Note 9 – Fair Value Measurements

Accounting guidance under GAAP defines fair value as 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. This accounting guidance also establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Securities available for sale and derivative assets and liabilities are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis, such as impaired loans, loans held for sale and other real estate and other assets owned (foreclosed assets). These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Under fair value accounting guidance, assets and liabilities are grouped 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 their fair values. These hierarchy levels are:

Level 1 inputs – Unadjusted quoted prices in active markets for identical assets or liabilities that the entity has the ability to access at the measurement date.

Level 2 inputs – Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3 inputs – Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

Below is a discussion on the Company’s assets measured at fair value on a recurring basis.

Investment Securities Available for Sale

Fair value measurement for investment securities available for sale is based on quoted prices from an independent pricing service. The fair value measurements consider observable data that may include present value of future cash flows, prepayment assumptions, credit loss assumptions and other factors. The Company classifies its investments in U.S. Treasury securities as Level 1 in the fair value hierarchy, and it classifies its investments in U.S. Government agencies securities and mortgage-backed securities issued or guaranteed by U.S. Government sponsored entities as Level 2.

Derivative Assets

Derivative instruments held by the Company for risk management purposes are traded in over-the-counter markets where quoted market prices are not readily available. For those derivatives, the Company measures fair value using third-party models that use primarily market observable inputs, such as yield curves and option volatilities, and include the value associated with counterparty credit risk. The Company classifies its derivative instruments held for risk management purposes as Level 2 in the fair value hierarchy and includes them in other assets in the accompanying consolidated balance sheets. As of September 30, 2013, the Company had no derivative instruments. At December 31, 2012, the Company’s derivative instruments consisted solely of interest rate caps.

The tables below present the recorded amount of assets measured at fair value on a recurring basis at September 30, 2013 and December 31, 2012. No assets were transferred from one hierarchy level to another during the first nine months of 2013 or 2012.

					Significant
					Other		Significant
			Quoted		Observable		Unobservable
			Prices		Inputs		Inputs
(Dollars in thousands)	Fair Value		(Level 1)		(Level 2)		(Level 3)
September 30, 2013
Securities available for sale:
U.S. Treasury	$	5,369	$	5,369	$	-	$	-
U.S. Government agencies		46,214		-		46,214		-
Mortgage-backed securities		83,671		-		83,671		-
Other equity securities		608		-		608		-
Total	$	135,862	$	5,369	$	130,493	$	-

Interest rate caps	$	-	$	-	$	-	$	-

					Significant
					Other		Significant
			Quoted		Observable		Unobservable
			Prices		Inputs		Inputs
(Dollars in thousands)	Fair Value		(Level 1)		(Level 2)		(Level 3)
December 31, 2012
Securities available for sale:
U.S. Government agencies	$	36,107	$	-	$	36,107	$	-
Mortgage-backed securities		108,780		-		108,780		-
Other equity securities		621		-		621		-
Total	$	145,508	$	-	$	145,508	$	-

Interest rate caps	$	14	$	-	$	14	$	-

Below is a discussion on the Company’s assets measured at fair value on a nonrecurring basis.

Loans held for sale

Loans held for sale are adjusted for fair value upon transfer of loans to loans held for sale. Subsequently, loans held for sale are carried at the lower of carrying value and fair value. Fair value is based on independent market prices, appraised value of the collateral or management’s estimation of the value of the collateral. At September 30, 2013, loans held for sale were classified as Level 3 in the fair value hierarchy.

Loans

The Company does not record loans at fair value on a recurring basis; however, from time to time, a loan is considered impaired and a valuation allowance may be established if there are losses associated with the loan. Loans are considered impaired if it is probable that payment of interest and principal will not be made in accordance with contractual terms. The fair value of impaired loans can be estimated using one of several methods, including the collateral value, market value of similar debt, liquidation value and discounted cash flows. At September 30, 2013 and December 31, 2012, substantially all impaired loans were evaluated based on the fair value of the collateral and were classified as Level 3 in the fair value hierarchy.

Other Real Estate and Other Assets Owned (Foreclosed Assets)

Foreclosed assets are adjusted for fair value upon transfer of loans to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value and fair value. Fair value is based on independent market prices, appraised value of the collateral or management’s estimation of the value of the collateral. At September 30, 2013 and December 31, 2012, foreclosed assets were classified as Level 3 in the fair value hierarchy.

The tables below summarize the changes in the recorded amount of assets measured at fair value on a nonrecurring basis for the nine months ended September 30, 2013 and 2012. All assets measured at fair value on a nonrecurring basis were classified as Level 3 in the fair value hierarchy for the periods presented.

(Dollars in thousands)	Construction		Residential real estate		Commercial real estate		Commercial		Consumer		Total
For the nine months ended September 30, 2013
Impaired loans:
Beginning balance	$	36,088	$	17,951	$	31,833	$	715	$	39	$	86,626
Charge-offs		(19,377)		(4,664)		(6,893)		(90)		(38)		(31,062)
Payments		(1,510)		(2,183)		(8,170)		(47)		(13)		(11,923)
Transferred to loans held for sale		(9,820)		(5,492)		(6,795)		-		-		(22,107)
Transferred to other real estate owned		(205)		(729)		(1,601)		-		-		(2,535)
Returned to performing status		-		(2,448)		(1,075)		-		-		(3,523)
Changed to nonaccrual status		-		(1,626)		(1,741)		-		-		(3,367)
Additions		3,821		20,764		8,747		374		44		33,750
Changes in allowance		519		(326)		159		(305)		(13)		34
Ending balance	$	9,516	$	21,247	$	14,464	$	647	$	19	$	45,893

(Dollars in thousands)	Construction		Residential real estate		Commercial real estate		Commercial		Consumer		Total
For the nine months ended September 30, 2012
Impaired loans:
Beginning balance	$	27,166	$	22,602	$	23,578	$	1,738	$	28	$	75,112
Charge-offs		(4,965)		(7,628)		(2,177)		(1,264)		-		(16,034)
Payments		(976)		(8,405)		(1,858)		(105)		(4)		(11,348)
Transferred to loans held for sale		-		-		-		-		-		-
Transferred to other real estate owned		(1,631)		(1,463)		(1,334)		(30)		-		(4,458)
Returned to performing status		-		(201)		-		(39)		-		(240)
Changed to nonaccrual status		(666)		(786)		-		-		-		(1,452)
Additions		20,856		14,256		10,693		1,346		30		47,181
Changes in allowance		151		1,296		-		-		-		1,447
Ending balance	$	39,935	$	19,671	$	28,902	$	1,646	$	54	$	90,208

	For the Nine Months Ended
(Dollars in thousands)	September 30,
	2013		2012
Other real estate owned:
Beginning balance	$	7,659	$	9,385
Sales		(3,793)		(4,605)
Write-downs		(947)		(1,077)
Additions		2,857		4,715
Ending balance	$	5,776	$	8,418

The following information relates to the estimated fair values of financial assets and liabilities that are reported in the Company’s consolidated balance sheets at their carrying amounts. The discussion below describes the methods and assumptions used to estimate the fair value of each class of financial asset and liability for which it is practicable to estimate that value.

Cash and Cash Equivalents

Cash equivalents include interest-bearing deposits with other banks and federal funds sold. For these short-term instruments, the carrying amount is a reasonable estimate of fair value.

Investment Securities Held to Maturity

For all investments in debt securities, fair values are based on quoted market prices. If a quoted market price is not available, then fair value is estimated using quoted market prices for similar securities.

Loans

The fair values of categories of fixed rate loans, such as commercial loans, residential real estate, and other consumer loans, are estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Other loans, including variable rate loans, are adjusted for differences in loan characteristics.

Financial Liabilities

The fair values of demand deposits, savings accounts, and certain money market deposits are the amounts payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. These estimates do not take into consideration the value of core deposit intangibles. Generally, the carrying amount of short-term borrowings is a reasonable estimate of fair value. The fair values of securities sold under agreements to repurchase (included in short-term borrowings) and long-term debt are estimated using the rates offered for similar borrowings.

Commitments to Extend Credit and Standby Letters of Credit

The majority of the Company’s commitments to grant loans and standby letters of credit are written to carry current market interest rates if converted to loans. In general, commitments to extend credit and letters of credit are not assignable by the Company or the borrower, so they generally have value only to the Company and the borrower. Therefore, it is impractical to assign any value to these commitments.

The following table provides information on the estimated fair values of the Company’s financial assets and liabilities that are reported in the balance sheets at their carrying amounts. The financial assets and liabilities have been segregated by their classification level in the fair value hierarchy.

	September 30, 2013				December 31, 2012
			Estimated				Estimated
	Carrying		Fair		Carrying		Fair
(Dollars in thousands)	Amount		Value		Amount		Value
Financial assets
Level 2 inputs
Cash and cash equivalents	$	106,922	$	106,922	$	200,193	$	200,193
Investment securities held to maturity		2,357		2,471		2,657		2,884
Level 3 inputs
Loans, net		707,326		728,466		769,091		798,381

Financial liabilities
Level 2 inputs
Deposits	$	930,413	$	929,587	$	1,049,273	$	1,052,382
Short-term borrowings		11,468		11,468		13,761		13,761