NOTE 7 – FAIR VALUE

Fair value is 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. There are three levels of inputs that may be 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.

When possible, the Company looks to active and observable markets to price identical assets or liabilities. When identical assets and liabilities are not traded in active markets, the Company looks to observable market data for similar assets and liabilities. However, certain assets and liabilities are not traded in observable markets and the Company must use other valuation methods to develop a fair value.

Carrying amount is the estimated fair value for cash and due from banks, Federal funds sold, accrued interest receivable and payable, demand deposits, short-term debt, and deposits that reprice frequently and fully. Fair values of time deposits with other banks are based on current rates for similar time deposits using the remaining time to maturity. It was not practicable to determine the fair value of Federal Home Loan Bank stock due to the restrictions placed on its transferability. For deposits and variable rate deposits with infrequent repricing, fair value is based on discounted cash flows using current market rates applied to the estimated life. The methodology for the fair value valuation of loans held for investment has been impacted by the adoption of ASU 2016-01. Fair values for loans had been previously based upon the measured at the entry price notion by using the discounted cash flow or collateral value. The newly adopted exit price notion uses the same approach but also incorporates additional factors such as using economic factors, credit risk, and market rates and conditions. The new definition using the exit price focuses on the price that would be received to sell the asset or paid to transfer the liability, not the price that would be paid to acquire the asset or received to assume the liability. As of June 30, 2018, the technique used by the Company to estimate the exit price of the loan portfolio consists of similar procedures to those used as of December 31, 2017, but with added emphasis on both illiquidity risk and credit risk not captured by the previously applied entry price notion. 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, using the eight categories as disclosed in Note 3 – Loans.

Fair values for impaired loans are estimated using discounted cash flow analysis or underlying collateral values. Fair value of debt is based on current rates for similar financing. The fair value of commitments to extend credit and standby letters of credit is not material.

The Company used the following methods and significant assumptions to estimate the fair value of each type of financial instrument measured on a recurring basis:

Investment Securities: The fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3).

The carrying amounts and estimated fair values of financial instruments at June 30, 2018 were as follows:

				Fair Value Measurements at June 30, 2018 Using
	Carrying Amount			Level 1			Level 2			Level 3		Total
Financial assets
Cash and due from banks	$	108,436		$	108,436		$	-		$	-	$	108,436
Time deposits with other banks		2,582			-			2,569			-		2,569
Federal funds sold		3,092			3,092			-			-		3,092
Securities available for sale		297,692			-			297,692			-		297,692
Loans, net		1,014,671			-			-			1,005,002		1,005,002
Federal Home Loan Bank stock		3,173			n/a			n/a			n/a		n/a
Interest receivable		3,764			-			763			3,001		3,764

Financial liabilities
Deposits	$	(1,294,156	)	$	(954,185	)	$	(333,058	)	$	-	$	(1,287,243	)
Securities sold under agreements to repurchase		(21,865	)		-			(21,865	)		-		(21,865	)
Other borrowed funds		(3,800	)		-			(3,747	)		-		(3,747	)
Subordinated debt		(5,391	)		-			(5,500	)		-		(5,500	)
Interest payable		(462	)		(10	)		(452	)		-		(462	)

The carrying amounts and estimated fair values of financial instruments at December 31, 2017 were as follows:

				Fair Value Measurements at December 31, 2017 Using
	Carrying Amount			Level 1			Level 2			Level 3		Total
Financial assets
Cash and due from banks	$	78,005		$	78,005		$	-		$	-	$	78,005
Time deposits with other banks		2,582			-			2,581			-		2,581
Federal funds sold		4,658			4,658			-			-		4,658
Securities available for sale		278,466			-			278,466			-		278,466
Loans, net		1,036,948			-			-			1,016,723		1,016,723
Federal Home Loan Bank stock		3,185			n/a			n/a			n/a		n/a
Interest receivable		4,043			-			700			3,343		4,043

Financial liabilities
Deposits	$	(1,272,675	)	$	(929,202	)	$	(338,291	)	$	-	$	(1,267,493	)
Securities sold under agreements to repurchase		(23,310	)		-			(23,310	)		-		(23,310	)
Other borrowed funds		(5,000	)		-			(4,955	)		-		(4,955	)
Subordinated debt		(5,376	)		-			(5,439	)		-		(5,439	)
Interest payable		(393	)		(7	)		(386	)		-		(393	)

Assets and Liabilities Measured on a Recurring Basis

Assets and liabilities measured at fair value on a recurring basis are summarized below:

			Fair Value Measurements at June 30, 2018 Using:
	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Available for sale
Mortgage-backed securities
U. S. agency MBS - residential	$	208,468	$	-	$	208,468	$	-
U. S. agency CMO’s - residential		66,033		-		66,033		-
Total mortgage-backed securities of government sponsored agencies		274,501		-		274,501		-
U. S. government sponsored agency securities		14,023		-		14,023		-
Obligations of states and political subdivisions		9,168		-		9,168		-
Total securities available for sale	$	297,692	$	-	$	297,692	$	-

			Fair Value Measurements at December 31, 2017 Using:
	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Available for sale
Mortgage-backed securities
U. S. agency MBS - residential	$	196,590	$	-	$	196,590	$	-
U. S. agency CMO’s		51,108		-		51,108		-
Total mortgage-backed securities of government sponsored agencies		247,698		-		247,698		-
U. S. government sponsored agency securities		19,134		-		19,134		-
Obligations of states and political subdivisions		11,634		-		11,634		-
Total securities available for sale	$	278,466	$	-	$	278,466	$	-

There were no transfers between Level 1 and Level 2 during 2018 or 2017.

Assets and Liabilities Measured on a Non-Recurring Basis

The Company used the following methods and significant assumptions to estimate the fair value of each type of financial instrument measured on a non-recurring basis:

Impaired loans: The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent collateral appraisals. Real estate 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 typically significant and unique to each property and result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports. Management periodically evaluates the appraised collateral values and will discount the collateral’s appraised value to account for a number of factors including but not limited to the cost of liquidating the collateral, the age of the appraisal, observable deterioration since the appraisal, management’s expertise and knowledge of the client and client’s business, or other factors unique to the collateral. To the extent an adjusted collateral value is lower than the carrying value of an impaired loan, a specific allocation of the allowance for loan losses is assigned to the loan.

Other real estate owned (OREO): The fair value of OREO is based on appraisals less cost to sell at the date of foreclosure. Management may obtain additional updated appraisals depending on the length of time since foreclosure. 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 typically significant and result in a Level 3 classification of the inputs for determining fair value. Management periodically evaluates the appraised values and will discount a property’s appraised value to account for a number of factors including but not limited to the cost of liquidating the collateral, the age of the appraisal, observable deterioration since the appraisal, or other factors unique to the property. To the extent an adjusted appraised value is lower than the carrying value of an OREO property, a direct charge to earnings is recorded as an OREO write-down.

Assets and liabilities measured at fair value on a non-recurring basis at June 30, 2018 are summarized below:

			Fair Value Measurements at June 30, 2018 Using
	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Impaired loans:
Multifamily real estate	$	1,900	$	-	$	-	$	1,900
Commercial real estate
Owner occupied		468		-		-		468
Non-owner occupied		1,928		-		-		1,928
Construction and land		3,521		-		-		3,521
Total impaired loans	$	7,817	$	-	$	-	$	7,817

Other real estate owned:
Residential real estate	$	372	$	-	$	-	$	372
Commercial real estate
Owner occupied		175		-		-		175
Non-owner occupied		200		-		-		200
Construction and land		150		-		-		150
Total OREO	$	897	$	-	$	-	$	897

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $9,423,000 at June 30, 2018 with a valuation allowance of $1,605,000 and a carrying amount of $9,384,000 at December 31, 2017 with a valuation allowance of $1,502,000. The change resulted in a provision for loan losses of $520,000 for the six-months ended June 30, 2018, compared to a $763,000 provision for loan losses for the six-months ended June 30, 2017 and a $187,000 decrease in provision for loans losses for the three months ended June 30, 2018, compared to a $678,000 provision for loan losses for the three months ended June 30, 2017. The detail of impaired loans by loan class is contained in Note 3 above.

Other real estate owned measured at fair value less costs to sell, had a net carrying amount of $897,000 which is made up of the outstanding balance of $1,638,000 net of a valuation allowance of $741,000 at June 30, 2018. There were $120,000 of write downs during the six months ended June 30, 2018, compared to $363,000 of write downs during the six months ended June 30, 2017. For the three months ended June 30, 2018 there were $120,000 of additional write downs compared to $324,000 of additional write downs during the three months ended June 30, 2017. At December 31, 2017, other real estate owned had a net carrying amount of $2,641,000, made up of the outstanding balance of $4,082,000, net of a valuation allowance of $1,441,000.

The significant unobservable inputs related to assets and liabilities measured at fair value on a non-recurring basis at June 30, 2018 are summarized below:

	June 30, 2018		Valuation Techniques	Unobservable Inputs	Range (Weighted Avg)
Impaired loans:
Multifamily real estate	$	1,900	sales comparison	adjustment for estimated realizable value		46.7%-46.7% (46.7	%)
Commercial real estate
Owner occupied		468	sales comparison	adjustment for estimated realizable value		36.9%-36.9% (36.9	%)
Non-owner occupied		1,928	income approach	adjustment for differences in net operating income expectations		67.4%-67.4% (67.4	%)
Construction and land		3,521	sales comparison	adjustment for percentage of completion of construction		25.1%-35.8% (34.1	%)
Total impaired loans	$	7,817

Other real estate owned:
Residential real estate	$	372	sales comparison	adjustment for estimated realizable value		9.2%-19.2% (13.5	%)
Commercial real estate
Owner occupied		175	sales comparison	adjustment for estimated realizable value		21.8%-21.8% (21.8	%)
Non-owner occupied		200	sales comparison	adjustment for estimated realizable value		58.9%-58.9% (58.9	%)
Construction and land		150	sales comparison	adjustment for estimated realizable value		50.3%-50.3% (50.3	%)
Total OREO	$	897

Assets and liabilities measured at fair value on a non-recurring basis at December 31, 2017 are summarized below:

			Fair Value Measurements at December 31, 2017 Using
	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Impaired loans:
Multifamily real estate	$	1,910	$	-	$	-	$	1,910
Commercial real estate
Owner occupied		568		-		-		568
Non-owner occupied		1,984		-		-		1,984
Commercial and industrial		111		-		-		111
Construction and land		3,309		-		-		3,309
Total impaired loans	$	7,882	$	-	$	-	$	7,882

Other real estate owned:
Residential real estate	$	352	$	-	$	-	$	352
Commercial real estate
Owner occupied		175		-		-		175
Non-owner occupied		200		-		-		200
Construction and land		1,914		-		-		1,914
Total OREO	$	2,641	$	-	$	-	$	2,641

The significant unobservable inputs related to assets and liabilities measured at fair value on a non-recurring basis at December 31, 2017 are summarized below:

	December 31, 2017		Valuation Techniques	Unobservable Inputs	Range (Weighted Avg)
Impaired loans:
Multifamily real estate	$	1,910	sales comparison	adjustment for estimated realizable value		46.0%-46.7% (46.4	%)
Commercial real estate
Owner occupied		568	sales comparison	adjustment for estimated realizable value		23.1%-23.1% (23.1	%)
Non-owner occupied		1,984	income approach	adjustment for differences in net operating income expectations		67.4%-67.4% (67.4	%)
Commercial and industrial		111	sales comparison	adjustment for estimated realizable value		8.0%-71.1% (64.2	%)
Construction and land		3,309	sales comparison	adjustment for percentage of completion of construction		27.7%-27.7% (27.7	%)
Total impaired loans	$	7,882

Other real estate owned:
Residential real estate	$	352	sales comparison	adjustment for estimated realizable value		8.8%-50.2% (20.0	%)
Commercial real estate
Owner occupied		175	sales comparison	adjustment for estimated realizable value		21.8%-21.8% (21.8	%)
Non-owner occupied		200	sales comparison	adjustment for estimated realizable value		58.9%-58.9% (58.9	%)
Construction and land		1,914	sales comparison	adjustment for estimated realizable value		25.2%-69.0% (27.8	%)
Total OREO	$	2,641