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 FASB 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.

See Footnote 3 “Investment Securities” for additional discussion regarding the Bank’s private label mortgage backed 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 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. 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 received, a member of the CAD 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 of the remaining collateral dependent assets to arrive at a 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 on that tranche so that the servicing asset is carried at fair value. The valuation model utilizes assumptions that market participants would use in estimating future net servicing income and that can 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, 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

Securities available for sale:
U.S. Treasury securities and
U.S. Government agencies	$	-	$	92,681	$	-	$	92,681
Private label mortgage backed security		-		-		4,952		4,952
Mortgage backed securities - residential		-		224,593		-		224,593
Collateralized mortgage obligations		-		211,010		-		211,010
Total securities available for sale	$	-	$	528,284	$	4,952	$	533,236

Mandatory forward contracts	$	-	$	31,166	$	-	$	31,166

Rate lock loan commitments		-		26,489		-		26,489

Mortgage loans held for sale		-		3,385		-		3,385

	Fair Value Measurements at
	December 31, 2011 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

Securities available for sale:
U.S. Treasury securities and
U.S. Government agencies	$	-	$	152,674	$	-	$	152,674
Private label mortgage backed security		-		-		4,542		4,542
Mortgage backed securities - residential		-		293,329		-		293,329
Collateralized mortgage obligations		-		195,403		-		195,403
Total securities available for sale	$	-	$	641,406	$	4,542	$	645,948

Mandatory forward contracts	$	-	$	20,394	$	-	$	20,394

Rate lock loan commitments		-		15,639		-		15,639

Mortgage loans held for sale		-		4,392		-		4,392

All transfers between levels are generally recognized at the end of each quarter. There were no transfers into or out of Level 1, 2 or 3 assets during the three and nine months ended September 30, 2012 and 2011.

The table below presents a reconciliation of the Bank’s private label mortgage backed security. This is the only asset that is measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three and nine month periods ended September 30, 2012 and 2011:

	Three Months Ended					Nine Months Ended
	September 30,					September 30,
(in thousands)	2012		2011			2012		2011

Balance, beginning of period	$	4,579	$	4,402		$	4,542	$	5,124

Total gains or losses included in earnings:
Net impairment loss recognized in earnings		-		-			-		(279	)
Net change in unrealized gain/(loss)		373		2,628			410		4,595
Realized pass through of actual losses		-		(2,347	)		-		(4,399	)
Principal paydowns		-		(141	)		-		(499	)
Balance, end of period	$	4,952	$	4,542		$	4,952	$	4,542

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 several steps: 1) detailed collateral analysis of the underlying mortgages, including consideration of geographic location, original loan-to-value and the weighted average FICO 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.

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

	Fair
	Value		Valuation	Unobservable
	(in thousands)		Technique	Inputs	Range


Private label mortgage backed security	$	4,952	Discounted cash flow	(1) Constant prepayment rate		2% - 6	%

				(2) Probability of default		7% - 31.50	%

				(2) 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. Generally, a change in the assumption used for the probability of default is accompanied by a directionally similar change in the assumption used for loss severity and a directionally opposite change in the assumption used for prepayment rate.

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

	Fair Value Measurements at
	September 30, 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	$	-	$	-	$	904	$	904
Non owner occupied		-		-		355		355
Commercial real estate		-		-		2,827		2,827
Real estate construction		-		-		247		247
Commercial		-		-		23		23
Home equity		-		-		994		994
Total impaired loans *	$	-	$	-	$	5,350	$	5,350

Other real estate owned:
Residential real estate:
Owner occupied	$	-	$	-	$	1,355	$	1,355
Non owner occupied		-		-		-		-
Commercial real estate		-		-		6,069		6,069
Real estate construction		-		-		1,033		1,033
Total other real estate owned	$	-	$	-	$	8,457	$	8,457

Mortgage servicing rights	$	-	$	-	$	3,467	$	3,467

	Fair Value Measurements at
	December 31, 2011 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	$	-	$	-	$	885	$	885
Non owner occupied		-		-		545		545
Commercial real estate		-		-		4,520		4,520
Real estate construction		-		-		285		285
Commercial		-		-		60		60
Home equity		-		-		1,721		1,721
Total impaired loans *	$	-	$	-	$	8,016	$	8,016

Other real estate owned:
Residential real estate:
Owner occupied	$	-	$	-	$	3,477	$	3,477
Non owner occupied		-		-		417		417
Commercial real estate		-		-		1,418		1,418
Real estate construction		-		-		1,000		1,000
Total other real estate owned	$	-	$	-	$	6,312	$	6,312

Mortgage servicing rights	$	-	$	-	$	3,412	$	3,412

* - The impaired loan balances in the preceding two tables excludes TDRs. The difference between the carrying value and the fair value represents loss reserves recorded within the allowance for loan losses in accordance with FASB ASC Topic 310-10-35, “Accounting by Creditors for Impairment of a Loan.”

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, 2012:

	Fair				Range
	Value		Valuation	Unobservable	(Weighted
	(in thousands)		Technique	Inputs	Average)

Impaired loans - commercial real estate	$	3,098	(1) Sales comparison approach	(1) Adjustments determined by		10% - 69%	(19%)
				Management for differences
				between the comparable sales

	$	1,813	(2) Income approach	(2) Adjustments for differences		9% - 9%	(9%)
				between net operating income
				expectations

Impaired loans - residential real estate	$	2,252	Sales comparison approach	Adjustments determined by		14% - 65%	(27%)
				Management for differences
				between the comparable sales

Other real estate owned - residential	$	1,355	Sales comparison approach	Adjustments determined by		4% - 26%	(11%)
				Management for differences
				between the comparable sales
Other real estate owned - commercial
real estate	$	7,102	Sales comparison approach	Adjustments determined by		7% - 54%	(25%)
				Management for differences
				between the comparable sales

Mortgage servicing rights	$	3,467	Third party valuation pricing	Prepayment speeds		200% - 411%	(222%)
				Default rate		1.50% - 1.50%	(1.50%)
				Discount rate		9% - 9%	(9%)

The following section details impairment charges recognized during the period:

The Bank recorded realized impairment losses related to its single Level 3 private label mortgage backed security as follows:

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(in thousands)	2012		2011		2012		2011

Net impairment loss recognized in earnings	$	-	$	-	$	-	$	279

See Footnote 3 “Investment Securities” for additional detail regarding impairment losses.

Collateral dependent impaired loans are generally measured for impairment using the fair market 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 may 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 results of the impairment review results in an increase in the allowance for loan loss or in a partial charge-off of the loan, if warranted. Impaired loans that are collateral dependent are classified within Level 3 of the fair value hierarchy when impairment is determined using the fair value method.

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount and valuation allowance as follows:

(in thousands)	September 30, 2012		December 31, 2011

Carrying amount of loans with a valuation allowance	$	5,903	$	5,391
Valuation allowance		1,147		1,717

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. At September 30, 2012 and December 31, 2011, the carrying value of other real estate owned was $25 million and $11 million, respectively. The fair value of the Bank’s individual other real estate owned properties exceeded their carrying value at September 30, 2012 and December 31, 2011.

Mortgage servicing rights, carried at fair value because the fair value was less than the amortized cost, totaled $3.4 million at September 30, 2012. The $3.4 million consisted of an outstanding balance of $3.7 million, net of a valuation allowance of $333,000 at September 30, 2012, resulting in net impairment expense of $130,000 for the nine months ended September 30, 2012. At December 31, 2011, mortgage servicing rights carried at fair value totaled $3 million, made up of the outstanding balance of $3.2 million, net of a valuation allowance of $203,000, resulting in net impairment expense of $203,000 for the year ended December 31, 2011.

Detail of other real estate owned write downs follows:

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(in thousands)	2012		2011		2012		2011

Other real estate owned write-downs	$	866	$	236	$	1,207	$	463

The carrying amounts and estimated fair values of all financial instruments, at September 30, 2012 and December 31, 2011 follows:

			Fair Value Measurements at
			September 30, 2012 Using:
									Total
	Carrying								Fair
(in thousands)	Value		Level 1		Level 2		Level 3		Value

Assets:
Cash and cash equivalents	$	96,187	$	96,187	$	-	$	-	$	96,187
Securities available for sale		533,236		-		528,284		4,952		533,236
Securities to be held to maturity		48,026		-		48,448		-		48,448
Mortgage loans held for sale		3,385		-		3,385		-		3,385
Loans, net		2,618,257		-		-		2,692,285		2,692,285
Federal Home Loan Bank stock		28,784		-		-		-		N/A
Accrued interest receivable		10,088		-		10,088		-		10,088

Liabilities:
Non interest-bearing deposits		514,893		-		514,893		-		514,893
Transaction deposits		1,679,822		-		1,679,822		-		1,679,822
Time deposits		375,788		-		379,866		-		379,866
Securities sold under agreements
to repurchase and other short-term
borrowings		169,839		-		169,839		-		169,839
Federal Home Loan Bank advances		553,487		-		569,667		-		569,667
Subordinated note		41,240		-		41,162		-		41,162
Accrued interest payable		1,496		-		1,496		-		1,496

	December 31, 2011
	Carrying		Fair
(in thousands)	Value		Value

Assets:
Cash and cash equivalents	$	362,971	$	362,971
Securities available for sale		645,948		645,948
Securities to be held to maturity		28,074		28,342
Mortgage loans held for sale		4,392		4,392
Loans, net		2,261,232		2,305,208
Federal Home Loan Bank stock		25,980		25,980
Accrued interest receivable		9,679		9,679

Liabilities:
Non interest-bearing deposits		408,483		408,483
Transaction deposits		1,019,809		1,019,809
Time deposits		305,686		308,049
Securities sold under agreements
to repurchase and other short-term
borrowings		230,231		230,231
Federal Home Loan Bank advances		934,630		960,671
Subordinated note		41,240		41,158
Accrued interest payable		1,724		1,724

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 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. Certain financial instruments and all nonfinancial instruments are excluded from disclosure requirements.

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 – 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 for loan losses 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 classified as Level 1.

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 Bank 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 September 30, 2012 and December 31, 2011. 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.