Note 9 – Fair Value

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair values:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2: Significant other 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.

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The Company used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:

Investment Securities: The fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3). Level 3 pricing is obtained from a third-party based upon similar trades that are not traded frequently without adjustment by the Company. At September 30, 2013, the Company held $11.4 million in Level 3 securities which consist of $11.0 million of non-rated Obligations of State and Political Subdivisions and $353 thousand of equity securities that are not actively traded. Absent the credit rating, significant assumptions must be made such that the credit risk input becomes an unobservable input and thus these securities are reported by the Company in a Level 3 classification.

Derivatives: The fair values of derivatives are based on valuation models using observable market data as of the measurement date (Level 2).

Impaired Loans: Fair values for impaired collateral dependent loans are generally based on appraisals obtained from licensed real estate appraisers and in certain circumstances consideration of offers obtained to purchase properties prior to foreclosure. Appraisals for commercial real estate generally use three methods to derive value: cost, sales or market comparison and income approach. The cost method bases value in the cost to replace the current property. Value of market comparison approach evaluates the sales price of similar properties in the same market area. The income approach considers net operating income generated by the property and an investors required return. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Comparable sales adjustments are based on known sales prices of similar type and similar use properties and duration of time that the property has been on the market to sell. Such adjustments made in the appraisal process are typically significant and result in a Level 3 classification of the inputs for determining fair value.

Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by the Company. Once received, a member of the Company’s Risk Management Area reviews the assumptions and approaches utilized in the appraisal. In determining the value of impaired collateral dependent loans and other real estate owned, significant unobservable inputs may be used which include: physical condition of comparable properties sold, net operating income generated by the property and investor rates of return.

Other Real Estate: Nonrecurring adjustments to certain commercial and residential real estate properties classified as other real estate (ORE) are measured at the lower of carrying amount or fair value, less costs to sell. Fair values are generally based on third party appraisals of the property utilizing similar techniques as discussed above for Impaired Loans, resulting in a Level 3 classification. In cases where the carrying amount exceeds the fair value, less costs to sell, impairment loss is recognized.

Loans Held-for-Sale: The fair values of loans held for sale are determined by using quoted prices for similar assets, adjusted for specific attributes of that loan resulting in a Level 2 classification.

Assets and Liabilities Measured on a Recurring Basis

Assets and liabilities measured at fair value on a recurring basis, including financial assets and liabilities for which the Company has elected the fair value option, are summarized below:

	Fair Value Measurements at September 30, 2013 Using
	Quoted Prices in
	Active Markets for		Significant Other		Significant
	Identical Assets		Observable Inputs		Unobservable Inputs
	(Level 1)		(Level 2)		(Level 3)		Total
Assets:
U.S. Treasury and Agency Securities	$	—	$	19,787	$	—	$	19,787
Corporate Securities		—		—		—		—
Obligations of State and
Political Subdivisions		—		86,269		11,002		97,271
Mortgage-backed Securities-Residential		—		490,569		—		490,569
Equity Securities		673		—		353		1,026
Total Securities	$	673	$	596,625	$	11,355	$	608,653

Loans Held-for-Sale	$	—	$	9,054	$	—	$	9,054

Derivatives	$	—	$	511	$	—	$	511

Financial Liabilities Derivatives	$	—	$	392	$	—	$	392

	Fair Value Measurements at December 31, 2012 Using
	Quoted Prices in
	Active Markets for		Significant Other		Significant
	Identical Assets		Observable Inputs		Unobservable Inputs
	(Level 1)		(Level 2)		(Level 3)		Total
Assets:
U.S. Treasury and Agency Securities	$	—	$	23,472	$	—	$	23,472
Corporate Securities		—		—		—		—
Obligations of State and
Political Subdivisions		—		64,316		12,169		76,485
Mortgage-backed Securities-Residential		—		486,912		—		486,912
Equity Securities		380		—		353		733
Total Securities	$	380	$	574,700	$	12,522	$	587,602

Loans Held-for-Sale	$	—	$	16,641	$	—	$	16,641

Derivatives	$	—	$	187	$	—	$	187

Financial Liabilities Derivatives	$	—	$	178	$	—	$	178

There were no transfers between Level 1 and Level 2 for the periods ended September 30, 2013 and December 31, 2012.

At September 30, 2013, the aggregate fair value of the Loans Held-for-Sale was $9,054, aggregate contractual principal balance was $8,937 with a difference of $117. At December 31, 2012, the aggregate fair value of the Loans Held-for-Sale was $16,641, aggregate contractual principle balance was $16,413 with a difference of $228.

The table below presents a reconciliation of all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three and nine months ended September 30, 2013 and 2012:

	Obligations of State
	and Political
	Subdivisions				Equity Securities				Corporate Securities
	2013		2012		2013		2012		2013		2012

Balance of Recurring Level 3 Assets at June 30	$	11,439	$	11,791	$	353	$	353	$	—	$	—
Total Gains or Losses (realized/unrealized)
Included in Earnings		(12)		9		—		—		—		—
Maturities / Calls		(425)		—		—		—		—		—
Purchases		—		—		—		—		—		—
Balance of Recurring Level 3 Assets at September 30	$	11,002	$	11,800	$	353	$	353	$	—	$	—

	Obligations of State
	and Political
	Subdivisions				Equity Securities				Corporate Securities
	2013		2012		2013		2012		2013		2012

Balance of Recurring Level 3 Assets at December 31	$	12,169	$	4,772	$	353	$	353	$	—	$	1,005
Total Gains or Losses (realized/unrealized)
Included in Earnings		(162)		60		—		—		—		—
Maturities / Calls		(1,005)		(697)		—		—		—		(1,005)
Purchases		—		7,665		—		—		—		—
Balance of Recurring Level 3 Assets at September 30	$	11,002	$	11,800	$	353	$	353	$	—	$	—

Of the total gain/loss included in earnings for the three and nine months ended September 30, 2013, $12 and $162 was attributable to other changes in fair value, respectively. The three and nine months ended September 30, 2013 included no gain/loss attributable to interest income on securities. Of the total gain/loss included in earnings for the three and nine months ended September 30, 2012, $9 and $60 was attributable to other changes in fair value, respectively. The three and nine months ended September 30, 2012 included no gain/loss attributable to interest income on securities.

Assets and Liabilities Measured on a Non-Recurring Basis

Assets and liabilities measured at fair value on a non-recurring basis are summarized below:

	Fair Value Measurements at September 30, 2013 Using
	Quoted Prices in
	Active Markets for		Significant Other		Significant
	Identical Assets		Observable Inputs		Unobservable Inputs
	(Level 1)		(Level 2)		(Level 3)		Total
Assets:
Impaired Loans with Specific Allocations
Commercial and Industrial Loans	$	—	$	—	$	—	$	—
Commercial Real Estate Loans		—		—		1,257		1,257
Agricultural Loans		—		—		—		—
Other Real Estate
Commercial Real Estate		—		—		290		290

	Fair Value Measurements at December 31, 2012 Using
	Quoted Prices in
	Active Markets for		Significant Other		Significant
	Identical Assets		Observable Inputs		Unobservable Inputs
	(Level 1)		(Level 2)		(Level 3)		Total
Assets:
Impaired Loans with Specific Allocations
Commercial and Industrial Loans	$	—	$	—	$	1,231	$	1,231
Commercial Real Estate Loans		—		—		1,497		1,497
Agricultural Loans		—		—		135		135
Other Real Estate
Commercial Real Estate		—		—		150		150

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $4,947 with a valuation allowance of $3,690, resulting in an additional provision for loan losses of $229 and $608 for the three and nine months ended September 30, 2013. Impaired loans resulted in an additional provision for loan losses of $393 for the three months ended September 30, 2012 and an additional provision for loan losses of $1,023 for the nine months ended September 30, 2012. Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $8,274 with a valuation allowance of $5,411, resulting in an additional provision for loan losses of $2,320 for the year ended December 31, 2012.

Other Real Estate which is measured at the lower of carrying or fair value less costs to sell had a carrying value of $290 at September 30, 2013. No charge to earnings was included in the three months ended September 30, 2013. A charge to earnings through Other Operating Income of $301 was included in the nine months ended September 30, 2013. A charge to earnings through Other Operating Income of $100 was included in the three and nine months ended September 30, 2012. Other Real Estate which is measured at the lower of carrying or fair value less costs to sell had a carrying value of $150 at December 31, 2012.

The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at September 30, 2013:

					Range
			Valuation		(Weighted
	Fair Value		Technique(s)	Unobservable Input(s)	Average)
Impaired Loans - Commercial	$	1,257	Sales comparison	Adjustment for physical	12%-80%
Real Estate Loans			approach	condition of comparable	(52)%
			Income approach	properties sold
			Cost approach	Adjustment for net operating
				income generated by the
				property
				Adjustment for investor rates
				of return
Other Real Estate - Commercial	$	290	Sales comparison	Adjustment for physical	50%
Real Estate Loans			approach	condition of comparable	(50)%
			Income approach	properties sold
			Cost approach	Adjustment for net operating
				income generated by the
				property
				Adjustment for investor rates
				of return

The carrying amounts and estimated fair values of the Company’s financial instruments not previously presented are provided in the table below for the periods ending September 30, 2013 and December 31, 2012. Not all of the Company’s assets and liabilities are considered financial instruments, and therefore are not included in the table. Because no active market exists for a significant portion of the Company’s financial instruments, fair value estimates were based on subjective judgments, and therefore cannot be determined with precision.

			Fair Value Measurements at
			September 30, 2013 Using
	Carrying Value		Level 1		Level 2		Level 3		Total
Financial Assets:
Cash and Short-term Investments	$	64,671	$	46,657	$	18,014	$	—	$	64,671
Securities Held-to-Maturity		268		—		271		—		271
FHLB Stock and Other Restricted Stock		8,340		N/A		N/A		N/A		N/A
Loans, Net		1,265,721		—		—		1,270,263		1,270,263
Accrued Interest Receivable		7,402		—		1,906		5,496		7,402
Financial Liabilities:
Demand, Savings, and Money Market Deposits		(1,338,858)		(1,338,858)		—		—		(1,338,858)
Time Deposits		(332,181)		—		(335,093)		—		(335,093)
Short-term Borrowings		(102,792)		—		(102,792)		—		(102,792)
Long-term Debt		(88,762)		—		(85,026)		(5,287)		(90,313)
Accrued Interest Payable		(690)		—		(647)		(43)		(690)
Unrecognized Financial Instruments:
Commitments to Extend Credit		—		—		—		—		—
Standby Letters of Credit		—		—		—		—		—
Commitments to Sell Loans		—		—		—		—		—

			Fair Value Measurements at
			December 31, 2012 Using
	Carrying Value		Level 1		Level 2		Level 3		Total
Financial Assets:
Cash and Short-term Investments	$	51,794	$	41,624	$	10,170	$	—	$	51,794
Securities Held-to-Maturity		346		—		351		—		351
FHLB Stock and Other Restricted Stock		8,340		N/A		N/A		N/A		N/A
Loans, Net		1,186,483		—		—		1,199,566		1,199,566
Accrued Interest Receivable		7,419		—		1,893		5,526		7,419
Financial Liabilities:
Demand, Savings, and Money Market Deposits		(1,311,748)		(1,311,748)		—		—		(1,311,748)
Time Deposits		(329,183)		—		(333,170)		—		(333,170)
Short-term Borrowings		(71,534)		—		(71,534)		—		(71,534)
Long-term Debt		(89,472)		—		(66,892)		(28,872)		(95,764)
Accrued Interest Payable		(1,275)		—		(829)		(446)		(1,275)
Unrecognized Financial Instruments:
Commitments to Extend Credit		—		—		—		—		—
Standby Letters of Credit		—		—		—		—		—
Commitments to Sell Loans		—		—		—		—		—

Cash and Short-term Investments:

The carrying amount of cash and short-term investments approximate fair values and are classified as Level 1 or Level 2.

Securities Held-to-Maturity:

The fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2).

FHLB Stock and Other Restricted Stock:

It is not practical to determine the fair values of FHLB stock and other restricted stock due to restrictions placed on their transferability.

Loans:

Fair values of loans, excluding loans held for sale and collateral dependent impaired loans having a specific allowance allocation, are estimated as follows: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Impaired loans are valued as described previously. The methods utilized to estimate fair value of loans do not necessarily represent an exit price.

Accrued Interest Receivable:

The carrying amount of accrued interest approximates fair value resulting in a Level 2 or Level 3 classification consistent with the asset they are associated with.

Deposits:

The fair values disclosed for demand deposits (e.g., interest and non-interest checking, savings and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amount) resulting in a Level 1 classification. Fair values for fixed rate time deposits are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

Short-term Borrowings:

The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings, generally maturing within ninety days, approximate their fair values resulting in a Level 2 classification.

Long-term Debt:

The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 2 classification.

The fair values of the Company’s subordinated debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 3 classification.

Accrued Interest Payable:

The carrying amount of accrued interest approximates fair value resulting in a Level 2 or Level 3 classification consistent with the liability they are associated with.

Off-balance Sheet Instruments:

Commitments to extend credit and standby letters of credit are generally short-term or variable rate with minimal fees charged. These instruments have no carrying value, and the fair value is not material. The fair value of commitments to sell loans is the cost or benefit of settling the commitments with the counter-party at the reporting date. At September 30, 2013 and December 31, 2012, none of the Company’s commitments to sell loans were mandatory, and there is no cost or benefit to settle these commitments.