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 period-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 September 30, 2013 and December 31, 2012.

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 September 30, 2013 and December 31, 2012, management made adjustments to prices provided by the third-party pricing service as a result of illiquid or inactive markets.

At September 30, 2013 and December 31, 2012, the Corporation’s pooled trust preferred security, ALESCO VII, was classified as Level 3. Market pricing for the Level 3 security varied widely from one pricing service to another based on the lack of trading. As such, the security was 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 of private label CMO 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 a net settlement principal loss of $24,000 for the nine months ended September 30, 2013; this security was sold at its book value on January 4, 2013.

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 September 30, 2013 and December 31, 2012 are as follows:

			Fair Value Measurements at Reporting Date Using
Assets Measured at Fair Value on a Recurring Basis	September 30, 2013		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(in thousands)
U.S. Treasury & agency securities	$	41,695	$	41,695	$	—	$	—
Federal agency obligations		20,746		—		20,746		—
Residential mortgage pass-through securities		50,942		—		50,942		—
Commercial mortgage pass-through securities		9,518		—		9,518		—
Obligations of U.S. states and political subdivisions		40,277		—		40,277		—
Trust preferred securities		19,537		—		19,443		94
Corporate bonds and notes		205,235		—		205,235		—
Asset-backed securities		16,228		—		16,228		—
Certificates of deposit		2,295		—		2,295		—
Equity securities		287		287		—		—
Mutual funds and money market funds		6,387		6,387		—		—
Investment securities available-for-sale	$	413,147	$	48,369	$	364,684	$	94

			Fair Value Measurements at Reporting Date Using
Assets Measured at Fair Value on a Recurring Basis	December 31, 2012		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(in thousands)
U.S. treasury and agency securities	$	11,909	$	11,909	$	—	$	—
Federal agency obligations		20,535		—		20,535		—
Residential mortgage pass-through securities		53,784		—		53,784		—
Commercial mortgage pass-through securities		9,969		—		9,969		—
Obligations of U.S. states and political subdivisions		107,714		469		107,245		—
Trust preferred securities		21,249		—		21,213		36
Corporate bonds and notes		237,405		—		237,405		—
Collateralized mortgage obligations		2,120		—		2,120		—
Asset-backed securities		19,742		—		19,742		—
Certificates of deposit		2,865		—		2,865		—
Equity securities		325		325		—		—
Mutual funds and money market funds		9,198		9,198		—		—
Securities available-for-sale	$	496,815	$	21,901	$	474,878	$	36

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 value of the obligations of states and political subdivisions securities was measured at fair value using Level 1 inputs at December 31, 2012 represented the purchase price of the securities since they were acquired near year-end 2012.

The following tables present the changes in investment securities available-for-sale with significant unobservable inputs (Level 3) for the three and nine months ended September 30, 2013 and 2012.

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2013		2012		2013		2012
	(in thousands)
Balance, beginning of the period	$	72	$	1,856	$	36	$	2,115
Interest payment deferrals		14		33		43		101
Principal repayments		—		(102)		—		(272)
Total net losses included in net income		—		(32)		—		(60)
Total net unrealized gains		8		296		15		167
Balance, end of the period	$	94	$	2,051	$	94	$	2,051

For the nine months ended September 30, 2013, there were no transfers of investment securities available-for-sale into or out of Level 1, Level 2, or Level 3 assets, except for securities purchased at year end included in Level 1, representing purchase prices, which subsequently were evaluated and placed in the appropriate Level depending on the observable inputs.

Assets Measured at Fair Value on a Non-Recurring Basis

For assets measured at fair value on a non-recurring basis, the unobservable inputs used to derive fair value measurements at September 30, 2013 and December 31, 2012 were as follows:

Impaired Loans	Valuation Techniques	Range of Unobservable Inputs
Residential	Appraisals of collateral value	Adjustment for age of comparable sales, generally a decline of 0-25%
Commercial	Discounted cash flow model	Discount rate from 0% to 6%
Commercial real estate	Appraisals of collateral value	Market capitalization rates between 8% to 12%. Market rental rates for similar properties
Construction	Appraisals of collateral value	Adjustment for age comparable sales. Generally a decline of 5% to no change

Other Real Estate Owned
Residential	Appraisals of collateral value	Adjustment for age of comparable sales, generally a decline of 0-25% and estimated selling costs of 6-8%
Commercial	Appraisals of collateral value	Adjustment for age of comparable sales, generally a decline of 15% to no change and estimated selling costs of 6-8%

			Fair Value Measurements at Reporting Date Using
Assets Measured at Fair Value on a Non-Recurring Basis	September 30, 2013		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	$	1,069	$	—	$	—	$	1,069
Other real estate owned		220		—		—		220

			Fair Value Measurements at Reporting Date Using
Assets Measured at Fair Value on a Non-Recurring Basis	December 31, 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	$	4,790	$	—	$	—	$	4,790
Other real estate owned		1,300		—		—		1,300

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 September 30, 2013 and December 31, 2012.

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 September 30, 2013 that required a valuation allowance during 2013 were $1.3 million with a related valuation allowance of $219,000 compared to $5.4 million with a related valuation allowance of $645,000 at December 31, 2012. Impaired loans that required a valuation allowance were $6.9 million with a related valuation allowance of $758,000 during the nine months ended September 30, 2012. Impaired loans of $1.5 million had no recorded valuation allowance for December 31, 2012.

Fair Value of Financial Instruments

Other Real Estate Owned. Other real estate owned (“OREO”) is measured at fair value less costs to sell, generally a decline of 0-25% for residential OREO and a decline of 15% to no change for commercial OREO. 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.

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 not to 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 Held-for-Sale. Fair value is estimated using the prices of the Corporation’s existing commitments to sell such loans and/or the quoted market price for commitments to sell similar loans.

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.

Non Interest-Bearing Deposits. The fair value for non interest-bearing deposits is equal to the amount payable on demand at the reporting date.

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 September 30, 2013 and December 31, 2012.

					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)
September 30, 2013
Financial assets
Cash and due from banks	$	33,557	$	33,557	$	33,557	$	—	$	—
Investment securities available-for-sale		413,147		413,147		48,369		364,684		94
Investment securities held-to-maturity		153,486		152,008		—		152,008		—
Restricted investment in bank stocks		8,986		8,986		—		8,986		—
Loans held for sale		101		101		101		—		—
Net loans		947,298		950,226		—		—		950,226
Accrued interest receivable		6,570		6,570		—		4,122		2,448

Financial liabilities
Non interest-bearing deposits		238,214		238,214		—		238,214		—
Interest-bearing deposits		1,076,103		1,076,997		—		1,076,997		—
Long-term borrowings		146,000		158,093		—		158,093		—
Subordinated debentures		5,155		5,145		—		5,145		—
Accrued interest payable		821		821		—		821		—

December 31, 2012
Financial assets
Cash and due from banks	$	104,134	$	104,134	$	104,134	$	—	$	—
Interest bearing deposits with banks		2,004		2,004		2,004		—		—
Investment securities available-for-sale		496,815		496,815		21,901		474,878		36
Investment securities held-to-maturity		58,064		62,431		—		62,431		—
Restricted investment in bank stocks		8,964		8,964		—		8,964		—
Loans held for sale		1,491		1,491		1,491		—		—
Net loans		879,435		897,030		—		—		897,030
Accrued interest receivable		6,849		6,849		—		4,465		2,384

Financial liabilities
Non interest-bearing deposits		215,071		215,071		—		215,071		—
Interest-bearing deposits		1,091,851		1,092,822		—		1,092,822		—
Long-term borrowings		146,000		162,992		—		162,992		—
Subordinated debentures		5,155		5,046		—		5,046		—
Accrued interest payable		874		874		—		874		—