Note 8 – Disclosures about fair value of assets and liabilities

The Fair Value Measurements topic of the FASB ASC defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. There are three levels of inputs that may be used to measure fair value:


Level 1		Quoted prices in active markets for identical assets or liabilities

Level 2		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 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 valuation methodologies used for instruments measured at fair value on a recurring basis and recognized in the accompanying condensed consolidated financial statements, as well as the general classification of such instruments pursuant to the valuation hierarchy. There have been no significant changes in the valuation techniques during the period ended September 30, 2013. For assets classified within Level 3 of the fair value hierarchy, the process used to develop the reported fair value is described below.

Available for sale securities

When quoted market prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics or discounted cash flows. Level 2 securities include U.S. Treasury and federal agency securities, state and municipal securities, federal agency mortgage obligations and mortgage-backed pools, private-label mortgage-backed pools and corporate notes. Level 2 securities are valued by a third party pricing service commonly used in the banking industry utilizing observable inputs. Observable inputs include dealer quotes, market spreads, cash flow analysis, the U.S. Treasury yield curve, trade execution data, market consensus prepayment spreads and available credit information and the bond’s terms and conditions. The pricing provider utilizes evaluated pricing models that vary based on asset class. These models incorporate available market information including quoted prices of securities with similar characteristics and, because many fixed-income securities do not trade on a daily basis, apply available information through processes such as benchmark curves, benchmarking of like securities, sector grouping, and matrix pricing. In addition, model processes, such as an option adjusted spread model is used to develop prepayment and interest rate scenarios for securities with prepayment features.

Hedged loans

Certain fixed rate loans have been converted to variable rate loans by entering into interest rate swap agreements. The fair value of those fixed rate loans is based on discounting the estimated cash flows using interest rates determined by the respective interest rate swap agreement. Loans are classified within Level 2 of the valuation hierarchy based on the unobservable inputs used.

Interest rate swap agreements

The fair value of the Company’s interest rate swap agreements is estimated by a third party using inputs that are primarily unobservable including a yield curve, adjusted for liquidity and credit risk, contracted terms and discounted cash flow analysis, therefore, are classified within Level 2 of the valuation hierarchy.

The following table presents the fair value measurements of assets and liabilities recognized in the accompanying financial statements measured at fair value on a recurring basis and the level within the FASB ASC fair value hierarchy in which the fair value measurements fall at the following:


	Fair Value			Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)
September 30, 2013
Available-for-sale securities
U.S. Treasury and federal agencies	$	42,757		$	—	$	42,757		$	—
State and municipal		179,517			—		179,517			—
Federal agency collateralized mortgage obligations		110,782			—		110,782			—
Federal agency mortgage-backed pools		179,194			—		179,194			—
Private labeled mortgage-backed pools		1,334			—		1,334			—
Corporate notes		560			—		560			—

Total available-for-sale securities		514,144			—		514,144			—

Hedged loans		89,718			—		89,718			—
Forward sale commitments		619			—		619			—
Interest rate swap agreements		(4,014	)		—		(4,014	)		—
Commitments to originate loans		—			—		—			—

December 31, 2012
Available-for-sale securities
U.S. Treasury and federal agencies	$	51,779		$	—	$	51,779		$	—
State and municipal		172,905			—		172,905			—
Federal agency collateralized mortgage obligations		96,831			—		96,831			—
Federal agency mortgage-backed pools		159,204			—		159,204			—
Private labeled mortgage-backed pools		2,031			—		2,031			—
Corporate notes		51			—		51			—

Total available-for-sale securities		482,801			—		482,801			—

Hedged loans		81,018			—		81,018			—
Forward sale commitments		858			—		858			—
Interest rate swap agreements		(7,707	)		—		(7,707	)		—
Commitments to originate loans		—			—		—			—

Transfers between levels

Transfers between Levels 1, 2 and 3 and the reasons for those transfers are as follows:


December 31, 2012	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)		Reason for Transfer
Transfers to level:

Hedged loans	$	—	$	59,911		$	—		(a)
Forward sale commitments		—		510			—		(b)
Interest rate swap agreements		—		(6,464	)		—		(a)
Commitments to originate loans		—		(71	)		—		(b)


Total transfers to level	$	—	$	53,886		$	—


(a)	-	Valuation determined by widely accepted techniques including discounted cash flow analysis on expected cash flows of each derivative and observable market rate inputs such as yield curves and contractual terms on each instrument.
(b)	-	Valuation determined by quoted prices for similar loans in the secondary market with an expected fallout rate (interest rate locked pipeline loans not expected to close). Fallout rate is not considered a significant input to the fair value in its entirety.

The following is a reconciliation of the beginning and ending balances of recurring fair value measurements recognized in the accompanying condensed consolidated balance sheet using significant unobservable (Level 3) inputs:


	Hedged Loans			Forward Sale Commitments			Interest Rate Swaps			Commitments to Originate Loans
Beginning balance December 31, 2011	$	54,362		$	662		$	(7,101	)	$	—
Total realized and unrealized gains and losses
Included in net income		(74	)		(152	)		74			(71	)
Included in other comprehensive income, gross		—			—			563			—
Purchases, issuances, and settlements		6,114			—			—			—
Principal payments		(491	)		—			—			—
Transfers out to Level 2		(59,911	)		(510	)		6,464			71

Ending balance December 31, 2012	$	—		$	—		$	—		$	—

Realized gains and losses included in net income for the periods are reported in the condensed consolidated statements of income as follows:


	Three Months Ended September 30						Nine Months Ended September 30
	2013			2012			2013			2012
Non Interest Income	(Unaudited)			(Unaudited)			(Unaudited)			(Unaudited)
Total gains and losses from:
Hedged loans	$	211		$	112		$	(1,635	)	$	336
Fair value interest rate swap agreements		(211	)		(112	)		1,635			(336	)
Derivative loan commitments		169			320			(239	)		600

	$	169		$	320		$	(239	)	$	600

Certain other assets are measured at fair value on a nonrecurring basis in the ordinary course of business and are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment):


	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
September 30, 2013
Impaired loans	$	6,571	$	—	$	—	$	6,571
Mortgage servicing rights		6,302		—		—		6,302

December 31, 2012
Impaired loans	$	8,652	$	—	$	—	$	8,652
Mortgage servicing rights		5,145		—		—		5,145

Impaired (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 include estimating fair value 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. Fair value adjustments on impaired loans were $1.3 million at September 30, 2013 and $1.9 million at December 31, 2012.

Mortgage Servicing Rights (MSRs): MSRs do not trade in an active market with readily observable prices. Accordingly, the fair value of these assets is classified as Level 3. The Company determines the fair value of MSRs using an income approach model based upon the Company’s month-end interest rate curve and prepayment assumptions. The model utilizes assumptions to estimate future net servicing income cash flows, including estimates of time decay, payoffs and changes in valuation inputs and assumptions. The Company reviews the valuation assumptions against this market data for reasonableness and adjusts the assumptions if deemed appropriate. The carrying amount of the MSR’s fair value increased by $208,000 during the first nine months of 2013 and decreased by $369,000 during the first nine months of 2012.

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


	Fair Value at September 30, 2013		Valuation Technique	Unobservable Inputs	Range (Weighted Average)

Impaired loans	$	6,571	Collateral based measurement	Discount to reflect current market conditions and ultimate collectability	10% - 15%(12%)
Mortgage servicing rights	$	6,302	Discounted cashflows	Discount rate, Constant prepayment rate, Probably of default	10% - 15%(12%), 4% - 7%(4.6%), 1% - 10%(4.5%)


	Fair Value at December 31, 2012		Valuation Technique	Unobservable Inputs	Range (Weighted Average)

Impaired loans	$	8,652	Collateral based measurement	Discount to reflect current market conditions and ultimate collectability	10% - 15%(12%)
Mortgage servicing rights	$	5,145	Discounted cashflows	Discount rate, Constant prepayment rate, Probably of default	10% - 15%(12%), 4% - 7%(4.6%), 1% - 10%(4.5%)