11. FAIR VALUE MEASUREMENT AND FAIR VALUES OF FINANCIAL INSTRUMENTS

A financial instrument is defined as cash, evidence of an ownership interest in an entity, or a contract that conveys or imposes the contractual right or obligation to either receive or deliver cash or another financial instrument. Examples of financial instruments included in Bancorp’s balance sheet are cash, federal funds sold, debt and equity securities, loans, demand, savings and other interest-bearing deposits, notes and debentures. Examples of financial instruments which are not included in the Bancorp balance sheet are commitments to extend credit and standby letters of credit.

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 at the measurement date.

Accounting standards require the fair value of deposit liabilities with no stated maturity, such as demand deposits, NOW and money market accounts, to equal the carrying value of these financial instruments and does not allow for the recognition of the inherent value of core deposit relationships when determining fair value.

Bancorp has estimated fair value based on quoted market prices where available. In cases where quoted market prices were not available, fair values were based on the quoted market price of a financial instrument with similar characteristics, the present value of expected future cash flows or other valuation techniques that utilize assumptions which are subjective and judgmental in nature. Subjective factors include, among other things, estimates of cash flows, the timing of cash flows, risk and credit quality characteristics, interest rates and liquidity premiums or discounts. Accordingly, the results may not be precise, and modifying the assumptions may significantly affect the values derived. Further, fair values may or may not be realized if a significant portion of the financial instruments were sold in a bulk transaction or a forced liquidation. Therefore, any aggregate unrealized gains or losses should not be interpreted as a forecast of future earnings or cash flows. Furthermore, the fair values disclosed should not be interpreted as the aggregate current value of Bancorp.

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

Cash and cash equivalents - The carrying amount is a reasonable estimate of fair value.

Trading securities – Trading securities held at June 30, 2011, are related solely to bonds, equity securities and mutual funds held in a Rabbi Trust for benefit of the Company’s deferred compensation plans. Fair values for trading securities are based on quoted market prices.

Investment securities - For substantially all securities within the categories U.S. Treasuries, U.S. Government agencies, mortgage-backed, obligations of state and political subdivisions, and equity investments and other securities held for investment purposes, fair values are based on quoted market prices or dealer quotes if available. When quoted market prices are not readily accessible or available, the use of alternative approaches, such as matrix or model pricing or indicators from market makers, is used. If a quoted market price is not available due to illiquidity, fair value is estimated using quoted market prices for similar securities or other modeling techniques. If neither a quoted market price nor market prices for similar securities are available, fair value is estimated by discounting expected cash flows using a market derived discount rate as of the valuation date.

Level 3 assets consist of pooled trust preferred securities and auction rate securities. The fair values of these securities were estimated using the discounted cash flow method. The fair value for these securities used inputs for base case default, recovery and prepayment rates to estimate the probable cash flows for the security. The estimated cash flows were discounted using a rate for comparably rated securities adjusted for an additional liquidity premium.

Loans - The fair value of loans is estimated by discounting the future cash flows using the current rate at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. An additional liquidity discount is also incorporated to more closely align the fair value with observed market prices.

Impaired loans - A loan is considered to be impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due (both interest and principal) according to the contractual terms of the loan agreement. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical expedient, at the loan’s observable market price or the fair value of the collateral. A significant portion of the Bank's impaired loans are measured using the fair value of the collateral.

Bank owned life insurance - The carrying amount is the cash surrender value of all policies, which approximates fair value.

Other real estate owned - Management obtains third party appraisals as well as independent fair market value assessments from realtors or persons involved in selling OREO in determining the fair value of particular properties. Accordingly, the valuation of OREO is subject to significant external and internal judgment. Management periodically reviews OREO and obtains periodic appraisals to determine whether the property continues to be carried at the lower of its recorded book value or fair value less estimated selling costs.

Deposit liabilities - The fair value of demand deposits, savings accounts and other deposits is the amount payable on demand at the reporting date. The fair value of time deposits is estimated using the rates currently offered for deposits of similar remaining maturities.

Short-term borrowings - The carrying amount is a reasonable estimate of fair value given the short-term nature of these financial instruments.

Long-term borrowings - The fair value of the long-term borrowings is estimated by discounting the future cash flows using the current rate at which similar borrowings with similar remaining maturities could be made.

Junior subordinated debentures - The fair value of the variable rate junior subordinated debentures and trust preferred securities approximates the pricing of a preferred security at current market prices.

Commitments to extend credit, standby letters of credit and financial guarantees - The majority of commitments to extend credit carry current market interest rates if converted to loans.

The tables below present fair value information on certain assets broken down by recurring or nonrecurring measurement status. Recurring assets are initially measured at fair value and are required to be reflected at fair value in the financial statements at each reporting date. Assets measured on a nonrecurring basis are assets that due to an event or circumstance were required to be re-measured at fair value after initial recognition in the financial statements at some time during the reporting period.

Assets are classified as level 1-3 based on the lowest level of input that has a significant effect on fair value. The following definitions describe the level 1-3 categories for inputs used in the tables presented below.

Quoted prices in active markets for identical assets (Level 1): Inputs that are quoted unadjusted prices in active markets for identical assets that the Company has the ability to access at the measurement date. An active market for the asset is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis.
Other observable inputs (Level 2): Inputs that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the reporting entity including quoted prices for similar assets, quoted prices for securities in inactive markets and inputs derived principally from or corroborated by observable market data by correlation or other means.
Significant unobservable inputs (Level 3): Inputs that reflect the reporting entity's own estimates about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances.

The following tables present fair value measurements for assets that are measured at fair value on a recurring basis subsequent to initial recognition for the periods shown:

(Dollars in thousands)			Fair value measurements at June 30, 2011, using
			Quoted prices in active		Other observable		Significant unobservable
	Total fair value		markets for identical assets		inputs		inputs
	June 30, 2011		(Level 1)		(Level 2)		(Level 3)
Trading securities	$	781	$	781	$	-	$	-
Available for sale securities:
U.S. Treasury securities		4,237		-		4,237		-
U.S. Government agency securities		221,958		-		221,958		-
Corporate securities		9,506		-		-		9,506
Mortgage-backed securities		454,029		-		454,029		-
Obligations of state and political subdivisions		59,122		-		58,318		804
Equity investments and other securities		11,852		1,978		9,874		-
Total recurring assets measured at fair value	$	761,485	$	2,759	$	748,416	$	10,310

(Dollars in thousands)			Fair value measurements at December 31, 2010, using
			Quoted prices in active		Other observable		Significant unobservable
	Total fair value		markets for identical assets		inputs		inputs
	December 31, 2010		(Level 1)		(Level 2)		(Level 3)
Trading securities	$	808	$	808	$	-	$	-
Available for sale securities:
U.S. Treasury securities		14,392		-		14,392		-
U.S. Government agency securities		194,230		-		194,230		-
Corporate securities		9,392		-		-		9,392
Mortgage-backed securities		363,618		-		363,618		-
Obligations of state and political subdivisions		52,645		-		51,688		957
Equity investments and other securities		11,835		1		11,834		-
Total recurring assets measured at fair value	$	646,920	$	809	$	635,762	$	10,349

The Company transferred $2.0 million in equity investments and other securities from a level 2 to a level 1 at June 30, 2011. The Company transferred $14.4 million in U.S. Treasury securities from a level 1 instrument to a level 2 instrument at December 31, 2010. In addition, the Company had no material changes in valuation techniques for recurring and nonrecurring assets measured at fair value from the quarter ended June 30, 2011.

The following table represents a reconciliation of level 3 instruments for assets that are measured at fair value on a recurring basis for the three and six months ended June 30, 2011, and 2010:

	Three months ended June 30, 2011
						Reclassification of
			Gains (losses)			losses from
			included in other			adjustment for		Purchases,
	Balance		comprehensive			impairment of		Issuances, and		Balance
(Dollars in thousands)	March 31, 2011		income			securities		Settlements		June 30, 2011
Corporate securities	$	9,850	$	(523	)	$	179	$	-	$	9,506
Obligations of state and political subdivisions		889		(85	)		-		-		804
Fair value	$	10,739	$	(608	)	$	179	$	-	$	10,310

	Six months ended June 30, 2011
						Reclassification of
			Gains (losses)			losses from
			included in other			adjustment for		Purchases,
	Balance		comprehensive			impairment of		Issuances, and		Balance
(Dollars in thousands)	January 1, 2011		income			securities		Settlements		June 30, 2011
Corporate securities	$	9,392	$	(65	)	$	179	$	-	$	9,506
Obligations of state and political subdivisions		957		(153	)		-		-		804
Fair value	$	10,349	$	(218	)	$	179	$	-	$	10,310

	Three months ended June 30, 2010
						Reclassification of
			Gains (losses)			losses from
			included in other			adjustment for		Purchases,
	Balance		comprehensive			impairment of		Issuances, and		Balance
(Dollars in thousands)	March 31, 2010		income			securities		Settlements		June 30, 2010
Corporate securities	$	10,231	$	(557	)	$	-	$	-	$	9,674
Obligations of state and political subdivisions		993		9			-		-		1,002
Fair value	$	11,224	$	(548	)	$	-	$	-	$	10,676

	Six months ended June 30, 2010
						Reclassification of
			Gains (losses)			losses from
			included in other			adjustment for		Purchases,
	Balance		comprehensive			impairment of		Issuances, and		Balance
(Dollars in thousands)	January 1, 2010		income			securities		Settlements		June 30, 2010
Corporate securities	$	9,753	$	(79	)	$	-	$	-	$	9,674
Obligations of state and political subdivisions		973		29			-		-		1,002
Fair value	$	10,726	$	(50	)	$	-	$	-	$	10,676

Certain assets, such as loans held for sale, loans measured for impairment, and OREO, are measured at fair value on a nonrecurring basis after initial recognition. For the three months ended June 30, 2011, loans held for sale were subject to the lower of cost or market method of accounting. However, there were no impairments recognized on loans held for sale in second quarter 2011. As of June 30, 2011, $64.5 million loans included in Bancorp’s loan portfolio were deemed impaired. In addition, during the second quarter, certain properties were written down by a total of $1.5 million to reflect additional decreases in estimated fair market value subsequent to the time such properties were placed into OREO.

There were no nonrecurring level 1 or 2 fair value measurements for the three or six months ended June 30, 2011, or the full year 2010. The following tables represent the level 3 fair value measurements for nonrecurring assets for the periods presented:

	Three months ended June 30, 2011
(Dollars in thousands)	Impairment		Fair Value 1
Loans measured for impairment	$	4,860	$	19,638
OREO		1,555		15,465
Total nonrecurring assets measured at fair value	$	6,415	$	35,103

	Six months ended June 30, 2011
(Dollars in thousands)	Impairment		Fair Value 1
Loans measured for impairment	$	8,274	$	39,061
OREO		2,212		33,511
Total nonrecurring assets measured at fair value	$	10,486	$	72,572

	Twelve months ended December 31, 2010
(Dollars in thousands)	Impairment		Fair Value 1
Loans measured for impairment	$	19,476	$	82,910
OREO		6,649		74,146
Total nonrecurring assets measured at fair value	$	26,125	$	157,056

1	Fair value excludes cost to sell collateral.

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

(Dollars in thousands)	Carrying Value		Fair Value
FINANCIAL ASSETS:
Cash and cash equivalents	$	90,246	$	90,246
Trading securities		781		781
Investment securities		760,704		760,704
Federal Home Loan Bank stock		12,148		12,148
Net loans (net of allowance for loan losses
and including loans held for sale)		1,483,475		1,393,318
Bank owned life insurance		25,736		25,736

FINANCIAL LIABILITIES:
Deposits	$	1,930,997	$	1,931,866
Short-term borrowings		39,200		39,200
Long-term borrowings		129,399		135,304

Junior subordinated debentures-variable		51,000		26,792

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

(Dollars in thousands)	Carrying Value		Fair Value
FINANCIAL ASSETS:
Cash and cash equivalents	$	177,991	$	177,991
Trading securities		808		808
Investment securities		646,112		646,112
Federal Home Loan Bank stock		12,148		12,148
Net loans (net of allowance for loan losses
and including loans held for sale)		1,499,155		1,407,366
Bank owned life insurance		25,313		25,313

FINANCIAL LIABILITIES:
Deposits	$	1,940,522	$	1,942,301
Long-term borrowings		168,599		175,305

Junior subordinated debentures-variable		51,000		26,597