Note 12:

Fair Value and Interest Rate Risk

The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. A fair value hierarchy has been established that prioritizes the inputs used to measure fair value, requiring entities to maximize the use of observable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs generally require significant management judgment.

The three levels within the fair value hierarchy are as follows:

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Level 1- Unadjusted quoted market prices for identical assets or liabilities in active markets that the entity has the ability to access at the measurement date (such as active exchange-traded equity securities and certain U.S. and government agency debt securities).

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Level 2- Observable inputs other than quoted prices included in Level 1, such as:

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quoted prices for similar assets or liabilities in active markets (such as U.S. agency and government sponsored mortgage-backed securities)

■

quoted prices for identical or similar assets or liabilities in less active markets (such as certain U.S. and government agency debt securities, and corporate and municipal debt securities that trade infrequently)

■

Other inputs that are observable for substantially the full term of the asset or liability (i.e. interest rates, yield curves, prepayment speeds, default rates, etc.)

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Level 3- Valuation techniques that require unobservable inputs that are supported by little or no market activity and are significant to the fair value measurement of the asset or liability (such as pricing and discounted cash flow models that typically reflect management’s estimates of the assumptions a market participant would use in pricing the asset or liability).

A description of the valuation methodologies used for assets and liabilities recorded at fair value, and for estimating fair value for financial and non-financial instruments not recorded at fair value, is set forth below.

Cash and due from banks, federal funds sold, short-term investments and accrued interest receivable and payable:

The carrying amount is a reasonable estimate of fair value and accordingly these are classified as Level 1. These financial instruments are not recorded at fair value on a recurring basis.

Available-for-Sale Securities:

The fair value of securities available for sale (carried at fair value) and held to maturity (carried at amortized cost) is determined by obtaining quoted market prices on nationally recognized securities exchanges (Level 1), or matrix pricing (Level 2), which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific securities but rather by relying on the securities' relationship to other benchmark quoted prices.

Other Investments:

The Bank’s investment portfolio includes the Solomon Hess SBA Loan Fund totaling $4.5 million. This investment is utilized for the purposes of the Bank satisfying its CRA lending requirements. As this fund operates as a private fund, shares in the Fund are not publicly traded and therefore have no readily determinable market value. The investment in the Fund is reported in the financial statements at cost, as adjusted for income, losses, and cash distributions attributable to the investment.

Loans:

For variable rate loans, which reprice frequently and have no significant change in credit risk, carrying values are a reasonable estimate of fair values, adjusted for credit losses inherent in the portfolios. The fair value of fixed rate loans is estimated by discounting the future cash flows using the period-end rates, estimated by using local market data, at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities, adjusted for credit losses inherent in the portfolios. As estimates are dependent on management’s observations, loans are classified as Level 3. The Company does not record loans at fair value on a recurring basis. However, from time to time, nonrecurring fair value adjustments to collateral-dependent impaired loans are recorded to reflect partial write-downs based on the observable market price or current appraised value of collateral. Fair values estimated in this manner do not fully incorporate an exit-price approach to fair value, but instead are based on a comparison to current market rates for comparable loans.

OREO:

The fair value of other OREO properties the Company may obtain is based on the estimated current property valuations less estimated selling costs. When the fair value is based on current observable appraised values, OREO is classified within Level 2. The Company classifies OREO within Level 3 when unobservable adjustments are made to appraised values.

Deposits:

The fair value of demand deposits, regular savings and certain money market deposits is the amount payable on demand at the reporting date. The fair value of certificates of deposit and other time deposits is estimated using a discounted cash flow calculation that applies interest rates currently being offered for deposits of similar remaining maturities, estimated using local market data, to a schedule of aggregated expected maturities on such deposits. The Company does not record deposits at fair value on a recurring basis.

Junior Subordinated Debt:

Junior subordinated debt reprices quarterly and as a result the carrying amount is considered a reasonable estimate of fair value. The Company does not record junior subordinated debt at fair value on a recurring basis.

Federal Home Loan Bank Borrowings:

The fair value of the advances is estimated using a discounted cash flow calculation that applies current Federal Home Loan Bank interest rates for advances of similar maturity to a schedule of maturities of such advances. The Company does not record these borrowings at fair value on a recurring basis.

Off-balance sheet instruments:

Fair values for the Company’s off-balance-sheet instruments (lending commitments) are based on interest rate changes and fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The Company does not record its off-balance-sheet instruments at fair value on a recurring basis.

The following table details the financial assets measured at fair value on a recurring basis as of September 30, 2016 and December 31, 2015, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine fair value:

(in thousands)	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Balance as of September 30, 2016
September 30, 2016:
U.S. Government agency mortgage-backed securities	$	-		11,412		-		11,412
Corporate bonds		-		8,937		-		8,937
Subordinated Notes		-		3,025		-		3,025
Securities available for sale	$	-		23,374		-		23,374

	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)		Balance as of December 31, 2015
December 31, 2015:
U.S. Government agency bonds	$	-		4,954			-		4,954
U.S. Government agency mortgage-backed securities		-		13,413	#		-		13,413
Corporate bonds		-		9,010	#		-		9,010
Subordinated Notes		-		2,000			-		2,000
Securities available for sale	$	-		29,377			-		29,377

The Company regularly monitors significant market inputs and assumptions used in its fair value measurements and evaluates the level of the valuation input according to the fair value hierarchy. This may result in a transfer between levels in the hierarchy from period to period.

There were no transfers of assets between levels 1, 2 or 3 during the nine months ended September 30, 2016 or 2015. Certain financial assets and financial liabilities are measured at fair value on a nonrecurring basis; that is, the instruments are not measured at fair value on an ongoing basis, but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment).

The following table reflects financial assets measured at fair value on a non-recurring basis as of September 30, 2016 and December 31, 2015, segregated by the level of the valuation inputs within the fair value hierarchy utilized:

(in thousands)
Asset Description	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Balance
September 30, 2016:
Impaired loans	$	-		-		-		-
Other real estate owned	$	-		-		851		851

December 31, 2015:
Impaired loans	$	-		-		363		363

(in thousands)
	Quantitative Information about Level 3 Fair Value Measurements
Asset Description	Fair Value		Valuation Technique	Unobservable Input	Range/ (Weighted Average )

September 30, 2016:
Other real estate owned	$	851	Appraised Value of Property (1)	Liquidation Costs (2)	9.6% / (9.6%) (3)

December 31, 2015:
Impaired loans	$	363	Appraised Value of Collateral (1)	Liquidation Costs (2)	8% / (8%) (3)

(1)

Fair value is generally determined through independent appraisals of the underlying collateral (in the case of impaired loans) or property (in the case of OREO), which include Level 3 inputs that are not identifiable.

(2)

Appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated liquidation expenses.

(3)

The range and weighted average of qualitative factors such as economic conditions and estimated liquidation expenses are presented as a percent of the appraised value.

The Company discloses fair value information about financial instruments, whether or not recognized in the consolidated balance sheet, for which it is practicable to estimate that value. Certain financial instruments are excluded from disclosure requirements and, accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.

The estimated fair value amounts have been measured as of September 30, 2016 and December 31, 2015 and have not been reevaluated or updated for purposes of these financial statements subsequent to those respective dates. As such, the estimated fair value of these financial instruments subsequent to the respective reporting dates may be different than amounts reported on those dates.

The information presented should not be interpreted as an estimate of the fair value of the Company since a fair value calculation is only required for a limited portion of the Company’s assets and liabilities. Due to the wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between the Company’s disclosures and those of other bank holding companies may not be meaningful.

The following is a summary of the carrying amounts and estimated fair values of the Company’s financial instruments not measured and not reported at fair value on the consolidated balance sheets at September 30, 2016 and December 31, 2015:

(in thousands)		September 30, 2016				December 31, 2015
	Fair Value	Carrying		Estimated		Carrying		Estimated
Financial Assets:	Hierarchy	Amount		Fair Value		Amount		Fair Value
Cash and noninterest bearing balances due from banks	Level 1	$	2,454		2,454		2,588		2,588
Interest-bearing deposits due from banks	Level 1		43,060		43,060		82,812		82,812
Available for sale securities	Level 2		23,374		23,374		29,377		29,377
Other investments	Level 2		4,450		4,450		4,450		4,450
Federal Home Loan Bank and Federal Reserve Bank stock	Level 2		7,818		7,818		8,645		8,645
Loans receivable, net	Level 3		552,822		562,114		479,127		478,160
Accrued interest receivable	Level 2		2,308		2,308		2,010		2,010

Financial Liabilities:
Demand deposits	Level 2	$	77,304		77,304		85,812		85,812
Savings deposits	Level 2		130,901		130,901		106,291		106,291
Money market deposits	Level 2		17,230		17,230		19,508		19,508
NOW accounts	Level 2		24,672		24,672		27,951		27,951
Time deposits	Level 2		163,893		221,105		156,964		156,964
Brokered Deposits	Level 1		57,185		57,725		48,154		48,154
FHLB Borrowings	Level 2		135,000		135,497		132,000		132,000
Subordinated debentures	Level 2		8,248		8,248		8,248		8,248
Note Payable	Level 3		1,800		1,780		1,939		1,939
Accrued interest payable	Level 2		180		180		532		532

The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of the Company’s financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent possible to mitigate interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company’s overall interest rate risk.

Off-balance sheet instruments

Loan commitments on which the committed interest rate is less than the current market rate were insignificant at September 30, 2016 and December 31, 2015. The estimated fair value of fee income on letters of credit at September 30, 2016 and December 31, 2015 was also insignificant.