Note 10.

Fair Value Measurements

The Company adopted ASC 820, Fair Value Measurements, on January 1, 2008 to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. ASC 820 clarifies that fair value of certain assets and liabilities is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.

ASC 820 specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company's market assumptions. The three levels of the fair value hierarchy under ASC 820 based on these two types of inputs are as follows:

Level I:

Quoted prices are available in active markets for identical assets or liabilities as of the reported date.

Level II:

Pricing inputs are other than the quoted prices in active markets, which are either directly or indirectly observable as of the reported date. The nature of these assets and liabilities includes items for which quoted prices are available but traded less frequently and items that are fair-valued using other financial instruments, the parameters of which can be directly observed.

Level III:

Assets and liabilities that have little to no pricing observability as of the reported date. These items do not have two-way markets and are measured using management's best estimate of fair value, where the inputs into the determination of fair value require significant management judgment or estimation.

Measured on recurring basis

The following describes the valuation techniques used by the Company to measure certain financial assets and liabilities recorded at fair value on a recurring basis in the consolidated financial statements:

Securities available for sale

Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level I). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level II).

Derivatives

Derivatives are recorded at fair value on a recurring basis. Third party vendors compile prices from various sources and may determine the fair value of identical or similar instruments by using pricing models that consider observable market data (Level II).

The following tables present the balances of financial assets and liabilities measured at fair value on a recurring basis as of September 30, 2011 and December 31, 2010.

	September 30, 2011 (In thousands)
	Total		Level I		Level II		Level III

Assets:
U.S. government agency
securities	$	7,524	$	-	$	7,524	$	-
Obligations of states and
political subdivision		65,404		-		65,404		-
Mortgage-backed securities:
Agency		190,283		-		190,283		-
Non-agency		29,278		-		29,278		-
Corporate preferred stock		37		-		37		-
Corporate securities		10,239		-		10,239		-
Trust preferred securities		249		-		249		-
Liabilities:
Derivative financial instruments	$	284	$	-	$	284		-

	December 31, 2010 (In thousands)
	Total		Level I		Level II		Level III

Assets:
U.S. government agency
securities	$	4,649	$	-	$	4,649	$	-
Obligations of states and
political subdivision		59,140		-		59,140		-
Mortgage-backed securities:
Agency		152,304		-		152,304		-
Non-agency		26,081		-		26,081		-
Corporate preferred stock		13		-		13		-
Corporate securities		9,532		-		9,532		-
Trust preferred securities		323		-		323		-
Derivative financial instruments		312		-		312		-

There were no assets measured at fair value on a recurring basis using significant unobservable inputs (Level III) for the nine months ended September 30, 2011. Additionally, there were no changes in unrealized gains and losses recorded in earnings for the periods ended September 30, 2011 or December 31, 2010 for Level III assets that were still held at September 30, 2011 and December 31, 2010.

Measured on nonrecurring basis

Certain financial assets and certain financial liabilities are measured at fair value on a nonrecurring basis; that is, the instruments are not measured at fair value on a recurring basis but are subject to fair value adjustments in certain circumstances. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or impairment of individual assets.

The following describes the valuation techniques used by the Company to measure certain financial assets recorded at fair value on a nonrecurring basis in the consolidated financial statements:

Loans Held for Sale

Loans held for sale are carried at the lower of cost or market value. These loans currently consist of one-to-four-family residential loans originated for sale in the secondary market. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data which is not materially different than cost due to the short duration between origination and sale (Level II). As such, the Company records any fair value adjustments on a nonrecurring basis. No nonrecurring fair value adjustments were recorded on loans held for sale during the nine or three months ended September 30, 2011. Gains and losses on the sale of loans are recorded within income from mortgage banking on the consolidated statements of operations.

Impaired Loans

Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. The measurement of loss associated with impaired loans can be based on the present value of expected future cash flows discounted at the loan's effective interest rate, the observable market price of the loan, or the fair value of the underlying collateral. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the collateral is real estate. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser using observable market data (Level II). However, if the collateral is a house or building in the process of construction or if an appraisal of the real estate property is over two years old, then the fair value is considered Level III. As of September 30, 2011, four impaired loans with a net balance of $463,000 were categorized as having a Level III valuation due to the date of the last appraisal. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business' financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivable collateral are based on financial statement balances or aging reports (Level III). Impaired loans allocated to the Allowance for Loan Losses are measured at fair value on a nonrecurring basis. Impaired loans for which no further loss is expected are not considered to be measured at fair value on a nonrecurring basis. Any fair value adjustments as a result of the evaluation process are recorded in the period incurred as provision for loan losses on the consolidated statements of operations.

When collateral-dependent loans are performing in accordance with the original terms of their contract, the Company continues to use the appraisal that was done at origination as the basis for the collateral value. When collateral-dependent loans are considered non-performing, they are assessed to determine the next appropriate course of action: either foreclosure or modification with forbearance agreement. The loans would then be re-appraised prior to foreclosure or before a forbearance agreement is executed. Thereafter, collateral for loans under a forbearance agreement may be re-appraised as the circumstances warrant. This process does not vary by loan type.

The Company's procedure to monitor the value of collateral for collateral dependent impaired loans between the receipt of an original appraisal and an updated appraisal is to review tax assessment records when they change annually, to obtain on a judgmental basis, independent real estate evaluations, and to monitor the general level and direction of movement of regional real estate market conditions. At the time of any change in tax assessment, an appropriate adjustment is made to the existing appraised value and any resulting initial or additional fair value adjustment is made at that time. Information considered in a determination not to order an updated appraisal includes the availability and reliability of tax assessment records, the results of any independent real estate evaluation, and significant changes in capitalization rates for income properties since the original appraisal. Other facts and circumstances on a case by case basis may be considered relative to a decision to order or not to order an updated appraisal. If, in the judgment of management, a reliable collateral value estimate can not be obtained by an alternative method, an updated appraisal is obtained.

Circumstances that may warrant a re-appraisal for non-performing (impaired) loans might include foreclosure proceedings or a material adverse change in the borrower's condition or that of the collateral underlying the loan. Examples include bankruptcy filing by the debtor or guarantors, loss of a major tenant in an income property, or a significant increase in capitalization rates for income properties. In some cases, management may decide that an updated appraisal for a non-performing loan is not necessary. In such cases, an estimate of the fair value of the collateral for the loans would be made by management by reference to current tax assessment records, a current independent real estate evaluation, the latest appraised value, and knowledge of collateral value fluctuations in a loan's market area.

For the purpose of the evaluation of the adequacy of our allowance for loan losses, new appraisals are discounted 10% for selling costs when determining the amount of the specific reserve. Thereafter, for collateral dependent impaired loans, we consider each loan on a case-by-case basis to determine whether or not the recorded values are appropriate given current market conditions. When warranted, new appraisals or independent real estate evaluations are obtained. If an appraisal is less than 12 months old, the only adjustment made to appraised values is the 10% discount for selling costs. If an appraisal is older than 12 months, management will use judgment based on knowledge of current market values and specific facts surrounding any particular property to determine if an additional valuation adjustment may be necessary.

For real estate-secured impaired loans, if the Company does not have an adequate appraisal a new one is ordered to determine fair value. An appraisal that would be considered adequate for real estate-secured loans is one that is less than 12 months or one that is more than 12 months old but alternative methods with which to monitor the collateral value exist, such as reference to frequently updated tax assessments, or independent real estate evaluations. Appraisals that would be considered inadequate for real estate-secured loans include appraisals older than 12 months and with a property located in a jurisdiction that does not reassess property values on a regular basis, or with a property to which substantial changes have been made since the last assessment. If the loan is secured by assets other than real estate and an appraisal is neither available nor feasible, the loan is treated as unsecured.

It is the Company's policy to account for partially charged-off loans consistently both before and after updated appraisals are obtained. Partially charged-off loans are placed in non-accrual status and remain in that status until the borrower has made a minimum of six consecutive monthly payments on a timely basis and there is evidence that the borrower has the ability to repay the balance of the loan plus accrued interest in full. Partially charged-off loans are not automatically returned to accrual status when updated appraisals are obtained.

Impaired loans allocated to the Allowance for Loan Losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the consolidated statements of operations.

The following table summarizes the Company's financial assets that were measured at fair value on a nonrecurring basis as of September 30, 2011 and December 31, 2010:

	September 30, 2011 (In thousands)
	Total		Level I		Level II		Level III

Assets:
Loans held for sale	$	66,910	$	-	$	66,910	$	-
Impaired loans		14,100		-		13,637		463

	December 31, 2010 (In thousands)
Description	Total		Level I		Level II		Level III

Assets:
Loans held for sale	$	59,361	$	-	$	59,361	$	-
Impaired loans		13,267		-		12,528		739

Other Real Estate Owned

The value of other real estate owned (“OREO”) is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser using observable market data (Level II). For other real estate owned properties, the Company's policy is to obtain “as-is” appraisals on an annual basis as opposed to “as-completed” appraisals. This approach provides current values without regard to completion of any construction or renovation that may be in process on OREO properties. Accordingly, the Company considers the valuations to be Level II valuations even though some properties may be in process of renovation or construction. As of September 30, 2011, the Company had one OREO property considered to be in construction with a carrying value of approximately $1.1 million.

For the purpose of OREO valuations, appraisals are discounted 10% for selling and holding costs and it is the policy of the Company to obtain annual appraisals for properties held in OREO.

Any fair value adjustments are recorded in the period incurred as “Other real estate owned expenses” on the consolidated statements of operations.

The following table summarizes the Company's non-financial assets that were measured at fair value on a nonrecurring basis during the period.

	September 30, 2011 (In thousands)
	Total		Level I		Level II		Level III

Assets:
Other real estate owned	$	6,096	$	-	$	6,096	$	-

	December 31, 2010 (In thousands)
Description	Total		Level I		Level II		Level III

Assets:
Other real estate owned	$	8,394	$	-	$	8,394	$	-

The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company's various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. U.S. generally accepted accounting principles excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.

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 Cash Equivalents

For those cash equivalents, the carrying amount is a reasonable estimate of fair value.

Loans, Net and Loans Held for Sale

For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair value is estimated by discounting future cash flows using current market inputs at which loans with similar terms and qualities would be made to borrowers of similar credit quality. Where quoted market prices were available, primarily for certain residential mortgage loans, such market rates were utilized as estimates for fair value.

Accrued Interest Receivable and Payable

The carrying amounts of accrued interest approximate fair values.

Deposits

The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. For all other deposits, the fair value is determined using the discounted cash flow method. The discount rate used is equal to the rate currently offered on similar products.

Securities Sold Under Agreements to Repurchase and Short-Term Debt

The carrying amounts approximate fair values.

FHLB Borrowings, Long-Term and Subordinated Debt

For variable rate long-term debt, fair values are based on carrying values. For fixed rate debt, fair values are estimated based on observable market prices and discounted cash flow analysis using interest rates for borrowings of similar remaining maturities and characteristics. The fair values of the Company's Subordinated Debentures are estimated using discounted cash flow analyses based on the Company's current incremental borrowing rates for similar types of borrowing arrangements.

Off-Balance-Sheet Financial Instruments

The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date. At September 30, 2011 and December 31, 2010, the fair values of loan commitments and standby letters of credit were deemed immaterial; therefore, they have not been included in the table below.

The estimated fair values, and related carrying amounts, of the Company's financial instruments are as follows as of the indicated dates:

	September 30, 2011				December 31, 2010
	Carrying		Fair		Carrying		Fair
	Amount		Value		Amount		Value
	(In thousands)
Financial assets:
Cash and cash equivalents	$	41,358	$	41,358	$	64,724	$	64,724
Securities		303,014		303,014		252,042		252,042
Loans		727,599		749,547		703,706		723,629
Accrued interest receivable		3,669		3,669		3,655		3,655
Interest rate swap		-		-		312		312

Financial liabilities:
Deposits	$	909,696	$	899,965	$	890,306	$	869,606
Securities sold under agreements
to repurchase		31,286		31,286		25,562		25,562
Short-term debt		12,864		12,864		13,320		13,320
FHLB borrowings		77,912		79,038		62,912		63,512
Trust preferred capital notes		5,155		5,229		5,155		5,167
Accrued interest payable		757		757		879		879
Interest rate swap		284		284		-		-

The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of the Company's financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company's overall interest rate risk.