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.

Available-for-sale securities: For securities where quoted prices are not available, fair values are calculated on market prices of similar securities or 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).

Impaired Loans:At the time a loan is considered impaired, it is valued at the lower of cost or fair value. Impaired loans carried at fair value generally receive specific allocations of the allowance for loan losses. For collateral dependent loans, fair value is commonly 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. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Once a loan is considered impaired, it is evaluated by a member of the Credit Department on at least a quarterly basis for additional impairment and adjusted accordingly.

Other Real Estate Owned: Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly 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.

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 us. Once received, a member of the Credit Department reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with via independent data sources such as recent market data or industry-wide statistics.

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 transfers between Level 1 and Level 2 during the periods presented.

			Quoted Prices in
			Active Markets for		Significant Other		Significant
	June 30,		Identical Assets		Observable Inputs		Unobservable Inputs
(Dollars in thousands)	2013		(Level 1)		(Level 2)		(Level 3)

Assets:
Government-sponsored mortgage-backed residential	$	129,346	$	-	$	129,346	$	-
Government-sponsored collateralized mortgage obligations		82,937		-		82,937		-
Asset backed-collateralized loan obligations		24,415		-		24,415		-
State and municipal		15,222		-		15,222		-
Corporate bonds		57,212		-		57,212		-

Total	$	309,132	$	-	$	309,132	$	-

			Quoted Prices in
			Active Markets for		Significant Other		Significant
	December 31,		Identical Assets		Observable Inputs		Unobservable Inputs
(Dollars in thousands)	2012		(Level 1)		(Level 2)		(Level 3)

Assets:
U.S. Treasury and agencies	$	8,278	$	-	$	8,278	$	-
Government-sponsored mortgage-backed residential		144,889		-		144,889		-
Government-sponsored collateralized mortgage obligations		150,147		-		150,147		-
Private asset backed		5,132		-		5,132		-
State and municipal		12,718		-		12,718		-
Corporate bonds		32,967		-		32,967		-

Total	$	354,131	$	-	$	354,131	$	-

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 a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the periods ended June 30, 2012. The level 3 assets consist of trust preferred securities which were called or sold in the fourth quarter of 2012. We did not have any Level 3 assets measured at fair value on a recurring basis at June 30, 2013.

	Fair Value Measurements		Fair Value Measurements
	Using Significant		Using Significant
	Unobservable Inputs		Unobservable Inputs
	(Level 3)		(Level 3)
	Three Months Ended		Six Months Ended
	June 30,		June 30,
(Dollars in thousands)	2012		2012

Beginning balance	$	268	$	264
Total gains or losses:
Impairment charges on securities		-		-
Included in other comprehensive income		(2)		2
Purchases		-		-
Sales or calls		-		-
Settlements		-		-
Transfers in and/or out of Level 3		-		-
Ending balance	$	266	$	266

There were no changes in unrealized gains and losses recorded in earnings for the quarter and six months ended June 30, 2013 for Level 3 assets and liabilities that are still held at June 30, 2013.

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
	June 30,		Identical Assets		Observable Inputs		Unobservable Inputs
(Dollars in thousands)	2013		(Level 1)		(Level 2)		(Level 3)

Assets:
Impaired loans:
Commercial	$	1	$	-	$	-	$	1
Commercial Real Estate:
Land Development		1,969		-		-		1,969
Other		14,508		-		-		14,508
Residential Mortgage		446		-		-		446
Consumer and Home Equity		188		-		-		188
Real estate acquired through foreclosure:
Commercial Real Estate:
Land Development		980		-		-		980
Other		5,672		-		-		5,672

			Quoted Prices in
			Active Markets for		Significant Other		Significant
	December 31,		Identical Assets		Observable Inputs		Unobservable Inputs
(Dollars in thousands)	2012		(Level 1)		(Level 2)		(Level 3)

Assets:
Impaired loans:
Commercial	$	231	$	-	$	-	$	231
Commercial Real Estate:
Land Development		1,775		-		-		1,775
Other		12,560		-		-		12,560
Residential Mortgage		127		-		-		127
Consumer and Home Equity		137		-		-		137
Real estate acquired through foreclosure:
Commercial Real Estate:
Land Development		2,459		-		-		2,459
Building Lots		2,220		-		-		2,220
Other		8,350		-		-		8,350
Residential Mortgage		224		-		-		224

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $24.2 million, with a valuation allowance of $7.1 million, resulting in an additional provision for loan losses of $737,000 and a reversal of provision for loan losses of $342,000 and for the quarter and six months ended June 30, 2013. Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $22.8 million, with a valuation allowance of $5.5 million, resulting in an additional provision for loan losses of $1.4 million and $1.7 million for the three and six months ended June 30, 2012. Values for 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 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 investors 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. Many of the appraisals utilize an income approach, such as the discounted cash flow method, to estimate future income and profits or cash flows. Appraisals may also utilize a single valuation approach or a combination of approaches including a market comparison approach, where prices and other relevant information generated by market transactions involving identical or comparable properties are used to determine fair value. The fair value may be subsequently reduced if the estimated fair value declines below the original appraised value. Fair value adjustments of $400,000 and $1.5 million were made to real estate owned during the quarter and six months ended June 30, 2013. Fair value adjustments of $1.9 million and $3.5 million were made to real estate owned during the quarter and six months ended June 30, 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 June 30, 2013.

	Fair		Valuation	Unobservable	Range (Weighted
(Dollars in thousands)	Value		Technique(s)	Input(s)	Average)

Impaired loans:
Commercial	$	1	Market value approach	Adjustment for receivables and inventory discounts	0.00% (1)
Commercial Real Estate:
Land Development		1,301	Income approach	Discount or capitalization rate	25.00% (1)
		668	Sales comparison approach	Adjustment for differences between comparable sales	3.39% (1)

Other		13,264	Income approach	Discount or capitalization rate	8.50%-11.00% (9.19%)
		1,244	Sales comparison approach	Adjustment for differences between comparable sales	10.00%-21.87% (19.69%)

Residential Mortgage		446	Sales comparison approach	Adjustment for differences between comparable sales	0.00%-3.87% (1.06%)

Consumer and Home Equity		188	Sales comparison approach	Adjustment for differences between comparable sales	0.00%-2.25% (1.82%)

Real estate acquired through foreclosure:
Commercial Real Estate:
Land Development		312	Income approach	Discount or capitalization rate	8.50%-17.50% (11.24%)
		668	Sales comparison approach	Adjustment for differences between comparable sales	25.00% (1)

Other		5,006	Income approach	Discount or capitalization rate	8.50%-10.50% (8.91%)
		666	Sales comparison approach	Adjustment for differences between comparable sales	2.75%-9.00% (4.26%)

(1) Unobservable inputs with a single discount listed include only one property.

Fair Value of Financial Instruments

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

					June 30, 2013
(Dollars in thousands)	Carrying				Fair Value Measurements
	Value		Total		Level 1		Level 2		Level 3
Financial assets:
Cash and due from banks	$	27,925	$	27,925	$	6,069	$	21,856	$	-
Mortgage loans held for sale		3,595		3,654		-		3,654		-
Loans, net		457,527		460,246		-		-		460,246
Accrued interest receivable		2,390		2,390		-		-		2,390
FHLB stock		4,430		N/A		N/A		N/A		N/A

Financial liabilities:
Deposits		798,377		760,870		-		760,870		-
Advances from Federal Home Loan Bank		22,526		23,249		-		23,249		-
Subordinated debentures		18,000		12,222		-		-		12,222
Accrued interest payable		3,798		3,798		-		3,798		-

					December 31, 2012
(Dollars in thousands)	Carrying				Fair Value Measurements
	Value		Total		Level 1		Level 2		Level 3
Financial assets:
Cash and due from banks	$	63,103	$	63,103	$	6,468	$	56,635	$	-
Mortgage loans held for sale		3,887		3,967		-		3,967		-
Loans, net		492,740		493,998		-		-		493,998
Accrued interest receivable		2,690		2,690		-		-		2,690
FHLB stock		4,805		N/A		N/A		N/A		N/A

Financial liabilities:
Deposits		922,620		934,637		-		934,637		-
Advances from Federal Home Loan Bank		12,596		13,944		-		13,944		-
Subordinated debentures		18,000		12,695		-		-		12,695
Accrued interest payable		3,121		3,121		-		3,121		-

The methods and assumptions, not previously presented, used to estimate fair values are described below:

(a) Cash and due from banks

The carrying amount of cash on hand approximates fair value and is classified as a Level 1. The carrying amount of cash due from bank accounts is classified as a Level 2.

(b) Mortgage loans held for sale

The fair value of mortgage loans held for sale is estimated based upon the binding contracts and quotes from third party investors resulting in a Level 2 classification.

(c) Loans, net

Fair values of loans 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 at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

(d) FHLB Stock

It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.

(e) Deposits

The carrying amounts of variable rate interest bearing deposits approximate their fair values at the reporting date resulting in a Level 2 classification. Fair values for fixed rate interest bearing 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.

(f) Advances from Federal Home Loan Bank

The fair value of the FHLB advances is obtained from the FHLB and is calculated by discounting contractual cash flow using an estimated interest rate based on the current rates available to us for debt of similar remaining maturities and collateral terms resulting in a Level 2 classification.

(g) Subordinated debentures

The fair value for subordinated debentures is calculated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 3 classification.

(h) 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.

(i) Off-balance Sheet Instruments

Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The fair value of commitments is not material.