Fair Value of Financial Instruments

3 Months Ended

Mar. 31, 2013

Fair Value of Financial Instruments

Fair Value of Financial Instruments

8.             Fair Value of Financial Instruments

In accordance with accounting guidance, the Company groups its financial assets and financial liabilities measured 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 — Valuations for assets and liabilities traded in active exchange markets, such as the New York Stock Exchange.  Level 1 also includes U.S. Treasury, other U.S. government and agency mortgage-backed securities that are traded by dealers or brokers in active markets.  Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities.

Level 2 — Valuations for assets and liabilities traded in less active dealer or broker markets.  Valuations are obtained from third party pricing services for identical or comparable assets or liabilities.

Level 3 — Valuations for assets and liabilities that are derived from other valuation methodologies, including option pricing models, discounted cash flow models and similar techniques, and not based on market exchange, dealer, or broker traded transactions.  Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities.

The balances of assets and liabilities measured at fair value on a recurring basis are as follows:

	As of March 31, 2013
(dollars in thousands)	Total			Level 1		Level 2			Level 3
Securities available for sale	$	274,603		$	—	$	274,603		$	—
Cash flow hedge	(1,615		)	—		(1,615		)	—
Warrant portfolio	424			—		—			424
Total	$	273,412		$	—	$	272,988		$	424

	As of December 31, 2012
	Total			Level 1		Level 2			Level 3
Securities available for sale	$	251,967		$	—	$	251,967		$	—
Cash flow hedge	(1,784		)	—		(1,784		)	—
Warrant portfolio	418			—		—			418
Total	$	250,601		$	—	$	250,183		$	418

There were no transfers between Level 1 and Level 2 during the period for assets measured at fair value on a recurring basis.

The changes in Level 3 assets and liabilities measured at fair value on a recurring basis were not material for the quarter ended March 31, 2013.

The Company may be required, from time to time, to measure certain other financial assets at fair value on a non-recurring basis in accordance with GAAP.  These adjustments to fair value usually result from application of lower-of-cost-or-market accounting or write-downs of individual assets.  The assets measured at fair value on a non-recurring basis at March 31, 2013 and December 31, 2012 included OREO of $31,000 and $144,000, respectively.  The fair value of OREO was determined using Level 2 assumptions.  The Company charged-off $10,000 for the current quarter as a result of declines in the OREO property values compared to $9,000 for the quarter ended March 31, 2012.  The assets measured at fair value on a non-recurring basis as of March 31, 2013 and December 31, 2012 also included impaired loans of $18.4 million and $19.4 million, respectively.  The Company charged-off $350,000 and $1.0 million during the quarters ended March 31, 2013 and March 31, 2012, respectively, as a result of impaired loans. The fair value of impaired loans was determined using Level 3 assumptions. In determining the net realizable value of the underlying collateral for impaired loans, the Company primarily relied on third party appraisals which were then discounted from 15% to 25% (with additional discounts depending on the age of the appraisal) to cover both market price fluctuations and selling costs the Company expected would be incurred in the event of foreclosure.  In addition to the discounts taken, the Company’s calculation of net realizable value considered any other senior liens in place on the underlying collateral.

The following estimated fair value amounts have been determined by using available market information and appropriate valuation methodologies.  However, considerable judgment is required to interpret market data to develop the estimates of fair value.  Accordingly, the estimates presented are not necessarily indicative of the amounts that could be realized in a current market exchange.  The use of different market assumptions and/or estimation techniques may have a material effect on the estimated fair value amounts.

The following table presents the carrying amount and estimated fair value of certain assets and liabilities of the Company at March 31, 2013 and December 31, 2012:

	March 31, 2013				December 31, 2012
	Carrying		Fair		Carrying		Fair
(dollars in thousands)	Value		Value		Value		Value
Financial assets:
Cash and due from banks	$	23,023	$	23,023	$	17,251	$	17,251
Federal funds sold	42,030		42,030		113,790		113,790
Interest bearing deposits in other banks	326		326		335		335
Investments securities	289,054		288,964		267,204		267,574
Loans and leases, net of unearned fees	950,462		950,587		905,523		906,228
Bank owned life insurance	16,098		16,098		15,954		15,954
Financial liabilities:
Deposits	1,166,280		1,164,066		1,162,548		1,158,518
Trust preferred securities	17,527		17,860		17,527		17,588
Other borrowings	—		—		—		—
Cash flow hedge	1,615		1,615		1,784		1,784

Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding current economic conditions, risk characteristics of various financial instruments and other factors.  These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision.  Changes in assumptions could significantly affect the fair values presented.  The following methods and assumptions were used by the Company to estimate the fair values of its financial instruments at March 31, 2013 and December 31, 2012:

Cash and Cash Equivalents

The carrying amount of cash and cash equivalents approximate the fair value and are classified as Level 1 in the fair value hierarchy.

Investment Securities

For investment securities, fair values are based on quoted market prices and are classified as Level 2.

Loans

The fair value of variable rate loans that reprice frequently and with no significant change in credit risk is based on the carrying value and results in a classification of Level 3 within the fair value hierarchy.  Fair value for other loans are estimated using discounted cash flow analysis using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification in the fair value hierarchy.  The methods used to estimate the fair value of loans do not necessarily represent an exit price.

Trust Preferred Securities

The fair value of the trust preferred securities approximates the pricing of a preferred security at current market prices and are classified as Level 3.

Deposits

The fair value of demand deposits (e.g. interest and non-interest bearing, savings and certain types of money market accounts) are, by definition , equal to the amount payable in demand at the reporting date (i.e. carrying value) resulting in a Level 2 classification in the fair value hierarchy.  The carrying amounts of variable rate, fixed-term money market accounts and certificate of deposits approximates their fair value at the reporting date in a Level 2 classification in the fair value hierarchy. Fair values for fixed rate certificate of deposits are estimated using a discounted cash flow 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.

Cash Flow Hedge

Although the Company has determined that the majority of the inputs used to value its derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its derivatives utilize Level 3 inputs — model-derived credit spreads.  The level in the fair value hierarchy within which the fair value measurement in their entirety fall shall be determined based on the lowest level input that is significant to the fair value measurement in its entirety.  Because the inputs used to measure the fair value of the Company’s derivatives fall into different levels of the fair value hierarchy, as of March 31, 2013 and December 31, 2012, the Company has assessed the significance of the impact of the credit valuations adjustment on the overall valuation of its derivative positions and has determined that the credit valuation adjustment is not significant to the overall valuation of its derivative portfolios.  As a result, the Company classifies its derivative valuations in Level 2 of the fair value hierarchy.