15. FAIR VALUE MEASUREMENTS

The Company applies guidance issued by FASB regarding fair value measurements which provides a framework for measuring and disclosing fair value under generally accepted accounting principles. This guidance requires disclosures about the fair value of assets and liabilities recognized in the balance sheet in periods subsequent to initial recognition, whether the measurements are made on a recurring basis (for example, available-for-sale investment securities) or on a nonrecurring basis (for example, impaired loans).

The guidance defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an 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. The guidance also establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

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

Under the guidance, the Company groups 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 the fair value. These hierarchy levels are:

Level 1 inputs — Unadjusted quoted process in active markets for identical assets or liabilities that the entity has the ability to access at the measurement date.

Level 2 inputs - Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3 inputs - Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

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

Investment Securities Available-for-Sale

Investment securities available-for-sale is 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, 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, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.

Loans

We do not record loans at fair value on a recurring basis, however, from time to time, a loan is considered impaired and an allowance for loan loss is established. Loans for which it is probable that payment of interest and principle will not be made in accordance with the contractual terms of the loan are considered impaired. Once a loan is identified as individually impaired, management measures impairment in accordance with the FASB’s Accounting Standards Codification Receivables Topic. The fair value of impaired loans is estimated using one of several methods, including the collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring a specific allowance represent loans for which the fair value of expected repayments or collateral exceed the recorded investment in such loans. At December 31, 2012, a majority of all of the totally impaired loans were evaluated based upon the fair value of the collateral. In accordance with guidance regarding fair value measurements, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, we record the loan as nonrecurring Level 3.

Loans Held for Sale- Loans held for sale are value based quotations from the secondary market for similar instruments and are classified as level 2 of the fair value hierarchy.

Real Estate Acquired in Settlement of Loans- We record foreclosed real estate assets at the lower cost or estimated fair value on their acquisition dates and at the lower of such initial amount or estimated fair value less estimated selling costs thereafter. Estimated fair value is generally based upon independent appraisal of the collateral. We consider these collateral values to be estimated using Level 2 inputs.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The table below presents the recorded amount of assets and liabilities measured at fair value on a recurring basis as of December 31, 2012 and 2011.

	At December 31, 2012 (In thousands)
			Quoted Prices in		Other		Significant				Total Changes
			Active Markets for		Observable		Unobservable		Trading		in Fair Values
	Carrying Value		Identical Assets		Inputs		Inputs		Gains and		Included in
	December 31, 2012		(Level 1)		(Level 2)		(Level 3)		(Losses)		Period Earnings
Loans Held-for-sale	$	17,844	$	—	$	17,844	$	—	$	—	$	—
Available-for-Sale Agencies callable	59,118		—		59,118		—		—		—
Available-for-Sale Mortgage-Backed Securities	24,809		—		24,809		—		—		—
	$	101,771	$	—	$	101,771	$	0	$	—	$	—

	At December 31, 2011 (In thousands)
			Quoted Prices in		Other		Significant				Total Changes
			Active Markets for		Observable		Unobservable		Trading		in Fair Values
	Carrying Value		Identical Assets		Inputs		Inputs		Gains and		Included in
	December 31, 2011		(Level 1)		(Level 2)		(Level 3)		(Losses)		Period Earnings
Loans Held-for-sale	$	10,245	$	—	$	10,245	$	—	$	—	$	—
Available-for-Sale Agencies callable	37,660		—		37,660		—		—		—
Available-for-Sale, Municipal Bonds	2,330		—		2,330		—		—		—
Available-for-Sale, Corporate Bonds	4,947		—		4,947		—		—		—
Available-for-Sale Mortgage-Backed Securities	80,808		—		64,449		16,359		—		—
	$	135,990	$	—	$	119,631	$	16,359	$	—	$	—

Loans held-for-sale, which are carried at the lower of cost or market, did not have any impairment charge at December 31, 2012.

Assets included in Level 3 at December 31, 2011 included our private-labeled mortgage-backed securities (“MBS”) due to lack of observable market data due to decreases in market activity for these securities. Our policy is to recognize transfers in and out as of the actual date of the event or change in circumstances that caused the transfer. No assets were transferred to Level 3 during the period ending December 31, 2012. The private-labeled MBS were sold during the current fiscal year ending December 31, 2012. The level 3 balance at December 31, 2011 was due to principal repayments and the change in unrealized gains/losses for the twelve month period ending December 31, 2011. The following assumptions were used for the Level 3 valuations on the five remaining private-labeled MBS for the period ending December 31, 2011:

· Estimated future defaults are derived by an analysis of the performance of the underlying collateral as well as obtaining models from a third party. The model addresses each component of the net present value calculation, which includes loss severity rate, current default rate and current voluntary prepayment rate.

· Each individual security is reviewed and an analysis is prepared for specific credit characteristics of the underlying collateral including recent developments specific to each organization issuing the security, market liquidity, extension risks and credit rating downgrades and an estimate of future defaults is derived.

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 periods ended December 31, 2012 and December 31, 2011.

	Fair Value Measurements
	Using Significant Unobservable Inputs
	(Level 3)
	Private Labeled Mortgage-Backed
	Securities-Available for Sale
	Twelve months ended December 31,
	2012			2011

Beginning Balance	$	16,359		$	23,365
Accretion/Amortization of Discount/Premiums	4			9
Sales	(11,993		)	—
Payments received	(5,037		)	(7,926		)
Difference in Unrealized gain (loss)	667			911
Other than temporary impairment	—			—

Ending Balance	$	—		$	16,359

In accordance with the merger agreement, the Company has been repositioning a portion of the investment portfolio by selling existing securities and purchasing new securities with Old Line Bancshares’ consent. As a result, the remaining five non-agency private labeled MBS were sold in 2012, resulting in a net loss of approximately $648,000 pretax and approximately $392,000 net of tax.

Assets and Liabilities measured 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 non-recurring basis in accordance with U.S. generally accepted accounting principles. These include assets that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period. Assets measured at fair value on a nonrecurring basis are included in the tables below:

	At December 31, 2012 (In thousands)
	Carrying Value December 31, 2012		Quoted Prices in Active Markets for Identical Assets (Level 1)		Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Impaired Loans:
Residential Real estate	$	15,134	$	—	$	15,134	$	—
Construction	—		—		—		—
Land and land Acquisition	4,770		—		4,770		—
Commercial Real Estate and Commercial	12,616		—		12,616		—
Consumer	5		—		5		—
Total Impaired Loans	32,525		—		32,525		—

Real estate acquired in settlement of loans:
Residential Real estate	$	621	$	—	$	621	$	—
Construction	913		—		913		—
Land and land Acquisition	1,447		—		1,447		—
Commercial Real Estate and Commercial	2,201		—		2,201		—
Consumer	—		—		—		—
Total Real estate acquired in settlement of loans:	5,182		—		5,182		—

Total	$	37,707	$	—	$	37,707	$	—

	At December 31, 2011 (In thousands)
	Carrying Value December 31, 2011		Quoted Prices in Active Markets for Identical Assets (Level 1)		Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Impaired Loans:
Residential Real estate	$	12,531	$	—	$	12,531	$	—
Construction	—		—		—		—
Land and land Acquisition	3,203		—		3,203		—
Commercial Real Estate and Commercial	12,661		—		12,661		—
Consumer	—		—		—		—
Total Impaired Loans	28,395		—		28,395		—

Real estate acquired in settlement of loans:
Residential Real estate	$	739	$	—	$	739	$	—
Construction	744		—		744		—
Land and land Acquisition	2,176		—		2,176		—
Commercial Real Estate and Commercial	1,162		—		1,162		—
Consumer	—		—		—		—
Total Real estate acquired in settlement of loans:	4,821		—		4,821		—

Total	$	33,216	$	—	$	33,216	$	—

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a principal balance of $33.7 million, with a related valuation allowance of $1.2 million as of December 31, 2012.

Real estate acquired in settlement of loans is carried at the lower of our recorded investment or fair value at the date of acquisition. Write-downs to fair value at the date of acquisition are charged to the allowance for loan losses. Subsequent write downs are included in non-interest expense. Costs relating to the development and improvement of a property are capitalized, whereas those relating to holding the property are charged to expense when incurred. The real estate is carried at the lower of acquisition or fair value net of estimated costs to sell subsequent to acquisition. Operating expenses of real estate owned are reflected in other non-interest expenses. The value of OREO properties held due to foreclosures at December 31, 2012 was $5.2 million, which included a valuation allowance of $316,138.

The following disclosures of the estimated fair value of financial instruments are made in accordance with the requirements of ASC 825, “Disclosures about Fair Value of Financial Instruments”. We have determined the fair value amounts by using available market information and appropriate valuation methodologies. However, considerable judgment is required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts we could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.

	December 31, 2012								December 31, 2011
			Quoted Prices		Significant		Significant				Quoted Prices		Significant		Significant
			in Active		Other		Other				in Active		Other		Other
	Carrying		Markets for		Observable		Unobservable		Carrying		Markets for		Observable		Unobservable
	Amount		Identical Assets		Inputs		Inputs		Amount		Identical Assets		Inputs		Inputs
	(000’s)		(Level 1)		(Level 2)		(Level 3)		(000’s)		(Level 1)		(Level 2)		(Level 3)

Assets:
Cash and cash equivalents	$	41,429	$	—	$	41,429	$	—	$	4,402	$	—	$	4,402	$	—
Loans receivable, net	194,045		—		196,180		—		215,599		—		219,198		—
Mortgage-backed securities:
Available for sale	24,809		—		24,809		—		80,808		—		64,449		16,359
Investment securities:
Available for sale	59,118		—		59,118		—		44,937		—		44,937		—
Investment in Federal Home
Loan Bank stock	3,636		—		3,636		—		4,504		—		4,504		—
Bank Owned Life Insurance	12,825		—		12,825		—		12,369		—		12,369		—

Liabilities:
Deposits:
Non-interest-bearing	6,668		—		6,668		—		5,256		—		5,256		—
Interest bearing	224,764		—		226,162		—		239,795		—		240,958		—
Borrowings	68,000		—		69,385		—		84,000		—		84,315		—

Cash and Cash Equivalents - For cash and cash equivalents, the carrying amount is a reasonable estimate of fair value.

Loans Receivable, Net - Loans not having quoted market prices are priced using the discounted cash flow method. The discount rate used is the rate currently offered on similar products. The estimated fair value of loans held-for-sale is based on the terms of the related sale commitments.

Mortgage-Backed Securities - Fair values are based on quoted market prices or dealer quotes. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.

Investment Securities - Fair values are based on quoted market prices or dealer quotes. If a quoted market price is not available, fair values are estimated using quoted market prices for similar securities.

Investment in Federal Home Loan Bank Stock - The carrying amount of Federal Home Loan Bank (FHLB) Stock is a reasonable estimate of fair value as FHLB stock does not have a readily available market and can only be sold back to the FHLB at its par value of $100 per share.

Bank Owned Life Insurance - The carrying amount of bank owned life insurance (“BOLI”) purchased on a group of officers is a reasonable estimate of fair value. BOLI is an insurance product that provides an effective way to offset current employee benefit costs.

Deposits - The fair value of non-interest bearing accounts is the amount payable on demand at the reporting date. The fair value of interest-bearing deposits is determined using the discounted cash flow method. The discount rate used is the rate currently offered on similar products.

Borrowings — The fair value of borrowings is determined using the discounted cash flow method. The discount rate used is the rate currently offered on similar products.

Commitments to Grant Loans and Standby Letters of Credit and Financial Guarantees Written - The majority of our commitments to grant loans and standby letters of credit and financial guarantees written carry current market interest rates if converted to loans. Because commitments to extend credit and letters of credit are generally un-assignable by either us or the borrower, they only have value to us and the borrower and therefore it is impractical to assign any value to these commitments.

The fair value estimates presented herein are based on pertinent information available to management as of December 31, 2012 and December 31, 2011. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively reevaluated for purposes of these financial statements since that date and, therefore, current estimates of fair value may differ significantly from the amounts presented herein.