20. Fair Value

Fair Value Measurement

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an 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. A fair value hierarchy has also been established which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The following three levels of inputs are used to measure fair value:

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 fair values of most trading securities and securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or matrix pricing, which 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 relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs).

The Corporation’s structured pooled trust preferred securities are priced using Level 3 inputs. The decline in the level of observable inputs and market activity in this class of investments by the measurement date has been significant and resulted in unreliable external pricing. Broker pricing and bid/ask spreads, when available, vary widely, and the once-active market has become comparatively inactive. The Corporation engaged a third party consultant who has developed a model for pricing these securities. Information such as historical and current performance of the underlying collateral, deferral and default rates, collateral coverage ratios, break in yield calculations, cash flow projections, liquidity and credit premiums required by a market participant, and financial trend analysis with respect to the individual issuing financial institutions and insurance companies are utilized in determining the security valuation. Due to the current market conditions as well as the limited trading activity of these types of securities, the market value of the Corporation’s structured pooled trust preferred securities are highly sensitive to assumption changes and market volatility.

The Corporation’s derivative instruments are interest rate swaps that are similar to those that trade in liquid markets. As such, significant fair value inputs can generally be verified and do not typically involve significant management judgments (Level 2 inputs).

The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals prepared by third-parties. 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. Management also adjusts appraised values based on the length of time that has passed since the appraisal date and other factors. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

Assets and liabilities measured at fair value on a recurring basis are as follows at December 31, 2017 and 2016:


				Fair Value Measurements at December 31, 2017 Using
Description	Total			Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)
Assets:
Securities Available For Sale:
U.S. Government sponsored entities	$	108,148		$	0	$	108,148		$	0
States and political subdivisions		137,723			0		137,723			0
Residential and multi-family mortgage		109,636			0		109,636			0
Corporate notes and bonds		17,200			0		17,200			0
Pooled SBA		36,040			0		36,040			0
Other equity securities		962			962		0			0

Total Securities Available For Sale	$	409,709		$	962	$	408,747		$	0

Interest Rate swaps:	$	149		$	0	$	149		$	0

Trading Securities:
Corporate equity securities	$	5,125		$	5,125	$	0		$	0
Mutual funds		1,499			1,499		0			0
Certificates of deposit		220			220		0			0
Corporate notes and bonds		254			254		0			0
U.S. Government sponsored entities		52			0		52			0

Total Trading Securities	$	7,150		$	7,098	$	52		$	0

Liabilities
Interest rate swaps	$	(310	)	$	0	$	(310	)	$	0


				Fair Value Measurements at December 31, 2016 Using
Description	Total			Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)
Assets:
Securities Available For Sale:
U.S. Government sponsored entities	$	140,351		$	0	$	140,351		$	0
States and political subdivisions		157,037			0		157,037			0
Residential and multi-family mortgage		134,976			0		134,976			0
Corporate notes and bonds		17,414			0		17,414			0
Pooled trust preferred		2,049			0		0			2,049
Pooled SBA		43,037			0		43,037			0
Other equity securities		971			971		0			0

Total Securities Available For Sale	$	495,835		$	971	$	492,815		$	2,049

Interest Rate swaps:	$	211		$	0	$	211		$	0

Trading Securities:
Corporate equity securities	$	3,312		$	3,312	$	0		$	0
Mutual funds		1,037			1,037		0			0
Certificates of deposit		202			202		0			0
Corporate notes and bonds		254			254		0			0
U.S. Government sponsored entities		53			0		53			0

Total Trading Securities	$	4,858		$	4,805	$	53		$	0

Liabilities
Interest rate swaps	$	(670	)	$	0	$	(670	)	$	0

The table below presents a reconciliation and income statement classification of gains and losses for all securities available for sale measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the year ended December 31, 2017:


	Pooled trust preferred
Balance, January 1, 2017	$	2,049
Total gains or (losses):
Included in other comprehensive income (loss)		134
Sale of available-for-sale securities		(2,183	)

Balance, December 31, 2017	$	0


	Pooled trust preferred
Balance, January 1, 2016	$	3,413
Total gains or (losses):
Included in other comprehensive income (loss)		(442	)
Included in realized gains on available-for-sale securities		0
Sale of available-for-sale securities		(922	)

Balance, December 31, 2016	$	2,049

There were no Level 3 financial instruments carried at fair value on a recurring basis at December 31, 2017.

The following table presents quantitative information about Level 3 fair value measurements at December 31, 2016:


	Fair value	Valuation Technique	Unobservable Inputs	Input Utilized
Pooled trust preferred	$2,049	Discounted cash flow	Collateral default rate Yield	0.5% in 2016 and thereafter 10%
			Prepayment speed	2.0% constant prepayment rate in 2016 and thereafter

At December 31, 2016 the significant unobservable inputs used in the fair value measurement of the Corporation’s pooled trust preferred securities are collateral default rate, yield, and prepayment speed. Significant increases in specific-issuer default assumptions or decreases in specific-issuer recovery assumptions would result in a lower fair value measurement. Conversely, decreases in specific-issuer default assumptions or increases in specific-issuer recovery assumptions would result in a higher fair value measurement.

Assets and liabilities measured at fair value on a non-recurring basis are as follows at December 31, 2017 and 2016:


			Fair Value Measurements at December 31, 2017 Using
Description	Total		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Impaired loans:
Commercial mortgages	$	11		0		0	$	11

			Fair Value Measurements at December 31, 2016 Using
Description	Total		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Impaired loans:
Commercial mortgages	$	2,067		0		0	$	2,067

Impaired loans measured for impairment using the fair value of collateral for collateral dependent loans had a recorded investment of $646, with a valuation allowance of $635 as of December 31, 2017, resulting in an additional provision for loan losses of ($418) for the year then ended. Impaired loans measured for impairment using the fair value of collateral for collateral dependent loans had a recorded investment of $3,120, with a valuation allowance of $1,053 as of December 31, 2016, resulting in an additional provision for loan losses of ($189) for the year then ended.

The estimated fair values of impaired collateral dependent loans such as commercial or residential mortgages are determined primarily through third-party appraisals. When a collateral dependent loan, such as a commercial or residential mortgage loan, becomes impaired, a decision is made regarding whether an updated certified appraisal of the real estate is necessary. This decision is based on various considerations, including the age of the most recent appraisal, the loan-to-value ratio based on the original appraisal, and the condition of the property. Appraised values are discounted to arrive at the estimated selling price of the collateral and a further reduction for estimated costs to sell the property is applied, which results in an amount that is considered to be the estimated fair value. If a loan becomes impaired and the appraisal of related loan collateral is outdated, management applies an appropriate adjustment factor based on its experience with current valuations of similar collateral in determining the loan’s estimated fair value and resulting allowance for loan losses. Third-party appraisals are not customarily obtained in respect of unimpaired loans, unless in management’s view changes in circumstances warrant obtaining an updated appraisal.

The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at December 31, 2017:


	Fair value		Valuation Technique	Unobservable Inputs	Range (Weighted Average)
Impaired loans – commercial mortgages	$	11	Discounted cash flow method	Discount used in discounted cash flow method	10% (10%)

The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at December 31, 2016:


	Fair value		Valuation Technique	Unobservable Inputs	Range (Weighted Average)
Impaired loans – commercial mortgages	$	2,067	Sales comparison approach and discounted cash flow method	Adjustment for differences between the comparable sales and discount used in discounted cash flows	10% – 14% (13%)

Fair Value of Financial Instruments

The following table presents the carrying amount and fair value of financial instruments at December 31, 2017:


	Carrying Amount			Fair Value Measurement Using:									Total Fair Value
	Carrying Amount			Level 1			Level 2			Level 3			Total Fair Value
ASSETS
Cash and cash equivalents	$	35,345		$	35,345		$	0		$	0		$	35,345
Securities available for sale		409,709			962			408,747			0			409,709
Trading securities		7,150			7,098			52			0			7,150
Loans held for sale		852			0			853			0			853
Net loans		2,126,266			0			0			2,126,824			2,126,824
FHLB and other equity interests		21,517			n/a			n/a			n/a			n/a
Interest rate swaps		149			0			149			0			149
Accrued interest receivable		9,254			6			2,651			6,597			9,254

LIABILITIES
Deposits	$	(2,167,815	)	$	(1,802,844	)	$	(362,756	)	$	0		$	(2,165,600	)
FHLB and other borrowings		(257,359	)		0			(257,361	)		0			(257,361	)
Subordinated debentures		(70,620	)		0			(63,575	)		0			(63,575	)
Deposits held for sale		0			0			0			0			0
Interest rate swaps		(310	)		0			(310	)		0			(310	)
Accrued interest payable		(554	)		0			(554	)		(0	)		(554	)

The following table presents the carrying amount and fair value of financial instruments at December 31, 2016:


	Carrying Amount			Fair Value Measurement Using:								Total Fair Value
	Carrying Amount			Level 1			Level 2			Level 3		Total Fair Value
ASSETS
Cash and cash equivalents	$	29,183		$	29,183		$	0		$	0	$	29,183
Securities available for sale		495,835			971			492,815			2,049		495,835
Trading securities		4,858			4,805			53			0		4,858
Loans held for sale		7,528			0			7,553			0		7,553
Net loans		1,857,206			0			0			1,817,341		1,817,341
FHLB and other equity interests		19,186			n/a			n/a			n/a		n/a
Interest rate swaps		211			0			211			0		211
Accrued interest receivable		8,264			6			3,014			5,244		8,264

LIABILITIES
Deposits	$	(2,017,522	)	$	(1,785,649	)	$	(219,765	)	$	0	$	(2,005,414	)
FHLB and other borrowings		(237,004	)		0			(226,769	)		0		(226,769	)
Subordinated debentures		(70,620	)		0			(61,831	)		0		(61,831	)
Deposits held for sale		(6,456	)		0			(6,417	)		0		(6,417	)
Interest rate swaps		(670	)		0			(670	)		0		(670	)
Accrued interest payable		(510	)		0			(510	)		0		(510	)

The methods and assumptions, not otherwise presented, used to estimate fair values are described as follows:

Cash and cash equivalents: The carrying amounts of cash and cash equivalents approximate fair values and are classified as Level 1.

Loans held for sale: The fair value of loans held for sale is estimated based upon binding contracts and quotes from third party investors resulting in a Level 2 classification.

Loans: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values, resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality, resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

Deposits held for sale: The fair value of deposits held for sale is estimated based upon binding contracts and quotes from third party investors resulting in a Level 2 classification.

FHLB and other equity interests: It is not practical to determine the fair value of Federal Home Loan Bank stock and other equity interests due to restrictions placed on the transferability of these instruments.

Accrued interest receivable: The carrying amount of accrued interest receivable approximates fair value resulting in a classification that is consistent with the asset with which it is associated.

Deposits: The fair values disclosed for demand deposits are, by definition, equal to the amount payable on demand at the reporting date (i.e. their carrying amount), resulting in a Level 1 classification. Fair values for time deposits are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits, resulting in a Level 2 classification.

FHLB and other borrowings: The fair values of the Corporation’s FHLB and other borrowings are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements, resulting in a Level 2 classification.

Subordinated debentures: The fair value of the Corporation’s subordinated debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of arrangements, resulting in a Level 3 classification.

Accrued interest payable: The carrying amount of accrued interest payable approximates fair value resulting in a classification that is consistent with the liability with which it is associated.

While estimates of fair value are based on management’s judgment of the most appropriate factors as of the balance sheet date, there is no assurance that the estimated fair values would have been realized if the assets had been disposed of or the liabilities settled at that date, since market values may differ depending on various circumstances. The estimated fair values would also not apply to subsequent dates.

In addition, other assets and liabilities that are not financial instruments, such as premises and equipment, are not included in the disclosures. Also, non-financial assets such as, among other things, the estimated earnings power of core deposits, the earnings potential of trust accounts, the trained workforce, and customer goodwill, which typically are not recognized on the balance sheet, may have value but are not included in the fair value disclosures.