Note 5 - Fair Value Measurements

Fair value is the exchange price that would be received to sell 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 at the measurement date. The fair value hierarchy 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 values:

Level 1 — Quoted prices in active markets for identical assets or liabilities.

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, and other inputs that are observable or can be corroborated by observable market data.

Level 3 — Significant unobservable inputs that are supported by little or no market activity, reflect a company’s own assumptions about market participant assumptions of fair value, and are significant to the fair value of the assets or liabilities.

In determining the appropriate levels, the Company used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:

Investment Securities: The fair value of securities available-for-sale are determined by obtaining quoted prices on nationally recognized securities exchanges (level 1 inputs) or 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). The Company does not have any Level 1 securities. Level 2 securities include certain U.S. agency bonds, collateralized mortgage and debt obligations, and certain municipal securities. The Company also has one Level 3 security. The fair value of this security is obtained directly from the broker which originally handled the security issue. The value is determined based on trades of similar securities with similar coupons.

Impaired Loans: The fair value of impaired loans with specific allocations of the allowance for loan losses is generally 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.

Other Real Estate Owned: Commercial and residential real estate properties classified as other real estate owned (OREO) are measured at fair value, less costs to sell. Fair values are based on recent real estate appraisals. These appraisals may use 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 collateral-dependent impaired loans and real estate properties classified as 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 Bank management. The appraisal values for collateral-dependent impaired loans are discounted to allow for selling expenses and fees, the limited use nature of various properties, the age of the most recent appraisal, and additional discretionary discounts for location, condition, etc. The Bank annually obtains an updated current appraisal value for each OREO property to certify that the fair value has not declined. For each parcel of OREO that has declined in value, the Bank records the decline in value by a direct writedown of the asset.

Assets measured on a recurring basis:

	Fair Value Measurements at June 30, 2014 (Dollars in Thousands)
	Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Securities available-for-sale
U. S. government agencies and government sponsored entities		$	5,924
State and municipal		21,302
Agency mortgage-backed securities -residential		25,740
Trust preferred security				1,440
Corporate bonds		999
Total investment securities	—	$	53,965	$	1,440

	Fair Value Measurements at December 31, 2013 (Dollars in Thousands)
	Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Securities available-for-sale
U. S. government agencies and government sponsored entities		$	5,819
State and municipal		19,676
Agency mortgage-backed securities -residential		23,744
Trust preferred security		1,400
Corporate Bond		994
Total investment securities	—	$	51,633	—

Assets measured on a non-recurring basis:

	Fair Value Measurements (Dollars in Thousands)
	June 30, 2014 Significant Unobservable Inputs (Level 3)		December 31, 2013 Significant Unobservable Inputs (Level 3)
Impaired loans:
Commercial	$	26	$	530
Commercial RE	243		808
Residential	157		739

Other real estate owned:
Commercial RE	$	471	$	516
Residential	127		317

Impaired loans which are measured for impairment using the fair value of collateral for collateral dependent loans, had a principal balance of $761,000 at June 30, 2014 with a valuation allowance of $335,000. Impaired loans had a principal balance of $3.5 million at December 31, 2013, with a valuation allowance of $1.4 million. An increase in the provision for loan losses of $22,000 was recognized for the six months ended June 30, 2014, as a result of net changes in fair values on collateral dependent loans and other factors affecting the provision for loan losses.

Other real estate owned, which is measured at fair value less costs to sell, had a net carrying value of $598,000 at June 30, 2014 and $833,000 at December 31, 2013. Total writedowns of other real estate owned year to date June 30, 2014 and 2013, were $33,000 and $11,000 respectively.

The following table presents quantitative and qualitative information about Level 3 fair value measurements for financial instruments measured on a non-recurring basis at June 30, 2014.

	June 30, 2014		Valuation Techniques	Unobservable Inputs (Dollars in thousands)	Range (Weighted Avg)
Impaired loans:
Commercial	$	26	Market Approach	Discounts to allow for market value of assets	(50.00%)
Commercial RE	243		Sales Comparison	Adjustments for limited use nature of certain properties, age of appraisal, location, and/or condition	20%-50% (34.08%)
Residential	157		Sales Comparison	Adjustments for limited use nature of certain properties, age of appraisal, location, and/or condition	0%-20% (11.94%)
Other real estate owned:
Commercial RE	471		Sales Comparison	Adjustments for limited use nature of certain properties, age of appraisal, location, and/or condition	8%-55% (44.24%)
Residential	127		Sales Comparison	Adjustments for limited use nature of certain properties, age of appraisal, location, and/or condition	6%-69% (17.36%)

The following table presents quantitative and qualitative information about Level 3 fair value measurements for financial instruments measured on a non-recurring basis at December 31, 2013.

	December 31, 2013		Valuation Techniques	Unobservable Inputs (Dollars in thousands)	Range (Weighted Avg)
Impaired loans:
Commercial	$	530	Market Approach	Discounts to allow for market value of assets	0%-50% (39.42%)
Commercial RE	808		Sales Comparison	Adjustments for limited use nature of certain properties, age of appraisal, location, and/or condition	20%-50% (24.92%)
Residential	739		Sales Comparison	Adjustments for limited use nature of certain properties, age of appraisal, location, and/or condition	0%-20% (18.43%)
Other real estate owned:
Residential	317		Sales Comparison	Adjustments for limited use nature of certain properties, age of appraisal, location, and/or condition	6%-42.3% (21.47%)
Commercial RE	516		Sales Comparison	Adjustments for limited use nature of certain properties, age of appraisal, location, and/or condition	7.9%-54.5% (42.93%)

Carrying amount and estimated fair values of financial instruments, not previously presented, were as follows:

			Fair Value Measurements at June 30, 2014
	Carrying Amount		Level 1		Level 2	Level 3	Total
Financial Assets
Cash and cash equivalents	$	22,830	$	22,830			$	22,830
Loans held for sale	286				291		291
Loans, net of allowance	306,076					313,542	313,542
Accrued interest receivable	1,536				284	1,252	1,536
Federal Home Loan Bank stock	2,025						N/A

Financial Liabilities
Demand and savings deposits	$	184,265	$	150,376			$	150,376
Time deposits	161,545				162,395		162,395
FHLB advances	22,000				21,868		21,868
Subordinate debentures	5,000					2,836	2,836
Accrued interest payable	239		13		226		239

			Fair Value Measurements at December 31, 2013
	Carrying Amount		Level 1		Level 2	Level 3	Total
Financial Assets
Cash and cash equivalents	$	37,062	$	37,062			$	37,062
Loans, net of allowance	288,338					295,850	295,850
Accrued interest receivable	1,554				274	1,280	1,554
Federal Home Loan Bank stock	2,025						N/A

Financial Liabilities
Demand and savings deposits	$	183,569	$	144,220			$	144,220
Time deposits	159,382				160,284		160,284
FHLB advances	22,000				21,794		21,794
Subordinate debentures	5,000					2,836	2,836
Accrued interest payable	243		15		228		243

The methods and assumptions used to estimate fair value are described as follows:

(a) Cash and Cash Equivalents: The carrying amounts of cash and short-term instruments approximate fair values and are classified as Level 1.

(b) FHLB Stock: It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.

(c) Loans: Fair values of loans, excluding loans held for sale, are estimated as follows: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price. 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.

(d) Deposits: The fair values disclosed for demand deposits (e.g., interest and non-interest 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 amount) resulting in a Level 1 classification. The carrying amounts of variable rate money market accounts and certificates of deposit approximate their fair values at the reporting date resulting in a Level 2 classification. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

(e) FHLB Advances/ Subordinated Debentures: The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 2 classification. The fair values of the Company’s Subordinated Debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 3 classification.

(f) Accrued Interest Receivable/Payable: The carrying amounts of accrued interest approximate fair value resulting in a Level 1 or Level 2 classification consistent with the asset/liability they are associated with.