12	Fair Value

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair values:

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.

A description of the valuation methodologies used for assets and liabilities measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below. While management believes the Company’s valuation methodologies are appropriate and consistent with other financial institutions, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.

Investment Securities — The fair values of investment securities are determined by obtaining quoted prices on nationally recognized securities exchanges, if available (Level 1), or matrix pricing, 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, which is a Level 2 input. The Company’s available for sale securities at December 31, 2013 and December 31, 2012 include several pooled trust preferred instruments. The downturn in the overall economy and, in particular, in the financial services industry has created a situation where significant observable inputs (Level 2) are not readily available for these instruments. As an alternative, the Company combined Level 2 input of market yield requirements of similar instruments together with certain Level 3 assumptions addressing the impact of current market illiquidity to estimate the fair value of these instruments. The fair values of Level 3 investment securities are determined by the Company’s Controller and Investment Officer who report to the Chief Financial Officer. See Note 2 “Securities” for further discussion of pooled trust preferred securities.

Impaired Loans — At the time a loan is considered impaired, it is generally valued at lower of cost or fair value. Impaired loans carried at fair value generally are partially charged off or receive specific allocations of the allowance for loan losses. For collateral dependent loans, fair value is commonly based on recent real estate appraisals adjusted for market conditions and costs to sell. Management may apply additional discounts based on changes in the market from the time of valuation. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining value. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and the client’s business, resulting in a Level 3 fair value classification. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly.

Other Real Estate Owned (“OREO”) — Real estate properties acquired through loan foreclosure are recorded at estimated fair value, net of estimated selling costs, at time of foreclosure establishing a new cost basis. Fair value is commonly based on real estate appraisals. 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 independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs used in determining fair value.

Loans Held for Sale — Loans held for sale are carried at lower of cost or fair value. The fair value of loans held for sale is determined using average bid indicators from third parties expected to participate in the loan sales, in some cases adjusted for specific attributes of that loan or other observable market data. Such bids and adjustments often vary significantly and typically result in Level 3 classification of the inputs used in determining fair value.

Assets and liabilities measured at fair value are summarized below:


	Fair Value Measurements at
	December 31, 2013
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
	(In thousands)
Measured on a recurring basis:
Available for sale securities:
U.S. Treasury and government agencies		—	$	93,692		—	$	93,692
Mortgage-backed securities — residential		—		339,695		—		339,695
Obligations of states and political subdivisions		—		89,304		—		89,304
Other debt securities		—		9,529		—		9,529
Mutual funds and other equity securities	$	9,978		—		—		9,978

Total assets at fair value	$	9,978	$	532,220		—	$	542,198

Measured on a non-recurring basis:
Impaired loans: (1)
Commercial Real Estate		—		—		—		—
Construction		—		—		—		—
Residential		—		—	$	380	$	380
Commercial & Industrial		—		—		895		895

Total assets at fair value		—		—	$	1,275	$	1,275

(1)

Impaired loans are reported at the fair value of the underlying collateral if repayment is expected solely from the collateral. Collateral values are estimated using Level 2 and Level 3 inputs which include independent appraisals and internally customized discounting criteria. The recorded investment in impaired loans subject to fair value reporting on December 31, 2013 was $1,275 for which no specific allowance has been established within the allowance for loan losses. During 2013, $31 of charge-offs were recorded related to these loans. The level of charge-offs has a direct impact on the determination of the provision for loan losses. The fair values were based on internally customized discounting criteria of the collateral and thus classified as Level 3 fair values.


	Fair Value Measurements at
	December 31, 2012
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
	(In thousands)
Measured on a recurring basis:
Available for sale securities:
U.S. Treasury and government agencies		—	$	53,223		—	$	53,223
Mortgage-backed securities — residential		—		295,088		—		295,088
Obligations of states and political subdivisions		—		82,602		—		82,602
Other debt securities		—		798	$	2,950		3,748
Mutual funds and other equity securities	$	10,409		—		—		10,409

Total assets at fair value	$	10,409	$	431,711	$	2,950	$	445,070

Measured on a non-recurring basis:
Impaired loans: (1)
Commercial Real Estate		—		—	$	6,835	$	6,835
Construction		—		—		3,219		3,219
Residential		—		—		8,514		8,514
Commercial & Industrial		—		—		1,737		1,737
Loans held for sale (2)		—		—		2,317		2,317
Other real estate owned (3)		—		—		250		250

Total assets at fair value		—		—	$	22,872	$	22,872

(1)

Impaired loans are reported at the fair value of the underlying collateral if repayment is expected solely from the collateral. Collateral values are estimated using Level 2 and Level 3 inputs which include independent appraisals and internally customized discounting criteria. The recorded investment in impaired loans subject to fair value reporting on December 31, 2012 was $20,305 for which no specific allowance has been established within the allowance for loan losses. During 2012, $7,344 of charge-offs were recorded related to these loans. The level of charge-offs has a direct impact on the determination of the provision for loan losses. The fair values were based on internally customized discounting criteria of the collateral and thus classified as Level 3 fair values.

(2)	Loans held for sale are reported at lower of cost or fair value. Fair value is based on average bid indicators received from third parties expected to participate in the loan sales.

(3)

Other real estate owned is reported at fair value less anticipated costs to sell. Fair value is based on third party or internally developed appraisals which, considering the assumptions in the valuation, are considered Level 2 or Level 3 inputs. The fair value of other real estate owned at December 31, 2013 was derived by management from appraisals which used various assumptions and were discounted as necessary, resulting in a Level 3 classification.

The table below presents a reconciliation and income statement classification of gains and losses for securities available for sale measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the periods indicated:


	Level 3 Assets Measured on a Recurring Basis
	For the Year Ended
	2013			2012
	(In thousands)
Balance at beginning of period	$	2,950		$	2,816
Additions to Level 3		263			441
Net unrealized gain (loss) included in other comprehensive income (1)		7,571			1,267
Principal payments		(791	)		(1,046	)
Recognized impairment charge included in the statement of income (2)		(1,240	)		(528	)
Transfers out of Level 3		(8,753	)		—

Balance at end of period	$	—		$	2,950

(1)	Reported under “Gains recognized in comprehensive income”

(2)	Reported under “Net impairment loss recognized in earnings”

All of the Company’s pooled trust preferred securities, with a fair value of $8,753 as of December 31, 2013, were transferred from Level 3 to Level 2 because observable market data became available for the securities.

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 the dates indicated:


Asset	Fair Value at December 31, 2013 (In thousands)		Valuation Technique	Unobservable Inputs	Range (Weighted Average)
Impaired loans — residential real estate	$	380	Sales comparison approach	Discounts to appraisals for market conditions	0% (0%)

Impaired loans — commercial and industrial		895	Sales comparison approach	Discounts to appraisals for market conditions	0% (0%)


Asset	Fair Value at December 31, 2012 (In thousands)		Valuation Technique	Unobservable Inputs	Range (Weighted Average)
Impaired loans — commercial real estate	$	6,835	Sales comparison or income approach	Discounts to appraisals for market conditions	0%-62% (8%)
				Capitalization rate	8%

Impaired loans — construction		3,219	Sales comparison approach	Discounts to appraisals for market conditions	0%-21% (6%)

Impaired loans — residential real estate		8,514	Sales comparison or income approach	Discounts to appraisals for market conditions	0%-47% (4%)

Impaired loans — commercial and industrial		1,737	Sales comparison approach — secondary collateral	Discounts to appraisals for market conditions	7% (7%)

Other real estate owned		250	Sales comparison approach	Discounts to appraisals for market conditions	0% (0%)

Loans held for sale		2,317	Third party bids	Bids from interested third parties	60%-65% (64%)