3. Fair Value

FASB ASC Topic 820, Fair Value Measurements, defines fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction. Market participants are buyers and sellers in the principal market that are (i) independent, (ii) knowledgeable, (iii) able to transact and (iv) willing to transact.

FASB ASC Topic 820 requires the use of valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets and liabilities. The income approach uses valuation techniques to convert future amounts, such as cash flows or earnings, to a single present amount on a discounted basis. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (replacement cost). Valuation techniques should be consistently applied. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability developed based on the best information available. In that regard, FASB ASC Topic 820 established a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

Level 2: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by a correlation or other means.

Level 3: Unobservable inputs for determining fair value of assets and liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.

Available for sale securities - Securities classified as available for sale are generally reported at fair value utilizing Level 2 inputs where the Company obtains fair value measurements from an independent pricing service that uses 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 by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs). The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows and the bonds’ terms and conditions, among other things. Securities in Level 2 include U.S. federal government agencies, mortgage-backed securities, corporate bonds and municipal securities.

Impaired loans - Fair values for impaired collateral dependent loans are generally based on appraisals obtained from licensed real estate appraisers and in certain circumstances consideration of offers obtained to purchase properties prior to foreclosure. Appraisals for commercial real estate generally use three methods to derive value: cost, sales or market comparison and income approach. The cost method bases value on the cost to replace the current property. Value of market comparison approach evaluates the sales price of similar properties in the same market area. The income approach considers net operating income generated by the property and an investor’s required return. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Comparable sales adjustments are based on known sales prices of similar type and similar use properties and duration of time that the property has been on the market to sell. Such adjustments made in the appraisal process are typically significant and result in a Level 3 classification of the inputs for determining fair value.

Real estate held for sale - Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are then reviewed monthly by members of the asset review committee for valuation changes and are accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals which may utilize a single valuation approach or a combination of approaches including cost, comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments may be significant and typically result in a Level 3 classification of the inputs for determining fair value.

Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by the Company. Once received, a member of the Company’s asset quality or collections department reviews the assumptions and approaches utilized in the appraisal. Appraisal values are discounted from 0% to 30% to account for other factors that may impact the value of collateral. In determining the value of impaired collateral dependent loans and other real estate owned, significant unobservable inputs may be used, which include but are not limited to: physical condition of comparable properties sold, net operating income generated by the property and investor rates of return.

Mortgage servicing rights - On a quarterly basis, mortgage servicing rights are evaluated for impairment based upon the fair value of the rights as compared to the carrying amount. If the carrying amount of an individual tranche exceeds fair value, impairment is recorded on that tranche so that the servicing asset is carried at fair value. Fair value is determined at a tranche level based on a model that calculates the present value of estimated future net servicing income. The valuation model utilizes assumptions that market participants would use in estimating future net servicing income and are validated against available market data (Level 2).

Mortgage banking derivative - The fair value of mortgage banking derivatives are evaluated monthly based on derivative valuation models using quoted prices for similar assets adjusted for specific attributes of the commitments and other observable market data at the valuation date (Level 2).

The following table summarizes the financial assets measured at fair value on a recurring basis segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:

Assets and Liabilities Measured on a Recurring Basis


September 30, 2019	Level 1		Level 2		Level 3		Total Fair
	Inputs		Inputs		Inputs		Value
	(In Thousands)
Available for sale securities:
Obligations of U.S. federal government corporations and agencies	$	—	$	2,531	$	—	$	2,531
Mortgage-backed - residential		—		82,080		—		82,080
REMICs		—		2,087		—		2,087
Collateralized mortgage obligations-residential		—		90,708		—		90,708
Preferred Stock		1		—		—		1
Corporate bonds		—		12,970		—		12,970
Obligations of state and political subdivisions		—		99,677		—		99,677
Mortgage banking derivative - asset		—		1,657		—		1,657
Mortgage banking derivative - liability		—		—		—		—


December 31, 2018	Level 1		Level 2		Level 3		Total Fair
	Inputs		Inputs		Inputs		Value
	(In Thousands)
Available for sale securities:
Obligations of U.S. federal government corporations and agencies	$	—	$	2,503	$	—	$	2,503
Mortgage-backed - residential		—		74,710		—		74,710
REMICs		—		2,709		—		2,709
Collateralized mortgage obligations-residential		—		101,461		—		101,461
Corporate bonds		—		12,806		—		12,806
Obligations of state and political subdivisions		—		99,887				99,887
Mortgage banking derivative - asset		—		367		—		367
Mortgage banking derivative -liability		—		73		—		73

The following table summarizes the financial assets measured at fair value on a non-recurring basis segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:

Assets and Liabilities Measured on a Non-Recurring Basis


							Total Fair
September 30, 2019	Level 1 Inputs		Level 2 Inputs		Level 3 Inputs		Value
	(In Thousands)
Impaired loans
Other Commercial real estate	$	—	$	—	$	24	$	24
Total impaired loans		—		—		24		24
Mortgage servicing rights		—		288		—		288


							Total Fair
December 31, 2018	Level 1 Inputs		Level 2 Inputs		Level 3 Inputs		Value
	(In Thousands)
Impaired loans
Commercial real estate	$	—	$	—	$	1,456	$	1,456
Commercial		—		—		319		319
Total impaired loans		—		—		1,775		1,775
Mortgage servicing rights		—		629		—		629
Real estate held for sale
Commercial real estate		—		—		705		705
Total real estate held for sale		—		—		705		705

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

Fair

Range of

Weighted

Value

Valuation Technique

Unobservable Inputs

Inputs

Average

(Dollars in Thousands)

Impaired Loans- Applies to all loan classes

Appraisals which utilize sales comparison, net income and cost approach

Discounts for collection issues and changes in market conditions

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


	Fair				Range of		Weighted
	Value		Valuation Technique	Unobservable Inputs	Inputs		Average
	(Dollars in Thousands)

Impaired Loans- Applies to all loan classes	$	1,775	Appraisals which utilize sales comparison, net income and cost approach	Discounts for collection issues and changes in market conditions	10-13	%	10.86	%

Real estate held for sale – Applies to all classes	$	705	Appraisals which utilize sales comparison, net income and cost approach	Discounts for changes in market conditions	20	%	20	%

In accordance with FASB ASC Topic 825, the Fair Value Measurements tables are a comparative condensed consolidated statement of financial condition based on carrying amount and estimated fair values of financial instruments as of September 30, 2019, and December 31, 2018. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of First Defiance.

Much of the information used to arrive at “fair value” is highly subjective and judgmental in nature and therefore the results may not be precise. Subjective factors include, among other things, estimated cash flows, risk characteristics and interest rates, all of which are subject to change. With the exception of investment securities, the Company’s financial instruments are not readily marketable and market prices do not exist. Since negotiated prices for the instruments, which are not readily marketable, depend greatly on the motivation of the buyer and seller, the amounts that will actually be realized or paid per settlement or maturity of these instruments could be significantly different.

The carrying amount of cash and cash equivalents and notes payable, as a result of their short-term nature, is considered to be equal to fair value and are classified as Level 1.

It was not practicable to determine the fair value of FHLB stock due to restrictions placed on its transferability.

The Company adopted the amendments to ASU 2016-01 relating to the loan portfolio in the first quarter of 2018 and an exit price income approach is now used to determine the fair value. The loans were valued on an individual basis, with consideration given to the loans underlying characteristics, including account types, remaining terms (in months), annual interest rates or coupons, interest types, past delinquencies, timing of principal and interest payments, current market rates, loss exposures, and remaining balances. The model utilizes a discounted cash flow approach to estimate the fair value of the loans using assumptions for the coupon rates, remaining maturities, prepayment speeds, projected default probabilities, losses given defaults, and estimates of prevailing discount rates. The discounted cash flow approach models the credit losses directly in the projected cash flows. The model applies various assumptions regarding credit, interest, and prepayment risks for the loans based on loan types, payment types and fixed or variable classifications. The estimated fair value of impaired loans is based on the fair value of the collateral, less estimated cost to sell, or the present value of the loan’s expected future cash flows (discounted at the loan’s effective interest rate). All impaired loans are classified as Level 3 within the valuation hierarchy.

The fair value of accrued interest receivable is equal to the carrying amounts resulting in a Level 2 or Level 3 classification which is consistent with its underlying value.

The fair value of non-interest bearing deposits are considered equal to the amount payable on demand at the reporting date (i.e. carrying value) and are classified as Level 1. The fair value of savings, checking and certain money market accounts are equal to their carrying amounts and are a Level 2 classification. Fair values of fixed rate certificates of deposit 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.

The fair values of securities sold under repurchase agreements are equal to their carrying amounts resulting in a Level 2 classification. The carrying value of subordinated debentures and deposits with fixed maturities is estimated based discounted cash flow analyses based on interest rates currently being offered on instruments with similar characteristics and maturities resulting in a Level 3 classification.

FHLB advances with maturities greater than 90 days are valued based on a discounted cash flow analysis, using interest rates currently being quoted for similar characteristics and maturities resulting in a Level 2 classification. The cost or value of any call or put options is based on the estimated cost to settle the option at September 30, 2019.


					Fair Value Measurements at September 30, 2019
					(In Thousands)
	Carrying
	Value		Total		Level 1		Level 2		Level 3
Financial Assets:
Cash and cash equivalents	$	111,994	$	111,994	$	111,994	$	—	$	—
Investment securities		290,535		290,535		1		290,534		—
Federal Home Loan Bank Stock		11,915		N/A		N/A		N/A		N/A
Loans, net, including loans held for sale		2,657,959		2,675,786		—		23,417		2,652,369
Accrued interest receivable		11,386		11,386		12		1,576		9,798

Financial Liabilities:
Deposits	$	2,760,615	$	2,758,523	$	604,129	$	2,154,394	$	—
Advances from Federal Home Loan Bank		85,095		85,339		—		85,339		—
Securities sold under repurchase agreements		2,851		2,851		—		2,851		—
Subordinated debentures		36,083		33,102		—		—		33,102


					Fair Value Measurements at December 31, 2018
					(In Thousands)
	Carrying
	Value		Total		Level 1		Level 2		Level 3
Financial Assets:
Cash and cash equivalents	$	98,962	$	98,962	$	98,962	$	—	$	—
Investment securities		294,602		294,602		—		294,602		—
FHLB Stock		14,217		N/A		N/A		N/A		N/A
Loans, net, including loans held for sale		2,518,321		2,501,096		—		6,865		2,494,231
Accrued interest receivable		9,641		9,641		18		1,168		8,455

Financial Liabilities:
Deposits	$	2,620,882	$	2,613,965	$	607,198	$	2,006,767	$	—
Advances from FHLB		85,189		84,281		—		84,281		—
Securities sold under repurchase agreements		5,741		5,741		—		5,741		—
Subordinated debentures		36,083		28,854		—		—		28,854