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Fair Value Measurements

9 Months Ended

Sep. 30, 2018

Note 11. Fair Value Measurements

The fair value of an asset or liability is the price that would be received to sell that asset or paid to transfer that liability in an orderly transaction occurring in the principal market (or most advantageous market in the absence of a principal market) for such asset or liability. In estimating fair value, the Company utilizes valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. Such valuation techniques are consistently applied. Inputs to valuation techniques include the assumptions that market participants would use in pricing an asset or liability. ASC Topic 820, “Fair Value Measurements and Disclosures,” establishes 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 in active exchange markets for identical assets or liabilities; also includes certain U.S. Treasury and other U.S. Government and agency securities actively traded in over-the-counter markets.

Level 2

Observable inputs other than Level 1 including quoted prices for similar assets or liabilities, quoted prices in less active markets, or other observable inputs that can be corroborated by observable market data; also includes derivative contracts whose value is determined using a pricing model with observable market inputs or can be derived principally from or corroborated by observable market data. This category generally includes certain U.S. Government and agency securities, corporate debt securities, derivative instruments, and residential mortgage loans held for sale.

Level 3

Unobservable inputs supported by little or no market activity for financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation; also includes observable inputs for single dealer nonbinding quotes not corroborated by observable market data. This category generally includes certain private equity investments, retained interests from securitizations, and certain collateralized debt obligations.

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

The table below presents the recorded amount of assets and liabilities measured at fair value on a recurring basis as of September 30, 2018 and December 31, 2017.

(dollars in thousands)	Quoted Prices (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Other Unobservable Inputs (Level 3)		Total (Fair Value)
September 30, 2018
Assets:
Investment securities available for sale:
U. S. agency securities	$	—	$	230,325	$	—	$	230,325
Residential mortgage backed securities		—		436,349		—		436,349
Municipal bonds		—		47,736		—		47,736
Corporate bonds		—		6,546		1,500		8,046
Other equity investments		—		—		218		218
Loans held for sale		—		18,728		—		18,728
Mortgage banking derivatives		—		—		80		80
Interest rate swap derivatives		—		6,427		—		6,427
Total assets measured at fair value on a recurring basis as of September 30, 2018	$	—	$	746,111	$	1,798	$	747,909
Liabilities:
Mortgage banking derivatives	$	—	$	—	$	28	$	28
Total liabilities measured at fair value on a recurring basis as of September 30, 2018	$	—	$	—	$	28	$	28
December 31, 2017
Assets:
Investment securities available for sale:
U. S. agency securities	$	—	$	195,984	$	—	$	195,984
Residential mortgage backed securities		—		317,836		—		317,836
Municipal bonds		—		62,057		—		62,057
Corporate bonds		—		11,673		1,500		13,173
Other equity investments		—		—		218		218
Loans held for sale		—		25,096		—		25,096
Mortgage banking derivatives		—		—		43		43
Interest rate swap derivatives		—		2,256		—		2,256
Total assets measured at fair value on a recurring basis as of December 31, 2017	$	—	$	614,902	$	1,761	$	616,663
Liabilities:
Mortgage banking derivatives	$	—	$	—	$	10	$	10
Total liabilities measured at fair value on a recurring basis as of December 31, 2017	$	—	$	—	$	10	$	10

Investment Securities Available-for-Sale: Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair value is measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange such as the New York Stock Exchange, Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include U.S. agency debt securities, mortgage backed securities issued by Government Sponsored Entities (“GSE’s”) and municipal bonds. Securities classified as Level 3 include securities in less liquid markets, the carrying amounts approximate the fair value.

Loans held for sale: The Company has elected to carry loans held for sale at fair value. This election reduces certain timing differences in the Consolidated Statement of Operations and better aligns with the management of the portfolio from a business perspective. Fair value is derived from secondary market quotations for similar instruments. Gains and losses on sales of residential mortgage loans are recorded as a component of noninterest income in the Consolidated Statements of Operations. Gains and losses on sales of multifamily FHA securities are recorded as a component of noninterest income in the Consolidated Statements of Operations. As such, the Company classifies loans subjected to fair value adjustments as Level 2 valuation.

The following table summarizes the difference between the aggregate fair value and the aggregate unpaid principal balance for loans held for sale measured at fair value as of September 30, 2018 and December 31, 2017.

	September 30, 2018
			Aggregate Unpaid
(dollars in thousands)	Fair Value		Principal Balance		Difference

Residential mortgage loans held for sale	$	18,728	$	18,488	$	240
FHA mortgage loans held for sale	$	—	$	—	$	—

	December 31, 2017
			Aggregate Unpaid
(dollars in thousands)	Fair Value		Principal Balance		Difference

Residential mortgage loans held for sale	$	25,096	$	24,674	$	422
FHA mortgage loans held for sale	$	—	$	—	$	—

No residential mortgage loans held for sale were 90 or more days past due or on nonaccrual status as of September 30, 2018 or December 31, 2017.

Interest rate swap derivatives: These derivative instruments consist of forward starting interest rate swap agreements, which are accounted for as cash flow hedges under ASC 815. The Company’s derivative position is classified within Level 2 of the fair value hierarchy and is valued using models generally accepted in the financial services industry and that use actively quoted or observable market input values from external market data providers and/or non-binding broker-dealer quotations. The fair value of the derivatives is determined using discounted cash flow models. These models’ key assumptions include the contractual terms of the respective contract along with significant observable inputs, including interest rates, yield curves, nonperformance risk and volatility. Derivative contracts are executed with a Credit Support Annex, which is a bilateral agreement that requires collateral postings when the market value exceeds certain threshold limits. These agreements protect the interests of the Company and its counterparties should either party suffer a credit rating deterioration.

Credit Risk Participation Agreements: The Company enters into credit risk participation agreements (“RPAs”) with institutional counterparties, under which the Company assumes its pro-rata share of the credit exposure associated with a borrower’s performance related to interest rate derivative contracts. The fair value of RPAs is calculated by determining the total expected asset or liability exposure of the derivatives to the borrowers and applying the borrowers’ credit spread to that exposure. Total expected exposure incorporates both the current and potential future exposure of the derivatives, derived from using observable inputs, such as yield curves and volatilities. Accordingly, RPAs fall within Level 2.

Mortgage banking derivatives: The Company relies on a third-party pricing service to value its mortgage banking derivative financial assets and liabilities, which the Company classifies as a Level 3 valuation. The external valuation model to estimate the fair value of its interest rate lock commitments to originate residential mortgage loans held for sale includes grouping the interest rate lock commitments by interest rate and terms, applying an estimated pull-through rate based on historical experience, and then multiplying by quoted investor prices determined to be reasonably applicable to the loan commitment groups based on interest rate, terms, and rate lock expiration dates of the loan commitment groups. The Company also relies on an external valuation model to estimate the fair value of its forward commitments to sell residential mortgage loans (i.e., an estimate of what the Company would receive or pay to terminate the forward delivery contract based on market prices for similar financial instruments), which includes matching specific terms and maturities of the forward commitments against applicable investor pricing.

The following is a reconciliation of activity for assets and liabilities measured at fair value based on Significant Other Unobservable Inputs (Level 3):

	Investment		Mortgage Banking
(dollars in thousands)	Securities		Derivatives		Total
Assets:
Beginning balance at January 1, 2018	$	1,718	$	43	$	1,761
Realized gain included in earnings - net mortgage banking derivatives		—		37		37
Purchases of available-for-sale securities		—		—		—
Principal redemption		—		—		—
Ending balance at September 30, 2018	$	1,718	$	80	$	1,798

Liabilities:
Beginning balance at January 1, 2018	$	—	$	10	$	10
Realized loss included in earnings - net mortgage banking derivatives		—		18		18
Principal redemption		—		—		—
Ending balance at September 30, 2018	$	—	$	28	$	28

	Investment		Mortgage Banking
(dollars in thousands)	Securities		Derivatives			Total
Assets:
Beginning balance at January 1, 2017	$	1,718	$	114		$	1,832
Realized loss included in earnings - net mortgage banking derivatives		—		(71	)		(71	)
Purchases of available-for-sale securities		—		—			—
Principal redemption		—		—			—
Ending balance at December 31, 2017	$	1,718	$	43		$	1,761

Liabilities:
Beginning balance at January 1, 2017	$	—	$	55		$	55
Realized loss included in earnings - net mortgage banking derivatives		—		(45	)		(45	)
Principal redemption		—		—			—
Ending balance at December 31, 2017	$	—	$	10		$	10

The other equity securities classified as Level 3 consist of equity investments in the form of common stock of two local banking companies which are not publicly traded, and for which the carrying amount approximates fair value.

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

The Company measures certain assets at fair value on a nonrecurring basis and the following is a general description of the methods used to value such assets.

Impaired loans: The Company does not record loans at fair value on a recurring basis; however, from time to time, a loan is considered impaired and an allowance for loan loss is established. The Company considers a loan impaired when it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the note agreement, including both principal and interest. Management has determined that nonaccrual loans and loans that have had their terms restructured in a troubled debt restructuring meet this impaired loan definition. Once a loan is identified as individually impaired, management measures impairment in accordance with ASC Topic 310, “Receivables.” The fair value of impaired loans is estimated using one of several methods, including the collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring a specific allowance represent loans for which the fair value of expected repayments or collateral exceed the recorded investment in such loans. At September 30, 2018, substantially all of the Company’s impaired loans were evaluated based upon the fair value of the collateral. In accordance with ASC Topic 820, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the loan as nonrecurring Level 3. For individually evaluated impaired loans, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan’s effective interest rate or the estimated fair value of the underlying collateral for collateral-dependent loans, which the Company classifies as a Level 3 valuation.

Other real estate owned: Other real estate owned is initially recorded at fair value less estimated selling costs. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral, which the Company classifies as a Level 3 valuation. Assets measured at fair value on a nonrecurring basis are included in the table below:

(dollars in thousands)	Quoted Prices (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Other Unobservable Inputs (Level 3)		Total (Fair Value)
September 30, 2018
Impaired loans:
Commercial	$	—	$	—	$	6,200	$	6,200
Income producing - commercial real estate		—		—		6,217		6,217
Owner occupied - commercial real estate		—		—		5,261		5,261
Real estate mortgage - residential		—		—		1,522		1,522
Construction - commercial and residential						3,030		3,030
Home equity		—		—		487		487
Other consumer		—		—		36		36
Other real estate owned		—		—		1,394		1,394
Total assets measured at fair value on a nonrecurring basis as of September 30, 2018	$	—	$	—	$	24,147	$	24,147

(dollars in thousands)	Quoted Prices (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Other Unobservable Inputs (Level 3)		Total (Fair Value)
December 31, 2017
Impaired loans:
Commercial	$	—	$	—	$	2,266	$	2,266
Income producing - commercial real estate		—		—		7,664		7,664
Owner occupied - commercial real estate		—		—		5,214		5,214
Real estate mortgage - residential		—		—		775		775
Construction - commercial and residential		—		—		1,552		1,552
Home equity		—		—		494		494
Other consumer		—		—		11		11
Other real estate owned		—		—		1,394		1,394
Total assets measured at fair value on a nonrecurring basis as of December 31, 2017	$	—	$	—	$	19,370	$	19,370

Fair Value of Financial Instruments

The Company discloses fair value information about financial instruments for which it is practicable to estimate the value, whether or not such financial instruments are recognized on the balance sheet. Fair value is the amount at which a financial instrument could be exchanged in a current transaction between willing parties, other than in a forced sale or liquidation, and is best evidenced by quoted market price, if one exists.

Quoted market prices, if available, are shown as estimates of fair value. Because no quoted market prices exist for a portion of the Company’s financial instruments, the fair value of such instruments has been derived based on management’s assumptions with respect to future economic conditions, the amount and timing of future cash flows and estimated discount rates. Different assumptions could significantly affect these estimates. Accordingly, the net realizable value could be materially different from the estimates presented below. In addition, the estimates are only indicative of individual financial instrument values and should not be considered an indication of the fair value of the Company taken as a whole.

The following methods and assumptions were used to estimate the fair value of each category of financial instrument for which it is practicable to estimate value:

Cash due from banks and federal funds sold: For cash and due from banks and federal funds sold the carrying amount approximates fair value.

Interest bearing deposits with other banks: For interest bearing deposits with other banks the carrying amount approximates fair value.

Investment securities: For these instruments, fair values are based upon quoted prices, if available. If quoted prices are not available, fair value is measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions.

Federal Reserve and Federal Home Loan Bank stock: The carrying amounts approximate the fair values at the reporting date.

Loans held for sale: As the Company has elected the fair value option, the fair value of loans held for sale is the carrying value and is based on commitments outstanding from investors as well as what secondary markets are currently offering for portfolios with similar characteristics for residential mortgage loans held for sale since such loans are typically committed to be sold (servicing released) at a profit. The fair value of multifamily FHA loans held for sale is the carrying value and is based on commitments outstanding from investors as well as what secondary markets are currently offering for portfolios with similar characteristics for multifamily FHA loans held for sale since such loans are typically committed to be securitized and sold (servicing retained) at a profit.

Loans: The loan portfolio is valued using an exit price notion. The present value of cash flows projection is established for each loan in the portfolio projecting contractual payments, default adjusted payments, cash flows in the event of default (including deferred timing of recoveries), and pre-payments. These expected cash flows are then discounted to present value using the note interest rate and an established market rate which, if different from the note rate, allows the Bank to isolate the amount above or below par a potential acquirer would pay to acquire the Bank’s portfolio.

Bank owned life insurance: The fair value of bank owned life insurance is the current cash surrender value, which is the carrying value.

Annuity investment: The fair value of the annuity investments is the carrying amount at the reporting date.

Mortgage banking derivatives: The Company enters into interest rate lock commitments with prospective residential mortgage borrowers. These commitments are carried at fair value based on the fair value of the underlying mortgage loans which are based on market data. These commitments are classified as Level 3 in the fair value disclosures, as the valuations are based on market unobservable inputs. The Company hedges the risk of the overall change in the fair value of loan commitments to borrowers by selling forward contracts on securities of GSEs. These forward settling contracts are classified as Level 3, as valuations are based on market unobservable inputs. See Note 4 to the Consolidated Financial Statements for additional detail.

Interest rate swap derivatives: These derivative instruments consist of forward starting interest rate swap agreements, which are accounted for as cash flow hedges. The Company’s derivative position is classified within Level 2 of the fair value hierarchy and is valued using models generally accepted in the financial services industry and that use actively quoted or observable market input values from external market data providers and/or non-binding broker-dealer quotations. The fair value of the derivatives is determined using discounted cash flow models. These models’ key assumptions include the contractual terms of the respective contract along with significant observable inputs, including interest rates, yield curves, nonperformance risk and volatility. Derivative contracts are executed with a Credit Support Annex, which is a bilateral ratings-sensitive agreement that requires collateral postings when the market value exceeds certain threshold limits. These agreements protect the interests of the Company and its counterparties should either party suffer a credit rating deterioration.

Noninterest bearing deposits: The fair value of these deposits is the amount payable on demand at the reporting date, since generally accepted accounting standards do not permit an assumption of core deposit value.

Interest bearing deposits: The fair value of interest bearing transaction, savings, and money market deposits with no defined maturity is the amount payable on demand at the reporting date, since generally accepted accounting standards do not permit an assumption of core deposit value.

Certificates of deposit: The fair value of certificates of deposit is estimated by discounting the future cash flows using the current rates at which similar deposits with remaining maturities would be accepted.

Customer repurchase agreements: The carrying amount approximate the fair values at the reporting date.

Borrowings: The carrying amount for variable rate borrowings approximate the fair values at the reporting date. The fair value of fixed rate FHLB advances and the subordinated notes are estimated by computing the discounted value of contractual cash flows payable at current interest rates for obligations with similar remaining terms. The fair value of variable rate FHLB advances is estimated to be carrying value since these liabilities are based on a spread to a current pricing index.

Off-balance sheet items: Management has reviewed the unfunded portion of commitments to extend credit, as well as standby and other letters of credit, and has determined that the fair value of such instruments is equal to the fee, if any, collected and unamortized for the commitment made.

The estimated fair values of the Company’s financial instruments at September 30, 2018 and December 31, 2017 are as follows:

					Fair Value Measurements
(dollars in thousands)	Carrying Value		Fair Value		Quoted Prices (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
September 30, 2018
Assets
Cash and due from banks	$	4,459	$	4,459	$	—	$	4,459	$	—
Federal funds sold		17,284		17,284		—		17,284		—
Interest bearing deposits with other banks		162,734		162,734		—		162,734		—
Investment securities		722,674		722,674		—		720,956		1,718
Federal Reserve and Federal Home Loan Bank stock		37,257		37,257		—		37,257		—
Loans held for sale		18,728		18,728		—		18,728		—
Loans (1)		6,776,483		6,713,861		—		—		6,713,861
Bank owned life insurance		73,007		73,007		—		73,007		—
Annuity investment		12,375		12,375		—		12,375		—
Mortgage banking derivatives		80		80		—		—		80
Interst rate swap derivatives		6,427		6,427		—		6,427		—

Liabilities
Noninterest bearing deposits		2,057,886		2,057,886		—		2,057,886		—
Interest bearing deposits		3,032,713		3,032,713		—		3,032,713		—
Certificates of deposit		1,281,706		1,279,407		—		1,279,407		—
Customer repurchase agreements		36,446		36,446		—		36,446		—
Borrowings		542,198		533,304		—		533,304		—
Mortgage banking derivatives		28		28		—		—		28

December 31, 2017
Assets
Cash and due from banks	$	7,445	$	7,445	$	—	$	7,445	$	—
Federal funds sold		15,767		15,767		—		15,767		—
Interest bearing deposits with other banks		167,261		167,261		—		167,261		—
Investment securities		589,268		589,268		—		587,550		1,718
Federal Reserve and Federal Home Loan Bank stock		36,324		36,324		—		36,324		—
Loans held for sale		25,096		25,096		—		25,096		—
Loans (2)		6,346,770		6,381,213		—		—		6,381,213
Bank owned life insurance		60,947		60,947		—		60,947		—
Annuity investment		11,632		11,632		—		11,632		—
Mortgage banking derivatives		43		43		—		—		43
Interst rate swap derivatives		2,256		2,256		—		2,256		—

Liabilities
Noninterest bearing deposits		1,982,912		1,982,912		—		1,982,912		—
Interest bearing deposits		3,041,563		3,041,563		—		3,041,563		—
Certificates of deposit		829,509		829,886		—		829,886		—
Customer repurchase agreements		76,561		76,561		—		76,561		—
Borrowings		541,905		533,162		—		533,162		—
Mortgage banking derivatives		10		10		—		—		10

(1)

Carrying amount is net of unearned income and the allowance for credit losses. In accordance with the prospective adoption of ASU No. 2016-01, the fair value of loans was measured using an exit price notion.

(2)

Carrying amount is net of unearned income and the allowance for credit losses. The fair value of loans was measured using an entry price notion.