7. FAIR VALUE DISCLOSURES OF FINANCIAL ASSETS

FAIR VALUE OF FINANCIAL ASSETS

ASC 820-10 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC 820-10 establishes a fair value hierarchy that prioritizes the use of inputs used in valuation methodologies into the following three levels:

Level 1: Inputs to the valuation methodology are quoted prices, unadjusted, for identical assets or liabilities in active markets. A quoted price in an active market provides the most reliable evidence of fair value and shall be used to measure fair value whenever available.

Level 2: Inputs to the valuation methodology include quoted prices for similar assets or liabilities in active markets; inputs to the valuation methodology include quoted prices for identical or similar assets or liabilities in markets that are not active; or inputs to the valuation methodology that are derived principally from or can be corroborated by observable market data by correlation or other means.

Level 3: Inputs to the valuation methodology are unobservable and significant to the fair value measurement. Level 3 assets and liabilities include financial instruments whose value is determined using discounted cash flow methodologies, as well as instruments for which the determination of fair value requires significant management judgment or estimation.

A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.

The table below presents the balances of assets measured at fair value as of September 30, 2012 (there are no material liabilities measured at fair value):


Description	Quoted Prices in Active Markets for Identical Asset (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)			Total Fair Value
	(in Thousands)
Assets Measured at Fair Value on a Recurring Basis
Available-for-sale securities:
Collateralized mortgage obligations	$	—	$	249,272	$	6,050		$	255,322
FNMA		—		461,435		—			461,435
FHLMC		—		72,356		—			72,356
GNMA		—		67,294		—			67,294
U.S. Government and agencies		—		51,052		—			51,052
State and political subdivisions		—		3,148		—			3,148
Reverse mortgages		—		—		(552	)		(552	)
Trading Securities		—		—		12,590			12,590

Total assets measured at fair value on a recurring basis	$	—	$	904,557	$	18,088		$	922,645

Assets Measured at Fair Value on a Nonrecurring Basis
Other real estate owned	$	—	$	—	$	6,996		$	6,996
Impaired Loans		—		—		47,291			47,291

Total assets measured at fair value on a nonrecurring basis	$	—	$	—	$	54,287		$	54,287

The table below presents the balances of assets measured at fair value as of December 31, 2011 (there are no material liabilities measured at fair value):


Description	Quoted Prices in Active Markets for Identical Asset (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)			Total Fair Value
	(in Thousands)
Assets Measured at Fair Value on a Recurring Basis
Available-for-sale securities:
Collateralized mortgage obligations	$	—	$	324,450	$	3,936		$	328,386
FNMA		—		329,354		—			329,354
FHLMC		—		95,086		—			95,086
GNMA		—		63,967		—			63,967
U.S. Government and agencies		—		39,025		—			39,025
State and political subdivisions		—		4,190		—			4,190
Reverse mortgages		—		—		(646	)		(646	)
Trading Securities		—		—		12,432			12,432

Total assets measured at fair value on a recurring basis	$	—	$	856,072	$	15,722		$	871,794

Assets Measured at Fair Value on a Nonrecurring Basis
Other real estate owned	$	—	$	11,695	$	—		$	11,695
Impaired Loans		—		74,562		—			74,562

Total assets measured at fair value on a nonrecurring basis	$	—	$	86,257	$	—		$	86,257

Fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon internally developed models or obtained from third parties that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include unobservable parameters. Our valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While we believe our valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.

Available- for-sale securities. As of September 30, 2012, securities classified as available for sale are reported at fair value using both Level 2 and Level 3 inputs. Included in the Level 2 total are approximately $51.0 million in Federal Agency debentures, $850.4 million in Federal Agency MBS, and $3.1 million in municipal bonds. Agency and MBS securities are predominately AAA-rated. We believe this Level 2 designation is appropriate for these securities under ASC 820-10 as, with almost all fixed income securities, none are exchange traded, and all are priced by correlation to observed market data. For these securities we obtain fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, U.S. government and agency yield curves, live trading levels, trade execution data, market consensus prepayment speeds, credit information, and the security’s terms and conditions, among other factors.

Included in the Level 3 total is a small equity traunche of a reverse mortgage security purchased on July 15, 2011. This security is Level 3 because there is no active market for this security and no observable inputs that reflect quoted prices for identical assets in active markets (Level 1) or inputs other than quoted prices that are observable for the asset through corroboration with observable market data (Level 2). In order to establish the fair value for a Level 3 asset a “mark-to-model” has been developed using the income approach described in ASC 820-10-35-32 and is similar to the methodology used to value our trading securities described below.

The amount of our investment in reverse mortgages represents the estimated value of future cash flows of the reverse mortgages at a rate deemed appropriate for these mortgages, based on the market rate for similar collateral. The projected cash flows depend on assumptions about life expectancy of the mortgagor and the future changes in collateral values. Due to the significant amount of management judgment and the unobservable input calculations, these reverse mortgages have been classified as Level 3.

Trading securities. The amount included in the trading securities category represents the fair value of a BBB-rated traunche of a reverse mortgage security. There has never been an active market for these securities. As such, we classify these trading securities as Level 3 under ASC 820-10. As prescribed by ASC 820-10 management used various observable and unobservable inputs to develop a range of likely fair value prices where this security would be exchanged in an orderly transaction between market participants at the measurement date. The unobservable inputs reflect assumptions about the assumptions market participants would use in pricing this asset. Included in these inputs were the median of a selection of other BBB-rated securities as well as quoted market prices from higher rated traunches of this asset class. The unobservable inputs consist of prepayments, house price appreciation and interest rates. We have completed a sensitivity analysis at September 30, 2012, which showed any increase or decrease in these inputs would not have a significant impact on the fair value of these assets. As a result, the value assigned to this security is determined primarily through a discounted cash flow analysis. All of these assumptions require a significant degree of management judgment.

The changes in Level 3 assets measured at fair value on a recurring basis are summarized as follows:


	Trading Securities		Reverse Mortgages			Available- for-sale Securities			Total
(In Thousands)

Balance at December 31, 2010	$	12,432	$	(686	)	$	—		$	11,746
Total net (losses) income for the period included in net income		—		(137	)		265			128
Purchases, sales, issuances, and settlements, net		—		177			2,755			2,932
Mark-to-market adjustment		—		—			916			916

Balance at December 31, 2011	$	12,432	$	(646	)		3,936		$	15,722
Total net income (losses) for the period included in net income		33		(29	)		—			4
Purchases, sales, issuances, and settlements, net		—		45			—			45
Mark-to-market adjustment		—		—			(436	)		(436	)

Balance at March 31, 2012	$	12,465	$	(630	)	$	3,500		$	15,335
Total net losses for the period included in net income		—		(47	)		—			(47	)
Purchases, sales, issuances, and settlements, net		—		45			—			45
Mark-to-market adjustment		—		—			845			845

Balance at June 30, 2012	$	12,465	$	(632	)	$	4,345		$	16,178
Total net income for the period included in net income		—		35			—			35
Purchases, sales, issuances, and settlements, net		—		45			—			45
Mark-to-market adjustment		125		—			1,705			1,830

Balance at September 30, 2012	$	12,590	$	(552	)	$	6,050		$	18,088

Other real estate owned. Other real estate owned consists of loan collateral which has been repossessed through foreclosure or other measures. Initially, foreclosed assets are recorded as held for sale at the lower of the loan balance or fair value of the collateral less estimated selling costs. Subsequent to foreclosure, valuations are updated periodically and the assets may be marked down further, reflecting a new cost basis. The fair value of our real estate owned was estimated using Level 3 inputs based on appraisals obtained from third parties.

Impaired loans. We evaluate and value impaired loans at the time the loan is identified as impaired, and the fair values of such loans are estimated using Level 3 inputs in the fair value hierarchy. The collateral for each loan has a unique appraisal and our discount of the value is based on the factors unique to each impaired loan. The significant unobservable input in determining the fair value is our subjective discount on appraisals of the collateral securing the loan, which range from 10% - 50%. Collateral may consist of real estate and/or business assets including equipment, inventory and accounts receivable. The value of these assets is determined based on appraisals by qualified licensed appraisers hired by us. Appraised and reported values may be discounted based on our historical knowledge, changes in market conditions from the time of valuation, estimated costs to sell, and/or our expertise and knowledge of the client and the client’s business.

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a net amount of $47.3 million and $75.3 million at September 30, 2012 and December 31, 2011, respectively. The valuation allowance on impaired loans was $2.9 million as of September 30, 2012 and $4.7 million as of December 31, 2011.

Due to the continuing weakness in the real estate market, we now utilize a more significant level of unobservable inputs and, as such, have reclassified the hierarchical levels of both Other Real Estate Owned and Impaired Loans to Level 3 as of March 31, 2012.

FAIR VALUE OF FINANCIAL INSTRUMENTS

The reported fair values of financial instruments are based on a variety of factors. In certain cases, fair values represent quoted market prices for identical or comparable instruments. In other cases, fair values have been estimated based on assumptions regarding the amount and timing of estimated future cash flows that are discounted to reflect current market rates and varying degrees of risk. Accordingly, fair values may not represent actual values of the financial instruments that could have been realized as of period-end or that will be realized in the future.

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and Short-Term Investments: For cash and short-term investments, including due from banks, federal funds sold, securities purchased under agreements to resell and interest-bearing deposits with other banks, the carrying amount is a reasonable estimate of fair value.

Investments and Mortgage-Backed Securities: Since quoted market prices are not available, fair value is estimated using quoted prices for similar securities, which we obtain from a third party vendor. We utilize one of the largest providers of securities pricing to the industry and we periodically assesses the inputs used by this vendor to price the various types of securities owned by us to validate the vendor’s methodology. The fair value of our investment in reverse mortgages is based on the net present value of estimated cash flows, which have been updated to reflect recent external appraisals of the underlying collateral. For additional discussion of our mortgage-backed securities-trading or our internally developed models, see Fair Value of Financial Assets, to the Consolidated Financial Statements.

Loans: Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type: commercial, commercial mortgages, construction, residential mortgages and consumer. For loans that reprice frequently, book value approximates fair value. The fair values of other types of loans are estimated by discounting expected cash flows using the current rates at which similar loans would be made to borrowers with comparable credit ratings and for similar remaining maturities. The fair value of nonperforming loans is based on recent external appraisals of the underlying collateral. Estimated cash flows, discounted using a rate commensurate with current rates and the risk associated with the estimated cash flows, are utilized if appraisals are not available. This technique does not contemplate an exit price.

Bank-Owned Life Insurance: The estimated fair value approximates the book value for this investment.

Stock in the Federal Home Loan Bank of Pittsburgh: The fair value of FHLB stock is assumed to be equal to its cost. We carry FHLB stock at cost, or par value, and evaluate FHLB stock for impairment based on the ultimate recoverability of par value rather than by recognizing temporary declines in value. As part of the impairment assessment of FHLB stock, management considers, among other things, (i) the significance and length of time of any declines in net assets of the FHLB compared to its capital stock, (ii) commitments by the FHLB to make payments required by law or regulations and the level of such payments in relation to its operating performance and (iii) the impact of legislative and regulatory changes on FHLB. The FHLB has access to the U.S. Government-Sponsored Enterprise Credit Facility, a secured lending facility that serves as a liquidity backstop, substantially reducing the likelihood that the FHLB would need to sell securities to raise liquidity and, thereby, cause the realization of large economic losses. On August 8, 2011, Standard & Poors (“S&P”) downgraded the FHLB from AAA to AA+, similar to their downgrade of the U.S. sovereign rating. The reduction in the FHLB credit rating was due to the belief, by S&P, that the FHLB system is certain to receive U.S. government support, if necessary, resulting from the important role the FHLB system plays as primary liquidity providers to U.S. mortgage and housing-market participants. Despite the downgrade, the FHLB continues to have a very high degree of government support and was in compliance with all regulatory capital requirements as of September 30, 2012. As a result, we have determined there was no OTTI related to our FHLB stock investment as of September 30, 2012.

Demand Deposits, Savings Deposits and Time Deposits: The fair value of demand deposits and savings deposits is determined by projecting future cash flows using an estimated economic life based on account characteristics. The resulting cash flow is discounted using rates available on alternative funding sources. The fair value of time deposits is estimated using the rate and maturity characteristics of the deposits to estimate their cash flow. The cash flow is discounted at rates for similar term wholesale funding.

Borrowed Funds: Rates currently available to us for debt with similar terms and remaining maturities are used to estimate fair value of existing debt.

Off-Balance Sheet Instruments: The fair value of off-balance sheet instruments, including commitments to extend credit and standby letters of credit, is estimated using the fees currently charged to enter into similar agreements with comparable remaining terms and reflects the present creditworthiness of the counterparties.

The book value and estimated fair value of our financial instruments are as follows:

Fair Value

September 30, 2012

December 31, 2011

Measurement

Book Value

Fair Value

Book Value

Fair Value

(In Thousands)

Financial assets:

Cash and cash equivalents

Level 1

447,100

468,017

Investment securities

See Footnote 7

922,645

871,794

Loans held for sale

Level 3

20,905

10,185

Loans, net

Level 3

2,656,161

2,677,467

2,702,589

2,721,804

Stock in Federal Home Loan Bank of Pittsburgh

Level 2

30,171

35,756

Accrued interest receivable

Level 2

10,292

11,743

Financial liabilities:

Deposits

Level 2

3,159,804

3,079,661

3,135,304

3,087,464

Borrowed funds

Level 2

644,823

650,389

723,620

731,522

Standby letters of credit

Level 3

257

322

Accrued interest payable

Level 2

6,335

1,910

The estimated fair value of our off-balance sheet financial instruments is as follows:


	September 30, 2012		December 31, 2011
(In Thousands)
Off-balance sheet instruments:
Commitments to extend credit	$	5,123	$	4,445