(9)Fair Value Measurements and Fair Value of Financial Instruments

Fair value is the exchange price that would be received for 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 on the measurement date. There are three levels of inputs that may be used to measure fair values:

Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets.

Level 2 - Significant other observable inputs other than Level 1 prices such as quoted prices in markets that are not active, quoted prices for similar assets, or other inputs that are observable, either directly or indirectly, for substantially the full term of the asset.

Level 3 - Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the instrument’s fair value measurement. Transfers of financial instruments between levels within the fair value hierarchy are recognized on the date management determines that the underlying circumstances or assumptions have changed.

The fair values of securities available for sale are generally determined by matrix pricing, which is a mathematical technique widely used in the financial 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). For securities where market values of similar securities are not available management utilizes a discounted cash flow model with market-adjusted discount rates or other unobservable inputs to estimate fair value. Due to the lack of ratings available on these securities, management determined that a relationship to other benchmark quoted securities was unobservable and as a result these securities should be classified as Level 3 (Level 3 inputs). The valuation of the Company’s Level 3 bonds is highly sensitive to changes in unobservable inputs.

Currently, the Company uses interest rate swaps to manage interest rate risk. The fair value of each interest rate swap is determined using the market standard methodology of netting the discounted future fixed cash payments (or receipts) and the discounted expected variable cash receipts (or payments). The variable cash receipts (or payments) are based on the expectation of future interest rates (forward curves) derived from observed market interest rate curves (Level 2 inputs). The Company considers the value of the swap to be highly sensitive to fluctuations in interest rates.

Upon being designated impaired, impaired loans are evaluated to determine whether or not they are collateral-dependent. Collateral-dependent impaired loans are generally carried at the lower of cost or fair value of the collateral, less estimated selling costs. Collateral values are determined based on appraisals performed by qualified licensed appraisers hired by the Company and then further adjusted if warranted based on relevant facts and circumstances. The appraisals may utilize a single valuation approach or a combination of approaches including the comparable sales and income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value. Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors identified above. Because of the high degree of judgment required in estimating the fair value of collateral underlying impaired loans and because of the relationship between fair value and general economic conditions, management considers the fair value of impaired loans to be highly sensitive to changes in market conditions.

OREO is valued at the time the related loan is foreclosed upon and the asset is transferred to OREO. The value is based primarily on third party appraisals, less estimated selling costs. The appraised value may be adjusted if warranted based on relevant facts and circumstances. The appraisals may utilize a single valuation approach or a combination of approaches including the comparable sales and income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value. OREO is reviewed and evaluated on at least an annual basis for additional impairment and

adjusted accordingly, based on the same factors identified above. Because of the high degree of judgment required in estimating the fair value of OREO properties and because of the relationship between fair value and general economic conditions management considers the fair value of OREO to be highly sensitive to changes in market conditions.

Financial Assets and Liabilities Measured on a Recurring Basis

Assets and liabilities measured at fair value on a recurring basis are summarized below:



		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Balance
		(In thousands)
Assets/Liabilities at March 31, 2014
State and municipal securities	$	-	$	17,500	$	24,646	$	42,146
Mortgage-backed securities – agency /
residential		-		249,437		-		249,437
Mortgage-backed securities – private /
residential		-		534		-		534
Asset-backed securities		-		22,446		-		22,446
Marketable equity securities		-		1,535		-		1,535
Trust preferred securities		-		18,520		-		18,520
Corporate securities		-		65,061		-		65,061
Interest rate swaps - cash flow hedge		-		183		-		183

Assets/Liabilities at December 31, 2013
State and municipal securities	$	-	$	16,918	$	24,167	$	41,085
Mortgage-backed securities – agency /
residential		-		254,103		-		254,103
Mortgage-backed securities – private /
residential		-		561		-		561
Asset-backed securities		-		22,503		-		22,503
Marketable equity securities		-		1,535		-		1,535
Trust preferred securities		-		26,096		-		26,096
Corporate securities		-		39,074		-		39,074
Interest rate swaps - cash flow hedge		-		465		-		465

There were no transfers of financial assets and liabilities among Level 1, Level 2 and Level 3 during the three months ended March 31, 2014.

The table below presents a reconciliation and income statement classification of gains and losses for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three months ended March 31, 2014 and March 31, 2013:




		State and Municipal Securities
		Three Months Ended March 31, 2014

		(In thousands)
Beginning balance	$	24,167
Total unrealized gains (losses) included in:
Net income (loss)		-
Other comprehensive income (loss)		479
Sales, calls and prepayments		-
Transfer to OREO		-
Transfers in and (out) of Level 3		-
Balance end of period	$	24,646



		State and Municipal Securities
		Three Months Ended March 31, 2013

		(In thousands)
Beginning balance	$	49,889
Total unrealized gains (losses) included in:
Net income (loss)		-
Other comprehensive income (loss)		(22)
Transfer to OREO		(814)
Transfers in and (out) of Level 3		-
Balance end of period	$	49,053

For the three months ended March 31, 2014 and March 31, 2013, the entire amount of other comprehensive income for assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) consisted of changes in unrealized gains and losses on the mark-to-market of securities designated as available for sale.

The following tables present quantitative information about Level 3 fair value measurements on the Company’s state and municipal securities at March 31, 2014 and December 31, 2013:



March 31, 2014		Fair Value	Valuation Technique	Unobservable Inputs	Range
		(In thousands)
State and municipal securities	$	24,115	discounted cash flow	discount rate	4.75%
State and municipal securities		531	matrix pricing	discount rate or yield	N/A*
Total	$	24,646



December 31, 2013		Fair Value	Valuation Technique	Unobservable Inputs	Range
		(In thousands)
State and municipal securities	$	23,636	discounted cash flow	discount rate	5.10%
State and municipal securities		531	matrix pricing	discount rate or yield	N/A*
Total	$	24,167

* The Company relies on a third-party pricing service to value non-rated municipal securities. Because of the lack of credit ratings, management considers the relationship between rates on these securities and benchmarks rates to be unobservable. The unobservable adjustments used by the third-party pricing service were not readily available.

Financial Assets and Liabilities Measured on a Nonrecurring Basis

The following tables present impaired loans measured at fair value on a non-recurring basis as of March 31, 2014 and December 31, 2013. The valuation methodology used to measure the fair value of these loans is described earlier in this Note.



		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Balance
		(In thousands)
March 31, 2014
Impaired loans:
Other	$	-	$	-	$	191	$	191
Total impaired loans	$	-	$	-	$	191	$	191



		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Balance
		(In thousands)
December 31, 2013
Impaired loans:
Commercial and residential real estate	$	-	$	-	$	115	$	115
Other		-		-		231		231
Total impaired loans	$	-	$	-	$	346	$	346

Impaired loans, which are measured for impairment using either the fair value of collateral or the present value of expected future cash flows, had a carrying amount of $20,362,000 at March 31, 2014, after a partial charge-off of $1,541,000. In addition, these loans have a specific valuation allowance of $104,000 at March 31, 2014. Of the $20,362,000 impaired loan portfolio at March 31, 2014, $191,000 were carried at fair value as a result of the aforementioned charge-offs and specific valuation allowances. The remaining $20,171,000 of impaired loans were not carried at fair value at March 31, 2014, because these loans did not require a specific reserve calculated based on the fair value of collateral or have amounts previously charged-off. During the three months ended March 31, 2014, the single charge-off of a loan impaired as of December 31, 2013 accounted for the majority of the reduction in the specific valuation allowance on impaired loans during the first quarter 2014.

Impaired loans had a carrying amount of $21,703,000 at December 31, 2013, after a partial charge-off of $1,507,000. In addition, these loans had a specific valuation allowance of $565,000 at December 31, 2013. Of the $21,703,000 impaired loan portfolio at December 31, 2013, $425,000 were carried at fair value as a result of the aforementioned charge-offs and specific valuation allowances. The remaining $21,278,000 of impaired loans were not carried at fair value at December 31, 2013, because these loans did not require a specific reserve calculated based on the fair value of collateral or have amounts previously charged-off.

Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors identified above.

The following tables present quantitative information about Level 3 fair value measurements for impaired loans measured at fair value on a non-recurring basis as of March 31, 2014 and December 31, 2013.



March 31, 2014		Fair Value	Valuation Technique	Unobservable Inputs	Range
		(In thousands)
Impaired loans:
Other	$	191	sales comparison	adjustment to comparable sales	6%-8%
Total impaired loans	$	191



December 31, 2013		Fair Value	Valuation Technique	Unobservable Inputs	Range
		(In thousands)
Impaired loans:
Commercial and residential	$	115	sales comparison	adjustment to comparable sales	6%-8%
real estate
Other		231	sales comparison	adjustment to comparable sales	6%-8%
Total impaired loans	$	346

Nonfinancial Assets and Liabilities Measured on a Nonrecurring Basis

Nonfinancial assets and liabilities measured at fair value on a nonrecurring basis are summarized below:



		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Balance
		(In thousands)
March 31, 2014
Other real estate owned and foreclosed assets:
Commercial real estate	$	-	$	-	$	-	$	-
Land		-		-		-		-
Total other real estate owned and foreclosed assets	$	-	$	-	$	-	$	-

December 31, 2013
Other real estate owned and foreclosed assets:
Commercial real estate	$	-	$	-	$	1,636	$	1,636
Land		-		-		2,857		2,857
Total other real estate owned and foreclosed assets	$	-	$	-	$	4,493	$	4,493

OREO had a carrying amount of $4,419,000 at March 31, 2014, which is made up of an outstanding balance of $5,441,000, with a valuation allowance of $1,022,000. OREO write-downs and sales had no impact on the OREO valuation during the first quarter 2014. Because there were no additions to our OREO properties nor any valuation adjustments on these properties during the first quarter 2014 none of our OREO properties were carried at fair value as of March 31, 2014.

OREO had a carrying amount of $4,493,000 at December 31, 2013, which was made up of an outstanding balance of $5,515,000, with a valuation allowance of $1,022,000.

The following table presents quantitative information about Level 3 fair value measurements for OREO measured at fair value on a non-recurring basis as of December 31, 2013:



December 31, 2013		Fair Value	Valuation Technique	Unobservable Inputs	Range
		(In thousands)
Other real estate owned and
foreclosed assets:
Commercial real estate	$	1,636	broker opinion	discount to broker opinion	10% - 20%
Land		2,857	sales comparison	adjustment to comparable sales	10% - 55%
			broker opinion	discount to broker opinion	10% - 20%
Total other real estate owned
and foreclosed assets	$	4,493

Fair Value of Financial Instruments

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



				Fair Value Measurements at March 31, 2014:
		Carrying Amount		Level 1		Level 2		Level 3		Total
		(In thousands)
Financial assets:
Cash and cash equivalents	$	35,311	$	35,311	$	-	$	-	$	35,311
Securities available for sale		399,679		-		375,033		24,646		399,679
Securities held to maturity		54,021		-		49,268		4,190		53,458
Bank stocks		17,147		n/a		n/a		n/a		n/a
Loans held for investment, net		1,340,762		-		-		1,334,280		1,334,280
Accrued interest receivable		6,032		-		6,032		-		6,032
Interest rate swap - cash flow hedge		183		-		183		-		183

Financial liabilities:
Deposits	$	1,533,010	$	-	$	1,531,625	$	-	$	1,531,625
Federal funds purchased and sold under
agreements to repurchase		27,045		-		27,045		-		27,045
Short-term borrowings		63,017		-		63,017		-		63,017
Subordinated debentures		25,774		-		-		18,345		18,345
Long-term borrowings		110,000		-		116,778		-		116,778
Accrued interest payable		606		-		606		-		606




				Fair Value Measurements at December 31, 2013:
		Carrying Amount		Level 1		Level 2		Level 3		Total
		(In thousands)
Financial assets:
Cash and cash equivalents	$	28,077	$	28,077	$	-	$	-	$	28,077
Securities available for sale		384,957		-		360,790		24,167		384,957
Securities held to maturity		41,738		-		36,463		3,754		40,217
Bank stocks		15,605		n/a		n/a		n/a		n/a
Loans held for sale		507		558		-		-		558
Loans held for investment, net		1,298,912		-		-		1,291,439		1,291,439
Accrued interest receivable		5,156		-		5,156		-		5,156
Interest rate swap - cash flow hedge		465		-		465		-		465

Financial liabilities:
Deposits	$	1,528,457	$	-	$	1,527,034	$	-	$	1,527,034
Federal funds purchased and sold under
agreements to repurchase		24,284		-		24,284		-		24,284
Short-term borrowings		20,000		-		20,000		-		20,000
Subordinated debentures		25,774		-		-		18,351		18,351
Long-term borrowings		110,000		-		117,316		-		117,316
Accrued interest payable		600		-		600		-		600

The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.

Certain financial instruments and all nonfinancial instruments are excluded from the disclosure requirements. Therefore, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.

The following methods and assumptions are used by the Company in estimating fair value disclosures for financial instruments:

(a)

Cash and Cash Equivalents and Time Deposits with Banks

The carrying amounts of cash and short-term instruments approximate fair values (Level 1).

(b)

Securities and Bank Stocks

Fair values for securities available for sale and held to maturity are generally determined by matrix pricing, which is a mathematical technique widely used 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). For positions that are not traded in active markets or are subject to transfer restrictions (i.e., bonds valued with Level 3 inputs), management uses a combination of reviews of the underlying financial statements, appraisals and management’s judgment regarding credit quality and intent to sell in order to determine the value of the bond.

It is not practical to determine the fair value of bank stocks due to restrictions placed on the transferability of FHLB stock, Federal Reserve Bank stock and Bankers’ Bank of the West stock. These three stocks comprise the majority of the balance of the Company’s bank stocks.

For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values (Level 3). Fair values for other loans (e.g., commercial real estate and investment property mortgage loans, commercial 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 (Level 3). Impaired loans are valued at the lower of cost or fair value as described above in this note. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

(d) Loans Held for Sale

Loans held for sale are carried at the lower of cost or fair value, with fair value determined by the sales price agreed upon in negotiation with the purchaser (Level 1).

(e) Deposits

The fair values of 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) (Level 2). The carrying amounts of variable rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date (Level 2). 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 (Level 2).

(f) Short-term Borrowings

The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings maturing within ninety days approximate their fair values (Level 2).

(g) Long-term Borrowings

The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements (Level 2).

(h) Subordinated Debentures

The fair values of the Company’s Subordinated Debentures are estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements (Level 3).

(i) Accrued Interest Receivable/Payable

The carrying amounts of accrued interest approximate fair value (Level 2).

(j) Interest Rate Swaps, net

The fair value of interest rate swaps are determined using the market standard methodology of netting the discounted future fixed cash payments (or receipts) and the discounted expected variable cash receipts (or payments). The variable cash receipts (or payments) are based on the expectation of future interest rates (forward curves) derived from observed market interest rate curves (Level 2).

(k) Off-balance Sheet Instruments

Fair values for off-balance sheet, credit-related financial instruments 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 fair value of commitments is not material.