Fair Value of Assets and Liabilities

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value measurements must maximize the use of observable inputs and minimize the use of unobservable inputs. There is a hierarchy of three levels of inputs that may be used to measure fair value:



Level 1	Valuations for assets and liabilities traded in active exchange markets, such as the New York Stock Exchange. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities.



Level 2	Valuations for assets and liabilities traded in less active dealer or broker markets. Valuations are obtained from third party pricing services for identical or comparable assets or liabilities which use observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in active markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.



Level 3	Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

Following is a description of the inputs and valuation methodologies used for assets measured at fair value on a recurring basis and recognized in the accompanying balance sheets, as well as the general classification of such assets pursuant to the valuation hierarchy.

Available-for-Sale Securities. The fair value of available-for-sale securities is determined by various valuation methodologies. Where quoted market prices are available in an active market, securities are classified within Level 1. If quoted market prices are not available, then fair values are estimated by using quoted prices of securities with similar characteristics or independent asset pricing services and pricing models, the inputs of which are market-based or independently sources market parameters, including but not limited to, yield curves, interest rates, volatilities, prepayments, defaults, cumulative loss projections and cash flows. Such securities are classified in Level 2 of the valuation hierarchy. In certain cases where Level 1 or Level 2 inputs are not available, securities are classified within Level 3 of the hierarchy and include subordinated tranches of collateralized mortgage obligations and investments in trust preferred securities.

Fair value determinations for Level 3 measurements of securities are the responsibility of the Treasury function of the Company. The Company contracts with a pricing specialist to generate fair value estimates on a monthly basis. The Treasury function of the Company challenges the reasonableness of the assumptions used and reviews the methodology to ensure the estimated fair value complies with accounting standards generally accepted in the United States, analyzes the changes in fair value and compares these changes to internally developed expectations and monitors these changes for appropriateness.

The trust preferred securities are collateralized debt obligation securities that are backed by trust preferred securities issued by banks, thrifts, and insurance companies. The market for these securities at September 30, 2012 is not active and markets for similar securities are also not active. The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which trust preferred securities trade and then by a significant decrease in the volume of trades relative to historical levels. The new issue market is also inactive and will continue to be, as a result of the Dodd-Frank Act’s elimination of trust preferred securities from Tier 1 capital for certain holding companies. There are currently very few market participants who are willing and or able to transact for these securities. The market values for these securities are very depressed relative to historical levels.

Given conditions in the debt markets today and the absence of observable transactions in the secondary and new issue markets, we determined:


•	The few observable transactions and market quotations that are available are not reliable for purposes of determining fair value at September 30, 2012,


•	An income valuation approach technique (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs will be equally or more representative of fair value than the market approach valuation technique used at prior measurement dates, and


•	The trust preferred securities held by the Company will be classified within Level 3 of the fair value hierarchy because we determined that significant adjustments are required to determine fair value at the measurement date.

The following table presents the Company’s assets that are measured at fair value on a recurring basis and the level within the fair value hierarchy in which the fair value measurements fall as of September 30, 2012 and December 31, 2011 (in thousands):



			Fair Value Measurements Using
September 30, 2012	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Available-for-sale securities:
U.S. Treasury securities and obligations of U.S. government corporations and agencies	$	175,475	$	—	$	175,475	$	—
Obligations of states and political subdivisions	54,611		—		54,611		—
Mortgage-backed securities	285,412		—		285,412		—
Trust preferred securities	450		—		—		450
Other securities	9,804		48		9,756		—
Total available-for-sale securities	$	525,752	$	48	$	525,254	$	450
December 31, 2011
Available-for-sale securities:
U.S. Treasury securities and obligations of U.S. government corporations and agencies	$	166,066	$	—	$	166,066	$	—
Obligations of states and political subdivisions	41,202		—		41,202		—
Mortgage-backed securities	261,833		—		261,775		58
Trust preferred securities	719		—		—		719
Other securities	9,096		29		9,067		—
Total available-for-sale securities	$	478,916	$	29	$	478,110	$	777

The change in fair value of assets measured on a recurring basis using significant unobservable inputs (Level 3) for the nine months ended September 30, 2012 and 2011 is summarized as follows (in thousands):



	Available-for-Sale Securities
September 30, 2012	Mortgage-backed Securities			Trust Preferred Securities			Total
Beginning balance	$	58		$	719		$	777
Transfers into Level 3	—			—			—
Transfers out of Level 3	(58		)	—			(58		)
Total gains or losses
Included in net income	—			—			—
Included in other comprehensive income (loss)	—			383			383
Purchases, issuances, sales and settlements
Purchases	—			—			—
Issuances	—			—			—
Sales	—			—			—
Settlements	—			(652		)	(652		)
Ending balance	$	—		$	450		$	450
Total gains or losses for the period included in net income attributable to the change in unrealized gains or losses related to assets and liabilities still held at the reporting date	$	—		$	—		$	—



	Available-for-Sale Securities
September 30, 2011	Mortgage-backed Securities			Trust Preferred Securities			Total
Beginning balance	$	68		$	581		$	649
Transfers into Level 3	—			—			—
Transfers out of Level 3	—			—			—
Total gains or losses
Included in net income	—			(584		)	(584		)
Included in other comprehensive income (loss)	—			723			723
Purchases, issuances, sales and settlements
Purchases	—			—			—
Issuances	—			—			—
Sales	—			—			—
Settlements	(7		)	(17		)	(24		)
Ending balance	$	61		$	703		$	764
Total gains or losses for the period included in net income attributable to the change in unrealized gains or losses related to assets and liabilities still held at the reporting date	$	—		$	(584	)	$	(584	)

Following is a description of the valuation methodologies used for assets measured at fair value on a nonrecurring basis and recognized in the accompanying balance sheets, as well as the general classification of such assets pursuant to the valuation hierarchy.

Impaired Loans (Collateral Dependent). Loans for which it is probable that the Company will not collect all principal and interest due according to contractual terms are measured for impairment. Allowable methods for determining the amount of impairment and estimating fair value include using the fair value of the collateral for collateral dependent loans.

If the impaired loan is identified as collateral dependent, then the fair value method of measuring the amount of impairment is utilized. This method requires obtaining a current independent appraisal of the collateral and applying a discount factor to the value. Impaired loans that are collateral dependent are classified within Level 3 of the fair value hierarchy when impairment is determined using the fair value method.

Management establishes a specific allowance for loans that have an estimated fair value that is below the carrying value. The total carrying amount of loans for which a specific allowance has been established as of September 30, 2012 was $3,542,000 and a fair value of $2,851,000 resulting in specific loss exposures of $691,000.

When there is little prospect of collecting principal or interest, loans, or portions of loans, may be charged-off to the allowance for loan losses. Losses are recognized in the period an obligation becomes uncollectible. The recognition of a loss does not mean that the loan has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off the loan even though partial recovery may be affected in the future.

Foreclosed Assets Held For Sale. Other real estate owned acquired through loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. The adjustment at the time of foreclosure is recorded through the allowance for loan losses. Due to the subjective nature of establishing the fair value when the asset is acquired, the actual fair value of the other real estate owned or foreclosed asset could differ from the original estimate. If it is determined that fair value declines subsequent to foreclosure, a valuation allowance is recorded through noninterest expense. Operating costs associated with the assets after acquisition are also recorded as noninterest expense. Gains and losses on the disposition of other real estate owned and foreclosed assets are netted and posted to other noninterest expense. The total carrying amount of other real estate owned as of September 30, 2012 was $1,103,000. Other real estate owned included in the total carrying amount and measured at fair value on a nonrecurring basis during the period amounted to $385,000.

The following table presents the fair value measurement of assets measured at fair value on a nonrecurring basis and the level within the fair value hierarchy in which the fair value measurements fall at September 30, 2012 and December 31, 2011 (in thousands):



	Fair Value Measurements Using
September 30, 2012	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Impaired loans (collateral dependent)	$	2,851	$	—	$	—	$	2,851
Foreclosed assets held for sale	385		—		—		385
December 31, 2011
Impaired loans (collateral dependent)	$	2,282	$	—	$	—	$	2,282
Foreclosed assets held for sale	2,336		—		—		2,336

Sensitivity of Significant Unobservable Inputs

The following is a discussion of the sensitivity of significant unobservable inputs, the interrelationships between those inputs and other unobservable inputs used in recurring fair value measurement and of how those inputs might magnify or mitigate the effect of changes in the unobservable inputs on the fair value measurement.

Trust Preferred Securities. The significant unobservable inputs used in the fair value measurement of the Company’s trust preferred securities are offered quotes and comparability adjustments. Significant increases (decreases) in any of those inputs in isolation would result in a significantly lower (higher) fair value measurement. Generally, changes in either of those inputs will not affect the other input.

The following table presents quantitative information about unobservable inputs used in recurring and nonrecurring Level 3 fair value measurements other than goodwill.



	Fair Value at September 30, 2012		Valuation Technique	Unobservable Inputs	Range (Weighted Average)
Trust Preferred Securities	$	450	Discounted cash flow	Discount rate	8.3	%	-	22.8%	(	19.3	%	)
				Constant prepayment rate (1)	1	%
				Cumulative projected prepayments	10.8	%	-	63.3%	(	21.7	%	)
				Probability of default	0.6	%	-	1.5%	(	0.8	%	)
				Projected cures given deferral	0	%	-	0%	(	0	%	)
				Loss severity	92.2	%	-	96.1%	(	94.8	%	)
Impaired loans (collateral dependent)	$	2,851	Third party valuations	Discount to reflect realizable value	0	%	-	40%	(	20	%	)
Foreclosed assets held for sale	$	385	Third party valuations	Discount to reflect realizable value less estimated selling costs	0	%	-	40%	(	35	%	)


(1)	Every five years

Other. The following methods were used to estimate the fair value of all other financial instruments recognized in the accompanying balance sheets at amounts other than fair value.

Cash and Cash Equivalents and Federal Reserve and Federal Home Loan Bank Stock

The carrying amount approximates fair value.

Certificates of Deposit Investments

The fair value of certificates of deposit investments is estimated using a discounted cash flow calculation that applies the rates currently offered for deposits of similar remaining maturities.

Held-to-maturity Securities

Fair value is based on quoted market prices, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.

Loans

For loans with floating interest rates, it is assumed that the estimated fair values generally approximate the carrying amount balances. Fixed rate loans have been valued using a discounted present value of projected cash flow. The discount rate used in these calculations is the current rate at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. The carrying amount of accrued interest approximates its fair value.

Deposits

Deposits include demand deposits, savings accounts, NOW accounts and certain money market deposits. The carrying amount of these deposits approximates fair value. The fair value of fixed-maturity time deposits is estimated using a discounted cash flow calculation that applies the rates currently offered for deposits of similar remaining maturities.

Securities Sold Under Agreements to Repurchase

The fair value of securities sold under agreements to repurchased is estimated using a discounted cash flow calculation that applies the rates currently offered for deposits of similar remaining maturities.

Short-term Borrowings and Interest Payable

The carrying amount approximates fair value.

Long-term Debt and Federal Home Loan Bank Advances

Rates currently available to the Company for debt with similar terms and remaining maturities are used to estimate the fair value of existing debt.

The following tables present estimated fair values of the Company’s financial instruments at September 30, 2012 and December 31, 2011 in accordance with FAS 107-1 and APB 28-1, codified with ASC 805 (in thousands):



September 30, 2012	Carrying Amount		Fair Value		Level 1		Level 2		Level 3
Financial Assets
Cash and due from banks	$	39,736	$	39,736	$	39,736	$	—	$	—
Federal funds sold	5,992		5,992		5,992		—		—
Certificates of deposit investments	8,504		8,497		8,497		—		—
Available-for-sale securities	525,752		525,752		48		525,254		450
Held-to-maturity securities	—		—		—		—		—
Loans held for sale	1,390		1,390		—		1,390		—
Loans net of allowance for loan losses	886,332		888,925		—		—		888,925
Interest receivable	7,325		7,325		—		7,325		—
Federal Reserve Bank stock	1,522		1,522		—		1,522		—
Federal Home Loan Bank stock	3,293		3,293		—		3,293		—
Financial Liabilities
Deposits	$	1,240,668	$	1,241,227	$	—	$	1,021,538	$	219,689
Securities sold under agreements to repurchase	111,870		111,865		—		111,865		—
Interest payable	385		385		—		385		—
Federal Home Loan Bank borrowings	9,750		10,528		—		10,528		—
Junior subordinated debentures	20,620		11,712		—		11,712		—



December 31, 2011	Carrying Amount		Fair Value
Financial Assets
Cash and due from banks	$	52,105	$	52,105
Federal funds sold	20,997		20,997
Certificates of deposit investments	13,231		13,225
Available-for-sale securities	478,916		478,916
Held-to-maturity securities	51		51
Loans held for sale	1,046		1,046
Loans net of allowance for loan losses	847,908		850,308
Interest receivable	7,052		7,052
Federal Reserve Bank stock	1,520		1,520
Federal Home Loan Bank stock	3,727		3,727
Financial Liabilities
Deposits	$	1,170,734	$	1,172,069
Securities sold under agreements to repurchase	132,380		132,383
Interest payable	510		510
Federal Home Loan Bank borrowings	19,750		20,619
Other Borrowings	8,250		8,250
Junior subordinated debentures	20,620		11,969