Fair Value

Generally accepted accounting principles define fair value, establish a framework for measuring fair value, recommend disclosures about fair value, and establish a hierarchy for determining fair value measurement. The hierarchy includes three levels and is based upon the valuation techniques used to measure assets and liabilities. The three levels are as follows:

Level 1 - Inputs to the valuation method are quoted prices (unadjusted) for identical assets or liabilities in active markets;

Level 2 - Inputs to the valuation method include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument; and

Level 3 - Inputs to the valuation method are unobservable and significant to the fair value measurement.

Fair value measurements on a recurring basis

Investment securities available for sale - The fair values of the Company's investment securities available for sale are provided by an independent pricing service. The fair values of the Company's securities are determined based on quoted prices for similar securities under Level 2 inputs.

Loans held for sale - The fair value of loans held for sale is determined using Level 2 inputs of quoted prices for a similar asset, adjusted for specific attributes of that loan.

Derivative financial instruments - Derivative instruments used to hedge residential mortgage loans held for sale and the related interest rate lock commitments include forward commitments to sell mortgage loans and are reported at fair value utilizing Level 2 inputs. The fair values of derivative financial instruments are based on derivative market data inputs as of the valuation date and the underlying value of mortgage loans for rate lock commitments.

The interest rate swap is reported at fair value utilizing Level 2 inputs. The Company obtains dealer quotations to value its swap. For purposes of potential valuation adjustments to its derivative position, the Company evaluates the credit risk of its counterparty. Accordingly, the Company has considered factors such as the likelihood of default by the counterparty and the remaining contractual life, among other things, in determining if any fair value adjustment related to credit risk is required.

The Company has categorized its financial instruments measured at fair value on a recurring basis as of June 30, 2019 and December 31, 2018 as follows:



Fair Value of Financial Instruments
(in thousands)
June 30, 2019	Total		Level 1 Inputs		Level 2 Inputs		Level 3 Inputs
Investment securities available for sale
U.S. government-sponsored enterprises	$	6,477	$	—	$	6,477	$	—
Municipal	521		—		521		—
Corporate	2,890		—		2,890		—
Mortgage-backed securities	29,269		—		29,269		—
	$	39,157	$	—	$	39,157	$	—
Loans held for sale	$	47,744	$	—	$	47,744	$	—
Derivative assets	$	465	$	—	$	465	$	—
Derivative liabilities	$	446	$	—	$	446	$	—

December 31, 2018
Investment securities available for sale
U.S. government-sponsored enterprises	$	17,360	$	—	$	17,360	$	—
Municipal	501		—		501		—
Corporate	2,885		—		2,885		—
Mortgage-backed securities	26,186		—		26,186		—
	$	46,932	$	—	$	46,932	$	—
Loans held for sale	$	18,526	$	—	$	18,526	$	—
Derivative assets	$	172	$	—	$	172	$	—
Derivative liabilities	$	253	$	—	$	253	$	—

Financial instruments recorded using FASB ASC 825-10

Under FASB ASC 825-10, the Company may elect to report most financial instruments and certain other items at fair value on an instrument-by-instrument basis with changes in fair value reported in net income. After the initial adoption, the election is made at the acquisition of an eligible financial asset, financial liability or firm commitment or when certain specified reconsideration events occur. The fair value election, with respect to an item, may not be revoked once an election is made.

The following table reflects the difference between the fair value carrying amount of loans held for sale, measured at fair value under FASB ASC 825-10, and the aggregate unpaid principal amount the Company is contractually entitled to receive at maturity:



Fair Value of Loans Held for Sale
(in thousands)	June 30, 2019		December 31, 2018
Aggregate fair value	$	47,744	$	18,526
Contractual principal	46,145		17,822
Difference	$	1,599	$	704

The Company has elected to account for loans held for sale at fair value to eliminate the mismatch that would occur by recording changes in market value on derivative instruments used to hedge loans held for sale while carrying the loans at the lower of cost or market.

Fair value measurements on a nonrecurring basis

Impaired loans - The Company has measured impairment generally based on the fair value of the loan's collateral and discounted cash flow analysis. Fair value 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 as Level 3 fair values. As of June 30, 2019 and December 31, 2018, the fair values consist of loan balances of $6.8 million and $4.4 million, with specific reserves of $377 thousand and $262 thousand, respectively.

Foreclosed real estate - The Company's foreclosed real estate is measured at fair value less cost to sell. Fair value was determined based on offers and/or appraisals. Cost to sell the real estate was based on standard market factors. The Company has categorized its foreclosed real estate as Level 3.

The Company has categorized its impaired loans and foreclosed real estate as follows:



Fair Value of Impaired Loans and Foreclosed Real Estate
(in thousands)	June 30, 2019		December 31, 2018
Impaired loans
Level 1 inputs	$	—	$	—
Level 2 inputs	—		—
Level 3 inputs	6,420		4,093
Total	$	6,420	$	4,093

Foreclosed real estate
Level 1 inputs	$	—	$	—
Level 2 inputs	—		—
Level 3 inputs	149		142
Total	$	149	$	142

The following table provides information describing the unobservable inputs used in Level 3 fair value measurements at June 30, 2019 and December 31, 2018:



Unobservable Inputs
	Valuation Technique	Unobservable Inputs	Range of Inputs
	Valuation Technique	Unobservable Inputs	Range of Inputs
Impaired Loans	Appraised Value/Discounted Cash Flows	Discounts to appraisals or cash flows for estimated holding and/or selling costs	11 to 25%
Foreclosed Real Estate	Appraised Value/Comparable Sales	Discounts to appraisals for estimated holding and/or selling costs	11 to 25%

Fair value of financial instruments

Fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practical to estimate the value is based upon the characteristics of the instruments and relevant market information. Financial instruments include cash, evidence of ownership in an entity, or contracts that convey or impose on an entity that contractual right or obligation to either receive or deliver cash for another financial instrument.

The information used to determine fair value is highly subjective and judgmental in nature and, therefore, the results may not be precise. Subjective factors include, among other things, estimates of cash flows, risk characteristics, credit quality, and interest rates, all of which are subject to change. Since the fair value is estimated as of the balance sheet date, the amounts that will actually be realized or paid upon settlement or maturity on these various instruments could be significantly different.

During the first quarter of 2018, the Company adopted ASU 2016-01, “Recognition and Measurement of Financial Assets and Liabilities.” The amendments included within this standard, which are applied prospectively, require the Company to disclose fair value of financial instruments measured at amortized cost on the balance sheet and to measure that fair value using an exit price notion. Prior to adopting the amendments included in the standard, the Company was allowed to measure fair value under an entry price notion. The entry price notion previously applied by the Company used a discounted cash flows technique to calculate the present value of expected future cash flows for a financial instrument. The exit price notion uses the same approach, but also incorporates other factors, such as enhanced credit risk, illiquidity risk, and market factors that sometimes exist in exit prices in dislocated markets.

The fair value of the Company’s loan portfolio has always included a credit risk assumption in the determination of the fair value of its loans. This credit risk assumption is intended to approximate the fair value that a market participant would realize in a hypothetical orderly transaction. The Company’s loan portfolio is initially fair valued using a segmented approach. The Company divides its loan portfolio into the following categories: variable rate loans, impaired loans, and all other loans. The results are then adjusted to account for credit risk as described above. However, under the new guidance, the Company believes a further credit risk discount must be applied through the use of a discounted cash flow model to compensate for illiquidity risk, based on certain assumptions included within the discounted cash flow model, primarily the use of discount rates that better capture inherent credit risk over the lifetime of a loan. This consideration of enhanced credit risk provides an estimated exit price for the Company’s loan portfolio.

For variable-rate loans that reprice frequently and have no significant change in credit risk, fair values approximate carrying values. Fair values for impaired loans are estimated using discounted cash flow models or based on the fair value of the underlying collateral.

The fair value of cash and cash equivalents and investments in restricted stocks is the carrying amount. Restricted stock includes equity of the Federal Reserve and other banker’s banks.

The fair value of noninterest bearing deposits and securities sold under agreements to repurchase is the carrying amount.

The fair value of checking, savings, and money market deposits is the amount payable on demand at the reporting date. Fair value of fixed maturity term accounts and individual retirement accounts is estimated using rates currently offered for accounts of similar remaining maturities.

The fair value of certificates of deposit in other financial institutions is estimated based on interest rates currently offered for deposits of similar remaining maturities.

The fair value of borrowings is estimated by discounting the value of contractual cash flows using current market rates for borrowings with similar terms and remaining maturities.

The fair value of outstanding loan commitments, unused lines of credit, and letters of credit are not included in the table since the carrying value generally approximates fair value. These instruments generate fees that approximate those currently charged to originate similar commitments.

The table below presents the carrying amount, fair value, and placement in the fair value hierarchy of the Company’s financial instruments.



Fair Value of Selected Financial Instruments
	June 30, 2019				December 31, 2018
(in thousands)	Carrying Amount		Fair Value		Carrying Amount		Fair Value
Financial assets
Level 1
Cash and due from banks	$	12,253	$	12,253	$	10,431	$	10,431
Interest bearing deposits at other financial institutions	65,284		65,284		22,007		22,007
Federal funds sold	1,991		1,991		2,285		2,285
Restricted investments	4,137		4,137		2,503		2,503
Level 3
Loans receivable, net	$	1,044,377	$	1,039,071	$	988,960	$	979,058

Financial liabilities
Level 1
Noninterest bearing deposits	$	279,484	$	279,484	$	242,259	$	242,259
Securities sold under agreements to repurchase	—		—		3,332		3,332
Level 3
Interest bearing deposits	$	757,520	$	757,497	$	712,981	$	711,876
FHLB advances and other borrowed funds	54,298		54,132		19,393		19,447