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Fair Value

9 Months Ended

Sep. 30, 2022

Note 10 – Fair Value

The fair value of a financial instrument is the current amount that would be exchanged between willing parties in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques.

Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.

The Company records fair value adjustments to certain assets and liabilities and determines fair value disclosures utilizing a definition of fair value of assets and liabilities that states that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market

participants. Additional considerations are involved to determine the fair value of financial assets in markets that are not active.

The Company uses a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. The three levels of the fair value hierarchy based on these two types of inputs are as follows:


Level 1 –		Valuation is based on quoted prices in active markets for identical assets and liabilities.
Level 2 –		Valuation is based on observable inputs including quoted prices in active markets for similar assets and liabilities, quoted prices for identical or similar assets and liabilities in less active markets, and model-based valuation techniques for which significant assumptions can be derived primarily from or corroborated by observable data in the market.
Level 3 –		Valuation is based on model-based techniques that use one or more significant inputs or assumptions that are unobservable in the market.

The following describes the valuation techniques used by the Company to measure certain financial assets and liabilities recorded at fair value on a recurring basis in the financial statements.

Securities

Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities would include highly-liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flow. Level 2 securities would include U.S. agency securities, mortgage-backed agency securities, obligations of states and political subdivisions, and certain corporate, asset backed and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy. The carrying value of restricted FRB and FHLB stock approximates fair value based upon the redemption provisions of each entity and is therefore excluded from the following table.

Mortgage servicing rights

A third-party model is used to determine the fair value of the Company’s MSR assets. The model establishes pools of performing loans, calculates projected future cash flows for each pool, and applies a discount rate to each pool. As of September 30, 2022 and December 31, 2021, the Company was servicing approximately $2.17 billion and $1.91 billion of loans, respectively. Loans are segregated into homogenous pools based on loan term, interest rates, and other similar characteristics. Cash flows are then estimated based on net servicing fee income and utilizing assumed servicing costs and prepayment speeds. The weighted average net servicing fee income of the portfolio was 28.4 basis points as of September 30, 2022. Estimated base annual servicing costs were $65.00 to $80.00 per loan depending on the guarantor. Prepayment speeds in the model are based on empirically derived data for mortgage pool factors and differences between a mortgage pool’s weighted average coupon and its current mortgage rate. The weighted average prepayment speed assumption used in the fair value model was 7.99% as of September 30, 2022. A base discount rate of 9% to 11% (9.32% weighted average discount rate) was then applied to each pool’s projected future cash flows as of September 30, 2022. The discount rate is intended to represent the estimated market yield for the highest quality grade of comparable servicing. MSR assets are classified as Level 3.

As previously noted, the Company changed its accounting method for MSR assets from the amortization method to the fair value measurement method effective January 1, 2022. This was a prospective change in accounting method; therefore, the carrying value of the MSR assets in periods prior to January 1, 2022 were stated at amortized cost.

Rabbi trust assets

The Company's rabbi trust is associated with a deferred compensation plan. The assets held by the rabbi trust are invested at the direction of the individual participants and are generally invested in marketable investment securities, such as common stocks and mutual funds or short-term investments (e.g., cash) (Level 1). Rabbi trust assets and the

associated deferred compensation plan liability are included in other assets and other liabilities, respectively, in the consolidated balance sheets.

Derivative financial instruments

Derivative instruments used to hedge residential mortgage loans held for sale and the related interest rate lock commitments include forward commitments to sell mortgage loans and are reported at fair value utilizing Level 2 inputs. The fair values of derivative financial instruments are based on derivative market data inputs as of the valuation date and the underlying value of mortgage loans for rate lock commitments.

The Company has interest rate swap assets and liabilities associated with certain customer commercial loans. The interest rate swap asset with the customer is offset with an equal swap agreement with a highly-rated third-party financial institution (i.e., "back-to-back"). Both the interest rate swap assets and liabilities are free-standing derivatives and are recorded at fair value utilizing Level 2 inputs.

The following tables present the balances of financial assets measured at fair value on a recurring basis as of the dates stated.


	September 30, 2022
(Dollars in thousands)	Total		Level 1		Level 2		Level 3
Securities available for sale
State and municipals	$	51,032	$	—	$	51,032	$	—
U.S. Treasury and agencies		60,085		—		60,085		—
Mortgage backed securities		207,820		—		200,203		7,617
Corporate bonds		40,579		1,500		31,034		8,045
Total securities available for sale	$	359,516	$	1,500	$	342,354	$	15,662
Other assets
MSR assets	$	29,861	$	—	$	—	$	29,861
Rabbi trust assets		765		765		—		—
Mortgage derivative asset		1,045		—		1,045		—
Interest rate swap asset		102		—		102		—
Other liabilities
Mortgage derivative liability	$	—	$	—	$	—	$	—
Interest rate swap liability		102		—		102		—


	December 31, 2021
(Dollars in thousands)	Total		Level 1		Level 2		Level 3
Securities available for sale
State and municipals	$	51,113	$	—	$	51,113	$	—
U.S. Treasury and agencies		64,066		—		64,066		—
Mortgage backed securities		219,110		—		211,194		7,916
Corporate bonds		39,243		3,000		25,179		11,064
Total securities available for sale	$	373,532	$	3,000	$	351,552	$	18,980
Other assets
Rabbi trust assets	$	994	$	994	$	—	$	—
Mortgage derivative asset		1,876		—		1,876		—
Interest rate swap asset		199		—		199		—
Other liabilities
Mortgage derivative liability	$	75	$	—	$	75	$	—
Interest rate swap liability		199		—		199		—

The following table presents the change in financial assets valued using Level 3 inputs for the period stated.


(Dollars in thousands)	MSR Assets		Corporate Bonds			Mortgage backed securities
Balance as of December 31, 2021	$	16,469	$	11,064		$	7,916
Change in accounting method		4,484		—			—
Transfers from Level 2 to Level 3		—		—			—
Transfers from Level 3 to Level 2		—		(5,684	)		—
Additions		5,412		3,000			—
Sales or paydowns		—		—			(280	)
Fair value adjustments		3,496		(335	)		(19	)
Balance as of September 30, 2022	$	29,861	$	8,045		$	7,617

As of September 30, 2022, 14 corporate bonds totaling $8.0 million and six mortgage backed securities totaling $7.6 million were reported at their respective purchase prices and as Level 3 assets in the fair value hierarchy, as there were no observable market prices for similar investments.

Certain financial assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or the write-down of individual assets.

The following describes the valuation techniques used by the Company to measure certain financial assets recorded at fair value on a nonrecurring basis in the financial statements.

Impaired Loans

Impaired loans with specific reserves are carried at fair value. Fair value is based on the discounted cash flows of the loan or the fair value of the collateral less estimated costs to sell, if the loan is collateral-dependent. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. A loan may have multiple types of collateral; however, the majority of the Company’s loan collateral is real estate. The value of real estate collateral is generally determined utilizing a market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the collateral value is significantly adjusted due to differences in the comparable properties or is discounted by the Company because of lack of marketability, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal if deemed significant or the net book value on the applicable borrower’s financial statements if not considered significant. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Fair value adjustments are recorded in the period incurred as provision for loan losses on the consolidated statements of operations.

Loans Held for Sale

Mortgage loans originated or purchased and intended for sale in the secondary market (i.e., loans held for sale) are carried at estimated market value in the aggregate. Changes in fair value are recognized in residential mortgage banking income, net on the consolidated statements of operations (Level 2).

Certain consumer loans originated by the Bank and sourced by fintech partners are classified on the Company's consolidated balance sheets as held for sale. After origination, these loans are sold directly to the applicable fintech partner or another investor at par, generally up to 10 days from origination. Due to relatively short time between origination and sale, these loans are held at cost, which approximates fair value (Level 2).

Other Real Estate Owned ("OREO")

Certain assets such as OREO are measured at fair value less estimated costs to sell. Valuation of OREO is generally determined using current appraisals from independent appraisers (Level 2). If current appraisals cannot be obtained prior to reporting dates, or if declines in value are identified after a recent appraisal is received, appraisal values are

discounted, resulting in Level 3 estimates. If the Company markets the property with a real estate agent or broker, estimated selling costs reduce the listing price, resulting in a valuation based on Level 3 inputs.

The following tables summarize assets that were measured at fair value on a nonrecurring basis as of the dates stated.


	September 30, 2022
(Dollars in thousands)	Total		Level 1		Level 2		Level 3
Impaired loans, net	$	3,142	$	—	$	—	$	3,142
Loans held for sale		25,800		—		25,800		—
OREO		195		—		—		195


	December 31, 2021
(Dollars in thousands)	Total		Level 1		Level 2		Level 3
Impaired loans, net	$	8,344	$	—	$	—	$	8,344
Loans held for sale		121,943		—		121,943		—
OREO		157		—		—		157

The following tables present quantitative information about Level 3 fair value measurements as of the dates stated.


(Dollars in thousands)	Balance as of September 30, 2022		Unobservable Input	Range
Impaired loans, net
Discounted appraised value technique	$	661	Selling Costs	0% - 7%
Discounted cash flows technique		2,481	Discount Rate	4% - 11%
OREO
Discounted appraised value technique		195	Selling Costs		7	%


(Dollars in thousands)	Balance as of December 31, 2021		Unobservable Input	Range
Impaired loans, net
Discounted appraised value technique	$	8,108	Selling Costs		7	%
Discounted cash flows technique		236	Discount Rate	4% - 7%
OREO
Discounted appraised value technique		157	Selling Costs		7	%

Fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practical to estimate the value is based upon the characteristics of the instruments and relevant market information. Financial instruments include cash, evidence of ownership in an entity, or contracts that convey or impose on an entity that contractual right or obligation to either receive or deliver cash for another financial instrument. The information used to determine fair value is highly subjective and judgmental in nature and, therefore, the results may not be precise. Subjective factors include, among other things, estimates of cash flows, risk characteristics, credit quality, and interest rates, all of which are subject to change. Since the fair value is estimated as of the balance sheet date, the amounts that will actually be realized or paid upon settlement or maturity on these various instruments could be significantly different.

The following tables present the estimated fair values, related carrying amounts, and valuation level of the financial instruments as of the dates stated.


	September 30, 2022
					Fair Value Measurements
(Dollars in thousands)	Carrying Value		Fair Value		Level 1		Level 2		Level 3
Financial Assets
Cash and due from banks	$	98,305	$	98,305	$	98,305	$	—	$	—
Federal funds sold		10,581		10,581		10,581		—		—
Securities available for sale		359,516		359,516		1,500		342,354		15,662
Restricted equity investments		13,639		13,639		—		13,639		—
Other equity investments		23,570		23,570		—		23,570		—
PPP loans receivable, net		13,148		13,148		—		—		13,148
Loans held for investment, net		2,137,808		2,093,433		—		—		2,093,433
Accrued interest receivable		9,577		9,577		—		9,577		—
Bank owned life insurance		47,095		47,095		—		47,095		—
MSR assets		29,861		29,861		—		—		29,861
Financial Liabilities
Noninterest-bearing deposits	$	787,514	$	787,514	$	787,514	$	—	$	—
Interest-bearing demand and money market deposits		1,097,585		1,097,585		—		1,097,585		—
Savings deposits		152,225		152,225		—		152,225		—
Time deposits		372,162		370,898		—		—		370,898
FHLB borrowings		150,100		150,100		—		150,100		—
FRB borrowings		55		55		—		55		—
Subordinated notes, net		39,937		37,608		—		—		37,608


	December 31, 2021
					Fair Value Measurements
(Dollars in thousands)	Carrying Value		Fair Value		Level 1		Level 2		Level 3
Financial Assets
Cash and due from banks	$	130,548	$	130,548	$	130,548	$	—	$	—
Federal funds sold		43,903		43,903		43,903		—		—
Securities available for sale		373,532		373,532		3,000		351,552		18,980
Restricted equity investments		8,334		8,334		—		8,334		—
Other equity investments		14,184		14,184		—		14,184		—
PPP loans receivable, net		30,406		30,406		—		—		30,406
Loans held for investment, net		1,765,051		1,766,820		—		—		1,766,820
Accrued interest receivable		9,573		9,573		—		9,573		—
Bank owned life insurance		46,545		46,545		—		46,545		—
Financial Liabilities
Noninterest-bearing deposits	$	685,801	$	685,801	$	685,801	$	—	$	—
Interest-bearing demand and money market deposits		962,092		962,092		—		962,092		—
Savings deposits		150,376		150,376		—		150,376		—
Time deposits		499,502		503,968		—		—		503,968
FHLB borrowings		10,111		9,943		—		9,943		—
FRB borrowings		17,901		17,901		—		17,901		—
Subordinated notes, net		39,986		41,388		—		—		41,388

- Definition

The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information.

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