Note 13:

Fair Value Measurements

The Company uses fair value to record certain assets and liabilities and to determine fair value disclosures. Authoritative accounting guidance clarifies that fair value of certain assets and liabilities is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.

Authoritative accounting guidance specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. The three levels of the fair value hierarchy based on these two types of inputs are as follows:

Level 1 – Valuation is based on quoted prices in active markets for identical assets and liabilities.

Level 2 – Valuation is based on observable inputs including quoted prices in active markets for similar assets and liabilities, quoted prices for identical or similar assets and liabilities in less active markets, and model-based valuation techniques for which significant assumptions can be derived primarily from or corroborated by observable data in the market.

Level 3 – Valuation is based on model-based techniques that use one or more significant inputs or assumptions that are unobservable in the market.

The following describes the valuation techniques used by the Company to measure certain financial assets and liabilities recorded at fair value on a recurring basis in the financial statements:

Securities available-for-sale: Securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2). In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy.

Defined benefit plan assets: Defined benefit plan assets are recorded at fair value on an annual basis at year end.

Mortgage servicing rights “(MSR”): The Bank currently owns MSRs from two portfolios, one serviced for Fannie Mae (“FNMA”) and one serviced for Freddie Mac (“FHLMC”).

The MSR for the portfolio serviced for FNMA is recorded at fair value on a recurring basis, with changes in fair value recorded in the results of operations. A model is used to determine fair value, which establishes pools of performing loans, calculates cash flows for each pool and applies a discount rate to each pool. Loans are segregated into 14 pools based on each loan’s term and seasoning (age). All loans have fixed interest rates. Cash flows are then estimated by utilizing assumed service costs and prepayment speeds. Monthly service costs were assumed to be $6.33 per loan as of June 30, 2017 and $6.00 per loan as of December 31, 2016. Prepayment speeds are determined primarily based on the average interest rate of the loans in each pool. The prepayment scale used is the Public Securities Association (“PSA”) model, where “100% PSA” means prepayments are zero in the first month, then increase by 0.2% of the loan balance each month until reaching 6.0% in month 30. Thereafter, the 100% PSA model assumes an annual prepayment of 6.0% of the remaining loan balance. The average PSA speed assumption in the fair value model is 147% and 150% as of June 30, 2017 and December 31, 2016, respectively. A discount rate of 14.0% was then applied to each pool both as of June 30, 2017 and December 31, 2016. This discount rate is intended to represent the estimated market yield for the highest quality grade of comparable servicing. This MSR is classified as Level 3.

Similarly, the MSR for the portfolio serviced for FHLMC is recorded at fair value on a recurring basis, with changes in fair value recorded in the results of operations. This MSR was acquired by the Bank as part of the merger with Virginia BanCorp effective April 1, 2017. A model is used to determine fair value, which establishes pools of performing loans, calculates cash flows for each pool and applies a discount rate to each. Loans are segregated into five pools based on each loan’s term and coupon strata. All loans have fixed interest rates. Cash flows are then estimated by utilizing assumed service costs and prepayment speeds. Monthly service costs were assumed to be $7.67 per loan as of June 30, 2017. Prepayment speeds are determined primarily based on the average interest rate and seasoning of the loans in each pool. The prepayment scale used is the PSA model as described above. The average PSA speed assumption in the fair value model is 195% as of June 30, 2017. The PSA speeds are converted to a constant prepayment rate (CPR) and then adjusted by applying betas in order to reflect the prepayment speeds of the portfolio based on historical payment behavior. As of June 30, 2017, an average CPR of 7.51% was applied based on the prior two years of history. Utilizing observed market prices in the secondary market, an average price of 102.84% was effectively applied in determining the market discount rate to be applied to the portfolio’s servicing cash flows. This rate is intended to represent the estimated market yield for the highest quality grade of comparable servicing. This MSR is classified as Level 3.

The following table presents the balances of financial assets and liabilities measured at fair value on a recurring basis as of

June 30, 2017 and December 31, 2016:


(Dollars in thousands)			Fair Value Measurements at June 30, 2017 Using
Description	Balance		Level 1		Level 2		Level 3
Securities available-for-sale:
Corporate bonds	$	6,715	$	—	$	—	$	6,715
U. S. Government agencies		27,056		—		27,056		—
State and municipal obligations		20,677		—		20,677		—

Total securities available-for-sale:	$	54,448	$	—	$	47,733	$	6,715

Mortgage servicing rights	$	989	$	—	$	—	$	989

Defined benefit plan assets:
Cash and cash equivalents	$	21	$	21	$	—	$	—
Mutual funds - fixed income		1,016		1,016		—		—
Mutual funds - equity		1,524		1,524		—		—

Total defined benefit plan assets	$	2,561	$	2,561	$	—	$	—


			Fair Value Measurements at December 31, 2016 Using
Description	Balance		Level 1		Level 2		Level 3
Securities available-for-sale:
Corporate bonds	$	7,704	$	—	$	—	$	7,704
U. S. Government agencies		25,313		—		25,313		—
State and municipal obligations		18,156		—		18,156		—

Total securities available-for-sale:	$	51,173	$	—	$	43,469	$	7,704

Mortgage servicing rights	$	671	$	—	$	—	$	671

Defined benefit plan assets:
Mutual funds - fixed income	$	1,041	$	1,041	$	—	$	—
Mutual funds - equity		1,649		1,649		—		—

Total defined benefit plan assets	$	2,690	$	2,690	$	—	$	—

The reconciliation of items using Level 3 inputs is as follows:


				Corporate
(Dollars in thousands)	MSRs			Bonds
Balance, January 1, 2017	$	671		$	7,704
Purchases		—			—
Acquired in merger		324			—
Impairments		—			—
Fair value adjustments		(6	)		11
Sales		—			(1,000	)

Balance, June 30, 2017	$	989		$	6,715

Certain assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.

The following describes the valuation techniques used by the Company to measure certain assets recorded at fair value on a nonrecurring basis in the financial statements:

Impaired Loans: Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. Any given loan may have multiple types of collateral. The vast majority of the collateral is real estate. The value of real estate collateral is determined utilizing a market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the collateral value is significantly adjusted due to differences in the comparable properties, or is discounted by the Company because of marketability, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Impaired loans allocated to the ALL are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income.

Other Real Estate Owned: OREO is measured at fair value less estimated costs to sell, based on an appraisal conducted by an independent, licensed appraiser outside of the Company. If the collateral value is significantly adjusted due to differences in the comparable properties, or is discounted by the Company because of marketability, then the fair value is considered Level 3. OREO is measured at fair value on a nonrecurring basis. The initial fair value of OREO is based on an appraisal done at the time of foreclosure. Subsequent fair value adjustments are recorded in the period incurred and included in other noninterest income on the Consolidated Statements of Income.

The following table summarizes the Company’s assets that were measured at fair value on a nonrecurring basis at the end of the respective period.


			Fair Value Measurements at June 30, 2017 Using
(Dollars in thousands) Description	Balance as of June 30, 2017		Level 1		Level 2		Level 3
Impaired Loans, net	$	3,354	$	—	$	—	$	3,354
Other real estate owned, net		5,360		—		—		5,360

			Fair Value Measurements at December 31, 2016 Using
Description	Balance as of December 31, 2016		Level 1		Level 2		Level 3
Impaired Loans, net	$	2,774	$	—	$	—	$	2,774
Other real estate owned, net		2,494		—		—		2,494

The following table displays quantitative information about Level 3 Fair Value Measurements as of June 30, 2017:

(Dollars in thousands)

Balance as of
June 30, 2017

Valuation
Technique

Unobservable
Input

Range (Weighted
Average)

Impaired Loans, net

3,354

Discounted appraised value

Selling Cost

15% (15%)

Other real estate owned, net

5,360

Discounted appraised value

Selling Cost

0% - 100% (5%)

Lack of Marketability

10% -20% (11%)

The following table displays quantitative information about Level 3 Fair Value Measurements as of December 31, 2016:

(Dollars in thousands)

Balance as of
December 31, 2016

Valuation
Technique

Unobservable
Input

Range (Weighted
Average)

Impaired Loans, net

2,774

Discounted appraised value

Selling Cost

10% -20% (16%)

Lack of Marketability

50% (50%)

Other real estate owned, net

2,494

Discounted appraised value

Selling Cost

3% - 13% (5%)

Lack of Marketability

10% -20% (11%)

The estimated fair values of financial instruments are shown in the following table. The carrying amounts in the table are included in the balance sheet under the applicable captions.


					Fair Value Measurements at June 30, 2017 Using
(Dollars in thousands)	Balance as of		Fair Value as of
Description	June 30, 2017		June 30, 2017		Level 1		Level 2		Level 3
Financial Assets:
Cash and due from banks	$	7,454	$	7,454	$	7,454	$	—	$	—
Interest-bearing deposits		26,998		26,998		26,998		—		—
Certificates of deposit		3,224		3,224		—		3,224		—
Federal funds sold		6,559		6,559		6,559		—		—
Securities available-for-sale		54,448		54,448		—		47,733		6,715
Restricted securities		4,662		4,662		—		—		4,662
Loans, net		645,701		654,263		—		—		654,263
Loans held for sale		55,620		55,620		—		—		55,620
Accrued interest receivable		2,624		2,624		—		2,624		—
Bank owned life insurance		18,508		18,508		18,508		—		—
Mortgage servicing rights		989		989		—		—		989
Financial Liabilities:
Non-interest-bearing liabilities	$	97,299	$	97,299	$	97,299	$	—	$	—
Savings and other interest-bearing deposits		282,056		282,056		—		282,056		—
Time deposits		309,619		308,952		—		—		308,952
Securities sold under repurchase agreements		10,786		10,786		—		10,786		—
FHLB advances		70,000		70,591		—		70,591		—
Subordinated debt		6,868		7,000		—		—		7,000
Accrued interest payable		395		395		—		395		—

					Fair Value Measurements at December 31, 2016 Using
(Dollars in thousands)	Balance as of		Fair Value as of
Description	December 31, 2016		December 31, 2016		Level 1		Level 2		Level 3
Financial Assets:
Cash and due from banks	$	4,851	$	4,851	$	4,851	$	—	$	—
Interest-bearing deposits		7,945		7,945		7,945		—		—
Certificates of deposit		4,216		4,216		—		4,216		—
Federal funds sold		1,906		1,906		1,906		—		—
Securities available-for-sale		51,173		51,173		—		43,469		7,704
Restricted securities		2,649		2,649		—		—		2,649
Loans, net		381,537		384,468		—		—		384,468
Loans held for sale		276		276		—		—		276
Accrued interest receivable		1,372		1,372		—		1,372		—
Bank owned life insurance		9,869		9,869		9,869		—		—
Mortgage servicing rights		671		671		—		—		671
Financial Liabilities:
Non-interest-bearing liabilities	$	74,799	$	74,799	$	74,799	$	—	$	—
Savings and other interest-bearing deposits		178,869		178,869		—		178,869		—
Time deposits		128,050		127,497		—		—		127,497
Securities sold under repurchase agreements		18,310		18,310		—		18,310		—
FHLB advances		35,000		35,668		—		35,668		—
Subordinated debt		6,860		7,000		—		—		7,000
Accrued interest payable		331		331		—		331		—

The carrying amounts of cash and due from banks, interest-bearing deposits, federal funds sold or purchased, accrued interest receivable, loans held for sale and non-interest-bearing deposits, are payable on demand, or are of such short duration that carrying value approximates market value.

Securities available-for-sale are carried at quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2). In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy.

The carrying value of restricted securities approximates fair value based on the redemption provisions of the issuer.

The fair value of loans held for sale is based upon their contracted sales price.

Bank owned life insurance is carried at its cash surrender value.

MSRs are carried at fair value. As described above, a valuation model is used to determine fair value. This model utilizes a discounted cash flow analysis with servicing costs and prepayment assumptions based on comparable instruments and a discount rate.

The fair value of performing loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar remaining maturities. This calculation ignores loan fees and certain factors affecting the interest rates charged on various loans such as the borrower’s creditworthiness and compensating balances and dissimilar types of real estate held as collateral. The fair value of impaired loans is measured as described within the Impaired Loans section of this note. The fair value of loans does not consider the lack of liquidity and uncertainty in the market that would affect the valuation.

Time deposits are presented at estimated fair value by discounting the future cash flows using interest rates offered for deposits of similar remaining maturities.

The fair value of the Company’s subordinated debt is estimated by utilizing observable market prices for comparable securities. Qualitative factors like asset quality, market factors and liquidity are also considered.

The fair value of the FHLB advances is estimated by discounting the future cash flows using the current interest rates offered for similar advances.

The fair value of commitments to extend credit is estimated using the fees currently charged to enter similar agreements, taking into account the remaining terms of the agreements and the present credit worthiness of the counter parties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counter parties at the reporting date. At June 30, 2017 and December 31, 2016, the fair value of loan commitments and standby letters of credit was immaterial and therefore, they are not included in the table above.

The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair value of the Company’s financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company’s overall interest rate risk.