Fair Value

The Company utilizes fair value measurements to record fair value adjustments for certain assets and liabilities and to determine fair value disclosures. Available-for-sale securities, interest rate swaps, mortgage servicing rights, interest rate lock commitments and forward sale loan commitments are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record other assets at fair value, such as loans held-for-investment and certain other assets. These nonrecurring fair value adjustments usually involve writing the asset down to fair value or the lower of cost or market value.

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

Available-for-Sale Investment Securities

Available-for-sale investment securities 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 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 securities include mortgage-backed securities issued by government sponsored entities and private label entities, municipal bonds and corporate debt securities. There have been no changes in valuation techniques for the three and nine months ended September 30, 2013. Valuation techniques are consistent with techniques used in prior periods.

Interest Rate Swaps

Interest rate swaps are recorded at fair value on a recurring basis. Fair value measurement is based on discounted cash flow models run by a third-party on a monthly basis. All future floating cash flows are projected and both floating and fixed cash flows are discounted to the valuation date. As a result, the Company classifies interest rate swaps as Level 3.

The following table presents a rollforward of interest rate swaps from December 31, 2012 to September 30, 2013, and from December 31, 2011 to September 30, 2012.



	Level 3
	Fair Value- Assets			Fair Value- Liabilities
	(Amounts in thousands)
Balance, June 30, 2012	$	213		$	213
Purchases, sales, issuances and settlements	—			—
Gains (losses) included in other income	—			—
Balance, September 30, 2012	$	213		$	213

Balance, June 30, 2013	$	154		$	154
Purchases, sales, issuances and settlements	—			—
Gains (losses) included in other income	(8		)	(8		)
Balance, September 30, 2013	$	146		$	146

The following table presents a rollforward of interest rate swaps from December 31, 2011 to September 30, 2012, and from December 31, 2012 to September 30, 2013.
	Level 3
	Fair Value- Assets			Fair Value- Liabilities
	(Amounts in thousands)
Balance, December 31, 2011	$	217		$	217
Purchases, sales, issuances and settlements	—			—
Gains (losses) included in other income	(4		)	(4		)
Balance, September 30, 2012	$	213		$	213

Balance, December 31, 2012	$	196		$	196
Purchases, sales, issuances and settlements	—			—
Gains (losses) included in other income	(50		)	(50		)
Balance, September 30, 2013	$	146		$	146

Interest Rate Locks and Forward Loan Sale Commitments

The Bank enters into interest rate lock commitments and commitments to sell mortgages. At September 30, 2013, the amount of fair value associated with these interest rate lock commitments and sale commitments was $483,935 and $(259,855), respectively. At December 31, 2012, the amount of fair value associated with these interest rate lock commitments and sale commitments was $872,844 and $(480,806), respectively. The fair value of interest rate lock commitments is based on servicing rate premium, origination income net of origination costs, fall out rates and changes in loan pricing between the commitment date and period end, typically month end.

The Company classifies interest rate lock commitments as Level 3. The fair value of forward sales commitments is based on changes in loan pricing between the commitment date and period end. The Company classified forward sale commitments as Level 2. There have been no changes in valuation techniques for the three and nine months ended September 30, 2013. Valuation techniques are consistent with techniques used in prior periods.

The following table presents a rollforward of interest rate lock commitments for the three months ended September 30, 2013 and 2012, respectively.



	Interest Rate Lock Commitments
	Level 3
	Fair Value			Fair Value
	(In thousands)
Balance, June 30, 2013 and 2012	$	(312	)	$	578
Gains (losses) included in other income	796			(1,069		)
Transfer in and out	—			—
Balance, September 30, 2013 and 2012	$	484		$	(491	)

The following table presents a rollforward of interest rate lock commitments for the nine months ended September 30, 2013 and 2012, respectively.

	Interest Rate Lock Commitments
	Level 3
	Fair Value			Fair Value
	(In thousands)
Balance, December 31, 2012 and 2011	$	873		$	130
Gains (losses) included in other income	(389		)	(621		)
Transfer in and out	—			—
Balance, September 30, 2013 and 2012	$	484		$	(491	)

Mortgage Servicing Rights

A valuation of mortgage servicing rights is performed using a pooling methodology. Similar loans are pooled together and evaluated on a discounted earnings basis to determine the present value of future earnings. The present value of the future earnings is the estimated market value for the pool, calculated by a third party at least semi-annually, using assumptions that a third party purchaser would utilize in evaluating a potential acquisition of the servicing. As such, the Company classifies loan servicing rights as a Level 3 asset. There have been no changes in valuation techniques for the three and nine months ended September 30, 2013. Valuation techniques are consistent with techniques used in prior periods.

The following table presents a rollforward of mortgage servicing rights for the three and nine months ended September 30, 2013 and 2012 and shows that the mortgage servicing rights are classified as Level 3 as discussed above.



	Level 3
	Fair Value		Fair Value
	(In thousands)
Balance, June 30, 2013 and 2012	$	3,825	$	1,889
Capitalized	506		300
Gains (losses) included in other income	50		(153		)
Balance, September 30, 2013 and 2012	$	4,381	$	2,036

	Level 3
	Fair Value		Fair Value
	(In thousands)
Balance, December 31, 2012 and 2011	$	2,525	$	1,871
Capitalized	1,193		645
Gains (losses) included in other income	663		(480		)
Balance, September 30, 2013 and 2012	$	4,381	$	2,036

Mortgage Loans Held-for-Sale

Loans held-for-sale are carried at lower of cost or market value. The fair value of loans held-for-sale is based on what secondary markets are currently offering for portfolios with similar characteristics. The changes in fair value of the assets are largely driven by changes in interest rates subsequent to loan funding and changes in the fair value of servicing associated with the mortgage loan held for sale. As such, the Company classifies loans measured at fair value on a nonrecurring basis as a Level 2 asset. At September 30, 2013, the cost of the Company's mortgage loans held-for-sale was less than the market value. Accordingly, the Company's loans held-for-sale are carried at cost. There have been no changes in valuation techniques for the three and nine months ended September 30, 2013. Valuation techniques are consistent with techniques used in prior periods.

Impaired Loans

The Company does not record loans held-for-investment at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment in accordance with the Receivables topic of the FASB Accounting Standards Codification. The fair value of impaired loans is estimated using one of several methods, including collateral value (through appraisal processes and applying liquidity discounts and deducting expected selling costs), market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At September 30, 2013, the majority of impaired loans were evaluated based on the fair value of the collateral by obtaining third-party appraisals and applying liquidity discounts. Third party appraisals are obtained at least annually for all impaired loans greater than $250,000. The Company records impaired loans as nonrecurring Level 3. There have been no changes in valuation techniques for the three and nine months ended September 30, 2013. Valuation techniques are consistent with techniques used in prior periods.

Other Real Estate Owned

Other real estate owned (“OREO”) is adjusted to fair value upon transfer of the loans to OREO. Subsequently, OREO is carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised values of the collateral or management's estimation of the value of the collateral (through appraisal processes and applying liquidity discounts and deducting expected selling costs). When the fair value of the collateral is measured due to further deterioration in the value of the OREO since initial recognition, the Company records the foreclosed asset as nonrecurring Level 3. The current carrying value of OREO at September 30, 2013 is $3.0 million. At December 31, 2012 the carrying value of OREO was $8.7 million. There have been no changes in valuation techniques for the three and nine months ended September 30, 2013. Valuation techniques are consistent with techniques used in prior periods.

The following table presents assets and (liabilities) measured at fair value on a recurring basis:



September 30, 2013 (in thousands)	Fair Value			Level 1		Level 2			Level 3
Available-for-sale securities:
U.S. government agencies	$	16,536		$	—	$	16,536		$	—
Government sponsored agencies:
Residential mortgage-backed securities	118,568			—		118,568			—
Collateralized mortgage obligations	69,492			—		69,492			—
Private label collateralized mortgage obligations	11,432			—		11,432			—
State and municipal securities	109,626			—		109,626			—
Common and preferred stocks	3,036			3,036		—			—
Interest rate swap agreements	146			—		—			146
Interest rate swap agreements	(146		)	—		—			(146		)
Interest rate lock commitments	484			—		—			484
Forward loan sale commitments	(260		)	—		(260		)	—
Mortgage servicing rights	4,381			—		—			4,381



December 31, 2012 (in thousands)	Fair Value			Level 1		Level 2			Level 3
Available-for-sale securities:
U.S. government agencies	$	27,527		$	—	$	27,527		$	—
Government sponsored agencies:
Residential mortgage-backed securities	107,257			—		107,257			—
Collateralized mortgage obligations	122,593			—		122,593			—
Private label collateralized mortgage obligations	1,045			—		1,045			—
State and municipal securities	84,565			—		84,565			—
Common and preferred stocks	133			133		—			—
Interest rate swap agreements	196			—		—			196
Interest rate swap agreements	(196		)	—		—			(196		)
Interest rate lock commitments	873			—		—			873
Forward loan sale commitments	(481		)	—		(481		)	—
Mortgage servicing rights	2,525			—		—			2,525

Quantitative Information about Level 3 Fair Value Measurements



	Fair Value at September 30, 2013 (in thousands)		Valuation Technique	Unobservable Input	Range (Weighted Avg)
Recurring measurements:
Interest Rate Swaps	$	146	Discounted cash flow	Discount rate	0.99%
Interest Rate Lock Commitments	484		Pricing model	Pull through rates	81.17%
Mortgage Servicing Rights	4,381		Discounted cash flow	Constant prepayment rate	10.09%
				Cost of service	$50
				Discount rate	8%
Nonrecurring measurements:
Impaired loans	$	4,825	Discounted appraisals	Collateral discounts	15%
Other real estate owned	291		Discounted appraisals	Collateral discounts	15%



	Fair Value at December 31, 2012 (in thousands)		Valuation Technique	Unobservable Input	Range (Weighted Avg)
Recurring measurements:
Interest Rate Swaps	$	196	Discounted cash flow	Discount rate	1.00%
Interest Rate Lock Commitments	873		Pricing model	Pull through rates	83.90%
Mortgage Servicing Rights	2,525		Discounted cash flow	Constant prepayment rate	17.96%
				Cost of service	$50
				Discount rate	8%
Nonrecurring measurements:
Impaired loans	$	7,276	Discounted appraisals	Collateral discounts	10-15%
Other real estate owned	5,281		Discounted appraisals	Collateral discounts	15%

The unobservable input used in the fair value measurement of the Company's interest rate swap agreements is the discount rate. A significant increase (decrease) in the discount rate could result in a significantly lower (higher) fair value measurement. The discount rate is determined by the third-party by obtaining third party market quotes from Reuters, which handle up to 30 year swap maturities. The Company's asset liability management team periodically reviews the discount rates utilized in determining the fair value of the interest rate swap agreements.

The significant unobservable input used in the fair value measurement of the Company's interest rate lock commitments is the pull through ratio, which represents the percentage of loans currently in a lock position which management estimates will ultimately close. Generally, the fair value of an interest rate lock commitment is positive (negative) if the prevailing interest rate is lower (higher) than the interest rate lock commitment rate. Therefore, an increase in the pull through rates (i.e., higher percentage of loans are estimated to close) will result in the fair value of the interest rate lock commitments to increase if in a gain position, or decrease if in a loss position. The pull through ratio is largely dependent on the loan processing stage that a loan is currently in and the change in prevailing interest rates from the time of the rate lock. The pull through rate is computed by our secondary marketing system using historical data and the ratio is periodically reviewed by the Company's mortgage banking division.

The significant unobservable inputs used in the fair value measurement of the Company's mortgage servicing rights are the weighted average constant prepayment rate and weighted average discount rate. Significant increases (decreases) in any of those inputs in isolation could result in a significantly lower (higher) fair value measurement. Although the constant prepayment rate and the discount rate are not directly interrelated, they will generally move in opposite directions. The Company utilizes an independent third-party to estimate the fair value of mortgage servicing rights through use of a discounted cash flow model to calculate the present value of estimated future net servicing income based on observable and unobservable inputs into the model to arrive at an estimated fair value. To assess the reasonableness of the fair value measurement, the fair value and constant prepayment rates are compared to forward-looking estimates by the Company.

The following table presents assets measured at fair value on a nonrecurring basis:



	Fair Value		Level 1		Level 2		Level 3
September 30, 2013	(Amounts in thousands)
Other real estate owned	$	291	$	—	$	—	$	291
Impaired loans:
Owner occupied	4,472		—		—		4,472
Secured 1-4 family real estate	352		—		—		352



	Fair Value		Level 1		Level 2		Level 3
December 31, 2012	(Amounts in thousands)
Other real estate owned	$	5,281	$	—	$	—	$	5,281
Impaired loans:
Construction	1,767		—		—		1,767
Commercial real estate:
Owner occupied	4,772		—		—		4,772
Non-owner occupied	472		—		—		472
Commercial	265		—		—		265

There were no transfers between valuation levels for any assets during the three and nine months ended September 30, 2013 or 2012. If different valuation techniques are deemed necessary, we would consider those transfers to occur at the end of the period when the assets are valued.

- Definition

The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information.

+ References

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