Fair Value of Financial Instruments

6 Months Ended

Jun. 30, 2020

Fair Value of Financial Instruments [Abstract]

Note 8 – Fair Value of Financial Instruments

Fair value is defined as the price to sell an asset or to transfer a liability in an orderly transaction between willing market participants as of the measurement date. Fair value is best determined by values quoted through active trading markets. Active trading markets are characterized by numerous transactions of similar financial instruments between willing buyers and willing sellers. Because no active trading market exists for various types of financial instruments, many of the fair values disclosed were derived using present value discounted cash flows or other valuation techniques described below. As a result, the Corporation’s ability to actually realize these derived values cannot be assumed.

The Corporation measures fair values based on the fair value hierarchy established in ASC Paragraph 820-10-35-37. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of inputs that may be used to measure fair value under the hierarchy are as follows:

Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets and liabilities. This level is the most reliable source of valuation.

Level 2: Quoted prices that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability. Level 2 inputs include inputs other than quoted prices that are observable for the asset or liability (for example, interest rates and yield curves at commonly quoted intervals, volatilities, prepayment speeds, loss severities, credit risks, and default rates). It also includes inputs that are derived principally from or corroborated by observable market data by correlation or other means (market-corroborated inputs). Several sources are utilized for valuing these assets, including a contracted valuation service, Standard & Poor’s (“S&P”) evaluations and pricing services, and other valuation matrices.

Level 3: Prices or valuation techniques that require inputs that are both significant to the valuation assumptions and not readily observable in the market (i.e. supported with little or no market activity). Level 3 instruments are valued based on the best available data, some of which is internally developed, and consider risk premiums that a market participant would require.

The level established within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

Management believes that the Corporation’s valuation techniques are appropriate and consistent with the techniques used by other market participants. However, the use of different methodologies and assumptions could result in a different estimate of fair values at the reporting date. The valuation techniques used by the Corporation to measure, on a recurring basis and on a non-recurring basis, the fair value of assets as of June 30, 2020 are discussed in the paragraphs that follow.

Investments – The fair value of investments is determined using a market approach. As of June 30, 2020, the U.S. Government agencies, residential and commercial mortgage-backed securities, collateralized mortgage obligations, and state and political subdivisions bonds, excluding the tax increment financing (“TIF”) bonds, segments are classified as Level 2 within the valuation hierarchy. Their fair values were determined based upon market-corroborated inputs and valuation matrices, which were obtained through third party data service providers or securities brokers through which the Corporation has historically transacted both purchases and sales of investment securities. The TIF bonds are classified as Level 3 within the valuation hierarchy as they are not openly traded.

The collateralized debt obligation (“CDO”) segment, which consists of pooled trust preferred securities issued by banks, thrifts and insurance companies, is classified as Level 3 within the valuation hierarchy. At June 30, 2020, the Corporation owned nine trust preferred securities with an amortized cost of $18.5 million and a fair value of $12.0 million. As of June 30, 2020, the market for these securities is not active and the markets for similar securities are also not active. The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which these securities trade and then by a significant decrease in the volume

of trades relative to historical levels. The new issue market is also inactive, as few CDOs have been issued since 2007. There are currently very few market participants who are willing to effect transactions in these securities. The market values for these securities or any securities other than those issued or guaranteed by the U.S. Department of the Treasury are depressed relative to historical levels. Therefore, in the current market, a low market price for a particular bond may only provide evidence of stress in the credit markets in general rather than being an indicator of credit problems with a particular issue. Given the conditions in the current debt markets and the absence of observable transactions in the secondary and new issue markets, management has determined that (a) the few observable transactions and market quotations that are available are not reliable for the purpose of obtaining fair value at June 30, 2020, (b) an income valuation approach technique (i.e. present value) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs will be equally or more representative of fair value than a market approach, and (c) the CDO segment is appropriately classified within Level 3 of the valuation hierarchy because management determined that significant adjustments were required to determine fair value at the measurement date.

Management utilizes on an independent third party to prepare both the evaluations of OTTI as well as the fair value determinations for its CDO portfolio. Management believes that the valuations are adequately reflected at June 30, 2020.

The approach used by the third party to determine fair value involved several steps, which included detailed credit and structural evaluation of each piece of collateral in each bond, projection of default, recovery and prepayment/amortization probabilities for each piece of collateral in the bond, and discounted cash flow modeling. The discount rate methodology used by the third party combines a baseline current market yield for comparable corporate and structured credit products with adjustments based on evaluations of the differences found in structure and risks associated with actual and projected credit performance of each CDO being valued. Currently, the only active and liquid trading market that exists is for stand-alone trust preferred securities, with a limited market for highly-rated CDO securities that are more senior in the capital structure than the securities in the CDO portfolio. Therefore, adjustments to the baseline discount rate are also made to reflect the additional leverage found in structured instruments.

At June 30, 2020, there has been minimal impact on the trust preferred bonds, although there has been a significant effect on several asset classes in the equity and fixed income markets related to COVID-19. A review of assumptions, as they relate to the impact of COVID-19, will be on-going through the remainder of the year.

Derivative financial instruments (Cash flow hedge) – The Corporation’s open derivative positions are interest rate swap agreements. Those classified as Level 2 open derivative positions are valued using externally developed pricing models based on observable market inputs provided by a third party and validated by management. The Corporation has considered counterparty credit risk in the valuation of its interest rate swap assets.

Impaired loans – Loans included in the table below are those that are considered impaired with a specific allocation or with a partial charge-off. Fair value consists of the loan balance less its valuation allowance and is generally determined based on independent third-party appraisals of the collateral or discounted cash flows based upon the expected proceeds. These assets are included as Level 3 fair values based upon the lowest level of input that is significant to the fair value measurements.

Other real estate owned – OREO included in the table below are considered impaired with specific write-downs. Fair value of other real estate owned is based on independent third-party appraisals of the properties. These values were determined based on the sales prices of similar properties in the approximate geographic area. These assets are included as Level 3 fair values based upon the lowest level of input that is significant to the fair value measurements.

For Level 3 assets and liabilities measured at fair value on a recurring and non-recurring basis as of June 30, 2020 and December 31, 2019, the significant unobservable inputs used in the fair value measurements were as follows:



(in thousands)	Fair Value at ‎June 30, ‎2020		Valuation ‎Technique	Significant ‎Unobservable ‎Inputs	Significant ‎Unobservable ‎Input Value
Recurring:
Investment Securities – available for sale	$	11,952	Discounted ‎Cash Flow	Discount Rate	LIBOR+ 6.00%
Non-recurring:
Impaired Loans	$	6,994	Market Comparable ‎Properties	Marketability ‎Discount	10.0% - 15.0% (1) ‎(weighted avg 13.1%)
Other Real Estate Owned	$	476	Market Comparable ‎Properties	Marketability ‎Discount	15.0%

(in thousands)	Fair Value at ‎December 31, ‎2019		Valuation ‎Technique	Significant ‎Unobservable ‎Inputs	Significant ‎Unobservable ‎Input Value
Recurring:
Investment Securities – available for sale	$	14,354	Discounted ‎Cash Flow	Discount ‎Rate	LIBOR+ 4.75%
Non-recurring:
Impaired Loans	$	6,995	Market Comparable ‎Properties	Marketability ‎Discount	10.0% - 15.0% (1) ‎(weighted avg 12.9%)
Other Real Estate Owned	$	2,571	Market Comparable ‎Properties	Marketability ‎Discount	10.0% - 15.0% (1) ‎(weighted avg 12.5%)

NOTE:

(1)Range would include discounts taken since appraisal and estimated values

‎

For assets measured at fair value on a recurring and non-recurring basis, the fair value measurements by level within the fair value hierarchy used at June 30, 2020 and December 31, 2019 are as follows:



			Fair Value Measurements ‎at June 30, 2020 Using
	Assets/(liabilities) ‎Measured at ‎Fair Value		Quoted ‎Prices in ‎Active Markets ‎for Identical ‎Assets	Significant ‎Other ‎Observable ‎Inputs		Significant ‎Unobservable ‎Inputs
(in thousands)	06/30/20		(Level 1)	(Level 2)		(Level 3)
Recurring:
Investment securities available-for-sale:
U.S. government agencies	$	46,945		$	46,945
Residential mortgage-backed agencies	$	18,776		$	18,776
Commercial mortgage-backed agencies	$	29,143		$	29,143
Collateralized mortgage obligations	$	25,818		$	25,818
Obligations of states and political subdivisions	$	13,556		$	13,556
Collateralized debt obligations	$	11,952				$	11,952
Loans held for sale	$	6,283		$	6,283
Financial derivatives	$	(1,558)		$	(1,558)
Non-recurring:
Impaired loans	$	6,994				$	6,994
Other real estate owned	$	476				$	476



			Fair Value Measurements ‎at December 31, 2019 Using
	Assets/(liabilities) ‎Measured at ‎Fair Value		Quoted ‎Prices in ‎Active Markets ‎for Identical ‎Assets	Significant ‎Other ‎Observable ‎Inputs		Significant ‎Unobservable ‎Inputs
(in thousands)	12/31/19		(Level 1)	(Level 2)		(Level 3)
Recurring:
Investment securities available-for-sale:
U.S. government agencies	$	39,894		$	39,894
Residential mortgage-backed agencies	$	4,900		$	4,900
Commercial mortgage-backed agencies	$	27,764		$	27,764
Collateralized mortgage obligations	$	29,923		$	29,923
Obligations of states and political subdivisions	$	14,470		$	14,470
Collateralized debt obligations	$	14,354				$	14,354
Loans held for sale	$	1,749		$	1,749
Financial derivatives	$	(133)		$	(133)
Non-recurring:
Impaired loans	$	6,995				$	6,995
Other real estate owned	$	2,571				$	2,571

There were no transfers of assets between any of the fair value hierarchy for the six and three month periods ended June 30, 2020 or 2019.

The following tables show a reconciliation of the beginning and ending balances for fair valued assets measured on a recurring basis using Level 3 significant unobservable inputs for the six and three month periods ended June 30, 2020 and 2019:



	Fair Value Measurements ‎Using Significant Unobservable Inputs ‎(Level 3)
(in thousands)	Investment Securities ‎Available for Sale
Beginning balance January 1, 2020	$	14,354
Total losses realized/unrealized:
Included in other comprehensive loss		(2,402)
Ending balance June 30, 2020	$	11,952



	Fair Value Measurements ‎Using Significant Unobservable Inputs ‎(Level 3)
(in thousands)	Investment Securities ‎Available for Sale
Beginning balance January 1, 2019	$	15,277
Total losses realized/unrealized:
Included in other comprehensive income		(405)
Ending balance June 30, 2019	$	14,872



	Fair Value Measurements ‎Using Significant Unobservable Inputs ‎(Level 3)
(in thousands)	Investment Securities ‎Available for Sale
Beginning balance April 1, 2020	$	12,380
Total losses realized/unrealized:
Included in other comprehensive income		(428)
Ending balance June 30, 2020	$	11,952



	Fair Value Measurements ‎Using Significant Unobservable Inputs ‎(Level 3)
(in thousands)	Investment Securities ‎Available for Sale
Beginning balance April 1, 2019	$	15,152
Total losses realized/unrealized:
Included in other comprehensive income		(280)
Ending balance June 30, 2019	$	14,872

There were no gains or losses included in earnings attributable to the change in realized/unrealized gains or losses related to the assets for the six and three month periods ended June 30, 2020 and 2019.

The disclosed fair values may vary significantly between institutions based on the estimates and assumptions used in the various valuation methodologies. The derived fair values are subjective in nature and involve uncertainties and significant judgment. Therefore, they cannot be determined with precision. Changes in the assumptions could significantly impact the derived estimates of fair value. Disclosure of non-financial assets such as buildings as well as certain financial instruments such as leases is not required. Accordingly, the aggregate fair values presented do not represent the underlying value of the Corporation.

The following tables present fair value information about financial instruments, whether or not recognized in the Consolidated Statement of Financial Condition, for which it is practicable to estimate that value. The actual carrying amounts and estimated fair values of the Corporation’s financial instruments that are included in the Consolidated Statement of Financial Condition are as follows:



	June 30, 2020				Fair Value Measurements
	Carrying		Fair		Quoted ‎Prices in ‎Active Markets ‎for Identical ‎Assets		Significant ‎Other ‎Observable ‎Inputs		Significant ‎Unobservable ‎Inputs
(in thousands)	Amount		Value		(Level 1)		(Level 2)		(Level 3)
Financial Assets:
Cash and due from banks	$	114,513	$	114,513	$	114,513
Interest bearing deposits in banks		2,577		2,577		2,577
Investment securities - AFS		146,190		146,190			$	134,238	$	11,952
Investment securities - HTM		73,975		80,702				55,385		25,317
Restricted bank stock		4,468		4,468				4,468
Loans, net		1,166,220		1,176,909						1,176,909
Loans held for sale		6,283						6,283
Accrued interest receivable		5,789		5,789				5,789
Financial Liabilities:
Deposits - non-maturity		1,116,739		1,116,739				1,116,739
Deposits - time deposits		234,829		238,577				238,577
Financial derivatives		1,558		1,558				1,558
Short-term borrowed funds		36,001		36,001				36,001
Long-term borrowed funds		100,929		103,304				103,304
Accrued interest payable		470		470				470



	December 31, 2019				Fair Value Measurements
	Carrying		Fair		Quoted ‎Prices in ‎Active Markets ‎for Identical ‎Assets		Significant ‎Other ‎Observable ‎Inputs		Significant ‎Unobservable ‎Inputs
(in thousands)	Amount		Value		(Level 1)		(Level 2)		(Level 3)
Financial Assets:
Cash and due from banks	$	48,512	$	48,512	$	48,512
Interest bearing deposits in banks		1,467		1,467		1,467
Investment securities - AFS		131,305		131,305			$	116,951	$	14,354
Investment securities - HTM		93,979		100,656				79,084		21,572
Restricted bank stock		4,415		4,415				4,415
Loans, net		1,038,894		1,037,032						1,037,032
Loans held for sale		1,749						1,749
Accrued interest receivable		4,116		4,116				4,116
Financial Liabilities:
Deposits - non-maturity		888,141		888,141				888,141
Deposits - time deposits		253,890		256,227				256,227
Financial derivative		133		133				133
Short-term borrowed funds		48,728		48,728				48,728
Long-term borrowed funds		100,929		100,848				100,848
Accrued interest payable		499		499				499

- 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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