NOTE 15 - Fair Value Disclosures

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (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 values:

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.

Assets measured at fair value on a recurring basis are summarized in the table below. There were no liabilities measured at fair value on a recurring basis at December 31, 2014 and 2013.

(Dollars in thousands)	Fair Value Measurements Using						Total
December 31, 2014	Level 1		Level 2		Level 3		Fair Value
Securities available for sale
U.S. Government agency obligations	$	—	$	93,841	$	—	$	93,841
Mortgage-backed securities-residential		—		28,878		—		28,878
Asset backed securities		—		18,598		—		18,598
State and municipal		—		3,592		3,269		6,861
Corporate bonds		—		13,636		—		13,636
SBA pooled securities		—		210		—		210
	$	—	$	158,755	$	3,269	$	162,024

Loans held for sale	$	—	$	3,288	$	—	$	3,288

(Dollars in thousands)	Fair Value Measurements Using						Total
December 31, 2013	Level 1		Level 2		Level 3		Fair Value
Securities available for sale
U.S. Government agency obligations	$	—	$	95,834	$	—	$	95,834
Mortgage-backed securities-residential		—		36,285		—		36,285
Asset backed securities		—		18,839		—		18,839
State and municipal		—		5,423		3,582		9,005
Corporate bonds		—		20,843		—		20,843
SBA pooled securities		—		248		—		248
Trust preferred		—		3,600		—		3,600
	$	—	$	181,072	$	3,582	$	184,654

Loans held for sale	$	—	$	5,393	$	—	$	5,393

The Company used the following methods and assumptions to estimate fair value of financial instruments that are measured at fair value on a recurring basis:

Securities available for sale – The fair values of securities available for sale are determined by third party 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 (primarily Level 2 inputs).

Loans held for sale – Loans held for sale represent mortgage loan originations intended to be sold in the secondary market. Loans held for sale are valued using commitments on hand from investors or prevailing market prices and are classified in Level 2 of the valuation hierarchy.

There were no transfers between levels for the years ended December 31, 2014 and 2013. At December 31, 2014 and 2013, the Company classified $3,269,000 and $3,582,000, respectively, of municipal securities as Level 3. Acquired by the Company in the NBI acquisition, these municipal securities are bond issues for municipal government entities located in northwestern Illinois and are privately placed, non-rated bonds without CUSIP numbers. As these securities are not typically rated by the rating agencies and trading volumes are thin, it was determined that these were valued using Level 3 inputs. The municipal securities are valued by an independent third party using matrix pricing according to the municipal bond index that most closely matches the bond issue. Fair values for each maturity of the bond issue are then calculated based on the index yield at the appropriate point on the yield curve. The Company does not make any internal adjustments to the third party bond valuations. Significant increases/(decreases) in any of those inputs in isolation would result in a significantly lower/(higher) fair value measurement.

The only activity related to the above Level 3 securities during the years ended December 31, 2014 and 2013 was associated with immaterial contractual payments and changes in fair value that were recorded in other comprehensive income. There were no Level 3 securities measured at fair value on a recurring basis during the year ended December 31, 2012.

Assets measured at fair value on a non-recurring basis are summarized in the table below. There were no liabilities measured at fair value on a non-recurring basis at December 31, 2014 and 2013.

(Dollars in thousands)	Fair Value Measurements Using						Total
December 31, 2014	Level 1		Level 2		Level 3		Fair Value
Impaired loans
Commercial	$	—	$	—	$	1,129	$	1,129
Factored receivables		—		—		238		238
Other real estate owned⁽¹⁾:
1-4 family residential properties		—		—		97		97
Commercial		—		—		2,163		2,163
Construction, land development, land		—		—		1,487		1,487
	$	—	$	—	$	5,114	$	5,114

(Dollars in thousands)	Fair Value Measurements Using						Total
December 31, 2013	Level 1		Level 2		Level 3		Fair Value
Impaired loans
1-4 family residential properties	$	—	$	—	$	106	$	106
Commercial		—		—		200		200
Factored receivables		—		—		345		345
Other real estate owned⁽¹⁾:
1-4 family residential properties		—		—		367		367
Commercial		—		—		653		653
Construction, land development, land		—		—		—		—
	$	—	$	—	$	1,671	$	1,671

(Dollars in thousands)			2014		2013
Provision recorded for loans classified as impaired			$	1,296	$	14
Valuation adjustments recorded on other real estate owned			$	671	$	144

⁽¹⁾ Represents the fair value of OREO that was adjusted subsequent to its initial classification as OREO.

As of December 31, 2014 and 2013, the only Level 3 assets with material unobservable inputs are associated with impaired loans and OREO.

Impaired Loans with Specific Allocation of ALLL

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due pursuant to the contractual terms of the loan agreement. Impairment is measured by estimating the fair value of the loan based on the present value of expected cash flows, the market price of the loan, or the underlying fair value of the loan’s collateral. Fair value of the impaired loan’s collateral is determined by third party appraisals, which are then adjusted for the estimated selling and closing costs related to liquidation of the collateral. For this asset class, the actual valuation methods (income, sales comparable, or cost) vary based on the status of the project or property. For example, land is generally based on the sales comparable method while construction is based on the income and/or sales comparable methods. The unobservable inputs may vary depending on the individual assets with no one of the three methods being the predominant approach. The Company reviews the third party appraisal for appropriateness and adjusts the value downward to consider selling and closing costs, which typically range from 5% to 8% of the appraised value.

OREO

OREO is comprised of real estate acquired in partial or full satisfaction of loans. OREO is recorded at its estimated fair value less estimated selling and closing costs at the date of transfer, with any excess of the related loan balance over the fair value less expected selling costs charged to the ALLL. Subsequent changes in fair value are reported as adjustments to the carrying amount and are recorded against earnings. The Company outsources the valuation of OREO with material balances to third party appraisers. For this asset class, the actual valuation methods (income, sales comparable, or cost) vary based on the status of the project or property. For example, land is generally based on the sales comparable method while construction is based on the income and/or sales comparable methods. The unobservable inputs may vary depending on the individual assets with no one of the three methods being the predominant approach. The Company reviews the third party appraisal for appropriateness and adjusts the value downward to consider selling and closing costs, which typically range from 5% to 8% of the appraised value.

The estimated fair values of the Company’s financial instruments not previously presented at December 31, 2014 and 2013 were as follows:

	December 31, 2014
	Carrying		Fair Value Measurements Using						Total
(Dollars in thousands)	Amount		Level 1		Level 2		Level 3		Fair Value
Financial assets:
Cash and cash equivalents	$	160,888	$	160,888	$	—	$	—	$	160,888
Securities - held to maturity		745		—		750		—		750
Loans not previously presented, net		995,668		—		—		1,001,548		1,001,548
FHLB and Federal Reserve Bank stock		4,903	N/A		N/A		N/A		N/A
Accrued interest receivable		3,727		—		3,727		—		3,727

Financial liabilities:
Deposits		1,165,229		—		1,167,479		—		1,167,479
Customer repurchase agreements		9,282		—		9,282		—		9,282
Federal Home Loan Bank advances		3,000		—		3,000		—		3,000
Senior secured note		—		—		—		—		—
Junior subordinated debentures		24,423		—		24,423		—		24,423
Accrued interest payable		971		—		971		—		971


	December 31, 2013
	Carrying		Fair Value Measurements Using						Total
(Dollars in thousands)	Amount		Level 1		Level 2		Level 3		Fair Value
Financial assets:
Cash and cash equivalents	$	85,797	$	85,797	$	—	$	—	$	85,797
Securities - held to maturity		743		—		745		—		745
Loans not previously presented, net		876,803		—		—		883,656		884,307
FHLB and Federal Reserve Bank stock		5,802	N/A		N/A		N/A		N/A
Accrued interest receivable		3,748		—		3,748		—		3,748

Financial liabilities:
Deposits		1,044,854		—		1,046,226		—		1,046,226
Customer repurchase agreements		11,330		—		11,330		—		11,330
Federal Home Loan Bank advances		21,000		—		21,000		—		21,000
Senior secured note		12,573		—		12,379		—		12,379
Junior subordinated debentures		24,171		—		24,171		—		24,171
Accrued interest payable		2,426		—		2,426		—		2,426

For those assets not previously described, the following methods and assumptions were used by the Company in estimating the fair values of financial instruments as disclosed herein:

Cash and Cash Equivalents

For financial instruments with a shorter-term or with no stated maturity, prevailing market rates, and limited credit risk, the carrying amounts approximate fair value and are considered a Level 1 classification.

Securities held to maturity

The fair values of securities held to maturity are determined by third party 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, resulting in a Level 2 classification.

Loans

Loans exclude impaired loans previously described above. For variable-rate loans that reprice frequently and have no significant changes in credit risk, excluding previously presented impaired loans measured at fair value on a non-recurring basis, fair values are based on carrying values. Fair values for fixed-rate 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. Loans are considered a Level 3 classification.

FHLB and Federal Reserve Bank stock

The fair value of FHLB and FRB stock was not practicable to determine due to restrictions placed on its transferability.

Deposits

The fair values disclosed for demand deposits and non-maturity transaction accounts are, by definition, equal to the amount payable on demand at the reporting date (that is, their carrying amounts) and are considered a Level 2 classification. Fair values for fixed-rate 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.

Customer repurchase agreements

The carrying amount of customer repurchase agreements approximates fair value due to their short-term nature. The customer repurchase agreement fair value is considered a Level 2 classification.

Federal Home Loan Bank advances

The advances have a maturity of less than one month at December 31, 2014 and 2013. As such, fair value materially approximates carrying value and is considered a Level 2 classification.

Senior secured note

The carrying amount of the senior secured note approximates fair value because the terms were estimated to be market terms for similar instruments resulting in a Level 2 classification. The senior secured note was retired in 2014.

Junior subordinated debentures

The junior subordinated debentures were valued at their acquisition date by discounting future cash flows using current interest rates for similar financial instruments, resulting in a Level 2 classification. The fair value as of December 31, 2014 and 2013 approximates the carrying amount of the junior subordinated debentures.

Accrued Interest Receivable and Payable

The carrying amounts of accrued interest receivable and payable approximate their fair values given the short-term nature of the receivables and are considered a Level 2 classification.