Note 9. Fair Value Measurements and Fair Value of Financial Instruments

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, 2012 and December 31, 2011.

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, 2012, management made adjustments to prices provided by the third-party pricing service as a result of illiquid or inactive markets.

At June 30, 2012, the Corporation's two pooled trust preferred securities, ALESCO VI and ALESCO VII, and one 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, 2012 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, the private label CMO had interruptions of its scheduled principal payments and the Corporation recorded principal loss of $112,000 and $170,000 for the three and six months ended June 30, 2012, respectively.

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, 2012 and December 31, 2011 are as follows:


			Fair Value Measurements at Reporting Date Using
Assets Measured at Fair Value on a Recurring Basis	June 30, 2012		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(in thousands)
Federal agency obligations	$	18,683	$	—	$	18,683	$	—
Residential mortgage-backed securities		88,794		—		88,794		—
Commercial mortgage-backed securities		9,799		—		9,799		—
Obligations of U.S. states and political subdivisions		85,144		256		84,888		—
Trust preferred securities		18,825		—		18,721		104
Corporate bonds and notes		212,704		—		212,704		—
Collateralized mortgage obligations		1,752		—		—		1,752
Asset-backed securities		19,633		—		19,633		—
Equity securities		601		601		—		—
Other securities		11,255		11,255		—		—
Investment securities available-for-sale	$	467,190	$	12,112	$	453,222	$	1,856


			Fair Value Measurements at Reporting Date Using
Assets Measured at Fair Value on a Recurring Basis	December 31, 2011		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(in thousands)
Federal agency obligations	$	24,969	$	2,004	$	22,965	$	—
Residential mortgage pass-through securities		115,364		—		115,364		—
Obligations of U.S. states and political subdivision		69,173		397		68,776
Trust preferred securities		16,187		—		15,971		216
Corporate bonds and notes		173,117		2,000		171,117		—
Collateralized mortgage obligations		1,899		—		—		1,899
Asset-backed securities		7,653		—		7,653		—
Equity securities		262		262		—		—
Other securities		5,883		5,883		—		—
Securities available-for-sale	$	414,507	$	10,546	$	401,846	$	2,115

The fair values used by the Corporation are obtained from an independent pricing service and represent either quoted market prices for the identical securities (Level 1 inputs) or fair values determined by pricing models using a market approach that considers observable market data, such as interest rate volatilities, LIBOR yield curve, credit spreads and prices from market makers and live trading systems (Level 2). The fair values of the federal agency obligations, obligations of states and political subdivision and corporate bonds and notes measured at fair value using Level 1 inputs at June 30, 2012 and December 31, 2011 represented the purchase price of the securities since they were acquired near quarter-end June 30, 2012 and year-end 2011.

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, 2012 and 2011.


	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
	(in thousands)
Balance, beginning of the period	$	1,963		$	3,009		$	2,115		$	2,870
Principal interest deferrals		34			30			68			59
Principal repayments		(112	)		(268	)		(170	)		(452	)
Total net losses included in net income		(28	)		—			(28	)		—
Total net unrealized (losses) gains		(1	)		(76	)		(129	)		218
Balance, end of the period	$	1,856		$	2,695		$	1,856		$	2,695

For the six months ended June 30, 2012, 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, 2012 and December 31, 2011 were as follows:


				Fair Value Measurements at Reporting Date Using
Assets Measured at Fair Value on a Non-Recurring Basis		June 30, 2012		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(in thousands)
Impaired loans		$	7,355	$	—	$	—	$	7,355
Other real estate owned			453		—		—		453


				Fair Value Measurements at Reporting Date Using
Assets Measured at Fair Value on a Non-Recurring Basis		December 31, 2011		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(in thousands)
Impaired loans		$	10,740	$	—	$	—	$	10,740
Other real estate owned			591		—		—		591

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, 2012 and December 31, 2011.

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, 2012 that required a valuation allowance were $8,226,000 with a related valuation allowance of $871,000 compared to $11,825,000 with related valuation allowance of $1,085,000 at December 31, 2011. Impaired loans of $2,093,000 and $2,121,000 didn't record a valuation allowance for June 30, 2012 and December 31, 2011, respectively.

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.

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.

Investment Securities Held-to-Maturity. The fair value of the Corporation's investment securities held-to-maturity was primarily measured using information from a third-party pricing service. If quoted prices were not available, fair values were estimated primarily by obtaining quoted prices for similar assets in active markets or through the use of pricing models. In cases where there may be limited or less transparent information provided by the Corporation's third-party pricing service, fair value may be estimated by the use of secondary pricing services or through the use of non-binding third-party broker quotes.

Loans. The fair value of the Corporation's loans was estimated by discounting the expected future cash flows using the current interest rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Loans were segregated by types such as commercial, residential and consumer loans. Expected future cash flows were projected based on contractual cash flows, adjusted for estimated prepayments.

Interest-Bearing Deposits. The fair values of the Corporation's interest-bearing deposits were estimated using discounted cash flow analyses. The discounted rates used were based on rates currently offered for deposits with similar remaining maturities. The fair values of the Corporation's interest-bearing deposits do not take into consideration the value of the Corporation's long-term relationships with depositors, which may have significant value.

Term Borrowings and Subordinated Debentures. The fair value of the Corporation's long-term borrowings and subordinated debentures were calculated using a discounted cash flow approach and applying discount rates currently offered based on weighted remaining maturities.

Accrued Interest Receivable/Payable. The carrying amounts of accrued interest approximate fair value resulting in a level 2 or level 3 classification based on the level of the asset or liability with which the accrual is associated.

The following presents the carrying amount, fair value, and placement in the fair value hierarchy of the Corporation's financial instruments as of June 30, 2012 and December 31, 2011.


					Fair Value Measurements
	Carrying Amount		Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(in thousands)
June 30, 2012
Financial assets
Cash and due from banks	$	73,668	$	73,668	$	73,668	$	—	$	—
Interest bearing deposits with banks		12,000		12,000		12,000		—		—
Investment securities held-to-maturity		62,997		66,562		—		66,562		—
Restricted investment in bank stocks		9,139		9,139		9,139		—		—
Net loans (including loans held for sale)		797,233		803,952		501		—		803,451
Accrued interest receivable		6,465		6,465		—		4,302		2,163

Financial liabilities
Non interest-bearing deposits		181,282		181,282		—		181,282		—
Interest-bearing deposits		993,367		994,379		—		994,379		—
Short-term borrowings		107		107		—		107		—
Long-term borrowings		161,000		179,241		—		179,241		—
Subordinated debentures		5,155		5,184		—		5,184		—
Accrued interest payable		912		912		—		912		—

December 31, 2011
Financial assets
Cash and due from banks	$	111,101	$	111,101	$	111,101	$	—	$	—
Investment securities held-to-maturity		72,233		74,922		—		74,922		—
Restricted investment in bank stocks		9,233		9,233		9,233		—		—
Net loans (including loans held for sale)		746,408		752,252		1,029		—		751,223
Accrued interest receivable		6,219		6,219		—		3,894		2,325

Financial liabilities
Non interest-bearing deposits		167,164		167,164		—		167,164		—
Interest-bearing deposits		954,251		928,777		—		928,777		—
Long-term borrowings		161,000		175,933		—		175,933		—
Subordinated debentures		5,155		5,159		—		5,159		—
Accrued interest payable		992		992		—		992		—