7. FAIR VALUE

Fair value is 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 company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The Company used the following methods and significant assumptions to estimate the fair value:

Investment Securities: The fair values for investment securities are determined by quoted market prices (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3).

Loans Held for Sale, at Fair Value: The fair value of loans held for sale is determined using quoted prices for similar assets, adjusted for specific attributes of that loan or other observable market data, such as outstanding commitments from third party investors (Level 2).

Derivatives: The fair values of derivatives are based on valuation models using observable market data as of the measurement date (Level 2). Our derivatives are traded in an over-the-counter market where quoted market prices are not always available. Therefore, the fair values of derivatives are determined using quantitative models that utilize multiple market inputs. The inputs will vary based on the type of derivative, but could include interest rates, prices and indices to generate continuous yield or pricing curves, prepayment rates, and volatility factors to value the position. The majority of market inputs are actively quoted and can be validated through external sources, including brokers, market transactions and third-party pricing services.

Impaired Loans: The fair value of impaired loans with specific allocations of the allowance for loan and lease losses is generally 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 are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

Other Real Estate Owned: Nonrecurring adjustments to certain commercial and residential real estate properties classified as other real estate owned (OREO) are measured at fair value, less costs to sell. Fair values are based on recent real estate appraisals. These appraisals may use 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 are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by Management. Once received, a third party conducts a review of the appraisal for compliance with the Uniform Standards of Professional Appraisal Practice and appropriate analysis methods for the type of property. Subsequently, a member of the Credit Department reviews the assumptions and approaches utilized in the appraisal, as well as the overall resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics. Appraisals on collateral dependent impaired loans and other real estate owned (consistent for all loan types) are obtained on an annual basis, unless a significant change in the market or other factors warrants a more frequent appraisal. On an annual basis, Management compares the actual selling price of any collateral that has been sold to the most recent appraised value to determine what additional adjustment should be made to the appraisal value to arrive at fair value for other properties. The most recent analysis performed indicated that a discount up to 15 percent should be applied to appraisals on properties. The discount is determined based on the nature of the underlying properties, aging of appraisals and other factors. For each collateral-dependent impaired loan, we consider other factors, such as certain indices or other market information, as well as property specific circumstances to determine if an adjustment to the appraised value is needed. In situations where there is evidence of change in value, the Bank will determine if there is a need for an adjustment to the specific reserve on the collateral dependent impaired loans. When the Bank applies an interim adjustment, it generally shows the adjustment as an incremental specific reserve against the loan until it has received the full updated appraisal. All collateral-dependent impaired loans and other real estate owned valuations were supported by an appraisal less than 12 months old or in the process of obtaining an appraisal as of September 30, 2018.

The following table summarizes, for the periods indicated, assets measured at fair value on a recurring basis, including financial assets for which the Corporation has elected the fair value option:

Assets Measured on a Recurring Basis

				Fair Value Measurements Using
				Quoted
				Prices in
				Active		Significant
				Markets For		Other			Significant
				Identical		Observable			Unobservable
	September 30,			Assets		Inputs			Inputs
(In thousands)	2018			(Level 1)		(Level 2)			(Level 3)
Assets:
Available for sale:
U.S. government-sponsored agencies	$	99,258		$	—	$	99,258		$	—
Mortgage-backed securities-residential		243,896			—		243,896			—
SBA pool securities		4,182			—		4,182			—
State and political subdivisions		18,173			—		18,173			—
Corporate bond		3,045			—		3,045			—
CRA investment fund		4,673			4,673		—			—
Loans held for sale, at fair value		310			—		310			—
Derivatives:
Cash flow hedges		3,536			—		3,536			—
Loan level swaps		12,027			—		12,027			—
Total	$	389,100		$	4,673	$	384,427		$	—

Liabilities:
Derivatives:
Loan level swaps	$	(12,027	)	$	—	$	(12,027	)	$	—
Total	$	(12,027	)	$	—	$	(12,027	)	$	—

Assets Measured on a Recurring Basis

				Fair Value Measurements Using
				Quoted
				Prices in
				Active		Significant
				Markets For		Other			Significant
				Identical		Observable			Unobservable
	December 31,			Assets		Inputs			Inputs
(In thousands)	2017			(Level 1)		(Level 2)			(Level 3)
Assets:
Securities available for sale:
U.S. government-sponsored agencies	$	43,701		$	—	$	43,701		$	—
Mortgage-backed securities-residential		243,116			—		243,116			—
SBA pool securities		5,205			—		5,205			—
State and political subdivisions		24,868			—		24,868			—
Corporate bond		3,082			—		3,082			—
Single-issuer trust preferred security		2,837			—		2,837			—
CRA investment fund		4,824			4,824		—			—
Loans held for sale, at fair value		984			—		984			—
Derivatives:
Cash flow hedges		1,394			—		1,394			—
Loan level swaps		3,131			—		3,131			—
Total	$	333,142		$	4,824	$	328,318		$	—

Liabilities:
Derivatives:

Loan level swaps	$	(3,131	)	$	—	$	(3,131	)	$	—
Total	$	(3,131	)	$	—	$	(3,131	)	$	—

The Company has elected the fair value option for certain loans held for sale. These loans are intended for sale and the Company 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 loan and in accordance with the Company’s policy on loans held for investment. None of these loans are 90 days or more past due nor on nonaccrual as of September 30, 2018 and December 31, 2017.

The following tables present residential loans held for sale, at fair value for the periods indicated:

(In thousands)	September 30, 2018		December 31, 2017
Residential loans contractual balance	$	306	$	972
Fair value adjustment		4		12
Total fair value of residential loans held for sale	$	310	$	984

There were no transfers between Level 1 and Level 2 during the three and nine months ended September 30, 2018.

The following table summarizes, for the periods indicated, assets measured at fair value on a non-recurring basis (Quantitative disclosures for non-recurring Level 3 assets have been omitted due to immateriality):

Assets Measured on a Non-Recurring Basis

Fair Value Measurements Using

Quoted

Prices in

Active

Significant

Markets For

Other

Significant

Identical

Observable

Unobservable

September 30,

Assets

Inputs

(In thousands)

2018

(Level 1)

(Level 2)

(Level 3)

Assets:

Impaired loans:

Investment commercial real estate

884

—

884

—

There were no loans measured for impairment using the fair value of collateral as of December 31, 2017.

The carrying amounts and estimated fair values of financial instruments at September 30, 2018 are as follows:

			Fair Value Measurements at September 30, 2018 using
	Carrying
(In thousands)	Amount		Level 1		Level 2		Level 3		Total
Financial assets
Cash and cash equivalents	$	123,004	$	123,004	$	—	$	—	$	123,004
Securities available for sale		368,554		—		368,554		—		368,554
CRA investment fund		4,673		4,673		—		—		4,673
FHLB and FRB stock		21,561		—		—		—	N/A
Loans held for sale, at fair value		310		—		310		—		310
Loans held for sale, at lower of cost or fair value		4,002		—		4,042		—		4,042
Loans, net of allowance for loan and lease losses		3,761,297		—		—		3,712,754		3,712,754
Accrued interest receivable		10,849		—		1,612		9,237		10,849
Cash flow hedges		3,536		—		3,536		—		3,536
Loan level swaps		12,027		—		12,027		—		12,027
Financial liabilities
Deposits	$	3,659,294	$	3,046,069	$	605,548	$	—	$	3,651,617
Overnight borrowings		95,190		—		95,190		—		95,190
Federal home loan bank advances		84,000		—		83,774		—		83,774
Subordinated debt		83,138		—		—		83,691		83,691
Accrued interest payable		3,784		207		2,356		1,221		3,784
Loan level swap		12,027		—		12,027		—		12,027

The carrying amounts and estimated fair values of financial instruments at December 31, 2017 are as follows:

			Fair Value Measurements at December 31, 2017 using
	Carrying
(In thousands)	Amount		Level 1		Level 2		Level 3		Total
Financial assets
Cash and cash equivalents	$	113,447	$	113,447	$	—	$	—	$	113,447
Securities available for sale		327,633		4,824		322,809		—		327,633
FHLB and FRB stock		13,378		—		—		—	N/A
Loans held for sale, at fair value		984		—		984		—		984
Loans held for sale, at lower of cost or fair value		187		—		206		—		206
Loans, net of allowance for loan and lease losses		3,668,000		—		—		3,649,132		3,649,132
Accrued interest receivable		9,452		—		1,041		8,411		9,452
Cash flow Hedges		1,394		—		1,394		—		1,394
Loan level swaps		3,131		—		3,131		—		3,131
Financial liabilities
Deposits	$	3,698,354	$	3,082,728	$	612,591	$	—	$	3,695,319
Federal home loan bank advances		37,898		—		37,907		—		37,907
Subordinated debt		83,024		—		—		84,150		84,150
Accrued interest payable		1,756		192		1,495		69		1,756
Loan level swaps		3,131		—		3,131		—		3,131