Note 10 — Fair Value of Financial Instruments

Fair value is 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. Financial instruments are considered Level 1 when the valuation is based on quoted prices in active markets for identical assets or liabilities. Level 2 financial instruments are valued using quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or models using inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Financial instruments are considered Level 3 when their values are determined using pricing models, discounted cash flow methodologies or similar techniques, and at least one significant model assumption or input is unobservable and when determination of the fair value requires significant management judgment or estimation.

Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding 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 fair values presented. The following methods and assumptions were used by the Company to estimate the fair value of its financial instruments at September 30, 2013, December 31, 2012 and September 30, 2012:

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

Securities Available for Sale — Where possible, the Company utilizes quoted market prices to measure debt and equity securities; such items are classified as Level 1 in the hierarchy and include equity securities, US government bonds and securities issued by federally sponsored agencies. When quoted market prices for identical assets are unavailable or the market for the asset is not sufficiently active, varying valuation techniques are used. Common inputs in valuing these assets include, among others, benchmark yields, issuer spreads, forward mortgage-backed securities trade prices and recently reported trades. Such assets are classified as Level 2 in the hierarchy and typically include private label mortgage-backed securities and corporate bonds. Pricing on these securities are provided to the Company by a pricing service vendor. In the Level 3 category, the Company is classifying the securities that reflected an other-than-temporary impairments (“OTTI”) charge based on the discounted cash flow of the security or a determination of fair value that requires significant management judgment or consideration.

FHLB, Federal Reserve Bank Stock and The Independent BankersBank (“TIB”) Stock — The carrying value approximates the fair value based upon the redemption provisions of the stock and are classified as Level 1.

Loans Held for Sale - The fair value of loans held for sale is determined, when possible, using quoted secondary-market prices. If no such quoted price exists, the fair value of a loan is determined using quoted prices for a similar asset or assets, adjusted for the specific attributes of that loan. Loans held for sale are classified as Level 2.

Loans Held for Investment— For variable-rate loans that re-price frequently and have no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. The carrying amount of accrued interest receivable approximates its fair value as a Level 1 classification.

OREO— OREO assets are recorded at the fair value less estimated costs to sell at the time of foreclosure. The fair value of OREO assets is generally based on recent real estate appraisals adjusted for estimated selling costs. 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 appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value.

Accrued Interest Receivable/Payable — The carrying amount approximates fair value and are classified as Level 1.

Deposit Accounts— The fair values estimated for demand deposits (interest and noninterest checking, passbook savings, and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts) resulting in a Level 1 classification. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of the aggregate expected monthly maturities on time deposits in a Level 2 classification. The carrying amount of accrued interest payable approximates its fair value as a Level 1 classification.

FHLB Advances and Other Borrowings— For these instruments, the fair value of short term borrowings is estimated to be the carrying amount and is classified as Level 1. The fair value of long term borrowings and debentures is determined using rates currently available for similar borrowings or debentures with similar credit risk and for the remaining maturities and are classified as Level 2. The carrying amount of accrued interest payable approximates its fair value as a Level 1 classification.

Subordinated Debentures — The fair value of subordinated debentures is estimated by discounting the balance by the current three-month LIBOR rate plus the current market spread. The fair value is determined based on the maturity date as the Company does not currently have intentions to call the debenture and is classified as Level 2.

Off-Balance Sheet Commitments and Standby Letters of Credit — The majority of the Bank’s commitments to extend credit carry current market interest rates if converted to loans. Because these commitments are generally unassignable by either the Bank or the borrower, they only have value to the Bank and the borrower. The notional amount disclosed for off-balance sheet commitments and standby letters of credit is the amount available to be drawn down on all lines and letters of credit. The cost to assume is calculated at 10% of the notional amount and is classified as Level 2.

Estimated fair values are disclosed for financial instruments for which it is practicable to estimate fair value. These estimates are made at a specific point in time based on relevant market data and information about the financial instruments. These estimates do not reflect any premium or discount that could result from offering the Company’s entire holdings of a particular financial instrument for sale at one time, nor do they attempt to estimate the value of anticipated future business related to the instruments. In addition, the tax ramifications related to the realization of unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of these estimates.

The fair value estimates presented herein are based on pertinent information available to management as of the periods indicated.

	At September 30, 2013
	Carrying Amount		Level 1		Level 2		Level 3		Estimated Fair Value
	(in thousands)
Assets:
Cash and cash equivalents	$	61,419	$	61,419	$	—	$	—	$	61,419
Securities available for sale	282,846		187,961		94,885		—		282,846
Federal Reserve Bank, TIB and FHLB stock, at cost	10,827		10,827		—		—		10,827
Loans held for sale, net	3,176		—		3,176		—		3,176
Loans held for investment, net	1,130,975		—		—		1,225,352		1,225,352
Accrued interest receivable	5,629		5,629		—		—		5,629

Liabilities:
Deposit accounts	1,284,134		998,217		284,403		—		1,282,620
FHLB advances	35,000		35,000		—		—		35,000
Other borrowings	51,474		—		53,435		—		53,435
Subordinated debentures	10,310		—		4,766		—		4,766
Accrued interest payable	195		195		—		—		195

	Notional Amount		Level 1		Level 2		Level 3		Cost to Cede or Assume
Off-balance sheet commitments and standby letters of credit	$	333,592	$	—	$	33,359	$	—	$	33,359

	At December 31, 2012
	Carrying Amount		Level 1		Level 2		Level 3		Estimated Fair Value
	(in thousands)
Assets:
Cash and cash equivalents	$	59,352	$	59,352	$	—	$	—	$	59,352
Securities available for sale	84,066		81,042		2,072		952		84,066
Federal Reserve Bank and FHLB stock, at cost	11,247		11,247		—		—		11,247
Loans held for sale, net	3,681		—		3,681		—		3,681
Loans held for investment, net	974,213		—		—		1,049,589		1,049,589
Accrued interest receivable	4,126		4,126		—		—		4,126

Liabilities:
Deposit accounts	904,768		548,101		363,382		—		911,483
FHLB advances	87,000		87,000		—		—		87,000
Other borrowings	28,500		—		31,267		—		31,267
Subordinated debentures	10,310		—		4,973		—		4,973
Accrued interest payable	142		142		—		—		142

	Notional Amount		Level 1		Level 2		Level 3		Cost to Cede or Assume
Off-balance sheet commitments and standby letters of credit	$	131,450	$	—	$	13,145	$	—	$	13,145

	At September 30, 2012
	Carrying Amount		Level 1		Level 2		Level 3		Estimated Fair Value
	(in thousands)
Assets:
Cash and cash equivalents	$	58,243	$	58,243	$	—	$	—	$	58,243
Securities available for sale	114,250		54,099		59,190		961		114,250
Federal Reserve Bank and FHLB stock, at cost	12,191		12,191		—		—		12,191
Loans held for sale, net	4,728		—		4,728		—		4,728
Loans held for investment, net	851,715		—		—		931,640		931,640
Accrued interest receivable	3,933		3,933		—		—		3,933

Liabilities:
Deposit accounts	895,870		476,852		422,036		—		898,888
FHLB advances	47,000		47,000		—		—		47,000
Other borrowings	28,500		—		32,360		—		32,360
Subordinated debentures	10,310		—		8,222		—		8,222
Accrued interest payable	213		213		—		—		213

	Notional Amount		Level 1		Level 2		Level 3		Cost to Cede or Assume
Off-balance sheet commitments and standby letters of credit	$	152,057	$	—	$	15,206	$	—	$	15,206

A loan is considered impaired when it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement. Impairment is measured based on the fair value of the underlying collateral or the discounted expected future cash flows. The Company measures impairment on all non-accrual loans for which it has reduced the principal balance to the value of the underlying collateral less the anticipated selling cost. As such, the Company records impaired loans as non-recurring Level 2 when the fair value of the underlying collateral is based on an observable market price or current appraised value. When current market prices are not available or the Company determines that the fair value of the underlying collateral is further impaired below appraised values, the Company records impaired loans as Level 3. At September 30, 2013, substantially all the Company’s impaired loans were evaluated based on the fair value of their underlying collateral based upon the most recent appraisal available to management.

The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.

The following fair value hierarchy table presents information about the Company’s assets measured at fair value on a recurring basis at the dates indicated:

	September 30, 2013
	Fair Value Measurement Using
	Level 1		Level 2		Level 3		Securities at Fair Value
	(in thousands)
Investment securities available for sale:
U.S. Treasury	$	82	$	—	$	—	$	82
Municipal bonds	—		94,885		—		94,885
Mortgage-backed securities	187,879		—		—		187,879
Total securities available for sale	$	187,961	$	94,885	$	—	$	282,846
Stock:
FHLB stock	$	7,532	$	—	$	—	$	7,532
Federal Reserve Bank stock	3,295		—		—		3,295
Total stock	10,827		—		—		10,827
Total securities	$	198,788	$	94,885	$	—	$	293,673

	September 30, 2012
	Fair Value Measurement Using
	Level 1		Level 2		Level 3		Securities at Fair Value
	(in thousands)
Investment securities available for sale:
U.S. Treasury	$	160	$	—	$	—	$	160
Municipal bonds	—		57,097		—		57,097
Mortgage-backed securities	53,939		2,093		961		56,993
Total securities available for sale	$	54,099	$	59,190	$	961	$	114,250
Stock:
FHLB stock	$	10,172	$	—	$	—	$	10,172
Federal Reserve Bank stock	2,019		—		—		2,019
Total stock	12,191		—		—		12,191
Total securities	$	66,290	$	59,190	$	961	$	126,441

The following table provides a summary of the changes in balance sheet carrying values associated with Level 3 financial instruments during the nine months ended for the periods indicated:

	Nine Months Ended
	September 30, 2013			September 30, 2012
	(in thousands)
Balance, beginning of period	$	952		$	991
Total gains or (losses) realized/unrealized:
Included in earnings (or changes in net assets)	194			(118		)
Included in other comprehensive income	(140		)	290
Purchases, issuances, and settlements	(1,077		)	(202		)
Transfer in and/or out of Level 3	71			—
Balance, end of period	$	—		$	961

The following table provides a summary of the financial instruments the Company measures at fair value on a non-recurring basis as of the periods indicated:

	September 30, 2013
	Fair Value Measurement Using
	Level 1		Level 2		Level 3		Assets at Fair Value
	(in thousands)
Assets
Impaired loans	$	—	$	—	$	1,161	$	1,161
Other real estate owned	—		—		1,186		1,186
Total assets	$	—	$	—	$	2,347	$	2,347

	September 30, 2012
	Fair Value Measurement Using
	Level 1		Level 2		Level 3		Assets at Fair Value
	(in thousands)
Assets
Impaired loans	$	—	$	—	$	2,866	$	2,866
Other real estate owned	—		—		5,521		5,521
Total assets	$	—	$	—	$	8,387	$	8,387