NOTE 6 – FAIR VALUE

ASC Topic 820 provides a framework for measuring and disclosing fair value under GAAP. ASC 820 requires disclosures about the fair value of assets and liabilities recognized in the balance sheet in periods subsequent to initial recognition, whether the measurements are made on a recurring basis (for example, available-for-sale investment securities) or a nonrecurring basis (for example, impaired loans).

ASC 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820 also establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

The Fair Value Hierarchy

ASC 820‑10 specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. In accordance with ASC 820‑10, these inputs are summarized in the three broad levels listed below:

Level 1 – Unadjusted quoted prices in active markets for identical assets or liabilities that the entity has the ability to access at the measurement date.

Level 2 – Other significant observable inputs (including quoted prices in active markets for similar securities)

Level 3 – Significant unobservable inputs (including the Company’s own assumptions in determining the fair value of investments)

The following is a description of valuation methodologies used for assets and liabilities recorded at fair value:

Investment Securities Available-for-Sale and Interest Rate Swaps. Investment securities available-for-sale and interest rate swap contracts 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 values are measured using independent pricing models or other model-based valuation techniques such as 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 mortgage backed securities issued by government sponsored entities, municipal bonds and corporate debt securities, and interest rate swap contracts. Securities classified as Level 3 include asset-backed securities in illiquid markets.

The Bank may be required, from time to time, to measure certain other financial and non-financial assets and liabilities at fair value on a non-recurring basis in accordance with GAAP.

Loans. At September 30, 2018, these assets include 23 loans, excluding $271,000 of residential real estate and indirect loans, classified as impaired, which include nonaccrual, past due 90 days or more and still accruing, and a homogeneous pool of indirect loans all considered to be impaired loans, which are valued under Level 3 inputs. Loans which are deemed to be impaired ($2.8 million of loans with $282,000 of specific reserves as of September 30, 2018) and foreclosed real estate assets are primarily valued on a nonrecurring basis at the fair values of the underlying real estate collateral. The Company is predominantly a cash flow lender with real estate serving as collateral on a majority of loans ($2.6 million of the total impaired loans as of September 30, 2018). On a quarterly basis, the Company determines such fair values through a variety of data points and mostly rely on appraisals from independent appraisers. We obtain an appraisal on properties when they become impaired and have new appraisals at least every year. Typically, these appraisals do not include an inside inspection of the property as our loan documents do not require the borrower to allow access to the property. Therefore the most significant unobservable inputs is the details of the amenities included within the property and the condition of the property. Further, we cannot always accurately assess the amount of time it takes to gain ownership of our collateral through the foreclosure process and the damage, as well as potential looting, of the property further decreasing our value. Thus, in determining the fair values we discount the current independent appraisals, with a range from 0% to 16%, based on individual circumstances. The remaining impaired loans ($523,000 million with $223,000 of specific reserves as of September 30, 2018) include mobile homes, commercial, consumer, and indirect auto loans, which are valued based on the value of the underlying collateral.

The changes in the assets subject to fair value measurements are summarized below by level:


							Fair
(dollars in thousands)	Level 1		Level 2		Level 3		Value
September 30, 2018
Recurring:
Securities available for sale
Collateralized mortgage obligations	$	—	$	20,565	$	—	$	20,565
Agency mortgage-backed securities		—		25,614		—		25,614
Municipal securities		—		34,446		—		34,446
U.S. Government agency securities		—		1,919		—		1,919
U.S. Treasury securities		—		1,485		—		1,485
Interest rate swap		—		517		—		517

Non-recurring:
Maryland Financial Bank stock		—		—		23		23
Impaired loans		—		—		2,844		2,844
OREO		—		705		—		705
	$	—	$	85,251	$	2,867	$	88,118
December 31, 2017
Recurring:
Securities available for sale
Collateralized mortgage obligations	$	—	$	23,514	$	—	$	23,514
Agency mortgage-backed securities		—		25,229		—		25,229
Municipal securities		—		35,633		—		35,633
U.S. Government agency securities		—		3,480		—		3,480
U.S. Treasury securities		—		1,493		—		1,493
Interest rate swap		—		49		—		49
Non-recurring:
Maryland Financial Bank stock		—		—		30		30
Impaired loans		—		—		3,532		3,532
OREO		—		114		—		114
	$	—	$	89,512	$	3,562	$	93,074

The estimated fair values of the Company’s financial instruments at September 30, 2018 and December 31, 2017 are summarized below. The fair values of a significant portion of these financial instruments are estimates derived using present value techniques and may not be indicative of the net realizable or liquidation values. Also, the calculation of estimated fair values is based on market conditions at a specific point in time and may not reflect current or future fair values.


	September 30, 2018				December 31, 2017
(dollars in thousands)	Carrying		Fair		Carrying		Fair
	Amount		Value		Amount		Value
Financial assets:
Cash and due from banks	$	5,282	$	5,282	$	2,610	$	2,610
Interest-bearing deposits in other financial institutions		10,208		10,208		9,846		9,846
Federal funds sold		327		327		149		149
Investment securities available for sale		84,029		84,029		89,349		89,349
Investments in restricted stock		2,073		2,073		1,232		1,232
Ground rents		146		146		153		153
Loans, less allowance for credit losses		292,526		294,316		269,023		275,819
Accrued interest receivable		1,233		1,233		1,133		1,133
Cash value of life insurance		7,818		7,818		8,713		8,713

Financial liabilities:
Deposits		336,847		314,413		334,238		324,512
Long-term borrowings		—		—		—		—
Short-term borrowings		40,000		39,957		20,000		20,739
Accrued interest payable		149		149		101		101
Unrecognized financial instruments:
Commitments to extend credit		31,401		31,401		19,109		19,109
Standby letters of credit		1,025		1,025		71		71

The following presents the carrying amount, fair value, and placement in the fair value hierarchy of the Company’s financial instruments.


(dollars in thousands)
	Carrying		Fair
September 30, 2018	Amount		Value		Level 1		Level 2	Level 3

Financial instruments - Assets
Cash and cash equivalents	$	15,817	$	15,817	$	15,817	—	$	—
Loans receivable, net		292,526		294,316		—	—		294,316
Cash value of life insurance		7,818		7,818		—	7,818		—
Financial instruments - Liabilities
Deposits		336,847		314,413		—	314,413		—
Short-term debt		40,000		39,957		—	39,957		—

Fair values are based on quoted market prices for similar instruments or estimated using discounted cash flows. The discounts used are estimated using comparable market rates for similar types of instruments adjusted to be commensurate with the credit risk, overhead costs and optionality of such instruments.

The fair value of cash and due from banks, federal funds sold, investments in restricted stocks and accrued interest receivable are equal to the carrying amounts. The fair values of investment securities are determined using market quotations if available, or measured using pricing models or other model-based valuation techniques such as present value and future value cash flows. The fair value of loans receivable is estimated using discounted cash flow analysis. For cash surrender value of life insurance, the carrying value is a reasonable estimate of fair value. Cash surrender value of life insurance is reported in the Level 2 fair value category. The fair value of FHLB borrowings is estimated based upon discounted future cash flows using a discounted rate comparable to the current market rate for such borrowings. FHLB borrowings are reported in the Level 2 fair value category.

The fair value of non-interest bearing deposits, interest-bearing checking, savings, and money market deposit accounts, securities sold under agreements to repurchase, and accrued interest payable are equal to the carrying amounts. The fair value of fixed-maturity time deposits is estimated using discounted cash flow analysis.