NOTE 8 – FAIR VALUE

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (an 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 value:

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 company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

When possible, the Company looks to active and observable markets to price identical assets or liabilities. When identical assets and liabilities are not traded in active markets, the Company looks to observable market data for similar assets and liabilities. However, certain assets and liabilities are not traded in observable markets and the Company must use other valuation methods to develop a fair value.

The Company used the following methods and significant assumptions to estimate the fair value of each type of financial instrument measured on a recurring basis:

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).

The carrying amounts and estimated fair values of financial instruments at September 30, 2013 were as follows:

				Fair Value Measurements at June 30, 2013 Using
	Carrying Amount			Level 1			Level 2			Level 3		Total
Financial assets
Cash and due from banks	$	75,645		$	75,645		$	-		$	-	$	75,645
Federal funds sold		855			855			-			-		855
Securities available for sale		241,294			-			241,154			140		241,294
Loans held for sale		690			-			-			690		690
Loans, net		719,869			-			-			719,549		719,549
Federal Home Loan Bank stock		4,183			n/a			n/a			n/a		n/a
Interest receivable		2,995			-			707			2,288		2,995

Financial liabilities
Deposits	$	(924,304	)	$	(586,804	)	$	(338,816	)	$	-	$	(925,620	)
Securities sold under agreements to repurchase		(14,571	)		-			(14,571	)		-		(14,571	)
Federal funds purchased		(2,219	)		-			(2,219	)		-		(2,219	)
Federal Home Loan Bank advances		(5,000	)		-			(5,000	)		-		(5,000	)
Other borrowed funds		(14,400	)		-			(14,412	)		-		(14,412
Interest payable		(412	)		(6	)		(406	)		-		(412	)

The carrying amounts and estimated fair values of financial instruments at December 31, 2012 were as follows:

				Fair Value Measurements at December 31, 2012 Using
	Carrying Amount			Level 1			Level 2			Level 3		Total
Financial assets
Cash and due from banks	$	66,009		$	66,009		$	-		$	-	$	66,009
Federal funds sold		4,236			4,236			-			-		4,236
Securities available for sale		283,975			-			283,835			140		283,975
Loans held for sale		200			-			-			200		200
Loans, net		693,137			-			-			691,519		691,519
Federal Home Loan Bank stock		4,181			n/a			n/a			n/a		n/a
Interest receivable		3,403			-			827			2,576		3,403

Financial liabilities
Deposits	$	(930,583	)	$	(577,274	)	$	(356,730	)	$	-	$	(934,004	)
Securities sold under agreements to repurchase		(26,102	)		-			(26,102	)		-		(26,102	)
Other borrowed funds		(16,049	)		-			(16,022	)		-		(16,022	)
Interest payable		(489	)		(6	)		(483	)		-		(489	)

Assets and Liabilities Measured on a Recurring Basis

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

			Fair Value Measurements at September 30, 2013 Using:
	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Available for sale
Mortgage-backed securities
U. S. agency MBS - residential	$	35,480	$	-	$	35,480	$	-
U. S. agency CMO’s - residential		190,192		-		190,192		-
Total mortgage-backed securities of government sponsored agencies		225,672		-		225,672		-
U. S. government sponsored agency securities		6,986		-		6,986		-
Obligations of states and political subdivisions		6,576		-		6,436		140
Other securities		2,060		-		2,060		-
Total available for sale	$	241,294	$	-	$	241,154	$	140

			Fair Value Measurements at December 31, 2012 Using:
	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Available for sale
Mortgage-backed securities
U. S. agency MBS - residential	$	37,100	$	-	$	37,100	$	-
U. S. agency CMO’s - residential		212,847		-		212,847		-
Total mortgage-backed securities of government sponsored agencies		249,947		-		249,947		-
U. S. government sponsored agency securities		22,244		-		22,244		-
Obligations of states and political subdivisions		7,860		-		7,720		140
Other securities		3,924		-		3,924		-
Total available for sale	$	283,975	$	-	$	283,835	$	140

Carrying amount is the estimated fair value for cash and due from banks, Federal funds sold, accrued interest receivable and payable, demand deposits, short-term debt, and variable rate loans or deposits that reprice frequently and fully. It was not practicable to determine the fair value of Federal Home Loan Bank stock due to the restrictions placed on its transferability. For fixed rate loans or deposits and for variable rate loans or deposits with infrequent repricing or repricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life and credit risk. Fair values for impaired loans are estimated using discounted cash flow analysis or underlying collateral values. Fair value of debt is based on current rates for similar financing. The fair value of commitments to extend credit and standby letters of credit is not material.

The Company used the following methods and significant assumptions to estimate the fair value of each type of financial instrument measured on a non-recurring basis:

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 appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are typically significant and unique to each property and result in a Level 3 classification of the inputs for determining fair value. Management periodically evaluates the appraised values and will discount a property’s appraised value to account for a number of factors including but not limited to the cost of liquidating the collateral, the age of the appraisal, observable deterioration since the appraisal, or other factors unique to the property. To the extent an adjusted appraised value is lower than the carrying value of an impaired loan, a specific allocation of the allowance for loan losses is assigned to the loan.

Other real estate owned (OREO): The fair value of OREO is based on appraisals less cost to sell at the date of foreclosure. 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 appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value. Management periodically evaluates the appraised values and will discount a property’s appraised value to account for a number of factors including but not limited to the cost of liquidating the collateral, the age of the appraisal, observable deterioration since the appraisal, or other factors unique to the property. To the extent an adjusted appraised value is lower than the carrying value of an OREO property, a direct charge to earnings is recorded as an OREO writedown.

Assets and Liabilities Measured on a Non-Recurring Basis

Assets and liabilities measured at fair value on a non-recurring basis at September 30, 2013 are summarized below:

			Fair Value Measurements at September 30, 2013 Using
	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Impaired loans:
Residential Real Estate	$	2,340	$	-	$	-	$	2,340
Commercial Real Estate
Owner Occupied		346		-		-		346
Non-owner Occupied		428		-		-		428
Commercial and Industrial		4,171		-		-		4,171
All Other		4,147		-		-		4,147
Total impaired loans		11,432	$	-	$	-	$	11,432

Other real estate owned:
Commercial Real Estate
Non-owner Occupied		490		-		-		490
All Other		7,752		-		-		7,752
Total OREO	$	8,242	$	-	$	-	$	8,242

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $15,228,000 at September 30, 2013 with a valuation allowance of $3,796,000 and a carrying amount of $20,285,000 at December 31, 2012 with a valuation allowance of $3,842,000, resulting in a provision for loan losses of $187,000 for the nine months ended September 30, 2013, compared to a $370,000 provision for loan losses for the nine months ended September 30, 2012; and a negative $296,000 provision for loan losses for the three months ended September 30, 2013, compared to a $369,000 provision for loan losses for the three months ended September 30, 2012. The detail of impaired loans by loan class is contained in Note 3 above.

Other real estate owned measured at fair value less costs to sell, had a net carrying amount of $8,242,000 which is made up of the outstanding balance of $9,837,000 net of a valuation allowance of $1,595,000 at September 30, 2013. There were no additional write downs during the nine months ended September 30, 2013, compared to $85,000 of additional write downs during the nine months ended September 30, 2012. There were no additional write downs during the three months ended September 30, 2013 or September 30, 2012. At December 31, 2012, other real estate owned had a net carrying amount of $7,968,000, made up of the outstanding balance of $9,945,000, net of a valuation allowance of $1,977,000.

The significant unobservable inputs related to assets and liabilities measured at fair value on a non-recurring basis at September 30, 2013 are summarized below:

	September 30, 2013		Valuation Techniques	Unobservable Inputs	Range (Weighted Avg)
Impaired loans:
Residential Real Estate	$	2,340	sales comparison	adjustment for differences between the comparable sales		0.8%-87.9%(11.8%)
Commercial Real Estate
Owner Occupied		346	sales comparison	adjustment for limited salability of specialized property		62.5%-70.0%(64.0%)
Non-owner Occupied		428	sales comparison	adjustment for limited salability of specialized property		50.5%-50.5%(50.5%)
Commercial and Industrial		4,171	sales comparison	adjustment for limited salability of specialized property		0.0%-82.5%(58.5%)
All Other		4,147	sales comparison	adjustment for percentage of completion of construction		10.0%-99.3%(65.1%)
Total impaired loans		11,432

Other real estate owned:
Commercial Real Estate
Non-owner Occupied		490	sales comparison	adjustment for differences between the comparable sales		1.9%-1.9%(1.9%)
All Other		7,752	sales comparison	adjustment for estimated realizable value		4.7%-9.5%(8.2%)
Total OREO	$	8,242

Assets and liabilities measured at fair value on a non-recurring basis at December 31, 2012 are summarized below:

			Fair Value Measurements at December 31, 2012 Using
	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Impaired loans:
Residential Real Estate	$	2,739	$	-	$	-	$	2,739
Commercial Real Estate
Owner Occupied		512		-		-		512
Non-owner Occupied		427		-		-		427
Commercial and Industrial		8,300		-		-		8,300
All Other		4,465		-		-		4,465
Total impaired loans		16,443	$	-	$	-	$	16,443

Other real estate owned:
Residential Real Estate	$	255	$	-	$	-	$	255
Commercial Real Estate
Owner Occupied		250		-		-		250
Non-owner Occupied		1,031		-		-		1,031
All Other		6,432		-		-		6,432
Total OREO	$	7,968	$	-	$	-	$	7,968

The significant unobservable inputs related to assets and liabilities measured at fair value on a non-recurring basis at December 31, 2012 are summarized below:

	December 31, 2012		Valuation Techniques	Unobservable Inputs	Range (Weighted Avg)
Impaired loans:
Residential Real Estate	$	2,739	sales comparison	adjustment for differences between the comparable sales		0.8%-76.8%(10.5%)
Commercial Real Estate
Owner Occupied		512	sales comparison	adjustment for limited salability of specialized property		40.0%-70.0%(44.1%)
Non-owner Occupied		427	sales comparison	adjustment for limited salability of specialized property		59.0%-59.0%(59.0%)
Commercial and Industrial		8,300	sales comparison	adjustment for limited salability of specialized property		0.0%-70.0%(44.3%)
All Other		4,465	sales comparison	adjustment for percentage of completion of construction		64.0%-91.4%(64.8%)
Total impaired loans		16,443

Other real estate owned:
Residential Real Estate	$	255	sales comparison	adjustment for differences between the comparable sales		0.0%-62.3%(44.1%)
Commercial Real Estate
Owner Occupied		250	sales comparison	adjustment for estimated realizable value		0.0%-17.9%(7.2%)
Non-owner Occupied		1,031	sales comparison	adjustment for differences between the comparable sales		82.7%-82.7%(82.7%)
All Other		6,432	sales comparison	adjustment for estimated realizable value		4.7%-16.6%(12.7%)
Total OREO	$	7,968