15. Fair Value of Financial Instruments

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. The fair value hierarchy prioritizes inputs to valuation techniques used in fair value calculations. The three levels of inputs are defined as follows:

Level 1 – unadjusted quoted prices for identical assets or liabilities in active markets accessible by the Company

Level 2 – inputs that are observable in the marketplace other than those inputs classified as Level 1

Level 3 – inputs that are unobservable in the marketplace and significant to the valuation

Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding 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 fair values presented. The following methods and assumptions were used by the Company to estimate the fair value of its financial instruments at December 31, 2013 and 2012:

Cash and due from banks – The carrying amounts of cash and short-term instruments approximate fair values and are classified as Level 1.

Securities Available for Sale – Where possible, the Company utilizes quoted market prices to measure debt and equity securities; such items are classified as Level 1 in the hierarchy and include equity securities, US government bonds and securities issued by federally sponsored agencies. When quoted market prices for identical assets are unavailable or the market for the asset is not sufficiently active, varying valuation techniques are used. Common inputs in valuing these assets include, among others, benchmark yields, issuer spreads, forward mortgage-backed securities trade prices and recently reported trades. Such assets are classified as Level 2 in the hierarchy and typically include private label mortgage-backed securities and corporate bonds. Pricing on these securities are provided to the Company by a pricing service vendor. In the Level 3 category, the Company is classifying all the securities that the Company pricing service vendor cannot price due to lack of trade activity in these securities.

FHLB and Federal Reserve Bank Stock – The carrying value approximates the fair value based upon the redemption provisions of the stock and are classified as Level 1.

Loans Held for Sale – The fair value of loans held for sale is determined, when possible, using quoted secondary-market prices. If no such quoted price exists, the fair value of a loan is determined using quoted prices for a similar asset or assets, adjusted for the specific attributes of that loan. Loans held for sale are classified as Level 2.

Loans Held for Investment – For variable-rate loans that re-price frequently and have no significant change in credit risk, fair values are based on carrying values resulting in a Level 2 classification. The carrying amount of accrued interest receivable approximates its fair value as a Level 2 classification.

Other real estate owned – Other real estate owned represents real estate that the Company has taken control of in partial or full satisfaction of loans. At the time of foreclosure, other real estate owned is recorded at the fair value of the real estate, less costs to sell, which becomes the property’s new basis. Fair values are generally based on third party appraisals of the property less any estimated selling costs and are classified as Level 2.

Accrued Interest Receivable/Payable – The carrying amount approximates fair value and are classified as Level 1.

Deposit Accounts – The fair values estimated for demand deposits (interest and noninterest checking, passbook savings, and certain types of money market accounts) are equal to the amount payable on demand at the reporting date (i.e., their carrying amounts) resulting in a Level 1 classification. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of the aggregate expected monthly maturities on time deposits in a Level 2 classification. The carrying amount of accrued interest payable approximates its fair value as a Level 1 classification.

FHLB Advances and Other Borrowings – For these instruments, the fair value of short term borrowings is estimated to be the carrying amount and is classified as Level 1. The fair value of long term borrowings and debentures is determined using rates currently available for similar borrowings or debentures with similar credit risk and for the remaining maturities and are classified as Level 2. The carrying amount of accrued interest payable approximates its fair value as a Level 2 classification.

Subordinated Debentures – The fair value of subordinated debentures is estimated by discounting the balance by the current three-month LIBOR rate plus the current market spread. The fair value is determined based on the maturity date as the Company does not currently have intentions to call the debenture and are classified as Level 2.

Off-balance sheet commitments and standby letters of credit – The majority of the Bank’s commitments to extend credit carry current market interest rates if converted to loans. Because these commitments are generally unassignable by either the Bank or the borrower, they only have value to the Bank and the borrower. The notional amount disclosed for off-balance sheet commitments and standby letters of credit is the amount available to be drawn down on all lines and letters of credit. The cost to assume is calculated at 10% of the notional amount and is classified as Level 2.

Estimated fair values are disclosed for financial instruments for which it is practicable to estimate fair value. These estimates are made at a specific point in time based on relevant market data and information about the financial instruments. These estimates do not reflect any premium or discount that could result from offering the Company’s entire holdings of a particular financial instrument for sale at one time, nor do they attempt to estimate the value of anticipated future business related to the instruments. In addition, the tax ramifications related to the realization of unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of these estimates.

The fair value estimates presented herein are based on pertinent information available to management as of December 31, 2013 and 2012.

	At December 31, 2013
	Carrying Amount		Level 1		Level 2		Level 3		Estimated Fair Value
	(in thousands)
Assets:
Cash and cash equivalents	$	126,813	$	126,813	$	—	$	—	$	126,813
Securities available for sale	256,089		—		256,089		—		256,089
Federal Reserve Bank and FHLB stock, at cost	15,450		15,450		—		—		15,450
Loans held for sale, net	3,147		—		3,147		—		3,147
Loans held for investment, net	1,231,923		—		1,227,889		2,427		1,230,316
Accrued interest receivable	6,254		6,254		—		—		6,254
Other real estate owned	1,186		—		1,186		—		1,186

Liabilities:
Deposit accounts	1,306,286		991,630		301,007		—		1,292,637
FHLB advances	156,000		156,000		—		—		156,000
Other borrowings	48,091		—		49,058		—		49,058
Subordinated debentures	10,310		—		4,696		—		4,696
Accrued interest payable	166		166		—		—		166

	Notional Amount		Level 1		Level 2		Level 3		Cost to Cede or Assume
Off-balance sheet commitments and standby letters of credit	$	337,181	$	—	$	33,718	$	—	$	33,718

	At December 31, 2012
	Carrying Amount		Level 1		Level 2		Level 3		Estimated Fair Value
	(in thousands)
Assets:
Cash and cash equivalents	$	59,352	$	59,352	$	—	$	—	$	59,352
Securities available for sale	84,066		—		83,114		952		84,066
Federal Reserve Bank and FHLB stock, at cost	11,247		11,247		—		—		11,247
Loans held for sale, net	3,681		—		3,681		—		3,681
Loans held for investment, net	974,213		—		1,046,853		2,736		1,049,589
Accrued interest receivable	4,126		4,126		—		—		4,126
Other real estate owned	2,258		—		2,258		—		2,258

Liabilities:
Deposit accounts	904,768		548,101		363,382		—		911,483
FHLB advances	87,000		87,000		—		—		87,000
Other borrowings	28,500		—		31,267		—		31,267
Subordinated debentures	10,310		—		4,973		—		4,973
Accrued interest payable	142		142		—		—		142

	Notional Amount		Level 1		Level 2		Level 3		Cost to Cede or Assume
Off-balance sheet commitments and standby letters of credit	$	131,450	$	—	$	13,145	$	—	$	13,145

A loan is considered impaired when it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement. Impairment is measured based on the fair value of the underlying collateral or the discounted expected future cash flows. The Company measures impairment on all non-accrual loans for which it has reduced the principal balance to the value of the underlying collateral less the anticipated selling cost. As such, the Company records impaired loans as non-recurring Level 2 when the fair value of the underlying collateral is based on an observable market price or current appraised value. When current market prices are not available or the Company determines that the fair value of the underlying collateral is further impaired below appraised values, the Company records impaired loans as Level 3. At December 31, 2013, substantially all the Company’s impaired loans were evaluated based on the fair value of their underlying collateral based upon the most recent appraisal available to management.

The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.

The following fair value hierarchy table presents information about the Company’s assets measured at fair value on a recurring basis at the dates indicated:

	At December 31, 2013
	Fair Value Measurement Using
	Level 1		Level 2		Level 3		Assets at Fair Value
	(in thousands)
Assets
Marketable securities	$	—	$	256,089	$	—	$	256,089
Total assets	$	—	$	256,089	$	—	$	256,089


	At December 31, 2012
	Fair Value Measurement Using
	Level 1		Level 2		Level 3		Assets at Fair Value
	(in thousands)
Assets
Marketable securities	$	—	$	83,114	$	952	$	84,066
Total assets	$	—	$	83,114	$	952	$	84,066

The following table provides a summary of the changes in consolidated statements of financial condition carrying values associated with Level 3 financial instruments during the twelve months ended December 31, 2013:

Marketable Securities	Fair Value Measurement Using Significant Other Unobservable Inputs (Level 3)
	(in thousands)
Beginning Balance, January 1, 2013	$	952
Total gains or losses (realized/unrealized):
Included in earnings (or changes in net assets)	194
Included in other comprehensive income	(140		)
Purchases, issuances, and settlements	(1,077		)
Transfer in and/or out of Level 3	71
Ending Balance, December 31, 2013	$	—

The following table provides a summary of the financial instruments the Company measures at fair value on a non-recurring basis as of December 31, 2013:

	Fair Value Measurement Using
	Level 1		Level 2		Level 3		Assets at Fair Value
	(in thousands)

Assets
Impaired Loans	$	—	$	—	$	2,427	$	2,427
Loans held for sale	—		3,147		—		3,147
Other real estate owned	—		1,186		—		1,186
Total assets	$	—	$	4,333	$	2,427	$	6,760