3.	Fair Value Measurements

The following tables shows the recorded amounts of assets and liabilities measured at fair value on a recurring basis at June 30, 2013 and December 31, 2012:


	At June 30, 2013
(Dollars in thousands)	Total			Level 1		Level 2			Level 3
Investment securities available for sale
Mortgage backed securities issued by U.S. agencies	$	62,634		$	—	$	62,634		$	—
Collateralized mortgage obligations issued by non-agency		2,308			—		2,308			—
Asset backed securities		775			—		—			775
Mutual funds		4,233			4,233		—			—

Total securities available for sale at fair value		69,950			4,233		64,942			775
Loans held for sale		10,672			—		10,672			—
Other assets – Mortgage servicing rights		3,823			—		—			3,823
Derivative assets – IRLC’s		81			—		—			81
Derivative assets – TBA securities		540			—		—			540

Total assets measured at fair value on a recurring basis	$	85,066		$	4,233	$	75,614		$	5,219


	At December 31, 2012
(Dollars in thousands)	Total			Level 1		Level 2			Level 3
Investment securities available for sale
Mortgage backed securities issued by U.S. agencies	$	78,446		$	—	$	78,446		$	—
Collateralized mortgage obligations issued by non agency		2,625			—		1,963			662
Asset back securities		900			—		—			900
Mutual funds		4,407			4,407		—			—

Total securities available for sale at fair value		86,378			4,407		80,409			1,562
Loans held for sale		55,809			—		55,809			—
Other assets – Mortgage servicing rights		2,801			—		—			2,801
Derivative assets – IRLC’s		580			—		—			580

Total assets measured at fair value on a recurring basis	$	145,568		$	4,407	$	136,218		$	4,943

Derivative liabilities – TBA securities	$	(158	)	$	—	$	(158	)	$	—

Total liabilities measured at fair value on a recurring basis	$	(158	)	$	—	$	(158	)	$	—

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


(Dollars in thousands)	Investment Securities Available for Sale
Balance of recurring Level 3 instruments at January 1, 2013	$	4,943
Total gains or losses (realized/unrealized):
Included in earnings-realized		—
Included in earnings-unrealized		—
Included in other comprehensive income		(1,413	)
Purchases		—
Sales		—
Issuances		—
Settlements		1,689
Transfers in and/or out of Level 3		—

Balance of Level 3 assets at June 30, 2013	$	5,219

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

Investment Securities Available for Sale. 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, if available, prices for other traded mortgage loans with similar characteristics, purchase commitments and bid information received from market participants. We classify those loans subject to recurring fair value adjustments as Level 2, given the meaningful level of secondary market activity for conforming mortgage loans.

Mortgage Servicing Rights. 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 that would incorporate assumptions that market participants would use in estimating the fair value of servicing. These assumptions might include estimates of prepayment speeds, discount rate, costs to service, escrow account earnings, contractual servicing fee income, prepayment and late fees, among other considerations. Mortgage servicing rights are considered a Level 3 measurement at June 30, 2013 and are included in other assets in the accompanying consolidated balance sheets.

Derivative Assets and Liabilities. The Company’s derivative assets and liabilities are carried at fair value as required by GAAP and are accounted for as free standing derivatives. The derivative assets are interest rate lock commitments (“IRLCs”) with prospective residential mortgage borrowers whereby the interest rate on the loan is determined prior to funding and the borrowers have locked in that interest rate. These commitments are determined to be derivative instruments in accordance with GAAP. The derivative liabilities are hedging instruments (typically TBA securities) used to hedge the risk of fair value changes associated with changes in interest rates relating to its mortgage loan origination operations. The Company hedges the period from the interest rate lock (assuming a fall-out factor) to the date of the loan sale. The estimated fair value is based on current market prices for similar assets plus a fall-out factor estimated by management and accordingly, the Company classifies its derivative assets and liabilities as Level 3 measurement at June 30, 2013 and such assets are included in other assets in the accompanying consolidated statement of financial condition.

The following descriptions present qualitative information about the valuation techniques and unobservable inputs applied to Level 3 fair value measurements for financial instruments measured at fair value on a recurring and non-recurring basis at June 30, 2013.

Investment Securities Available for Sale. The valuation technique used for Level 3 investment securities 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 any of those inputs in isolation would result in significantly lower or higher fair value measurement. In general, a change in the assumption regarding the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity in an event of default. Prepayment rates are subject to change based on market conditions. For the asset backed security, the security was priced using an option adjusted discounted cash flow model. This discount margin of 6.5% was based on sector spreads and trading in related credit markets. A 2% constant default rate was presumed based on historical analysis and forward projection. A loss severity of 90% was based on low recovery expectations in this sector.

Mortgage Servicing Rights. The valuation technique used for Level 3 mortgage servicing rights is based upon market prices for similar instruments and an internal discounted cash flow model. The valuation model incorporates assumptions that market participants would use in estimating the fair value of servicing, the most significant of which include estimates of prepayment speeds of between 10% and 15%, and a discount rate of 12%. For mortgage servicing rights, a significant increase in discount rates would result in a significantly lower estimated fair value. The impact of changes in prepayment speeds would have differing impacts depending on the seniority or other characteristics of the instrument.

Derivative assets – IRLC’s. The valuation technique used for Level 3 IRLC’s is based on pricing of related loan instruments (which includes the value of servicing), which are Level 2 inputs, however also includes an estimate for a fall-out factor, otherwise known as the “pull-through” rate. A significant increase or decrease in pull-through rate assumptions would result in a significant increase or decrease in the fair value of IRLCs. The Company believes that the imprecision of an estimate could be significant.

Derivative assets and liabilities – TBA’s. The valuation technique used for Level 2 TBA’s is based on pricing of the hedging instruments (TBA’s), which are used to hedge the fair value changes associated with changes in interest rates relating to its mortgage lending operations. The Company hedges the period from the interest rate lock (assuming a fall-out factor) to the date of the loan sale. The fair value of the hedging instruments is based on the actively quoted TBA MBS market using observable inputs related to the characteristics of the underlying MBS stratified by product, coupon and settlement date. TBA’s are classified as Level 2 measurement as of June 30, 2013.

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 GAAP. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Impaired Loans. Loans measured for impairment are measured at an observable market price (if available), or the fair value of the loan’s collateral (if the loan is collateral dependent). The fair value of an impaired loan may be 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 loan 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. Mortgage 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 subject 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, 2013
(Dollars in thousands)	Total		Level 1		Level 2		Level 3
Assets at Fair Value:
Impaired loans	$	31,085	$	—	$	6,743	$	24,342
Loans held for sale		10,672		—		10,672		—
Other assets⁽¹⁾		17,331		—		17,331		—

Total	$	59,088	$	—	$	34,746	$	24,342

⁽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, 2013.

Risks with Fair Value Measurements.

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, the occurrence of unexpected events or changes in 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.

Fair Value Measurements for all Financial Instruments.

The following methods and assumptions were used to estimate the fair value of financial instruments not previously discussed.

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.

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 “FRBSF”). As members, we are required to own stock of the FHLB and the FRBSF, 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 FRBSF; 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.

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.

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


	At June 30, 2013
(Dollars in thousands)	Total			Level 1			Level 2			Level 3
Cash and cash equivalents	$	89,362		$	89,362		$	—		$	—
Interest-bearing deposits with financial institutions		2,423			2,423			—			—
Federal Reserve Bank and Federal Home Loan Bank Stock		8,918			8,918			—			—
Investment securities available for sale:
Mortgage backed securities issued by U.S. agencies		62,634			—			62,634			—
Collateralized mortgage obligations issued by non-agency		2,308			—			2,308			—
Asset backed securities		775			—			—			775
Mutual funds		4,233			4,233			—			—
Loans held for sale		10,672			—			10,672			—
Loans, net		717,818			—			717,818			—
Other assets – Mortgage servicing rights		3,823			—			—			3,823
Derivative assets – IRLC’s		81			—			—			81
Derivative assets – TBA securities		540			—			540			—

Total assets measured at fair value on a recurring basis	$	903,587		$	104,936		$	793,972		$	4,679

Noninterest bearing deposits	$	(188,149	)	$	(188,149	)	$	—		$	—
Interest-bearing deposits		(560,831	)		(560,831	)		—			—
Borrowings		(45,000	)		(45,000	)		—			—
Junior subordinated debentures		(17,527	)		(17,527	)		—			—

Total liabilities measured at fair value on a recurring basis	$	(811,507	)	$	(811,507	)	$	—		$	—


	At December 31, 2012
(Dollars in thousands)	Total			Level 1			Level 2			Level 3
Cash and cash equivalents	$	128,208		$	128,208		$	—		$	—
Interest-bearing deposits with financial institutions		2,423			2,423			—			—
Federal Reserve Bank and Federal Home Loan Bank Stock		10,284			10,284			—			—
Investment securities available for sale:
Mortgage backed securities issued by U.S. agencies		78,446			—			78,446			—
Collateralized mortgage obligations issued by non agency		2,625			—			1,963			662
Asset back securities		900			—			—			900
Mutual funds		4,407			4,407			—			—
Loans held for sale		55,809			—			55,809			—
Loans, net		719,257			—			719,257			—
Other assets – Mortgage servicing rights		2,801			—			—			2,801
Derivative assets – IRLC’s		580			—			—			580

Total assets measured at fair value on a recurring basis	$	1,005,740		$	145,322		$	855,475		$	4,943

Noninterest bearing deposits	$	(170,259	)	$	(170,259	)	$	—		$	—
Interest-bearing deposits		(675,136	)		(675,136	)		—			—
Borrowings		(45,000	)		(45,000	)		—			—
Junior subordinated debentures		(17,527	)		(17,527	)		—			—
Derivative liabilities – TBA securities		(158	)		—			(158	)		—

Total liabilities measured at fair value on a recurring basis	$	(908,080	)	$	(907,922	)	$	(158	)	$	—

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.

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)	2013			2012		2013			2012
Changes in fair value included in net income:
Mortgage banking noninterest income (loss)	$	(610	)	$	4,901	$	(2,192	)	$	6,352


	June 30, 2013
(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	$	10,672	$	10,595	$	77
Nonaccrual loans		—		—		—
Loans 90 days or more past due and still accruing interest		—		—		—

Information Regarding Derivative Financial Instruments.

The following table includes information for the derivative assets and liabilities for the periods presented:


					Total Gains (Losses)
	Notional Balance				Three Months Ended June 30						Six Months Ended June 30
(Dollars in thousands)	June 30, 2013		June 30, 2012		2013			2012			2013			2012
Derivative assets – IRLC’s	$	8,712	$	80,836	$	(238	)	$	1,581		$	(427	)	$	2,600
Derivative liabilities – TBAs	$	15,500	$	132,719	$	628		$	(1,029	)	$	698		$	(1,005	)