FAIR VALUE

9 Months Ended

Sep. 30, 2011

FAIR VALUE

9. FAIR VALUE

U.S. GAAP 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 and establishes a fair value hierarchy that prioritizes the use of inputs used in valuation methodologies into the following three levels:

Level 1: 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: 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.

We used the following methods and significant assumptions to estimate the fair value of available-for-sale-securities.

Securities: The fair values of some equity securities are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs).  The fair values of most debt securities are determined by a matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs).  In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy.  For trust preferred securities, discounted cash flows are calculated using spread to swap and LIBOR curves that are updated to incorporate loss severities, volatility, credit spread and optionality.  Rating agency and industry research reports as well as defaults and deferrals on individual securities are reviewed and incorporated into the calculations.  For other equity securities, discounted cash flows are calculated with available market information through processes using benchmark yields, market spreads sourced from new issues, dealer quotes and trade prices among other sources.  Equity securities are carried at cost which approximates fair value.

Impaired Loans:  The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals.  These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach.  Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available.  Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

 

Other Real Estate Owned:  Nonrecurring adjustments to certain commercial and residential real estate properties classified as other real estate owned are measured at fair value, less costs to sell.  Fair values are based on recent real estate appraisals.  These appraisals may use a single valuation approach or a combination of approaches including comparable sales and the income approach.  Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available.  Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

Assets measured at fair value on a recurring basis are summarized below:  There were no significant transfers between Level 1 and Level 2 during the periods presented.

			Quoted Prices in
			Active Markets for		Significant Other		Significant
	September 30,		Identical Assets		Observable Inputs		Unobservable Inputs
(Dollars in thousands)	2011		(Level 1)		(Level 2)		(Level 3)
Assets:
U.S. Treasury and agencies	$	52,076	$	-	$	52,076	$	-
Government-sponsored mortgage-backed residential		255,764		-		255,764		-
Equity		293		2		-		291
State and municipal		23,851		-		23,851		-
Trust preferred securities		373		-		-		373
Total	$	332,357	$	2	$	331,691	$	664

			Quoted Prices in
			Active Markets for		Significant Other		Significant
	December 31,		Identical Assets		Observable Inputs		Unobservable Inputs
(Dollars in thousands)	2010		(Level 1)		(Level 2)		(Level 3)
Assets:
U.S. Treasury and agencies	$	113,893	$	-	$	113,893	$	-
Government-sponsored mortgage-backed residential		59,170		-		59,170		-
Equity		293		2		-		291
State and municipal		22,618		-		22,618		-
Trust preferred securities		55		-		-		55
Total	$	196,029	$	2	$	195,681	$	346

Between June 2002 and July 2006, we invested in four available-for-sale and one held-to-maturity investment grade tranches of trust preferred collateralized debt obligation (“CDO”) securities.  The securities were issued and are referred to as Preferred Term Securities Limited (“PreTSL”).  The underlying collateral for the PreTSL is unguaranteed pooled trust preferred securities issued by banks, insurance companies and REITs geographically dispersed across the United States.  We hold five PreTSL securities, none of which are currently investment grade.  Prior to September 30, 2008, we determined the fair value of the trust preferred securities using a valuation technique based on Level 2 inputs.  The Level 2 inputs included estimates of the market value for each security provided through our investment broker.

Since late 2007, the markets for collateralized debt obligations and trust preferred securities have become increasingly inactive.  The inactivity began in late 2007 when new issues of similar securities were discounted in order to complete the offering.  Beginning in the second quarter of 2008, the purchase and sale activity of these securities substantially decreased as investors elected to hold the

 

securities instead of selling them at substantially depressed prices.  Our brokers have indicated that little if any activity is occurring in this sector and that the PreTSL securities trades that are taking place are primarily distressed sales where the seller must liquidate as a result of insolvency, redemptions or closure of a fund holding the security, or other distressed conditions.  As a result, the bid-ask spreads have widened significantly and the volume of trades decreased significantly compared to historical volumes.

During 2008, we concluded that the market for the trust preferred securities that we hold and for similar CDO securities (such as higher-rated tranches within the same CDO security) was also not active.  That determination was made considering that there are few observable transactions for the trust preferred securities or similar CDO securities and the observable prices for those transactions have varied substantially over time.  Consequently, we have considered those observable inputs and determined that our trust preferred securities are classified within Level 3 of the fair value hierarchy.

We have determined that an income approach valuation technique (using cash flows and present value techniques) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs is equally or more representative of fair value than relying on the estimation of market value technique used at prior measurement dates, which now has few observable inputs and relies on an inactive market with distressed sales conditions that would require significant adjustments.  

We received valuation estimates on our trust preferred securities for September 30, 2011.  Those valuation estimates were based on proprietary pricing models utilizing significant unobservable inputs in an inactive market with distressed sales, Level 3 inputs, rather than actual transactions in an active market.  In accordance with current accounting guidance, we determined that a risk-adjusted discount rate appropriately reflects the reporting entity’s estimate of the assumptions that market participants would use in an active market to estimate the selling price of the asset at the measurement date.  

We conduct a thorough review of fair value hierarchy classifications on a quarterly basis.  Reclassification of certain financial instruments may occur when input observability changes.

The table below presents reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the periods ended September 30, 2011 and 2010:

	Fair Value Measurements						Fair Value Measurements
	Using Significant						Using Significant
	Unobservable Inputs						Unobservable Inputs
	(Level 3)						(Level 3)
	Three Months Ended						Nine Months Ended
	September 30,						September 30,
(Dollars in thousands)	2011			2010			2011			2010
Beginning balance	$	668		$	334		$	346		$	340
Total gains or losses:
Impairment charges on securities		(58	)		(649	)		(83	)		(782	)
Included in other comprehensive income		54			667			401			794
Transfers in and/or out of Level 3		-			-			-			-
Ending balance	$	664		$	352		$	664		$	352

 

The table below summarizes changes in unrealized gains and losses recorded in earnings for the quarter and nine months ended September 30 for Level 3 assets and liabilities that are still held at September 30.

	Changes in Unrealized Gains/Losses				Changes in Unrealized Gains/Losses
	Relating to Assets Still Held at Reporting				Relating to Assets Still Held at Reporting
	Date for the Three Months Ended				Date for the Nine Months Ended
	September 30,				September 30,
(Dollars in thousands)	2011		2010		2011		2010
Interest income on securities	$	-	$	-	$	-	$	-
Other changes in fair value		58		649		83		782
Total	$	58	$	649	$	83	$	782

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

Assets measured at fair value on a nonrecurring basis are summarized below:

			Quoted Prices in
			Active Markets for		Significant Other		Significant
	September 30,		Identical Assets		Observable Inputs		Unobservable Inputs
(Dollars in thousands)	2011		(Level 1)		(Level 2)		(Level 3)
Assets:
Impaired loans:
Commercial	$	3,273	$	-	$	-	$	3,273
Commercial Real Estate:
Land Development		11,396		-		-		11,396
Building Lots		1,517		-		-		1,517
Other		36,430		-		-		36,430
Real Estate Construction		-		-		-		-
Residential Mortgage		4,127		-		-		4,127
Consumer and Home Equity		833		-		-		833
Indirect Consumer		260		-		-		260
Real estate acquired through foreclosure:
Commercial		959		-		-		959
Commercial Real Estate:
Land Development		2,684		-		-		2,684
Building Lots		5,575		-		-		5,575
Other		6,881		-		-		6,881
Residential Mortgage		221		-		-		221
Trust preferred security held-to-maturity		23		-		-		23

			Quoted Prices in
			Active Markets for		Significant Other		Significant
	December 31,		Identical Assets		Observable Inputs		Unobservable Inputs
(Dollars in thousands)	2010		(Level 1)		(Level 2)		(Level 3)
Assets:
Impaired loans:
Commercial	$	1,092	$	-	$	-	$	1,092
Commercial Real Estate:
Land Development		18,333		-		-		18,333
Building Lots		3,391		-		-		3,391
Other		49,505		-		-		49,505
Real Estate Construction		1,057		-		-		1,057
Residential Mortgage		4,821		-		-		4,821
Consumer and Home Equity		824		-		-		824
Indirect Consumer		171		-		-		171
Real estate acquired through foreclosure
Commercial		1,103		-		-		1,103
Commercial Real Estate:
Land Development		2,190		-		-		2,190
Building Lots		1,483		-		-		1,482
Other		3,375		-		-		3,375
Residential Mortgage		428		-		-		428
Trust preferred security held-to-maturity		22		-		-		22

 

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $61.0 million, with a valuation allowance of $3.2 million, resulting in an additional provision for loan losses of $4.1 million and $12.8 million for the three and nine month periods ended September 30, 2011.  Values for collateral dependent loans are generally based on appraisals obtained from licensed real estate appraisals 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 on the estimated cost to replace the current property after considering adjustments for depreciation.  Values of the market comparison approach evaluate the sales price of similar properties in the same market area.  The income approach considers net operating income generated by the property and an investor’s required return.  The final value is a reconciliation of these three approaches and takes into consideration any other factors management deems relevant to arrive at a representative fair value.

Real estate owned acquired through foreclosure is recorded at fair value less estimated selling costs at the date of foreclosure.  Fair value is based on the appraised market value of the property based on sales of similar assets.  The fair value may be subsequently reduced if the estimated fair value declines below the original appraised value.  Fair value adjustments of $3.3 million and $7.9 million were made to real estate owned during the quarter and nine months ended September 30, 2011.  Fair value adjustments of $363,000 and $751,000 were made to real estate owned during the quarter and nine months ended September 30, 2010.

Our held-to-maturity trust preferred security is valued using an income approach valuation technique (using cash flows and present value techniques) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs. The income approach is equally or more representative of fair value than relying on the estimation of market value technique used at prior measurement dates, which now has few observable inputs and relies on an inactive market with distressed sales conditions that would require significant adjustments.  

We received a valuation estimate on our trust preferred security for September 30, 2011.  The valuation estimate was based on proprietary pricing models utilizing significant unobservable inputs in an inactive market with distressed sales, Level 3 inputs, rather than actual transactions in an active market.  

      Fair Value of Financial Instruments

The estimated fair value of financial instruments not previously presented is as follows:

(Dollars in thousands)	September 30, 2011				December 31, 2010
	Carrying		Fair		Carrying		Fair
	Value		Value		Value		Value
Financial assets:
Cash and due from banks	$	33,948	$	33,948	$	166,176	$	166,176
Securities held-to-maturity		-		-		102		104
Loans held for sale		7,367		7,466		6,388		6,472
Loans, net		691,858		705,253		782,672		792,486
Accrued interest receivable		3,268		3,268		3,807		3,807
FHLB stock		4,805		N/A		4,909		N/A
Financial liabilities:
Deposits		1,108,400		1,122,077		1,173,908		1,163,654
Advances from Federal Home Loan Bank		27,770		31,068		52,532		55,190
Subordinated debentures		18,000		12,743		18,000		12,743
Accrued interest payable		1,476		1,476		594		594

 

The methods and assumptions used in estimating fair value disclosures for financial instruments are presented below:

Carrying amount is the estimated fair value for cash and cash equivalents, interest bearing deposits, accrued interest receivable and payable, demand deposits, short-term debt and variable rate loans or deposits that re-price frequently and fully.  Held-to-maturity securities fair values are based on market prices or dealer quotes and if no such information is available, on the rate and term of the security and information about the issuer.  The value of loans held for sale is based on the underlying sale commitments.  For fixed rate loans or deposits and for variable rate loans or deposits with infrequent re-pricing or re-pricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life.  Fair values of advances from Federal Home Loan Bank and subordinated debentures are based on current rates for similar financing.  The fair value of off-balance-sheet items is based on the current fees or cost that would be charged to enter into or terminate such arrangements and is not material.  It is not practicable to determine the fair value of FHLB stock due to restrictions placed on its transferability.