Note 12 Fair Values of Assets and Liabilities

FASB ASC Topic 820, “Fair Value Measurements and Disclosures” requires disclosures for non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). All non-financial assets are included either as a separate line item on the Condensed Consolidated Statements of Financial Condition or in the “Other assets” category of the Condensed Consolidated Statements of Financial Condition. Currently, First Commonwealth does not have any non-financial liabilities to disclose.

FASB ASC Topic 825, “Financial Instruments” permits entities to irrevocably elect to measure select financial instruments and certain other items at fair value. The unrealized gains and losses are required to be included in earnings each reporting period for the items that fair value measurement is elected. First Commonwealth has elected not to measure any existing financial instruments at fair value under FASB ASC Topic 825; however, in the future we may elect to adopt this guidance for select financial instruments.

In accordance with FASB ASC Topic 820, First Commonwealth groups financial assets and financial liabilities measured at fair value in three levels based on the principal markets in which the assets and liabilities are transacted and the observability of the data points used to determine fair value. These levels are:

•

Level 1 – Valuations for assets and liabilities traded in active exchange markets, such as the New York Stock Exchange (“NYSE”). Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities. Level 1 securities include equity holdings comprised of publicly traded bank stocks which were priced using quoted market prices.

•

Level 2 – Valuations for assets and liabilities traded in less active dealer or broker markets. Valuations are obtained for identical or comparable assets or liabilities from alternative pricing sources with reasonable levels of price transparency. Level 2 includes Obligations of U.S. Government securities issued by Agencies and Sponsored Enterprises, Obligations of States and Political Subdivisions, certain corporate securities, FHLB stock, interest rate derivatives that include interest rate swaps and risk participation agreements, certain other real estate owned and certain impaired loans.

Level 2 investment securities are valued by a recognized third party pricing service using observable inputs. The model used by the pricing service varies by asset class and incorporates available market, trade and bid information as well as cash flow information when applicable. Because many fixed-income investment securities do not trade on a daily basis, the model uses available information such as benchmark yield curves, benchmarking of like investment securities, sector groupings and matrix pricing. The model will also use processes such as an option adjusted spread to assess the impact of interest rates and to develop prepayment estimates. Market inputs normally used in the pricing model include benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and reference data including market research publications.

Management validates the market values provided by the third party service by having another recognized pricing service price a random sample of securities each quarter, monthly monitoring of variances from prior period pricing and, on a monthly basis, evaluating pricing changes compared to expectations based on changes in the financial markets.

Other investments are comprised of FHLB stock whose fair value is based on its par value. Additional information on FHLB stock is provided in Note 8, “Other Investments.”

Interest rate derivatives are reported at an estimated fair value utilizing Level 2 inputs and are included in other assets and other liabilities and consist of interest rate swaps where there is no significant deterioration in the counterparties (loan customers) credit risk since origination of the interest rate swap. First Commonwealth values its interest rate swap positions using a yield curve by taking market prices/rates for an appropriate set of instruments. The set of instruments currently used to determine the U.S. Dollar yield curve includes cash LIBOR rates from overnight to three months, Eurodollar futures contracts and swap rates from three years to thirty years. These yield curves determine the valuations of interest rate swaps. Interest rate derivatives are further described in Note 13, “Derivatives.”

For purposes of potential valuation adjustments to our derivative positions, First Commonwealth evaluates the credit risk of its counterparties as well as our own credit risk. Accordingly, we have considered factors such as the likelihood of default, expected loss given default, net exposures and remaining contractual life, among other things, in determining if any fair value adjustments related to credit risk are required. We review our counterparty exposure quarterly, and when necessary, appropriate adjustments are made to reflect the exposure.

We also utilize this approach to estimate our own credit risk on derivative liability positions. In 2012, we have not realized any losses due to a counterparty’s inability to pay any net uncollateralized position.

The fair value for other real estate owned included in Level 2 is determined by either an independent market based appraisal less estimated costs to sell or an executed sales agreement.

•

Level 3 – Valuations for assets and liabilities that are derived from other valuation methodologies, including option pricing models, discounted cash flow models and similar techniques, and not based on market exchange, dealer or broker traded transactions. If the inputs used to provide the valuation are unobservable and/or there is very little, if any, market activity for the security or similar securities, the securities would be considered Level 3 securities. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities. The assets included in Level 3 are pooled trust preferred collateralized debt obligations, non-marketable equity investments, loans held for sale and certain interest rate derivatives, certain other real estate owned and certain impaired loans.

Our pooled trust preferred collateralized debt obligations are collateralized by the trust preferred securities of individual banks, thrifts and bank holding companies in the U.S. There has been little or no active trading in these securities since 2009; therefore it was more appropriate to determine fair value using a discounted cash flow analysis. Detail on our process for determining the appropriate cash flows for this analysis is provided in Note 9, “Impairment of Investment Securities.” The discount rate applied to the cash flows is determined by evaluating the current market yields for comparable corporate and structured credit products along with an evaluation of the risks associated with the cash flows of the comparable security. Due to the fact that there is no active market for the pooled trust preferred collateralized debt obligations, one key reference point is the market yield for the single issue trust preferred securities issued by banks and thrifts for which there is more activity than for the pooled securities. Adjustments are then made to reflect the credit and structural differences between these two security types.

Management validates the fair value of the pooled trust preferred collateralized debt obligations by monitoring the performance of the underlying collateral, discussing the discount rate, cash flow assumptions and general market trends with the specialized third party and confirming changes in the underlying collateral to the trustee reports. Management’s monitoring of the underlying collateral includes deferrals of interest payments, payment defaults, cures of previously deferred interest payments, any regulatory filings or actions and general news related to the underlying collateral. Management also evaluates fair value changes compared to expectations based on changes in the interest rates used in determining the discount rate and general financial markets.

The estimated fair value of the non-marketable equity investments included in Level 3 is based on par value.

Loans held for sale are carried at the lower of cost or fair value with the fair value being the expected sales price of the loan. The estimated fair value of the loans held for sale was determined by calculating the discounted expected future cash flows of the loan. The discount rate applied to the future cash flows was determined based on a risk based expected return and capital structure of potential buyers. If a sales agreement has been executed, the fair value is equal to the sales price.

For interest rate derivatives included in Level 3, the fair value incorporates credit risk by considering such factors as likelihood of default and expected loss given default based on the credit quality of the underlying counterparties (loan customers).

In 2012, we have not realized any losses due to a counterparty’s inability to pay any net uncollateralized position. However, as the result of deterioration in the counterparties (loan customers) credit quality for certain interest rate derivatives, future amounts previously believed to be collectible under the terms of the interest rate derivative have now been deemed to be uncollectible.

In accordance with ASU 2011-04, the following table provides information related to quantitative inputs and assumptions used in Level 3 fair value measurements.


	Fair Value (dollars in thousands)	Valuation Technique	Unobservable Inputs	Range / (weighted average)
Pooled Trust Preferred Securities	$23,051	Discounted Cash Flow	Probability of default	0% -100% (21.73%)
			Prepayment rates	0% -100% (13.44%)
			Discount rates	6.75% - 20%(a)
Other Investments	1,420	Par Value	N/A	N/A

Interest Rate Swap	0	Option model	Counterparty credit risk	15.08% - 17.63%(b)

Impaired Loans	15,755(c)	Discounted Cash Flow	Discount rate	8.42% - 8.83%

Other Real Estate Owned	338	Internal Valuation	N/A	N/A

(a)	incorporates premium related to credit quality and illiquidity of securities.

(b)	represents the range of the credit spread curve used in valuation.

(c)	the remainder of impaired loans valued using Level 3 inputs are not included in this disclosure as the values of those loans are based on bankruptcy agreement documentation.

The significant unobservable inputs used in the fair value measurement of pooled trust preferred securities are the probability of default, discount rates and prepayment rates. Significant increases in the probability of default or discount rate used would result in a decrease in the estimated fair value of these securities while decreases in these variables would result in higher fair value measurements. In general, a change in the assumption of probability of default is accompanied by a directionally similar change in the discount rate. In most cases, increases in the prepayment rate assumptions would result in a higher estimated fair value for these securities while decreases would provide for a lower value. The direction of this change is somewhat dependent on the structure of the investment and the amount of the investment tranches senior to our position.

The discount rate is the significant unobservable input used in the fair value measurement of impaired loans. Significant increases in this rate would result in a decrease in the estimated fair value of the loans, while a decrease in this rate would result in higher fair value measurement.

The significant unobservable input used in the fair value measurement of interest rate swaps classified as Level 3 is counterparty credit risk and the resulting range of the credit spread curve used in the valuation. Higher credit risk would result in an increased credit spread, which would reduce the fair value of the interest rate swap.

The tables below present the balances of assets and liabilities measured at fair value on a recurring basis:


	September 30, 2012
	Level 1		Level 2		Level 3		Total
	(dollars in thousands)
Obligations of U.S. Government Agencies:
Mortgage-Backed Securities—Residential	$	0	$	33,355	$	0	$	33,355
Obligations of U.S. Government-Sponsored Enterprises:
Mortgage-Backed Securities—Residential		0		818,278		0		818,278
Mortgage-Backed Securities—Commercial		0		166		0		166
Other Government-Sponsored Enterprises		0		242,881		0		242,881
Obligations of States and Political Subdivisions		0		87		0		87
Corporate Securities		0		11,144		0		11,144
Pooled Trust Preferred Collateralized Debt Obligations		0		0		23,051		23,051

Total Debt Securities		0		1,105,911		23,051		1,128,962
Equities		440		0		1,420		1,860

Total Securities Available for Sale		440		1,105,911		24,471		1,130,822
Other Investments		0		32,479		0		32,479
Other Assets^(a)		0		18,122		0		18,122

Total Assets	$	440	$	1,156,512	$	24,471	$	1,181,423

Other Liabilities^(a)	$	0	$	20,004	$	0	$	20,004

Total Liabilities	$	0	$	20,004	$	0	$	20,004

(a)	Non-hedging interest rate derivatives


	December 31, 2011
	Level 1		Level 2		Level 3		Total
	(dollars in thousands)
Obligations of U.S. Government Agencies:
Mortgage-Backed Securities—Residential	$	0	$	36,194	$	0	$	36,194
Obligations of U.S. Government-Sponsored Enterprises:
Mortgage-Backed Securities—Residential		0		801,031		0		801,031
Mortgage-Backed Securities—Commercial		0		193		0		193
Other Government-Sponsored Enterprises		0		268,648		0		268,648
Obligations of States and Political Subdivisions		0		459		0		459
Corporate Securities		0		11,411		0		11,411
Pooled Trust Preferred Collateralized Debt Obligations		0		0		22,980		22,980

Total Debt Securities		0		1,117,936		22,980		1,140,916
Equities		440		0		1,420		1,860

Total Securities Available for Sale		440		1,117,936		24,400		1,142,776
Other Investments		0		39,796		0		39,796
Loans Held for Sale		0		0		13,412		13,412
Other Assets^(a)		0		16,064		0		16,064

Total Assets	$	440	$	1,173,796	$	37,812	$	1,212,048

Other Liabilities^(a)	$	0	$	18,986	$	0	$	18,986

Total Liabilities	$	0	$	18,986	$	0	$	18,986

(a)	Non-hedging interest rate derivatives

For the nine-month periods ended September 30, changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows:


	2012
	Pooled Trust Preferred Collateralized Debt Obligations			Equities		Loans Held for Sale			Other Assets			Total
	(dollars in thousands)
Balance, beginning of period	$	22,980		$	1,420	$	13,412		$	0		$	37,812
Total gains or losses
Included in earnings		0			0		2,870			(461	)		2,409
Included in other comprehensive income		3,610			0		0			0			3,610
Purchases, issuances, sales, and settlements
Purchases		0			0		0			0			0
Issuances		0			0		0			0			0
Sales		0			0		(15,981	)		0			(15,981	)
Settlements		(3,539	)		0		(301	)		0			(3,840	)
Transfers into Level 3		0			0		0			461			461

Balance, end of period	$	23,051		$	1,420	$	0		$	0		$	24,471


	2011
	Obligations of States and Political Subdivisions			Corporate Securities			Pooled Trust Preferred Collateralized Debt Obligations			Equities		Other Assets			Total
	(dollars in thousands)
Balance, beginning of period	$	343		$	21,376		$	26,352		$	1,570	$	0			49,641
Total gains or losses
Included in earnings		4			387			0			0		(4,520	)		(4,129	)
Included in other comprehensive income		(20	)		(98	)		809			0		0			691
Purchases, issuances, sales, and settlements
Purchases		0			0			0			0		0			0
Issuances		0			0			0			0		0			0
Sales		(327	)		(6,700	)		0			0		0			(7,027	)
Settlements		0			(3,000	)		(2,463	)		0		0			(5,463	)
Transfers from Level 3		0			(11,965	)		0			0		0			(11,965	)
Transfers into Level 3		0			0			0			0		4,520			4,520

Balance, end of period	$	0		$	0		$	24,698		$	1,570	$	0		$	26,268

For the nine-months ended September 30, 2012, there were no transfers between fair value Levels 1 and 2. However, $0.5 million of interest rate swaps were transferred into Level 3 from Level 2 due to deterioration of the counterparty’s credit risk. Because the credit quality of the underlying counterparty declined below investment grade, the swaps were valued utilizing more than interest rate yield curves. During the second quarter of 2011, $12.0 million of corporate securities were transferred from Level 3 to Level 2. Corporate securities were transferred from Level 3 to Level 2 based on increased frequency in the volume of observable trades. Fair values on these securities at September 30, 2011 were determined based on market data, including trade and bid prices. During the third quarter of 2011, $4.5 million of interest rate swaps were transferred into Level 3 from Level 2 also due to deterioration of the counterparty’s credit risk. There were no gains or losses included in earnings for the periods presented that are attributable to the change in realized gains (losses) relating to assets held at September 30, 2012 and 2011.

For the three-month periods ended September 30, changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows:


	2012
	Pooled Trust Preferred Collateralized Debt Obligations			Equities		Loans Held for Sale		Other Assets		Total
	(dollars in thousands)
Balance, beginning of period	$	21,792		$	1,420	$	0	$	0	$	23,212
Total gains or losses
Included in earnings		0			0		0		0		0
Included in other comprehensive income		2,030			0		0		0		2,030
Purchases, issuances, sales, and settlements
Purchases		0			0		0		0		0
Issuances		0			0		0		0		0
Sales		0			0		0		0		0
Settlements		(771	)		0		0		0		(771	)
Transfers from Level 3		0			0		0		0		0
Transfers into Level 3		0			0		0		0		0

Balance, end of period	$	23,051		$	1,420	$	0	$	0	$	24,471


	2011
	Obligations of States and Political Subdivisions		Corporate Securities		Pooled Trust Preferred Collateralized Debt Obligations			Equities		Other Assets			Total
	(dollars in thousands)
Balance, beginning of period	$	0	$	0	$	26,984		$	1,570	$	0			28,554
Total gains or losses
Included in earnings		0		0		0			0		(4,520	)		(4,520	)
Included in other comprehensive income		0		0		(2,211	)		0		0			(2,211	)
Purchases, issuances, sales, and settlements
Purchases		0		0		0			0		0			0
Issuances		0		0		0			0		0			0
Sales		0		0		0			0		0			0
Settlements		0		0		(75	)		0		0			(75	)
Transfers from Level 3		0		0		0			0		4,520			4,520

Balance, end of period	$	0	$	0	$	24,698		$	1,570	$	0		$	26,268

For the three-months ended September 30, 2012, there were no transfers of securities between Levels 1, 2 or 3. During the third quarter of 2011, $4.5 million of interest rate swaps were transferred into Level 3 from Level 2 due to deterioration of the counterparty’s credit risk. There were no gains or losses included in earnings for the periods presented that are attributable to the change in realized gains (losses) relating to assets held at September 30, 2012 and 2011.

The tables below present the balances of assets measured at fair value on a non-recurring basis at:


	September 30, 2012
	Level 1		Level 2		Level 3		Total
	(dollars in thousands)
Impaired loans	$	0	$	59,241	$	21,751	$	80,992
Other real estate owned		0		16,002		338		16,340

Total Assets	$	0	$	75,243	$	22,089	$	97,332


	December 31, 2011
	Level 1		Level 2		Level 3		Total
	(dollars in thousands)
Impaired loans	$	0	$	73,783	$	26,349	$	100,132
Other real estate owned		0		31,232		438		31,670

Total Assets	$	0	$	105,015	$	26,787	$	131,802

The following losses were realized on the assets measured on a nonrecurring basis:


	For the Three-Months Ended September 30,						For the Nine-Months Ended September 30,
	2012			2011			2012			2011
	(dollars in thousands)
Impaired loans	$	(3,890	)	$	(7,148	)	$	(7,352	)	$	(28,075	)
Other real estate owned		(366	)		(88	)		(523	)		(4,185	)

Total losses	$	(4,256	)	$	(7,236	)	$	(7,875	)	$	(32,260	)

Impaired loans over $0.1 million are individually reviewed to determine the amount of each loan considered to be at risk of non-collection. The fair value for impaired loans that are collateral based is determined by reviewing real property appraisals, equipment valuations, accounts receivable listings and other financial information. A discounted cash flow analysis is performed to determine fair value for impaired loans when an observable market price or a current appraisal is not available. First Commonwealth’s loan policy requires updated appraisals be obtained at least every twelve months on all impaired loans with balances of $250 thousand and over.

The fair value for other real estate owned is determined by either an independent market based appraisal less estimated costs to sell or an executed sales agreement and is classified as Level 2. Other real estate owned has a book cost of $16.0 million as of September 30, 2012 and consisted primarily of a manufacturing plant in northern Pennsylvania, residential real estate in eastern Pennsylvania and a commercial real estate property in eastern Pennsylvania. During the first quarter of 2012, the sale of an office building in western Pennsylvania which was previously in OREO for $6.8 million was completed and resulted in a $0.3 million loss at the time of sale. During the third quarter of 2012, a real estate property located in central Pennsylvania which was in OREO for $1.2 million was sold and resulted in a $0.6 million gain. We review whether events and circumstances subsequent to a transfer to other real estate owned have occurred that indicate the balance of those assets may not be recoverable. If events and circumstances indicate further impairment we will record a charge to the extent that the carrying value of the assets exceed their fair values, less estimated cost to sell, as determined by valuation techniques appropriate in the circumstances.

Certain other assets and liabilities, including goodwill and core deposit intangibles, are measured at fair value on a non-recurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments only in certain circumstances. Additional information related to goodwill is provided in Note 14, “Goodwill.” There were no other assets or liabilities measured at fair value on a non-recurring basis during the nine-months ended September 30, 2012.

FASB ASC 825-10, “Transition Related to FSP FAS 107-1” and APB 28-1, “Interim Disclosures about Fair Value of Financial Instruments,” requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis. The methodologies for estimating the fair value of financial assets and financial liabilities that are measured at fair value on a recurring or non-recurring basis are as discussed above. The methodologies for other financial assets and financial liabilities are discussed below.

Cash and due from banks and interest-bearing bank deposits: The carrying amounts for cash and due from banks and interest-bearing bank deposits approximate the estimated fair values of such assets.

Securities: Fair values for securities available for sale are based on quoted market prices, if available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. Pooled trust preferred collateralized debt obligations values are derived from other valuation methodologies, including option pricing models, discounted cash flow models and similar techniques, and not based on market exchange, dealer or broker traded transactions. These valuations incorporate certain assumptions and projections in determining the fair value assigned to each instrument. The carrying value of other investments, which includes FHLB stock, is considered a reasonable estimate of fair value.

Loans held for sale: The fair value of loans held for sale is estimated utilizing a present value of future discounted cash flows of the loan utilizing a risk based expected return to discount the value unless a sales agreement has been executed, in which case the sales price would equal fair value.

Loans: The fair values of all loans are estimated by discounting the estimated future cash flows using interest rates currently offered for loans with similar terms to borrowers of similar credit quality adjusted for past due and nonperforming loans, which is not an exit price under FASB ASC Topic 820, “Fair Value Measurements and Disclosures.”

Off-balance sheet instruments: Many of First Commonwealth’s off-balance sheet instruments, primarily loan commitments and standby letters of credit, are expected to expire without being drawn upon; therefore, the commitment amounts do not necessarily represent future cash requirements. FASB ASC Topic 460, “Guarantees” clarified that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The carrying amount and fair value for standby letters of credit was $0.2 million and $0.1 million at September 30, 2012 and December 31, 2011, respectively. See Note 6, “Commitments and Contingent Liabilities,” for additional information.

Deposit liabilities: Management estimates that the fair value of deposits is based on a market valuation of similar deposits. The carrying value of variable rate time deposit accounts and certificates of deposit approximate their fair values at the report date. Also, fair values of fixed rate time deposits for both periods are estimated by discounting the future cash flows using interest rates currently being offered and a schedule of aggregated expected maturities.

Short-term borrowings: The fair values of borrowings from the FHLB were estimated based on the estimated incremental borrowing rate for similar types of borrowings. The carrying amounts of other short-term borrowings such as federal funds purchased and securities sold under agreement to repurchase were used to approximate fair value due to the short-term nature of the borrowings.

Long-term debt and subordinated debt: The fair value of long-term debt and subordinated debt is estimated by discounting the future cash flows using First Commonwealth’s estimated incremental borrowing rate for similar types of borrowing arrangements.

The following table presents carrying amounts and fair values of First Commonwealth’s financial instruments:


	September 30, 2012
			Fair Value Measurements Using:
	Carrying Amount		Total		Level 1		Level 2		Level 3
	(dollars in thousands)
Financial assets
Cash and due from banks	$	85,183	$	85,183	$	85,183	$	0	$	0
Interest-bearing deposits		3,881		3,881		3,881		0		0
Securities available for sale		1,130,822		1,130,822		440		1,105,911		24,471
Other investments		32,479		32,479		0		32,479		0
Loans		4,214,299		4,269,822		0		59,241		4,210,581
Financial liabilities
Deposits		4,494,434		4,435,555		0		4,435,555		0
Short-term borrowings		461,770		461,760		0		461,760		0
Long-term debt		74,721		77,470		0		77,470		0
Subordinated debt		105,750		76,995		0		0		76,995


	December 31, 2011
	Carrying Amount		Estimated Fair Value
	(dollars in thousands)
Financial assets
Cash and due from banks	$	74,967	$	74,967
Interest-bearing deposits		3,511		3,511
Securities available for sale		1,142,776		1,142,776
Other investments		39,796		39,796
Loans held for sale		13,412		13,412
Loans		4,043,643		4,113,525
Financial liabilities
Deposits		4,504,684		4,452,235
Short-term borrowings		312,777		312,777
Long-term debt		101,664		103,749
Subordinated debt		105,750		75,310