Note 15. Fair Value of Financial Instruments

Under FASB ASC Topic 820 “Fair Value Measurements” (“ASC Topic 820”), fair values are based on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When available, management uses quoted market prices to determine fair value. If quoted prices are not available, fair value is based upon valuation techniques such as matrix pricing or other models that use, where possible, current market-based or independently sourced market parameters, such as interest rates. If observable market-based inputs are not available, the Company uses unobservable inputs to determine appropriate valuation adjustments using discounted cash flow methodologies.

Management uses its best judgment in estimating the fair value of the Company’s financial instruments; however, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts the Company could have realized in a sales transaction on the dates indicated. The estimated fair value amounts have been measured as of their respective period end and have not been re-evaluated or updated for purposes of these financial statements subsequent to those respective dates. As such, the estimated fair values of these financial instruments subsequent to the respective reporting dates may be different than the amounts reported at each period-end.

ASC Topic 820 provides guidance for estimating fair value when the volume and level of activity for an asset or liability has significantly declined and for identifying circumstances when a transaction is not orderly. ASC Topic 820 establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy under ASC Topic 820 are as follows:

Level 1:

Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Level 2:

Quoted prices in markets that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability. Level 2 includes debt securities with quoted prices that are traded less frequently then exchange-traded instruments. Valuation techniques include matrix pricing which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices.

Level 3:

Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported with little or no market activity).

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. The Company did not have transfers of financial instruments within the fair value hierarchy during the three and nine months ended September 30, 2013 and 2012.

Items Measured on a Recurring Basis

The Company’s available for sale investment securities are recorded at fair value on a recurring basis.

Fair value for Level 1 securities are determined by obtaining quoted market prices on nationally recognized securities exchanges. Level 1 securities include common stocks.

Level 2 securities include obligations of U.S. government-sponsored agencies, debt securities with quoted prices, which are traded less frequently than exchange-traded instruments, whose value is determined using matrix pricing with inputs that are observable in the market or can be derived principally from or corroborated by observable market data. The prices were obtained from third party vendors. This category generally includes mortgage-backed securities and CMOs issued by U.S. government and government-sponsored agencies, non-agency CMOs, and corporate and municipal bonds.

Level 3 securities include investments in seven private equity funds which are predominantly invested in real estate. The value of the private equity funds are derived from the funds’ financials and K-1 filings. The Company also reviews the funds’ asset values and its near-term projections.

For financial assets measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy used at September 30, 2013 and December 31, 2012 are as follows:

	Fair Value Measurements Using:
	Quoted Prices
	in Active		Significant
	Markets for		Other		Significant
	Identical		Observable		Unobservable
Balances as of September 30, 2013	Assets		Inputs		Inputs
(In thousands)	Level 1		Level 2		Level 3		Fair Value
Investment securities available-for-sale
U.S. government agencies	$	-	$	69,751	$	-	$	69,751
Mortgage-backed securities-residential		-		31,839		-		31,839
Collateralized mortgage obligations:
Issued or guaranteed by U.S. government agencies		-		165,958		-		165,958
Non-agency		-		4,566		-		4,566
Corporate bonds		-		9,593		-		9,593
Municipal bonds		-		5,328		-		5,328
Other securities		-		-		4,262		4,262
Common stocks		48		-		-		48
Total investment securities available-for-sale	$	48	$	287,035	$	4,262	$	291,345

	Fair Value Measurements Using:
	Quoted Prices
	in Active		Significant
	Markets for		Other		Significant
	Identical		Observable		Unobservable
Balances as of December 31, 2012	Assets		Inputs		Inputs
(In thousands)	Level 1		Level 2		Level 3		Fair Value
Investment securities available-for-sale
U.S. government agencies	$	-	$	66,444	$	-	$	66,444
Mortgage-backed securities-residential		-		30,509		-		30,509
Collateralized mortgage obligations:
Issued or guaranteed by U.S. government agencies		-		233,976		-		233,976
Non-agency		-		1,011		-		1,011
Corporate bonds		-		7,437		-		7,437
Municipal bonds		-		5,615		-		5,615
Other securities		-		-		4,164		4,164
Common stocks		47		-		-		47
Total investment securities available-for-sale	$	47	$	344,992	$	4,164	$	349,203

The following table presents additional information about assets measured at fair value on a recurring basis and for which the Company has utilized Level 3 inputs to determine fair value for the nine months ended September 30, 2013 and 2012:

(In thousands)
Investment Securities Available for Sale	Other securities
Beginning balance January 1, 2013	$	4,164
Total gains/(losses) - (realized/unrealized):
Included in earnings		5
Included in other comprehensive income		361
Purchases		32
Sales and calls		(300	)
Transfers in and/or out of Level 3		-
Ending balance September 30, 2013	$	4,262

	Investment Securities Available for Sale
	Trust
	preferred			Other
(In thousands)	securities			securities			Total
Beginning balance January 1, 2012	$	12,603		$	6,918		$	19,521
Total gains/(losses) - (realized/unrealized):
Included in earnings		89			(818	)		(729	)
Included in other comprehensive income		(392	)		(189	)		(581	)
Purchases		-			500			500
Sales and calls		(4,362	)		(575	)		(4,937	)
Amortization of premium		(16	)		-			(16	)
Transfers in and/or out of Level 3		-			-			-
Ending balance September 30, 2012	$	7,922		$	5,836		$	13,758

Items Measured on a Nonrecurring Basis

Non-accrual loans and TDRs are evaluated for impairment on an individual basis under FASB ASC Topic 310 “Receivables”. The impairment analysis includes current collateral values, known relevant factors that may affect loan collectability, and risks inherent in different kinds of lending. When the collateral value or discounted cash flows less costs to sell is less than the carrying value of the loan a specific reserve (valuation allowance) is established. Loans held for sale are carried at the lower of cost or fair value. OREO is carried at the lower of cost or fair value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. These assets are included as Level 3 fair values, based upon the lowest level of input that is significant to the fair value measurements.

For financial assets measured at fair value on a nonrecurring basis, the fair value measurements by level within the fair value hierarchy used at September 30, 2013 and December 31, 2012 are as follows:

Fair Value Measurements Using:

Quoted Prices

in Active

Significant

Markets for

Other

Significant

Identical

Observable

Unobservable

Balances as of September 30, 2013

Assets

Inputs

(In thousands)

Level 1

Level 2

Level 3

Fair Value

Assets

Impaired loans and leases

9,555

Other real estate owned

8,740

	Fair Value Measurements Using:
	Quoted Prices
	in Active		Significant
	Markets for		Other		Significant
	Identical		Observable		Unobservable
Balances as of December 31, 2012	Assets		Inputs		Inputs
(In thousands)	Level 1		Level 2		Level 3		Fair Value
Assets
Impaired loans and leases	$	-	$	-	$	9,180	$	9,180
Other real estate owned		-		-		7,632		7,632
Loans and leases held for sale		-		-		1,572		1,572

The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis and for which the Company has utilized Level 3 inputs to determine fair value:

	Qualitative Information about Level 3 Fair Value Measurements
Balances as of September 30, 2013			Valuation	Unobservable	Range (Weighted
(In thousands)	Fair Value		Techniques	Input	Average)
Impaired loans and leases	$	9,555	Appraisal of collateral (1)	Appraisal adjustments	0.0% to -20.0% (-9.2%)
				Liquidation expenses	-4.0% to -23.3% (-6.5%)

			Salvageable value of			0.0	%
			collateral (2)

Other real estate owned		8,740	Appraisal of collateral (1)	Appraisal adjustments	0.0% to -81.1% (-4.4%)
			Sales prices	Liquidation expenses	-5.0% to -8.0% (-6.3%)

(1)	Appraisals may be adjusted for qualitative factors such as interior condition of the property and liquidation expenses. Fair value may also be based on negotiated settlements with the borrower.

(2)	Leases are measured using the salvageable value of the collateral.

The following methods and assumptions were used to estimate the fair values of the Company’s financial instruments at September 30, 2013 and December 31, 2012. The following information should not be interpreted as an estimate of the fair value of the entire Company since a fair value calculation is only provided for a limited portion of the Company’s assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between the Company’s disclosures and those of other companies may not be meaningful. The methodologies for estimating the fair value of financial instruments that are measured on a recurring or nonrecurring basis are discussed above.

Cash and cash equivalents (carried at cost):

The carrying amounts reported in the balance sheet for cash and short-term instruments approximate those assets’ fair values.

Securities:

Management uses quoted market prices to determine fair value of securities (level 1). If quoted prices are not available, fair value is based upon valuation techniques such as matrix pricing or other models that use, where possible, current market-based or independently sourced market parameters, such as interest rates (level 2). If observable market-based inputs are not available, the Company uses unobservable inputs to determine appropriate valuation adjustments using discounted cash flow methodologies (level 3).

Other Investment (carried at cost):

This investment includes the Solomon Hess SBA Loan Fund, which the Company invested in to partially satisfy its community reinvestment requirement. Shares in this fund are not publicly traded and therefore have no readily determinable fair market value. An investor can have their investment in the Fund redeemed for the balance of their capital account at any quarter end with 60 days notice to the Fund. The investment in this Fund is recorded at cost. The fair value is computed by applying the Company’s ownership percentage of the fund to the fund’s net asset value at year end.

Restricted investment in bank stock (carried at cost):

The carrying amount of restricted investment in bank stock approximates fair value, and considers the limited marketability of such securities.

Loans held for sale (carried at lower of cost or fair value):

The fair values of loans held for sale are based upon appraised values of the collateral less costs to sell, management’s estimation of the value of the collateral or expected net sales proceeds. These assets are included as Level 3 fair values, based upon the lowest level of input that is significant to the fair value measurements.

Loans receivable (carried at cost):

The fair values of loans are estimated using discounted cash flow analyses, using market rates at the balance sheet date that reflect the credit and interest rate-risk inherent in the loans. Projected future cash flows are calculated based upon contractual maturity or call dates, projected repayments and prepayments of principal. Generally, for variable rate loans that re-price frequently and with no significant change in credit risk, fair values are based on carrying values.

Impaired loans (generally carried at fair value):

Impaired loans are accounted for under ASC Topic 310. Impaired loans are those in which the Company has measured impairment generally based on the fair value of the loan’s collateral. Fair value is generally determined based upon independent third-party appraisals of the properties, or discounted cash flows based on the expected proceeds. These assets are included as Level 3 fair values, based upon the lowest level of input that is significant to the fair value measurements.

Accrued interest receivable and payable (carried at cost):

The carrying amount of accrued interest receivable and accrued interest payable approximates its fair value.

Deposit liabilities (carried at cost):

The fair values disclosed for demand deposits (e.g., interest and noninterest checking, passbook savings and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market on certificates to a schedule of aggregated expected monthly maturities on time deposits.

Short-term borrowings (carried at cost):

The carrying amounts of short-term borrowings approximate their fair values.

Long-term debt (carried at cost):

Fair values of FHLB advances and other long-term borrowings are estimated using discounted cash flow analysis, based on quoted prices for new FHLB advances with similar credit risk characteristics, terms and remaining maturity. These prices obtained from this active market represent a market value that is deemed to represent the transfer price if the liability were assumed by a third party.

Subordinated debt (carried at cost):

Fair values of junior subordinated debt are estimated using discounted cash flow analysis, based on market rates currently offered on such debt with similar credit risk characteristics, terms, and remaining maturity.

Off-balance sheet financial instruments (disclosed at cost):

Fair values for the Company’s off-balance sheet financial instruments (lending commitments and letters of credit) are based on fees currently charged in the market to enter into similar agreements, taking into account, the remaining terms of the agreements and the counterparties’ credit standing. They are not shown in the table because the amounts are immaterial.

The tables below state the fair value of the Company’s financial instruments at September 30, 2013 and December 31, 2012.

					Fair Value Measurements
					At September 30, 2013
					Quoted Prices
					in Active		Significant
					Markets for		Other		Significant
					Identical		Observable		Unobservable
	Carrying		Estimated		Assets		Inputs		Inputs
(In thousands)	amount		fair value		Level 1		Level 2		Level 3
Financial Assets:
Cash and cash equivalents	$	18,854	$	18,854	$	18,854	$	-	$	-
Investment securities available-for-sale		291,345		291,345		48		287,035		4,262
Other investment		2,250		2,250		-		-		2,250
Federal Home Loan Bank stock		4,364		4,364		-		-		4,364
Loans, net		362,650		356,964		-		-		356,964
Accrued interest receivable		7,869		7,869		-		7,869		-
Financial Liabilities:
Demand deposits		63,338		63,338		-		63,338		-
NOW and money markets		202,014		202,014		-		202,014		-
Savings		17,588		17,588		-		17,588		-
Time deposits		239,680		237,679		-		237,679		-
Short-term borrowings		14,000		14,000		14,000		-		-
Long-term borrowings		97,994		94,832		-		94,832		-
Subordinated debt		25,774		24,579		-		24,579		-
Accrued interest payable		2,471		2,471		-		2,471		-

					Fair Value Measurements
					At December 31, 2012
					Quoted Prices
					in Active		Significant
					Markets for		Other		Significant
					Identical		Observable		Unobservable
	Carrying		Estimated		Assets		Inputs		Inputs
(In thousands)	amount		fair value		Level 1		Level 2		Level 3
Financial Assets:
Cash and cash equivalents	$	28,802	$	28,802	$	28,802	$	-	$	-
Investment securities available-for-sale		349,203		349,203		47		344,992		4,164
Other investment		2,250		2,250		-		-		2,250
Federal Home Loan Bank stock		6,011		6,011		-		-		6,011
Loans held for sale		1,572		1,572		-		-		1,572
Loans, net		326,904		330,260		-		-		330,260
Accrued interest receivable		10,256		10,256		-		10,256		-
Financial Liabilities:
Demand deposits		58,531		58,531		-		58,531		-
NOW and money markets		223,279		223,279		-		223,279		-
Savings		17,472		17,472		-		17,472		-
Time deposits		255,635		251,532		-		251,532		-
Long-term borrowings		108,333		102,824		-		102,824		-
Subordinated debt		25,774		23,837		-		23,837		-
Accrued interest payable		3,760		3,760		-		3,760		-

Limitations

The fair value estimates are made at a discrete point in time based on relevant market information and information about the financial instruments. Fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors.

These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Further, the foregoing estimates may not reflect the actual amount that could be realized if all or substantially all of the financial instruments were offered for sale. This is due to the fact that no market exists for a sizable portion of the loan, deposit and off balance sheet instruments.

In addition, the fair value estimates are based on existing on-and-off balance sheet financial instruments without attempting to value anticipated future business and the value of assets and liabilities that are not considered financial instruments. Other significant assets that are not considered financial assets include premises and equipment. 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.

Finally, reasonable comparability between financial institutions may not be likely due to the wide range of permitted valuation techniques and numerous estimates which must be made given the absence of active secondary markets for many of the financial instruments. This lack of uniform valuation methodologies introduces a greater degree of subjectivity to these estimated fair values.