Fair Value Measurements and Fair Value of Financial Instruments

6 Months Ended

Jun. 30, 2011

Fair Value Measurements and Fair Value of Financial Instruments

Fair Value Measurements and Fair Value of Financial Instruments

Note 8.  Fair Value Measurements and Fair Value of Financial Instruments

Fair Value Measurements

Management uses its best judgment in estimating the fair value of the Corporation's financial and non-financial instruments; however, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial and non-financial instruments, the fair value estimates herein are not necessarily indicative of the amounts the Corporation could have realized in a sale transaction on the dates indicated. The estimated fair value amounts have been measured as of the respective period-end dates indicated herein and have not been re-evaluated or updated for purposes of these financial statements subsequent to those respective dates. As such, the estimated fair values of these financial and non-financial instruments subsequent to the respective reporting dates may be different than the amounts reported at each year-end.

U.S. GAAP establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described below:

· Level 1: Unadjusted exchange quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

· Level 2: Quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

· Level 3: Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (for example, supported with little or no market activity).

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.

The following information should not be interpreted as an estimate of the fair value of the entire Corporation since a fair value calculation is only provided for a limited portion of the Corporation's assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between the Corporation's disclosures and those of other companies may not be meaningful. The following methods and assumptions were used to estimate the fair values of the Corporation's assets measured at fair value on a recurring basis at June 30, 2011 and December 31, 2010.

Investment Securities Available-for-Sale

Where quoted prices are available in an active market, investment securities are classified in Level 1 of the valuation hierarchy. Level 1 inputs include investment securities that have quoted prices in active markets for identical assets. 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. Examples of instruments, which would generally be classified within Level 2 of the valuation hierarchy, include municipal bonds and certain agency collateralized mortgage obligations. In certain cases where there is limited

activity in the market for a particular instrument, assumptions must be made to determine their fair value and are classified as Level 3. Due to the inactive condition of the markets amidst the financial crisis, the Corporation treated certain investment securities as Level 3 assets in order to provide more appropriate valuations. For assets in an inactive market, the infrequent trades that do occur are not a true indication of fair value. When measuring fair value, the valuation techniques available under the market approach, income approach and/or cost approach are used. The Corporation's evaluations are based on market data and the Corporation employs combinations of these approaches for its valuation methods depending on the asset class. In certain cases where there were limited or less transparent information provided by the Corporation's third-party pricing service, fair value was estimated by the use of secondary pricing services or through the use of non-binding third-party broker quotes.

On a quarterly basis, management reviews the pricing information received from the Corporation's third-party pricing service. This review process includes a comparison to non-binding third-party broker quotes, as well as a review of market-related conditions impacting the information provided by the Corporation's third-party pricing service.

Management primarily identifies investment securities which may have traded in illiquid or inactive markets by identifying instances of a significant decrease in the volume and frequency of trades, relative to historical levels, as well as instances of a significant widening of the bid-ask spread in the brokered markets. Investment securities that are deemed to have been trading in illiquid or inactive markets may require the use of significant unobservable inputs. For example, management may use quoted prices for similar investment securities in the absence of a liquid and active market for the securities being valued. As of June 30, 2011, management made adjustments to prices provided by the third-party pricing service as a result of illiquid or inactive markets.

At June 30, 2011, the Corporation's two pooled trust preferred securities and a variable rate CMO were classified as Level 3. Market pricing for these Level 3 securities varied widely from one pricing service to another based on the lack of trading. As such, these securities were not considered to have readily observable market data that was accurate to support a fair value as prescribed by FASB ASC 820-10-05. The Corporation determined that significant adjustments using unobservable inputs are required to determine fair value at the measurement date.

The Corporation determined that an income approach valuation 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 the prior measurement dates. As a result, the Corporation used the discount rate adjustment technique to determine fair value.

The fair value as of June 30, 2011 was determined by discounting the expected cash flows over the life of the security. The discount rate was determined by deriving a discount rate when the markets were considered more active for this type of security. To this estimated discount rate, additions were made for more liquid markets and increased credit risk as well as assessing the risks in the security, such as default risk and severity risk. However, during the quarter ended June 30, 2011 the private label CMO had interruptions of its scheduled principal payments and the Corporation recorded principal loss of $133,000. For the six month ended June 30, 2011, principal loss amounted to $219,000.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

For financial assets and liabilities measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy used at June 30, 2011 and December 31, 2010 are as follows:

			Fair Value Measurements at
			Reporting Date Using
			Quoted
			Prices in
			Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs
Assets Measured at Fair Value on a Recurring Basis	June 30, 2011		(Level 1)		(Level 2)		(Level 3)
			(in thousands)
Federal agency obligations	$	53,622	$	—	$	53,622	$	—
Residential mortgage pass-through securities		158,212		—		158,212		—
Obligations of U.S. states and political subdivisions		32,834		4,372		28,462		—
Trust preferred securities		20,655		—		20,319		336
Collateralized mortgage obligations		2,359		—		—		2,359
Corporate bonds and notes		104,631		—		104,631		—
Equity securities		4,901		4,901		—		—
Investment securities available-for-sale	$	377,214	$	9,273	$	365,246	$	2,695
			Fair Value Measurements at
			Reporting Date Using
			Quoted
			Prices in
			Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
	December 31,		Assets		Inputs		Inputs
Assets Measured at Fair Value on a Recurring Basis	2010		(Level 1)		(Level 2)		(Level 3)
			(in thousands)
U.S. Treasury & agency securities	$	6,995	$	6,995	$	—	$	—
Federal agency obligations		68,481		—		68,481		—
Residential mortgage pass-through securities		177,733		—		177,733		—
Obligations of U.S. states and political subdivisions		37,225		16,936		20,289		—
Trust preferred securities		18,731		—		18,589		142
Collateralized mortgage obligations		2,728		—		—		2,728
Corporate bonds and notes		61,434		—		61,434		—
Equity securities		4,753		4,753		—		—
Investment securities available-for-sale	$	378,080	$	28,684	$	346,526	$	2,870

The following tables present the changes in investment securities available-for-sale with significant unobservable inputs (Level 3) for the three and six months ended June 30, 2011 and 2010.

	Three Months Ended
	June 30, 2011		June 30, 2010
	(in thousands)
Balance at April 1,	$	3,009	$	8,431
Transfers into Level 3		—		—
Transfers out of Level 3		—		(5,174)
Principal interest deferrals		30		28
Principal repayments		(268)		(314)
Total net losses included in net income		—		(3,000)
Total net unrealized gains (loss)		(76)		3,304
Balance at period end,	$	2,695	$	3,275

Six Months Ended
	June 30, 2011		June 30, 2010
	(in thousands)
Balance at January 1,	$	2,870	$	2,349
Transfers into Level 3		—		8,197
Transfers out of Level 3		—		(5,174)
Principal interest deferrals		59		56
Principal repayments		(452)		(475)
Total net losses included in net income		—		(3,000)
Total net unrealized gains		218		1,322
Balance at period end,	$	2,695	$	3,275

For the six months ended June 30, 2011, there were no transfers of investment securities available-for-sale into or out of Level 1, Level 2, or Level 3 assets.

Assets Measured at Fair Value on a Non-Recurring Basis

For assets measured at fair value on a non-recurring basis, the fair value measurements used at June 30, 2011 and December 31, 2010 were as follows:

			Fair Value Measurements at Reporting Date Using
			Quoted
			Prices
			in Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs
Assets Measured at Fair Value on a Non-Recurring Basis	June 30, 2011		(Level 1)		(Level 2)		(Level 3)
			(in thousands)
Impaired loans	$	10,491	$	—	$	—	$	10,491
			Fair Value Measurements at Reporting Date Using
			Quoted
			Prices
			in Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
	December 31,		Assets		Inputs		Inputs
Assets Measured at Fair Value on a Non-Recurring Basis	2010		(Level 1)		(Level 2)		(Level 3)
			(in thousands)
Impaired loans	$	4,895	$	—	$	—	$	4,895

The following methods and assumptions were used to estimate the fair values of the Corporation's assets measured at fair value on a non-recurring basis at June 30, 2011 and December 31, 2010.

Impaired Loans. The value of an impaired loan is measured based upon the present value of expected future cash flows discounted at the loan's effective interest rate, or the fair value of the collateral if the loan is collateral dependent. Smaller balance homogeneous loans that are collectively evaluated for impairment, such as residential mortgage loans and installment loans, are specifically excluded from the impaired loan portfolio. The Corporation's impaired loans are primarily collateral dependent. Impaired loans are individually assessed to determine that each loan's carrying value is not in excess of the fair value of the related collateral or the present value of the expected future cash flows. Impaired loans at June 30, 2011 were $11,781 with a specific reserve of $1,290 compared to $5,534 with a specific reserve of $639 at December 31, 2010.

Other Real Estate Owned.  Other real estate owned ("OREO") is measured at fair value less costs to sell. The Corporation believes that the fair value component in its valuation follows the provisions of FASB ASC 820-10-05. The fair value of OREO is determined by sales agreements or appraisals by qualified licensed appraisers approved and hired by the Corporation. Costs to sell associated with OREO is based on estimation per the terms and conditions of the sales agreements or appraisals. At June 30, 2011 and December 31, 2010 the Corporation held no OREO.

Fair Value of Financial Instruments

FASB ASC 825-10 requires all entities to disclose the estimated fair value of their financial instrument assets and liabilities. For the Corporation, as for most financial institutions, the majority of its assets and liabilities are considered financial instruments as defined in FASB ASC 825-10. Many of the Corporation's financial instruments, however, lack an available trading market as characterized by a willing buyer and willing seller engaging in an exchange transaction. It is also the Corporation's general practice and intent to hold its financial instruments to maturity and to not engage in trading or sales activities except for loans held-for-sale and investment securities available-for-sale. Therefore, significant estimations and assumptions, as well as present value calculations, were used by the Corporation for the purposes of this disclosure.

Estimated fair values have been determined using the best available data and an estimation methodology suitable for each category of financial instruments. For those loans and deposits with floating interest rates, it is presumed that estimated fair values generally approximate the recorded book balances. The estimation methodologies used, the estimated fair values, and the recorded book balances at June 30, 2011 and December 31, 2010, were as follows:

	June 30, 2011				December 31, 2010
	Carrying		Fair		Carrying		Fair
	Amount		Value		Amount		Value
	(in thousands)
Financial assets:
Cash and cash equivalents	$	109,467	$	109,467	$	37,497	$	37,497
Investment securities available-for-sale		377,214		377,214		378,080		378,080
Investment securities held-to-maturity		41,804		42,122		—		—
Net loans		688,312		690,060		699,577		706,309
Restricted investment in bank stocks		9,194		9,194		9,596		9,596
Accrued interest receivable		5,229		5,229		4,134		4,134
Financial liabilities:
Non interest-bearing deposits	$	158,689	$	158,689	$	144,210	$	144,210
Interest-bearing deposits		806,987		807,939		716,122		716,887
Short-term borrowings		32,374		32,374		41,855		41,855
Long-term borrowings		161,000		170,759		171,000		179,570
Subordinated debentures		5,155		5,135		5,155		5,157
Accrued interest payable		1,011		1,011		1,041		1,041

Financial instruments actively traded in a secondary market have been valued using quoted available market prices. Cash and due from banks, interest-bearing time deposits in other banks, federal funds sold, loans held-for-sale and interest receivable are valued at book value, which approximates fair value.  Financial liability instruments with stated maturities have been valued using a present value discounted cash flow analysis with a discount rate approximating current market for similar liabilities. Interest payable is valued at book value, which approximates fair value. Financial liability instruments with no stated maturities have an estimated fair value equal to both the amount payable on demand and the recorded book balance.

The fair value of the Corporation's investment securities held-to-maturity was primarily measured using information from a third-party pricing service. Quoted prices in active markets were used whenever available. If quoted prices were not available, fair values were measured using pricing models or other valuation techniques such as the present value of future cash flows, adjusted for credit loss assumptions.

Loans held for sale are required to be measured at the lower of cost or fair value. Under FASB ASC 820-10-05, market value is to represent fair value. Management obtains quotes or bids on all or part of these loans directly from the purchasing financial institutions.  There was $378,000 in loans held for sale at June 30, 2011 and none at December 31, 2010.

The net loan portfolio has been valued using a present value discounted 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, same remaining maturities, and assumed prepayment risk.

The fair value of commitments to originate loans is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness  of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair values of letters of credit and lines of credit are based on fees  currently charged for similar agreements or on the estimated cost to terminate or otherwise settle the obligations with the counterparties at the reporting date.

Changes in assumptions or estimation methodologies may have a material effect on these estimated fair values.

The Corporation's remaining assets and liabilities, which are not considered financial instruments, have not been valued differently than has been customary with historical cost accounting. No disclosure of the relationship value of the Corporation's core deposit base is required by FASB ASC 825-10.

Fair value estimates are based on existing balance sheet financial instruments, without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Other significant assets and liabilities that are not considered financial assets or liabilities include the deferred taxes, premises and equipment and goodwill. In addition, the tax ramifications related to the realization of unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.

Management believes that reasonable comparability between financial institutions may not be likely, due to the wide range of permitted valuation techniques and numerous estimates which must be made, given the absence of active secondary markets for many of the financial instruments. This lack of uniform valuation methodologies also introduces a greater degree of subjectivity to these estimated fair values.