Note 14 - Fair Value of Financial Instruments

Management uses its best judgment in estimating the fair value of the Company’s financial instruments; however, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts the Company could have realized in a sale transaction on the dates indicated. The estimated fair value amounts have been measured as of December 31, 2012 and 2011 and have not been re-evaluated or updated for purposes of these consolidated financial statements subsequent to those respective dates. The estimated fair values of these financial instruments subsequent to the respective reporting dates may be different than the amounts reported here.

The measurement of fair value under FASB ASC Topic 820, “Fair Value Measurements and Disclosures” establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities measurements (Level 1) and the lowest priority to unobservable input measurements (Level 3). The three levels of the fair value hierarchy under FASB ASC Topic 820 are as follows:

Level 1: Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity can access at the measurement date.

Level 2: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability either directly or indirectly.

Level 3: 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.

An asset’s or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

For assets measured at fair value on a recurring and nonrecurring basis, the fair value measurements by level within the fair value hierarchy used at December 31, 2012 and 2011 were as follows:


	Fair Value Measurements at December 31, 2012
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Other Unobservable Inputs
	December 31, 2012		(Level 1)		(Level 2)		(Level 3)
		(Dollars in thousands)
Measured at fair value on a recurring basis:
Securities available for sale:
U.S. Treasury bonds	$	15,195	$	15,195	$	-	$	-
Municipal bonds		56,264		-		56,264		-
Mortgage-backed securities:
Collateralized mortgage obligations-private label		94		-		94		-
Collateralized mortgage obligations-government sponsored entities		58,167		-		58,167		-
Government National Mortgage Association		2,896		-		2,896		-
Federal National Mortgage Association		16,272		-		16,272		-
Federal Home Loan Mortgage Corporation		6,194		-		6,194		-
Asset-backed securities:
Private label		4,117		-		244		3,873
Government sponsored entities		163		-		163		-
Equity securities		6		-		6		-
Total	$	159,368	$	15,195	$	140,300	$	3,873

Measured at fair value on a non-recurring basis:
Impaired loans	$	151	$	-	$	-	$	151
Foreclosed real estate		352		-		-		352

Any transfers between levels would be recognized as of the actual date of event or change in circumstances that caused the transfer. There were no reclassifications between the Level 1 and Level 2 categories for the year ended December 31, 2012.


	Fair Value Measurements at December 31, 2011
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Other Unobservable Inputs
	December 31, 2011		(Level 1)		(Level 2)		(Level 3)
		(Dollars in thousands)
Measured at fair value on a recurring basis:
Securities available for sale:
U.S. Treasury bonds	$	15,078	$	15,078	$	-	$	-
Municipal bonds		53,676		-		53,676		-
Mortgage-backed securities:
Collateralized mortgage obligations-private label		129		-		129		-
Collateralized mortgage obligations-government sponsored entities		60,771		-		60,771		-
Government National Mortgage Association		3,349		-		3,349		-
Federal National Mortgage Association		20,570		-		20,570		-
Federal Home Loan Mortgage Corporation		5,766		-		5,766		-
Asset-backed securities:
Private label		4,632		-		696		3,936
Government sponsored entities		189		-		189		-
Equity securities		5		-		5		-
Total	$	164,165	$	15,078	$	145,151	$	3,936

Measured at fair value on a non-recurring basis:
Impaired loans	$	125	$	-	$	-	$	125
Foreclosed real estate		315		-		-		315

Level 2 inputs for assets or liabilities measured at fair value on a recurring basis might include 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, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by correlation or other means.

The following table presents a reconciliation of the securities available for sale measured at fair value on a recurring basis using significant unobservable inputs (Level 3), specifically, asset-backed securities - private label, for the years ended December 31, 2012 and 2011:


	2012		2011
		(Dollars in thousands)
Beginning Balance	$	3,936	$	4,278
Total gains - realized/unrealized:
Included in earnings		-		-
Included in other comprehensive income		420		166
Total losses - realized/unrealized:
Included in earnings		(102)		-
Included in other comprehensive income		-		(75)
Purchases, issuances and settlements		-		-
Sales		-		-
Principal paydowns		(381)		(433)
Transfers to (out of) Level 3		-		-

Ending Balance	$	3,873	$	3,936

Both observable and unobservable inputs may be used to determine the fair value of assets and liabilities measured on a recurring basis that the Company has classified within the Level 3 category. As a result, any unrealized gains and losses for assets within the Level 3 category may include changes in fair value attributable to both observable (e.g., changes in market interest rates) and unobservable (e.g., changes in unobservable long-dated volatilities) inputs.

The following table presents additional quantitative information about the Level 3 inputs for the asset backed securities - private label category. The fair values for this category were developed using the discounted cash flow technique with the following unobservable input ranges as of December 31, 2012 (dollars in thousands):

Unobservable Inputs

Security Category

Fair Value Estimate

Loan Type/Collateral

Credit Ratings

Constant Prepayment Speed (CPR)

Probability of Default (Annual Default Rate)

Loss Severity

Asset-backed securities - private label

3,873

Prime First and Second Lien - Residential Real Estate

CCC thru D

1 - 7

5.0% - 10.5%

70.0% - 100.0%

Level 3 inputs are determined by internal management with inputs from its third party financial advisor on a quarterly basis. The significant unobservable inputs used in the fair value measurement of the reporting entity’s asset-backed, private label securities are prepayment rates, probability of default and loss severity in the event of default. Significant increases or decreases in any of those inputs in isolation would result in a significantly lower or higher fair value measurement. Generally, a change in the assumption used for the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity and a directionally opposite change in the assumption used for prepayment rates.

Fair value on impaired loans is based on either recent appraisals less estimated selling costs of related collateral or discounted cash flows based on current market conditions. As of December 31, 2012, impaired loans with a specific allowance had a gross carrying amount of $201,000 with a valuation allowance of $50,000, resulting in a $42,000 additional provision for loan losses for the year ended December 31, 2012. As of December 31, 2011 impaired loans with a specific allowance had a gross carrying amount of $133,000 with a valuation allowance of $8,000. The use of independent appraisals, discounted cash flow models and management’s best judgment are significant inputs in arriving at the fair value of the underlying collateral and impaired loans are therefore classified within Level 3 of the fair value hierarchy.

Foreclosed real estate consists of property acquired in settlement of loans which is carried at its fair value based on recent appraisals less estimated selling costs and which has been subsequently written down during the period. Fair value is based upon independent market prices or appraised value of the property. These assets are included in Level 3 fair value based upon the lowest level of input that is significant to the fair value measurement. The use of independent appraisals and management’s best judgment are significant inputs in arriving at the fair value of the underlying collateral and foreclosed real estate is therefore classified within Level 3 of the fair value hierarchy.

The carrying amount and estimated fair value of the Company’s financial instruments, whether carried at cost or fair value, are as follows:


	Fair Value Measurements at December 31, 2012
	Carrying Amount		Estimated Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Other Unobservable Inputs (Level 3)
	(Dollars in thousands)
Financial assets:
Cash and cash equivalents	$	19,765	$	19,765	$	19,765	$	-	$		-
Securities available for sale		159,368		159,368		15,195		140,300			3,873
Federal Home Loan Bank stock		1,852		1,852		-		1,852			-
Loans receivable		272,933		273,202		-		-			273,202
Accrued interest receivable		1,802		1,802		-		1,802			-

Financial liabilities:
Deposits		378,543		383,578		-		383,578			-
Short-term borrowings		11,200		11,200		-		11,200			-
Long-term debt		14,400		14,748		-		14,748			-
Accrued interest payable		43		43		-		43			-

Off-balance-sheet financial instruments		-		-		-		-			-


	Fair Value Measurements at December 31, 2011
			Carrying Amount		Estimated Fair Value
		(Dollars in thousands)
Financial assets:
Cash and cash equivalents		$	23,704	$	23,704
Securities available for sale			164,165		164,165
Federal Home Loan Bank stock			2,219		2,219
Loans receivable			275,068		278,647
Accrued interest receivable			1,919		1,919

Financial liabilities:
Deposits			379,798		385,995
Short-term borrowings			6,910		6,910
Long-term debt			27,230		27,978
Accrued interest payable			80		80

Off-balance-sheet financial instruments			-		-

The following valuation techniques were used to measure the fair value of financial instruments in the above table:

Cash and cash equivalents (carried at cost)

The carrying amount of cash and cash equivalents approximates fair value.

Securities available for sale (carried at fair value)

The fair value of securities available for sale are determined by obtaining quoted market prices on nationally recognized securities exchanges (Level 1) or matrix pricing (Level 2), which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific securities, but rather by relying on the securities’ relationship to other benchmark quoted prices. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. treasury yield curve, live trading levels, trade execution date, market consensus prepayment speeds, credit information and the security’s terms and conditions, among other things. Level 2 securities which are fixed income instruments that are not quoted on an exchange, but are traded in active markets, are valued using prices obtained from our custodian, who use third party data service providers. Securities available for sale measured within the Level 3 category consist of private label asset-backed securities. The fair value measurement for these Level 3 securities is explained more fully earlier in this footnote.

Federal Home Loan Bank stock (carried at cost)

The carrying amount of Federal Home Loan Bank stock approximates fair value.

Loans Receivable (carried at cost)

The fair value of fixed-rate and variable rate performing loans is estimated using a discounted cash flow method. The discount rates take into account interest rates currently being offered to customers for loans with similar terms, the credit risk associated with the loan, estimated maturity and market factors including liquidity. The estimate of maturity is based on the Company’s contractual cash flows adjusted for prepayment estimates based on current economic and lending conditions. Fair value for significant nonperforming loans is based on carrying value which does not exceed recent external appraisals of any underlying collateral. Due to the significant judgment involved in evaluating credit quality, loans are classified within Level 3 of the fair value hierarchy.

Accrued Interest Receivable and Payable (carried at cost)

The carrying amount of accrued interest receivable and payable approximates fair value.

Deposits (carried at cost)

The fair value of deposits with no stated maturity, such as savings, money market and checking is the amount payable on demand at the reporting date and are classified within Level 2 of the fair value hierarchy. The fair value of time deposits is based on the discounted value of contractual cash flows at current rates of interest for similar deposits using market rates currently offered for deposits of similar remaining maturities. Due to the minimal amount of unobservable inputs involved in evaluating assumptions used for discounted cash flows of time deposits, these deposits are classified within Level 2 of the fair value hierarchy.

Borrowings (carried at cost)

The fair value of long-term debt was calculated by discounting scheduled cash flows at current market rates of interest for similar borrowings through maturity of each instrument. Due to the minimal amount of unobservable inputs involved in evaluating assumptions used for discounted cash flows of long-term debt, they are classified within Level 2 of the fair value hierarchy. The carrying amount of short term borrowings approximates fair value of such liability.

Off-Balance Sheet Financial Instruments (disclosed at cost)

Fair values of the Company’s off-balance sheet financial instruments (lending commitments) 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. Other than loan commitments, the Company does not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on its financial condition.