9) Fair Value

Accounting guidance 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 standard describes three levels of inputs that may be used to measure fair value:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has 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 assets or liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data (for example, interest rates and yield curves observable at commonly quoted intervals, prepayment speeds, credit risks, and default rates).

Level 3: Significant unobservable inputs that reflect a reporting entity's own assumptions about the assumptions that market participants would use in pricing an asset or liability.

Financial Assets and Liabilities Measured on a Recurring Basis

The fair values of securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the securities' relationship to other benchmark quoted securities (Level 2 inputs).

The fair value of interest-only ("I/O") strip receivable assets is based on a valuation model used by a third party. The Company is able to compare the valuation model inputs and results to widely available published industry data for reasonableness (Level 2 inputs).

			Fair Value Measurements Using

	Balance		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(Dollars in thousands)
Assets at June 30, 2014:
Available-for-sale securities:
Agency mortgage-backed securities	$	158,996		—	$	158,996		—
Asset-backed securities	$	27,313			$	27,313
Corporate bonds	$	53,868		—	$	53,868		—
Trust preferred securities	$	21,312		—	$	21,312		—
I/O strip receivables	$	1,633		—	$	1,633		—
Assets at December 31, 2013:
Available-for-sale securities:
Agency mortgage-backed securities	$	207,644		—	$	207,644		—
Corporate bonds	$	52,046		—	$	52,046		—
Trust preferred securities	$	20,410		—	$	20,410		—
I/O strip receivables	$	1,647		—	$	1,647		—

There were no transfers between Level 1 and Level 2 during the period for assets measured at fair value on a recurring basis.

Assets and Liabilities Measured on a Non-Recurring Basis

The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals. The appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

Foreclosed assets are valued at the time the loan is foreclosed upon and the asset is transferred to foreclosed assets. The fair value is based primarily on third party appraisals, less costs to sell. The appraisals may utilize a single valuation approach or a combination of approaches including the comparable sales and income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value.

			Fair Value Measurements Using

	Balance		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(Dollars in thousands)
Assets at June 30, 2014:
Impaired loans—held-for-investment:
Commercial	$	1,445		—		—	$	1,445
Real estate:
Commercial and residential		1,675		—		—		1,675
Land and construction		1,232		—		—		1,232
Consumer		28		—		—		28


	$	4,380		—		—	$	4,380




Assets at December 31, 2013:
Impaired loans—held-for-investment:
Commercial	$	1,780		—		—	$	1,780
Real estate:
Commercial and residential		2,846		—		—		2,846
Land and construction		1,290		—		—		1,290
Consumer		100		—		—		100


	$	6,016		—		—	$	6,016




Foreclosed assets:
Land and construction	$	575		—		—	$	575


	$	575					$	575

The following table shows the detail of the impaired loans held-for- investment and the impaired loans held-for-investment carried at fair value for the periods indicated:

	June 30, 2014			December 31, 2013

	(Dollars in thousands)
Impaired loans held-for-investment:
Book value of impaired loans held-for-investment carried at fair value	$	5,892		$	8,472
Book value of impaired loans held-for-investment carried at cost		3,430			3,346


Total impaired loans held-for-investment	$	9,322		$	11,818




Impaired loans held-for-investment carried at fair value:
Book value of impaired loans held-for-investment carried at fair value	$	5,892		$	8,472
Specific valuation allowance		(1,512	)		(2,456	)


Impaired loans held-for-investment carried at fair value, net	$	4,380		$	6,016

Impaired loans held-for-investment which are measured primarily for impairment using the fair value of the collateral were $9,322,000 at June 30, 2014, after partial charge-offs of $264,000 in the first six months of 2014. In addition, these loans had a specific valuation allowance of $1,512,000 at June 30, 2014. Impaired loans held-for-investment totaling $5,892,000 at June 30, 2014 were carried at fair value as a result of the aforementioned partial charge-offs and specific valuation allowances at period-end. The remaining $3,430,000 of impaired loans were carried at cost at June 30, 2014, as the fair value of the collateral exceeded the cost basis of each respective loan. Partial charge-offs and changes in specific valuation allowances during the first six months of 2014 on impaired loans held-for-investment carried at fair value at June 30, 2014 resulted in an additional provision for loan losses of $421,000.

Impaired loans held for investment of $11,818,000 at December 31, 2013, after partial charge offs of $318,000 in 2013, were analyzed for additional impairment primarily using the fair value of collateral. In addition, these loans had a specific valuation allowance of $2,456,000 at December 31, 2013. Impaired loans held for investment totaling $8,472,000 at December 31, 2013 were carried at fair value as a result of the aforementioned partial charge offs and specific valuation allowances at year end. The remaining $3,346,000 of impaired loans were carried at cost at December 31, 2013, as the fair value of the collateral exceeded the cost basis of each respective loan. Partial charge offs and changes in specific valuation allowances during 2013 on impaired loans held for investment carried at fair value at December 31, 2013 resulted in an additional provision for loan losses of $508,000.

At December 31, 2013, foreclosed assets had a carrying amount of $575,000, with no valuation allowance at December 31, 2013.

The following table presents quantitative information about level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at the periods indicated:

	June 30, 2014

	Fair Value		Valuation Techniques	Unobservable Inputs	Range (Weighted Average)
	(Dollars in thousands)
Impaired loans—held-for-investment:
Commercial	$	1,445	Market Approach	Discount adjustment for differences between comparable sales	0% to 3% (3%)
Real estate:
Commercial and residential	$	1,675	Market Approach	Discount adjustment for differences between comparable sales	2% to 3% (2%)
Land and construction	$	1,232	Market Approach	Discount adjustment for differences between comparable sales	1% to 2% (2%)

	December 31, 2013

	Fair Value		Valuation Techniques	Unobservable Inputs	Range (Weighted Average)
	(Dollars in thousands)
Impaired loans—held-for-investment:
Commercial	$	1,780	Market Approach	Discount adjustment for differences between comparable sales	2% to 3% (2%)
Real estate:
Commercial and residential	$	2,846	Market Approach	Discount adjustment for differences between comparable sales	1% to 15% (2%)
Land and construction	$	1,290	Market Approach	Discount adjustment for differences between comparable sales	1% to 2% (2%)
Foreclosed assets:
Land and construction	$	575	Market Approach	Discount adjustment for differences between comparable sales	1% to 16% (7%)

The Company obtains third party appraisals on its impaired loans held- for-investment and foreclosed assets to determine fair value. Generally, the third party appraisals apply the "market approach," which is a valuation technique that uses prices and other relevant information generated by market transactions involving identical or comparable (that is, similar) assets, liabilities, or a group of assets and liabilities, such as a business. Adjustments are then made based on the type of property, age of appraisal, current status of property and other related factors to estimate the current value of collateral.

The carrying amounts and estimated fair values of financial instruments at June 30, 2014 are as follows:

			Estimated Fair Value

	Carrying Amounts		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
	(Dollars in thousands)
Assets:
Cash and cash equivalents	$	49,418	$	49,418		—		—	$	49,418
Securities available-for-sale	$	261,489		—	$	261,489		—	$	261,489
Securities held-to-maturity	$	95,972		—	$	92,841		—	$	92,841
Loans (including loans held-for-sale), net	$	974,018		—	$	2,269	$	965,646	$	967,915
FHLB and FRB stock	$	10,314		—		—		—		N/A
Accrued interest receivable	$	4,218		—	$	1,605	$	2,613	$	4,218
Loan servicing rights and I/O strips receivables	$	2,239		—	$	4,280		—	$	4,280
Liabilities:
Time deposits	$	257,547		—	$	257,984		—	$	257,984
Other deposits	$	1,010,301		—	$	1,010,301		—	$	1,010,301
Accrued interest payable	$	181		—	$	181		—	$	181

The carrying amounts and estimated fair values of the Company's financial instruments at December 31, 2013:

			Estimated Fair Value

	Carrying Amounts		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
	(Dollars in thousands)
Assets:
Cash and cash equivalents	$	112,605	$	112,605		—		—	$	112,605
Securities available-for-sale	$	280,100		—	$	280,100		—	$	280,100
Securities held-to-maturity	$	95,921		—	$	86,032		—	$	86,032
Loans (including loans held-for-sale), net	$	898,897		—	$	3,148	$	890,368	$	893,516
FHLB and FRB stock	$	10,435		—		—		—		N/A
Accrued interest receivable	$	4,085		—	$	1,729	$	2,356	$	4,085
Loan servicing rights and I/O strips receivables	$	2,172		—	$	4,203		—	$	4,203
Liabilities:
Time deposits	$	277,844		—	$	278,239		—	$	278,239
Other deposits	$	1,008,377		—	$	1,008,377		—	$	1,008,377
Accrued interest payable	$	192		—	$	192		—	$	192

The methods and assumptions, not previously discussed, used to estimate the fair value are described as follows:

Cash and Cash Equivalents

The carrying amounts of cash on hand, noninterest and interest bearing due from bank accounts, and Fed funds sold approximate fair values and are classified as Level 1.

Loans

The fair value of loans held-for-sale is estimated based upon binding contracts and quotes from third parties resulting in a Level 2 classification.

Fair values of loans, excluding loans held for sale, are estimated as follows: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

FHLB and FRB Stock

It was not practical to determine the fair value of FHLB and FRB stock due to restrictions placed on their transferability.

Accrued Interest Receivable/Payable

The carrying amounts of accrued interest approximate fair value resulting in a Level 2 or Level 3 classification.

Deposits

The fair values disclosed for demand deposits (e.g., interest and noninterest checking, passbook savings, and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amount) resulting in a Level 2 classification. The carrying amounts of variable rate, fixed-term money market accounts approximate their fair values at the reporting date resulting in a Level 2 classification. The carrying amounts of variable rate, certificates of deposit approximate their fair values at the reporting date resulting in a Level 2 classification. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

Off-balance Sheet Instruments

Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties' credit standing. The fair value of commitments is not material.

Limitations

Fair value estimates are made at a specific point in time, based on relevant market information about the financial instruments. These estimates do not reflect any premium or discount that could result from offering for sale at one time the entire holdings of a particular financial instrument. 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.