7. FAIR VALUE

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

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

The Bank used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:

Securities available for sale: For all securities available for sale, excluding the Bank’s private label mortgage backed security, fair value is typically determined by matrix pricing, which is a mathematical technique used widely 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). With the exception of the private label mortgage backed security, all securities available for sale are classified as Level 2 in the fair value hierarchy.

The Bank’s private label mortgage backed security remains extremely illiquid, and as such, the Bank classifies this security as a Level 3 security in accordance with ASC Topic 820, Fair Value Measurements and Disclosures. Based on this determination, the Bank utilized an income valuation model (present value model) approach, in determining the fair value of this security.

Mortgage loans held for sale: The fair value of mortgage loans held for sale is determined using quoted secondary market prices. Mortgage loans held for sale are classified as Level 2 in the fair value hierarchy.

Derivative instruments: Mortgage Banking derivatives used in the ordinary course of business primarily consist of mandatory forward sales contracts (“forward contracts”) and rate lock loan commitments. The fair value of the Bank’s derivative instruments is primarily measured by obtaining pricing from broker-dealers recognized to be market participants. The pricing is derived from market observable inputs that can generally be verified and do not typically involve significant judgment by the Bank. Forward contracts and rate lock loan commitments are classified as Level 2 in the fair value hierarchy.

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 anticipated selling costs of the underlying collateral. 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. Impaired loans are evaluated on 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 the Bank. Once the appraisal is received, a member of the Bank’s Credit Administration Department reviews the assumptions and approaches utilized in the appraisal, as well as the overall resulting fair value in comparison with independent data sources, such as recent market data or industry-wide statistics. On an annual basis, the Bank compares the actual selling price of collateral that has been sold to the most recent appraised value to determine what additional adjustment, if any, should be made to the appraisal value to arrive at an estimated fair value.

Mortgage Servicing Rights: On a monthly basis, mortgage servicing rights are evaluated for impairment based upon the fair value of the rights as compared to carrying amount. If the carrying amount of an individual tranche exceeds fair value, impairment is recorded and the respective individual tranche is carried at fair value. If the carrying amount of an individual tranche does not exceed fair value, impairment is reversed if previously recognized and the carrying value of the individual tranche is based on the amortization method. The valuation model utilizes assumptions that market participants would use in estimating future net servicing income and that can generally be validated against available market data (Level 2).

Assets and liabilities measured at fair value on a recurring basis, including financial assets and liabilities for which the Bank has elected the fair value option, are summarized below:

	Fair Value Measurements at
	September 30, 2013 Using:
	Quoted Prices in		Significant
	Active Markets		Other		Significant
	for Identical		Observable		Unobservable		Total
	Assets		Inputs		Inputs		Fair
(in thousands)	(Level 1)		(Level 2)		(Level 3)		Value
Financial Assets:

Securities available for sale:
U.S. Treasury securities and U.S. Government agencies	$	—	$	122,933	$	—	$	122,933
Private label mortgage backed security	—		—		5,457		5,457
Mortgage backed securities - residential	—		161,112		—		161,112
Collateralized mortgage obligations			177,218				177,218
Corporate bonds	—		14,904		—		14,904
Total securities available for sale	$	—	$	476,167	$	5,457	$	481,624

Rate lock commitments	$	—	$	401	$	—	$	401

Mortgage loans held for sale	—		9,803		—		9,803

Financial Liabilities:

Mandatory forward contracts	$	—	$	160	$	—	$	160

	Fair Value Measurements at
	December 31, 2012 Using:
	Quoted Prices in		Significant
	Active Markets		Other		Significant
	for Identical		Observable		Unobservable		Total
	Assets		Inputs		Inputs		Fair
(in thousands)	(Level 1)		(Level 2)		(Level 3)		Value
Financial Assets:

Securities available for sale:
U.S. Treasury securities and U.S. Government agencies	$	—	$	39,472	$	—	$	39,472
Private label mortgage backed security	—		—		5,687		5,687
Mortgage backed securities - residential	—		197,210		—		197,210
Collateralized mortgage obligations	—		195,877		—		195,877
Total securities available for sale	$	—	$	432,559	$	5,687	$	438,246

Mandatory forward contracts	$	—	$	47	$	—	$	47

Rate lock loan commitments	—		833		—		833

Mortgage loans held for sale	—		10,614		—		10,614

There were no transfers between Level 1, 2 or 3 assets during the three and nine months ended September 30, 2013 and 2012. All transfers between levels, if applicable, would be generally recognized at the end of each quarter.

The table below presents a reconciliation of the Bank’s private label mortgage backed security. This is the only asset that was measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the periods ended September 30, 2013 and 2012:

	Three Months Ended					Nine Months Ended
	September 30,					September 30,
(in thousands)	2013			2012		2013			2012

Balance, beginning of period	$	5,641		$	4,579	$	5,687		$	4,542

Total gains or losses included in earnings:
Net change in unrealized gain/(loss)	(4		)	373		418			410
Reversal of actual losses previously recorded	37			—		37			—
Principal paydowns	(217		)	—		(685		)	—
Balance, end of period	$	5,457		$	4,952	$	5,457		$	4,952

The Bank’s single private label mortgage backed security is supported by analysis prepared by an independent third party. The third party’s approach to determining fair value involved the following steps: 1) detailed collateral analysis of the underlying mortgages, including consideration of geographic location, original loan-to-value and the weighted average credit score of the borrowers; 2) collateral performance projections for each pool of mortgages underlying the security (probability of default, severity of default, and prepayment probabilities) and 3) discounted cash flow modeling.

There were no transfers between Level 3 assets during the three and nine months ended September 30, 2013 and 2012.

The following table presents quantitative information about recurring Level 3 fair value measurements at September 30, 2013 and December 31, 2012:

	Fair		Valuation	Unobservable
September 30, 2013 (dollars in thousands)	Value		Technique	Inputs	Range

Private label mortgage backed security	$	5,457	Discounted cash flow	Constant prepayment rate	0.67% - 7%

				Probability of default	3% - 7%

				Loss severity	60% - 81%

	Fair		Valuation	Unobservable Inputs
December 31, 2012 (dollars in thousands)	Value		Technique	Unobservable Inputs	Range

Private label mortgage backed security	$	5,687	Discounted cash flow	Constant prepayment rate	1% - 6%

				Probability of default	3.50% - 7%

				Loss severity	60% - 70%

The significant unobservable inputs in the fair value measurement of the Bank’s single private label mortgage backed security are prepayment rates, probability of default and loss severity in the event of default. Significant fluctuations in any of those inputs in isolation would result in a significantly lower/higher fair value measurement.

See Footnote 3 “Investment Securities” for additional detail regarding the private label mortgage backed security in this section of the filing.

Assets measured at fair value on a non-recurring basis are summarized below:

	Fair Value Measurements at
	September 30, 2013 Using:
	Quoted Prices in		Significant
	Active Markets		Other		Significant
	for Identical		Observable		Unobservable		Total
	Assets		Inputs		Inputs		Fair
(in thousands)	(Level 1)		(Level 2)		(Level 3)		Value

Impaired loans:
Residential real estate:
Owner occupied	$	—	$	—	$	1,059	$	1,059
Commercial real estate	—		—		5,415		5,415
Home equity	—		—		275		275
Total impaired loans *	$	—	$	—	$	6,749	$	6,749

Other real estate owned:
Commercial real estate	$	—	$	—	$	536	$	536
Construction & land development	—		—		4,200		4,200
Total other real estate owned	$	—	$	—	$	4,736	$	4,736

	Fair Value Measurements at
	December 31, 2012 Using:
	Quoted Prices in		Significant
	Active Markets		Other		Significant
	for Identical		Observable		Unobservable		Total
	Assets		Inputs		Inputs		Fair
(in thousands)	(Level 1)		(Level 2)		(Level 3)		Value

Impaired loans:
Residential real estate:
Owner occupied	$	—	$	—	$	782	$	782
Non owner occupied	—		—		1,788		1,788
Commercial real estate	—		—		15,618		15,618
Construction & land development	—		—		1,552		1,552
Commercial	—		—		182		182
Home equity	—		—		303		303
Total impaired loans *	$	—	$	—	$	20,225	$	20,225

Other real estate owned:
Residential real estate:
Owner occupied	$	—	$	—	$	1,195	$	1,195
Non owner occupied	—		—		—		—
Commercial real estate	—		—		1,219		1,219
Construction & land development	—		—		5,161		5,161
Total other real estate owned	$	—	$	—	$	7,575	$	7,575

Mortgage servicing rights**	$	—	$	3,484	$	—	$	3,484

* - Impaired loan balances exclude loans measured for impairment using the present value of future cash flows.

** - Mortgage Servicing Rights at fair value only include those tranches which were considered impaired at the reported period end.

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 September 30, 2013 and December 31, 2012:

					Range
	Fair		Valuation	Unobservable	(Weighted
September 30, 2013 (dollars in thousands)	Value		Technique	Inputs	Average)

Impaired loans - commercial real estate	$	5,415	Sales comparison approach	Adjustments determined by Management for differences between the comparable sales	0% - 26% (11%)

Impaired loans - residential real estate	$	1,334	Sales comparison approach	Adjustments determined by Management for differences between the comparable sales	0% - 25% (8%)

Other real estate owned - commercial real estate	$	536	Sales comparison approach	Adjustments determined by Management for differences between the comparable sales	11% - 26 (18%)

Other real estate owned - construction & land development	$	600	Sales comparison approach	Adjustments determined by Management for differences between the comparable sales	40% (40%)

	$	3,600	Income approach	Adjustments for differences between net operating income expectations	28% (28%)

					Range
	Fair		Valuation	Unobservable	(Weighted
December 31, 2012 (dollars in thousands)	Value		Technique	Inputs	Average)

Impaired loans - commercial real estate	$	15,230	Sales comparison approach	Adjustments determined by Management for differences between the comparable sales	0% - 50% (18%)

	$	1,940	Income approach	Adjustments for differences between net operating income expectations	12% - 12% (12%)

Impaired loans - residential real estate	$	2,873	Sales comparison approach	Adjustments determined by Management for differences between the comparable sales	2% - 60% (17%)

Impaired loans - commercial	$	182	Sales comparison approach	Adjustments determined by Management for differences between the comparable sales	0% - 50% (44%)

Other real estate owned - residential	$	1,195	Sales comparison approach	Adjustments determined by Management for differences between the comparable sales	4% - 71% (14%)

Other real estate owned - commercial real estate	$	1,219	Sales comparison approach	Adjustments determined by Management for differences between the comparable sales	1% - 33% (16%)

Other real estate owned - real estate construction	$	663	Sales comparison approach	Adjustments determined by Management for differences between the comparable sales	1% - 54% (35%)

	$	4,498	Income approach	Adjustments for differences between net operating income expectations	25% - 25% (25%)

The following section details impairment charges recognized during the period:

Impaired Loans

Collateral dependent impaired loans are measured for impairment using the fair value for reasonable disposition of the underlying collateral. The Bank’s practice is to obtain new or updated appraisals on the loans subject to the initial impairment review and then to evaluate the need for an update to this value on an as necessary or possibly annual basis thereafter (depending on the market conditions impacting the value of the collateral). The Bank will discount the appraisal amount, as necessary for selling costs and past due real estate taxes. If a new or updated appraisal is not available at the time of a loan’s impairment review, the Bank may apply a discount to the existing value of an old appraisal to reflect the property’s current estimated value if it is believed to have deteriorated in either: (i) the physical or economic aspects of the subject property or (ii) material changes in market conditions. The review may result in an increase in the Allowance or in a partial charge-off of the loan. Impaired loans that are collateral dependent are classified within Level 3 of the fair value hierarchy when impairment is determined using this fair value method.

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans are as follows:

(in thousands)	September 30, 2013			December 31, 2012

Carrying amount of loans measured at fair value	$	6,568		$	23,070
Estimated selling costs considered in carrying amount	943			1,839
Valuation allowance	(762		)	(4,684		)
Total fair value	$	6,749		$	20,225

Other Real Estate Owned

Other real estate owned, which is carried at the lower of cost or fair value, is periodically assessed for impairment based on fair value at the reporting date. Fair value is determined from external appraisals using judgments and estimates of external professionals. Many of these inputs are not observable and, accordingly, these measurements are classified as Level 3. The fair value of the Bank’s individual other real estate owned properties exceeded their carrying value at September 30, 2013 and December 31, 2012.

Details of other real estate owned carrying value and write downs follows:

(in thousands)	September 30, 2013		December 31, 2012

Carrying value of other real estate owned	$	15,247	$	26,203

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(in thousands)	2013		2012		2013		2012

Other real estate owned write-downs	$	190	$	866	$	1,074	$	1,207

Mortgage Servicing Rights

MSRs are carried at lower of cost or fair value with fair value determined by MSR tranche. There were no tranches carried at fair value at September 30, 2013, while nine of 21 tranches were carried at fair value at December 31, 2012. Details of the tranches carried at fair value follow:

(in thousands)	September 30, 2013		December 31, 2012

Outstanding balance	$	—	$	3,829
Valuation allowance	—		(345		)
Fair value	$	—	$	3,484

	Three Months Ended					Nine Months Ended
	September 30,					September 30,
(in thousands)	2013			2012		2013			2012

Charge (credit) to mortgage banking income due to impairment evaluation	$	(33	)	$	160	$	(345	)	$	129

Mortgage Loans Held for Sale

The Bank has elected the fair value option for mortgage loans held for sale. These loans are intended for sale and the Bank believes that the fair value is the best indicator of the resolution of these loans. Interest income is recorded based on the contractual terms of the loan and in accordance with Bank policy for such instruments. None of these loans were past due 90-days-or- more nor on nonaccrual as of September 30, 2013 and December 31, 2012.

As of September 30, 2013 and December 31, 2012, the aggregate fair value, contractual balance (including accrued interest), and gain or loss was as follows:

(in thousands)	September 30, 2013		December 31, 2012

Aggregate fair value	$	9,803	$	10,614
Contractual balance	9,557		10,037
Gain	246		577

The total amount of gains and losses from changes in fair value included in earnings for the three and nine months ended September 30, 2013 and 2012 for mortgage loans held for sale are presented in the following table:

	Three Months Ended					Nine Months Ended
	September 30,					September 30,
(in thousands)	2013			2012		2013			2012

Interest income	$	130		$	110	$	388		$	283
Change in fair value	(218		)	82		(331		)	134
Total change in fair value	$	(88	)	$	192	$	57		$	417

The carrying amounts and estimated fair values of all financial instruments, at September 30, 2013 and December 31, 2012 follows:

			Fair Value Measurements at
			September 30, 2013:
									Total
	Carrying								Fair
(in thousands)	Value		Level 1		Level 2		Level 3		Value

Assets:
Cash and cash equivalents	$	141,585	$	141,585	$	—	$	—	$	141,585
Securities available for sale	481,624		—		476,167		5,457		481,624
Securities to be held to maturity	52,057		—		52,408		—		52,408
Mortgage loans held for sale	9,803		—		9,803		—		9,803
Loans, net of allowance for loan losses	2,529,943		—		—		2,568,974		2,568,974
Federal Home Loan Bank stock	28,342		—		—		—		N/A
Accrued interest receivable	8,130		—		8,130		—		8,130

Liabilities:
Non interest-bearing deposits	492,126		—		492,126		—		492,126
Transaction and money market deposits	1,259,782		—		1,259,782		—		1,259,782
Time deposits	267,877		—		270,462		—		270,462
Securities sold under agreements to repurchase and other short-term borrowings	106,373		—		106,373		—		106,373
Federal Home Loan Bank advances	587,020		—		602,458		—		602,458
Subordinated note	41,240		—		38,049		—		38,049
Accrued interest payable	1,435		—		1,435		—		1,435

			Fair Value Measurements at
			December 31, 2012:
									Total
	Carrying								Fair
(in thousands)	Value		Level 1		Level 2		Level 3		Value

Assets:
Cash and cash equivalents	$	137,691	$	137,691	$	—	$	—	$	137,691
Securities available for sale	438,246		—		432,559		5,687		438,246
Securities to be held to maturity	46,010		—		46,416		—		46,416
Mortgage loans held for sale	10,614		—		10,614		—		10,614
Loans, net of allowance for loan losses	2,626,468		—		—		2,702,686		2,702,686
Federal Home Loan Bank stock	28,377		—		—		—		N/A
Accrued interest receivable	9,245		—		9,245		—		9,245

Liabilities:
Non interest-bearing deposits	479,046		—		479,046		—		479,046
Transaction and money market deposits	1,193,339		—		1,193,339		—		1,193,339
Time deposits	310,543		—		314,972		—		314,972
Securities sold under agreements to repurchase and other short-term borrowings	250,884		—		250,884		—		250,884
Federal Home Loan Bank advances	542,600		—		576,158		—		576,158
Subordinated note	41,240		—		37,917		—		37,917
Accrued interest payable	1,403		—		1,403		—		1,403

Fair value estimates are based on existing on and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of the Bank’s estimates.

The assumptions used in the estimation of the fair value of the Company’s financial instruments are explained below. Where quoted market prices are not available, fair values are based on estimates using discounted cash flow and other valuation techniques. Discounted cash flows can be significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The following fair value estimates cannot be substantiated by comparison to independent markets and should not be considered representative of the liquidation value of the Company’s financial instruments, but rather a good-faith estimate of the fair value of financial instruments held by the Company.

The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments:

Cash and cash equivalents — The carrying amounts of cash and short-term instruments approximate fair values and are classified as Level 1.

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

Loans, net of Allowance — The fair value of loans is calculated using discounted cash flows by loan type resulting in a Level 3 classification. The discount rate used to determine the present value of the loan portfolio is an estimated market rate that reflects the credit and interest rate risk inherent in the loan portfolio without considering widening credit spreads due to market illiquidity. The estimated maturity is based on the Bank’s historical experience with repayments adjusted to estimate the effect of current market conditions. The Allowance is considered a reasonable discount for credit risk. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

Federal Home Loan Bank stock — It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.

Accrued interest receivable/payable — The carrying amounts of accrued interest, due to their short-term nature, approximates fair value resulting in a Level 2 classification.

Deposits — Fair values for certificates of deposit have been determined using discounted cash flows. The discount rate used is based on estimated market rates for deposits of similar remaining maturities and are classified as Level 2. The carrying amounts of all other deposits, due to their short-term nature, approximate their fair values and are also classified as Level 2.

Securities sold under agreements to repurchase — The carrying amount for securities sold under agreements to repurchase generally maturing within ninety days approximates its fair value resulting in a Level 2 classification.

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

Subordinated note — The fair value for subordinated debentures is calculated using discounted cash flows based upon current market spreads to LIBOR for debt of similar remaining maturities and collateral terms resulting in a Level 2 classification.

The fair value estimates presented herein are based on pertinent information available to management as of the respective period ends. Although management is not aware of any factors that would dramatically affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since that date and, therefore, estimates of fair value may differ significantly from the amounts presented.