Note 13 - Fair Value

 

The Fair Value Measurements Topic establishes a hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The Topic describes three levels of inputs that may be used to measure fair value:

 

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

 

Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

 

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

 

The fair values of securities available-for-sale are determined on a recurring basis by obtaining quoted prices on nationally recognized securities exchanges or pricing models utilizing significant observable inputs such as matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities. Different judgments and assumptions used in pricing could result in different estimates of value. In certain cases where market data is not readily available because of a lack of market activity or little public disclosure, values may be based on unobservable inputs and classified in Level 3 of the fair value hierarchy.

 

At the end of each reporting period, securities held in the investment portfolio are evaluated on an individual security level for other-than-temporary impairment in accordance with the Investments – Debt and Equity Securities Topic. Impairment is other-than-temporary if the decline in the fair value is below its amortized cost and it is probable that all amounts due according to the contractual terms of a debt security will not be received. Significant judgments are required in determining impairment, which include making assumptions regarding the estimated prepayments, loss assumptions and the change in interest rates. The Bancorp considers the following factors when determining an other-than-temporary impairment for a security: the length of time and the extent to which the market value has been less than amortized cost; the financial condition and near-term prospects of the issuer; the underlying fundamentals of the relevant market and the outlook for such market for the near future; an assessment of whether the Bancorp (1) has the intent to sell the debt securities or (2) more likely than not will be required to sell the debt securities before their anticipated market recovery. If either of these conditions is met, management will recognize other-than-temporary impairment. If, in management’s judgment, an other-than-temporary impairment exists, the cost basis of the security will be written down for the credit loss, and the unrealized loss will be transferred from accumulated other comprehensive loss as an immediate reduction of current earnings.

 

The Bancorp’s management utilizes a specialist to perform an other-than-temporary impairment analysis for each of its four pooled trust preferred securities. The analysis is performed semiannually on June 30 and December 31 and utilizes analytical models used to project future cash flows for the pooled trust preferred securities based on current assumptions for prepayments, default and deferral rates, and recoveries. The projected cash flows are then tested for impairment consistent with the Investments – Other Topic and the Investments – Debt and Equity Securities Topic. The other-than-temporary impairment testing compares the present value of the cash flows from quarter to quarter to determine if there is a “favorable” or “adverse” change. Other-than-temporary impairment is recorded if the projected present value of cash flows is lower than the book value of the security. To perform the semi-annual other-than-temporary impairment analysis, management utilizes current reports issued by the trustee, which contain principal and interest tests, waterfall distributions, note valuations, collection detail and credit ratings for each pooled trust preferred security. In addition, a detailed review of the performing collateral was performed. The review of the collateral began with a review of financial information provided by SNL Financial, a comprehensive database, widely used in the industry, which gathers financial data on banks and thrifts from U.S. GAAP financial statements for public companies (annual and quarterly reports on Forms 10-K and 10-Q, respectively), as well as regulatory reports for private companies, including consolidated financial statements for bank holding companies (FR Y-9C reports) and parent company-only financial statements for bank holding companies (FR Y-9LP reports) filed with the Federal Reserve, and bank call reports filed with the FDIC and the Office of the Comptroller of Currency. Using the information sources described above, for each bank and thrift examined the following items were examined: nature of the issuer’s business, years of operating history, corporate structure, loan composition and loan concentrations, deposit mix, asset growth rates, geographic footprint and local economic environment. The issuers’ historical financial performance was reviewed and their financial ratios were compared to appropriate peer groups of regional banks or thrifts with similar asset sizes. The analysis focused on six broad categories: profitability (revenue streams and earnings quality, return on assets and shareholder’s equity, net interest margin and interest rate sensitivity), credit quality (charge-offs and recoveries, non-current loans and total non-performing assets as a percentage of total loans, loan loss reserve coverage and the adequacy of the loan loss provision), operating efficiency (non-interest expense compared to total revenue), capital adequacy (Tier-1, total capital and leverage ratios and equity capital growth), leverage (tangible equity as a percentage of tangible assets, short-term and long-term borrowings and double leverage at the holding company) and liquidity (the nature and availability of funding sources, net non-core funding dependence and quality of deposits). In addition, for publicly traded companies’ stock price movements were reviewed and the market price of publicly traded debt instruments was examined. Based on current market conditions and a review of the trustee reports, management performed an analysis of the four pooled trust preferred securities and no additional impairment was taken at March 31, 2018. A specialist will be used to review all four pooled trust preferred securities again at June 30, 2018.

 

The table below shows the credit loss roll forward on a year-to-date basis for the Bancorp’s pooled trust preferred securities that have been classified with other-than-temporary impairment:

 

		(Dollars in thousands)
		Collateralized debt obligations
		other-than-temporary impairment
Ending balance, December 31, 2017		$	271
Additions not previously recognized			-
Ending balance, March 31, 2018		$	271

 

The following table contains information regarding the Bancorp’s pooled trust preferred securities impairment evaluation as of December 31, 2017:

 

Cusip			74043CAC1				74042TAJ0				01449TAB9				01450NAC6
Deal name			PreTSLXXIV				PreTSL XXVII				Alesco IX				Alesco XVII
Class			B-1				C-1				A-2A				B
Lowest credit rating assigned			CCC				CC				BB				CCC
Number of performing banks			62				33				63				51
Number of performing insurance companies			13				7				10				n/a
Number of issuers in default			16				7				2				4
Number of issuers in deferral			2				2				1				1
Defaults & deferrals as a % of performing collateral			26.56	%			20.06	%			2.93	%			8.11	%
Subordination:
As a % of performing collateral			23.55	%			8.35	%			53.11	%			35.58	%
As a % of performing collateral-adjusted for projected future defaults			18.67	%			1.24	%			49.64	%			31.69	%
Other-than-temporary impairment model assumptions:
Defaults:
Year 1 - issuer average			2.00	%			2.40	%			2.30	%			1.90	%
Year 2 - issuer average			2.00	%			2.40	%			2.30	%			1.90	%
Year 3 - issuer average			2.00	%			2.40	%			2.30	%			1.90	%
> 3 Years - issuer average			(1)				(1)				(1)				(1)
Discount rate - 3 month Libor, plus implicit yield spread at purchase			1.48	%			1.23	%			1.27	%			1.44	%
Recovery assumptions			(2)				(2)				(2)				(2)
Prepayments			0.00	%			0.00	%			0.00	%			0.00	%
Other-than-temporary impairment		$	41			$	132			$	36			$	62

(1) - Default rates > 3 years are evaluated on a issuer by issuer basis and range from 0.25% to 5.00%.

(2) - Recovery assumptions are evaluated on a issuer by issuer basis and range from 0% to 15% with a five year lag.  

 

In the preceding table, the Bancorp’s subordination for each trust preferred security is calculated by taking the total performing collateral and subtracting the sum of the total collateral within the Bancorp’s class and the total collateral within all senior classes, and then stating this result as a percentage of the total performing collateral. This measure is an indicator of the level of collateral that can default before potential cash flow disruptions may occur. In addition, management calculates subordination assuming future collateral defaults by utilizing the default/deferral assumptions in the Bancorp’s other-than-temporary-impairment analysis. Subordination assuming future default/deferral assumptions is calculated by deducting future defaults from the current performing collateral. At March 31, 2018, management reviewed the subordination levels for each security in context of the level of current collateral defaults and deferrals within each security; the potential for additional defaults and deferrals within each security; the length of time that the security has been in “payment in kind” status; and the Bancorp’s class position within each security.

 

Management calculated the other-than-temporary impairment model assumptions based on the specific collateral underlying each individual security. The following assumption methodology was applied consistently to each of the four pooled trust preferred securities: For collateral that has already defaulted, no recovery was assumed; no cash flows were assumed from collateral currently in deferral, with the exception of the recovery assumptions. The default and recovery assumptions were calculated based on a detailed collateral review. The discount rate assumption used in the calculation of the present value of cash flows is based on the discount margin (i.e., credit spread) at the time each security was purchased using the original purchase price. The discount margin is then added to the appropriate 3-month LIBOR forward rate obtained from the forward LIBOR curve.

 

 

Assets and Liabilities Measured at Fair Value on a Recurring Basis

 

There were no transfers to or from Levels 1 and 2 during the three months ended March 31, 2018. Assets measured at fair value on a recurring basis are summarized below:

 

					(Dollars in thousands)
					Fair Value Measurements at March 31, 2018 Using
(Dollars in thousands)		Estimated Fair Value			Quoted Prices in Active Markets for Identical Assets (Level 1)			Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)
Available-for-sale debt securities:
Money market fund		$	924		$	924		$	-		$	-
U.S. government sponsored entities			5,838			-			5,838			-
Collateralized mortgage obligations and residential mortgage-backed securities			139,169			-			139,169			-
Municipal securities			92,085			-			92,085			-
Collateralized debt obligations			3,455			-			-			3,455
Total securities available-for-sale		$	241,471		$	924		$	237,092		$	3,455

 

					(Dollars in thousands)
					Fair Value Measurements at December 31, 2017 Using
(Dollars in thousands)		Estimated Fair Value			Quoted Prices in Active Markets for Identical Assets (Level 1)			Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)
Available-for-sale debt securities:
Money market fund		$	476		$	476		$	-		$	-
U.S. government sponsored entities			3,890			-			3,890			-
Collateralized mortgage obligations and residential mortgage-backed securities			132,938			-			132,938			-
Municipal securities			103,747			-			103,747			-
Collateralized debt obligations			3,439			-			-			3,439
Total securities available-for-sale		$	244,490		$	476		$	240,575		$	3,439

A roll forward of available-for-sale securities, which require significant adjustment based on unobservable data, are presented in the following table:

 

		(Dollars in thousands)
		Estimated Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
		Available-for- sale securities
Beginning balance, January 1, 2017		$	2,409
Principal payments			(154)
Total unrealized gains, included in other comprehensive income			1,184
Transfers in and/or (out) of Level 3			-
Ending balance, December 31, 2017		$	3,439
Beginning balance, January 1, 2018		$	3,439
Principal payments			(12)
Total unrealized gains, included in other comprehensive income			28
Transfers in and/or (out) of Level 3			-
Ending balance, March 31, 2018		$	3,455

 

Assets measured at fair value on a non-recurring basis are summarized below:

					(Dollars in thousands)
					Fair Value Measurements at March 31, 2018 Using
(Dollars in thousands)		Estimated Fair Value			Quoted Prices in Active Markets for Identical Assets (Level 1)			Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)
Impaired loans		$	1,973		$	-		$	-		$	1,973
Foreclosed real estate			1,432			-			-			1,432

 

					(Dollars in thousands)
					Fair Value Measurements at December 31, 2017 Using
(Dollars in thousands)		Estimated Fair Value			Quoted Prices in Active Markets for Identical Assets (Level 1)			Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)
Impaired loans		$	1,818		$	-		$	-		$	1,818
Foreclosed real estate			1,699			-			-			1,699

 

The fair value of impaired loans with specific allocations of the allowance for loan losses or loans for which charge-offs have been taken is generally based on a present value of cash flows or, for collateral dependent loans, based on recent real estate appraisals. Appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. The recorded investment in impaired loans was approximately $2.0 million and the related specific reserves totaled approximately $59 thousand, resulting in a fair value of impaired loans totaling approximately $1.9 million, at March 31, 2018. The recorded investment of impaired loans was approximately $2.5 million and the related specific reserves totaled approximately $704 thousand, resulting in a fair value of impaired loans totaling approximately $1.8 million, at December 31, 2017. Fair value is determined, where possible, using market prices derived from an appraisal or evaluation, which are considered to be Level 2 inputs. However, certain assumptions and unobservable inputs are often used by the appraiser, therefore, qualifying the assets as Level 3 in the fair value hierarchy. The fair value of foreclosed real estate is similarly determined by using the results of recent real estate appraisals. The numerical range of unobservable inputs for these valuation assumptions is not meaningful to this presentation.

 

The following table shows carrying values and related estimated fair values of financial instruments as of the dates indicated. Estimated fair values are further categorized by the inputs used to measure fair value. Items that are not financial instruments are not included.

 

		March 31, 2018						Estimated Fair Value Measurements at March 31, 2018 Using
(Dollars in thousands)		Carrying Value			Estimated Fair Value			Quoted Prices in Active Markets for Identical Assets (Level 1)			Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)
Financial assets:
Cash and cash equivalents		$	20,415		$	20,415		$	20,415		$	-		$	-
Certificates of deposit in other financial institutions			1,526			1,493			-			1,493			-
Securities available-for-sale			241,471			241,471			924			237,092			3,455
Loans held-for-sale			1,908			1,949			1,949			-			-
Loans receivable, net			617,565			602,764			-			-			602,764
Federal Home Loan Bank stock			3,000			3,000			-			3,000			-
Accrued interest receivable			3,052			3,052			-			3,052			-
Financial liabilities:
Non-interest bearing deposits			126,582			126,582			126,582			-			-
Interest bearing deposits			668,791			666,925			474,069			192,856			-
Repurchase agreements			13,396			13,387			11,642			1,745			-
Borrowed funds			30,360			30,254			260			29,994			-
Interest rate swap agreements			18			18			-			18			-
Accrued interest payable			42			42			-			42			-

 

		December 31, 2017						Estimated Fair Value Measurements at December 31, 2017 Using
(Dollars in thousands)		Carrying Value			Estimated Fair Value			Quoted Prices in Active Markets for Identical Assets (Level 1)			Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)
Financial assets:
Cash and cash equivalents		$	11,025		$	11,025		$	11,025		$	-		$	-
Certificates of deposit in other financial institutions			1,676			1,640			-			1,640			-
Securities available-for-sale			244,490			244,490			476			240,575			3,439
Loans held-for-sale			1,592			1,625			1,625			-			-
Loans receivable, net			612,729			608,506			-			-			608,506
Federal Home Loan Bank stock			3,000			3,000			-			3,000			-
Accrued interest receivable			3,262			3,262			-			3,262			-
Financial liabilities:
Non-interest bearing deposits			120,556			120,556			120,556			-			-
Interest bearing deposits			672,448			670,967			488,528			182,439			-
Repurchase agreements			11,300			11,292			9,545			1,747			-
Borrowed funds			20,881			20,818			600			20,218			-
Accrued interest payable			42			42			-			42			-

 

The following methods were used to estimate the fair value of financial instruments presented in the preceding table for the periods ended March 31, 2018:

 

Cash and cash equivalents carrying amounts approximate fair value. The fair values of securities available-for-sale are obtained from broker pricing (Level 2), with the exception of collateralized debt obligations, which are valued by a third-party specialist (Level 3). Loans held-for-sale comprise residential mortgages and are priced based on values established by the secondary mortgage markets (Level 1). The estimated fair value for net loans receivable is based on estimates of the rate the Bancorp would charge for similar such loans, applied for the time period until estimated repayment, in addition to appraisals which may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach (Level 3). Federal Home Loan Bank stock is estimated at book value due to restrictions that limit the sale or transfer of the security. Fair value of accrued interest receivable and payable approximates book value, as the carrying values are determined using the observable interest rate, balance, and last payment date.

 

Non-interest and interest bearing deposits, which include checking, savings, and money market deposits, are estimated to have fair values based on the amount payable as of the reporting date (Level 1). The fair value of fixed-maturity certificates of deposit (included in interest bearing deposits) are based on estimates of the rate the Bancorp would pay on similar deposits, applied for the time period until maturity (Level 2). Estimated fair values for short-term repurchase agreements, which represent sweeps from demand deposits to accounts secured by pledged securities, are estimated based on the amount payable as of the reporting date (Level 1). Longer-term repurchase agreements, with contractual maturity dates of quarter or more, are based on estimates of the rate the Bancorp would pay on similar deposits, applied for the time period until maturity (Level 2). Short-term borrowings are generally only held overnight, therefore, their carrying amount is a reasonable estimate of fair value (Level 1). The fair value of FHLB Advances (included in borrowed funds) are estimated by discounting the future cash flows using quoted rates from the FHLB for similar advances with similar maturities (Level 2). The estimated fair value of other financial instruments, and off-balance sheet loan commitments, approximate cost and are not considered significant to this presentation.

 

The following methods were used to estimate the fair value of financial instruments presented in the preceding table for the periods ended December 31, 2017:

 

Cash and cash equivalent carrying amounts approximate fair value. Certificates of deposits in other financial institutions carrying amounts approximate fair value (Level 2). The fair values of securities available-for-sale are obtained from broker pricing (Level 2), with the exception of collateralized debt obligations, which are valued by a third-party specialist (Level 3). Loans held-for-sale comprise residential mortgages and are priced based on values established by the secondary mortgage markets (Level 1). The estimated fair value for net loans receivable is based on estimates of the rate the Bancorp would charge for similar such loans, applied for the time period until estimated repayment, in addition to appraisals which may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach (Level 3). Federal Home Loan Bank stock is estimated at book value due to restrictions that limit the sale or transfer of the security. Fair values of accrued interest receivable and payable approximate book value, as the carrying values are determined using the observable interest rate, balance, and last payment date.

   

Non-interest and interest bearing deposits, which include checking, savings, and money market deposits, are estimated to have fair values based on the amount payable as of the reporting date (Level 1). The fair value of fixed-maturity certificates of deposit (included in interest bearing deposits) are based on estimates of the rate the Bancorp would pay on similar deposits, applied for the time period until maturity (Level 2). Estimated fair values for short-term repurchase agreements, which represent sweeps from demand deposits to accounts secured by pledged securities, are estimated based on the amount payable as of the reporting date (Level 1). Longer-term repurchase agreements, with contractual maturity dates of three months or more, are based on estimates of the rate the Bancorp would pay on similar deposits, applied for the time period until maturity (Level 2). Short-term borrowings are generally only held overnight, therefore, their carrying amount is a reasonable estimate of fair value (Level 1). The fair value of FHLB Advances are estimated by discounting the future cash flows using quoted rates from the FHLB for similar advances with similar maturities (Level 2). The estimated fair value of other financial instruments, and off-balance sheet loan commitments, approximate cost and are not considered significant to this presentation.