Note 7 – Fair Value of Financial Instruments

The Corporation complies with the guidance of ASC Topic 820, Fair Value Measurements and Disclosures, which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements required under other accounting pronouncements. The Corporation also follows the guidance on matters relating to all financial instruments found in ASC Subtopic 825-10, Financial Instruments – Overall.

Fair value is defined as the price to sell an asset or to transfer a liability in an orderly transaction between willing market participants as of the measurement date. Fair value is best determined by values quoted through active trading markets. Active trading markets are characterized by numerous transactions of similar financial instruments between willing buyers and willing sellers. Because no active trading market exists for various types of financial instruments, many of the fair values disclosed were derived using present value discounted cash flows or other valuation techniques described below. As a result, the Corporation’s ability to actually realize these derived values cannot be assumed.

The Corporation measures fair values based on the fair value hierarchy established in ASC Paragraph 820-10-35-37. 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 inputs that may be used to measure fair value under the hierarchy are as follows:

Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets and liabilities. This level is the most reliable source of valuation.

Level 2: Quoted prices that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability. Level 2 inputs include inputs other than quoted prices that are observable for the asset or liability (for example, interest rates and yield curves at commonly quoted intervals, volatilities, prepayment speeds, loss severities, credit risks, and default rates). It also includes inputs that are derived principally from or corroborated by observable market data by correlation or other means (market-corroborated inputs). Several sources are utilized for valuing these assets, including a contracted valuation service, Standard & Poor’s (“S&P”) evaluations and pricing services, and other valuation matrices.

Level 3: Prices or valuation techniques that require inputs that are both significant to the valuation assumptions and not readily observable in the market (i.e. supported with little or no market activity). Level 3 instruments are valued based on the best available data, some of which is internally developed, and consider risk premiums that a market participant would require.

The level established within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. Transfers in and out of Level 1, 2 or 3 are recorded at fair value at the beginning of the reporting period.

Management believes that the Corporation’s valuation techniques are appropriate and consistent with the techniques used by other market participants. However, the use of different methodologies and assumptions could result in a different estimate of fair values at the reporting date. The valuation techniques used by the Corporation to measure, on a recurring and non-recurring basis, the fair value of assets as of September 30, 2019 are discussed in the paragraphs that follow.

Investments – The investment portfolio is classified and accounted for based on the guidance of ASC Topic 320, Investments – Debt and Equity Securities.

The fair value of investments is determined using a market approach. As of September 30, 2019, the U.S. Government agencies, residential and commercial mortgage-backed securities, collateralized mortgage obligations, and state and political subdivisions bonds, excluding the TIF bonds, segments are classified as Level 2 within the valuation hierarchy. Their fair values were determined based upon market-corroborated inputs and valuation matrices, which were obtained through third party data service providers or securities brokers through which the Corporation has historically transacted both purchases and sales of investment securities. The TIF bonds are classified as Level 3 within the valuation hierarchy as they are not openly traded.

The CDO segment, which consists of pooled trust preferred securities issued by banks, thrifts and insurance companies, is classified as Level 3 within the valuation hierarchy. At September 30, 2019, the Corporation owned nine pooled trust preferred securities with an amortized cost of $18.4 million and a fair value of $13.5 million. As of September 30, 2019, the market for these securities is not active and the markets for similar securities are also not active. The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which these securities trade and then by a significant decrease in the volume of trades relative to historical levels. The new issue market is also inactive, as few CDOs have been issued since 2007. There are currently very few market participants who are willing to effect transactions in these securities. The market values for these securities or any securities other than those issued or guaranteed by the U.S. Department of the Treasury (the “Treasury”) are depressed relative to historical levels. Therefore, in the current market, a low market price for a particular bond may only provide evidence of stress in the credit markets in general rather than being an indicator of credit problems with a particular issue. Given the conditions in the current debt markets and the absence of observable transactions in the secondary and new issue markets, management has determined that (a) the few observable transactions and market quotations that are available are not reliable for the purpose of obtaining fair value at September 30, 2019, (b) an income valuation approach technique (i.e. present value) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs will be equally or more representative of fair value than a market approach, and (c) the CDO segment is appropriately classified within Level 3 of the valuation hierarchy because management determined that significant adjustments were required to determine fair value at the measurement date.

Management relies on an independent third party to prepare both the evaluations of OTTI as well as the fair value determinations for its CDO portfolio. Management believes that the valuations are adequately reflected at September 30, 2019.

The approach used by the third party to determine fair value involved several steps, which included detailed credit and structural evaluation of each piece of collateral in each bond, projection of default, recovery and prepayment/amortization probabilities for each piece of collateral in the bond, and discounted cash flow modeling. The discount rate methodology used by the third party combines a baseline current market yield for comparable corporate and structured credit products with adjustments based on evaluations of the differences found in structure and risks associated with actual and projected credit performance of each CDO being valued. Currently, the only active and liquid trading market that exists is for stand-alone trust preferred securities, with a limited market for highly-rated CDO securities that are more senior in the capital structure than the securities in the CDO portfolio. Therefore, adjustments to the baseline discount rate are also made to reflect the additional leverage found in structured instruments.

Derivative financial instruments (Cash flow hedge) – The Corporation’s open derivative positions are interest rate swap agreements. Those classified as Level 2 open derivative positions are valued using externally developed pricing models based on observable market inputs provided by a third party and validated by management. The Corporation has considered counterparty credit risk in the valuation of its interest rate swap assets.

Impaired loans – Loans included in the table below are those that are considered impaired with a specific allocation or with a partial charge-off, based upon the guidance of the loan impairment subsection of the Receivables Topic, ASC Section 310-10-35, under which the Corporation has measured impairment generally based on the fair value of the loan’s collateral. Fair value consists of the loan balance less its valuation allowance and is generally determined based on independent third-party appraisals of the collateral or discounted cash flows based upon the expected proceeds. These assets are included as Level 3 fair values based upon the lowest level of input that is significant to the fair value measurements.

Other real estate owned – OREO included in the table below are considered impaired with specific write-downs. Fair value of other real estate owned is based on independent third-party appraisals of the properties. These values were determined based on the sales prices of similar properties in the approximate geographic area. These assets are included as Level 3 fair values based upon the lowest level of input that is significant to the fair value measurements.

For Level 3 assets and liabilities measured at fair value on a recurring and non-recurring basis as of September 30, 2019 and December 31, 2018, the significant unobservable inputs used in the fair value measurements were as follows:



(in thousands)	Fair Value at September 30, 2019		Valuation Technique	Significant Unobservable Inputs	Significant Unobservable Input Value
Recurring:
Investment Securities – available for sale	$	13,467	Discounted Cash Flow	Discount Rate	Range of LIBOR+ 5.25%
Non-recurring:
Impaired Loans	$	6,797	Market Comparable Properties	Marketability Discount	10.0% - 15.0% (1) (weighted avg 13.1%)
Other Real Estate Owned	$	3,114	Market Comparable Properties	Marketability Discount	10.0% - 15.0% (1) (weighted avg 12.2%)

(in thousands)	Fair Value at December 31, 2018		Valuation Technique	Significant Unobservable Inputs	Significant Unobservable Input Value
Recurring:
Investment Securities – available for sale	$	15,277	Discounted Cash Flow	Discount Rate	Range of LIBOR+ 4.50%
Non-recurring:
Impaired Loans	$	1,316	Market Comparable Properties	Marketability Discount	10.0% - 15.0% (1) (weighted avg 12.8%)
Other Real Estate Owned	$	2,707	Market Comparable Properties	Marketability Discount	10.0% - 15.0% (1) (weighted avg 13.5%)

NOTE:

(1)

Range would include discounts taken since appraisal and estimated values

For assets measured at fair value on a recurring and non-recurring basis, the fair value measurements by level within the fair value hierarchy used at September 30, 2019 and December 31, 2018 are as follows:



			Fair Value Measurements at September 30, 2019 Using
	Assets Measured at Fair Value		Quoted Prices in Active Markets for Identical Assets	Significant Other Observable Inputs		Significant Unobservable Inputs
(in thousands)	09/30/19		(Level 1)	(Level 2)		(Level 3)
Recurring:
Investment securities available-for-sale:
U.S. government agencies	$	39,914		$	39,914
Commercial mortgage-backed agencies	$	34,853		$	34,853
Collateralized mortgage obligations	$	32,330		$	32,330
Obligations of states and political subdivisions	$	14,512		$	14,512
Collateralized debt obligations	$	13,467				$	13,467
Financial Derivatives	$	(383)		$	(383)
Non-recurring:
Impaired loans	$	6,797				$	6,797
Other real estate owned	$	3,114				$	3,114



			Fair Value Measurements at December 31, 2018 Using
	Assets Measured at Fair Value		Quoted Prices in Active Markets for Identical Assets	Significant Other Observable Inputs		Significant Unobservable Inputs
(in thousands)	12/31/18		(Level 1)	(Level 2)		(Level 3)
Recurring:
Investment securities available-for-sale:
U.S. government agencies	$	29,026		$	29,026
Commercial mortgage-backed agencies	$	37,752		$	37,752
Collateralized mortgage obligations	$	35,704		$	35,704
Obligations of states and political subdivisions	$	19,882		$	19,882
Collateralized debt obligations	$	15,277				$	15,277
Financial Derivative	$	1,043		$	1,043
Non-recurring:
Impaired loans	$	1,316				$	1,316
Other real estate owned	$	2,707				$	2,707

There were no transfers of assets between any of the fair value hierarchy for the nine-month periods ended September 30, 2019 or 2018.

The following tables show a reconciliation of the beginning and ending balances for fair valued assets measured on a recurring basis using Level 3 significant unobservable inputs for the nine- and three-month periods ended September 30, 2019 and 2018:



	Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
(in thousands)	Investment Securities Available for Sale
Beginning balance January 1, 2019	$	15,277
Total losses realized/unrealized:
Included in other comprehensive income		(1,810)
Ending balance September 30, 2019	$	13,467



	Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
(in thousands)	Investment Securities Available for Sale
Beginning balance January 1, 2018	$	14,920
Total gains realized/unrealized:
Included in other comprehensive income		1,648
Ending balance September 30, 2018	$	16,568



	Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
(in thousands)	Investment Securities Available for Sale
Beginning balance July 1, 2019	$	14,872
Total losses realized/unrealized:
Included in other comprehensive loss		(1,405)
Ending balance September 30, 2019	$	13,467



	Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
(in thousands)	Investment Securities Available for Sale
Beginning balance July 1, 2018	$	16,147
Total gains realized/unrealized:
Included in other comprehensive income		421
Ending balance September 30, 2018	$	16,568

Gains/losses (realized and unrealized) included in earnings for the periods identified above are reported in the Consolidated Statement of Operations in Other Operating Income. There were no gains or losses included in earnings attributable to the change in realized/unrealized gains or losses related to the assets for the nine- and three-month periods ended September 30, 2019 and 2018.

The disclosed fair values may vary significantly between institutions based on the estimates and assumptions used in the various valuation methodologies. The derived fair values are subjective in nature and involve uncertainties and significant judgment. Therefore, they cannot be determined with precision. Changes in the assumptions could significantly impact the derived estimates of fair value. Disclosure of non-financial assets such as buildings as well as certain financial instruments such as leases is not required. Accordingly, the aggregate fair values presented do not represent the underlying value of the Corporation.

The following tables present fair value information about financial instruments, whether or not recognized in the Consolidated Statement of Financial Condition, for which it is practicable to estimate that value. The actual carrying amounts and estimated fair values of the Corporation’s financial instruments that are included in the Consolidated Statement of Financial Condition are as follows:



	September 30, 2019				Fair Value Measurements
	Carrying		Fair		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
(in thousands)	Amount		Value		(Level 1)		(Level 2)		(Level 3)
Financial Assets:
Cash and due from banks	$	82,219	$	82,219	$	82,219
Interest bearing deposits in banks		1,950		1,950		1,950
Investment securities - AFS		135,076		135,076			$	121,609	$	13,467
Investment securities - HTM		96,604		104,173				81,960		22,213
Restricted bank stock		4,415		4,415				4,415
Loans, net		985,313		974,145						974,145
Accrued interest receivable		4,088		4,088				4,088
Financial Liabilities:
Deposits - non-maturity		864,973		864,973				864,973
Deposits - time deposits		271,814		273,544				273,544
Financial derivatives		383		383				383
Short-term borrowed funds		50,345		50,345				50,345
Long-term borrowed funds		100,929		103,306				103,306
Accrued interest payable		519		519				519



	December 31, 2018				Fair Value Measurements
	Carrying		Fair		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
(in thousands)	Amount		Value		(Level 1)		(Level 2)		(Level 3)
Financial Assets:
Cash and due from banks	$	22,187	$	22,187	$	22,187
Interest bearing deposits in banks		1,354		1,354		1,354
Investment securities - AFS		137,641		137,641			$	122,364	$	15,277
Investment securities - HTM		94,010		93,760				80,780		12,980
Restricted bank stock		5,394		5,394				5,394
Loans, net		996,667		967,198						967,198
Financial derivative		1,043		1,043				1,043
Accrued interest receivable		4,175		4,175				4,175
Financial Liabilities:
Deposits - non-maturity		815,858		815,858				815,858
Deposits - time deposits		251,669		252,146				252,146
Short-term borrowed funds		77,707		77,707				77,707
Long-term borrowed funds		100,929		102,590				102,590
Accrued interest payable		455		455				455