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 value of this single issue trust preferred security is obtained on a quarterly basis directly from the originating broker.

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 at fair value on a recurring basis:

	Fair Value Measurements at:
	(Dollars in Thousands)						(Dollars in Thousands)
	June 30, 2016						December 31, 2015
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		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			$	3,000					$	2,994
Agency mortgage-backed securites-residential			28,783						29,657
State and municipal			24,504						25,222
Trust preferred security					1,260						1,340
Corporate bonds			994						987


Total investment securities	$	—	$	57,281	$	1,260	$	—	$	58,860	$	1,340

The table below presents a reconciliation of all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the six months ended June 30:

	Trust Preferred Security
	2016			2015

Balance of recurring Level 3 assets at January 1	$	1,340		$	1,480
Total losses for the period:
Included in other comprehensive income	(80		)	(30		)

Balance of recurring Level 3 assets at June 30	$	1,260		$	1,450

Impaired loans which are measured for impairment using the fair value of collateral for collateral dependent loans, had a principal balance of $49,000 at June 30, 2016 with a valuation allowance of $25,000. Impaired loans which were measured for impairment using the fair value of collateral for collateral-dependent loans had a principal balance of $537,000 at December 31, 2015, with a valuation allowance of $198,000. Increases in the provision for loan losses of $25,000 and $233,000 were recognized for the six months ended June 30, 2016 and 2015, respectively, 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 $66,000 at June 30, 2016 and $100,000 at December 31, 2015. Total writedowns of other real estate owned were $0 and $23,000 in the six months ending June 30, 2016 and 2015, 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, 2016.

	June 30, 2016		Valuation Techniques	Unobservable Inputs (Dollars in thousands)	Range (Weighted Avg)
Impaired loans:
Residential RE	$	24	Sales Comparison	Adjustments for limited use nature of certain properties, age of appraisal, location, and/or condition	(50%)

Other real estate owned:
Residentiall RE	66		Sales Comparison	Adjustments for limited use nature of certain properties, age of appraisal, location, and/or condition	48%-54% (51.63%)

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, 2015.

	December 31, 2015		Valuation Techniques	Unobservable Inputs (Dollars in thousands)	Range (Weighted Avg)
Impaired loans:
Commercial RE	$	260	Sales Comparison	Adjustments for limited use nature of certain properties, age of appraisal, location, and/or condition	(50.00%)
Residential	79		Sales Comparison	Adjustments for limited use nature of certain properties, age of appraisal, location, and/or condition	20%-60% (30.00%)

Other real estate owned:
Commercial RE	100		Sales Comparison	Adjustments for limited use nature of certain properties, age of appraisal, location, and/or condition	8%-40% (33.65%)

The carrying amount and estimated fair values of financial instruments at June 30, 2016 and December 31, 2015 were as follows:

			Fair Value Measurements at
	Carrying		June 30, 2016
	Amount		Level 1		Level 2	Level 3	Total
Financial Assets
Cash and cash equivalents	$	7,354	$	7,354			$	7,354
Interest-bearing deposits in other financial institutions	2,728		2,761				2,761
Available-for-sale securities	57,862				57,281	1,260	58,541
Loans, net of allowance	342,064					343,856	343,856
Loans held for sale	118				121		121
Accrued interest receivable	1,536		18		300	1,218	1,536
Federal Home Loan Bank stock	2,025						N/A

Financial Liabilities
Demand and savings deposits	$	213,574	$	213,574			$	213,574
Time deposits	139,859				140,196		140,196
FHLB advances	35,000				35,023		35,023
Other borrowings	1,000				1,000		1,000
Subordinate debentures	5,000					2,434	2,434
Accrued interest payable	223		11		182	30	223

			Fair Value Measurements at
			December 31, 2015
	Carrying Amount		Level 1		Level 2		Level 3	Total

Financial Assets
Cash and cash equivalents	$	15,255	$	15,255	$		$	$	15,255
Interest-bearing deposits in other financial institutions	2,728		$	2,728				2,728
Available-for-sale securities	59,965				$	58,860	1,340	60,200
Loans, net of allowance	325,866						326,886	326,886
Accrued interest receivable	1,680				337		1,343	1,680
Federal Home Loan Bank stock	2,025							N/A

Financial Liabilities
Demand and savings deposits	$	216,857	$	216,857				$	216,857
Time deposits	153,531				153,801			153,801
FHLB advances	13,000				12,902			12,902
Other borrowings	2,000				2,000			2,000
Subordinate debentures	5,000						2,434	2,434
Accrued interest payable	213		9		177		27	213

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)

Interest Bearing Deposits in Other Financial Institutions: Fair values are based on quoted market prices.

(c)

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

(d)

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 first party investors resulting in a Level 2 classification.

(e)

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 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.

(f)

FHLB Advances and Other Borrowings/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.

(g)

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.