Fair Value Measurements and Fair Values of Financial Instruments

9 Months Ended

Sep. 30, 2017

Fair Value Measurements and Fair Values of Financial Instruments

Note 9—Fair Value Measurements and Fair Values of Financial Instruments

Management uses its best judgment in estimating the fair value of the Bank’s financial instruments; however, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts the Company could have realized in a sales transaction on the dates indicated. The estimated fair value amounts have been measured as of September 30, 2017 and December 31, 2016 and have not been re-evaluated or updated for purposes of these financial statements subsequent to those respective dates. As such, the estimated fair values of these financial instruments subsequent to the respective reporting dates may be different than the amounts reported at each period-end.

The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. In accordance with FASB ASC Topic 820—Fair Value Measurements, the fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices. However, in some instances, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.

The fair value guidance provides a consistent definition of fair value, which focuses on exit price in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate. In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment. The fair value is a reasonable point within the range that is most representative of fair value under current market conditions.

FASB ASC Topic 820 establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value. 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 the fair value hierarchy under FASB ASC Topic 820 are as follows:

Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Level 2: Quoted prices in markets that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability.

Level 3: Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported with little or no market activity). Management utilizes inputs that it believes a market participant would use.

An asset’s or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

During the nine months ended September 30, 2017 there were no changes in methodologies for determining fair value measurements and there were no transfers between fair value hierarchy levels.

For financial assets measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy used at September 30, 2017 and December 31, 2016 are as follows:

Description	Fair Value		(Level 1) Quoted Prices in Active Markets for Identical Assets		(Level 2) Significant Other Observable Inputs		(Level 3) Significant Unobservable Inputs
	(Dollars in thousands)
As of September 30, 2017:
Investment securities available for sale:
Obligations of U.S. government agencies and corporations	$	13,986	$	—	$	13,986	$	—
Obligations of states and political subdivisions		11,422		—		11,422		—
Federal agency mortgage-backed securities		26,537		—		26,537		—
Federal agency collateralized mortgage obligations		121		—		121		—
Other debt securities		1,559		—		1,559		—
Money market mutual fund		36		36		—		—
Total assets measured at fair value on a recurring basis	$	53,661	$	36	$	53,625	$	—
As of December 31, 2016:
Investment securities available for sale:
Obligations of U.S. government agencies and corporations	$	45,987	$	—	$	45,987	$	—
Obligations of states and political subdivisions		6,139		—		6,139		—
Federal agency mortgage-backed securities		13,720		—		13,720		—
Federal agency collateralized mortgage obligations		189		—		189		—
Other debt securities		1,530		—		1,530		—
Money market mutual fund		2,995		2,995		—		—
Total assets measured at fair value on a recurring basis	$	70,560	$	2,995	$	67,565	$	—

For financial assets measured at fair value on a nonrecurring basis, the fair value measurements by level within the fair value hierarchy used at September 30, 2017 and December 31, 2016 are as follows:

Description	Fair Value		(Level 1) Quoted Prices in Active Markets for Identical Assets		(Level 2) Significant Other Observable Inputs		(Level 3) Significant Unobservable Inputs
	(Dollars in thousands)
As of September 30, 2017:
Impaired loans	$	1,480	$	—	$	—	$	1,480
Other real estate owned		69		—		—		69
Total assets measured at fair value on a nonrecurring basis	$	1,549	$	—	$	—	$	1,549
As of December 31, 2016:
Impaired loans	$	1,257	$	—	$	—	$	1,257
Other real estate owned		679		—		—		679
Total assets measured at fair value on a nonrecurring basis	$	1,936	$	—	$	—	$	1,936

Management generally uses a discounted appraisal technique in valuing impaired assets, resulting in the discounting of the collateral values underlying each impaired asset. A discounted tax assessment rate has been applied for smaller assets to determine the discounted collateral value. All impaired loans are classified as Level 3 in the fair value hierarchy. Collateral may be real estate and/or business assets. Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment.

Quantitative information about Level 3 fair value measurements at September 30, 2017 is included in the table below:

	Fair Value		Valuation Techniques	Unobservable Inputs (2)	Estimated Ratings (Weighted Average) (3)
	(Dollars in thousands)
Impaired loans	$	1,480	Appraisal of real estate collateral (1)	Appraisal adjustments	0%-25% (8.15%)
			Valuation of business assets used as collateral(4)	Valuation adjustments	50% (50.00%)
				Liquidation expenses	0%-22% (11.25%)
Other real estate owned	$	69	Appraisal of collateral(1)	Appraisal adjustments	0% (0.00%)
				Liquidation expenses	8% (8.00%)

Quantitative information about Level 3 fair value measurements at December 31, 2016 is included in the table below:

	Fair Value		Valuation Techniques	Unobservable Inputs (2)	Estimated Ratings (Weighted Average) (3)
	(Dollars in thousands)
Impaired loans	$	1,257	Appraisal of real estate collateral (1)	Appraisal adjustments	0%-25% (4.87%)
			Valuation of business assets used as collateral(4)	Valuation adjustments	0%-80% (75.32%)
				Liquidation expenses	0%-10% (8.01%)
Other real estate owned	$	679	Appraisal of collateral(1)	Appraisal adjustments	0% (0.00%)
				Liquidation expenses	5%-7% (6.94%)

(1)	Fair Value is generally determined through independent appraisals of the underlying collateral, which include Level 3 inputs that are not identifiable.

(2)	Appraisals and valuations of business assets may be adjusted by management for qualitative factors such as economic conditions, potential collectability 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.

(4) Fair value is generally determined based on specific customer’s business assets, such as accounts receivable, which have been used as collateral for loans.

Valuation of real estate collateral may be discounted based on the age of the existing appraisal. Discounts are typically not taken for recent appraisals. Valuations related to business assets used as collateral are typically discounted more heavily due to the inherent level of uncertainty in determining the fair value of these types of assets. Liquidation costs relating to these assets are charged to expense.

Other real estate owned measured at fair value on a nonrecurring basis consists of properties acquired as a result of accepting a deed in lieu of foreclosure, foreclosure or through other means related to collateral on Bank loans which resulted in a gain or loss recognized during the period. Costs relating to the development or improvement of assets are capitalized and costs relating to holding the property are charged to expense. As of September 30, 2017, the fair value of other real estate owned consists of balances of $69 thousand, net of a valuation allowance of $38 thousand. As of December 31, 2016, the fair value of other real estate owned consists of balances of $1.2 million, net of a valuation allowance of $520 thousand. Fair value is generally determined based upon independent third-party appraisals of the property.

Real estate properties acquired through, or in lieu of, foreclosure are to be sold and are carried at fair value less estimated cost to sell. Fair value is based upon independent market prices or appraised value of the property. These assets are included in Level 3 fair value based upon the lowest level of input that is significant to the fair value measurement.

The following information should not be interpreted as an estimate of the fair value of the entire Company since a fair value calculation is only provided for a limited portion of the Company’s assets and liabilities. Due to a 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 companies may not be meaningful.

The following methods and assumptions were used to estimate the fair values of the Company’s financial instruments at September 30, 2017 and December 31, 2016:

Cash and Cash Equivalents

The carrying amounts reported in the balance sheet for cash and short-term instruments approximate those assets’ fair values.

Securities

The fair value of securities available for sale (carried at fair value) and held to maturity (carried at amortized cost) are 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.

Loans Receivable

The fair values of loans are estimated using discounted cash flow analyses, using market rates at the balance sheet date that reflect the credit and interest rate-risk inherent in the loans. Projected future cash flows are calculated based upon contractual maturity or call dates, projected repayments and prepayments of principal.

Impaired Loans

Impaired loans, which are included in loans receivable, are those that are accounted for under FASB ASC Topic 310, “Receivables”, in which the Company has measured impairment generally based on the fair value of the loan’s collateral. Fair value is generally determined based upon independent third party appraisals of the properties, 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. The fair value of the impaired loans consists of the loan balances, net of any valuation allowance. As of September 30, 2017 the fair value of impaired loans consisted of loan balances with an allowance recorded of $1.16 million, net of valuation allowances of $155 thousand; and loan balances with no related allowance recorded of $533 thousand, net of partial charge-offs of $60 thousand. As of December 31, 2016 the fair value of impaired loans consisted of loan balances with an allowance recorded of $637 thousand, net of valuation allowances of $46 thousand; and loan balances with no related allowance recorded of $862 thousand, net of partial charge-offs of $196 thousand.

Restricted Investment in Bank Stock

The carrying amount of restricted investment in bank stock approximates fair value, and considers the limited marketability of such securities.

Accrued Interest Receivable and Payable

The carrying amount of accrued interest receivable and accrued interest payable approximates fair value.

Deposit Liabilities

The fair values disclosed for demand deposits (interest and noninterest checking), money market and savings accounts are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market to the maturities of the time deposits.

Short-Term Borrowings

The carrying amounts of short-term borrowings approximate their fair values.

Long-Term Debt

Fair values of FHLB advances are estimated using discounted cash flow analysis, based on quoted prices for new FHLB advances with similar credit risk characteristics, terms and remaining maturity. These prices obtained from this active market represent a market value that is deemed to represent the transfer price if the liability were assumed by a third party.

Subordinated Debt

The fair values of subordinated debt has been estimated using discounted cash flow calculation taking into account contractual maturities, call features, and market interest rates for instruments with similar financial and credit characteristics. These instruments are classified within Level 2 of the fair value hierarchy.

Off-Balance Sheet Financial Instruments

Fair values for the Company’s off-balance sheet financial instruments (lending commitments and letters of credit) are based on fees currently charged in the market to enter into similar agreements, taking into account, the remaining terms of the agreements and the counterparties’ credit standing.

At September 30, 2017 and December 31, 2016, the estimated fair values of the Company’s financial instruments were as follows:

	September 30, 2017
	Carrying Amount		Fair Value		Level 1		Level 2		Level 3
	(Dollars in thousands)
Assets:
Cash and cash equivalents	$	29,484	$	29,484	$	29,484	$	—	$	—
Securities available for sale		53,661		53,661		36		53,625		—
Securities held to maturity		18,705		19,544		—		19,544		—
Loans receivable, net		494,601		501,919		—		—		501,919
Restricted stock		2,208		2,208		—		2,208		—
Accrued interest receivable		1,918		1,918		—		1,918		—

Liabilities:
Deposits		500,533		499,944		—		499,944		—
Federal Home Loan Bank of Pittsburgh advances		44,439		44,410		—		44,410		—
Subordinated debt		9,225		9,076		—		9,076		—
Accrued interest payable		698		698		—		698		—

Off-balance sheet credit related instruments:
Commitments to extend credit		—		—		—		—		—

	December 31, 2016
	Carrying Amount		Fair Value		Level 1		Level 2		Level 3
	(Dollars in thousands)
Assets:
Cash and cash equivalents	$	4,761	$	4,761	$	4,761	$	—	$	—
Securities available for sale		70,560		70,560		2,995		67,565		—
Securities held to maturity		19,043		19,584		—		19,584		—
Loans receivable, net		484,913		490,890		—		—		490,890
Restricted stock		3,257		3,257		—		3,257		—
Accrued interest receivable		1,817		1,817		—		1,817		—

Liabilities:
Deposits		467,688		467,616		—		467,616		—
Federal Home Loan Bank of Pittsburgh advances		68,164		68,157		—		68,157		—
Subordinated debt		9,207		9,273		—		9,273		—
Accrued interest payable		510		510		—		510		—

Off-balance sheet credit related instruments:
Commitments to extend credit		—		—		—		—		—

- 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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FIRST PRIORITY FINANCIAL CORP. 10-Q