Note 12.

Fair Value Disclosures

Fair value is the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the measurement date. The Corporation determines the fair value of its financial instruments based on the fair value hierarchy. The Corporation maximizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value. Observable inputs are inputs that market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the Corporation. Unobservable inputs are inputs that reflect the Corporation’s assumptions that the market participants would use in pricing the asset or liability based on the best information available in the circumstances, including assumptions about risk. Three levels of inputs are used to measure fair value. A financial instrument’s level within the fair value hierarchy is based on the lowest level of input significant to the fair value measurement. Transfers between levels are recognized at the end of the reporting period.

Level 1: Valuations are based on quoted prices in active markets for identical assets or liabilities that the Corporation can access at the measurement date. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment.

Level 2: Valuations are based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly.

Level 3: Valuations are based on inputs that are unobservable and significant to the overall fair value measurement. Assets and liabilities utilizing Level 3 inputs include: financial instruments whose value is determined using pricing models, discounted cash-flow methodologies, or similar techniques, as well as instruments for which the fair value calculation requires significant management judgment or estimation.

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

Investment Securities

Where quoted prices are available in an active market for identical instruments, investment securities are classified within Level 1 of the valuation hierarchy. Level 1 investment securities include highly liquid U.S. Treasury securities, most equity securities and money market mutual funds. Mutual funds are registered investment companies which are valued at net asset value of shares on a market exchange at the close of business at period end. 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 flows. Examples of instruments, which would generally be classified within Level 2 of the valuation hierarchy, include U.S. Government sponsored enterprises, mortgage-backed securities, collateralized mortgage obligations, corporate and municipal bonds and certain equity securities. In cases where there is limited activity or less transparency around inputs to the valuation, investment securities are classified within Level 3 of the valuation hierarchy.

Fair values for securities are determined using independent pricing services and market-participating brokers. The Corporation’s independent pricing service utilizes evaluated pricing models that vary by asset class and incorporate available trade, bid and other market information for structured securities, cash flow and, when available, loan performance data. Because many fixed income securities do not trade on a daily basis, the pricing service’s evaluated pricing applications apply information as applicable through processes, such as benchmarking of like securities, sector groupings, and matrix pricing, to prepare evaluations. If at any time, the pricing service determines that it does have not sufficient verifiable information to value a particular security, the Corporation will utilize valuations from another pricing service. Management has a sufficient understanding of the third party service’s valuation models, assumptions and inputs used in determining the fair value of securities to enable management to maintain an appropriate system of internal control.

On a quarterly basis, the Corporation reviews changes, as submitted by the pricing service, in the market value of its security portfolio. Individual changes in valuations are reviewed for consistency with general interest rate movements and any known credit concerns for specific securities. Additionally, on an annual basis, the Corporation has its security portfolio priced by a second pricing service to determine consistency with another market evaluator, except for municipal bonds which are priced by another service provider on a sample basis. If, on the Corporation’s review or in comparing with another servicer, a material difference between pricing evaluations were to exist, the Corporation may submit an inquiry to its current pricing service regarding the data used to make the valuation of a particular security. If the Corporation determines it has market information that would support a different valuation than its current pricing service’s evaluation it can submit a challenge for a change to that security’s valuation. There were no material differences in valuations noted at June 30, 2013.

Derivative Financial Instruments

The fair values of derivative financial instruments are based upon the estimated amount the Corporation would receive or pay to terminate the contracts or agreements, taking into account current interest rates and, when appropriate, the current creditworthiness of the counterparties. Derivative financial instruments are classified within Level 2 of the valuation hierarchy.

Contingent Consideration Liability

The Corporation estimates the fair value of the contingent consideration liability by using a discounted cash flow model of future contingent payments based on projected revenue related to the acquired business. The estimated fair value of the contingent consideration liability is reviewed on a quarterly basis and any valuation adjustments resulting from a change in the discount rate or change of estimated future contingent payments based on projected revenue of the acquired business affecting the contingent consideration liability will be recorded through non-interest expense. Due to the significant unobservable input related to the projected revenue, the contingent consideration liability is classified within Level 3 of the valuation hierarchy. An increase in the projected revenue may result in a higher fair value of the contingent consideration liability. Alternatively, a decrease in the projected revenue may result in a lower estimated fair value of the contingent consideration liability.

For the Javers Group acquisition, the Corporation recorded a reduction to the contingent liability during the second quarter of 2013 which resulted in a reduction of other noninterest expense of $959 thousand. While the acquisition remains accretive, the adjustment reflects that revenue levels necessary for an earn-out payment in the first year post-acquisition were not met and that revenue growth levels necessary to qualify for subsequent years’ earn-out payments to be made are less than remote. Therefore, as of June 30, 2013, the fair value of this contingent consideration liability is $0. The Javers’ original contingent consideration arrangement ranged from $0 to a maximum of $1.7 million cumulative over the three-year period ending June 30, 2015.

For the John T. Fretz Insurance Agency, Inc. acquisition, the potential future cash payments that could result from the contingent consideration arrangement range from $0 to a maximum of $930 thousand cumulative over the three-year period ending April 30, 2016.

The following table presents the assets and liabilities measured at fair value on a recurring basis at June 30, 2013 and December 31, 2012, classified using the fair value hierarchy:


	At June 30, 2013
(Dollars in thousands)	Level 1		Level 2		Level 3		Assets/ Liabilities at Fair Value

Assets:
Available-for-sale securities:
U.S. treasuries	$	4,763	$	—	$	—	$	4,763
U.S. government corporations and agencies		—		173,421		—		173,421
State and political subdivisions		—		119,934		—		119,934
Residential mortgage-backed securities		—		67,923		—		67,923
Collateralized mortgage obligations		—		10,474		—		10,474
Corporate bonds		—		31,008		—		31,008
Money market mutual funds		5,500		—		—		5,500
Equity securities		3,012		—		—		3,012

Total available-for-sale securities		13,275		402,760		—		416,035
Forward loan sale commitments		—		772		—		772

Total assets	$	13,275	$	403,532	$	—	$	416,807

Liabilities:
Interest rate locks with customers	$	—	$	64	$	—	$	64
Contingent consideration liability		—		—		465		465

Total liabilities	$	—	$	64	$	465	$	529


	At December 31, 2012
(Dollars in thousands)	Level 1		Level 2		Level 3		Assets/ Liabilities at Fair Value

Assets:
Available-for-sale securities:
U.S. treasuries	$	4,938	$	—	$	—	$	4,938
U.S. government corporations and agencies		—		172,142		—		172,142
State and political subdivisions		—		122,168		—		122,168
Residential mortgage-backed securities		—		90,740		—		90,740
Collateralized mortgage obligations		—		27,012		—		27,012
Corporate bonds		—		5,014		—		5,014
Money market mutual funds		4,878		—		—		4,878
Equity securities		2.842		—		—		2,842

Total available-for-sale securities		12,658		417,076		—		429,734
Interest rate locks with customers		—		1,547		—		1,547

Total assets	$	12,658	$	418,623	$	—	$	431,281

Liabilities:
Interest rate swap	$	—	$	1,909	$	—	$	1,909
Forward loan sale commitments		—		54		—		54
Contingent consideration liability		—		—		903		903

Total liabilities	$	—	$	1,963	$	903	$	2,866

At June 30, 2013 and 2012, the Corporation had no assets measured at fair value on a recurring basis utilizing Level 3 inputs.

The following table presents the change in the balance of the contingent consideration liability related to acquisitions for which the Corporation utilized Level 3 inputs to determine fair value on a recurring basis for the six months ended June 30, 2013 and 2012:


	Six Months Ended June 30, 2013
(Dollars in thousands)	Balance at December 31, 2012		Contingent Consideration from New Acquisition		Payment of Contingent Consideration		Adjustment of Contingent Consideration			Balance at June 30, 2013

Javers Group	$	903	$	—	$	—	$	(903	)	$	—
John T. Fretz Insurance Agency, Inc.		—		454		—		11			465

Total contingent consideration liability	$	903	$	454	$	—	$	(892	)	$	465


	Six Months Ended June 30, 2012
(Dollars in thousands)	Balance at December 31, 2011		Contingent Consideration from New Acquisition		Payment of Contingent Consideration		Adjustment of Contingent Consideration		Balance at June 30, 2012

Javers Group	$	—	$	842	$	—	$	—	$	842

Total contingent consideration liability	$	—	$	842	$	—	$	—	$	842

The following table represents assets measured at fair value on a non-recurring basis at June 30, 2013 and December 31, 2012:

At June 30, 2013

(Dollars in thousands)

Level 1

Level 2

Level 3

Assets/Liabilities at
Fair Value

Impaired loans held for investment

—

38,324

Loans held for sale**

—

3,609

—

3,609

Total

—

3,609

38,324

41,933


	At December 31, 2012
(Dollars in thousands)	Level 1		Level 2		Level 3		Assets/Liabilities at Fair Value

Impaired loans held for investment	$	—	$	—	$	44,976	$	44,976
Mortgage servicing rights*		—		4,152		—		4,152
Other real estate owned*		—		1,607		—		1,607

Total	$	—	$	5,759	$	44,976	$	50,735

*	The fair value was lower than cost, therefore written down to fair value at December 31, 2012. At June 30, 2013, fair value was greater than cost.

**	The fair value was lower than cost, therefore written down to fair value at June 30, 2013. At December 31, 2012, fair value was greater than cost.

The following table presents assets and liabilities and off-balance sheet items not measured at fair value on a recurring or non-recurring basis in the Corporation’s consolidated balance sheets but for which the fair value is required to be disclosed at June 30, 2013 and December 31, 2012. The disclosed fair values are classified using the fair value hierarchy.

At June 30, 2013

(Dollars in thousands)

Level 1

Level 2

Level 3

Fair
Value

Carrying
Amount

Assets:

Cash and short-term interest-earning assets

86,554

—

86,554

Held-to-maturity securities

—

70,029

—

70,029

69,425

Net loans and leases held for investment

—

1,457,116

1,436,951

Mortgage servicing rights

—

6,476

—

6,476

5,227

Other real estate owned

—

1,650

—

1,650

Total assets

86,554

78,155

1,457,116

1,621,825

1,599,807

Liabilities:

Deposits:

Demand and savings deposits, non-maturity

1,574,035

—

1,574,035

Time deposits

—

297,283

—

297,283

299,016

Total deposits

1,574,035

297,283

—

1,871,318

1,873,051

Short-term borrowings

—

43,474

—

43,474

45,388

Long-term borrowings

—

20,583

—

20,583

20,619

Total liabilities

1,574,035

361,340

—

1,935,375

1,939,058

Off-Balance-Sheet:

Commitments to extend credit

—

(1,318

)

—

(1,318

)

—


	At December 31, 2012
(Dollars in thousands)	Level 1		Level 2			Level 3		Fair Value			Carrying Amount

Assets:
Cash and short-term interest-earning assets	$	146,112	$	—		$	—	$	146,112		$	146,112
Held-to-maturity securities		—		71,327			—		71,327			69,845
Loans held for sale		—		4,653			—		4,653			4,530
Net loans and leases held for investment		—		—			1,433,990		1,433,990			1,412,140

Total assets	$	146,112	$	75,980		$	1,433,990	$	1,656,082		$	1,632,627

Liabilities:
Deposits:
Demand and savings deposits, non-maturity	$	1,533,822	$	—		$	—	$	1,533,822		$	1,533,822
Time deposits		—		334,164			—		334,164			331,511

Total deposits		1,533,822		334,164			—		1,867,986			1,865,333
Short-term borrowings		—		94,066			—		94,066			96,282
Long-term borrowings		—		20,965			—		20,965			20,994

Total liabilities	$	1,533,822	$	449,195		$	—	$	1,983,017		$	1,982,609

Off-Balance-Sheet:
Commitments to extend credit	$	—	$	(1,286	)	$	—	$	(1,286	)	$	—

The following valuation methods and assumptions were used by the Corporation in estimating its fair value for financial instruments measured at fair value on a non-recurring basis and financial instruments not measured at fair value on a recurring or non-recurring basis in the Corporation’s consolidated balance sheets but for which the fair value is required to be disclosed:

Cash and short-term interest-earning assets: The carrying amounts reported in the balance sheets for cash and due from banks, interest-earning deposits with other banks, and other short-term investments approximates those assets’ fair values. Cash and short-term interest-earning assets are classified within Level 1 in the fair value hierarchy.

Held-to-maturity securities: Fair values for the held-to-maturity investment securities are estimated by using pricing models or quoted prices of securities with similar characteristics and are classified in Level 2 in the fair value hierarchy.

Loans held for sale: The fair value of the Corporation’s loans held for sale are generally determined using a pricing model based on current market information obtained from external sources, including interest rates, bids or indications provided by market participants on specific loans that are actively marketed for sale. The Corporation’s loans held for sale are primarily residential mortgage loans and are generally classified in Level 2 due to the observable pricing data. Loans held for sale are carried at the lower of cost or estimated fair value. At June 30, 2013, loans held for sale had a carrying amount of $3.6 million with a negative valuation allowance $79 thousand. There were no valuation adjustments for loans held for sale at December 31, 2012.

Loans and leases held for investment: The fair values for loans are estimated using discounted cash flow analyses, using a discount rate based on current interest rates at which similar loans with similar terms would be made to borrowers and include components for credit risk, operating expense and embedded prepayment options. An overall valuation adjustment is made for specific credit risks in addition to general portfolio risk and is significant to the valuation. As permitted, the fair value of the loans and leases are not based on the exit price concept as discussed in the first paragraph of this note. Loans and leases are classified within Level 3 in the fair value hierarchy.

Impaired loans held for investment: Impaired loans held for investment include those collateral-dependent loans for which the practical expedient was applied, resulting in a fair-value adjustment to the loan. Impaired loans are evaluated and valued at the time the loan is identified as impaired, at the lower of cost or fair value. Fair value is measured based on the value of the collateral securing these loans less cost to sell and is classified at a Level 3 in the fair value hierarchy. The fair value of collateral is based on appraisals performed by qualified licensed appraisers hired by the Corporation. At June 30, 2013, impaired loans held for investment had a carrying amount of $38.6 million with a valuation allowance of $230 thousand. At December 31, 2012, impaired loans held for investment had a carrying amount of $45.2 million with a valuation allowance of $208 thousand.

Mortgage servicing rights: The Corporation estimates the fair value of mortgage servicing rights using discounted cash flow models that calculate the present value of estimated future net servicing income. The model uses readily available prepayment speed assumptions for the current interest rates of the portfolios serviced. Mortgage servicing rights are classified within Level 2 of the valuation hierarchy. The Corporation reviews the mortgage servicing rights portfolio on a quarterly basis for impairment and the mortgage servicing rights are carried at the lower of amortized cost or estimated fair value. At June 30, 2013, mortgage servicing rights had a carrying amount of $5.5 million with a valuation allowance of $249 thousand. At December 31, 2012, mortgage servicing rights had a carrying amount of $4.6 million with a valuation allowance of $497 thousand.

Goodwill and other identifiable intangible assets: Certain non-financial assets subject to measurement at fair value on a non-recurring basis include goodwill and other identifiable intangible assets. In conjunction with the reduction in the contingent consideration liability for Javers during the six months ended June 30, 2013, an evaluation of goodwill and other identifiable intangible assets was performed with no indicated impairment.

Other real estate owned: The fair value of other real estate owned is estimated based upon its appraised value less costs to sell. The real estate is stated at an amount equal to the loan balance prior to foreclosure, plus costs incurred for improvements to the property but no more than the fair value of the property, less estimated costs to sell. New appraisals are generally obtained on an annual basis. Other real estate owned is classified within Level 2 of the valuation hierarchy.

Deposit liabilities: The fair values for demand and savings accounts, with no stated maturities, is the amount payable on demand at the reporting date (carrying value) and are classified within Level 1 in the fair value hierarchy. The fair values for time deposits with fixed maturities are estimated by discounting the final maturity using interest rates currently offered for deposits with similar remaining maturities. Time deposits are classified within Level 2 in the fair value hierarchy.

Short-term borrowings: The fair value of customer repurchase agreements are estimated using current market rates for similar borrowings and are classified within Level 2 in the fair value hierarchy. Short-term FHLB advances are estimated using a discounted cash flow analysis based on current market rates for similar borrowings, and include components for operating expense and embedded prepayment options that are observable. Short-term FHLB advances are classified within Level 2 in the fair value hierarchy.

Long-term borrowings: The fair values of the Corporation’s long-term borrowings are estimated using a discounted cash flow analysis based on current market rates for similar borrowings, and include components for credit risk, operating expense, and embedded prepayment options that are observable. Long-term borrowings are classified within Level 2 in the fair value hierarchy.

Off-balance-sheet instruments: Fair values for the Corporation’s off-balance-sheet instruments are based on the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing and are classified within Level 2 in the fair value hierarchy.