NOTE 15 – FAIR VALUE MEASUREMENTS

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability, or in the absence of a principal market, the most advantageous market for the asset or liability. The price of the principal (or most advantageous) market used to measure the fair value of the asset or liability is not adjusted for transaction costs. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction. Market participants are buyers and sellers in the principal market that are (i) independent, (ii) knowledgeable, (iii) able to transact and (iv) willing to transact.

We are required to use valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets and liabilities. The income approach uses valuation techniques to convert future amounts, such as cash flows or earnings, to a single present amount on a discounted basis. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (replacement cost). Valuation techniques should be consistently applied. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from independent sources, or unobservable, meaning those that reflect our own estimates about the assumptions market participants would use in pricing the asset or liability based on the best information available in the circumstances. In that regard, we utilize a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that we have the ability to access as of the measurement date.

Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; or other inputs that are observable or can be derived from or corroborated by observable market data by correlation or other means.

Level 3: Significant unobservable inputs that reflect our own estimates about the assumptions that market participants would use in pricing an asset or liability.

The following is a description of our valuation methodologies used to measure and disclose the fair values of our financial assets and liabilities on a recurring or nonrecurring basis:

Securities available for sale. Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based on quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models. Level 2 securities include U.S. Government agency debt obligations, mortgage-backed securities issued or guaranteed by U.S. Government agencies, municipal general obligation and revenue bonds, Michigan Strategic Fund bonds and mutual funds. We have no Level 1 or Level 3 securities available for sale.

Mortgage loans held for sale. Mortgage loans held for sale are carried at the lower of aggregate cost or fair value and are measured on a nonrecurring basis. Fair value is based on independent quoted market prices, where applicable, or the prices for other mortgage whole loans with similar characteristics. As of December 31, 2013 and 2012, we determined that the fair value of our mortgage loans held for sale approximated the recorded cost of $1.1 million and $3.5 million, respectively.

Loans. We do not record loans at fair value on a recurring basis. However, from time to time, we record nonrecurring fair value adjustments to collateral dependent loans to reflect partial write-downs or specific reserves that are based on the observable market price or current estimated value of the collateral. These loans are reported in the nonrecurring table below at initial recognition of impairment and on an ongoing basis until recovery or charge-off.

Foreclosed assets. At time of foreclosure or repossession, foreclosed and repossessed assets are adjusted to fair value less costs to sell upon transfer of the loans to foreclosed and repossessed assets, establishing a new cost basis. We subsequently adjust estimated fair value on foreclosed assets on a nonrecurring basis to reflect write-downs based on revised fair value estimates.

Derivatives. The interest rate swap agreement is measured at fair value on a recurring basis. We measure fair value utilizing models that use primarily market observable inputs, such as forecasted yield curves, and accordingly, the interest rate swap agreement is classified as Level 2.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The balances of assets and liabilities measured at fair value on a recurring basis as of December 31, 2013 are as follows:


				Quoted
				Prices in
				Active		Significant
				Markets for		Other			Significant
				Identical		Observable			Unobservable
				Assets		Inputs			Inputs
	Total			(Level 1)		(Level 2)			(Level 3)
Available for sale securities
U.S. Government agency debt obligations	$	98,477,000		$	0	$	98,477,000		$	0
Mortgage-backed securities		13,558,000			0		13,558,000			0
Municipal general obligation bonds		16,872,000			0		16,872,000			0
Municipal revenue bonds		916,000			0		916,000			0
Mutual funds		1,355,000			0		1,355,000			0
Derivatives
Interest rate swap agreement		(264,000	)		0		(264,000	)		0

Total	$	130,914,000		$	0	$	130,914,000		$	0

There were no transfers in or out of Level 1, Level 2 or Level 3 during 2013.

The balances of assets and liabilities measured at fair value on a recurring basis as of December 31, 2012 are as follows:


				Quoted
				Prices in
				Active		Significant
				Markets for		Other			Significant
				Identical		Observable			Unobservable
				Assets		Inputs			Inputs
	Total			(Level 1)		(Level 2)			(Level 3)
Available for sale securities
U.S. Government agency debt obligations	$	79,098,000		$	0	$	79,098,000		$	0
Mortgage-backed securities		21,996,000			0		21,996,000			0
Michigan Strategic Fund bonds		11,255,000			0		11,255,000			0
Municipal general obligation bonds		22,743,000			0		22,743,000			0
Municipal revenue bonds		1,817,000			0		1,817,000			0
Mutual funds		1,405,000			0		1,405,000			0
Derivatives
Interest rate swap agreement		(1,113,000	)		0		(1,113,000	)		0

Total	$	137,201,000		$	0	$	137,201,000		$	0

There were no transfers in or out of Level 1, Level 2 or Level 3 during 2012.

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

The balances of assets and liabilities measured at fair value on a nonrecurring basis as of December 31, 2013 are as follows:


			Quoted
			Prices in
			Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs
	Total		(Level 1)		(Level 2)		(Level 3)
Impaired loans ⁽¹⁾	$	23,405,000	$	0	$	0	$	23,405,000
Foreclosed assets ⁽¹⁾		2,851,000		0		0		2,851,000

Total	$	26,256,000	$	0	$	0	$	26,256,000

The balances of assets and liabilities measured at fair value on a nonrecurring basis as of December 31, 2012 are as follows:


			Quoted
			Prices in
			Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs
	Total		(Level 1)		(Level 2)		(Level 3)
Impaired loans ⁽¹⁾	$	34,406,000	$	0	$	0	$	34,406,000
Foreclosed assets ⁽¹⁾		6,970,000		0		0		6,970,000

Total	$	41,376,000	$	0	$	0	$	41,376,000

⁽¹⁾	Represents carrying value and related write-downs for which adjustments are based on the estimated value of the property or other assets.

Fair value estimates of collateral on impaired loans, as well as on foreclosed assets, are reviewed periodically. Our credit policies establish criteria for obtaining appraisals and determining internal value estimates. We may also adjust outside appraisals and internal evaluations based on identifiable trends within our markets, such as sales of similar properties or assets, listing prices and offers received. In addition, we may discount certain appraised and internal value estimates to address current distressed market conditions.