NOTE 6 – FAIR VALUE

Fair value is the exchange price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair values:

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, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data.

Level 3 – Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The Company used the following methods and significant assumptions to estimate the fair value:

Securities available for sale: The fair value of securities available for sale is determined using pricing models that vary based on asset class and include available trade, bid and other market information 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).

Loans held for sale, at fair value: Loans held for sale are carried at fair value, as determined by outstanding commitments from third party investors (Level 2).

Derivatives: The fair value of derivatives is based on valuation models using observable market data as of the measurement date (Level 2).

Loan servicing rights: On a quarterly basis, loan servicing rights are evaluated for impairment based on the fair value of the rights as compared to carrying amount. If the carrying amount of an individual tranche exceeds fair value, impairment is recorded on that tranche so that the servicing asset is carried at fair value. Fair value is determined at a tranche level based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model utilizes assumptions that market participants would use in estimating future net servicing income and that can be validated against available market data (Level 2).

Impaired loans: At the time a loan is considered impaired, it is valued at the lower of cost or fair value. Impaired loans carried at fair value generally receive specific allocations of the ALLL. For collateral dependent loans, fair value is commonly based on recent real estate appraisals. These 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 independent 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. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly.

Foreclosed assets: Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals. These 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 independent 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.

Assets and liabilities measured at fair value on a recurring basis, including financial assets and liabilities for which the Company has elected the fair value option, are summarized below:


	Fair Value Measurements at September 30, 2012 Using Significant Other Observable Inputs (Level 2)
Financial Assets:
Securities available for sale:
Issued by U.S. government-sponsored entities and agencies:
Mortgage-backed securities—residential	$	1,671
Collateralized mortgage obligations		12,629

Total securities available for sale	$	14,300

Loans held for sale	$	2,571

Yield maintenance provisions (embedded derivatives)	$	1,054

Interest rate lock commitments	$	45

Financial Liabilities:
Interest-rate swaps	$	1,054


	Fair Value Measurements at December 31, 2011 Using Significant Other Observable Inputs (Level 2)
Financial Assets:
Securities available for sale:
Issued by U.S. government-sponsored entities and agencies:
Mortgage-backed securities—residential	$	1,673
Collateralized mortgage obligations		16,843

Total securities available for sale	$	18,516

Loans held for sale	$	1,210

Yield maintenance provisions (embedded derivatives)	$	999

Interest rate lock commitments	$	39

Financial Liabilities:
Interest-rate swaps	$	999

The Company had no assets or liabilities measured at fair value on a recurring basis that were measured using Level 1 or Level 3 inputs at September 30, 2012 or December 31, 2011.

Assets and liabilities measured at fair value on a non-recurring basis are summarized below:


	Fair Value Measurements at September 30, 2012 Using
	Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Loan servicing rights	$	5

Impaired loans:
Commercial			$	121
Real Estate:
Multi-family residential				3,937
Commercial:
Non-owner occupied				1,839
Owner occupied				1,293
Land				159

Total impaired loans			$	7,349

Foreclosed assets
Real Estate:
Commercial:
Non-owner occupied			$	967
Land				447

Total foreclosed assets			$	1,414


	Fair Value Measurements at December 31, 2011 Using
	Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Loan servicing rights	$	9

Impaired loans:
Commercial			$	108
Real Estate:
Multi-family residential				3,065
Commercial:
Non-owner occupied				2,887
Owner occupied				516
Land				233

Total impaired loans			$	6,809

Foreclosed assets
Real Estate:
Commercial:
Land			$	1,209

Total foreclosed assets			$	1,209

The Company had no assets or liabilities measured at fair value on a non-recurring basis that were measured using Level 1 inputs at September 30, 2012 or December 31, 2011.

At September 30, 2012, impaired loan servicing rights, which are carried at fair value, were $5, which was made up of the amortized cost of $6, net of a valuation allowance of $1. At December 31, 2011, impaired loan servicing rights, which are carried at fair value, were $9, which was made up of the amortized cost of $11, net of a valuation allowance of $2. There was no charge against earnings with respect to servicing rights for the three months ended September 30, 2012, and a $1 increase in earnings for the nine months ended September 30, 2012. There was no charge against earnings with respect to servicing rights for the three months ended September 30, 2011, and a $3 increase in earnings for the nine months ended September 30, 2011.

Impaired loans carried at the fair value of the collateral for collateral dependent loans, had an unpaid principal balance of $10,193, and a fair value of $7,349, with no valuation allowance at September 30, 2012. Impaired collateral dependent loans were written down to the fair value of collateral during the three and nine months ended September 30, 2012, and there were no specific valuation allowances on these loans. The amount of charge-offs on these loans totaled $536 and $1,802, respectively, for the three and nine months ended September 30, 2012. Impaired loans carried at the fair value of collateral had an unpaid principal balance of $10,069 and a fair value of $6,809, with no valuation allowance at December 31, 2011. For the quarter ended September 30, 2011, there was a $379 additional provision recorded for impairment charges, and a $1,179 reduction in the valuation allowance for the nine months ended September 30, 2011.

Foreclosed assets which are carried at fair value less costs to sell, were carried at $1,414, which was made up of the outstanding balance of $3,509, with no valuation allowance at September 30, 2012. Foreclosed assets were written down to fair value less estimated costs to sell during the three and nine months ended September 30, 2012. The amount of charge-offs on foreclosed assets totaled $780 and $962, respectively, for the three and nine months ended September 30, 2012. Foreclosed assets which are carried at fair value less costs to sell, were carried at $1,209, which was made up of the outstanding balance of $2,348, net of a valuation allowance of $1,139, at December 31, 2011. There was a charge of $1,139 for the nine months ended September 30, 2011. There was no charge against earnings for the three months ended September 30, 2011.

During the nine months ended September 30, 2012, the Company did not have any significant transfers of assets or liabilities between those measured using Level 1 or 2 inputs. The Company recognizes transfers of assets and liabilities between Level 1 and 2 inputs based on the information relating to those assets and liabilities at the end of the reporting period.

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 September 30, 2012:


	Fair Value		Valuation Technique(s)	Unobservable Inputs	Range (Weighted Average)
Impaired loans:
Commercial	$	121	Income approach	Adjustment for differences in net operating income expectations	-10.0%

Commercial real estate:
Multi-family residential		3,937	Comparable sales approach	Adjustment for differences between the comparable market transactions	-39.0% to -27.1% (-32.7%)

Commercial:
Non-owner occupied		1,839	Comparable sales approach	Adjustment for differences between the comparable market transactions	-9.7% to 16.7% (3.2%)

Owner occupied		1,293	Comparable sales approach	Adjustment for differences between the comparable market transactions	-6.3% to 8.1% (5.4%)

Land		159	Income approach	Adjustment for differences in net operating income expectations	0.0%

			Comparable sales approach	Adjustment for differences between the comparable market transactions	8.1%
Foreclosed assets:
Real-estate
Commercial:
Non-owner occupied		967	Market approach	See note (1)	0.0%

Land		447	Comparable sales approach	Adjustment for differences between the comparable market transactions	-31.7%

Note (1) - The market approach reflects values represented by recent sales contracts related to this foreclosed asset.

Appraisals for both collateral-dependent impaired loans and foreclosed assets are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by a third-party appraisal management company approved by the Board of Directors annually. Once received, the loan officer or a member of the credit department reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics. Appraisals are updated as needed based on facts and circumstances associated with the individual properties. Real estate appraisals typically incorporate measures such as recent sales prices for comparable properties. Appraisers may make adjustments to the sales prices of the comparable properties as deemed appropriate based on the age, condition or general characteristics of the subject property. Management applies an additional discount to real estate appraised values, typically to reflect changes in market conditions since the date of the appraisal and to cover disposition costs (including selling expenses) based on the intended disposition method of the property.

Financial Instruments Recorded Using Fair Value Option

The Company has elected the fair value option for loans held for sale. These loans are intended for sale and the Company believes that the fair value is the best indicator of the resolution of these loans. Interest income is recorded based on the contractual terms of the loan and in accordance with the Company’s policy on loans held for investment. None of these loans were 90 days or more past due or on nonaccrual as of September 30, 2012 or December 31, 2011.

As of September 30, 2012 and December 31, 2011, the aggregate fair value, contractual balance (including accrued interest) and gain or loss was as follows:


	September 30, 2012		December 31, 2011
Aggregate fair value	$	2,571	$	1,210
Contractual balance		2,544		1,196
Gain		27		14

The total amount of gains and losses from changes in fair value included in earnings for the three and nine months ended September 30, 2012 and 2011 for loans held for sale were:


	Three months ended September 30,				Nine months ended September 30,
	2012		2011		2012		2011
Interest income	$	15	$	11	$	34	$	29
Interest expense		—		—		—		—
Change in fair value		9		20		13		8

Total change in fair value	$	24	$	31	$	47	$	37

The carrying amounts and estimated fair values of financial instruments at September 30, 2012 were as follows:


	Fair Value Measurements at September 30, 2012 Using:
	Carrying Value			Level 1			Level 2			Level 3		Total
Financial assets
Cash and cash equivalents	$	65,147		$	65,147		$	—		$	—	$	65,147
Interest-bearing deposits in other financial institutions		1,984			1,984						—		1,984
Securities available for sale		14,300			—			14,300			—		14,300
Loans held for sale		2,571			—			2,571			—		2,571
Loans, net		122,940			—			—			126,360		126,360
FHLB stock		1,942			—			—			—		n/a
Accrued interest receivable		68			11			57			—		68
Yield maintenance provisions (embedded derivatives)		1,054			—			1,054			—		1,054
Interest rate lock commitments		45			—			45			—		45

Financial liabilities
Deposits	$	(179,578	)	$	(76,931	)	$	(104,763	)	$	—	$	(181,694	)
FHLB advances		(10,000	)		—			(10,403	)		—		(10,403	)
Subordinated debentures		(5,155	)		—			(3,071	)		—		(3,071	)
Accrued interest payable		(451	)		—			(451	)		—		(451	)
Interest-rate swaps		(1,054	)		—			(1,054	)		—		(1,054	)

The carrying amounts and estimated fair values of financial instruments at December 31, 2011 were as follows:


	December 31, 2011
	Carrying			Fair
	Amount			Value
Financial assets
Cash and cash equivalents	$	61,436		$	61,436
Interest-bearing deposits in other financial institutions		1,984			1,984
Securities available for sale		18,516			18,516
Loans held for sale		1,210			1,210
Loans, net		151,160			155,159
FHLB stock		1,942			n/a
Accrued interest receivable		92			92
Yield maintenance provisions (embedded derivatives)		999			999
Interest rate lock commitments		39			39

Financial liabilities
Deposits	$	(217,049	)	$	(219,235	)
FHLB advances		(15,742	)		(16,327	)
Subordinated debentures		(5,155	)		(2,810	)
Accrued interest payable		(300	)		(300	)
Interest-rate swaps		(999	)		(999	)

The methods and assumptions, not previously presented, used to estimate fair values are described as follows:

Cash and Cash Equivalents

The carrying amounts of cash and short-term instruments approximate fair values and are classified as Level 1.

Interest-Bearing Deposits in Other Financial Institutions

The carrying amounts of interest bearing deposits in other financial institutions approximate fair values and are classified as Level 1.

FHLB Stock

It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.

Loans

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.

Deposits

The fair values disclosed for demand deposits (e.g., interest and noninterest bearing checking, passbook savings, and 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 1 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.

Other Borrowings

The fair values of the Company’s long-term FHLB advances are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 2 classification.

The fair values of the Company’s subordinated debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 2 classification.

Accrued Interest Receivable/Payable

The carrying amounts of accrued interest approximate fair value resulting in a Level 1 or 2 classification, consistent with the asset or liability with which they are associated.

Off-Balance-Sheet Instruments

The fair value of off-balance-sheet items is not considered material.