Fair Value

3 Months Ended

Mar. 31, 2021

Note 10 - Fair Value

Fair value is 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.

A fair value hierarchy that prioritizes the inputs to valuation methods is 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 market hierarchy 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).

An asset 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.

We record transfers between levels at the end of the reporting period in which the change in significant inputs occurs.

Assets Measured on a Recurring Basis

The following table presents fair value measurements for assets that are measured at fair value on a recurring basis as of and for the three months ended March 31, 2021:


					Significant
					Other		Significant		Total Changes
			Quoted		Observable		Unobservable		In Fair Values
	Carrying		Prices		Inputs		Inputs		Included In
	Value		(Level 1)		(Level 2)		(Level 3)		Period Income

Assets:	(dollars in thousands)
AFS securities - U.S. government agency notes	$	9,175	$	—	$	9,175	$	—	$	—
AFS securities - corporate obligations		2,021		—		2,021		—		—
AFS securities - MBS		121,502		—		121,502		—		—
LHFS		50,124		—		50,124		—		305
MSRs		2,927		—		—		2,927		826
IRLCs		781		—		—		781		(347)
Best efforts forward contracts		26		—		26		—		25
Mandatory forward contracts		94		—		94		—		(736)
TBA securities		1,465		—		1,465		—		1,465
Liabilities:
Mandatory forward contracts		1,061		—		1,061		—		1,055
TBA securities		4		—		4		—		553

The following table presents fair value measurements for assets and liabilities that are measured at fair value on a recurring basis as of and for the year ended December 31, 2020:


					Significant
					Other		Significant		Total Changes
			Quoted		Observable		Unobservable		In Fair Values
	Carrying		Prices		Inputs		Inputs		Included In
	Value		(Level 1)		(Level 2)		(Level 3)		Period Income

Assets:	(dollars in thousands)
AFS securities - U.S. government agency notes		6,660	$	—	$	6,660	$	—	$	—
AFS securities - corporate obligations		2,034		—		2,034		—		—
AFS securities - MBS		56,404		—		56,404		—		—
LHFS		36,299		—		36,299		—		323
MSRs		1,451		—		—		1,451		(1,013)
IRLCs		1,128		—		—		1,128		949
Liabilities:
TBA securities		557		—		557		—		(557)

The following table provides additional quantitative information about assets measured at fair value on a recurring basis and for which we have utilized Level 3 inputs to determine fair value:


	Fair Value		Valuation		Range
	Estimate		Technique	Unobservable Input	(Weighted-Average)

March 31, 2021:	(dollars in thousands)
MSRs (1)	$	2,927	Market Approach	Weighted average prepayment speed	155	%
IRLCs - net asset		781	Market Approach	Range of pull through rate	78% - 100	%
				Average pull through rate	97	%

December 31, 2020:
MSRs (1)	$	1,451	Market Approach	Weighted average prepayment speed	326	%
IRLCs - net asset		1,128	Market Approach	Range of pull through rate	77% - 100	%
				Average pull through rate	93	%

(1)	The weighted average was calculated with reference to the principal balance of the underlying mortgages.

The following table shows the activity in the MSRs:


	Three Months Ended March 31,
	2021		2020

	(dollars in thousands)
Beginning balance	$	1,451	$	323
Additions		650		—
Valuation adjustment		826		(83)
Ending balance	$	2,927	$	240

The following table shows the activity in the IRLCs:


	Three Months Ended March 31,
	2021		2020

	(dollars in thousands)
Beginning balance	$	1,128	$	179
Valuation adjustment		(347)		(240)
Ending balance	$	781	$	(61)

AFS Securities

The estimated fair values of AFS debt securities are obtained from a nationally-recognized pricing service. This pricing service develops estimated fair values by analyzing like securities and applying available market information through processes such as benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing to prepare valuations. Matrix pricing 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. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information, and the bond’s terms and conditions, among other things, and are based on market data obtained from sources independent from the Bank. U.S Treasury Securities are considered Level 1 and all of our other securities are considered Level 2. The Level 2 investments in the Bank’s portfolio are priced using those inputs that, based on the analysis prepared by the pricing service, reflect the assumptions that market participants would use to price the assets. The Bank has determined that the Level 2 designation is appropriate for these securities because, as with most fixed-income securities, those in the Bank’s portfolio are not exchange-traded, and such nonexchange-traded fixed income securities are typically priced by correlation to observed market data.

LHFS

LHFS are carried at fair value, which is determined based on outstanding investor commitments or, in the absence of such commitments, on current investor yield requirements or third party pricing models.

MSRs

The fair value of MSRs is determined using a valuation model administered by a third party that calculates the present value of estimated future net servicing income. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, discount rate, default rates, cost to service (including delinquency and foreclosure costs), escrow account earnings, contractual servicing fee income, and other ancillary income such as late fees. Management reviews all significant assumptions on a monthly basis. Mortgage loan prepayment speed, a key assumption in the model, is the annual rate at which borrowers are forecasted to repay their mortgage loan principal. The discount rate used to determine the present value of estimated future net servicing income, another key assumption in the model, is an estimate of the required rate of return investors in the market would require for an asset with similar risk. Both assumptions can, and generally will, change as market conditions and interest rates change.

IRLCs

We utilize a third party specialist model to estimate the fair value of our IRLCs, which are valued based upon mandatory pricing quotes from correspondent lenders less estimated costs to process and settle the loan. Fair value is adjusted for the estimated probability of the loan closing with the borrower.

Forward Contracts

To avoid interest rate risk, we enter into best efforts forward sales commitments with investors at the time we make an IRLC to a borrower. Once a loan has been closed and funded, the best efforts commitments convert to mandatory forward sales commitments. The mandatory commitments are derivatives, and the bank measures and reports them at fair value. Fair value is based on the gain or loss that would occur if we were to pair-off the transaction with the investor at the measurement date. This is a level 2 input. We have elected to measure and report best efforts commitments at fair value using a valuation methodology similar to that used for our mandatory commitments.

Assets Measured on a Nonrecurring Basis

March 31, 2021

Significant

Other

Significant

Quoted

Observable

Unobservable

Carrying

Prices

Inputs

Range of

Weighted

Value

(Level 1)

(Level 2)

(Level 3)

Discount (1)

Average (2)

(dollars in thousands)

Impaired loans

844

—

844

12% - 14%

December 31, 2020

Significant

Other

Significant

Quoted

Observable

Unobservable

Carrying

Prices

Inputs

Range of

Weighted

Value

(Level 1)

(Level 2)

(Level 3)

Discount (1)

Average (2)

(dollars in thousands)

Impaired loans

2,510

—

2,510

0% - 14%

(1)	Discount based on current market conditions and estimated selling costs

(2)	Inputs are weighted based on the relative fair values of the instruments

Impaired Loans

Impaired loans are those for which we have measured impairment based on the present value of expected future cash flows or 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. If it is determined that the repayment of the loan will be provided solely by the underlying collateral, and there are no other available and reliable sources of repayment, the loan is considered collateral dependent. Impaired loans that are considered collateral dependent are carried at LCM. Collateral may be in the form of real estate or business assets including equipment, inventory, and/or accounts receivable. The use of independent appraisals and management’s best judgment are significant inputs in arriving at the fair value measure of the underlying collateral and impaired loans are therefore classified within level 3 of the fair value hierarchy.

For such loans that are classified as impaired, an Allowance is established when the present value of the expected future cash flows of the impaired loan is lower than the carrying value of that loan. For such impaired loans that are classified as collateral dependent, an Allowance is established when the current market value of the underlying collateral less its estimated disposal costs has not been finalized, but management determines that it is likely that the value is lower than the carrying value of that loan. Once the net collateral value has been determined, a charge-off is taken for the difference between the net collateral value and the carrying value of the loan.

Real Estate Acquired Through Foreclosure

We record foreclosed real estate assets at the fair value less estimated selling costs on their acquisition dates and at the lower of such initial amount or estimated fair value less estimated selling costs thereafter. We generally obtain certified external appraisals of real estate acquired through foreclosure and estimate fair value using those appraisals. Other valuation sources may be used, including broker price opinions, letters of intent, and executed sale agreements.

Fair Value of All Financial Instruments

The carrying value and fair value of all financial instruments are summarized in the following tables:


	March 31, 2021
	Carrying		Fair Value
	Value		Level 1		Level 2		Level 3		Total

Assets:	(dollars in thousands)
Cash and cash equivalents	$	257,095	$	257,095	$	—	$	—	$	257,095
CDs held for investment		3,330		3,330		—		—		3,330
AFS securities		132,698		—		132,698		—		132,698
HTM securities		14,516		—		15,094		—		15,094
LHFS		50,124		—		50,124		—		50,124
Loans receivable, net		613,377		—		—		618,858		618,858
Restricted stock investments		970		—		970		—		970
Accrued interest receivable		2,439		—		2,439		—		2,439
MSRs		2,927		—		—		2,927		2,927
IRLCs		781		—		—		781		781
Best effort forward contracts		26		—		26		—		26
Mandatory forward contracts		94		—		94		—		94
TBA securities		1,465		—		1,465		—		1,465
Liabilities:
Deposits		964,096		—		970,488		—		970,488
Accrued interest payable		160		—		160		—		160
Borrowings		10,000		—		10,273		—		10,273
Subordinated debentures		20,619		—		—		16,276		16,276
Mandatory forward contracts		1,061		—		1,061		—		1,061
TBA securities		4		—		4		—		4


	December 31, 2020
	Carrying		Fair Value
	Value		Level 1		Level 2		Level 3		Total

Assets:	(dollars in thousands)
Cash and cash equivalents	$	156,609	$	156,609	$	—	$	—	$	156,609
CDs held for investment		3,580		3,580		—		—		3,580
AFS securities		65,098		—		65,098		—		65,098
HTM securities		15,943		—		16,603		—		16,603
LHFS		36,299		—		36,299		—		36,299
Loans receivable, net		634,212		—		—		639,597		639,597
Restricted stock investments		1,236		—		1,236		—		1,236
Accrued interest receivable		2,576		—		2,576		—		2,576
MSRs		1,451		—		—		1,451		1,451
IRLCs		1,128		—		—		1,128		1,128
Liabilities:
Deposits		806,456		—		806,444		—		806,444
Accrued interest payable		164		—		164		—		164
Borrowings		10,000		—		10,313		—		10,313
Subordinated debentures		20,619		—		—		16,157		16,157
TBA securities		557		—		557		—		557

Limitations

Fair value estimates are made at a specific point in time, based on relevant market information and information about financial instruments. These estimates do not reflect any premium or discount that could result from a one-time sale of our total holdings of a particular financial instrument. Because no market exists for a significant portion of our financial

instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect estimates. The above information should not be interpreted as an estimate of the fair value of the Company since a fair value calculation is only provided for a limited portion of our assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between our disclosures and those of other companies may not be meaningful.

There were no transfers between any of Levels 1, 2 and 3 for the three months ended March 31, 2021 or 2020 or for the year ended December 31, 2020.

- 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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SEVERN BANCORP INC 10-Q