FAIR VALUE OF FINANCIAL INSTRUMENTS

Management uses its best judgment in estimating the fair value of our financial instruments; however, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts we could have realized in a sale transaction on the dates indicated. The fair value amounts have been measured as of their respective period ends, and have not been re-evaluated or updated for purposes of these financial statements subsequent to those respective dates. As such, the fair values of these financial instruments subsequent to the respective reporting dates may be different than the amounts reported at each period end.

In accordance with U.S. GAAP, we use a hierarchical disclosure framework associated with the level of pricing observability utilized in measuring assets and liabilities at fair value. The three broad levels defined by the hierarchy are as follows:


•	Level I - Quoted prices are available in active markets for identical assets or liabilities as of the reported date.


•	Level II - Pricing inputs are other than quoted prices in active markets, which are either directly or indirectly observable as of the reported date. The nature of these asset and liabilities include items for which quoted prices are available but traded less frequently, and items that are fair valued using other financial instruments, the parameters of which can be directly observed.


•	Level III - Assets and liabilities that have little to no pricing observability as of reported date. These items do not have two-way markets and are measured using management’s best estimate of fair value, where the inputs into the determination of fair value require significant management judgment or estimation.

The following table summarizes the fair value of our financial assets measured on a recurring basis by the above pricing observability levels as of March 31, 2017 and December 31, 2016:

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(Dollars in thousands)	Fair Value Measurements		Quoted Prices in Active Markets for Identical Assets (Level I)		Significant Other Observable Inputs (Level II)		Significant Unobservable Inputs (Level III)
March 31, 2017
U.S. government agencies	$	22,244	$	—	$	22,244	$	—
State and political subdivisions	40,439		—		40,439		—
Mortgage-backed securities -
U.S. government-sponsored enterprises	35,081		—		35,081		—
Corporate debt	2,033		—		2,033		—
Derivative instruments
Interest rate swaps	1,687		—		1,687		—



December 31, 2016
U.S. government agencies	$	13,087	$	—	$	13,087	$	—
State and political subdivisions	40,688		—		40,688		—
Mortgage-backed securities -
U.S. government-sponsored enterprises	32,854		—		32,854		—
Corporate debt	1,982		—		1,982		—
Derivative instruments
Interest rate swaps	1,647		—		1,647		—

Our available for sale and held to maturity securities portfolios contain investments, which were all rated within our investment policy guidelines at time of purchase, and upon review of the entire portfolio all securities are marketable and have observable pricing inputs.

For financial assets measured at fair value on a nonrecurring basis, the fair value measurements by level within the fair value hierarchy used at March 31, 2017 and December 31, 2016 are as follows:

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(Dollars in thousands)	Fair Value Measurements		Quoted Prices in Active Markets for Identical Assets (Level I)		Significant Other Observable Inputs (Level II)		Significant Unobservable Inputs (Level III)
March 31, 2017
Impaired loans	$	861	$	—	$	—	$	861
Foreclosed real estate	3		—		—		3



December 31, 2016
Impaired loans	$	1,001	$	—	$	—	$	1,001
Foreclosed real estate	1,716		—		—		1,716

The following table presents additional qualitative information about assets measured at fair value on a nonrecurring basis and for which Level III inputs were used to determine fair value:

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	Qualitative Information about Level III Fair Value Measurements
(Dollars in thousands)	Fair Value Estimate		Valuation Techniques	Unobservable Input	Range (Weighted Average)
March 31, 2017
Impaired loans	$	861	Appraisal of	Appraisal	0% to -11.3%
			collateral	adjustments (1)	(-0.4%)

Foreclosed real estate	3		Appraisal of	Selling
			collateral	expenses (1)	-7.0%(-7.0%)



December 31, 2016
Impaired loans	$	1,001	Appraisal of	Appraisal	0% to -27.3%
			collateral	adjustments (1)	(-2.5%)

Foreclosed real estate	1,716		Appraisal of	Selling
			collateral	expenses ₍₁₎	-7.0% (-7.0%)

(1) Appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated selling expenses. The range and weighted average of selling expenses and other appraisal adjustments are presented as a percentage of the appraisal.

The following information should not be interpreted as an estimate of the fair value of the entire company since a fair value calculation is only provided for a limited portion of our assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between our disclosures and those of other companies may not be meaningful. The following methods and assumptions were used to estimate the fair value of our financial instruments at March 31, 2017 and December 31, 2016:

Cash and Cash Equivalents (Carried at Cost): The carrying amounts reported in the balance sheet for cash and cash equivalents approximate those assets’ fair value.

Deposits (Carried at Cost): Fair value for fixed-rate time certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market on certificates to a schedule of aggregated expected monthly maturities on time deposits. We generally purchase amounts below the insured limit, limiting the amount of credit risk on these time deposits.

Securities: The fair value of securities, available for sale (carried at fair value) and securities held to maturity (carried at amortized cost) are determined by obtaining quoted market prices on nationally recognized securities exchanges (Level I), or matrix pricing (Level II), which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices. For certain securities which are not traded in active markets or are subject to transfer restrictions, valuations are adjusted to reflect illiquidity and/or non-transferability, and such adjustments are generally based on available market evidence (Level III). In the absence of such evidence, management’s best estimate is used.

Federal Home Loan Bank Stock (Carried at Cost): The carrying amount of restricted investment in bank stock approximates fair value and considers the limited marketability of such securities.

Loans Receivable (Carried at Cost): The fair values of non-impaired loans are estimated using discounted cash flow analyses, using the market rates at the balance sheet date that reflect the credit and interest rate-risk inherent in the loans. Projected future cash flows are calculated based upon contractual maturity or call dates, projected repayments and prepayments of principal. Generally, for variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values.

Impaired Loans (Carried at Lower of Cost or Fair Value): Fair value of impaired loans is generally determined based upon independent third-party appraisals of the properties, or discounted cash flows based upon the expected proceeds. These assets are included in Level III fair values, based upon the lowest level of input that is significant to the fair value measurements. The fair value of impaired loans totaled $861 thousand and $1.0 million at March 31, 2017 and December 31, 2016, respectively. These balances consist of loans that were written down or required additional reserves during the periods ended March 31, 2017 and December 31, 2016, respectively.

Deposit Liabilities (Carried at Cost): The fair values disclosed for demand, savings and money market accounts are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market on certificates to a schedule of aggregated expected monthly maturities on time deposits.

Borrowings (Carried at Cost): Fair values of Federal Home Loan Bank (“FHLB”) advances are estimated using discounted cash flow analysis, based on quoted prices for new FHLB advances with similar credit risk characteristics, terms and remaining maturity. These prices obtained from this active market represent a market value that is deemed to represent the transfer price if the liability were assumed by a third party.

Derivatives (Carried at Fair Value): The Company also uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges, and which satisfy hedge accounting requirements, involve the receipt of variable amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without the exchange of the underlying notional amount. These derivatives were used to hedge the variable cash outflows associated with FHLB borrowings along with our junior subordinated debenture at U.S. Capital Trust. The effective portion of changes in the fair value of these derivatives are recorded in accumulated other comprehensive income, and are subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. The ineffective portion of the change in fair value of these derivatives are recognized directly in earnings.

The fair value of the Company's derivatives are determined using discounted cash flow analysis using observable market-based inputs, which are considered Level 2 inputs.

Subordinated Debentures (Carried at Cost): Fair values of subordinated debt are estimated using discounted cash flow analysis, based on market rates currently offered on such debt with similar credit risk characteristics, terms and remaining maturity.

Accrued Interest Receivable and Accrued Interest Payable (Carried at Cost): The carrying amounts of accrued interest receivable and payable approximate its fair value.

Off-Balance Sheet Instruments (Disclosed at Cost): Fair values for our off-balance sheet financial instruments (lending commitments and letters of credit) are based on fees currently charged in the market to enter into similar agreements, taking into account, the remaining terms of the agreements and the counterparties’ credit standing.

The fair values of our financial instruments at March 31, 2017 and December 31, 2016, were as follows:



	March 31, 2017				Quoted Prices in Active Markets for Identical Assets (Level I)		Significant Other Observable Inputs (Level II)		Significant Unobservable Inputs (Level III)
(Dollars in thousands)	Carrying Amount		Fair Value
Financial assets:
Cash and cash equivalents	$	7,688	$	7,688	$	7,688	$	—	$	—
Time deposits with other banks	100		100		—		100		—
Securities available for sale	99,797		99,797		—		99,797		—
Securities held to maturity	8,630		8,788		—		8,788		—
Federal Home Loan Bank stock	4,269		4,269		—		4,269		—
Loans receivable, net of allowance	712,003		695,158		—		—		695,158
Accrued interest receivable	2,006		2,006		—		2,006		—
Interest rate swaps	1,687		1,687		—		1,687		—

Financial liabilities:
Non-maturity deposits	550,289		550,289		—		550,289		—
Time deposits	146,287		145,823		—		145,823		—
Short-term borrowings	14,800		14,797		14,797		—		—
Long-term borrowings	66,000		64,520		—		64,520		—
Subordinated debentures	27,841		24,747		—		24,747		—
Accrued interest payable	352		352		—		352		—



	December 31, 2016				Quoted Prices in Active Markets for Identical Assets (Level I)		Significant Other Observable Inputs (Level II)		Significant Unobservable Inputs (Level III)
(Dollars in thousands)	Carrying Amount		Fair Value
Financial assets:
Cash and cash equivalents	$	14,638	$	14,638	$	14,638	$	—	$	—
Time deposits with other banks	100		100		—		100		—
Securities available for sale	88,611		88,611		—		88,611		—
Securities held to maturity	11,618		11,739		—		11,739		—
Federal Home Loan Bank stock	5,106		5,106		—		5,106		—
Loans receivable, net of allowance	688,561		672,912		—		—		672,912
Accrued interest receivable	2,058		2,058		—		2,058		—
Interest rate swaps	1,647		1,647		—		1,647		—

Financial liabilities:
Non-maturity deposits	479,025		479,025		—		479,025		—
Time deposits	181,896		181,346		—		181,346		—
Short-term borrowings	29,805		29,805		29,805		—		—
Long-term borrowings	66,000		66,388		—		66,388		—
Subordinated debentures	27,840		24,519		—		24,519		—
Accrued interest payable	364		364		—		364		—