NOTE 23. FAIR VALUES

The following table presents estimated fair values of the Company’s financial instruments as of December 31, 2013 and 2012, whether or not recognized or recorded at fair value in the Consolidated Balance Sheets.

Non-financial assets and non-financial liabilities defined by the FASB ASC 820, Fair Value Measurement, such as Bank premises and equipment, deferred taxes and other liabilities are excluded from the table. In addition, we have not disclosed the fair value of financial instruments specifically excluded from disclosure requirements of FASB ASC 825, Financial Instruments, such as Bank-owned life insurance policies.


(Dollars in thousands)	December 31, 2013				December 31, 2012
	Carrying Amounts		Fair Value		Carrying Amounts		Fair Value
Financial assets – Continued operations
Cash and cash equivalents	$	58,515	$	58,515	$	45,068	$	45,068
Securities available-for-sale		216,640		216,640		197,354		197,354
Securities held-to-maturity		36,696		34,025		31,483		31,493
Portfolio loans, net		584,126		591,315		653,260		664,119
Promissory note due from the former mortgage subsidiary		2,607		2,607		3,592		3,592
Federal Home Loan Bank Stock		4,531		4,531		5,875		5,875
Financial liabilities – Continued operations
Deposits	$	746,293	$	746,332	$	701,052	$	702,817
Securities sold under agreements to repurchase		0		0		13,095		13,095
Federal Home Loan Bank advances		75,000		75,000		125,000		125,231
Subordinated debenture		15,465		8,754		15,465		8,109
Derivatives		2,890		2,890		4,085		4,085

	Contract Amount				Contract Amount
Off balance sheet financial instruments:
Commitments to extend credit	$	192,351			$	144,333
Standby letters of credit	$	4,583			$	3,012
Guaranteed commitments outstanding	$	1,871			$	1,290

Fair Value Hierarchy

Level 1 valuations utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access.

Level 2 valuations utilize inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 valuations 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 valuations are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include the use of option pricing models, discounted cash flow models and similar techniques.

In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls has been determined based on the lowest level input that is significant to the fair value measurement in its entirety.

The Company maximizes the use of observable inputs and minimizes the use of unobservable inputs when developing fair value measurements. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.

The following methods and assumptions were used to estimate the fair value of each class of financial instrument for which it is practical to estimate that value:

Cash and cash equivalents – The carrying amounts reported in the Consolidated Balance Sheets for cash and cash equivalents are a reasonable estimate of fair value. The carrying amount is a reasonable estimate of fair value because of the relatively short term between the origination of the instrument and its expected realization. Therefore, the Company believes the measurement of fair value of cash and cash equivalents is derived from Level 1 inputs.

Portfolio loans, net – For variable rate loans that re-price frequently and with no significant change in credit risk, fair values are based on carrying values. For fixed rate loans, projected cash flows are discounted back to their present value based on specific risk adjusted spreads to the U.S. Treasury Yield Curve, with the rate determined based on the timing of the cash flows. The ALLL is considered to be a reasonable estimate of loan discount for credit quality concerns. Given that there are commercial loans with specific terms that are not readily available; the Company believes the fair value of portfolio loans is derived from Level 3 inputs.

Promissory note due from Mortgage Company – To determine the fair value of the promissory note, the Company discounts the expected future cash flows after each payment based on a discount rate derived by the average of the bid/ask yields on debt issued by a large mortgage lender with similar risk characteristics, whose debt is currently traded in an active open market. In addition, a risk premium adjustment was added to incorporate certain inherent risks and credit risks associated with the payment of certain cash flows from the former mortgage subsidiary. Accordingly, the Company derived a 10% discount rate to discount the future expected cash flows over the remaining life of the loan. The Company believes the fair value of the promissory note is derived from Level 3 inputs.

FHLB stock – The carrying value of FHLB stock approximates fair value as the shares can only be redeemed by the issuing institution at par. The Company measures the fair value of FHLB stock using Level 1 inputs.

Deposits – The Company measures fair value of maturing deposits using Level 2 inputs. The fair values of deposits were derived by discounting their expected future cash flows based on the FHLB yield curves, and maturities. The Company obtained FHLB yield curve rates as of the measurement date, and believes these inputs fall under Level 2 of the fair value hierarchy. Deposits with no defined maturities, the fair values are the amounts payable on demand at the respective reporting date.

Securities sold under agreements to repurchase – The fair value of securities sold under agreements to repurchase is estimated by discounting the expected contractual cash flows related to the outstanding borrowings at rates equal to the Company’s current offering rate, which approximate general market rates. The Company measures the fair value of securities sold under agreements to repurchase using Level 3 inputs.

FHLB advances – For variable rate FHLB borrowings, the carrying value approximates fair value. The Company measures the fair value of FHLB advances using Level 2 inputs.

Subordinated debenture – The fair value of the subordinated debenture is estimated by discounting the future cash flows using market rates at the reporting date, of which similar debentures would be issued with similar credit ratings as ours and similar remaining maturities. At December 31, 2013, future cash flows were discounted at 5.94%. The Company measures the fair value of subordinated debentures using Level 2 inputs.

Commitments – Loan commitments and standby letters of credit generate ongoing fees, which are recognized over the term of the commitment period. In situations where the borrower’s credit quality has declined, we record a reserve for these unfunded commitments. Given the uncertainty in the likelihood and timing of a commitment being drawn upon, a reasonable estimate of the fair value of these commitments is the carrying value of the related unamortized loan fees plus the reserve, which is not material. As such, no disclosures are made on the fair value of commitments.

The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Available-for-sale securities and derivatives are recorded at fair value on a recurring basis. From time to time, the Company may be required to record at fair value other assets on a nonrecurring basis, such as collateral dependent impaired loans and certain other assets including OREO. These nonrecurring fair value adjustments involve the application of lower of cost or fair value accounting or write downs of individual assets.

The following table presents information about the Company’s assets and liabilities measured at fair value on a recurring basis, and indicate the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value, as of December 31, 2013 and December 31, 2012.


(Dollars in thousands)	Fair Value at December 31, 2013
Recurring basis	Total		Level 1		Level 2		Level 3
Available-for-sale securities
U.S. government and agencies	$	6,264	$	0	$	6,264	$	0
Obligations of states and political subdivisions		59,209		0		59,209		0
Residential mortgage backed securities and collateralized mortgage obligations		62,991		0		62,991		0
Corporate securities		48,230		0		48,230		0
Commercial mortgage backed securities		10,472		0		10,472		0
Other investment securities (1)		29,474		0		29,474		0

Total assets measured at fair value	$	216,640	$	0	$	216,640	$	0

Derivatives – forward starting interest rate swap	$	2,890	$	0	$	2,890	$	0

Total liabilities measured at fair value	$	2,890	$	0	$	2,890	$	0


	Fair Value at December 31, 2012
Recurring basis	Total		Level 1		Level 2		Level 3
Available-for-sale securities
U.S. government and agencies	$	2,946	$	0	$	2,946	$	0
Obligations of states and political subdivisions		58,484				57,353		1,131
Residential mortgage backed securities and collateralized mortgage obligations		51,530				51,530		0
Corporate securities		61,556		0		61,556		0
Commercial mortgage backed securities		4,324		0		4,324		0
Other investment securities (1)		18,514		0		4,767		13,747

Total assets measured at fair value	$	197,354	$	0	$	182,476	$	14,878

Derivatives – forward starting interest rate swap	$	4,085	$	0	$	4,085	$	0

Total liabilities measured at fair value	$	4,085	$	0	$	4,085	$	0

(1)	Principally represents residential mortgage backed securities issued by both by governmental and nongovernmental agencies, and other asset backed securities.

Recurring Items

Debt Securities – The available-for-sale securities amount in the recurring fair value table above represents securities that have been adjusted to their fair values. For these securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions among other things. The Company has determined that the source of these fair values falls within Level 2 of the fair value hierarchy.

Forward starting interest rate swaps – The valuation of the Company’s interest rate swaps were obtained from third party pricing services. The fair values of the interest rate swaps were determined by using a discounted cash flow analysis on the expected cash flows of each derivative. The pricing analysis was based on observable inputs for the contractual terms of the derivatives, including the period to maturity and interest rate curves. The Company has determined that the source of these derivatives’ fair values falls within Level 2 of the fair value hierarchy.

Sensitivity of the Level 3 Fair Value Measurements

Other investments – At December 31, 2012, the Company held non-agency mortgage backed securities with a fair value of $13.8 million classified as Level 3 in the fair value hierarchy. The significant unobservable inputs used in the fair value measurement of these securities are prepayment rates, probabilities of default, and loss severities in the event of default. Significant increases (decreases) in any of those inputs in isolation would result in a significantly lower (higher) fair value measurement. Generally, a change in assumptions used for the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity and a directionally opposite change in the assumption used for prepayment rates.

Obligations of states and political subdivisions – At December 31, 2012 the Company held municipal securities with a fair value of $1.1 million classified as Level 3 in the fair value hierarchy. The fair value hierarchy classification for these securities differs from the remaining municipal bond portfolio which is classified as Level 2. Generally, for Level 2 municipal securities, the fair values are derived from discounted cash flows based on observable market yields for similarly rated securities with similar maturities.

The three municipal securities that comprise the $1.1 million classified as Level 3 in the fair value hierarchy were not rated by the respective rating agencies as of December 31, 2012, and did not have recent trade activity. As a result, unobservable inputs were used to derive the risk adjusted discount rate used to discount the expected future cash flows. Significant increases (decreases) in the risk adjusted discount rate in isolation would result in a significantly lower (higher) fair value measurement. Generally, a change in assumptions used for the perceived credit risk is accompanied by a directionally similar change in the discount rate used to discount the cash flows.

The following tables provide certain significant quantitative information about Level 3 fair value measurements for the year ended December 31, 2012:

December 31, 2012

Fair Value

Valuation Techniques(s)

Unobservable Input

Obligations of states and political subdivisions

1,131

Discounted cash flow

Risk adjusted discount rate

Other investment securities

13,747

Discounted cash flow

Constant prepayment rate

Probability of default

Loss Severity

The following table provides a reconciliation of assets and liabilities measured at fair value using significant unobservable inputs (Level 3) on a recurring basis for the years ended December 31, 2013, and 2012. The amount included in the “Beginning balance” column represents the beginning balance of an item in the period for which it was designated as a Level 3 fair value measure.


(Dollars in thousands)	Beginning balance		Transfers into Level 3		Change included in earnings		Purchases and issuances		Sales and settlements (1)			Transfers out			Ending balance		Net change in unrealized gains or (losses) relating to items held at end of period
2013
Obligations of states and political subdivisions	$	1,131		0		0		0		0		$	1,131		$	0	$	0
Mortgage backed securities	$	13,747		0		0		0		(749	)	$	(12,998	)	$	0	$	0
2012
Obligations of states and political subdivisions	$	0		1,131		0		0		0			0		$	1,131	$	0
Mortgage backed securities	$	0		13,747		0		0		0			0		$	13,747	$	0
Derivatives – interest rate lock commitments (1)	$	179		0		0		52		231			0		$	0	$	0
Earn out payable(1)(2)	$	600		0		0		0		600			0		$	0	$	0

(1)

Pursuant to the sale of the Mortgage Company effective June 30, 2012, the Company no longer has interest rate lock commitments, and has settled the earn out payable. See Note 8, Discontinued Operations in these Notes to Consolidated Financial Statements for further detail on the sale of the Mortgage Company. The changes included in earnings have been reclassified and are included in income from discontinued operations in the Consolidated Statement of Operations.

(2)

The earn out payable amount represents the fair value of the Company’s earn out incentive agreement with the Company’s former mortgage subsidiary. The non-controlling shareholder’s of the mortgage subsidiary earned certain cash payments from the Company, based on targeted results. The fair value of the earn out payable was estimated by using a discounted cash flow model whereby discounting the contractual cash flows expected to be paid out, under the assumption the mortgage subsidiary meets targeted results. During 2012, the remaining earn out incentive proceeds were netted with consideration received by the Company as part of the sales transaction of the mortgage subsidiary, and the liability was terminated as of July 1, 2012. The changes included in earnings have been reclassified and are included in income from discontinued operations in the Consolidated Statement of Operations.

Classification transfers of $1.1 million and $13.7 million in municipal bonds and non-agency mortgage backed securities from Level 2 to Level 3 were made in December 2012. The Company determined the fair values of these securities were derived by both observable and unobservable inputs. Accordingly, a Level 3 classification was deemed necessary. During the year ended December 31, 2013, the Company transferred $749 thousand associated with one non-agency mortgage backed security from Level 3 to Level 2 as the Company was able to obtain observable inputs to determine the securities fair value. During the year ended December 31, 2013, the Company transferred $1.1 million and $13.0 million in municipal bonds and non-agency mortgage backed securities from Level 3 to Level 2, the Company determined the fair values of these securities were derived from observable inputs.

Assets and Liabilities Recorded 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 nonrecurring basis. These adjustments to fair value generally result from the application of lower of cost or fair value accounting or write-downs of individual assets due to impairment. The following table presents information about the Company’s assets and liabilities measured at fair value on a nonrecurring basis for which a nonrecurring change in fair value has been recorded during the reporting period. The amounts disclosed below represent the fair values at the time the nonrecurring fair value measurements were made, and not necessarily the fair values as of the date reported upon.


(Dollars in thousands)	Fair Value at December 31, 2013
Nonrecurring basis	Total		Level 1		Level 2		Level 3
Collateral dependent impaired loans	$	2,317	$	0	$	0	$	2,317

Total assets measured at fair value	$	2,317	$	0	$	0	$	2,317


	Fair Value at December 31, 2012
Nonrecurring basis	Total		Level 1		Level 2		Level 3
Collateral dependent impaired loans	$	12,865	$	0	$	0	$	12,865
Other real estate owned		931		0		0		931

Total assets measured at fair value	$	13,796	$	0	$	0	$	13,796

The following table presents the losses resulting from nonrecurring fair value adjustments for the years ended December 31, 2013, 2012 and 2011:


(Dollars in thousands)	December 31,
	2013		2012		2011
Collateral dependent impaired loans	$	745	$	5,296	$	3,873
Other real estate owned		0		435		557

Total	$	745	$	5,731	$	4,430

For the year ended December 31, 2013 collateral dependent impaired loans with a carrying amount of $3.1 million were written down to their fair value of $2.3 million resulting in a $745 thousand adjustment to the ALLL.

The loan amounts above represent impaired, collateral dependent loans that have been adjusted to fair value during the respective reporting period. When we identify a collateral dependent loan as impaired, we measure the impairment using the current fair value of the collateral, less selling costs. Depending on the characteristics of a loan, the fair value of collateral is generally estimated by obtaining external appraisals. If we determine that the value of the impaired loan is less than the recorded investment in the loan, we recognize this impairment and adjust the carrying value of the loan to fair value through the ALLL.

The loss represents charge offs or impairments on collateral dependent loans for fair value adjustments based on the fair value of collateral. The carrying value of loans fully charged off is zero. When the fair value of the collateral is based on a current appraised value, or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the impaired loan as nonrecurring Level 3.

The OREO amount above represents impaired real estate that has been adjusted to fair value during the respective reporting period. The loss represents impairments on OREO for fair value adjustments based on the fair value of the real estate. The determination of fair value is based on recent appraisals of the foreclosed properties, which take into account recent sales prices adjusted for unobservable inputs, such as opinions provided by local real estate brokers and other real estate experts. The Company records OREO as a nonrecurring Level 3.

Limitations – Fair value estimates are made at a specific point in time, based on relevant market information and other information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature, involve uncertainties and matters of significant judgment, and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

Fair value estimates are based on current on and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Other significant assets and liabilities that are not considered financial assets or liabilities include deferred tax assets and liabilities, and property, plant and equipment. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of the estimates.