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Note 13. Fair Value Measurements

9 Months Ended

Sep. 30, 2019

Note 13. 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, 2019 and December 31, 2018.

(dollars in thousands)	Quoted Prices (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Other Unobservable Inputs (Level 3)		Total (Fair Value)
September 30, 2019
Assets:
Investment securities available-for-sale:
U. S. agency securities	$	—	$	171,820	$	—	$	171,820
Residential mortgage backed securities		—		438,029		—		438,029
Municipal bonds		—		63,958		—		63,958
Corporate bonds		—		—		9,614		9,614
U.S. Treasury		—		24,926		—		24,926
Other equity investments		—		—		198		198
Loans held for sale		—		52,199		—		52,199
Interest Rate Caps		—		228		—		228
Mortgage banking derivatives		—		—		313		313
Total assets measured at fair value on a recurring basis as of September 30, 2019	$	—	$	751,160	$	10,125	$	761,285

Liabilities:
Interest rate swap derivatives	$	—	$	362	$	—	$	362
Derivative liability		—		117		—		117
Interest Rate Caps		—		235		—		235
Mortgage banking derivatives		—		—		3		3
Total liabilities measured at fair value on a recurring basis as of September 30, 2019	$	—	$	714	$	3	$	717

December 31, 2018

Assets:

Investment securities available-for-sale:

U. S. agency securities $ —   $ 256,345 $ —   $ 256,345

Residential mortgage backed securities —   472,231 —   472,231

Municipal bonds —   45,769 —   45,769

Corporate bonds —   —   9,576 9,576

Other equity investments —   —   218 218

Loans held for sale —   19,254 —   19,254

Mortgage banking derivatives —   —   229 229

Interest rate swap derivatives —   3,727 —   3,727

Total assets measured at fair value on a recurring basis as of December 31, 2018 $ —   $ 797,326 $ 10,023 $ 807,349

Liabilities:

Mortgage banking derivatives $ —   $ —   $ 269 $ 269

Total liabilities measured at fair value on a recurring basis as of December 31, 2018 $ —   $ —   $ 269 $ 269

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, 2019 and December 31, 2018.


	September 30, 2019
(dollars in thousands)	Fair Value		Aggregate Unpaid Principal Balance		Difference

Residential mortgage loans held for sale	$	52,199	$	51,291	$	908
FHA mortgage loans held for sale	$	—	$	—	$	—

	December 31, 2018
(dollars in thousands)	Fair Value		Aggregate Unpaid Principal Balance		Difference

Residential mortgage loans held for sale	$	19,254	$	18,797	$	457
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, 2019 or December 31, 2018.

Interest rate swap derivatives: These derivative instruments consist of 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.

Interest Rate Caps: the Company entered into an interest rate cap agreement (“cap”) with an institutional counterparty, under which the Company will receive cash if and when market rates exceed the cap’s strike rate. The fair value of the cap is calculated by determining the total expected asset or liability exposure of the derivatives. Total expected exposure incorporates both the current and potential future exposure of the derivative, derived from using observable inputs, such as yield curves and volatilities. Accordingly, the cap falls 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):

(dollars in thousands)	Investment Securities			Mortgage Banking Derivatives		Total
Assets:
Beginning balance at January 1, 2019	$	9,794		$	229	$	10,023
Realized (loss) gain included in earnings		(20	)		84		64
Unrealized gain included in other comprehensive income		12			—		12
Purchases of available-for-sale securities		3,030			—		3,030
Principal redemption		(3,004	)		—		(3,004	)
Ending balance at September 30, 2019	$	9,812		$	313	$	10,125


Liabilities:
Beginning balance at January 1, 2019	$	—	$	269		$	269
Realized gain included in earnings		—		(266	)		(266	)
Principal redemption		—		—			—
Ending balance at September 30, 2019	$	—	$	3		$	3

(dollars in thousands)	Investment Securities		Mortgage Banking Derivatives		Total
Assets:
Beginning balance at January 1, 2018	$	1,718	$	43	$	1,761
Realized gain included in earnings		—		186		186
Purchases of available-for-sale securities		8,076		—		8,076
Principal redemption		—		—		—
Ending balance at December 31, 2018	$	9,794	$	229	$	10,023


Liabilities:
Beginning balance at January 1, 2018	$	—	$	10	$	10
Realized loss included in earnings		—		259		259
Principal redemption		—		—		—
Ending balance at December 31, 2018	$	—	$	269	$	269

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, 2019, 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, 2019
Impaired loans:
Commercial	$	—	$	—	$	8,776	$	8,776
Income producing - commercial real estate		—		—		8,841		8,841
Owner occupied - commercial real estate		—		—		7,032		7,032
Real estate mortgage - residential		—		—		4,985		4,985
Construction - commercial and residential		—		—		9,148		9,148
Home equity		—		—		474		474
Other real estate owned		—		—		1,487		1,487
Total assets measured at fair value on a nonrecurring basis as of September 30, 2019	$	—	$	—	$	40,743	$	40,743

(dollars in thousands)	Quoted Prices (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Other Unobservable Inputs (Level 3)		Total (Fair Value)
December 31, 2018
Impaired loans:
Commercial	$	—	$	—	$	3,338	$	3,338
Income producing - commercial real estate		—		—		18,937		18,937
Owner occupied - commercial real estate		—		—		5,131		5,131
Real estate mortgage - residential		—		—		1,510		1,510
Construction - commercial and residential		—		—		1,981		1,981
Home equity		—		—		487		487
Other real estate owned		—		—		1,394		1,394
Total assets measured at fair value on a nonrecurring basis as of December 31, 2018	$	—	$	—	$	32,778	$	32,778

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 estimated fair value of the Company’s financial instruments at September 30, 2019 and December 31, 2018 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, 2019
Assets
Cash and due from banks	$	6,657	$	6,657	$	—	$	6,657	$	—
Federal funds sold		27,711		27,711		—		27,711		—
Interest bearing deposits with other banks		361,154		361,154		—		361,154		—
Investment securities		708,545		708,545		—		698,733		9,812
Federal Reserve and Federal Home Loan Bank stock		28,725		28,725		—		28,725		—
Loans held for sale		52,199		52,199		—		52,199		—
Loans		7,485,441		7,572,385		—		—		7,572,385
Bank owned life insurance		74,726		74,726		—		74,726		—
Annuity investment		12,103		12,103		—		12,103		—
Interest Rate Caps		228		228		—		228		—
Mortgage banking derivatives		313		313		—		—		313

Liabilities
Noninterest bearing deposits		2,051,106		2,051,106		—		2,051,106		—
Interest bearing deposits		3,952,541		3,952,541		—		3,952,541		—
Certificates of deposit		1,398,866		1,443,542		—		1,443,542		—
Customer repurchase agreements		30,297		30,297		—		30,297		—
Borrowings		317,589		328,330		—		328,330		—
Interest rate swap derivatives		362		362				362		—
Derivative liability		117		117		—		117		—
Interest Rate Caps		235		235		—		235		—
Mortgage banking derivatives		3		3		—		—		3

December 31, 2018
Assets
Cash and due from banks	$	6,773	$	6,773	$	—	$	6,773	$	—
Federal funds sold		11,934		11,934		—		11,934		—
Interest bearing deposits with other banks		303,157		303,157		—		303,157		—
Investment securities		784,139		784,139		—		774,345		9,794
Federal Reserve and Federal Home Loan Bank stock		23,506		23,506		—		23,506		—
Loans held for sale		19,254		19,254		—		19,254		—
Loans		6,921,503		6,921,048		—		—		6,921,048
Bank owned life insurance		73,441		73,441		—		73,441		—
Annuity investment		12,417		12,417		—		12,417		—
Mortgage banking derivatives		229		229		—		—		229
Interest rate swap derivatives		3,727		3,727		—		3,727		—

Liabilities
Noninterest bearing deposits		2,104,220		2,104,220		—		2,104,220		—
Interest bearing deposits		3,542,666		3,542,666		—		3,542,666		—
Certificates of deposit		1,327,400		1,325,209		—		1,325,209		—
Customer repurchase agreements		30,413		30,413		—		30,413		—
Borrowings		217,196		218,006		—		218,006		—
Mortgage banking derivatives		269		269		—		—		269