NOTE 9: FAIR VALUE OF FINANCIAL INSTRUMENTS

We record certain assets and liabilities at fair value. 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. Fair value measurements are also utilized to determine the initial value of certain assets and liabilities, to perform impairment assessments, and for disclosure purposes. We use quoted market prices and observable inputs to the maximum extent possible when measuring fair value. In the absence of quoted market prices, various valuation techniques are utilized to measure fair value. When possible, observable market data for identical or similar financial instruments are used in the valuation. When market data is not available, fair value is determined using valuation models that incorporate Management’s estimates of the assumptions a market participant would use in pricing the asset or liability.

Our valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While Management believes our valuation methodologies are appropriate and consistent with other market participants, 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. Furthermore, the reported fair value amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein. A more detailed 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.

The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described below:

Ø	Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Ø	Level 2 - Quoted prices for similar assets or liabilities in active markets, quoted prices in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability.

Ø	Level 3 - Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e. supported by little or no market activity).

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.

Financial instruments on a recurring basis

The table below presents the balance of financial assets and liabilities at June 30, 2013 measured at fair value on a recurring basis:



			Fair Value Measurements at Reporting Date Using
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
(In thousands)	Total		(Level 1)		(Level 2)		(Level 3)
Assets
U.S. Treasury Obligations	$	100	$	0	$	100	$	0
U.S. Agency Obligations		24,410		0		24,410		0
U.S. GSEs		11,912		0		11,912		0
FHLB Obligations		7,186		0		7,186		0
Agency MBSs		122,486		0		122,486		0
Agency CMBSs		18,043		0		18,043		0
Agency CMOs		206,747		0		206,747		0
CLOs		36,786		0		36,786		0
ABSs		398		0		398		0
Interest rate swap agreements		441		0		441		0
Total assets	$	428,509	$	0	$	428,509	$	0
Liabilities
Interest rate swap agreements		1,243		0		1,243		0
Total liabilities	$	1,243	$	0	$	1,243	$	0

The table below presents the balance of financial assets and liabilities at December 31, 2012 measured at fair value on a recurring basis:



			Fair Value Measurements at Reporting Date Using
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
(In thousands)	Total		(Level 1)		(Level 2)		(Level 3)
Assets
U.S. Treasury Obligations	$	100	$	0	$	100	$	0
U.S. Agency Obligations		10,897		0		10,897		0
U.S. GSEs		59,366		0		59,366		0
FHLB Obligations		24,585		0		24,585		0
Agency MBSs		148,767		0		148,767		0
Agency CMBSs		5,029		0		5,029		0
Agency CMOs		230,399		0		230,399		0
Non-Agency CMOs		4,593		0		4,593		0
CLOs		24,527		0		24,527		0
ABSs		418		0		418		0
Interest rate swap agreements		552		0		552		0
Total assets	$	509,233	$	0	$	509,233	$	0
Liabilities
Interest rate swap agreements		1,610		0		1,610		0
Total liabilities	$	1,610	$	0	$	1,610	$	0

Investment securities are reported at fair value utilizing Level 2 inputs. The prices for these instruments are obtained through an independent pricing service or dealer market participant with whom we have historically transacted both purchases and sales of investment securities. Prices obtained from these sources include market quotations and matrix pricing. 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. More information regarding our investment securities can be found in Footnote 3 to these consolidated financial statements.

The interest rate swaps are reported at their fair value utilizing Level 2 inputs from third parties. The fair value of our interest rate swaps are determined using prices obtained from a third party advisor. The fair value measurement of the interest rate swap is determined by netting the discounted future fixed cash payments and the discounted expected variable cash receipts. The variable cash receipts are based on the expectation of future interest rates derived from observed market interest rate curves.

There were no transfers between Level 1 and Level 2 for the three or six months ended June 30, 2013 or June 30, 2012. There were no Level 3 assets measured at fair value on a recurring basis during the three or six months ended June 30, 2013.

Financial instruments on a non-recurring basis

Certain assets are also measured at fair value on a non-recurring basis. These other financial assets include impaired loans and OREO.

The table below presents the balance of financial assets by class at June 30, 2013 measured at fair value on a nonrecurring basis:



			Fair Value Measurements at Reporting Date Using
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
(In thousands)	Total		(Level 1)		(Level 2)		(Level 3)
OREO	$	140	$	0	$	0	$	140
Real estate-residential:
First mortgage		365		0		0		365
Real estate-commercial:
Owner occupied		113		0		0		113
Installment		6		0		0		6
Total	$	624	$	0	$	0	$	624

The table below presents the balance of financial assets by class at December 31, 2012 measured at fair value on a nonrecurring basis:



			Fair Value Measurements at Reporting Date Using
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
(In thousands)	Total		(Level 1)		(Level 2)		(Level 3)
Commercial, financial and agricultural	$	79	$	0	$	0	$	79
Real estate-residential:
First mortgage		593		0		0		593
Second mortgage		512		0		0		512
Real estate-commercial:
Owner occupied		415		0		0		415
Total	$	1,599	$	0	$	0	$	1,599

The related allowance associated with impaired loans measured at fair value did not result in material provisions for loan losses in any period presented. Valuation allowances recorded on OREO were not material for any periods presented.

We use the fair value of underlying collateral to estimate the specific reserves for collateral dependent impaired loans. Collateral may be real estate and/or business assets including equipment, inventory and accounts receivable. Real estate values are determined based on appraisals by qualified licensed appraisers we have hired. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Management’s ongoing review of appraisal information may result in additional discounts or adjustments to valuation based upon more recent market sales activity or more current appraisal information derived from properties of similar type and/or locale. Other business assets are valued using a variety of approaches including appraisals, depreciated book value, purchase price and independent confirmation of accounts receivable. Property acquired is carried at the lower of cost or the estimated fair value of the property, determined by an independent appraisal, and is adjusted for estimated disposal costs. Certain inputs used in appraisals, and possible subsequent adjustments, are not always observable, and therefore, collateral dependent impaired loans and OREO are categorized as Level 3 within the fair value hierarchy.

The table below presents the valuation methodology and unobservable inputs for Level 3 assets by class measured at fair value on a non-recurring basis at June 30, 2013:



					Range of
(Dollars in thousands)	Fair value		Valuation Methodology	Unobservable Inputs	Inputs
OREO	$	140	Appraisal of collateral	Appraisal adjustments	0%-40%
Real estate-residential:
First mortgage		365	Appraisal of collateral	Appraisal adjustments	0%-40%
Real estate-commercial:
Owner occupied		113	Appraisal of collateral	Appraisal adjustments	0%-40%
Installment		6	Appraisal of collateral	Appraisal adjustments	0%-40%
Total	$	624

The table below presents the valuation methodology and unobservable inputs for Level 3 assets by class measured at fair value on a non-recurring basis at December 31, 2012:



					Range of
(Dollars in thousands)	Fair value		Valuation Methodology	Unobservable Inputs	Inputs
Commercial, financial and agricultural	$	79	Appraisal of collateral	Appraisal adjustments	0%-40%
Real estate-residential:
First mortgage		593	Appraisal of collateral	Appraisal adjustments	0%-40%
Second mortgage		512	Appraisal of collateral	Appraisal adjustments	0%-40%
Real estate-commercial:
Owner occupied		415	Appraisal of collateral	Appraisal adjustments	0%-40%
Total	$	1,599

Changes to our assumptions about unobservable inputs will impact our estimate of fair value. Discounts to appraised values reflect the age of the appraisal and estimated costs of disposition.

GAAP requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring or non-recurring basis.

The fair value of Merchants’ financial instruments as of June 30, 2013 are summarized in the table below:



	Carrying
(In thousands)	Amount		Fair Value			Level 1		Level 2		Level 3
Cash and cash equivalents	$	49,130	$	49,130	$	49,130	$	0	$	0
Securities available for sale		428,068		428,068		0		428,068		0
Securities held to maturity		325		354		0		354		0
FHLB stock		7,496		7,496		0		7,496		0
Loans, net of allowance for loan losses		1,092,125		1,096,401		0		0		1,096,401
Interest rate contract-cash flow hedge		441		441		0		441		0
Accrued interest receivable		3,710		3,710		0		1,102		2,608
Total assets	$	1,581,295	$	1,585,600	$	49,130	$	437,461	$	1,099,009
Deposits	$	1,312,519	$	1,314,025	$	993,992	$	320,033	$	0
Short-term borrowings		21,000		21,000		0		21,000		0
Securities sold under agreement to repurchase		141,055		141,040		0		141,040		0
Other long-term debt		2,443		2,345		0		2,345		0
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		14,891		0		14,891		0
Interest rate contract-cash flow hedge		1,243		1,243		0		1,243		0
Accrued interest payable		208		208		17		191		0
Total liabilities	$	1,499,087	$	1,494,752	$	994,009	$	500,743	$	0

The fair value of Merchants’ financial instruments as of December 31, 2012 are summarized in the table below:



	Carrying
(In thousands)	Amount		Fair Value			Level 1		Level 2		Level 3
Cash and cash equivalents	$	77,228	$	77,228	$	77,228	$	0	$	0
Securities available for sale		508,681		508,681		0		508,681		0
Securities held to maturity		407		454		0		454		0
FHLB stock		8,145		8,145		0		8,145		0
Loans, net of allowance for loan losses		1,071,361		1,096,188		0		0		1,096,188
Interest rate contract-cash flow hedge		552		552		0		552		0
Accrued interest receivable		4,368		4,368		0		1,366		3,002
Total assets	$	1,670,742	$	1,695,616	$	77,228	$	519,198	$	1,099,190
Deposits	$	1,271,080	$	1,273,573	$	940,682	$	332,891	$	0
Securities sold under agreement to repurchase		287,520		287,837		0		287,837		0
Other long-term debt		2,483		2,502		0		2,502		0
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		15,177		0		15,177		0
Interest rate contract-cash flow hedge		1,610		1,610		0		1,610		0
Accrued interest payable		195		195		0		195		0
Total liabilities	$	1,583,507	$	1,580,894	$	940,682	$	640,212	$	0

The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, FHLBB stock, accrued interest receivable and accrued interest payable approximate fair value.

The methodologies for other financial assets and financial liabilities are discussed below.

Loans - The fair value for loans is estimated using discounted cash flow analyses, using interest rates and spreads currently being offered for loans with similar terms to borrowers of similar credit quality. The fair value estimates, methods and assumptions set forth below for our financial instruments, including those financial instruments carried at cost, are made solely to comply with disclosures required by generally accepted accounting principles in the United States and do not always incorporate the exit-price concept of fair value proscribed by ASC 820-10 and should be read in conjunction with the financial statements and associated footnotes.

Deposits - The fair value of deposits with no stated maturity, which includes demand, savings, interest bearing checking and money market accounts, is equal to the amount payable on demand resulting in a Level 1 classification. The fair value of variable rate, fixed term certificates of deposit also approximates the carrying amount reported in the consolidated balance sheets. The fair value of fixed rate and fixed term certificates of deposit is estimated using a discounted cash flow method which applies interest rates currently being offered for deposits of similar remaining maturities.

Debt - The fair value of debt is estimated using current market rates for borrowings of similar remaining maturity.

Commitments to Extend Credit and Standby Letters of Credit - The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness 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 fair value of financial standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties. The fair value of commitments to extend credit and standby letters of credit is approximately $50 thousand at June 30, 2013 and $45 thousand as of December 31, 2012, respectively.

Limitations ‑ Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instruments. Because no market exists for a significant portion of the 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 such factors.

These estimates do not reflect any premium or discount that could result from offering for sale at one time our entire holdings of a particular financial instrument. These estimates are subjective in nature and require considerable judgment to interpret market data. Accordingly, the estimates presented herein are not necessarily indicative of the amounts we could realize in a current market exchange, nor are they intended to represent the fair value of us as a whole. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. The fair value estimates presented herein are based on pertinent information available to Management as of the respective balance sheet date. Although we are not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein.

Other significant assets, such as premises and equipment, other assets, and liabilities not defined as financial instruments, are not included in the above disclosures. Also, the fair value estimates for deposits do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market.