Note 15.Fair Value of Financial Instruments

Under FASB ASC Topic 820 “Fair Value Measurements and Disclosures” (“ASC Topic 820”), fair values are based on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When available, management uses quoted market prices to determine fair value. If quoted prices are not available, fair value is based upon valuation techniques such as matrix pricing or other models that use, where possible, current market-based or independently sourced market parameters, such as interest rates. If observable market-based inputs are not available, we use unobservable inputs to determine appropriate valuation adjustments using discounted cash flow methodologies.

Management uses its best judgment in estimating the fair value of our financial instruments; however, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts we could have realized in a sales transaction on the dates indicated. The estimated fair value amounts have been measured as of their respective period end and have not been re-evaluated or updated for purposes of these financial statements subsequent to those respective dates. As such, the estimated fair values of these financial instruments subsequent to the respective reporting dates may be different from the amounts reported at each period-end.

ASC Topic 820 provides guidance for estimating fair value when the volume and level of activity for an asset or liability has significantly declined and for identifying circumstances when a transaction is not orderly. ASC Topic 820 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 ASC Topic 820 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 in markets 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 includes debt securities with quoted prices that are traded less frequently then exchange-traded instruments. Valuation techniques include matrix pricing which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices.

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

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. We did not have transfers of financial instruments within the fair value hierarchy during the three and six months ended June 30, 2017 and 2016.

Items Measured on a Recurring Basis

Our available for sale investment securities are recorded at fair value on a recurring basis.

Fair value for Level 1 securities are determined by obtaining quoted market prices on nationally recognized securities exchanges. Level 1 securities include common stocks.

Level 2 securities include obligations of U.S. government-sponsored agencies and debt securities with quoted prices, which are traded less frequently than exchange-traded instruments, whose value is determined using matrix pricing with inputs that are observable in the market or can be derived principally from or corroborated by observable market data. The prices were obtained from third party vendors. This category generally includes our mortgage-backed securities and CMOs issued by U.S. government and government-sponsored agencies, non-agency CMOs, and corporate and municipal bonds. Additionally, Level 2 includes derivative instruments whose valuations are based on observable market data.

Level 3 securities include investments in five private equity funds which are predominantly invested in real estate. The value of the private equity funds are derived from the funds’ financials and K-1 filings. We also review the funds’ asset values and its near-term projections.

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 June 30, 2017 and December 31, 2016 are as follows:


	Fair Value Measurements Using:
	Quoted Prices
	in Active		Significant
	Markets for		Other		Significant
	Identical		Observable		Unobservable
As of June 30, 2017	Assets		Inputs		Inputs
(In thousands)	Level 1		Level 2		Level 3		Fair Value
Assets:
Investment securities available for sale
U.S. government agencies	$	—	$	2,122	$	—	$	2,122
Mortgage-backed securities-residential		—		7,207		—		7,207
Collateralized mortgage obligations:
Issued or guaranteed by U.S. government agencies		—		115,589		—		115,589
Corporate bonds		—		1,728		—		1,728
Municipal bonds		—		7,558		—		7,558
Other securities		—		—		1,706		1,706
Common stocks		26		—		—		26
Total investment securities available for sale	$	26	$	134,204	$	1,706	$	135,936
Liabilities:
Derivative instruments
Interest rate swaps	$	—	$	464	$	—	$	464


	Fair Value Measurements Using:
	Quoted Prices
	in Active		Significant
	Markets for		Other		Significant
	Identical		Observable		Unobservable
As of December 31, 2016	Assets		Inputs		Inputs
(In thousands)	Level 1		Level 2		Level 3		Fair Value
Assets:
Investment securities available for sale
U.S. government agencies	$	—	$	966	$	—	$	966
Mortgage-backed securities-residential		—		7,038		—		7,038
Collateralized mortgage obligations:
Issued or guaranteed by U.S. government agencies		—		145,559		—		145,559
Non-agency		—		4,035		—		4,035
Corporate bonds		—		1,701		—		1,701
Municipal bonds		—		8,708		—		8,708
Other securities		—		—		1,821		1,821
Common stocks		26		—		—		26
Total investment securities available for sale	$	26	$	168,007	$	1,821	$	169,854
Liabilities:
Derivative instruments
Interest rate swaps	$	—	$	494	$	—	$	494

The following tables present additional information about assets measured at fair value on a recurring basis and for which the Company has utilized Level 3 inputs to determine fair value for the three and six months ended June 30, 2017 and 2016:


(In thousands)	Other securities
Investment Securities Available for Sale	2017		2016
Beginning balance April 1,	$	1,821	$	2,431
Total gains/(losses) - (realized/unrealized):
Included in earnings-net gains on sale and OTTI		192		634
Included in other comprehensive income		—		(315)
Purchases		—		31
Sales and calls		(307)		(904)
Transfers in and/or out of Level 3		—		—
Ending balance June 30,	$	1,706	$	1,877


(In thousands)	Other securities
Investment Securities Available for Sale	2017		2016
Beginning balance January 1,	$	1,821	$	2,495
Total gains/(losses) - (realized/unrealized):
Included in earnings-net gains on sale and OTTI		192		935
Included in other comprehensive income		—		(445)
Purchases		—		104
Sales and calls		(307)		(1,212)
Transfers in and/or out of Level 3		—		—
Ending balance June 30,	$	1,706	$	1,877

Items Measured on a Nonrecurring Basis

Non-accrual loans and TDRs are evaluated for impairment on an individual basis under FASB ASC Topic 310 “Receivables”. The impairment analysis includes current collateral values, known relevant factors that may affect loan collectability, and risks inherent in different kinds of lending. When the collateral value or discounted cash flows less costs to sell is less than the carrying value of the loan a specific reserve (valuation allowance) is established. Loans held for sale are carried at the lower of cost or fair value. OREO is carried at the lower of cost or fair value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the real estate. Additionally, for collateral acquired from tax liens, fair value may be established using brokers opinions due to their lower carrying value. 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 financial assets measured at fair value on a nonrecurring basis, the fair value measurements by level within the fair value hierarchy used at June 30, 2017 and December 31, 2016 are as follows:

Fair Value Measurements Using:

Quoted Prices

in Active

Significant

Markets for

Other

Significant

Identical

Observable

Unobservable

As of June 30, 2017

Assets

Inputs

(In thousands)

Level 1

Level 2

Level 3

Fair Value

Assets

Impaired loans and leases

—

2,300

Other real estate owned

—

925

Fair Value Measurements Using:

Quoted Prices

in Active

Significant

Markets for

Other

Significant

Identical

Observable

Unobservable

As of December 31, 2016

Assets

Inputs

(In thousands)

Level 1

Level 2

Level 3

Fair Value

Assets

Impaired loans and leases

—

6,102

Other real estate owned

—

1,471

The following tables present additional quantitative information about assets measured at fair value on a nonrecurring basis and for which we have utilized Level 3 inputs to determine fair value at June 30, 2017 and December 31, 2016:


	Qualitative Information about Level 3 Fair Value Measurements
As of June 30, 2017			Valuation		Range
(In thousands)	Fair Value		Techniques	Unobservable Input	(Weighted Average)
Impaired loans and leases	$	2,300	Appraisal of	Appraisal adjustments	0.0%	-	-20.0%	(-15.4%)
			collateral (1)	Liquidation expenses	0.0%	-	-8.2%	(-3.4%)

Other real estate owned		925	Appraisal of	Appraisal adjustments	0.0%	-	-43.8%	(-24.0%)
			collateral (1)	Liquidation expenses			-5.0%	(-5.0%)


	Qualitative Information about Level 3 Fair Value Measurements
As of December 31, 2016			Valuation		Range
(In thousands)	Fair Value		Techniques	Unobservable Input	(Weighted Average)
Impaired loans and leases	$	6,102	Appraisal of	Appraisal adjustments	0.0%	-	-27.4%	(-12.3%)
			collateral (1)	Liquidation expenses	0.0%	-	-12.8%	(-5.2%)

Other real estate owned		1,471	Appraisal of	Appraisal adjustments	0.0%	-	-61.5%	(-32.5%)
			collateral (1)	Liquidation expenses	0.0%	-	-5.6%	(-5.6%)

(1)

Appraisals may be adjusted for qualitative factors such as interior condition of the property and liquidation expenses.

The following methods and assumptions were used to estimate the fair values of our financial instruments at June 30, 2017 and December 31, 2016. 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 our assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between our disclosures and those of other companies may not be meaningful. The methodologies for estimating the fair value of financial instruments that are measured on a recurring or nonrecurring basis are discussed above.

Cash and cash equivalents (carried at cost):

The carrying amounts reported in the balance sheet for cash and short-term instruments approximate those assets’ fair values.

Securities:

Management uses quoted market prices to determine fair value of securities (level 1). If quoted prices are not available, fair value is based upon valuation techniques such as matrix pricing or other models that use, where possible, current market-based or independently sourced market parameters, such as interest rates (level 2). If observable market-based inputs are not available, we use unobservable inputs to determine appropriate valuation adjustments by reviewing the private equities funds’ financials and K-1 filings (level 3).

Other Investment (carried at cost):

This investment includes the Solomon Hess SBA Loan Fund, which we invested in to partially satisfy Royal Bank’s community reinvestment requirement. Shares in this fund are not publicly traded and therefore have no readily determinable fair market value. An investor can have its investment in the Fund redeemed for the balance of its capital account at any quarter end with 60-days notice to the Fund. The investment in this Fund is recorded at cost. We do not record this investment at fair value on a recurring basis, as this investment’s carrying amount approximates fair value.

Restricted investment in bank stock (carried at cost):

The carrying amount of restricted investment in bank stock approximates fair value, and considers the limited marketability of such securities.

Loans held for sale (carried at lower of cost or fair value):

The fair values of loans held for sale are based upon appraised values of the collateral less costs to sell, management’s estimation of the value of the collateral or expected net sales 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.

Loans receivable (carried at cost):

The fair values of loans are estimated using discounted cash flow analyses, using market rates at the balance sheet date that reflect the credit and interest rate-risk inherent in the loans. Projected future cash flows are calculated based upon contractual maturity or call dates, projected repayments and prepayments of principal. Generally, for variable rate loans that re-price frequently and with no significant change in credit risk, fair values are based on carrying values.

Impaired loans (generally carried at fair value):

Impaired loans are accounted for under ASC Topic 310. Impaired loans are those in which we have measured impairment generally based on the fair value of the loan’s collateral. Fair value is generally determined based upon independent third-party appraisals of the properties, or discounted cash flows based on 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.

Accrued interest receivable and payable (carried at cost):

The carrying amount of accrued interest receivable and accrued interest payable approximates its fair value.

Deposit liabilities (carried at cost):

The fair values disclosed for demand deposits (e.g., interest and noninterest checking, passbook savings and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market on certificates to a schedule of aggregated expected monthly maturities on time deposits.

Long-term debt (carried at cost):

Fair values of FHLB advances and other long-term borrowings are estimated using discounted cash flow analysis, based on quoted prices for new FHLB advances with similar credit risk characteristics, terms and remaining maturity. These prices obtained from this active market represent a market value that is deemed to represent the transfer price if the liability were assumed by a third party.

Subordinated debt (carried at cost):

Fair values of junior subordinated debt are estimated using discounted cash flow analysis, based on market rates currently offered on such debt with similar credit risk characteristics, terms and remaining maturity.

Derivative instruments:

We have contracted with a third party vendor to provide periodic valuations for our interest rate derivatives to determine the fair value of our interest rate swaps. The vendor utilizes standard valuation methodologies applicable to interest rate derivatives such as discounted cash flow analysis and extensions of the Black-Scholes model. Such valuations are based upon readily observable market data and are therefore considered Level 2 valuations by the Company.

Off-balance sheet financial instruments (disclosed at cost):

Fair values of our off-balance sheet financial instruments (lending commitments and letters of credit) are based on fees currently charged in the market to enter into similar agreements, taking into account, the remaining terms of the agreements and the counterparties’ credit standing. They are not shown in the table because the amounts are immaterial.

The tables below indicate the fair value of our financial instruments at June 30, 2017 and December 31, 2016.


					Fair Value Measurements
					At June 30, 2017
					Quoted Prices
					in Active		Significant
					Markets for		Other		Significant
					Identical		Observable		Unobservable
	Carrying		Estimated		Assets		Inputs		Inputs
(In thousands)	amount		fair value		Level 1		Level 2		Level 3
Financial Assets:
Cash and cash equivalents	$	31,711	$	31,711	$	31,711	$	—	$	—
Investment securities available for sale		135,936		135,936		26		134,204		1,706
Other investment		2,250		2,250		—		—		2,250
Federal Home Loan Bank stock		2,276		2,276		—		—		2,276
Loans, net		595,431		584,618		—		—		584,618
Accrued interest receivable		3,277		3,277		—		3,277		—
Financial Liabilities:
Demand deposits		101,379		101,379		—		101,379		—
NOW and money markets		199,657		199,657		—		199,657		—
Savings		87,432		87,432		—		87,432		—
Certificates of deposit and brokered funds		234,353		234,280		—		234,280		—
Short-term borrowings		21,000		21,000		21,000		—		—
Long-term borrowings		60,000		59,967		—		59,967		—
Subordinated debt		25,774		26,091		—		26,091		—
Accrued interest payable		1,930		1,930		—		1,930		—
Derivative Instruments (Liability):
Interest rate swaps		464		464		—		464		—


					Fair Value Measurements
					At December 31, 2016
					Quoted Prices
					in Active		Significant
					Markets for		Other		Significant
					Identical		Observable		Unobservable
	Carrying		Estimated		Assets		Inputs		Inputs
(In thousands)	amount		fair value		Level 1		Level 2		Level 3
Financial Assets:
Cash and cash equivalents	$	21,230	$	21,230	$	21,230	$	—	$	—
Investment securities available for sale		169,854		169,854		26		168,007		1,821
Other investment		2,250		2,250		—		—		2,250
Federal Home Loan Bank stock		3,216		3,216		—		—		3,216
Loans, net		591,589		578,732		—		—		578,732
Accrued interest receivable		3,968		3,968		—		3,968		—
Financial Liabilities:
Demand deposits		97,859		97,859		—		97,859		—
NOW and money markets		213,140		213,140		—		213,140		—
Savings		85,170		85,170		—		85,170		—
Certificates of deposit and brokered funds		233,377		233,288		—		233,288		—
Short-term borrowings		19,000		19,000		19,000		—		—
Long-term borrowings		85,000		84,617		—		84,617		—
Subordinated debt		25,774		26,538		—		26,538		—
Accrued interest payable		711		711		—		711		—
Derivative Instruments (Liability):
Interest rate swaps		494		494		—		494		—

Limitations

The fair value estimates are made at a discrete point in time based on relevant market information and information about the financial instruments. Fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors.

These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Further, the foregoing estimates may not reflect the actual amount that could be realized if all or substantially all of the financial instruments were offered for sale. This is due to the fact that no market exists for a sizable portion of the loan, deposit and off balance sheet instruments.

In addition, the fair value estimates are based on existing on-and-off balance sheet financial instruments without attempting to value anticipated future business and the value of assets and liabilities that are not considered financial instruments. Other significant assets that are not considered financial assets include premises and equipment. 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 any of the estimates.

Finally, 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 introduces a greater degree of subjectivity to these estimated fair values.