BOTJ 10-Q Quarter ended Sept. 30, 2018

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

Quarterly Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the Quarterly Period Ended September 30, 2018

BANK OF THE JAMES FINANCIAL GROUP, INC.

(Exact Name of Registrant as Specified in Its Charter)

Virginia		001-35402		20-0500300
(State or other jurisdiction of incorporation or organization)		(Commission file number)		(I.R.S. Employer Identification No.)
828 Main Street, Lynchburg, VA				24504
(Address of principal executive offices)				(Zip Code)

(434) 846-2000

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer		☐		Accelerated filer		☐
Non-accelerated filer		☒		Smaller reporting company		☒
Emerging growth company		☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).    Yes  ☐    No  ☒

APPLICABLE ONLY TO CORPORATE ISSUERS

State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date: 4,378,436 shares of Common Stock, par value $2.14 per share, were outstanding at November 8, 2018.

Table of Contents

PART I – FINANCIAL INFORMATION					1
Item 1.		Consolidated Financial Statements			1
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			31
Item 3.		Quantitative and Qualitative Disclosures About Market Risk			48
Item 4.		Controls and Procedures			48
PART II – OTHER INFORMATION					49
Item 1.		Legal Proceedings			49
Item 1A.		Risk Factors			49
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds			49
Item 3.		Defaults Upon Senior Securities			49
Item 4.		Mine Safety Disclosures			49
Item 5.		Other Information			50
Item 6.		Exhibits			50
SIGNATURES					52

PART I – FINANCIAL INFORMATION

I tem 1.

Consolidated Financial Statements

Bank of the James Financial Group, Inc. and Subsidiaries

Consolidated Balance Sheets

(dollar amounts in thousands, except per share amounts) (2018 unaudited)

		September 30,				December 31,
		2018				2017
Assets
Cash and due from banks		$	25,849			$	20,267
Federal funds sold			24,615				16,751
Total cash and cash equivalents			50,464				37,018
Securities held-to-maturity (fair value of $3,394 in 2018 and $5,619 in 2017)			3,703				5,713
Securities available-for-sale, at fair value			52,333				55,312
Restricted stock, at cost			1,462				1,505
Loans, net of allowance for loan losses of $4,561 in 2018 and 4,752 in 2017			524,104				491,022
Loans held for sale			2,529				2,626
Premises and equipment, net			12,080				12,055
Interest receivable			1,876				1,713
Cash value - bank owned life insurance			13,274				13,018
Other real estate owned			2,455				2,650
Income taxes receivable			1,315				1,366
Deferred tax asset, net			1,839				1,418
Other assets			1,004				925
Total assets		$	668,438			$	626,341
Liabilities and Stockholders’ Equity
Deposits
Noninterest bearing demand		$	89,844			$	74,102
NOW, money market and savings			329,870				307,987
Time			187,733				185,404
Total deposits			607,447				567,493
Capital notes			5,000				5,000
Interest payable			131				111
Other liabilities			2,743				2,072
Total liabilities		$	615,321			$	574,676
Commitments and Contingencies
Stockholders’ equity
Preferred stock; authorized 1,000,000 shares; none issued and outstanding		$	—			$	—
Common stock $2.14 par value; authorized 10,000,000 shares; issued and outstanding 4,378,436 as of September 30, 2018 and December 31, 2017			9,370				9,370
Additional paid-in-capital			31,495				31,495
Retained earnings			15,309				12,269
Accumulated other comprehensive (loss)			(3,057	)			(1,469	)
Total stockholders’ equity		$	53,117			$	51,665
Total liabilities and stockholders’ equity		$	668,438			$	626,341

1

See accompanying notes to these consolidated financial statements

Bank of the James Financial Group, Inc. and Subsidiaries

Consolidated Statements of Income

(dollar amounts in thousands, except per share amounts) (unaudited)

		For the Three Months								For the Nine Months
		Ended September 30,								Ended September 30,
		2018				2017				2018				2017
Interest Income
Loans		$	6,460			$	5,683			$	18,329			$	16,336
Securities
US Government and agency obligations			187				131				571				365
Mortgage backed securities			62				71				196				214
Municipals - taxable			81				81				243				230
Municipals - tax exempt			2				7				5				28
Dividends			9				7				40				42
Other (Corporates)			23				24				70				81
Interest bearing deposits			60				21				151				53
Federal Funds sold			96				45				255				81
Total interest income			6,980				6,070				19,860				17,430
Interest Expense
Deposits
NOW, money market savings			261				186				684				530
Time Deposits			679				537				1,885				1,488
FHLB borrowings			—				—				17				—
Reverse repurchase agreements			—				13				—				13
Capital notes 4% due 1/24/2022			50				50				150				137
Total interest expense			990				786				2,736				2,168
Net interest income			5,990				5,284				17,124				15,262
Provision for loan losses			190				200				527				745
Net interest income after provision for loan losses			5,800				5,084				16,597				14,517
Noninterest income
Gain on sales of loans held for sale			767				694				2,260				1,663
Service charges, fees and commissions			547				479				1,476				1,377
Increase in cash value of life insurance			86				86				256				259
Other			20				9				55				42
Gain on sales and calls of securities, net			—				51				—				113
Total noninterest income			1,420				1,319				4,047				3,454
Noninterest expenses
Salaries and employee benefits			2,853				2,538				8,398				7,314
Occupancy			388				390				1,143				1,127
Equipment			414				360				1,191				1,146
Supplies			124				133				413				390
Professional, data processing, and other outside expenses			761				735				2,413				2,112
Marketing			165				212				492				596
Credit expense			241				155				478				456
Other real estate expenses			110				42				236				78
FDIC insurance expense			99				94				299				285
Other			310				255				805				733
Total noninterest expenses			5,465				4,914				15,868				14,237
Income before income taxes			1,755				1,489				4,776				3,734
Income tax expense			351				474				949				1,172
Net Income		$	1,404			$	1,015			$	3,827			$	2,562
Weighted average shares outstanding - basic			4,378,436				4,378,436				4,378,436				4,378,436
Weighted average shares outstanding - diluted			4,378,436				4,378,519				4,378,466				4,378,524
Earnings per common share - basic		$	0.32			$	0.23			$	0.87			$	0.59
Earnings per common share - diluted		$	0.32			$	0.23			$	0.87			$	0.59

2

See accompanying notes to these consolidated financial statements

Bank of the James Financial Group, Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income

For the Three and Nine Months Ended September 30, 2018 and 2017

(dollar amounts in thousands) (unaudited)

		For the Three Months								For the Nine Months
		Ended September 30,								Ended September 30,
		2018				2017				2018				2017
Net Income		$	1,404			$	1,015			$	3,827			$	2,562
Other comprehensive (loss) income:
Unrealized (losses) gains on securities available-for-sale			(693	)			25				(2,009	)			1,019
Tax effect			144				(9	)			421				(347	)
Reclassification adjustment for gains included in net income (1)			—				(51	)			—				(113	)
Tax effect (2)			—				17				—				38
Other comprehensive (loss) income, net of tax			(549	)			(18	)			(1,588	)			597
Comprehensive income		$	855			$	997			$	2,239			$	3,159

(1)	Gains are included in “gain on sales and calls of securities, net” on the consolidated statements of income.

(2)	The tax effect on these reclassifications is reflected in “income tax expense” on the consolidated statements of income.

3

See accompanying notes to these consolidated financial statements

Bank of the James Financial Group, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

Nine Months Ended September 30, 2018 and 2017

(dollar amounts in thousands) (unaudited)

		For the Nine Months Ended September 30,
		2018				2017
Cash flows from operating activities
Net Income		$	3,827			$	2,562
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization			679				601
Net amortization and accretion of premiums and discounts on securities			312				280
(Gain) on sales of available-for-sale securities			—				(113	)
(Gain) on sales of loans held for sale			(2,260	)			(1,663	)
Proceeds from sales of loans held for sale			89,949				63,271
Origination of loans held for sale			(87,592	)			(59,277	)
Provision for loan losses			527				745
Loss on sale of other real estate owned			39				—
Impairment of other real estate owned			160				60
(Increase) in cash value of life insurance			(256	)			(259	)
(Increase) in interest receivable			(163	)			(218	)
(Increase) decrease in other assets			(79	)			69
Decrease (increase) in income taxes receivable			51				(61	)
Increase in interest payable			20				12
Increase in other liabilities			671				355
Net cash provided by operating activities		$	5,885			$	6,364
Cash flows from investing activities
Proceeds from calls of securities held-to-maturity		$	2,000			$	—
Purchases of securities available-for-sale			(998	)			(20,728	)
Proceeds from maturities, calls and paydowns of securities available-for-sale			1,666				2,655
Proceeds from sale of securities available-for-sale			—				9,941
(Purchase) of Federal Reserve Bank stock			—				(90	)
Redemption (purchase) of Federal Home Loan Bank stock			43				(42	)
Proceeds from sale of other real estate owned			846				515
Improvements to other real estate owned			—				(29	)
Origination of loans, net of principal collected			(34,459	)			(30,971	)
Proceeds from sale of other assets			—				1
Purchases of premises and equipment			(704	)			(1,574	)
Net cash (used in) investing activities		$	(31,606	)		$	(40,322	)
Cash flows from financing activities
Net increase in deposits		$	39,954			$	37,403
Dividends paid to common stockholders			(787	)			(788	)
Proceeds fom sale of 4% capital notes due 1/24/2022			—				5,000
Net cash provided by financing activities		$	39,167			$	41,615
Increase in cash and cash equivalents			13,446				7,657
Cash and cash equivalents at beginning of period		$	37,018			$	28,683
Cash and cash equivalents at end of period		$	50,464			$	36,340
Non cash transactions
Transfer of loans to other real estate owned		$	850			$	815
Unrealized (losses) gains on securities available-for-sale			(2,009	)			906
Cash transactions
Cash paid for interest		$	2,716			$	2,156
Cash paid for income taxes			975				1,275

4

See accompanying notes to these consolidated financial statements

Bank of the James Financial Group, Inc. and Subsidiaries

Consolidated Statements of Changes in Stockholders’ Equity

For the Nine Months Ended September 30, 2018 and 2017

(dollars in thousands, except per share amounts) (unaudited)

																		Accumulated
										Additional								Other
		Shares				Common				Paid-in				Retained				Comprehensive
		Outstanding				Stock				Capital				Earnings				(Loss)				Total
Balance at December 31, 2016			4,378,436			$	9,370			$	31,495			$	10,156			$	(1,600	)		$	49,421
Net Income			—				—				—				2,562				—				2,562
Dividends paid on common stock ($0.18 per share)			—				—				—				(788	)			—				(788	)
Other comprehensive income			—				—				—				—				597				597
Balance at September 30, 2017			4,378,436			$	9,370			$	31,495			$	11,930			$	(1,003	)		$	51,792
Balance at December 31, 2017			4,378,436			$	9,370			$	31,495			$	12,269			$	(1,469	)		$	51,665
Net Income			—				—				—				3,827				—				3,827
Dividends paid on common stock ($0.18 per share)			—				—				—				(787	)			—				(787	)
Other comprehensive loss			—				—				—				—				(1,588	)			(1,588	)
Balance at September 30, 2018			4,378,436			$	9,370			$	31,495			$	15,309			$	(3,057	)		$	53,117

5

See accompanying notes to these consolidated financial statements

Notes to Consolidated Financial Statements

Note 1 – Basis of Presentation

The unaudited consolidated financial statements have been prepared by Bank of the James Financial Group, Inc. (“Financial” or the “Company”) pursuant to the rules and regulations of the Securities and Exchange Commission. In management’s opinion the accompanying financial statements, which unless otherwise noted are unaudited, reflect all adjustments, consisting solely of normal recurring accruals, necessary for a fair presentation of the financial information as of September 30, 2018 and for the three and nine months ended September 30, 2018 and 2017 in conformity with accounting principles generally accepted in the United States of America. Additional information concerning the organization and business of Financial, accounting policies followed, and other related information is contained in Financial’s Annual Report on Form 10-K for the year ended December 31, 2017. These financial statements should be read in conjunction with the audited consolidated financial statements and footnotes for the year ended December 31, 2017 included in Financial’s Annual Report on Form 10-K. Results for the three and nine month periods ended September 30, 2018 are not necessarily indicative of the results that may be expected for the year ending December 31, 2018.

Certain immaterial reclassifications have been made to prior period balances to conform to the current period presentation. Reclassifications had no effect on prior year net income or stockholders’ equity.

The Company’s primary market area consists of the area commonly referred to as Region 2000 which encompasses the seven jurisdictions of the Town of Altavista, Amherst County, Appomattox County, the Town of Bedford, Bedford County, Campbell County, and the City of Lynchburg. Recently, the Company has expanded into Charlottesville, Roanoke, and Harrisonburg.

Financial’s critical accounting policies include the evaluation of the allowance for loan losses which is based on management’s estimate of an amount that is adequate to absorb probable losses inherent in the loan portfolio of Bank of the James (the “Bank”), Financial’s wholly-owned subsidiary. The allowance for loan losses is established through a provision for loan losses based on available information including the composition of the loan portfolio, historical loan losses, specific impaired loans, availability and quality of collateral, age of the various portfolios, changes in local economic conditions, and loan performance and quality of the portfolio. Different assumptions used in evaluating the adequacy of the Bank’s allowance for loan losses could result in material changes in Financial’s financial condition and results of operations. The Bank’s policy with respect to the methodology for determining the allowance for loan losses involves a higher degree of complexity and requires management to make subjective judgments that often require assumptions or estimates about uncertain matters. This critical policy and its assumptions are periodically reviewed with the Board of Directors.

Financial also considers valuation of other real estate owned (OREO) a critical accounting policy. OREO consists of properties acquired through foreclosure or deed in lieu of foreclosure. These properties are carried at fair value less estimated costs to sell at the date of foreclosure. Losses from the acquisition of property in full or partial satisfaction of loans are charged against the allowance for loan losses. Subsequent write-downs, if any, are charged against expense. Gains and losses on the sales of foreclosed properties are included in determining net income in the year of the sale. Operating costs after acquisition are expensed.

6

Note 2 – Use of Estimates

The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America which require management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Note 3 – Earnings Per Common Share (EPS)

The following is a summary of the earnings per share calculation for the three and nine months ended September 30, 2018 and 2017.

		Three Months Ended September 30,								Nine Months Ended September 30,
		2018				2017				2018				2017
Net income		$	1,404,000			$	1,015,000			$	3,827,000			$	2,562,000
Weighted average number of shares			4,378,436				4,378,436				4,378,436				4,378,436
Options effect of incremental shares			—				83				30				88
Weighted average diluted shares			4,378,436				4,378,519				4,378,466				4,378,524
Basic EPS (weighted avg shares)		$	0.32			$	0.23			$	0.87			$	0.59
Diluted EPS (Including Option Shares)		$	0.32			$	0.23			$	0.87			$	0.59

No option shares were excluded in calculating diluted earnings per share for any of the periods presented.

Note 4 – Stock Based Compensation

Accounting standards require companies to recognize the cost of employee services received in exchange for awards of equity instruments, such as stock options and restricted stock, based on the fair value of those awards at the date of grant.

7

Note 4 – Stock Based Compensation (continued)

Stock option plan activity for the nine months ended September 30, 2018 is summarized below:

		Shares				Weighted Average Exercise Price				Weighted Average Remaining Contractual Life (in years)				Intrinsic Value
Options outstanding, January 1, 2018			636			$	12.79
Granted			—				—
Exercised			—				—
Forfeited			(636	)			12.79
Options outstanding, September 30, 2018			—			$	—				—			$	—
Options exercisable, September 30, 2018			—			$	—				—			$	—

Intrinsic value is calculated by subtracting the exercise price of option shares from the market price of underlying shares as of September 30, 2018 and multiplying that amount by the number of options outstanding. No intrinsic value exists where the exercise price is greater than the market price on a given date.

All compensation expense related to the foregoing stock option plan has been recognized. The Company’s ability to grant additional options shares under the 1999 Plan has expired and no options remain outstanding from the 1999 Plan.

At the annual meeting of shareholders held on May 15, 2018, the shareholders approved the Bank of the James Financial Group, Inc. 2018 Equity Incentive Plan (the “2018 Incentive Plan”). The 2018 Incentive Plan permits the issuance of up to 250,000 shares of common stock for awards to key employees of the Company and its subsidiaries in the form of stock options, restricted stock, restricted stock units, stock awards and performance units. To date the Company has not awarded any equity compensation under the 2018 Incentive Plan.

Note 5 – Fair Value Measurements

Determination of Fair Value

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 the Fair Value Measurements and Disclosures topic of FASB ASC, 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 many 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

8

Note 5 – Fair Value Measurements (continued)

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.

Fair Value Hierarchy

In accordance with this guidance, the Company groups its financial assets and financial liabilities generally measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.

•

Level 1 inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

•

Level 2 inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

•

Level 3 inputs to the valuation methodology are unobservable and significant to the fair value measurement.

Following is a description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy:

Fair Value on a Recurring Basis

Securities Available-for-Sale

Fair values of securities, excluding restricted investments in Federal Reserve Bank stock, Federal Home Loan Bank stock, and Community Bankers’ Bank stock are based on quoted prices available in an active market. If quoted prices are available, these securities are classified within Level 1 of the valuation hierarchy. Level 1 securities would include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flow.

Level 2 securities would include U.S. agency securities, mortgage-backed agency securities, obligations of states and political subdivisions and certain corporate, asset backed and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy. Currently, all of the Company’s securities are considered to be Level 2 securities.

The following table summarizes the Company’s financial assets that were measured at fair value on a recurring basis during the period.

9

Note 5 – Fair Value Measurements (continued)

						Carrying Value at September 30, 2018 (in thousands)
Description		Balance as of September 30, 2018				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
US Treasuries		$	1,780			$	—			$	1,780			$	—
US agency obligations			22,712				—				22,712				—
Mortgage-backed securities			12,225				—				12,225				—
Municipals			11,851				—				11,851				—
Corporates			3,765				—				3,765				—
Total available-for-sale securities		$	52,333			$	—			$	52,333			$	—
						Carrying Value at December 31, 2017 (in thousands)
Description		Balance as of December 31, 2017				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
US Treasuries		$	1,858			$				$	1,858			$
US agency obligations			23,850				—				23,850				—
Mortgage-backed securities			13,388				—				13,388				—
Municipals			12,274				—				12,274				—
Corporates			3,942				—				3,942				—
Total available-for-sale securities		$	55,312			$	—			$	55,312			$	—

Fair Value on a Non-recurring Basis

Impaired loans

Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected when due. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Fair value is measured based on the value of the collateral securing the loans. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the collateral is real estate. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Bank using observable market data (Level 2). However, in situations where the collateral is a house or building in the process of construction, the appraisal is more than 12 months old, management has determined the fair value of the collateral is further impaired below the appraised value, or the appraisal is not based solely on market comparables adjusted for observable inputs, the value is considered Level 3. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income.

10

Note 5 – Fair Value Measurements (continued)

Loans held for sale

Loans held for sale are carried at cost which approximates estimated fair value. These loans currently consist of one-to-four family residential loans originated for sale in the secondary market. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data which is not materially different than cost due to the short duration between origination and sale (Level 2). As such, the Company records fair value adjustments on a nonrecurring basis. No nonrecurring fair value adjustments were recorded on loans held for sale during the period ended September 30, 2018. Gains and losses on the sale of loans are recorded within gains on sales of loans held for sale, net on the Consolidated Statements of Income.

Other real estate owned

Certain assets such as other real estate owned (OREO) are measured at fair value less cost to sell. We believe that the fair value component in its valuation follows the provisions of ASC 820.

Real estate acquired through foreclosure is transferred to OREO. The measurement of loss associated with OREO is based on the fair value of the collateral compared to the unpaid loan balance and anticipated costs to sell the property. The value of OREO property is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Bank using observable market data (Level 2).

Any fair value adjustments are recorded in the period incurred and expensed against current earnings. However, in situations where the collateral is a house or building in the process of construction, the appraisal is more than 12 months old, management has determined the fair value of the collateral is further impaired below the appraised value, or the appraisal is not based solely on market comparables adjusted for observable inputes, the value is considered Level 3.

The following table summarizes the Company’s impaired loans, loans held for sale, and OREO measured at fair value on a nonrecurring basis during the period (in thousands).

						Carrying Value at September 30, 2018
Description		Balance as of September 30, 2018				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Impaired loans*		$	1,857			$	—			$	—			$	1,857
Loans held for sale			2,529				—				2,529				—
Other real estate owned			2,455				—				—				2,455

*	Includes loans charged down to the net realizable value of the collateral.

						Carrying Value at December 31, 2017
Description		Balance as of December 31, 2017				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Impaired loans*		$	2,523			$	—			$	—			$	2,523
Loans held for sale			2,626				—				2,626				—
Other real estate owned			2,650				—				—				2,650

*	Includes loans charged down to the net realizable value of the collateral.

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Note 5 – Fair Value Measurements (continued)

The following table sets forth information regarding the quantitative inputs used to value assets classified as Level 3:

Quantitative information about Level 3 Fair Value Measurements for September 30, 2018 (dollars in thousands)

Fair Value

Valuation Technique(s)

Unobservable Input

Range (Weighted Average)

Assets

Impaired loans

$

1,857

Discounted appraised value

Selling cost

0% - 10% (8%)

Discount for lack of marketability and age of appraisal

0% - 20% (6%)

OREO

2,455

Discounted appraised value

Selling cost

0% - 10% (6%)

Discount for lack of marketability and age of appraisal

0% - 25% (15%)

Quantitative information about Level 3 Fair Value Measurements for December 31, 2017 (dollars in thousands)

Fair Value

Valuation Technique(s)

Unobservable Input

Range (Weighted Average)

Assets

Impaired loans

$

2,523

Discounted appraised value

Selling cost

0% - 10% (8%)

Discount for lack of marketability and age of appraisal

0% - 20% (6%)

OREO

2,650

Discounted appraised value

Selling cost

0% - 10% (6%)

Discount for lack of marketability and age of appraisal

0% - 25% (15%)

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Note 5 – Fair Value Measurements (continued)

The estimated fair values, and related carrying or notional amounts, of Financial’s financial instruments and their placement in the fair value hierarchy at September 30, 2018 and December 31, 2017 was as follows (in thousands):

						Fair Value Measurements at September 30, 2018 using
						Quoted Prices				Significant
						in Active				Other				Significant
						Markets for				Observable				Unobservable
		Carrying				Identical Assets				Inputs				Inputs
		Amounts				(Level 1)				(Level 2)				(Level 3)				Balance
Assets
Cash and due from banks		$	25,849			$	25,849			$	—			$	—			$	25,849
Fed funds sold			24,615				24,615				—				—				24,615
Securities
Available-for-sale			52,333				—				52,333				—				52,333
Held-to-maturity			3,703				—				3,394				—				3,394
Restricted stock			1,462								1,462				—				1,462
Loans, net (1)			524,104				—				—				511,788				511,788
Loans held for sale			2,529				—				2,529				—				2,529
Interest receivable			1,876				—				1,876				—				1,876
BOLI			13,274				—				13,274				—				13,274
Liabilities
Deposits		$	607,447			$	—			$	608,115			$	—			$	608,115
Capital notes			5,000				—				4,690				—				4,690
Interest payable			131				—				131				—				131
						Fair Value Measurements at December 31, 2017 using
						Quoted Prices				Significant
						in Active				Other				Significant
						Markets for				Observable				Unobservable
		Carrying				Identical Assets				Inputs				Inputs
		Amounts				(Level 1)				(Level 2)				(Level 3)				Balance
Assets
Cash and due from banks		$	20,267			$	20,267			$	—			$	—			$	20,267
Fed funds sold			16,751				16,751												16,751
Securities
Available-for-sale			55,312				—				55,312				—				55,312
Held-to-maturity			5,713				—				5,619				—				5,619
Restricted stock			1,505				—				1,505								1,505
Loans, net (1)			491,022				—				—				492,397				492,397
Loans held for sale			2,626				—				2,626				—				2,626
Interest receivable			1,713				—				1,713				—				1,713
BOLI			13,018				—				13,018				—				13,018
Liabilities
Deposits		$	567,493			$	—			$	568,224			$	—			$	568,224
Capital notes			5,000				—				5,310								5,310
Interest payable			111				—				111				—				111

(1)

Carrying amount is net of unearned income and the Allowance. In accordance with the prospective adoption of ASU No. 2016-01, the fair value of loans as of September 30, 2018 was measured using an exit price notion. The fair value of loans as of December 31, 2017 was measured using an entry price notion.

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Note 5 – Fair Value Measurements (continued)

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

Fair value estimates are based on existing on-balance-sheet and off-balance-sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Significant assets that are not considered financial assets include deferred income taxes and bank premises and equipment; a significant liability that is not considered a financial liability is accrued post-retirement benefits. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.

Financial assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of Financial’s financial instruments will change when interest rate levels change, and that change may be either favorable or unfavorable to Financial. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment.

Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate Financial’s overall interest rate risk.

Note 6 – Capital Notes

On January 25, 2017, Financial closed a private placement of unregistered debt securities (the “2017 Offering”) pursuant to which Financial issued $5,000,000 in principal of notes (the “2017 Notes”). The 2017 Notes bear interest at the rate of 4% per year with interest payable quarterly in arrears. The 2017 Notes are to mature on January 24, 2022, but are subject to prepayment in whole or in part on or after January 24, 2018 at Financial’s sole discretion on 30 days written notice to the holders. Of the proceeds, $3,000,000 was injected into the Bank as equity capital in March 2017. It is anticipated the remaining $2,000,000 will remain at the holding company level for debt service on the 2017 Notes.

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Note 7 - Securities

The following tables summarize the Bank’s holdings for both securities held-to-maturity and securities available-for-sale as of September 30, 2018 and December 31, 2017 (amounts in thousands):

		September 30, 2018
		Amortized				Gross Unrealized
		Costs				Gains				(Losses)				Fair Value
Held-to-Maturity
US agency obligations		$	3,703			$	—			$	(309	)		$	3,394
Available-for-Sale
US Treasuries			1,960				—				(180	)			1,780
US agency obligations			24,747				5				(2,040	)			22,712
Mortgage-backed securities			12,941				—				(716	)			12,225
Municipals			12,448				—				(597	)			11,851
Corporates			4,106				—				(341	)			3,765
		$	56,202			$	5			$	(3,874	)		$	52,333
		December 31, 2017
		Amortized				Gross Unrealized
		Costs				Gains				(Losses)				Fair Value
Held-to-Maturity
US agency obligations		$	5,713			$	8			$	(102	)		$	5,619
Available-for-Sale
US Treasuries			1,956				—				(98	)			1,858
US agency obligations			24,881				5				(1,036	)			23,850
Mortgage-backed securities			13,662				2				(276	)			13,388
Municipals			12,556				16				(298	)			12,274
Corporates			4,117				—				(175	)			3,942
		$	57,172			$	23			$	(1,883	)		$	55,312

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