bank policy for such instruments. None of these loans were past due 90-days-or-more or on nonaccrual as of March 31, 2019 and December 31, 2018.

The aggregate fair value, contractual balance, and unrealized gain were as follows:


(in thousands)	March 31, 2019		December 31, 2018

Aggregate fair value	$	11,313	$	8,971
Contractual balance		11,100		8,676
Unrealized gain		213		295

The total amount of gains and losses from changes in fair value included in earnings for the three months ended March 31, 2019 and 2018 for mortgage loans held for sale are presented in the following table:


	Three Months Ended
	March 31,
(in thousands)	2019		2018

Interest income	$	102	$	72
Change in fair value		(82)		(9)
Total included in earnings	$	20	$	63

Consumer Loans Held for Investment

RCS carries loans originated through its installment loan program at fair value. Interest income is recorded based on the contractual terms of the loan and in accordance with Bank policy for such instruments. None of these loans were past due 90-days-or-more or on nonaccrual as of March 31, 2019 and December 31, 2018.

The significant unobservable inputs in the fair value measurement of the Bank’s consumer loans were the constant prepayment rate, probability of default, and loss severity for these loans under a discounted-cash-flow model. Significant fluctuations in any of these inputs in isolation would result in a significantly lower/higher fair value measurement.

The following table presents quantitative information about recurring Level 3 fair value measurement inputs for installment loans:


	Fair		Valuation
March 31, 2019 (dollars in thousands)	Value		Technique	Unobservable Inputs	Rate

Consumer loans held for investment	$	1,718	Discounted Cash Flows	(1) Constant prepayment rate	15.0%

				(2) Probability of default	48.0%

				(3) Loss severity	24.0%


	Fair		Valuation
December 31, 2018 (dollars in thousands)	Value		Technique	Unobservable Inputs	Rate

Consumer loans held for investment	$	1,922	Discounted Cash Flows	(1) Constant prepayment rate	15.0%

				(2) Probability of default	45.0%

				(3) Loss severity	20.0%

The aggregate fair value, contractual balance, and unrealized gain on consumer loans held for sale, at fair value, were as follows:


(in thousands)	March 31, 2019		December 31, 2018

Aggregate fair value	$	1,718	$	1,922
Contractual balance		1,948		2,170
Unrealized (loss) gain		(230)		(248)

The total amount of net gains from changes in fair value included in earnings for consumer loans held for sale, at fair value, are presented in the following table:


	Three Months Ended
	March 31,
(in thousands)	2019		2018

Interest income	$	111	$	176
Change in fair value		18		(14)
Total included in earnings	$	129	$	162

Assets measured at fair value on a non-recurring basis are summarized below:


	Fair Value Measurements at
	March 31, 2019 Using:
	Quoted Prices in		Significant
	Active Markets		Other		Significant
	for Identical		Observable		Unobservable		Total
	Assets		Inputs		Inputs		Fair
(in thousands)	(Level 1)		(Level 2)		(Level 3)		Value

Impaired loans:
Residential real estate:
Owner occupied	$	—	$	—	$	4,570	$	4,570
Nonowner occupied		—		—		567		567
Commercial real estate		—		—		1,220		1,220
Commercial & industrial		—		—		574		574
Home equity		—		—		351		351
Total impaired loans*	$	—	$	—	$	7,282	$	7,282

Premises	$	—	$	—	$	1,618	$	1,618


	Fair Value Measurements at
	December 31, 2018 Using:
	Quoted Prices in		Significant
	Active Markets		Other		Significant
	for Identical		Observable		Unobservable		Total
	Assets		Inputs		Inputs		Fair
(in thousands)	(Level 1)		(Level 2)		(Level 3)		Value

Consumer loans held for sale	$	—	$	—	$	1,249	$	1,249

Impaired loans:
Residential real estate:
Owner occupied	$	—	$	—	$	4,708	$	4,708
Nonowner occupied		—		—		1,007		1,007
Commercial real estate		—		—		1,255		1,255
Commercial & industrial		—		—		609		609
Home equity		—		—		356		356
Total impaired loans*	$	—	$	—	$	7,935	$	7,935

Premises	$	—	$	—	$	1,694	$	1,694

* The difference between the carrying value and the fair value of impaired loans measured at fair value is reconciled in a subsequent table of this Footnote.

The following tables present quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis:


					Range
	Fair		Valuation	Unobservable	(Weighted
March 31, 2019 (dollars in thousands)	Value		Technique	Inputs	Average)

Impaired loans - residential real estate owner occupied	$	4,570	Sales comparison approach	Adjustments determined for differences between comparable sales	0% - 62% (8%)

Impaired loans - residential real estate nonowner occupied	$	567	Sales comparison approach	Adjustments determined for differences between comparable sales	0% - 12% (11%)

Impaired loans - commercial real estate	$	1,220	Sales comparison approach	Adjustments determined for differences between comparable sales	13% - 25% (21%)

Impaired loans - commercial & industrial	$	574	Sales comparison approach	Adjustments determined for differences between comparable sales	3% (3%)

Impaired loans - home equity	$	351	Sales comparison approach	Adjustments determined for differences between comparable sales	0% - 22% (2%)

Premises	$	1,618	Sales comparison approach	Adjustments determined for differences between comparable sales	30% - 73% (43%)


					Range
	Fair		Valuation	Unobservable	(Weighted
December 31, 2018 (dollars in thousands)	Value		Technique	Inputs	Average)

Consumer loans held for sale	$	1,249	Sales comparison approach	Adjustments determined for differences between comparable sales	6% (6%)

Impaired loans - residential real estate owner occupied	$	4,708	Sales comparison approach	Adjustments determined for differences between comparable sales	0% - 62% (30%)

Impaired loans - residential real estate nonowner occupied	$	1,007	Sales comparison approach	Adjustments determined for differences between comparable sales	0% - 27% (54%)

Impaired loans - commercial real estate	$	123	Sales comparison approach	Adjustments determined for differences between comparable sales	21% (21%)

Impaired loans - commercial real estate	$	1,132	Income approach	Adjustments for differences between net operating income expectations	17% (17%)

Impaired loans - commercial & industrial	$	609	Sales comparison approach	Adjustments determined for differences between comparable sales	3% (3%)

Impaired loans - home equity	$	356	Sales comparison approach	Adjustments determined for differences between comparable sales	0% - 22% (8%)

Premises	$	1,694	Sales comparison approach	Adjustments determined for differences between comparable sales	27% - 72% (40%)

Impaired Loans

Collateral-dependent impaired loans are generally measured for impairment using the fair value for reasonable disposition of the underlying collateral. The Bank’s practice is to obtain new or updated appraisals or BPOs on the loans subject to the initial impairment review and then to evaluate the need for an update to this value on an as-necessary or possibly annual basis thereafter (depending on the market conditions impacting the value of the collateral). The Bank may discount the valuation amount as necessary for selling costs and past due real estate taxes. If a new or updated appraisal or BPO is not available at the time of a loan’s impairment review, the Bank may apply a discount to the existing value of an old valuation to reflect the property’s current estimated value if it is believed to have deteriorated in either: (i) the physical or economic aspects of the subject property or (ii) material changes in market conditions. The impairment review generally results in a partial charge-off of the loan if fair value less selling costs are below the loan’s carrying value. Impaired loans that are collateral dependent are classified within Level 3 of the fair value hierarchy when impairment is determined using the fair value method.

Impaired collateral-dependent loans are as follows:


(in thousands)	March 31, 2019		December 31, 2018

Carrying amount of loans measured at fair value	$	6,761	$	7,380
Estimated selling costs considered in carrying amount		881		913
Valuation allowance		(360)		(358)
Total fair value	$	7,282	$	7,935


	Three Months Ended
	March 31,
(in thousands)	2019		2018

Provisions on collateral-dependent, impaired loans	$	14	$	429

Premises

The Company’s Traditional Banking segment classified three of its former banking centers as held for sale as of March 31, 2019 and December 31, 2018. Impairment charges are recorded when the value of a piece of property is reappraised or reassessed below the property’s then-carrying value. Impairment charges related to properties held for sale were as follows:


	Three Months Ended
	March 31,
(in thousands)	2019		2018

Impairment charges on premises	$	66	$	104

The carrying amounts and estimated exit price fair values of all financial instruments follow:


			Fair Value Measurements at
			March 31, 2019:
									Total
	Carrying								Fair
(in thousands)	Value		Level 1		Level 2		Level 3		Value

Assets:
Cash and cash equivalents	$	345,512	$	345,512	$	—	$	—	$	345,512
Available-for-sale debt securities		430,600		—		422,841		7,759		430,600
Held-to-maturity debt securities		64,623		—		65,129		—		65,129
Equity securities with readily determinable fair values		3,095		2,433		662		—		3,095
Mortgage loans held for sale, at fair value		11,313		—		11,313		—		11,313
Consumer loans held for sale, at the lower of cost or fair value		12,864		—		12,864		—		12,864
Loans, net		4,240,749		—		—		4,231,349		4,231,349
Federal Home Loan Bank stock		29,965		—		—		—		NA
Accrued interest receivable		14,256		—		14,256		—		14,256
Rate lock loan commitments		843		—		843		—		843
Interest rate swap agreements		2,260		—		2,260		—		2,260

Liabilities:
Noninterest-bearing deposits	$	1,184,480		—	$	1,184,480		—	$	1,184,480
Transaction deposits		2,056,556		—		2,056,556		—		2,056,556
Time deposits		533,280		—		531,373		—		531,373
Securities sold under agreements to repurchase and other short-term borrowings		173,168		—		173,168		—		173,168
Federal Home Loan Bank advances		560,000		—		556,003		—		556,003
Subordinated note		41,240		—		32,672		—		32,672
Accrued interest payable		1,620		—		1,620		—		1,620
Mandatory forward contracts		282		—		282		—		282
Interest rate swap agreements		2,234		—		2,234		—		2,234


			Fair Value Measurements at
			December 31, 2018:
									Total
	Carrying								Fair
(in thousands)	Value		Level 1		Level 2		Level 3		Value

Assets:
Cash and cash equivalents	$	351,474	$	351,474	$	—	$	—	$	351,474
Available-for-sale debt securities		475,738		—		467,951		7,787		475,738
Held-to-maturity debt securities		65,227		—		64,858		—		64,858
Equity securities with readily determinable fair values		2,806		2,396		410		—		2,806
Mortgage loans held for sale, at fair value		8,971		—		8,971		—		8,971
Consumer loans held for sale, at the lower of cost or fair value		12,838		—		12,838		—		12,838
Loans, net		4,103,552		—		—		4,062,457		4,062,457
Federal Home Loan Bank stock		32,067		—		—		—		NA
Accrued interest receivable		13,942		—		13,942		—		13,942
Rate lock loan commitments		356		—		356		—		356
Interest rate swap agreements		1,264		—		1,264		—		1,264

Liabilities:
Noninterest-bearing deposits	$	1,003,969		—	$	1,003,969		—	$	1,003,969
Transaction deposits		2,035,701		—		2,035,701		—		2,035,701
Time deposits		416,475		—		412,477		—		412,477
Securities sold under agreements to repurchase and other short-term borrowings		182,990		—		182,990		—		182,990
Federal Home Loan Bank advances		810,000		—		804,251		—		804,251
Subordinated note		41,240		—		33,724		—		33,724
Accrued interest payable		1,084		—		1,084		—		1,084
Mandatory forward contracts		262		—		262		—		262
Interest rate swap agreements		1,149		—		1,149		—		1,149