Note 18. FAIR VALUE MEASUREMENTS

In determining fair value, the Company uses various valuation approaches, including market, income and cost approaches. Accounting standards established a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability, which are developed based on market data obtained from sources independent of the Company. Unobservable inputs reflects the Company’s assumptions about the assumptions the market participants would use in pricing an asset or liability, which are developed based on the best information available in the circumstances.

The fair value hierarchy gives the highest priority to unadjusted quoted market prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurement). A financial asset or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. The fair value hierarchy is broken down into three levels based on the reliability of inputs as follows:

· Level 1 valuation is based upon unadjusted quoted market prices for identical instruments traded in active markets;

· Level 2 valuation is based upon quoted market prices for similar instruments traded in active markets, quoted market prices for identical or similar instruments traded in markets that are not active and model-based valuation techniques for which all significant assumptions are observable in the market or can be corroborated by market data; and

· Level 3 valuation is derived from other valuation methodologies including discounted cash flow models and similar techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in determining fair value.

A description of the valuation methodologies used for assets recorded at fair value, and for estimating fair value for financial instruments not recorded at fair value, is set forth below.

Cash, Short-term Investments, Accrued Interest Receivable and Accrued Interest Payable

For these short-term instruments, the carrying amount is a reasonable estimate of fair value.

Securities

The estimated fair values of available-for-sale equity securities are determined by obtaining quoted prices on nationally recognized exchanges (Level 1 inputs). The estimated fair values for the Company’s investments in obligations of U.S. government agencies, obligations of state and political subdivisions, government sponsored agency collateralized mortgage obligations, government sponsored agency residential mortgage-backed securities, and corporate debt securities are obtained by the Company from a nationally-recognized pricing service. This pricing service develops estimated fair values by analyzing like securities and applying available market information through processes such as benchmark curves, benchmarking of like securities, sector groupings and matrix pricing (Level 2 inputs), to prepare valuations. Matrix pricing is a mathematical technique widely used 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. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things and are based on market data obtained from sources independent from the Company. The Level 2 investments in the Company’s portfolio are priced using those inputs that, based on the analysis prepared by the pricing service, reflect the assumptions that market participants would use to price the assets. The Company has determined that the Level 2 designation is appropriate for these securities because, as with most fixed-income securities, those in the Company’s portfolio are not exchange-traded, and such non-exchange-traded fixed income securities are typically priced by correlation to observed market data. The Company has reviewed the pricing service’s methodology to confirm its understanding that such methodology results in a valuation based on quoted market prices for similar instruments traded in active markets, quoted markets for identical or similar instruments traded in markets that are not active and model-based valuation techniques for which the significant assumptions can be corroborated by market data as appropriate to a Level 2 designation.

For those securities for which the inputs used by an independent pricing service were derived from unobservable market information, the Company evaluated the appropriateness and quality of each price. The Company reviewed the volume and level of activity for all classes of securities and attempted to identify transactions which may not be orderly or reflective of a significant level of activity and volume. For securities meeting these criteria, the quoted prices received from either market participants or an independent pricing service may be adjusted, as necessary, to estimate fair value (fair values based on Level 3 inputs). If applicable, the adjustment to fair value was derived based on present value cash flow model projections prepared by the Company or obtained from third party providers utilizing assumptions similar to those incorporated by market participants. The estimated fair value of the PreTSLs and

Private Label Collateralized Mortgage Obligations in the Company’s securities portfolio were obtained from third-party service

providers that prepared the valuation using a discounted cash flow approach with inputs derived from unobservable market

information (Level 3 inputs). The valuation of PreTSLs is further described below.

At December 31, 2011, the Company owned four PreTSLs having an aggregate amortized cost of $10.6 million. The market for these securities at December 31, 2011 was not active and markets for similar securities are also not active. PreTSLs were historically priced using Level 2 inputs. However, the decline in the level of observable inputs and market activity in this class of investments had been significant and resulted in unreliable external pricing. Broker pricing and bid/ask spreads, when available, varied widely. The once active market had become comparatively inactive. Given these market conditions, the valuation of these investments was determined using Level 3 inputs. The Company obtained the valuations from a third-party service provider that prepared the valuations using a discounted cash flow approach. The Company took measures to validate the service provider’s analysis and was actively involved in the valuation process, including review and verification of the assumptions used in the valuation calculations.

Results of a discounted cash flow test are significantly affected by variables such as the estimate of the probability of default, estimates of future cash flows, discount rates, prepayment rates and the creditworthiness of the underlying issuers. The Company considers these inputs to be unobservable Level 3 inputs because they are based on the Company’s estimates about the assumptions market participants would use in pricing this type of asset and developed based on the best information available in the circumstances rather than on observable inputs. As it related to fair value measurements, at December 31, 2011, once each issuer was categorized and the forecasted default rates applied, the expected cash flows were modeled using the variables described above. The Company then applied a 10% discount rate to PreTSL XXVI, a 12% discount rate to PreTSL XIX, and a 15% discount rate to PreTSL IX and PreTSL XI to the expected cash flows to estimate fair value. The Company sold the four PreTSLs during the fourth quarter of 2012, and did not hold any such securities at December 31, 2012.

The Company owned two securities issued by state and political subdivisions having an amortized cost of $1.8 million that are valued using Level 3 inputs at December 31, 2012 and three such securities having an amortized cost of $2.8 million at December 31, 2011. These securities had credit ratings that were either withdrawn or downgraded by nationally recognized credit rating agencies, and as a result the market for these securities was inactive at December 31, 2012 and 2011. These securities were historically priced using Level 2 inputs. The credit ratings withdrawal and downgrade have resulted in a decline in the level of significant other observable inputs for these investment securities at the measurement dates. Broker pricing and bid/ask spreads are very limited for these securities. At December 31, 2012, the Company valued one security based on similar nonrated Pennsylvania Sewer bonds adjusted for coupon and maturity. For the other security, the Company obtained a bid indication from a third-party municipal trading desk to determine the fair value of this security.

At December 31, 2011, the Company owned investment grade Private Label Collateralized Mortgage Obligations, “(PLCMOs)”, having an amortized cost of $36.6 million. PLCMOs are securitized products where payments from residential mortgage loans are pooled together and passed on to different classes of owners in various tranches. The markets for such securities are generally characterized by a limited number of new issuances, a significant reduction in trading volumes and wide bid-ask spreads, all driven by the lack of market participants. Although estimated prices can generally be obtained for such securities, the level of market observable assumptions used is severely limited in the valuation. Specifically, market assumptions regarding credit adjusted cash flows and liquidity influences on discount rates were difficult to observe at the individual security level. Because of the inactivity in the markets and the lack of observable valuation inputs, seven of the eight PLCMOs were valued by a third party specialist using a discounted cash flow approach and proprietary pricing model. The model uses inputs such as estimated prepayment speeds, losses, recoveries, default rates that are implied by the underlying performance of collateral in the structure or similar structures, and discount rates that are implied by market prices for similar securities and collateral structure types. The eighth security with an amortized cost of $5.1 million was a new issue purchased in December 2011 for settlement in January 2012. Because the security was a new issue, no data on the underlying collateral was available to the third party valuation service. The Company used the purchase price as the fair value for this security at December 31, 2011. The Company sold the PLCMOs during the fourth quarter of 2012, and did not hold any such securities at December 31, 2012.

Loans

Except for collateral dependent impaired loans, fair values of loans are estimated by discounting the projected future cash flows using market discount rates that reflect the credit, liquidity, and interest rate risk inherent in the loan. Projected future cash flows are calculated based upon contractual maturity or call dates, projected repayments and prepayments of principal. The estimated fair value of collateral dependent impaired loans is based on the appraised loan value or other reasonable offers less estimated costs to sell. The Company does not record loans at fair value on a recurring basis. However from time to time, a loan is considered impaired and an allowance for credit losses is established. The specific reserves for collateral dependent impaired loans are based on the fair value of the collateral less estimated costs to sell. The fair value of the collateral is generally based on appraisals. In some cases, adjustments are made to the appraised values due to various factors including age of the appraisal, age of comparables included in the appraisal, and known changes in the market and in the collateral. When significant adjustments are based on unobservable inputs, the resulting fair value measurement is categorized as a Level 3 measurement. See also, Note 2 “Summary of Significant Accounting Policies-Loan Impairment” and Note 5-”Loans.”

Loans Held For Sale

Fair values of mortgage loans held for sale are based on commitments on hand from investors or prevailing market prices.

Mortgage Servicing Rights

The fair value of mortgage servicing rights is estimated using a discounted cash flow model that applies current estimated prepayments derived from the mortgage-backed securities market and utilizes a current market discount rate for observable credit spreads. The Bank does not record mortgage servicing rights at fair value on a recurring basis.

Federal Home Loan Bank (“FHLB”) and Federal Reserve Bank (“FRB”) Stock

Ownership in equity securities of FHLB of Pittsburgh and the FRB is restricted and there is no established market for their resale. The carrying amount is a reasonable estimate of fair value.

Deposits

The fair value of demand deposits, savings deposits, and certain money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated based on discounted cash flows using the rates currently offered for deposits of similar remaining maturities.

Borrowed funds

The Bank uses discounted cash flows using rates currently available for debt with similar terms and remaining maturities are used to estimate fair value.

Commitments to extend credit and standby letters of credit

The fair value of commitments to extend credit and standby letters of credit are estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of off-balance sheet commitments is insignificant and therefore not included in the table for non-recurring assets and liabilities.

Assets Measured at Fair Value on a Recurring Basis

The following tables detail the financial asset amounts that are carried at fair value and measured at fair value on a recurring basis at December 31, 2012 and 2011, and indicate the fair value hierarchy of the valuation techniques utilized by the Company to determine the fair value:

	Fair value measurements at December 31, 2012
					Significant
			Quoted prices		other		Significant
			in active markets		observable		unobservable
			for identical		inputs		inputs
(in thousands)	Fair value		assets (Level 1)		(Level 2)		(Level 3)
Available-for-sale securities:
Obligations of U.S. government agencies	$	1,891	$	—	$	1,891	$	—
Obligations of state and political subdivisions	103,501		—		101,762		1,739
Government sponsored agency CMOs	9,103		—		9,103		—
Residential mortgage-backed securities	69,456		—		69,456		—
Corporate debt securities	410		—		410		—
Equity securities	1,000		1,000		—		—
Total securities available-for-sale	$	185,361	$	1,000	$	182,622	$	1,739

	Fair value measurements at December 31, 2011
					Significant
			Quoted prices		other		Significant
			in active markets		observable		unobservable
			for identical		inputs		inputs
(in thousands)	Fair value		assets (Level 1)		(Level 2)		(Level 3)
Available-for-sale securities:
Obligations of U.S. government agencies	$	8,048	$	—	$	8,048	$	—
Obligations of state and political subdivisions	96,161		—		93,350		2,811
Government sponsored agency CMOs	8,468		—		8,468		—
Private label CMOs	36,256		—		—		36,256
Residential mortgage-backed securities	31,393		—		31,393		—
Pooled trust preferred Senior Class	1,604		—		—		1,604
Pooled trust preferred Mezzanine Class	2,197		—		—		2,197
Corporate debt securities	342		—		342		—
Equity securities	1,006		1,006		—		—
Total securities available-for-sale	$	185,475	$	1,006	$	141,601	$	42,868

The table below presents reconciliation and statement of operations classifications of gains and losses for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the years ended December 31, 2012 and 2011:

Fair Value Measurements Using Significant Unobservable Inputs (Level 3)

(in thousands)	PreTSLs			State and Political Subdivisions			Private Label CMOs			Total
Balance at December 31, 2010	$	3,069		$	2,245		$	—		$	5,314
Amortization	—			—			—			—
Accretion	—			—			—			—
Purchases	—			—			36,256			36,256
Paydowns	(106		)	(530		)	—			(636		)
Sales and calls	(19		)	—			—			(19		)
Transfers in and out of Level 3	—			1,182			—			1,182
Total gains or losses (realized/unrealized):
Included in earnings	(798		)	—			—			(798		)
Included in other comprehensive income	1,655			(86		)	—			1,569
Balance at December 31, 2011	$	3,801		$	2,811		$	36,256		$	42,868
Amortization	—			—			(395		)	(395		)
Accretion	—			—			101			101
Purchases	—			—			14,691			14,691
Paydowns	(172		)	(550		)	(13,478		)	(14,200		)
Sales and calls	(3,629		)	(585		)	(37,175		)	(41,389		)
Total gains or losses (realized/unrealized):
Included in earnings	—			—			—			—
Included in other comprehensive income	—			63			—			63
Balance at December 30, 2012	$	—		$	1,739		$	—		$	1,739

Assets Measured at Fair Value on a Non-Recurring Basis

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

	Fair value measurements at December 31, 2012
				Significant	Significant
			Quoted prices	other	other
			in active markets	observable	unobservable
			for identical	inputs	inputs
(in thousands)	Fair value (1)		assets (Level 1)	(Level 2)	(Level 3)
Collateral-dependent impaired loans	$	7,816			$	7,816
Other real estate owned	$	2,455			$	2,455

	Fair value measurements at December 31, 2011
				Significant	Significant
			Quoted prices	other	other
			in active markets	observable	unobservable
			for identical	inputs	inputs
(in thousands)	Fair value (1)		assets (Level 1)	(Level 2)	(Level 3)
Collateral-dependent impaired loans	$	12,555			$	12,555
Other real estate owned	$	5,212			$	5,212

(1) Represents carrying value and related write-downs for which adjustments are based on appraised value. Management makes adjustments to the appraised values as necessary to consider declines in real estate values since the time of the appraisal. Such adjustments are based on management’s knowledge of the local real estate markets.

Collateral-dependent impaired loans are classified as Level 3 assets and the estimated fair value of the collateral is based on the appraised loan value or other reasonable offers less estimated costs to sell. When the measure of the impaired loan is less than the recorded investment in the loan, the impairment is recorded through a valuation allowance or is charged off. The amount shown is the balance of impaired loans, net of any charge-offs and the related allowance for loan losses.

OREO properties are recorded at fair value less the estimated cost to sell at the date of acquisition. Subsequent to acquisition, the balance might be written down further. It is the Company’s policy to obtain certified external appraisals of real estate collateral underlying impaired loans, including OREO, and it estimates fair value using those appraisals. Other valuation sources may be used, including broker price opinions, letters of intent and executed sale agreements.

The Company discloses fair value information about financial instruments, whether or not recognized in the Statement of Financial Condition, for which it is practicable to estimate that value. The following estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. However, management judgment is required to interpret data and develop fair value estimates. Accordingly, the estimates below are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.

The following table summarizes the estimated fair values of the Company’s financial instruments at December 31, 2012 and 2011:

	Fair Value	December 31, 2012				December 31, 2011
(in thousands)	Measurement	Carrying Value		Fair Value		Carrying Value		Fair Value
Financial assets
Cash and short term investments	Level 1	$	115,271	$	115,271	$	168,646	$	168,646
Securities	See previous table	187,559		187,844		187,569		187,720
FHLB and FRB Stock	Level 2	7,308		7,308		9,659		9,659
Loans held for sale	Level 2	1,615		1,615		94		94
Loans, net	Level 3	579,396		592,504		659,044		661,833
Accrued interest receivable	Level 2	2,199		2,199		2,552		2,552
Mortgage servicing rights	Level 3	675		884		777		1,185

Financial liabilities
Deposits	Level 2	854,613		858,970		957,136		964,238
Borrowed funds	Level 2	53,903		59,021		83,571		89,628
Accrued interest payable	Level 2	6,427		6,427		4,301		4,301