Fair Value

Certain assets and liabilities are recorded at fair value to provide additional insight into the Company's quality of earnings. Some of these assets and liabilities are measured on a recurring basis while others are measured on a nonrecurring basis, with the determination based upon applicable existing accounting pronouncements. For example, securities available for sale are recorded at fair value on a recurring basis. Other assets, such as, other real estate owned and impaired loans, are recorded at fair value on a nonrecurring basis using the lower of cost or market methodology to determine impairment of individual assets. The Company groups assets and liabilities which are recorded at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. A financial instrument's level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement (with level 1 considered highest and level 3 considered lowest). A brief description of each level follows.

Level 1 - Valuation is based upon quoted prices for identical instruments in active markets.

Level 2 - Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

Level 3 - Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates that market participants would use in pricing the asset or liability. Valuation includes use of discounted cash flow models and similar techniques.

The fair value methods and assumptions for the Company's financial instruments and other assets measured at fair value are set forth below.

Cash, Cash Equivalents and Interest-Bearing Deposits in Other Banks

The carrying values of cash equivalents, due from banks and federal funds sold approximate their relative fair values. As such, the Company classifies these financial instruments as Level 1.

Investment Securities

The fair values of investment securities are estimated by independent providers using a market approach with observable inputs, including matrix pricing and recent transactions. In obtaining such valuation information from third parties, the Company has evaluated their valuation methodologies used to develop the fair values in order to determine whether the valuations are representative of an exit price in the Company's principal markets. The Company's principal markets for its securities portfolios are the secondary institutional markets, with an exit price that is predominantly reflective of bid level pricing in those markets. Fair values are calculated based on the value of one unit without regard to any premium or discount that may result from concentrations of ownership of a financial instrument, possible tax ramifications, or estimated transaction costs. If these considerations had been incorporated into the fair value estimates, the aggregate fair value could have been changed. The carrying values of restricted equity securities approximate fair values. As such, the Company classifies investment securities as Level 2.

Loans Held for Sale

Loans held for sale are recorded at the lower of aggregate carrying value or fair value. The fair value of mortgage loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics. As such, the Company classifies mortgage loans held for sale as Level 2.

Loans

Fair values are estimated for portfolios of loans with similar financial characteristics. The fair values of performing loans are calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest risk inherent in the loan. The estimates of maturity are based on the Company's historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions, and the effects of estimated prepayments. Assumptions regarding credit risk, cash flows, and discount rates are judgmentally determined using available market information and specific borrower information. Management has made estimates of fair value using discount rates that it believes to be reasonable. However, because there is no market for many of these financial instruments, Management has no basis to determine whether the fair value presented above would be indicative of the value negotiated in an actual sale. As such, the Company classifies loans as Level 3, except for certain collateral-dependent impaired loans. Fair values of impaired loans are based on estimated cash flows and are discounted using a rate commensurate with the risk associated with the estimated cash flows, or if collateral dependent, discounted to the appraised value of the collateral as determined by reference to sale prices of similar properties, less costs to sell. As such, the Company classifies collateral dependent impaired loans for which a specific reserve results in a fair value measure as Level 2. All other impaired loans are classified as Level 3.

Other Real Estate Owned

Real estate acquired through foreclosure is initially recorded at fair value. The fair value of other real estate owned is based on property appraisals and an analysis of similar properties currently available. As such, the Company records other real estate owned as nonrecurring Level 2.

Mortgage Servicing Rights

Mortgage servicing rights represent the value associated with servicing residential mortgage loans. Servicing assets and servicing liabilities are reported using the amortization method and compared to fair value for impairment. In evaluating the fair values of mortgage servicing rights, the Company obtains third party valuations based on loan level data including note rate, type and term of the underlying loans. As such, the Company classifies mortgage servicing rights as Level 2.

Accrued Interest Receivable

The fair value estimate of this financial instrument approximates the carrying value as this financial instrument has a short maturity. It is the Company's policy to stop accruing interest on loans for which it is probable that the interest is not collectible. Therefore, this financial instrument has been adjusted for estimated credit loss. As such, the Company classifies accrued interest receivable as Level 2.

Deposits

The fair value of deposits is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities. As such, the Company classifies deposits as Level 2. The fair value estimates do not include the benefit that results from the low-cost funding provided by the deposits compared to the cost of borrowing funds in the market. If that value were considered, the fair value of the Company's net assets could increase.

Borrowed Funds

The fair value of borrowed funds is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently available for borrowings of similar remaining maturities. As such, the Company classifies borrowed funds as Level 2.

Derivatives

The fair value of interest rate swaps is determined using inputs that are observable in the market place obtained from third parties including yield curves, publicly available volatilities, and floating indexes and, accordingly, are classified as Level 2 inputs. The credit value adjustments associated with derivatives utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by the Company and its counterparties. As of September 30, 2017 and 2016, and December 31, 2016, the Company has assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and has determined that the credit valuation adjustments are not significant to the overall valuation of its derivatives due to collateral postings.

Accrued Interest Payable

The fair value estimate approximates the carrying amount as this financial instrument has a short maturity. The Company classifies accrued interest payable as Level 2.

Off-Balance-Sheet Instruments

Off-balance-sheet instruments include loan commitments. Fair values for loan commitments have not been presented as the future revenue derived from such financial instruments is not significant.

Limitations

Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These values do not reflect any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company's financial instruments, fair value estimates are based on Management's judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Fair value estimates are based on existing on- and off-balance-sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Other significant assets and liabilities that are not considered financial instruments include the deferred tax asset, premises and equipment, and other real estate owned. In addition, tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of the estimates.

Assets Recorded at Fair Value on a Recurring Basis

The following tables present the balances of assets that were measured at fair value on a recurring basis as of September 30, 2017, December 31, 2016 and September 30, 2016.



	At September 30, 2017
	Level 1		Level 2		Level 3		Total
Securities available for sale
Mortgage-backed securities	$	—	$	288,789,000	$	—	$	288,789,000
State and political subdivisions	—		6,842,000		—		6,842,000
Other equity securities	—		3,368,000		—		3,368,000
Total securities available for sale	—		298,999,000		—		298,999,000
Interest rate swap agreements	—		1,592,000		—		1,592,000
Total assets	$	—	$	300,591,000	$	—	$	300,591,000



	At December 31, 2016
	Level 1		Level 2		Level 3		Total
Securities available for sale
Mortgage-backed securities	$	—	$	280,604,000	$	—	$	280,604,000
State and political subdivisions	—		16,482,000		—		16,482,000
Other equity securities	—		3,330,000		—		3,330,000
Total securities available for sale	—		300,416,000		—		300,416,000
Interest rate swap agreements	—		1,790,000		—		1,790,000
Total assets	$	—	$	302,206,000	$	—	$	302,206,000



	At September 30, 2016
	Level 1		Level 2		Level 3		Total
Securities available for sale
Mortgage-backed securities	$	—	$	261,514,000	$	—	$	261,514,000
State and political subdivisions	—		17,484,000		—		17,484,000
Other equity securities	—		3,295,000		—		3,295,000
Total securities available for sale	—		282,293,000		—		282,293,000
Interest rate swap agreements	—		90,000		—		90,000
Total assets	$	—	$	282,383,000	$	—	$	282,383,000

Assets Recorded at Fair Value on a Non-Recurring Basis

The following tables include assets measured at fair value on a nonrecurring basis that have had a fair value adjustment since their initial recognition. Other real estate owned is presented net of an allowance of $53,000, $205,000 and $162,000 at September 30, 2017, December 31, 2016, and September 30, 2016, respectively. Only collateral-dependent impaired loans with a related specific allowance for loan losses or a partial charge off are included in impaired loans for purposes of fair value disclosures. Impaired loans below are presented net of specific allowances of $1,553,000, $478,000 and $496,000 at September 30, 2017, December 31, 2016, and September 30, 2016, respectively.



	At September 30, 2017
	Level 1		Level 2		Level 3		Total
Other real estate owned	$	—	$	320,000	$	—	$	320,000
Impaired loans	—		7,334,000		—		7,334,000
Total assets	$	—	$	7,654,000	$	—	$	7,654,000



	At December 31, 2016
	Level 1		Level 2		Level 3		Total
Other real estate owned	$	—	$	375,000	$	—	$	375,000
Impaired loans	—		827,000		—		827,000
Total assets	$	—	$	1,202,000	$	—	$	1,202,000



	At September 30, 2016
	Level 1		Level 2		Level 3		Total
Other real estate owned	$	—	$	855,000	$	—	$	855,000
Impaired loans	—		1,311,000		—		1,311,000
Total assets	$	—	$	2,166,000	$	—	$	2,166,000

Fair Value of Financial Instruments

FASB ASC Topic 825 "Financial Instruments" requires disclosures of fair value information about financial instruments, whether or not recognized in the balance sheet, if the fair values can be reasonably determined. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company's 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 using observable inputs when available. 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. Topic 825 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.

The carrying amount and estimated fair values for financial instruments as of September 30, 2017 were as follows:



	Carrying value		Estimated fair value		Level 1		Level 2		Level 3
Financial assets
Cash and cash equivalents	$	22,375,000	$	22,375,000	$	22,375,000	$	—	$	—
Interest bearing deposits in other banks	584,000		584,000		584,000		—		—
Securities available for sale	298,999,000		298,999,000		—		298,999,000		—
Securities to be held to maturity	242,679,000		245,021,000		—		245,021,000		—
Restricted equity securities	10,798,000		10,798,000		—		10,798,000		—
Loans held for sale	434,000		434,000		—		434,000		—
Loans (net of allowance for loan losses)
Commercial
Real estate	296,888,000		290,475,000		—		351,000		290,124,000
Construction	32,348,000		31,649,000		—		—		31,649,000
Other	169,493,000		167,710,000		—		6,259,000		161,451,000
Municipal	33,289,000		33,466,000		—		—		33,466,000
Residential
Term	428,318,000		431,112,000		—		724,000		430,388,000
Construction	15,461,000		15,307,000		—		—		15,307,000
Home equity line of credit	109,433,000		107,891,000		—		—		107,891,000
Consumer	24,844,000		24,416,000		—		—		24,416,000
Total loans	1,110,074,000		1,102,026,000		—		7,334,000		1,094,692,000
Mortgage servicing rights	1,109,000		1,888,000		—		1,888,000		—
Interest rate swap agreements	1,592,000		1,592,000		—		1,592,000		—
Accrued interest receivable	5,820,000		5,820,000		—		5,820,000		—
Financial liabilities
Demand deposits	$	193,089,000	$	187,310,000	$	—	$	187,310,000	$	—
NOW deposits	291,403,000		274,629,000		—		274,629,000		—
Money market deposits	134,257,000		126,541,000		—		126,541,000		—
Savings deposits	234,456,000		207,813,000		—		207,813,000		—
Local certificates of deposit	220,702,000		220,047,000		—		220,047,000		—
National certificates of deposit	276,142,000		276,078,000		—		276,078,000		—
Total deposits	1,350,049,000		1,292,418,000		—		1,292,418,000		—
Repurchase agreements	75,412,000		72,948,000		—		72,948,000		—
Federal Home Loan Bank advances	158,916,000		158,424,000		—		158,424,000		—
Total borrowed funds	234,328,000		231,372,000		—		231,372,000		—
Accrued interest payable	605,000		605,000		—		605,000		—

The carrying amounts and estimated fair values for financial instruments as of December 31, 2016 were as follows:



	Carrying value		Estimated fair value		Level 1		Level 2		Level 3
Financial assets
Cash and cash equivalents	$	17,366,000	$	17,366,000	$	17,366,000	$	—	$	—
Interest bearing deposits in other banks	293,000		293,000		293,000		—		—
Securities available for sale	300,416,000		300,416,000		—		300,416,000		—
Securities to be held to maturity	226,828,000		225,537,000		—		225,537,000		—
Restricted equity securities	11,930,000		11,930,000		—		11,930,000		—
Loans held for sale	782,000		782,000		—		782,000		—
Loans (net of allowance for loan losses)
Commercial
Real estate	297,952,000		293,103,000		—		558,000		292,545,000
Construction	24,954,000		24,548,000		—		—		24,548,000
Other	148,737,000		147,394,000		—		33,000		147,361,000
Municipal	27,035,000		27,446,000		—		—		27,446,000
Residential
Term	409,999,000		410,327,000		—		236,000		410,091,000
Construction	18,253,000		18,125,000		—		—		18,125,000
Home equity line of credit	109,986,000		108,740,000		—		—		108,740,000
Consumer	24,472,000		24,131,000		—		—		24,131,000
Total loans	1,061,388,000		1,053,814,000		—		827,000		1,052,987,000
Mortgage servicing rights	1,113,000		1,696,000		—		1,696,000		—
Interest rate swap agreements	1,790,000		1,790,000		—		1,790,000		—
Accrued interest receivable	5,532,000		5,532,000		—		5,532,000		—
Financial liabilities
Demand deposits	$	140,482,000	$	133,342,000	$	—	$	133,342,000	$	—
NOW deposits	282,971,000		259,418,000		—		259,418,000		—
Money market deposits	125,544,000		115,087,000		—		115,087,000		—
Savings deposits	217,340,000		188,260,000		—		188,260,000		—
Local certificates of deposit	210,316,000		209,370,000		—		209,370,000		—
National certificates of deposit	266,304,000		266,372,000		—		266,372,000		—
Total deposits	1,242,957,000		1,171,849,000		—		1,171,849,000		—
Repurchase agreements	84,174,000		79,827,000		—		79,827,000		—
Federal Home Loan Bank advances	194,727,000		193,733,000		—		193,733,000		—
Total borrowed funds	278,901,000		273,560,000		—		273,560,000		—
Accrued interest payable	479,000		479,000		—		479,000		—

The carrying amount and estimated fair values for financial instruments as of September 30, 2016 were as follows:



	Carrying value		Estimated fair value		Level 1		Level 2		Level 3
Financial assets
Cash and cash equivalents	$	23,456,000	$	23,456,000	$	23,456,000	$	—	$	—
Interest bearing deposits in other banks	15,098,000		15,098,000		15,098,000		—		—
Securities available for sale	282,293,000		282,293,000		—		282,293,000		—
Securities to be held to maturity	188,770,000		195,797,000		—		195,797,000		—
Restricted equity securities	14,048,000		14,048,000		—		14,048,000		—
Loans held for sale	1,228,000		1,228,000		—		1,228,000		—
Loans (net of allowance for loan losses)
Commercial
Real estate	293,167,000		289,015,000		—		544,000		288,471,000
Construction	18,452,000		18,191,000		—		—		18,191,000
Other	129,258,000		129,143,000		—		—		129,143,000
Municipal	26,132,000		27,270,000		—		—		27,270,000
Residential
Term	401,597,000		409,916,000		—		703,000		409,213,000
Construction	14,226,000		14,170,000		—		—		14,170,000
Home equity line of credit	110,989,000		110,220,000		—		—		110,220,000
Consumer	24,873,000		24,724,000		—		64,000		24,660,000
Total loans	1,018,694,000		1,022,649,000		—		1,311,000		1,021,338,000
Mortgage servicing rights	1,071,000		1,683,000		—		1,683,000		—
Interest rate swap agreements	90,000		90,000		—		90,000		—
Accrued interest receivable	5,079,000		5,079,000		—		5,079,000		—
Financial liabilities
Demand deposits	$	158,476,000	$	163,498,000	$	—	$	163,498,000	$	—
NOW deposits	295,708,000		296,393,000		—		296,393,000		—
Money market deposits	76,685,000		71,714,000		—		71,714,000		—
Savings deposits	218,425,000		206,331,000		—		206,331,000		—
Local certificates of deposit	211,402,000		213,622,000		—		213,622,000		—
National certificates of deposit	213,053,000		213,332,000		—		213,332,000		—
Total deposits	1,173,749,000		1,164,890,000		—		1,164,890,000		—
Repurchase agreements	87,970,000		87,246,000		—		87,246,000		—
Federal Home Loan Bank advances	180,128,000		181,918,000		—		181,918,000		—
Total borrowed funds	268,098,000		269,164,000		—		269,164,000		—
Accrued interest payable	508,000		508,000		—		508,000		—