Note 10 - 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.

 

For the quarter ended March 31, 2014, the Bancorp’s management utilized a specialist to perform an other-than-temporary impairment analysis for each of its four pooled trust preferred securities. The analysis 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 quarterly 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. The other-than-temporary impairment analysis indicated that the Bancorp’s four pooled trust preferred securities had no additional other-than-temporary impairment during the quarter ended March 31, 2014.

 

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)
		Other-than-temporary impairment
Ending balance, December 31, 2013		$	271
Additions not previously recognized			-
Ending balance, March 31, 2014		$	271

 

The following table contains information regarding the Bancorp’s pooled trust preferred securities as of March 31, 2014:

 

(Dollars in thousands)
Cusip			74043CAC1				74042TAJ0				01449TAB9				01450NAC6
Deal name			PreTSL XXIV				PreTSL XXVII				Alesco IX				Alesco XVII
Class			B-1				C-1				A-2A				B
Book value		$	1,257			$	1,296			$	1,303			$	1,352
Fair value		$	533			$	492			$	839			$	566
Unrealized gains/(losses)		($	724)			($	804)			($	464)			($	786)
Lowest credit rating assigned			CC				C				BB				CC
Number of performing banks			51				29				55				46
Number of performing insurance companies			13				7				10				n/a
Number of issuers in default			17				9				1				3
Number of issuers in deferral			12				4				10				7
Defaults & deferrals as a % of performing collateral			45.04	%			29.24	%			17.22	%			22.89	%
Subordination:
As a % of performing collateral			3.13	%			-6.04	%			40.59	%			22.09	%
As a % of performing collateral - adjusted for projected future defaults			-4.39	%			-15.77	%			36.80	%			17.38	%
Other-than-temporary impairment model assumptions:
Defaults:
Year 1 - issuer average			2.40	%			2.80	%			2.00	%			1.90	%
Year 2 - issuer average			2.40	%			2.80	%			2.00	%			1.90	%
Year 3 - issuer average			2.40	%			2.80	%			2.00	%			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 table above, 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, 2014, 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.

 

At March 31, 2014, three of the trust preferred securities with a cost basis of $3.9 million continue to be in “payment in kind” status. The Bancorp’s securities that are classified as “payment in kind” are a result of not receiving the scheduled quarterly interest payments. For the securities in “payment in kind” status, management anticipates to receive the unpaid contractual interest payments from the issuer, because of the self correcting cash flow waterfall provisions within the structure of the securities. When a tranche senior to the Bancorp’s position fails the coverage test, the Bancorp’s interest cash flows are paid to the senior tranche and recorded as a reduction of principal. The coverage test represents an over collateralization target by stating the balance of the performing collateral as a percentage of the balance of the Bancorp’s tranche, plus the balance of all senior tranches. The principal reduction in the senior tranche continues until the appropriate coverage test is passed. As a result of the principal reduction in the senior tranche, more cash is available for future payments to the Bancorp’s tranche. Consistent with the Investments – Debt and Equity Securities Topic, management considered the failure of the issuer of the security to make scheduled interest payments in determining whether a credit loss existed. Management will not capitalize the “payment in kind” interest payments to the book value of the securities and will keep these securities in non-accrual status until the quarterly interest payments resume.

 

Assets and Liabilities Measured on a Recurring Basis

 

There were no transfers to or from Levels 1 and 2 during the three months ended March 31, 2014. Assets measured at fair value on a recurring basis are summarized below:

 

					Fair Value Measurements at March 31, 2014 Using
					Quoted Prices in
(Dollars in thousands)		Estimated			Active Markets for			Significant Other			Significant
		Fair			Identical Assets			Observable Inputs			Unobservable Inputs
		Value			(Level 1)			(Level 2)			(Level 3)
Available-for-sale debt securities
U.S. government sponsored entities		$	12,213		$	-		$	12,213		$	-
Collateralized mortgage obligations and residential mortgage-backed securities			103,428			-			103,428			-
Municipal securities			80,129			-			80,129			-
Collateralized debt obligations			2,430			-			-			2,430
Total securities available-for-sale		$	198,200		$	-		$	195,770		$	2,430

 

					Fair Value Measurements at December 31, 2013 Using
					Quoted Prices in
(Dollars in thousands)		Estimated			Active Markets for			Significant Other			Significant
		Fair			Identical Assets			Observable Inputs			Unobservable Inputs
		Value			(Level 1)			(Level 2)			(Level 3)
Available-for-sale debt securities
U.S. government sponsored entities		$	18,360		$	-		$	18,360		$	-
Collateralized mortgage obligations and residential mortgage-backed securities			100,315			-			100,315			-
Municipal securities			73,653			-			73,653			-
Collateralized debt obligations			1,968			-			-			1,968
Total securities available-for-sale		$	194,296		$	-		$	192,328		$	1,968

 

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

 

		Fair Value Measurements
		Using Significant
		Unobservable Inputs
(Dollars in thousands)		(Level 3)
		Available-for-sale securities
Beginning balance, December 31, 2013		$	1,968
Transfers in and/or (out) of Level 3			-
Total gains or (losses)
Included in earnings			-
Included in other comprehensive income			462
Purchases, issuances, sales, and settlements
Purchases			-
Issuances			-
Sales			-
Settlements			-
Ending balance, March 31, 2014		$	2,430

 

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

 

					Fair Value Measurements at March 31, 2014 Using
					Quoted Prices in
(Dollars in thousands)		Estimated			Active Markets for			Significant Other			Significant
		Fair			Identical Assets			Observable Inputs			Unobservable Inputs
		Value			(Level 1)			(Level 2)			(Level 3)
Impaired loans		$	7,820		$	-		$	-		$	7,820
Foreclosed real estate			1,119			-			-			1,119

 

					Fair Value Measurements at December 31, 2013 Using
					Quoted Prices in
(Dollars in thousands)		Estimated			Active Markets for			Significant Other			Significant
		Fair			Identical Assets			Observable Inputs			Unobservable Inputs
		Value			(Level 1)			(Level 2)			(Level 3)
Impaired loans		$	8,164		$	-		$	-		$	8,164
Foreclosed real estate			1,084			-			-			1,084

 

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 of impaired loans was $9.5 million and the related specific reserves totaled $1.7 million, resulting in a fair value of impaired loans totaling $7.8 million, at March 31, 2014. The recorded investment of impaired loans was $9.9 million and the related specific reserves totaled $1.7 million, resulting in a fair value of impaired loans totaling $8.2 million, at December 31, 2013. 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, 2014						Estimated Fair Value Measurements at March 31, 2014 Using
								Quoted Prices in			Significant			Significant
(Dollars in thousands)								Active Markets for			Other Observable			Unobservable
		Carrying			Estimated			Identical Assets			Inputs			Inputs
		Value			Fair Value			(Level 1)			(Level 2)			(Level 3)
Financial assets:
Cash and cash equivalents		$	30,894		$	30,894		$	30,894		$	-		$	-
Securities available-for-sale			198,200			198,200			-			195,770			2,430
Loans held-for-sale			1,693			1,712			1,712			-			-
Loans receivable, net			445,602			441,526			-			-			441,526
Federal Home Loan Bank stock			3,967			3,967			-			3,967			-
Accrued interest receivable			2,565			2,565			-			2,565			-
Financial liabilities:
Non-interest bearing deposits			82,760			82,760			82,760			-			-
Interest bearing deposits			509,044			509,063			349,178			159,885			-
Repurchase agreements			15,940			15,954			10,085			5,869			-
Borrowed funds			38,248			38,261			148			38,113			-
Accrued interest payable			47			47			-			47			-

 

		December 31, 2013						Estimated Fair Value Measurements at December 31, 2013 Using
								Quoted Prices in			Significant			Significant
(Dollars in thousands)								Active Markets for			Other Observable			Unobservable
		Carrying			Estimated			Identical Assets			Inputs			Inputs
		Value			Fair Value			(Level 1)			(Level 2)			(Level 3)
Financial assets:
Cash and cash equivalents		$	21,124		$	21,124		$	21,124		$	-		$	-
Securities available-for-sale			194,296			194,296			-			192,328			1,968
Loans held-for-sale			136			138			138			-			-
Loans receivable, net			430,632			427,719			-			-			427,719
Federal Home Loan Bank stock			3,086			3,086			-			3,086			-
Accrued interest receivable			2,480			2,480			-			2,480			-
Financial liabilities:
Non-interest bearing deposits			73,430			73,430			73,430			-			-
Interest bearing deposits			499,463			499,470			343,847			155,623			-
Repurchase agreements			14,031			14,043			8,042			6,001			-
Borrowed funds			30,898			30,956			799			30,157			-
Accrued interest payable			47			47			-			47			-

 

The following methods were used to estimate the fair value of financial instruments presented in the preceding table for the periods ended March 31, 2014 and December 31, 2013:

 

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 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 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 (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.