NOTE 8 — FAIR VALUE

ASC 820 establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The fair values of securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or using market data utilizing pricing models, primarily Interactive Data Corporation (IDC), that vary based upon asset class and include available trade, bid, and other market information. Matrix pricing is used for most municipals, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities. The grouping of securities is done according to insurer, credit support, state of issuance, and rating to incorporate additional spreads and municipal curves. For the general market municipals, the Thomson Municipal Market Data curve is used to determine the initial curve for determining the price, movement, and yield relationships with the municipal market (Level 2 inputs). Level 3 securities are largely comprised of small, local municipality issuances. Fair values are derived through consideration of funding type, maturity and other features of the issuance, and include reviewing financial statements, earnings forecasts, industry trends and the valuation of comparative issuers. In most cases, the book value of the security is used as the fair value as meaningful pricing data is not readily available. Twice a year, a sample of prices supplied by the pricing agent is validated by comparison to prices obtained from other third party sources.

The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals or industry accepted valuation methods. In a limited number of situations, the Company’s appraisal department is determining the value of appraisal. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the loan officers to adjust for differences between the comparable sales and income data available as well as costs to sell. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value. These adjustments typically range from 0%-50%. Impaired loans are evaluated quarterly for additional impairment and take into account changing market conditions, specific information in the market the property is located, and the overall economic climate as well as overall changes in the credit. The Company’s Appraisal Manager has the overall responsibility for all appraisals. The Company’s loan officer responsible for the loan, the special assets officer, as well as the senior officers of the Company review the adjustments made to the appraisal for market and disposal costs on the loan.

The fair value of servicing rights is based on a valuation model from a third party that calculates the present value of estimated net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income. The Company is able to compare the valuation model inputs and results to widely available published industry data for reasonableness (Level 2 inputs).

The fair value of other real estate owned is measured based on the value of the collateral securing those assets and is determined using several methods. The fair value of real estate is generally determined based on appraisals by qualified licensed appraisers (third party). The appraisers typically determine the value of the real estate by utilizing an income or market valuation approach. If an appraisal is not available, the fair value may be determined by using a cash flow analysis. Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers whose qualifications and licenses have been reviewed and verified by the Company. Once received, a member of the Appraisal Department reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics. Fair values are reviewed on at least an annual basis. The Company normally applies an internal discount to the value of appraisals used in the fair value evaluation of OREO. The deductions take into account changing business factors and market conditions as well as disposal costs. These deductions range from 0% to 50%. As noted in the impaired loans discussion above, the Company’s Appraisal Manager has the overall responsibility for all appraisals. The Appraisal Manager reports to the Vice President of Credit Administration who reports to the Chief Credit Officer of the Company.

The fair value of mortgage banking derivatives are based on derivative valuation models using market data inputs as of the valuation date (Level 2). The mortgage banking derivative is classified as Interest receivable and other assets on the balance sheet.

Assets and Liabilities Measured on a Recurring Basis

Assets and liabilities measured at fair value under ASC 820 on a recurring basis, including financial assets and liabilities for which the Company has elected the fair value option, are summarized below:

			Fair Value Measurements at September 30, 2014 Using:
					Significant
			Quoted Prices in		Other		Significant
			Active Markets for		Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
(Dollars in thousands)	Value		(Level 1)		(Level 2)		(Level 3)
Financial Assets
Investment securities available-for sale
U. S. government agency	$	582			$	582
States and municipals	323,698				310,841		12,857
Mortgage-backed securities — residential —Government Sponsored Entity	156,904				156,904
Collateralized mortgage obligations — Government Sponsored Entity	350,719				350,719
Equity securities	4,689		4,689
Other securities	3,509				1,002		2,507
Total investment securities available-for-sale	$	840,101	$	4,689	$	820,048	$	15,364

Mortgage banking derivative	$	750			$	750

			Fair Value Measurements at December 31, 2013 Using:
					Significant
			Quoted Prices in		Other		Significant
			Active Markets for		Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
(Dollars in thousands)	Value		(Level 1)		(Level 2)		(Level 3)
Financial Assets
Investment securities available-for sale
U. S. government agency	$	798			$	798
States and municipals	331,112				316,692		14,420
Mortgage-backed securities — residential —Government Sponsored Entity	185,429				185,429
Collateralized mortgage obligations — Government Sponsored Entity	365,309				365,309
Equity securities	4,939		4,689		250
Other securities	3,519				993		2,526
Total investment securities available-for-sale	$	891,106	$	4,689	$	869,221	$	17,196

Mortgage banking derivative	$	525			$	525

There were no transfers between Level 1 and Level 2 during the third quarter of 2014 or 2013 or the first nine months of 2014 or 2013.

The table below presents a reconciliation and income statement classification of gains and losses for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three and nine month periods ended September 30, 2014 and 2013:

Three months ended September 30:

States and municipal	2014			2013
Beginning balance, July 1	$	13,083		$	14,688
Total gains or losses (realized / unrealized)
Included in other comprehensive income	(8		)	(12		)
Settlements	(218		)	(206		)
Ending balance, September 30	$	12,857		$	14,470

Equity securities	2014		2013
Beginning balance, July 1	$	—	$	250
Total gains or losses (realized / unrealized)
Settlements	—		—
Ending balance, September 30	$	—	$	250

Other securities	2014			2013
Beginning balance, July 1	$	2,511		$	2,542
Total gains or losses (realized / unrealized)
Included in other comprehensive income	(4		)	(8		)
Ending balance, September 30	$	2,507		$	2,534

Nine months ended September 30:

States and municipal	2014			2013
Beginning balance, January 1	$	14,420		$	15,470
Total gains or losses (realized / unrealized)
Included in other comprehensive income	15			(84		)
Settlements	(1,578		)	(916		)
Ending balance, September 30	$	12,857		$	14,470

Equity securities	2014			2013
Beginning balance, January 1	$	250		$	250
Total gains or losses (realized / unrealized)
Settlements	(250		)	—
Ending balance, September 30	$	—		$	250

Other securities	2014			2013
Beginning balance, January 1	$	2,526		$	2,557
Total gains or losses (realized / unrealized)
Included in other comprehensive income	(19		)	(23		)
Ending balance, September 30	$	2,507		$	2,534

The Company’s state and municipal security valuations were supported by analysis prepared by an independent third party. Fair values are derived through consideration of funding type, maturity and other features of the issuance, and include reviewing financial statements, earnings forecasts, industry trends and the valuation of comparative issuers. In most cases, the book value of the security is used as the fair value as meaningful pricing data is not readily available.

The Company’s equity security valuation was supported by an analysis prepared by the Company’s Investments Manager. Fair value is derived through consideration of funding type, maturity and other features of the issuance, and include reviewing financial statements, earnings forecasts, industry trends and the valuation of comparative issuers. In this case, the book value of the security is used as the fair value as meaningful pricing data is not readily available.

The Company’s other security valuation was supported by analysis prepared by an independent third party. Fair values are derived through consideration of funding type, maturity and other features of the issuance, and include reviewing financial statements, earnings forecasts, industry trends and the valuation of comparative issuers. In most cases, the book value of the security is used as the fair value as meaningful pricing data is not readily available.

Assets and Liabilities Measured on a Non-Recurring Basis

Assets and liabilities measured at fair value on a non-recurring basis are summarized below:

			Fair Value Measurements at September 30, 2014 Using
	September 30, 2014		Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)	Significant Unobservable Inputs (Level 3)
Assets:
Impaired loans
Farm real estate	$	55			$	55
Hotel	1,292				1,292
Other commercial real estate	1,313				1,313
Total impaired loans	$	2,660			$	2,660
Impaired servicing rights	$	1,459			$	1,459
Other real estate owned
Other commercial real estate	$	198			$	198
1-4 family	28				28
Total other real estate owned	$	226			$	226

			Fair Value Measurements at December 31, 2013 Using
	December 31, 2013		Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)	Significant Unobservable Inputs (Level 3)
Assets:
Impaired loans
Commercial and industrial	$	76			$	76
Farm estate	375				375
Construction and development	226				226
Other commercial real estate	5,112				5,112
Total impaired loans	$	5,789			$	5,789
Impaired servicing rights	$	1,794			$	1,794
Other real estate owned
Construction and development	$	522			$	522
Home equity	67				67
Other commercial real estate	425				425
Total other real estate owned	$	1,014			$	1,014

The following represent impairment charges recognized during the period:

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a gross carrying amount of $4,232, with a valuation allowance of $1,572 at September 30, 2014. The Company recorded a charge of $1,061 to provision expense associated with these loans for the three months ended September 30, 2014 and a charge of $941 provision expense associated with these loans for the nine month period ended September 30, 2014. The Company recorded a charge of $526 of provision expense associated with these loans for the three month period ended September 30, 2013 and $842 of provision expense associated with these loans for the nine month period ended September 30, 2013. At December 31, 2013, impaired loans had a gross carrying amount of $6,879 with a valuation allowance of $1,090. A breakdown of these loans by portfolio class at September 30, 2014 is as follows:

	Gross Balance		Valuation Allowance		Net
Farm real estate	$	76	$	21	$	55
Hotel	1,909		617		1,292
Other commercial real estate	2,247		934		1,313
Ending Balance	$	4,232	$	1,572	$	2,660

Impaired tranches of servicing rights were carried at a fair value of $1,459, which is made up of the gross outstanding balance of $1,784, net of a valuation allowance of $325. A recovery of $50 was included in the both the third quarter and the nine month period ending September 30, 2014. A recovery of $225 was included in the third quarter 2013 earnings and a recovery of $650 was included in the nine month period ending September 30, 2013. At December 31, 2013, impaired servicing rights were carried at a fair value of $1,794 which was made up of the gross outstanding balance of $2,169, net of a valuation allowance of $375.

Other real estate owned is evaluated at the time a property is acquired through foreclosure or shortly thereafter. Fair value is based on appraisals by qualified licensed appraisers. At September 30, 2014, other real estate owned was carried at a fair value of $226, which is made up of the gross outstanding balance of $256, net of a valuation allowance of $30. During the third quarter of 2014, these properties were written down by $0. For the first nine months of 2014, these properties were written down by $30. During the third quarter of 2013, these properties were written down by $95. For the first nine months of 2013, these properties were written down by $193. At December 31, 2013, other real estate was carried at a fair value of $1,014, which is made up of the gross outstanding balance of $1,362, net of a valuation allowance of $348. A breakdown of these properties by portfolio class at September 30, 2014 is as follows:

	Gross Balance		Valuation Allowance		Net
Other commercial real estate	$	219	$	21	$	198
1-4 family	37		9		28
Ending Balance	$	256	$	30	$	226

The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at September 30, 2014 and December 31, 2013. Impaired commercial, commercial real estate loans, and other real estate owned that are deemed collateral dependent are valued based on the fair value of the underlying collateral. These estimates are based on the most recently available appraisals with certain adjustments made based on the type of property, age of appraisal, current status of the property and other related factors to estimate the current value of the collateral.

September 30, 2014	Fair Value (in thousands)		Valuation Technique(s)	Unobservable Input(s)	Range
Impaired Loans:
Farm real estate	55		Sales comparison approach	Adjustment for differences between comparable sales	40% 40% Avg
Hotel	1,292		Income approach	Adjustment for type of property, current status of property	20% 20% Avg
Other commercial real estate	1,313		Sales comparison approach	Adjustment for differences between comparable sales, type of property, current status of property	0%-50% 43% Avg
	$	2,660
Other real estate owned:
Other commercial real estate	$	198	Sales comparison approach	Adjustment for differences between comparable sales.	10% 10% Avg
1-4 Family	28		Sales comparison approach	Adjustment for differences between comparable sales.	10% 10% Avg
	$	226

Mortgage servicing rights	$	1,459	Cash flow analysis	Discount rate	10%

December 31, 2013	Fair Value (in thousands)		Valuation Technique(s)	Unobservable Input(s)	Range
Impaired Loans:
Commercial & industrial	$	76	Sales comparison approach	Adjustment for differences between comparable sales	0%-10% 10% Avg
Farm real estate	375		Sales comparison approach	Adjustment for differences between comparable sales	40% 40% Avg
Other/ 1-4 Family	5,338		Sales comparison approach	Adjustment for differences between comparable sales, type of property, current status of property	0%-40% 25% Avg
	5,789
Other real estate owned:
Construction and development	$	522	Sales comparison approach	Adjustment for differences between comparable sales.	10% 10%Avg
Other & Home Equity	492		Sales comparison approach	Adjustment for differences between comparable sales.	10%-15% 10%Avg
	1,014

Mortgage servicing rights	1,794		Cash flow analysis	Discount rate	10%

The carrying amounts and estimated fair values of financial instruments, not previously presented, are as follows:

September 30, 2014	Carrying Amount			Level 1		Level 2		Level 3	Total
Financial assets:
Cash and cash equivalents	$	69,914		60,150		9,764			69,914
Interest bearing time deposits	1,915					1,915			1,915
Loans including loans held for sale, net	1,730,793					4,928		1,732,588	1,737,516
Restricted stock	15,625								N/A
Interest receivable	9,266					4,158		5,108	9,266
Financial liabilities
Deposits	(2,221,699		)	(464,058	)	(1,756,444	)		(2,220,502	)
Other borrowings	(34,490		)			(34,490	)		(34,490	)
FHLB advances	(240,343		)			(244,060	)		(244,060	)
Interest payable	(491		)			(491	)		(491	)
Subordinated debentures	(41,239		)			(20,560	)		(20,560	)

December 31, 2013	Carrying Amount			Level 1			Level 2			Level 3	Total
Financial assets:
Cash and cash equivalents	$	61,320		$	55,826		$	5,494			$	61,320
Loans including loans held for sale, net	1,644,527						6,158			1,657,199	1,663,357
Restricted stock	15,629										N/A
Interest receivable	9,616						4,573			5,043	9,616
Financial liabilities
Deposits	(2,200,628		)	(436,550		)	(1,764,719		)		(2,201,269		)
Other borrowings	(38,594		)				(38,594		)		(38,594		)
FHLB advances	(247,858		)				(252,402		)		(252,402		)
Interest payable	(799		)				(799		)		(799		)
Subordinated debentures	(46,394		)				(23,130		)		(23,130		)

The difference between the loan balance included above and the amounts shown in Note 4 are the impaired loans discussed above.

The methods and assumptions, not previously presented, used to estimate fair values are described as follows:

(a) Cash and Cash Equivalents

The carrying amounts of cash, short-term instruments, and interest bearing time deposits approximate fair values and are classified as either Level 1 or Level 2. Noninterest bearing deposits are Level 1 whereas interest bearing due from bank accounts, fed funds sold, and interest bearing time deposits are Level 2.

(b) Restricted Stock

It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.

Fair values of loans are estimated as follows: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Loans held for sale is estimated based upon binding contracts and quotes from third party investors resulting in a Level 2 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

(d) Deposits

The fair values disclosed for non-interest bearing deposits are, by definition, equal to the amount payable on demand at the reporting date resulting in a Level 1 classification. The carrying amounts of variable rate interest bearing deposits approximate their fair values at the reporting date resulting in a Level 1 classification. Fair values for fixed rate interest bearing deposits are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

(e) Borrowings

The fair values of the Company’s FHLB advances are estimated using discounted cash flow analyses based on the current borrowing rates resulting in a Level 2 classification.

The fair values of the Company’s subordinated debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 2 classification.

The fair values of the Company’s Other borrowings are estimated using discounted cash flow analyses based on the current borrowing rates resulting in a Level 2 classification.

(f) Accrued Interest Receivable/Payable

The carrying amounts of accrued interest approximate fair value resulting in a Level 2 or Level 3 classification based on the level of the asset or liability with which the accrual is associated.