Note 2: Fair Value

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. Valuation techniques use certain inputs to arrive at fair value. Inputs to valuation techniques are the assumptions that market participants would use in pricing the asset or liability. They may be observable or unobservable. Applicable accounting principles establish a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. Assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The fair value hierarchy is as follows:

Level 1 Inputs – Unadjusted quoted market prices in active markets for identical assets or liabilities that the reporting 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 or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds or credit risks) or inputs that are derived principally from or corroborated by market data by correlation or other means.

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 table summarizes assets and liabilities measured at fair value on a recurring basis as of June 30, 2011 and December 31, 2010, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:

			Fair Value Measurements at
			June 30, 2011, Using
			Quoted
			Prices In
			Active
			Markets		Significant
	Assets/Liabilities		For		Other		Significant
	Measured at Fair		Identical		Observable		Unobservable
	Value		Assets		Inputs		Inputs
(Dollars in thousands)	June 30, 2011		(Level 1)		(Level 2)		(Level 3)

U.S. Government sponsored entities	$	44,823	$	-	$	44,823	$	-
Mortgage-backed investments		202,126		-		202,126		-
Obligations of states and political subdivisions		41,594		-		41,594		-
Collateralized debt obligations		946		-		-		946
Other debt securities		3,644		-		3,644		-
Total securities available for sale	$	293,133	$	-	$	292,187	$	946

Interest rate swap		103		-		-		103

Mortgage derivative assets		51		-		-		51

Mortgage derivative liabilities		17		-		-		17

			Fair Value Measurements at
			December 31, 2010, Using
			Quoted
			Prices In
			Active
			Markets		Significant
	Assets/Liabilities		For		Other		Significant
	Measured at Fair		Identical		Observable		Unobservable
	Value		Assets		Inputs		Inputs
(Dollars in thousands)	December 31, 2010		(Level 1)		(Level 2)		(Level 3)

U.S. Government sponsored entities	$	58,611	$	-	$	58,611	$	-
Mortgage-backed investments		173,921		-		173,921		-
Obligations of states and political subdivisions		41,828		-		41,828		-
Collateralized debt obligations		934		-		-		934
Other debt securities		1,635		-		1,635		-
Total available for sale securities	$	276,929	$	-	$	275,995	$	934

Interest rate swap		817						817

Mortgage derivative assets		246		-		-		246

Mortgage derivative liabilities		28		-		-		28

U.S. Treasury, Government sponsored entity and mortgage-backed securities. Securities issued by the U.S. Treasury and Government sponsored entities and mortgage-backed securities are traded in a dealer market and are reported at fair value utilizing Level 2 inputs. For these securities, the Company obtains fair value measurements from an independent pricing service that primarily uses trading activity in the dealer market to determine market prices.

Obligations of states and political subdivisions. Municipal securities include investments that are traded in a dealer market and investments that trade infrequently and are reported using Level 2 inputs. The fair value measurements are obtained from both an independent pricing service and from a correspondent bank’s broker-dealer portfolio accounting product that utilizes a pricing matrix that considers observable inputs obtained from a municipal security data provider which include dealer quotes, market yield curves, credit information (including observable default rates) and the instrument’s contractual terms and conditions, among other things.

Other debt securities. Other debt securities trade in a dealer market and are reported using Level 2 inputs. The fair value measurements are provided by an independent pricing service and are derived from trading activity in the dealer market.

Collateralized debt obligations. The Company owns certain beneficial interests in collateralized debt obligations secured by community bank trust preferred securities. These interests do not trade in a liquid market, and therefore, market quotes are not a reliable indicator of their ultimate realizability. The Company utilizes a discounted cash flow model using inputs of (1) market yields of trust-preferred securities as the discount rate and (2) expected cash flows which are estimated using assumptions related to defaults, deferrals and prepayments to determine the fair values of these beneficial interests. Many of the factors that adjust the timing and extent of cash flows are based on judgment and not directly observable in the markets. Therefore, these fair values are classified as Level 3 valuations for accounting and disclosure purposes.

Mortgage Derivatives. Mortgage derivative assets and liabilities represent the fair values of the interest rate lock commitments (IRLCs) of the Company to originate mortgages at certain rates as well as the commitments, or forward sale agreements (FSAs), to sell the mortgages to investors at locked prices within a specified period of time. The Company uses an internal valuation model with observable market data inputs consisting primarily of dealer quotes, market yield curves, estimated servicing values, credit-related adjustments and estimated pull-through rates. These instruments are classified as Level 3 fair values. Mortgage derivative assets are included in other assets and mortgage derivative liabilities are included in other liabilities in the Company’s balance sheet.

Interest rate swap. The interest rate swap is valued using a discounted cash flow model. Future net cash flows are estimated based on the forward LIBOR rate curve, the payment terms of the swap and potential credit events. These cash flows are discounted using a rate derived from the forward swap curve, with the resulting fair value being classified as a Level 3 valuation.

The following table reports the activity for the second quarter and year-to-date periods ending June 30, 2011 and 2010 in assets measured at fair value on a recurring basis using significant unobservable (Level 3) inputs.

(Dollars in thousands)	Three Months Ended									Six Months Ended
	June 30, 2011									June 30, 2011
	Collateralized						Interest			Collateralized						Interest
	Debt			Mortgage			Rate			Debt			Mortgage			Rate
	Obligations			Derivatives			Swap			Obligations			Derivatives			Swap
Beginning Balance	$	866		$	31		$	988		$	934		$	218		$	817
Total gains or losses (realized/unrealized)
Other-than-temporary impairment included in earnings		(85	)		-			-			(381	)		-			-
Other-than-temporary impairment (included in) transferred from other comprehensive income		87			-			-			143			-			-
Other gains/losses included in other comprehensive income		78			-			(1,049	)		250			-			(907	)
Net swap settlement recorded		-			-			164			-			-			193
IRLC and FSA issuances		-			39			-			-			206			-
IRLC and FSA expirations and fair value changes included in earnings		-			(5	)		-			-			(218	)		-
IRLC transfers into closed loans/FSA transferred on sales		-			(31	)		-			-			(172	)		-
Ending Balance	$	946		$	34		$	103		$	946		$	34		$	103

The amount of total gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets still held at the reporting date	$	(85	)	$	-		$	(164	)	$	(381	)	$	-		$	(193	)

	Three Months Ended						Six Months Ended
(Dollars in thousands)	June 30, 2010						June 30, 2010
	Collateralized						Collateralized
	Debt			Mortgage			Debt			Mortgage
	Obligations			Derivatives			Obligations			Derivatives
Beginning Balance	$	1,045		$	68		$	1,080		$	84
Total gains or losses (realized/unrealized)
Other-than-temporary impairment included in earnings		(164	)		-			(366	)		-
Other-than-temporary impairment (included in) transferred from other comprehensive income		68			-			(2	)		-
Other gains/losses included in other comprehensive income		(66	)		-			171			-
IRLC and FSA issuances, expirations and fair value changes included in earnings		-			66			-			61
IRLC transfers into closed loans		-			(44	)		-			(55	)
Ending Balance	$	883		$	90		$	883		$	90

The amount of total gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets still held at the reporting date	$	(164	)	$	-		$	(366	)	$	-

The following tables summarize assets and liabilities measured at fair value on a nonrecurring basis as of June 30, 2011, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:

			Fair Value Measurements Using
			Quoted
			Prices in
			Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs
(Dollars in thousands)	06/30/11 (a)		(Level 1)		(Level 2)		(Level 3)

Impaired loans	$	21,532	$	-	$	-	$	21,532
Loan foreclosures		1,178		-		-		1,178
Other real estate		8,678		-		-		8,678

The following tables summarize assets and liabilities measured at fair value on a nonrecurring basis as of December 31, 2010, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:

			Fair Value Measurements Using
			Quoted
			Prices in
			Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs
(Dollars in thousands)	12/31/10 (a)		(Level 1)		(Level 2)		(Level 3)

Impaired loans	$	27,335	$	-	$	-	$	27,335
Loan foreclosures		5,013		-		-		5,013
Other real estate		12,498		-		-		12,498

(a)

These amounts represent the carrying amounts on the consolidated statement of condition at the balance sheet date for impaired real estate- secured loans and other real estate for which fair value re-measurements took place during the period. Loan foreclosures represent the fair value portion of the carrying amounts of other real estate properties that were re-measured at the point of foreclosure during the period and were still owned at the balance sheet date.

The following table summarizes losses recognized related to nonrecurring fair value measurements of individual assets or portfolios:

(Dollars in thousands)	Three Months Ended June 30				Six Months Ended June 30
	2011		2010		2011		2010
Impaired loans (a)	$	2,356	$	2,537	$	4,416	$	3,648
Loan foreclosures (b)		345		276		817		1,596
Other real estate (c)		1,053		465		3,107		662

(a)

Represents additional impairments on loans which are based on the appraised value of the collateral. These impairments are accrued in the allowance for loan losses and charged to provision for loan loss expense.

(b)

Represents foreclosures of loans secured by real estate when the foreclosed value is lower than the carrying value of the loan. These amounts are charged to the allowance for loan losses with the fair value of the foreclosed property being recorded in other real estate.

(c)

Represents related losses of foreclosed properties that were measured at fair value subsequent to their initial acquisition.

Gains and losses recognized due to fair value re-measurements are recorded in the consolidated statements of operations in (1) provision for loan losses for impaired loans and (2) foreclosed property expenses for other real estate.

Impaired Loans. Collateral dependent loans, which are loans for which the repayment is expected to be provided solely by the underlying collateral, are valued for impairment purposes by using the fair value of the underlying collateral. For collateral dependent loans, collateral values are estimated using Level 3 inputs based on appraisals, observable market data and other internal estimates.

Loan Foreclosures. Certain foreclosed assets, upon initial recognition, were re-measured and reported at fair value through a charge-off to the allowance for possible loan losses based upon the fair value of the foreclosed asset. The fair value of a foreclosed asset, upon initial recognition, is estimated using Level 3 inputs based on appraisals, observable market data and other internal estimates.

Other real estate. Other real estate consists of real estate from loans that have been foreclosed on. It is carried at the lower of cost or fair value less costs to sell. Subsequent to foreclosure, these properties may experience further market declines. When this occurs, the Company writes the property down to management’s best estimate of what the market may be willing to pay. Management considers recent appraisals when available, what other properties have sold for, how long properties have been on the market, the condition of the property, the availability of liquid buyers and other assumptions that market participants may use in determining a price at which they would acquire the property. Since certain significant inputs to these estimates are management-derived and unobservable, fair values are reported as using Level 3 inputs.

Fair Value of Financial Instruments

The following table presents the carrying amounts and fair values of the Company’s financial instruments at June 30, 2011 and December 31, 2010:

	June 30, 2011						December 31, 2010
(Dollars in thousands)	Carrying			Estimated			Carrying			Estimated
	Amount			Fair Value			Amount			Fair Value
Financial assets:
Cash and short-term investments	$	169,993		$	169,993		$	142,202		$	142,202
Securities available for sale		293,133			293,133			276,929			276,929
Loans held for sale		2,117			2,148			6,242			6,242
Loans held for investment		1,025,790			950,043			1,044,121			965,894
Agency accounts receivable		453			453			346			346
Accrued interest receivable		5,970			5,970			6,380			6,380
Nonmarketable equity investments		7,367			7,367			7,353			7,353
Investments in unconsolidated VIEs		3,568			3,568			3,615			3,615
Mortgage derivative assets		51			51			246			246
Financial liabilities:
Noninterest-bearing deposits		243,626			243,626			212,199			212,199
NOW, MMDA and savings deposits		689,238			689,238			645,433			645,433
Certificates of deposit		491,635			498,648			517,780			527,971
Short-term borrowings		5,047			5,047			33,481			33,481
Other borrowings		45,492			48,036			50,416			53,213
Junior subordinated debt		30,928			26,736			30,928			25,123
Agency accounts payable		1,773			1,773			586			586
Accrued interest payable		1,306			1,306			1,470			1,470
Mortgage derivative liabilities		17			17			28			28
Other financial instruments:
Commitments to extend credit and letters of credit		(7	)		(286	)		(15	)		(306	)
Interest rate swap		103			103			817			817

The following methods and assumptions were used by the Company in estimating the fair value of financial instruments:

Cash and due from banks, interest-bearing deposits with banks and Federal funds sold are valued at their carrying amounts which are reasonable estimates of fair value due to the relatively short period to maturity of the instruments.

Securities available for sale are predominantly valued based on prices obtained from an independent nationally recognized pricing service and market yield matrices. The Company uses an external pricing service to electronically provide prices by CUSIP number. These prices include exchange quoted prices, dealer quoted prices and prices derived from market yields published by specialized financial database providers. The price used is the one price per instrument provided for the securities that the service can produce prices for. No additional adjustments are made to the prices that are obtained from external pricing services. Typically, all securities except for some small municipal issues and the collateralized debt obligations are priced by the primary external provider. For issues that are not priced by the primary provider, the pricing disclosed in the investment accounting product provided by the broker-dealer affiliate of a correspondent bank is used. The broker-dealer’s accounting system uses prices provided by (1) the same external pricing service that the Company uses, (2) Standard & Poor’s, (3) matrix pricing with market yield inputs provided by Bloomberg and a municipal securities market data provider and (4) the broker-dealer’s trading staff. Any quotes provided by a broker-dealer are usually non-binding. However, the Company rarely uses solicited broker-dealer quotes to price any of its securities. The broker-dealer prices all municipal securities through its pricing matrix. At June 30, 2011, the only securities that were not priced by the primary provider were 13 municipal bonds representing 6 issuers and the collateralized debt obligations. The broker-dealer’s matrix prices were used for the municipal securities and a third-party provider’s modeled prices were used for the collateralized debt obligations (CDOs).

CDOs are valued by an external party using a model. The model inputs are (1) discount margins based on current market activity and (2) cash flows based upon contractual amounts adjusted for expected defaults, expected deferrals and expected prepayments. Expected defaults and deferrals are determined through a credit analysis of and risk rating assignment to each obligor of the collateral that funds the investment vehicles. Most of these inputs are not directly observable in the market, resulting in the fair values being classified as Level 3 valuations within the fair value accounting hierarchy.

The primary method of validation of investment security values is the comparison of the prices received from the primary pricing service provider with the prices that are used in the broker-dealer’s investment accounting reports. The fair values used for selected agency, mortgage-backed and corporate securities are also periodically checked by comparing them to prices obtained from Bloomberg. The CDOs may be validated by comparing the fair values with those obtained by other valuation experts. We review the documentation provided with the CDO pricing and impairment models to assure that sound valuation methodologies are used and to determine whether or not the significant inputs are observable in the market.

Loans held for sale are valued by discounting the estimated cash flows using current market rates for instruments with similar credit ratings and maturities and adjusting those rates using dealer pricing adjustments for characteristics unique to the borrower’s circumstances or the structuring of the credit.

Loans held for investment are valued by discounting the estimated future cash flows, using rates at which these loans would currently be made to borrowers with similar credit ratings and similar maturities.

Agency accounts receivable are trade receivables of M&F Insurance Group, Inc. These receivables are short-term in nature and therefore the fair value is assumed to be the carrying value. These receivables are carried in other assets in the statement of condition.

Accrued interest receivable is short-term in nature and therefore the fair value is assumed to be the carrying value.

Nonmarketable equity securities are primarily securities of the Federal Home Loan Banks for which the carrying value is estimated to be an accurate approximation of fair value. These equity securities are carried in other assets in the statement of condition.

Investments in unconsolidated VIEs are the Company’s investment in the First M&F Statutory Trust I, which acquired the Company’s junior subordinated debt through funding provided by the issuance of trust preferred securities, and an investment in a low income housing tax credit entity. The investment in the statutory trust depends on the Company’s own cash flows and therefore, the carrying value is an accurate approximation of fair value. The low income housing tax credit investment is a limited partnership interest for which the carrying value is assumed to be a reasonable estimate of its fair value. These investments are carried in other assets in the statement of condition.

Noninterest-bearing deposits do not pay interest and do not have defined maturity dates. Therefore, the carrying value is equivalent to fair value for these deposits.

NOW, MMDA and savings deposits pay interest and generally do not have defined maturity dates. Although there are some restrictions on access to certain savings deposits, these restrictions are not assumed to have a material effect on the value of the deposits. Therefore, the fair value for NOW, MMDA and savings deposits is assumed to be their carrying value.

Certificates of deposit pay interest and do have defined maturity dates. The fair value of certificates of deposit is estimated by discounting the future cash flows, using current market rates for certificates of deposit of similar maturities.

Short-term borrowings are highly liquid and therefore the net book value of the majority of these financial instruments approximates fair value due to the short term nature of these items.

The fair value of other borrowings, which consist of Federal Home Loan Bank advances and borrowings from correspondent banks is estimated by discounting the future cash flows, using current market rates for borrowings of similar terms and maturities.

Junior subordinated debt is valued by discounting the expected cash flows using a current market rate for similar instruments.

Agency accounts payable are trade payables of M&F Insurance Group, Inc. due to insurance companies. These payables are very short term in nature and therefore the fair value of the payables is assumed to be their carrying value. These payables are carried in other liabilities in the statement of condition.

Accrued interest payable is short-term in nature and therefore the fair value is assumed to be the carrying value.

Commitments to extend credit and letters of credit are valued based on the fees charged to enter into similar credit arrangements.

Mortgage origination and sale commitments are considered derivatives and are therefore carried at fair value with the changes in fair value recorded in mortgage banking income. Mortgage-related commitments with positive values are carried in other assets and those with negative values are carried in other liabilities in the statement of condition. Mortgage derivatives are valued using a combination of market discount rates, dealer quotes, estimated servicing values and pull-through rates.

The interest rate swap is being used to hedge the interest cash flows on the Company’s junior subordinated debentures. It is valued using a discounted cash flow methodology with cash flows being estimated from the 3-month LIBOR curve and discount rates derived from the swap curve.