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.

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 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, 2014 were as follows:

				Fair Value Measurements at September 30, 2014 Using
	Carrying Amount			Level 1			Level 2			Level 3			Total
Financial assets
Cash and due from banks	$	74,040		$	74,040		$	-		$	-		$	74,040
Federal funds sold		7,877			7,877			-			-			7,877
Securities available for sale		253,559			-			253,419			140			253,559
Loans held for sale		395			-			-			395			395
Loans, net		844,214			-			-			845,396			845,396
Federal Home Loan Bank stock		3,895			n/	a		n/	a		n/	a		n/	a
Interest receivable		3,342			-			822			2,520			3,342

Financial liabilities
Deposits	$	(1,076,996	)	$	(703,039	)	$	(373,551	)	$	-		$	(1,076,590	)
Securities sold under agreements to repurchase		(13,155	)		-			(13,155	)		-			(13,155	)
FHLB advances		(5,000	)		(5,000	)		-			-			(5,000	)
Other borrowed funds		(12,330	)		-			(12,373	)		-			(12,373	)
Interest payable		(443	)		(6	)		(437	)		-			(443	)

The carrying amounts and estimated fair values of financial instruments at December 31, 2013 were as follows:

				Fair Value Measurements at December 31, 2013 Using
	Carrying Amount			Level 1			Level 2			Level 3			Total
Financial assets
Cash and due from banks	$	63,984		$	63,984		$	-		$	-		$	63,984
Federal funds sold		12,777			12,777			-			-			12,777
Securities available for sale		218,066			-			217,926			140			218,066
Loans held for sale		77			-			-			77			77
Loans, net		729,743			-			-			725,588			725,588
Federal Home Loan Bank stock		4,183			n/	a		n/	a		n/	a		n/	a
Interest receivable		3,132			-			593			2,539			3,132

Financial liabilities
Deposits	$	(924,023	)	$	(592,664	)	$	(332,475	)	$	-		$	(925,139	)
Securities sold under agreements to repurchase		(11,319	)		-			(11,319	)		-			(11,319	)
Other borrowed funds		(13,800	)		-			(13,811	)		-			(13,811	)
Interest payable		(383	)		(5	)		(378	)		-			(383	)

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, 2014 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	$	54,855	$	-	$	54,855	$	-
U. S. agency CMO’s - residential		152,800		-		152,800		-
Total mortgage-backed securities of government sponsored agencies		207,655		-		207,655		-
U. S. government sponsored agency securities		34,836		-		34,836		-
Obligations of states and political subdivisions		11,068		-		10,928		140
Total available for sale	$	253,559	$	-	$	253,419	$	140

			Fair Value Measurements at December 31, 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	$	27,823	$	-	$	27,823	$	-
U. S. agency CMO’s		176,722		-		176,722		-
Total mortgage-backed securities of government sponsored agencies		204,545		-		204,545		-
U. S. government sponsored agency securities		6,981		-		6,981		-
Obligations of states and political subdivisions		6,540		-		6,400		140
Total securities available for sale	$	218,066	$	-	$	217,926	$	140
Mortgage-backed securities

There were no transfers between Level 1 and Level 2 during 2014 or 2013.

Assets and Liabilities Measured on a Non-Recurring Basis

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 at fair value on a non-recurring basis at September 30, 2014 are summarized below:

			Fair Value Measurements at September 30, 2014 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:
Multifamily residential	$	332	$	-	$	-	$	332
Commercial real estate
Owner occupied		390		-		-		390
Non-owner occupied		588		-		-		588
Commercial and industrial		689		-		-		689
All other		4,218		-		-		4,218
Total impaired loans		6,217	$	-	$	-	$	6,217

Other real estate owned:
Commercial real estate
Non-owner occupied	$	2,003		-		-	$	2,003
All other		8,353		-		-		8,353
Total OREO	$	10,356	$	-	$	-	$	10,356

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $6,217,000 at September 30, 2014 made up of an outstanding balance of $7,745,000, net of a valuation allowance of $1,528,000. At December 31, 2013, impaired loans had a carrying amount of $9,808,000, made up of an outstanding balance of $12,300,000, net of a valuation allowance of $2,492,000. The change resulted in a negative provision for loan losses of $473,000 for the nine months ended September 30, 2014, compared to a $187,000 provision for loan losses for the nine months ended September 30, 2013; and an additional $413,000 provision for loan losses for the three months ended September 30, 2014, compared to a negative $296,000 provision for loan losses for the three months ended September 30, 2013. 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 $10,356,000 which is made up of the outstanding balance of $12,788,000 net of a valuation allowance of $2,432,000 at September 30, 2014. There were $380,000 of additional write downs during the nine months ended September 30, 2014, compared to no additional write downs during the nine months ended September 30, 2013. For the three months ended September 30, 2014 there were $100,000 of additional write downs compared to no additional write downs during the three months ended September 30, 2013. At December 31, 2013, other real estate owned had a net carrying amount of $8,786,000, made up of the outstanding balance of $11,163,000, net of a valuation allowance of $2,377,000.

The significant unobservable inputs related to assets and liabilities measured at fair value on a non-recurring basis at September 30, 2014 are summarized below:

	September 30, 2014		Valuation Techniques	Unobservable Inputs	Range (Weighted Avg)
Impaired loans:
Multifamily residential	$	332	sales comparison	adjustment for differences between the comparable sales		36.8%-36.8% (36.8	%)
Commercial real estate
Owner occupied		390	sales comparison	adjustment for limited salability of specialized property		44.8%-72.4% (64.4	%)
Non-owner occupied		588	sales comparison	adjustment for differences between the comparable sales		16.9%-16.9% (16.9	%)
Commercial and industrial		689	sales comparison	adjustment for limited salability of specialized property		8.0%-41.2% (26.5	%)
All other		4,218	sales comparison	adjustment for percentage of completion of construction		56.8%-56.8% (56.8	%)
Total impaired loans		6,217

Other real estate owned:
Commercial real estate
Non-owner occupied	$	2,003	sales comparison	adjustment for differences between the comparable sales		29.6%-29.6% (29.6	%)
All other		8,353	sales comparison	adjustment for estimated realizable value		24.6%-50.2% (45.0	%)
Total OREO	$	10,356

Assets and liabilities measured at fair value on a non-recurring basis at December 31, 2013 are summarized below:

			Fair Value Measurements at December 31, 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	$	1,518	$	-	$	-	$	1,518
Commercial real estate
Owner occupied		345		-		-		345
Non-owner occupied		428		-		-		428
Commercial and industrial		3,384		-		-		3,384
All other		4,133		-		-		4,133
Total impaired loans		9,808	$	-	$	-	$	9,808

Other real estate owned:
Commercial real estate
Non-owner occupied		290		-		-		290
All other		8,496		-		-		8,496
Total OREO	$	8,786	$	-	$	-	$	8,786

The significant unobservable inputs related to assets and liabilities measured at fair value on a non-recurring basis at December 31, 2013 are summarized below:

	December 31, 2013		Valuation Techniques	Unobservable Inputs	Range (Weighted Avg)
Impaired loans:
Residential real estate	$	1,518	sales comparison	adjustment for differences between the comparable sales		0.8%-63.5% (11.9	%)
Commercial real estate
Owner occupied		345	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		50.6%-50.6% (50.6	%)
Commercial and industrial		3,384	sales comparison	adjustment for limited salability of specialized property		25.0%-65.5% (57.8	%)
All other		4,133	sales comparison	adjustment for percentage of completion of construction		57.6%-99.3% (57.7	%)
Total impaired loans		9,808

Other real estate owned:
Commercial real estate
Non-owner occupied		290	sales comparison	adjustment for differences between the comparable sales		42.7%-42.7% (42.7	%)
All other		8,496	sales comparison	adjustment for estimated realizable value		9.5%-24.6% (12.5	%)
Total OREO	$	8,786