7. Fair Value

6 Months Ended

Jun. 30, 2012

Notes to Financial Statements

7. Fair Value

Note 7.  Fair Value

Certain assets and liabilities are recorded at fair value to provide additional insight into the Company’s quality of earnings. Some of these assets and liabilities are measured on a recurring basis while others are measured on a nonrecurring basis, with the determination based upon applicable existing accounting pronouncements. For example, securities available for sale are recorded at fair value on a recurring basis. Other assets, such as, mortgage servicing rights, loans held for sale, and impaired loans, are recorded at fair value on a nonrecurring basis using the lower of cost or market methodology to determine impairment of individual assets. The Company groups assets and liabilities which are recorded 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 fair value. A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement (with level 1 considered highest and level 3 considered lowest). A brief description of each level follows.

Level 1 Quoted prices in active markets for identical assets or liabilities.  Level 1 assets and liabilities include debt and equity securities and derivative contracts that are traded in an active exchange market, as well as U.S. Treasury, other U.S. Government and agency mortgage-backed debt securities that are highly liquid and are actively traded in over-the-counter markets.

Level 2 Observable inputs other than Level 1 prices such as quoted prices for similar assets and liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.  Level 2 assets and liabilities include debt securities with quoted prices that are traded less frequently than exchange-traded instruments and derivative contracts whose value is determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data.  This category generally includes mortgage servicing rights, impaired loans, and OREO.

Level 3 Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.  Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

Securities Available-for-Sale. Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices for similar assets, if available. If quoted prices are not available, fair values are measured using matrix pricing models, or other model-based valuation techniques requiring observable inputs other than quoted prices such as yield curves, prepayment speeds, and default rates. Recurring Level 1 securities would include U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets. Recurring Level 2 securities include federal agency securities.

Assets measured at fair value on a recurring basis and reflected in the balance sheet at the dates presented are summarized below:

June 30, 2012	Level 1		Level 2		Total
Assets: (market approach)
U.S. GSE debt securities	$	0	$	52,929,621	$	52,929,621
U.S. Government securities		7,058,909		0		7,058,909
U.S. GSE preferred stock		113,325		0		113,325
December 31, 2011
Assets: (market approach)
U.S. GSE debt securities	$	0	$	60,963,239	$	60,963,239
U.S. Government securities		5,043,555		0		5,043,555
U.S. GSE preferred stock		92,123		0		92,123
June 30, 2011
Assets: (market approach)
U.S. GSE debt securities	$	0	$	22,321,448	$	22,321,448
U.S. Government securities		4,042,594		1,015,118		5,057,712
U.S. GSE preferred stock		191,168		0		191,168

There were no transfers between Levels 1 and 2 for the periods presented.  There were no Level 3 financial instruments at June 30, 2012, December 31, 2011, or June 30, 2011.

Assets and Liabilities Recorded at Fair Value on a Non-Recurring Basis

Mortgage servicing rights. Mortgage servicing rights represent the value associated with servicing residential mortgage loans. Servicing assets and servicing liabilities are reported using the amortization method. In evaluating the carrying values of mortgage servicing rights, the Company obtains third party valuations based on loan level data including note rate, type and term of the underlying loans. As such, the Company classifies mortgage servicing rights as nonrecurring Level 2.

OREO. Real estate acquired through foreclosure is initially recorded at market value. The fair value of other real estate owned is based on property appraisals and an analysis of similar properties currently available. As such, the Company records other real estate owned as nonrecurring Level 2.

Impaired loans. A loan is considered to be impaired when it is probable that all of the principal and interest due under the original underwriting terms of the loan may not be collected. Impairment is measured based on the fair value of the underlying collateral or present value of expected cash flows. As such, the Company records impaired loans as nonrecurring Level 2.

The following table includes assets measured at fair value on a nonrecurring basis that have had a fair value adjustment since their initial recognition. Impaired loans measured at fair value only include impaired loans with a related specific allowance for loan losses and are presented net of specific allowances as disclosed in Note 5.

Assets measured at fair value on a nonrecurring basis and reflected in the balance sheet at the dates presented are summarized below:

June 30, 2012	Level 2
Assets: (market approach)
Residential mortgage servicing rights	$	1,052,235
Impaired loans, net of related allowance		1,885,819
OREO		1,010,198
December 31, 2011
Assets: (market approach)
Residential mortgage servicing rights	$	1,167,808
Impaired loans, net of related allowance		3,463,540
OREO		90,000
June 30, 2011
Assets: (market approach)
Residential mortgage servicing rights	$	1,203,811
Impaired loans, net of related allowance		1,617,955
OREO		131,000

There were no Level 1 or Level 3 financial instruments measured on a non-recurring basis at June 30, 2012, December 31, 2011, or June 30, 2011.

FASB ASC Topic 825 “Financial Instruments”, requires disclosures of fair value information about financial instruments, whether or not recognized in the balance sheet, if the fair values can be reasonably determined. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques using observable inputs when available. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. Topic 825 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.

Fair values of financial instruments

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

Cash and cash equivalents:  The carrying amounts reported in the balance sheet for cash and cash equivalents approximate their fair values.

Investment securities:  The fair value of securities available for sale equals quoted market prices, if available.  If quoted market prices are not available, fair value is determined using quoted market prices for similar securities.  Level 1 securities include certain U.S. Government securities and U.S. GSE preferred stock.  Level 2 securities include asset-backed securities, including obligations of U.S. GSEs and certain U.S. Government securities.

Restricted equity securities:  Restricted equity securities are comprised of FRBB stock and FHLBB stock.  These securities are carried at cost, which is believed to approximate fair value, based on the redemption provisions of the FRBB and the FHLBB.  The stock is nonmarketable, and redeemable at par value, subject to certain conditions, and, in the case of FHLBB stock, a moratorium on redemptions.

Loans and loans held-for-sale:  For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying amounts.  The fair values for other loans (for example, fixed rate residential, commercial real estate, and rental property mortgage loans, and commercial and industrial loans) are estimated using discounted cash flow analyses, based on interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Loan fair value estimates include judgments regarding future expected loss experience and risk characteristics.  Loan impairment is deemed to exist when full repayment of principal and interest according to the contractual terms of the loan is no longer probable.  Impaired loans are reported based on one of three measures: the present value of expected future cash flows discounted at the loan’s effective interest rate; the loan’s observable market price; or the fair value of the collateral if the loan is collateral dependent.  If the fair value is less than an impaired loan’s recorded investment, an impairment loss is recognized as part of the allowance for loan losses.  Accordingly, certain impaired loans may be subject to measurement at fair value on a non-recurring basis.  Management has estimated the fair values of these assets using Level 2 inputs, such as the fair value of collateral based on independent third-party appraisals for collateral-dependent loans. 

The fair value of loans held-for-sale is based upon an actual purchase and sale agreement between the Company and an independent market participant.  The sale is executed within a reasonable period following quarter end at the stated fair value.

Mortgage servicing rights:  Mortgage servicing rights are evaluated regularly for impairment based upon the fair   value of the servicing rights as compared to their amortized cost. The fair value of mortgage servicing rights is based on a valuation model that calculates the present value of estimated net servicing income, with loans divided into strata for valuation purposes based on their rates, terms and other features. The Company obtains a third party valuation based upon loan level data, including note rate, type and term. The model utilizes a variety of observable inputs for its assumptions, the most significant of which are loan prepayment assumptions and the discount rate used to discount future cash flows.  Mortgage servicing rights are subject to measurement at fair value on a nonrecurring basis and are classified as Level 2 assets.

Deposits, federal funds purchased and borrowed funds:  The fair values disclosed for demand deposits (for example, checking and savings accounts) are, by definition, equal to the amount payable on demand at the reporting date (that is, their carrying amounts). The fair values for certificates of deposit and borrowed funds are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates and indebtedness to a schedule of aggregated contractual maturities on such time deposits and indebtedness.

Junior subordinated debentures:  Fair value is estimated using current rates for debentures of similar maturity.

Capital lease obligations:  Fair value is determined using a discounted cash flow calculation using current rates.  Based on current rates, carrying value approximates fair value.

Accrued interest:  The carrying amounts of accrued interest approximate their fair values.

Off-balance-sheet credit related instruments:  Commitments to extend credit were evaluated and fair value was estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present credit-worthiness of the counterparties.  For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates.

The estimated fair values of the Company's financial instruments were as follows:

June 30, 2012	Carrying		Fair		Fair		Fair		Fair
	Amount		Value		Value		Value		Value
	(Dollars in Thousands)
Financial assets:			Level 1		Level 2		Level 3		Total
Cash and cash equivalents	$	15,097	$	15,097	$	0	$	0	$	15,097
Securities held-to-maturity		24,026		0		24,625		0		24,625
Securities available-for-sale		60,102		7,135		65,901		0		73,036
Restricted equity securities		4,021		0		4,021		0		4,021
Loans and loans held-for-sale
Commercial		52,697		0		0		53,404		53,404
Commercial real estate		131,240		0		0		132,750		132,750
Residential real estate - 1st lien		166,621		0		0		173,833		173,833
Residential real estate - Jr lien		46,253		0		0		47,162		47,162
Consumer		11,371		0		0		11,814		11,814
Mortgage servicing rights		1,052		0		1,052		0		1,052
Accrued interest receivable		1,756		0		1,756		0		1,756
Financial liabilities:
Deposits
Other deposits		413,719		0		416,120		0		416,120
Brokered deposits		18,435		0		18,449		0		18,449
Federal funds purchased and short term-borrowings		25,825		0		25,825		0		25,825
Long-term borrowings		12,010		0		12,351		0		12,351
Repurchase agreements		24,043		0		24,043		0		24,043
Capital lease obligations		805		0		805		0		805
Subordinated debentures		12,887		0		12,207		0		12,207
Accrued interest payable		128		0		128		0		128

	December 31, 2011				June 30, 2011
	Carrying		Fair		Carrying		Fair
	Amount		Value		Amount		Value
Financial assets:
Cash and cash equivalents	$	23,465	$	23,465	$	26,405	$	26,405
Securities held-to-maturity		29,702		30,289		21,940		22,624
Securities available-for-sale		66,099		66,099		27,570		27,570
Restricted equity securities		4,309		4,309		4,309		4,309
Loans and loans held-for-sale, net		384,793		395,386		389,632		400,174
Mortgage servicing rights		1,097		1,168		1,204		1,207
Accrued interest receivable		1,701		1,701		1,565		1,565
Financial liabilities:
Deposits		454,393		457,347		416,940		419,768
Federal funds purchased and other
borrowed funds		18,010		18,404		18,010		18,370
Repurchase agreements		21,645		21,645		20,859		20,859
Capital lease obligations		833		833		813		813
Subordinated debentures		12,887		11,691		12,887		13,592
Accrued interest payable		150		150		155		155

The estimated fair values of commitments to extend credit and letters of credit were immaterial as of the dates presented in the above table.