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FAIR VALUE DISCLOSURES

9 Months Ended

Sep. 30, 2019

NOTE 5. FAIR VALUE DISCLOSURES

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 of each type of financial instrument:

Securities: Securities available-for-sale are valued primarily by a third party pricing service. The fair values of securities available for sale are determined on a recurring basis by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or pricing models which utilize significant observable inputs such as matrix pricing. This is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs). These models utilize the market approach with standard inputs that include, but are not limited to benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and reference data. For certain municipal securities that are not rated and observable inputs about the specific issuer are not available, fair values are estimated using observable data from other municipal securities presumed to be similar or other market data on other non-rated municipal securities (Level 3 inputs).

The Company’s Finance Department, which is responsible for all accounting and SEC compliance, and the Company’s Treasury Department, which is responsible for investment portfolio management and asset/liability modeling, are the two areas that determine the Company’s valuation policies and procedures. Both of these areas report directly to the Executive Vice President and Chief Financial Officer of the Company. For assets or liabilities that may be considered for Level 3 fair value measurement on a recurring basis, these two departments and the Executive Vice President and Chief Financial Officer determine the appropriate level of the assets or liabilities under consideration. If there are new assets or liabilities that are determined to be Level 3 by this group, the Risk Management Committee of the Company and the Audit Committee of the Board are made aware of such assets at their next scheduled meeting.

Securities pricing is obtained on securities from a third party pricing service and all security prices are tested annually against prices from another third party provider and reviewed with a market value price tolerance variance that varies by sector: municipal securities +/- 5%, government mbs/cmo +/- 3% and U.S. treasuries +/-1%. If any securities fall outside the tolerance threshold and have a variance of $100,000 or more, a determination of materiality is made for the amount over the threshold. Any security that would have a material threshold difference would be further investigated to determine why the variance exists and if any action is needed concerning the security pricing for that individual security. Changes in market value are reviewed monthly in aggregate by security type and any material differences are reviewed to determine why they exist. At least annually, the pricing methodology of the pricing service is received and reviewed to support the fair value levels used by the Company. A detailed pricing evaluation is requested and reviewed on any security determined to be fair valued using unobservable inputs by the pricing service.

Mortgage banking derivative: The fair values of mortgage banking derivatives are based on observable market data as of the measurement date (Level 2).

Interest rate swap derivatives: 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. The fair value of interest rate swap derivatives is determined by pricing or valuation models using observable market data as of the measurement date (Level 2).

Impaired loans: Impaired loans with specific allocations of the allowance for loan losses are generally based on the fair value of the underlying collateral if repayment is expected solely from the collateral. Fair value is determined using several methods. Generally, the fair value of real estate is based on appraisals by qualified third party appraisers. 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 appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and result in a Level 3 classification of the inputs for determining fair value. In addition, the Company’s management routinely applies internal discount factors to the value of appraisals used in the fair value evaluation of impaired loans. The deductions to the appraisals take into account changing business factors and market conditions, as well as value impairment in cases where the appraisal date predates a likely change in market conditions. Commercial real estate is generally discounted from its appraised value by 0-50% with the higher discounts applied to real estate that is determined to have a thin trading market or to be specialized collateral. In addition to real estate, the Company’s management evaluates other types of collateral as follows: (a) raw and finished inventory is discounted from its cost or book value by 35-65%, depending on the marketability of the goods (b) finished goods are generally discounted by 30-60%, depending on the ease of marketability, cost of transportation or scope of use of the finished good (c) work in process inventory is typically discounted by 50-100%, depending on the length of manufacturing time, types of components used in the completion process, and the breadth of the user base (d) equipment is valued at a percentage of depreciated book value or recent appraised value, if available, and is typically discounted at 30-70% after various considerations including age and condition of the equipment, marketability, breadth of use, and whether the equipment includes unique components or add-ons; and (e) marketable securities are discounted by 10-30%, depending on the type of investment, age of valuation report and general market conditions. This methodology is based on a market approach and typically results in a Level 3 classification of the inputs for determining fair value.

Mortgage servicing rights: As of September 30, 2019, the fair value of the Company’s Level 3 servicing assets for residential mortgage loans (“MSRs”) was $4.7 million, none of which are currently impaired and therefore are carried at amortized cost. These residential mortgage loans have a weighted average interest rate of 3.94%, a weighted average maturity of 20 years and are secured by homes generally within the Company’s market area of Northern Indiana and Indianapolis. A valuation model is used to estimate fair value by stratifying the portfolios on the basis of certain risk characteristics, including loan type and interest rate. Impairment is

estimated based on an income approach. The inputs used include estimates of prepayment speeds, discount rate, cost to service, escrow account earnings, contractual servicing fee income, ancillary income, late fees, and float income. The most significant assumption used to value MSRs is prepayment rate. Prepayment rates are estimated based on published industry consensus prepayment rates. The most significant unobservable assumption is the discount rate. At September 30, 2019, the constant prepayment speed (“PSA”) used was 65 and discount rate used was 9.4%. At December 31, 2018, the PSA used was 81 and the discount rate used was 9.4%.

Other real estate owned: Nonrecurring adjustments to certain commercial and residential real estate properties classified as other real estate owned are measured at the lower of carrying amount or fair value less costs to sell. Fair values are generally based on third party appraisals of the property and are reviewed by the Company’s internal appraisal officer. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable properties used to determine value. Such adjustments are usually significant and result in a Level 3 classification. In addition, the Company’s management may apply discount factors to the appraisals to take into account changing business factors and market conditions, as well as value impairment in cases where the appraisal date predates a likely change in market conditions. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.

Real estate mortgage loans held for sale: Real estate mortgage loans held for sale are carried at the lower of cost or fair value, as determined by outstanding commitments, from third party investors, and result in a Level 2 classification.

The table below presents the balances of assets measured at fair value on a recurring basis:


	September 30, 2019
	Fair Value Measurements Using						Assets
(dollars in thousands)	Level 1		Level 2		Level 3		at Fair Value
Assets
U.S. Treasury securities	$	1,007	$	0	$	0	$	1,007
U.S. government sponsored agency securities		0		2,308		0		2,308
Mortgage-backed securities: residential		0		296,232		0		296,232
Mortgage-backed securities: commercial		0		37,669		0		37,669
State and municipal securities		0		275,864		150		276,014
Total Securities		1,007		612,073		150		613,230
Mortgage banking derivative		0		393		0		393
Interest rate swap derivative		0		8,992		0		8,992
Total assets	$	1,007	$	621,458	$	150	$	622,615

Liabilities
Mortgage banking derivative		0		10		0		10
Interest rate swap derivative		0		9,802		0		9,802
Total liabilities	$	0	$	9,812	$	0	$	9,812


	December 31, 2018
	Fair Value Measurements Using						Assets
(dollars in thousands)	Level 1		Level 2		Level 3		at Fair Value
Assets
U.S. Treasury securities	$	987	$	0	$	0	$	987
U.S. government sponsored agency securities		0		4,350		0		4,350
Mortgage-backed securities: residential		0		325,412		0		325,412
Mortgage-backed securities: commercial		0		38,141		0		38,141
State and municipal securities		0		216,509		150		216,659
Total Securities		987		584,412		150		585,549
Mortgage banking derivative		0		95		0		95
Interest rate swap derivative		0		3,869		0		3,869
Total assets	$	987	$	588,376	$	150	$	589,513

Liabilities
Mortgage banking derivative		0		23		0		23
Interest rate swap derivative		0		4,025		0		4,025
Total liabilities	$	0	$	4,048	$	0	$	4,048

There were no transfers between Level 1 and Level 2 during the nine months ended September 30, 2019 and there were no transfers between Level 1 and Level 2 during 2018.

The fair value of Level 3 available for sale securities was immaterial to warrant additional recurring fair value disclosure.

The table below presents the balances of assets measured at fair value on a nonrecurring basis:


	September 30, 2019
	Fair Value Measurements Using						Assets
(dollars in thousands)	Level 1		Level 2		Level 3		at Fair Value
Assets
Impaired loans:
Commercial and industrial loans:
Working capital lines of credit loans	$	0	$	0	$	3,152	$	3,152
Non-working capital loans		0		0		5,103		5,103
Commercial real estate and multi-family residential loans:
Owner occupied loans		0		0		973		973
Agri-business and agricultural loans:
Loans secured by farmland		0		0		57		57
Consumer 1‑4 family mortgage loans:
Closed end first mortgage loans		0		0		457		457
Open end and junior lien loans		0		0		587		587
Total impaired loans	$	0	$	0	$	10,329	$	10,329
Other real estate owned		0		0		0		0
Total assets	$	0	$	0	$	10,329	$	10,329


	December 31, 2018
	Fair Value Measurements Using						Assets
(dollars in thousands)	Level 1		Level 2		Level 3		at Fair Value
Assets
Impaired loans:
Commercial and industrial loans:
Working capital lines of credit loans	$	0	$	0	$	4,092	$	4,092
Non-working capital loans		0		0		4,967		4,967
Commercial real estate and multi-family residential loans:
Construction and land development loans		0		0		148		148
Owner occupied loans		0		0		1,669		1,669
Agri-business and agricultural loans:
Loans secured by farmland		0		0		77		77
Consumer 1‑4 family mortgage loans:
Closed end first mortgage loans		0		0		553		553
Total impaired loans	$	0	$	0	$	11,506	$	11,506
Other real estate owned		0		0		316		316
Total assets	$	0	$	0	$	11,822	$	11,822

The following table presents the valuation methodology and unobservable inputs for Level 3 assets measured at fair value on a non-recurring basis at September 30, 2019:


(dollars in thousands)	Fair Value		Valuation Methodology	Unobservable Inputs	Average		Range of Inputs
Impaired loans:
Commercial and industrial	$	8,255	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability	53	%	1	%	-	100	%
Impaired loans:
Commercial real estate		973	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability	42	%	30	%	-	100	%
Impaired loans:
Agri-business and agricultural		57	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability	61	%
Impaired loans:
Consumer 1‑4 family mortgage		1,044	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability	13	%	5	%	-	100	%

The following table presents the valuation methodology and unobservable inputs for Level 3 assets measured at fair value on a non-recurring basis at December 31, 2018:


(dollars in thousands)	Fair Value		Valuation Methodology	Unobservable Inputs	Average		Range of Inputs
Impaired loans:
Commercial and industrial	$	9,059	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability	48	%	4	%	-	100	%
Impaired loans:
Commercial real estate		1,817	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability	34	%	6	%	-	53	%
Impaired loans:
Agri-business and agricultural		77	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability	49	%
Impaired loans:
Consumer 1‑4 family mortgage		553	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability	23	%	0	%	-	64	%
Other real estate owned		316	Collateral based measurements	Discount to reflect current market conditions	0	%

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a gross carrying amount of $20.4 million, with a valuation allowance of $10.1 million at September 30, 2019. The change in the fair value of impaired loans resulted in increases in the provision for loan losses of $600,000 and $500,000, respectively, over the nine months and three months ended September 30, 2019, respectively. At September 30, 2018, impaired loans had a gross carrying amount of $15.0 million, with a valuation allowance of $5.5 million. The change in the fair value of impaired loans resulted in a net increase in the provision for loan losses of $8.3 million and $3.8 million, respectively, in the nine months and three months ended September 30, 2018, respectively, primarily due to a partial charge-off on one commercial lending relationship in the amount of $4.6 million, during the first quarter of 2018.

The following table contains the estimated fair values and the related carrying values of the Company’s financial instruments. Items which are not financial instruments are not included.

September 30, 2019

Carrying

Estimated Fair Value

(dollars in thousands)

Value

Level 1

Level 2

Level 3

Total

Financial Assets:

Cash and cash equivalents

136,575

133,799

2,776

136,575

Securities available-for-sale

613,230

1,007

612,073

150

613,230

Real estate mortgages held-for-sale

7,424

7,506

Loans, net

3,972,593

3,933,560

Federal Reserve and Federal Home Loan Bank stock

13,772

N/A

Accrued interest receivable

15,823

3,373

12,442

15,823

Financial Liabilities:

Certificates of deposit

(1,383,366)

(1,394,467)

All other deposits

(2,900,024)

Subordinated debentures

(30,928)

(31,158)

Standby letters of credit

(926)

Accrued interest payable

(12,071)

(92)

(11,975)

(4)

(12,071)


	December 31, 2018
	Carrying		Estimated Fair Value
(dollars in thousands)	Value		Level 1		Level 2		Level 3		Total
Financial Assets:
Cash and cash equivalents	$	216,922	$	214,452	$	2,470	$	0	$	216,922
Securities available-for-sale		585,549		987		584,412		150		585,549
Real estate mortgages held-for-sale		2,293		0		2,314		0		2,314
Loans, net		3,866,292		0		0		3,786,175		3,786,175
Federal Reserve and Federal Home Loan Bank stock		13,772		N/A		N/A		N/A		N/A
Accrued interest receivable		15,518		3		3,569		11,946		15,518
Financial Liabilities:
Certificates of deposit		(1,419,754)		0		(1,424,553)		0		(1,424,553)
All other deposits		(2,624,311)		(2,624,311)		0		0		(2,624,311)
Securities sold under agreements to repurchase		(75,555)		0		(75,555)		0		(75,555)
Federal Home Loan Bank advances		(170,000)		0		(169,996)		0		(169,996)
Subordinated debentures		(30,928)		0		0		(31,195)		(31,195)
Standby letters of credit		(978)		0		0		(978)		(978)
Accrued interest payable		(10,404)		(110)		(10,289)		(5)		(10,404)