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.

FASB ASC 820-10-05 defines fair value, establishes a framework for measuring fair value, establishes a three-level valuation hierarchy for disclosure of fair value measurements and enhances disclosure requirements for fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date.

FASB ASC 820-10-65 provides additional guidance for estimating fair value in accordance with FASB ASC 820-10-05 when the volume and level of activity for the asset or liability have significantly decreased. This ASC also includes guidance on identifying circumstances that indicate a transaction is not orderly.

FASB ASC 820-10-05 establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy under FASB ASC 820-10-05 are as follows:

Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Level 2: 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.

Level 3: Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (for example, supported with little or no market activity).

An asset’s or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. 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 the Company’s assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between the Company’s disclosures and those of other companies may not be meaningful.

The following methods and assumptions were used to estimate the fair values of the Company’s assets measured at fair value on a recurring basis at December 31, 2019 and December 31, 2018:

Securities Available-for-Sale: Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 inputs include securities that have quoted prices in active markets for identical assets. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flows. Examples of instruments, which would generally be classified within Level 2 of the valuation hierarchy include municipal bonds and certain agency collateralized mortgage obligations. In certain cases where there is limited activity in the market for a particular instrument, assumptions must be made to determine the fair value of the instruments and these are classified as Level 3. When measuring fair value, the valuation techniques available under the market approach, income approach and/or cost approach are used. The Company’s evaluations are based on market data and the Company employs combinations of these approaches for its valuation methods depending on the asset class.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 22 - Fair Value Measurements and Fair Value of Financial Instruments – (continued)

Derivatives: The fair value 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 rate, 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.

For financial assets and liabilities measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy used at December 31, 2019 and December 31, 2018 are as follows:

			December 31, 2019 Fair Value Measurements at Reporting Date Using
	Total Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
(dollars in thousands)
Recurring fair value measurements:
Assets
Investment securities:
Available-for-sale:
Federal agency obligations	$	28,237	$	-	$	28,237	$	-
Residential mortgage pass-through securities		200,496		-		200,496		-
Commercial mortgage pass-through securities		4,997		-		4,997		-
Obligations of U.S. states and political subdivision		136,519		-		127,405		9,114
Corporate bonds and notes		28,382		-		28,382		-
Asset-backed securities		5,780		-		5,780		-
Certificates of deposit		150		-		150		-
Other securities		140		140		-		-
Total available-for-sale	$	404,701	$	140	$	395,447	$	9,114

Equity securities		11,185		11,185		-		-
Total assets	$	415,886	$	11,325	$	395,447	$	9,114

Liabilities
Derivatives	$	(273)	$	-	$	(273)	$	-
Total liabilities	$	(273)		-		(273)

There were no transfers between Level 1 and Level 2 during the years ended December 31, 2019 and 2018.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 22 - Fair Value Measurements and Fair Value of Financial Instruments – (continued)

			December 31, 2018 Fair Value Measurements at Reporting Date Using
	Total Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
(dollars in thousands)
Recurring fair value measurements:
Assets
Investment securities:
Available-for-sale:
Federal agency obligations	$	44,955	$	-	$	44,955	$	-
Residential mortgage pass-through securities		185,204		-		185,204		-
Commercial mortgage pass-through securities		3,874		-		3,874		-
Obligations of U.S. states and political subdivision		139,185		-		129,808		9,377
Corporate bonds and notes		25,813		-		25,813		-
Asset-backed securities		9,691		-		9,691		-
Certificates of deposit		322		-		322		-
Other securities		2,990		2,990		-		-
Total available-for-sale	$	412,034	$	2,990	$	399,667	$	9,377

Equity securities		11,460		11,460		-		-
Derivatives		1,159		-		1,159		-
Total assets	$	424,653	$	14,450	$	400,826	$	9,377

There were no transfers between Level 1 and Level 2 during the years ended December 31, 2018 and 2017.

Assets Measured at Fair Value on a Non-Recurring Basis

The Company may be required periodically to measure certain assets at fair value on a non-recurring basis in accordance with GAAP. These adjustments to fair value usually result from the application of lower of cost or fair value accounting or impairment write-downs of individual assets. The following methods and assumptions were used to estimate the fair values of the Company’s assets measured at fair value on a non-recurring basis at December 31, 2019 and December 31, 2018:

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CONNECTONE BANCORP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 22 - Fair Value Measurements and Fair Value of Financial Instruments – (continued)

Impaired Loans: The Company may record adjustments to the carrying value of loans based on fair value measurements, generally as partial charge-offs of the uncollectible portions of these loans. These adjustments also include certain impairment amounts for collateral dependent loans calculated in accordance with GAAP. Impairment amounts are generally based on the fair value of the underlying collateral supporting the loan and, as a result, the carrying value of the loan less the calculated impairment amount applicable to that loan does not necessarily represent the fair value of the loan. Real estate collateral is valued using independent appraisals or other indications of value based on recent comparable sales of similar properties or assumptions generally observable by market participants. However, due to the substantial judgment applied and limited volume of activity as compared to other assets, fair value is based on Level 3 inputs. Estimates of fair value used for collateral supporting commercial loans generally are based on assumptions not observable in the market place and are also based on Level 3 inputs.

For assets measured at fair value on a non-recurring basis, the fair value measurements at December 31, 2019 and December 31, 2018 are as follows:

			Fair Value Measurements at Reporting Date Using
Assets measured at fair value on a nonrecurring basis:	December 31, 2019		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Impaired loans:	(dollars in thousands)
Commercial construction	$	2,286	$	-	$	-	$	2,286
Residential		240		-		-		240

			Fair Value Measurements at Reporting Date Using
Assets measured at fair value on a nonrecurring basis:	December 31, 2018		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Impaired loans:	(dollars in thousands)
Commercial real estate	$	1,481	$	-	$	-	$	1,481
Residential		231		-		-		231

Impaired Loans - Collateral dependent impaired loans at December 31, 2019 that required a valuation allowance were $3.8 million with a related valuation allowance of $1.3 million, compared to $1.7 million with a related valuation allowance of $36 thousand at December 31, 2018.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 22 - Fair Value Measurements and Fair Value of Financial Instruments – (continued)

Assets Measured With Significant Unobservable Level 3 Inputs

Recurring basis

The tables below present a reconciliation of all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the year ended December 31, 2019 and year ended December 31, 2018:

	Municipal Securities
	(dollars in thousands)
Beginning balance, January 1, 2019	$	9,377
Principal paydowns		(263)
Ending balance, December 31, 2019	$	9,114

	Municipal Securities
	(dollars in thousands)
Beginning balance, January 1, 2018	$	9,632
Principal paydowns		(255)
Ending balance, December 31, 2018	$	9,377

The following methods and assumptions were used to estimate the fair values of the Company’s assets measured at fair value on a recurring basis at December 31, 2019 and December 31, 2018. The table below provides quantitative information about significant unobservable inputs used in fair value measurements within Level 3 hierarchy.

December 31, 2019

Fair Value

Valuation

Techniques

Unobservable

Input

Range

Securities available-for-sale:

(dollars in thousands)

Municipal securities

9,114

Discounted cash flows

Discount rate

2.9%

December 31, 2018

Fair Value

Valuation

Techniques

Unobservable

Input

Range

Securities available-for-sale:

(dollars in thousands)

Municipal securities

9,377

Discounted cash flows

Discount rate

2.9%

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CONNECTONE BANCORP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 22 - Fair Value Measurements and Fair Value of Financial Instruments – (continued)

Non-recurring basis

The following methods and assumptions were used to estimate the fair values of the Company’s assets measured at fair value on a non-recurring basis for the periods presented. The tables below provide quantitative information about significant unobservable inputs used in fair value measurements within Level 3 hierarchy.

December 31, 2019

(dollars in thousands)	Fair Value		Valuation Techniques	Unobservable Input	Range (weighed average)
Impaired loans:
Commercial construction	$	2,286	Appraisals of collateral value	Comparable sales	0% - 5% (3%)

Residential	$	240	Appraisals of collateral value	Comparable sales	2% - 14% (9%)

December 31, 2018

(dollars in thousands)	Fair Value		Valuation Techniques	Unobservable Input	Range (weighed average)
Impaired loans:
Commercial real estate	$	1,481	Appraisals of collateral value	Comparable sales	6% - 9% (8%)

Residential	$	231	Appraisals of collateral value	Comparable sales	0% - 10% (5%)

Fair Value of Financial Instruments

FASB ASC 825-10 requires all entities to disclose the estimated fair value of their financial instrument assets and liabilities. For the Company, as for most financial institutions, the majority of its assets and liabilities are considered financial instruments as defined in FASB ASC 825-10. Many of the Company’s financial instruments, however, lack an available trading market as characterized by a willing buyer and willing seller engaging in an exchange transaction. It is also the Company’s general practice and intent to hold its financial instruments to maturity and not to engage in trading or sales activities except for loans held-for-sale and investment securities available-for-sale. Therefore, significant estimations and assumptions, as well as present value calculations, were used by the Company for the purposes of this disclosure.

Fair values for financial instruments must be estimated by management using techniques such as discounted cash flow analysis and comparison to similar instruments. These estimates are highly subjective and require judgments regarding significant matters, such as the amount and timing of future cash flows and the selection of discount rates that appropriately reflect market and credit risks. Changes in these judgments often have a material effect on the fair value estimates. Since these estimates are made as of a specific point in time, they are susceptible to material near-term changes. Fair values disclosed in accordance with ASC Topic 825 do not reflect any premium or discount that could result from the sale of a large volume of a particular financial instrument, nor do they reflect possible tax ramifications or estimated transaction costs.

Cash and cash equivalents. The carrying amounts of cash and short-term instruments approximate fair values.

FHLB stock. It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 22 - Fair Value Measurements and Fair Value of Financial Instruments – (continued)

Loans. The fair value of portfolio loans, net is determined using an exit price methodology. The exit price methodology continues to be based on a discounted cash flow analysis, in which projected cash flows are based on contractual cash flows adjusted for prepayments for certain loan types (e.g. residential mortgage loans and multi-family loans) and the use of a discount rate based on expected relative risk of the cash flows. The discount rate selected considers loan type, maturity date, a liquidity premium, cost to service, and cost of capital, which is a Level 3 fair value estimate.

Deposits. The carrying amounts of deposits with no stated maturities (i.e., noninterest-bearing, savings, NOW, and money market deposits) are assigned fair values equal to the carrying amounts payable on demand. The fair value of time deposits is based on the discounted value of contractual cash flows using estimated rates currently offered for alternative funding sources of similar remaining maturity.

Term Borrowings and Subordinated Debentures. The fair value of the Company’s long-term borrowings and subordinated debentures were calculated using a discounted cash flow approach and applying discount rates currently offered based on weighted remaining maturities.

Accrued Interest Receivable/Payable. The carrying amounts of accrued interest approximate fair value resulting in a level 2 or level 3 classification based on the level of the asset or liability with which the accrual is associated.

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CONNECTONE BANCORP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 22 - Fair Value Measurements and Fair Value of Financial Instruments – (continued)

The following presents the carrying amount, fair value, and placement in the fair value hierarchy of the Company’s financial instruments as of December 31, 2019 and December 31, 2018:

					Fair Value Measurements
	Carrying Amount		Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(dollars in thousands)
December 31, 2019
Financial assets:
Cash and due from banks	$	201,483	$	201,483	$	201,483	$	-	$	-
Investment securities available-for-sale		404,701		404,701		140		395,447		9,114
Restricted investment in bank stocks		27,397		n/a		n/a		n/a		n/a
Equity securities		11,185		11,185		11,185		-		-
Net loans		5,075,234		5,096,669		-		-		5,096,669
Accrued interest receivable		20,949		20,949		-		2,187		18,762

Financial liabilities:
Noninterest-bearing deposits		861,728		861,728		861,728		-		-
Interest-bearing deposits		3,905,814		3,917,405		2,352,093		1,565,312		-
Borrowings		500,293		502,026		-		502,026		-
Subordinated debentures		128,885		134,973		-		134,973		-
Derivatives		273		273		-		273		-
Accrued interest payable		4,018		4,018		-		4,018		-

December 31, 2018
Financial assets:
Cash and due from banks	$	172,366	$	172,366	$	172,366	$	-	$	-
Investment securities available-for-sale		412,034		412,034		2,990		399,667		9,377
Restricted investment in bank stocks		31,136		n/a		n/a		n/a		n/a
Equity securities		11,460		11,460		11,460		-		-
Net loans		4,506,138		4,402,878		-		-		4,402,878
Derivatives		1,159		1,159		-		1,159		-
Accrued interest receivable		18,214		18,214		-		2,064		16,150

Financial liabilities:
Noninterest-bearing deposits		768,584		768,584		768,584		-		-
Interest-bearing deposits		3,323,508		3,320,640		1,957,503		1,363,137		-
Borrowings		600,001		598,598		-		598,598		-
Subordinated debentures		128,556		132,426		-		132,426		-
Accrued interest payable		6,764		6,764		-		6,764		-

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CONNECTONE BANCORP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 22 - Fair Value Measurements and Fair Value of Financial Instruments – (continued)

The fair value of commitments to originate loans is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair values of letters of credit and lines of credit are based on fees currently charged for similar agreements or on the estimated cost to terminate or otherwise settle the obligations with the counterparties at the reporting date. The fair value of commitments to originate loans is immaterial and not included in the tables above.

Changes in assumptions or estimation methodologies may have a material effect on these estimated fair values.

The Company’s remaining assets and liabilities, which are not considered financial instruments, have not been valued differently than has been customary with historical cost accounting. No disclosure of the relationship value of the Company’s core deposit base is required by FASB ASC 825-10.

Fair value estimates are based on existing balance sheet financial instruments, without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. For example, there are certain significant assets and liabilities that are not considered financial assets or liabilities, such as the brokerage network, deferred taxes, premises and equipment, and goodwill. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.

Management believes that reasonable comparability between financial institutions may not be likely, due to the wide range of permitted valuation techniques and numerous estimates which must be made, given the absence of active secondary markets for many of the financial instruments. This lack of uniform valuation methodologies also introduces a greater degree of subjectivity to these estimated fair values.