7.	Fair Value Measurements

Fair Value Hierarchy. Under ASC 820-10, we group assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:


Level 1		Valuation is based upon quoted prices for identical instruments traded in active markets.

Level 2		Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

Level 3		Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

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

Assets Measured at Fair Value on a Recurring Basis

Investment Securities Available for Sale. Investment securities available-for-sale 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 investments securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 investment securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.

Loans Held for Sale (LHFS). Effective December 1, 2011, the Company elected to measure new LHFS at fair value. The remaining LHFS are carried at the lower of cost or market. Fair value is based on quoted market prices. We classify those loans subjected to recurring fair value adjustments as Level 2.

The following table shows the recorded amounts of assets measured at fair value on a recurring basis.


	At June 30, 2012
	Total		Level 1		Level 2		Level 3
(Dollars in thousands)
Investment securities available for sale:
Mortgage backed securities issued by U.S. agencies	$	91,339		—	$	91,339		—
Municipal securities		470		—		470		—
Collateralized mortgage obligations issued by non-agency		2,640		—		2,640		—
Asset backed securities		237		—		—		237
Mutual funds		4,425		4,425		—		—

Total securities available for sale at fair value		99,111		4,425		94,449		237
Loans held for sale		138,301		—		138,301		—

Total assets measured at fair value on a recurring basis	$	237,412	$	4,425	$	232,750	$	237

The valuation technique used for Level 3 assets in these investment categories is a discounted cash flow. Inputs considered in determining Level 3 pricing include, the securities anticipated prepayment rates, default rates, and the loss severity given a future default. Significant increases or decreases in either of those inputs in isolation would result in a significantly lower or higher fair value measurement. In general, a change in the assumption of the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity in an event of default.

For the asset backed security, the underlying issuer default probability is analyzed. These probabilities are then combined with correlation assumptions to generate 10,000 default paths using a Monte Carlo simulation. The results from each simulation path are averaged to obtain a final fundamental value and loss estimate. Recovery rates and prepayment rates are 0%. Prepayment rates are subject to change based on market conditions. There is a 50% asset correlation for issuers in the same industry and a 30% correlation for issuers in different industries.

The changes in Level 3 assets measured at fair value on a recurring basis are summarized in the following table:


	Investment Securities Available for Sale
(Dollars in thousands)
Balance of recurring Level 3 instruments at January 1, 2012	$	1,035
Total gains or losses (realized/unrealized):
Included in earnings-realized		—
Included in earnings-unrealized⁽¹⁾		(77	)
Included in other comprehensive income		2,022
Purchases		—
Sales		—
Issuances		—
Settlements		—
Transfers in and/or out of Level 3		(2,743	)

Balance of Level 3 assets at June 30, 2012	$	237

(1)	Amount reported as other than temporary impairment loss in the noninterest income portion of the Statement of Operations.

At June 30, 2012, a single non-agency collateralized mortgage obligation security was moved from a Level 3 asset to a Level 2 asset. As of that date, this security was determined to have a fair value of $657,000, an amortized cost of 669,000 and an unrealized loss of approximately $12,000. The recovery of home prices and the improved liquidity in the whole loan, jumbo mortgage market provided for additional liquidity for similar instruments and was the reason for the change in levels.

Assets Recorded at Fair Value on a Nonrecurring Basis

The Company 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 or that were recognized at a fair value below cost at the end of the period.

We have elected to use fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Securities available for sale and certain mortgage loans are recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record at fair value other assets on a nonrecurring basis, such as loans held for investment. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Impaired Loans. ASC 820-10 applies to loans measured for impairment in accordance with ASC 310-10, Accounting by Creditors for Impairment of a Loan, including impaired loans measured at an observable market price (if available), and at the fair value of the loan’s collateral (if the loan is collateral dependent). The fair value of an impaired loan is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance for possible losses represent loans for which the fair value of the expected repayments or collateral exceeds the recorded investments in such loans. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the impaired loan at Level 2. When an appraised value is not available or we determine that the fair value of the collateral is further impaired below the appraised value and there is no observable market price, we record the impaired loan at Level 3.

Foreclosed Assets. Foreclosed assets are adjusted to fair value, less estimated costs to sell, at the time the loans are transferred to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value less estimated costs to sell. Fair value is determined based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the foreclosed asset at Level 2. When an appraised value is not available or we determine that the fair value of the collateral is further impaired below the appraised value and there is no observable market price, we record the foreclosed asset at Level 3.

Loans Held for Sale. Loans held for sale and funded prior to December 1, 2011 are carried at the lower of cost or market value. The fair value of these loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics. As such, the Company classifies loans subjected to nonrecurring fair value adjustments as Level 2.

Information regarding assets measured at fair value on a nonrecurring basis is set forth in the table below.


	At June 30, 2012
(Dollars in thousands)	Total		Level 1		Level 2		Level 3
Impaired loans	$	38,556	$	—	$	15,064	$	23,492
Loans held for sale not held at fair value		5,287		—		5,287		—
Other assets⁽¹⁾		34,086		—		34,086		—

Total	$	77,929	$	—	$	54,437	$	23,492

(1)	Includes foreclosed assets.

There were no transfers in or out of Level 3 measurements for nonrecurring items during the six months ended June 30, 2012.

Fair value estimates are made at a discrete point in time based on relevant market information and other information about the financial instruments. Because no active market exists for a significant portion of our financial instruments, fair value estimates are based in large part on judgments we make primarily regarding current economic conditions, risk characteristics of various financial instruments, prepayment rates, and future expected loss experience. These estimates are subjective in nature and invariably involve some inherent uncertainties. Additionally unexpected changes in events or circumstances can occur that could require us to make changes to our assumptions and which, in turn, could significantly affect and require us to make changes to our previous estimates of fair value.

In addition, the fair value estimates are based on existing on and off-balance sheet financial instruments without attempting to estimate the value of existing and anticipated future customer relationships and the value of assets and liabilities that are not considered financial instruments, such as premises and equipment and other real estate owned.

The following methods and assumptions were used to estimate the fair value of financial instruments.

Cash and Cash Equivalents. The fair value of cash and cash equivalents approximates its carrying value.

Interest-Bearing Deposits with Financial Institutions. The fair values of interest-bearing deposits maturing within ninety days approximate their carrying values.

Investment Securities Available for Sale. Investment securities available-for-sale 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.

Federal Home Loan Bank and Federal Reserve Bank Stock. The Bank is a member of the Federal Home Loan Bank (the “FHLB”) and the Federal Reserve Bank of San Francisco (the “FRB”). As members, we are required to own stock of the FHLB and the FRB, the amount of which is based primarily on the level of our borrowings from those institutions. We also have the right to acquire additional shares of stock in either or both of the FHLB and the FRB; however, to date, we have not done so. The fair values of that stock are equal to their respective carrying amounts, are classified as restricted securities and are periodically evaluated for impairment based on our assessment of the ultimate recoverability of our investments in that stock. Any cash or stock dividends paid to us on such stock are reported as income.

Loans Held for Sale (LHFS). Effective December 1, 2011, in connection with the adoption of ASU 825, The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115 (ASU 825), the Company elected to measure, at fair value, LHFS originated or acquired on or after December 1, 2011. The remaining LHFS are carried at the lower of cost or market value. Fair value is based on quoted market prices.

Loans. The fair value for loans with variable interest rates less a credit discount is the carrying amount. The fair value of fixed rate loans is derived by calculating the discounted value of future cash flows expected to be received by the various homogeneous categories of loans. All loans have been adjusted to reflect changes in credit risk. Changes are not recorded directly as an adjustment to current earnings or comprehensive income, but rather as an adjustment component in determining the overall adequacy of the loan loss reserve.

Impaired Loans. ASC 820-10 applies to loans measured for impairment in accordance with ASC 310-10, Accounting by Creditors for Impairment of a Loan, including impaired loans measured at an observable market price (if available), and at the fair value of the loan’s collateral (if the loan is collateral dependent) less selling cost. The fair value of an impaired loan is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance for possible losses represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the impaired loan at nonrecurring Level 2.

Foreclosed Assets. Foreclosed assets are adjusted to the lower of cost or fair value, less estimated costs to sell, at the time the loans are transferred to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value, less estimated costs to sell. Fair value is determined on the basis of independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral.

Deposits. The fair value of demand deposits, savings deposits, and money market deposits is defined as the amounts payable on demand at quarter-end. The fair value of fixed maturity certificates of deposit is estimated based on the discounted value of the future cash flows expected to be paid on the deposits.

Borrowings. The fair value of borrowings is the carrying amount for those borrowings that mature on a daily basis. The fair value of term borrowings is derived by calculating the discounted value of future cash flows expected to be paid out by the Company.

Junior Subordinated Debentures. The fair value of the junior subordinated debentures is based on quoted market prices of the underlying securities. These securities are variable rate in nature and reprice quarterly.

Commitments to Extend Credit and Standby Letters of Credit. The fair value of commitments to extend credit and standby letters of credit, are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. These fees were not material in amount either at June 30, 2012, or December 31, 2011.

The estimated fair values and related carrying amounts of the Company’s financial instruments are as follows:


	June 30, 2012				December 31, 2011
(Dollars in thousands)	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
Financial Assets:
Cash and cash equivalents	$	61,776	$	61,776	$	96,467	$	96,467
Interest-bearing deposits with financial institutions		1,553		1,553		1,423		1,423
Federal Reserve Bank and Federal Home Loan Bank stock		10,729		10,729		11,154		11,154
Securities available for sale		99,111		99,111		147,909		147,909
Mortgage loans held for sale		143,588		143,588		66,230		66,230
Loans, net		693,115		683,497		641,962		626,227
Financial Liabilities:
Noninterest bearing deposits		170,011		170,011		164,382		164,382
Interest-bearing deposits		686,995		687,530		697,665		698,797
Borrowings		69,000		69,272		49,000		58,409
Junior subordinated debentures		17,527		17,527		17,527		17,527

Fair Value Option. The following table reflects the differences between the fair value carrying amount of LHFS measured at fair value under ASU 825 and the aggregate unpaid principal amount we are contractually entitled to receive at maturity.


	June 30, 2012
(Dollars in thousands)	Fair Value Carrying Amount		Aggregate Unpaid Principal		Fair Value Carrying Amount Less Aggregate Unpaid Principal
Loans held for sale reported at fair value:
Total loans	$	138,301	$	130,622	$	7,679
Nonaccrual loans		—		—		—
Loans 90 days or more past due and still accruing		—		—		—

The assets accounted for under the fair value option are initially measured at fair value. Gains and losses from initial measurement and subsequent changes in fair value are recognized in earnings. The changes in fair value related to initial measurement and subsequent changes in fair value included in earnings for these assets measured at fair value are shown, by income statement line item, below.

Loans Held for Sale at Fair Value

Three Months Ended June 30,

Six Months Ended June 30,

(Dollars in thousands)

2012

2011

2012

2011

Changes in fair value included in net income:

Mortgage banking noninterest income

4,901

—

6,352

—