7. Fair Value of Financial Instruments

The Corporation utilizes fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Effective January 1, 2008, the Corporation adopted FASB 157 (ASC 820-10-15), Fair Value Measurements, which provides a framework for measuring and disclosing fair value under generally accepted accounting principles. This standard requires disclosures about the fair value of assets and liabilities recognized in the balance sheet in periods subsequent to initial recognition, whether the measurements are made on a recurring basis (for example, available-for-sale investment securities) or on a nonrecurring basis (for example, impaired loans).

Fair Value Hierarchy

ASC 820-10-15 defines fair value as 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. ASC 820-10-15 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1	Valuation is based upon quoted prices in active markets for identical assets or liabilities.

Level 2	Valuation is based upon 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 for substantially the full term of the assets or liabilities.

Level 3	Valuation is based upon quoted prices for similar assets or liabilities; quoted prices in markets that are not active; and model-based techniques whose value is determined using pricing models, discounted cash flow methodologies and similar techniques.

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

Investment Securities Available-for-Sale

Available-for-sale investment securities are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange and U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets. Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 may include asset-backed securities in less liquid markets.

Loans

The Corporation is predominantly an asset based lender with real estate serving as collateral on a substantial majority of loans. The Corporation does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and the related impairment is charged against the allowance or a specific allowance is established. The Corporation performs its allowance for loan and lease losses calculation on a quarterly basis, which also includes an evaluation of all nonperforming loans for further impairment even if a new appraisal is not obtained on a quarterly basis. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Loans which are deemed to be impaired are primarily valued at the fair values of the underlying real estate collateral. Such fair values are obtained using collateral net liquidation value, market value of similar debt, enterprise value, and discounted cash flows. Those impaired loans not requiring a specific allowance represent loans for which the fair value of the expected repayment or collateral meet or exceed the recorded investment in such loans. The Corporation considers all nonaccrual loans and troubled debt restructurings to be impaired. When the fair value of the collateral is based on an observable market price or a current appraised value, the Corporation records the impaired loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Corporation records the impaired loans as nonrecurring Level 3. Certain assumptions and unobservable inputs are currently being used by appraisers, therefore qualifying impaired loans as Level 3. Consistent with the regulator’s appraisal guidance dated December 10, 2010, the Corporation has adopted a loan reappraisal policy. The regulatory guidance states that a bank should establish criteria for assessing whether an existing appraisal or evaluation continues to reflect the market value of the property. Generally, impaired loans will be evaluated using an existing appraisal if the valuation has been established within the previous twelve months. However, market conditions may dictate an updated appraisal for a lesser timeframe. Factors include deterioration in the credit since origination or changes in market conditions. Changes in market conditions could include material changes in current and projected vacancy, absorption rates, lease terms, rental rates, and sale prices, including concessions and overruns and delays in construction costs. Fluctuations in discount or direct capitalization rates also are indicators of changing market conditions. In assessing whether changes in market conditions are material, the Bank considers the individual and aggregate effect of these changes on its collateral protection and the risk in its real estate lending program or credit portfolios.

Real Estate Acquired Through Foreclosure

Other real estate owned (“OREO”) is adjusted to fair value upon transfer of the loans to OREO. Subsequently, OREO is carried at the lower of carrying value 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. Certain assumptions and unobservable inputs are currently being used by appraisers, therefore qualifying these assets as Level 3.

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

The following tables present the balances of assets recorded at fair value on a recurring basis by level within the hierarchy as of June 30, 2013 and December 31, 2012 (in thousands).

			Quoted Prices in		Significant Other		Significant
	Total		Active Markets for		Observable		Unobservable
	June 30,		Identical Assets		Inputs		Inputs
	2013		(Level 1)		(Level 2)		(Level 3)
Investment Securities:
Government Sponsored Enterprises	$	121,055	$	121,055	$	--	$	--
Trust Preferred Securities		4,247		--		2,554		1,693
Total Investment Securities		125,302		121,055		2,554		1,693
Mortgage-Backed and Related Securities		55,106		--		55,106		--
Total	$	180,408	$	121,055	$	57,660	$	1,693

			Quoted Prices in		Significant Other		Significant
	Total		Active Markets for		Observable		Unobservable
	December 31,		Identical Assets		Inputs		Inputs
	2012		(Level 1)		(Level 2)		(Level 3)
Investment Securities:
Government Sponsored Enterprises	$	123,679	$	123,679		--		--
Trust Preferred Securities		4,335		--		2,788		1,547
Total Investment Securities		128,014		123,679		2,788		1,547
Mortgage-Backed and Related Securities		41,200		--		41,200		--
Total	$	169,214	$	123,679	$	43,988	$	1,547

The following is a reconciliation of the beginning and ending balances for assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the period ended June 30, 2013.

	Fair Value Measurements Using Significant
	Unobservable Inputs (Level 3)
	(in thousands)
Investment Securities
	Available-for-Sale
Beginning balance at March 31, 2013	$	1,820
Transfers into Level 3		--
Total gains/ (losses) included in:
Net loss		--
Other comprehensive income		(123	)
Purchases, sales, issuances and settlements, net		(4	)
Ending balance at June 30, 2013	$	1,693

	Fair Value Measurements Using Significant
	Unobservable Inputs (Level 3)
	(in thousands)
Investment Securities
	Available-for-Sale
Beginning balance at December 31, 2012	$	1,547
Transfers into Level 3		--
Total gains/ (losses) included in:
Net loss		--
Other comprehensive income		150
Purchases, sales, issuances and settlements, net		(4	)
Ending balance at June 30, 2013	$	1,693

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

The Corporation may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with U.S. generally accepted accounting principles. These include assets that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period and assumes all nonperforming assets have specific reserves or have been written down to fair value.

For Level 3 assets and liabilities measured at fair value on a recurring or nonrecurring basis as of June 30, 2013, the significant unobservable inputs used in the fair value measurements were as follows: (in thousands)

	Fair Value at June 30, 2013		Valuation Technique	Significant Unobservable Inputs	General Range Of Significant Unobservable Input Values
Impaired loans	$	18,564	Appraised Value/ Discounted Cash Flows Market Value of Note	Appraisals and/or sales of comparable properties/ Independent quotes		0-25	%
Other real estate owned		5,182	Appraised Value/ Comparable Sales/ Other Estimates from Independent Sources	Appraisals and/or sales of comparable properties/ Independent quotes		0-40	%
Assets at fair value	$	23,746

For Level 3 assets and liabilities measured at fair value on a recurring or nonrecurring basis as of December 31, 2012, the significant unobservable inputs used in the fair value measurements were as follows: (in thousands)

	Fair Value at December 31, 2012		Valuation Technique	Significant Unobservable Inputs	General Range Of Significant Unobservable Input Values
Impaired loans	$	23,462	Appraised Value/ Discounted Cash Flows Market Value of Note	Appraisals and/or sales of comparable properties/ Independent quotes		0-25	%
Other real estate owned		9,174	Appraised Value/ Comparable Sales/ Other Estimates from Independent Sources	Appraisals and/or sales of comparable properties/ Independent quotes		0-40	%
Asets at fair value	$	32,636

Level 3 Valuation Methodologies. Following is a description of the unobservable inputs used for Level 3 fair value measurements.

Impaired Loans. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Loans which are deemed to be impaired are primarily valued at the fair values of the underlying real estate collateral. Such fair values are obtained using collateral net liquidation value, market value of similar debt, enterprise value, and discounted cash flows. Those impaired loans not requiring a specific allowance represent loans for which the fair value of the expected repayment or collateral meet or exceed the recorded investment in such loans. The Corporation considers all nonaccrual loans and troubled debt restructurings to be impaired. When the fair value of the collateral is based on an observable market price or a current appraised value, the Corporation records the impaired loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Corporation records the impaired loans as nonrecurring Level 3. Certain assumptions and unobservable inputs are currently being used by appraisers, therefore qualifying impaired loans as Level 3. Impaired loan totals represent nonperforming loans for the periods indicated.

OREO is adjusted to fair value upon transfer of the loans to OREO. Subsequently, OREO is carried at the lower of carrying value 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. Certain assumptions and unobservable inputs are currently being used by appraisers, therefore qualifying these assets as Level 3.

Investment Securities: Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange and U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets. Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 may include asset-backed securities in less liquid markets.

The following methods and assumptions were used by the Corporation in estimating fair values of financial instruments as disclosed herein:

Cash and federal funds sold- The carrying amounts of cash and due from banks and federal funds sold approximate their fair value.

Available for sale securities - Fair values for securities are based on quoted market prices. The carrying values of restricted equity securities approximate fair values. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions.

Loans - The Corporation is predominantly an asset based lender with real estate serving as collateral on a substantial majority of loans. The Corporation does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and the related impairment is charged against the allowance or a specific allowance is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Loans which are deemed to be impaired are primarily valued at the fair values of the underlying real estate collateral. Such fair values are obtained using collateral net liquidation value, market value of similar debt, enterprise value, and discounted cash flows. Those impaired loans not requiring a specific allowance represent loans for which the fair value of the expected repayment or collateral meet or exceed the recorded investment in such loans. The Corporation considers all nonaccrual loans and troubled debt restructurings to be impaired.

Cash surrender value of life insurance - The carrying amounts of cash surrender values of life insurance approximate their fair value.

Deposit liabilities - The fair values disclosed for demand deposits are, by definition, equal to the amount payable on demand at the reporting date (that is, their carrying amounts). The carrying amounts of variable-rate, fixed-term money-market accounts and certificates of deposit (CDs) approximate their fair values at the reporting date. Fair values for fixed-rate CDs are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.

Advances from the FHLB and other borrowings - The fair values of the Corporation’s borrowings are estimated using discounted cash flow analysis based on the Corporation’s current incremental borrowing rates for similar types of borrowing arrangements.

Securities sold under agreements to repurchase - The fair values of the Corporation’s repurchase agreements are estimated using discounted cash flow analysis based on the Corporation’s current incremental borrowing rates for similar types of borrowing arrangements.

Accrued interest - The carrying amounts of accrued interest approximate their fair values.

Floating rate junior subordinated deferrable interest debentures - The fair values of the Corporation’s floating rate debentures are estimated using discounted cash flow analysis based on the Corporation’s current incremental borrowing rates for similar types of borrowing arrangements.

Off-balance-sheet instruments - Fair values for off-balance-sheet lending commitments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counter parties’ credit standings.

The following presents the carrying amount, fair value, and placement in the fair value hierarchy of the Corporation’s financial instruments as of June 30, 2013 and December 31, 2012. This table excludes financial instruments for which the carrying amount approximates fair value. For short-term financial assets such as cash and cash equivalents, the carrying amount is a reasonable estimate of fair value due to the relatively short time between the origination of the instrument and its expected realization. For financial liabilities such as noninterest-bearing demand, interest-bearing demand, and savings deposits, the carrying amount is a reasonable estimate of fair value due to these products having no stated maturity.

					Fair Value Measurements

					Quoted
					Prices in
					Active Markets		Significant
					for Identical		Other		Significant
					Assets or		Observable		Unobservable
	Carrying				Liabilities		Inputs		Inputs
(dollars in thousands)	Amount		Fair Value		(Level 1)		(Level 2)		(Level 3)

June 30, 2013
Financial Instruments - Assets
Loans	$	120,088	$	120,040		--		--	$	120,040

Financial Instruments – Liabilities
Time deposits	$	113,745	$	114,166	$	--	$	114,166	$	--
Securities sold under agreements
to repurchase		5,449		5,449		--		5,449		--
Subordinated debentures		12,372		12,372		--		12,372		--

December 31, 2012
Financial Instruments - Assets
Loans	$	123,414	$	123,553		--		--	$	123,553

Financial Instruments – Liabilities
Time deposits	$	117,167	$	117,723	$	--	$	117,723	$	--
Securities sold under agreements
to repurchase		6,280		6,280		--		6,280		--
Subordinated debentures		12,372		12,372		--		12,372		--