Note 4. Fair Value of Financial Instruments

3 Months Ended

Jun. 30, 2011

Fair Value Disclosures [Text Block]

4.    Fair Value of Financial Instruments

The accounting guidance for fair value measurements and disclosures establishes a three-level valuation hierarchy for disclosure of fair value measurements.  The valuation hierarchy favors the transparency of inputs to the valuation of an asset or liability as of the measurement date and thereby favors use of Level 1 if appropriate information is available, and otherwise Level 2 and finally Level 3 if a Level 2 input is not available. The three levels are defined as follows.

· Level 1 — Fair value is based upon quoted prices (unadjusted) for identical assets or liabilities in active markets in which the Corporation can participate.

· Level 2 — Fair value is based upon quoted prices for similar (i.e., not identical) assets and liabilities in active markets, and other inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

· Level 3 — Fair value is based upon financial models using primarily unobservable inputs.

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input within the valuation hierarchy that is significant to the fair value measurement.

The Corporation has an established process for determining fair values.  Fair value is based upon quoted market prices, where available.  If listed prices or quotes are not available, fair value is based upon internally developed models that use primarily market-based or independently-sourced market parameters, including interest rate yield curves and option volatilities. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value.  These adjustments include amounts to reflect counterparty credit quality, creditworthiness, liquidity and unobservable parameters that are applied consistently over time.  Any changes to the valuation methodology are reviewed by management to determine appropriateness of the changes.  As markets develop and the pricing for certain products becomes more transparent, the Corporation expects to continue to refine its valuation methodologies.

The methods described above may produce a fair value estimate that may not be indicative of net realizable value or reflective of future fair values.  Further, while the Corporation believes its valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in different estimates of fair values of the same financial instruments at the reporting date.

The following is a description of the valuation methodologies used by the Corporation to estimate fair value, as well as the general classification of financial instruments pursuant to the valuation hierarchy:

Cash and cash equivalents – Due to their short-term nature, the carrying amount of cash and cash equivalents approximates fair value.

Fed funds sold – Due to their short-term nature, the carrying amount of Fed funds sold approximates fair value.

Held to maturity securities – The fair value is estimated using quoted market prices.

Federal Home Loan Bank Stock – It is not practical to determine the fair value of Federal Home Loan Bank (“FHLB”) Stock due to restrictions placed on its transferability.  No secondary market exists for FHLB stock.  The stock is bought and sold at par by the FHLB.  Management believes the recorded value is the fair value.

Non-marketable equity securities – The fair value is estimated using values of comparable securities.

Loans held for investment - The Bank does not record loans held for investment at fair value on a recurring basis.  However, from time to time, a particular loan may be considered impaired and an allowance for loan losses 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 relevant accounting guidance.  The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value or 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 June30, 2011, substantially all of the impaired loans were evaluated based on the fair value of the collateral.  In accordance with relevant accounting guidance, impaired loans where an allowance is established based on the fair value of collateralrequire classification in the fair value hierarchy.  When the fair value of the collateral is based on anobservable marketprice or a current appraised value, the Bank records the impaired loan as a nonrecurring Level 2 valuation.  Valuations based on management estimates are recorded as nonrecurring Level 3.  Mortgage loans available for sale and held for investment are valued using fair values attributable to similar mortgage loans.  The fair value of the other loans is based on the fair value of obligations with similar credit characteristics.

Cash surrender value of life insurance policies – Fair value is based on the cash surrender value of the individual policies as provided by the insurance agency.

Mortgage servicing rights - The Bank does not record mortgage servicing rights (MSRs) at fair value on a recurring basis.  However, from time to time, MSRs may be considered impaired and a valuation allowance is established.  MSRs for which amortized cost exceeds fair value are considered impaired.  The fair value of MSRs is estimated using third-party information for selected asset price tables for servicing cost and servicing fees applied to the Bank’s portfolio of serviced loans.  The Bank records impaired MSRs as a nonrecurring Level 2 valuation.

Other real estate owned - Loans on which the underlying collateral has been repossessed are recorded at the lesser of (i) carrying value or (ii) at fair valueless estimated costs to sell upon transfer to other real estate owned (“OREO”).  Fair value is 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, the Bank records the other real estate owned as a nonrecurring Level 2valuation.  Valuations based on management estimates are recorded as nonrecurring Level 3.

Deposit Accounts - The fair value of demand deposits and savings accounts approximates the carrying amount. The fair value of fixed maturity certificates of deposit is estimated using the rates currently offered forcertificates of deposit with similar remaining maturities.

As of June 30, 2011 and December 31, 2010 the Bank did not carry any assets that were measured at fair value on a recurring basis.   

Assets measured at fair value on a nonrecurring basis

The Bank has assets that under certain conditions are subject to measurement at fair value on a nonrecurring basis.  These include assets that are measured at the lower of cost or market and had a fair value below cost at the end of the period as summarized below.

	Balance at 06/30/11		Level 1		Level 2		Level 3
Loans held for investment	$	9,325,083	$	-	$	-	$	9,325,083
Other real estate owned		8,565,443		-		-		8,565,443
Totals	$	17,890,526	$	-	$	-	$	17,890,526

	Balance at 12/31/10		Level 1		Level 2		Level 3
Loans held for investment	$	12,630,600	$	-	$	-	$	12,630,600
Other real estate owned		5,407,205		-		-		5,407,205
Totals	$	18,037,805	$	-	$	-	$	18,037,805

The estimated fair values of financial instruments at June 30, 2011 and December 31, 2010 are as follows:

	June 30, 2011				December 31, 2010
	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
FINANCIAL ASSETS
Cash and due from banks	$	26,412,385	$	26,412,385	$	39,849,020	$	39,849.020
Federal funds sold		3,365,930		3,365,930		88,221,710		88,221,710
Held to maturity securities		314,946,712		317,062,830		227,803,832		227,276,572
Federal reserve stock		322,100		322,100		322,100		322,100
Loans held for investment, net		712,810,148		722,239,434		737,302,103		744,855,523
Cash surrender value of life insurance		12,256,383		12,256,383		12,024,264		12,024,264
Mortgage servicing rights		1,610,009		2,823,505		1,702,696		2,784,581
Accrued interest receivable		4,753,822		4,753,822		4,120,030		4,120,030
FINANCIAL LIABILITIES
Deposits	$	982,973,584	$	981,038,802	$	1,018,447,292	$	1,016,209,456
Other borrowings		2,148,562		2,148,562		4,815,964		4,815,964
Accrued interest payable		304,007		304,007		360,173		360,173

The estimated fair value of fee income on letters of credit outstanding at June 30, 2011 and December 31, 2010 is insignificant.  Loan commitments on which the committed interest rate is less than the current market rate are also insignificant at June 30, 2011 and December 31, 2010.

The Bank assumes interest rate risk (the risk that general interest rate levels will change) as part of its normal operations.  As a result, fair values of the Bank’s financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Bank.  Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment.  Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment.  Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Bank's overall interest rate risk.