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 AFS 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, 2020. 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 Community Reinvestment Act 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: In December 2019, the Bank began offering RCS installment loans with terms ranging from 12 to 60 months to borrowers in multiple states. Balances originated under this RCS installment loan program are carried as “held for sale” on the Bank’s balance sheet, with the intent to sell sixteen days following the Bank’s origination of the loans. Loans originated under this RCS installment loan program are carried at fair value under a fair-value option, with the portfolio marked to market monthly. Fair value for these loans is based on contractual sales terms, Level 3 inputs.

Consumer loans held for investment, at fair value: The Bank held an immaterial amount of consumer loans at fair value through a consumer loan program the Company is currently unwinding. The fair value of these loans was based on the discounted cash flows of the underlying loans, Level 3 inputs. Further disclosure of these loans is omitted due to materiality.

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.

Collateral-dependent loans: Collateral-dependent 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.

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).

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. Information as of March 31, 2020 is presented net of any applicable ACL.


	Fair Value Measurements at
	March 31, 2020 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	$	—	$	169,292	$	—	$	169,292
Private label mortgage backed security		—		—		3,249		3,249
Mortgage backed securities - residential		—		297,722		—		297,722
Collateralized mortgage obligations		—		59,881		—		59,881
Corporate bonds		—		9,615		—		9,615
Trust preferred security		—		—		4,100		4,100
Total available-for-sale debt securities	$	—	$	536,510	$	7,349	$	543,859

Equity securities with readily determinable fair value:
Freddie Mac preferred stock	$	—	$	294	$	—	$	294
Community Reinvestment Act mutual fund		2,513		—		—		2,513
Total equity securities with readily determinable fair value	$	2,513	$	294	$	—	$	2,807

Mortgage loans held for sale	$	—	$	39,384	$	—	$	39,384
Consumer loans held for sale		—		—		3,431		3,431
Consumer loans held for investment		—		—		827		827
Rate lock loan commitments		—		4,568		—		4,568
Interest rate swap agreements		—		14,013		—		14,013

Financial liabilities:
Mandatory forward contracts	$	—	$	2,826	$	—	$	2,826
Interest rate swap agreements		—		14,249		—		14,249


	Fair Value Measurements at
	December 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	$	—	$	134,640	$	—	$	134,640
Private label mortgage backed security		—		—		3,495		3,495
Mortgage backed securities - residential		—		255,847		—		255,847
Collateralized mortgage obligations		—		63,371		—		63,371
Corporate bonds		—		10,002		—		10,002
Trust preferred security		—		—		4,000		4,000
Total available-for-sale debt securities	$	—	$	463,860	$	7,495	$	471,355

Equity securities with readily determinable fair value:
Freddie Mac preferred stock	$	—	$	714	$	—	$	714
Community Reinvestment Act mutual fund		2,474		—		—		2,474
Total equity securities with readily determinable fair value	$	2,474	$	714	$	—	$	3,188

Mortgage loans held for sale	$	—	$	19,224	$	—	$	19,224
Consumer loans held for sale				—		598		598
Consumer loans held for investment		—		—		998		998
Rate lock loan commitments		—		789		—		789
Interest rate swap agreements		—		5,062		—		5,062

Financial liabilities:
Mandatory forward contracts	$	—	$	131	$	—	$	131
Interest rate swap agreements		—		5,166		—		5,166

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, 2020 and 2019.

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)	2020		2019

Balance, beginning of period	$	3,495	$	3,712
Total gains or losses included in earnings:
Net change in unrealized gain		1		(33)
Recovery of actual losses previously recorded		—		37
Principal paydowns		(247)		(57)
Balance, end of period	$	3,249	$	3,659

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, 2020 (dollars in thousands)	Value		Technique	Unobservable Inputs	Range

Private label mortgage backed security	$	3,249	Discounted cash flow	(1) Constant prepayment rate	2.7% - 5.0%

				(2) Probability of default	1.8% - 6.0%

				(3) Loss severity	50% - 75%


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

Private label mortgage backed security	$	3,495	Discounted cash flow	(1) Constant prepayment rate	2.3% - 5.0%

				(2) Probability of default	1.8% - 6.3%

				(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)	2020		2019

Balance, beginning of period	$	4,000	$	4,075
Total gains or losses included in earnings:
Discount accretion		11		10
Net change in unrealized gain		89		15
Balance, end of period	$	4,100	$	4,100

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, 2020 and December 31, 2019.

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


(in thousands)	March 31, 2020		December 31, 2019

Aggregate fair value	$	39,384	$	19,224
Contractual balance		38,208		18,690
Unrealized gain		1,176		534

The total amount of gains and losses from changes in fair value included in earnings for the three months ended March 31, 2020 and 2019 for mortgage loans held for sale are presented in the following table:


	Three Months Ended
	March 31,
(in thousands)	2020		2019

Interest income	$	214	$	102
Change in fair value		642		(82)
Total included in earnings	$	856	$	20

Consumer Loans Held for Sale

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, 2020 and December 31, 2019.

The significant unobservable inputs in the fair value measurement of the Bank’s short-term installment loans are the net contractual premiums and level of loans sold at a discount price. Significant fluctuations in any of those 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, 2020 (dollars in thousands)	Value		Technique	Unobservable Inputs	Rate

Consumer loans held for sale	$	3,431	Contract Terms	(1) Net Premium	1.4%

				(2) Discounted Sales	5.00%


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

Consumer loans held for sale	$	598	Contract Terms	(1) Net Premium	1.4%

				(2) Discounted Sales	5.00%

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, 2020		December 31, 2019

Aggregate fair value	$	3,431	$	598
Contractual balance		3,454		593
Unrealized (loss) gain		23		5

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)	2020		2019

Interest income	$	1,476	$	—
Change in fair value		18		—
Total included in earnings	$	1,494	$	—

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


	Fair Value Measurements at
	March 31, 2020 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

Collateral-dependent loans:
Residential real estate:
Owner occupied	$	—	$	—	$	3,794	$	3,794
Commercial real estate		—		—		2,602		2,602
Commercial & industrial		—		—		1,336		1,336
Home equity		—		—		331		331
Total collateral-dependent loans*	$	—	$	—	$	8,063	$	8,063

Mortgage servicing rights	$	—	$	328	$	—	$	328


	Fair Value Measurements at
	December 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	$	—	$	—	$	3,598	$	3,598
Nonowner occupied		—		—		14		14
Commercial real estate		—		—		3,276		3,276
Commercial & industrial		—		—		1,562		1,562
Home equity		—		—		470		470
Total impaired loans*	$	—	$	—	$	8,920	$	8,920

*The difference between the carrying value and the fair value of collateral-dependent/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, 2020 (dollars in thousands)	Value		Technique	Inputs	Average)

Collateral-dependent loans - residential real estate owner occupied	$	3,794	Sales comparison approach	Adjustments determined for differences between comparable sales	0% - 50% (16%)

Collateral-dependent loans - commercial real estate	$	2,602	Sales comparison approach	Adjustments determined for differences between comparable sales	0% - 44% (2%)

Collateral-dependent loans - commercial & industrial	$	1,336	Sales comparison approach	Adjustments determined for differences between comparable sales	14% - 50% (43%)

Collateral-dependent loans - home equity	$	331	Sales comparison approach	Adjustments determined for differences between comparable sales	2% (2%)


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

Impaired loans - residential real estate owner occupied	$	3,598	Sales comparison approach	Adjustments determined for differences between comparable sales	0% - 58% (12%)

Impaired loans - residential real estate nonowner occupied	$	14	Sales comparison approach	Adjustments determined for differences between comparable sales	5% (5%)

Impaired loans - commercial real estate	$	3,276	Sales comparison approach	Adjustments determined for differences between comparable sales	1% - 10% (4%)

Impaired loans - commercial & industrial	$	1,562	Income approach	Adjustments for differences between net operating income expectations	3% - 50% (37%)

Impaired loans - home equity	$	470	Sales comparison approach	Adjustments determined for differences between comparable sales	2% (2%)

Collateral Dependent/Impaired Loans

Collateral-dependent impaired loans are generally measured for loss 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 loss 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. Collateral-dependent loans are valued within Level 3 of the fair value hierarchy.

Collateral-dependent/impaired loans are as follows:


(in thousands)	March 31, 2020		December 31, 2019

Carrying amount of loans measured at fair value	$	6,870	$	7,729
Estimated selling costs considered in carrying amount		1,195		1,193
Valuation allowance		(2)		(2)
Total fair value	$	8,063	$	8,920


	Three Months Ended
	March 31,
(in thousands)	2020		2019

Credit loss expense on collateral-dependent, impaired loans	$	16	$	14

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


			Fair Value Measurements at
			March 31, 2020:
									Total
	Carrying								Fair
(in thousands)	Value		Level 1		Level 2		Level 3		Value

Assets:
Cash and cash equivalents	$	316,263	$	316,263	$	—	$	—	$	316,263
Available-for-sale debt securities		543,859		—		536,510		7,349		543,859
Held-to-maturity debt securities		61,664		—		59,725		—		59,725
Equity securities with readily determinable fair values		2,807		2,513		294		—		2,807
Mortgage loans held for sale, at fair value		39,384		—		39,384		—		39,384
Consumer loans held for sale, at fair value		3,431		—		—		3,431		3,431
Consumer loans held for sale, at the lower of cost or fair value		12,089		—		—		12,089		12,089
Loans, net		4,445,168		—		—		4,425,308		4,425,308
Federal Home Loan Bank stock		38,900		—		—		—		NA
Accrued interest receivable		12,037		—		12,037		—		12,037
Rate lock loan commitments		4,568		—		4,568		—		4,568
Interest rate swap agreements		14,013		—		14,013		—		14,013

Liabilities:
Noninterest-bearing deposits	$	1,300,891		—	$	1,300,891		—	$	1,300,891
Transaction deposits		2,033,829		—		2,033,829		—		2,033,829
Time deposits		736,737		—		748,977		—		748,977
Securities sold under agreements to repurchase and other short-term borrowings		126,080		—		126,080		—		126,080
Federal Home Loan Bank advances		572,500		—		575,135		—		575,135
Subordinated note		41,240		—		34,571		—		34,571
Accrued interest payable		3,437		—		3,437		—		3,437
Mandatory forward contracts		2,826		—		2,826		—		2,826
Interest rate swap agreements		14,249		—		14,249		—		14,249


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

Assets:
Cash and cash equivalents	$	385,303	$	385,303	$	—	$	—	$	385,303
Available-for-sale debt securities		471,355		—		463,860		7,495		471,355
Held-to-maturity debt securities		62,531		—		63,156		—		63,156
Equity securities with readily determinable fair values		3,188		2,474		714		—		3,188
Mortgage loans held for sale, at fair value		19,224		—		19,224		—		19,224
Consumer loans held for sale, at fair value		598		—		—		598		598
Consumer loans held for sale, at the lower of cost or fair value		11,646		—		—		11,646		11,646
Loans, net		4,389,800		—		—		4,381,396		4,381,396
Federal Home Loan Bank stock		30,831		—		—		—		NA
Accrued interest receivable		12,937		—		12,937		—		12,937
Rate lock loan commitments		789		—		789		—		789
Interest rate swap agreements		5,062		—		5,062		—		5,062

Liabilities:
Noninterest-bearing deposits	$	1,033,379		—	$	1,033,379		—	$	1,033,379
Transaction deposits		2,018,687		—		2,018,687		—		2,018,687
Time deposits		733,942		—		737,733		—		737,733
Securities sold under agreements to repurchase and other short-term borrowings		167,617		—		167,617		—		167,617
Federal Home Loan Bank advances		750,000		—		749,667		—		749,667
Subordinated note		41,240		—		32,587		—		32,587
Accrued interest payable		2,802		—		2,802		—		2,802
Mandatory forward contracts		131		—		131		—		131
Interest rate swap agreements		5,166		—		5,166		—		5,166