Fair Value Measurement and Fair Value of Financial Instruments

9 Months Ended

Sep. 30, 2012

Fair Value Measurement and Fair Value of Financial Instruments

Note 8: Fair Value Measurement and Fair Value of Financial Instruments

Accounting standards define fair value as the exchange price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.  Accounting standards also establish 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 applicable 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, and other inputs that are observable or can be corroborated by observable market data.  Level 3:  Significant unobservable inputs that reflect a company's own assumptions about the assumptions that market participants would use in pricing an asset or liability.

In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.  The Company evaluates fair value measurement inputs on an ongoing basis in order to determine if there is a change of sufficient significance to warrant a transfer between levels.  For example, changes in market activity or the addition of new unobservable inputs could, in the Company’s judgment, cause a transfer to either a higher or lower level.  For the nine months ended September 30, 2012 and the year ended December 31, 2011, there were no transfers between levels.

The Company utilizes a third-party valuation service provider to value its available for sale investment securities portfolio. Despite most of these securities being U.S. Government agency debt obligations, agency mortgage-backed securities and municipal securities traded in active markets, the fair values are determined using widely accepted valuation techniques including matrix pricing and broker-quote based applications.  Inputs include benchmark yields, reported trades, issuer spreads, prepayment speeds and other relevant items.  These are inputs used by a third-party pricing service used by the Company.  To validate the appropriateness of the valuations provided by the third party, the Company regularly updates its understanding of the inputs used and compares valuations to an additional third party source. Due to the nature and methodology of these valuations, the Company considers these fair value measurements as Level 2.

Assets and Liabilities Measured on a Recurring Basis:

Assets and liabilities measured at fair value on a recurring basis are summarized below.

September 30, 2012
(In thousands)
	Carrying Value in Balance Sheet		Quoted Prices In Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
U.S. Treasury securities	$	509	$	0	$	509	$	0
Obligations of U.S. Government sponsored enterprises		173,853		0		173,853		0
Obligations of states and political subdivisions		882		0		882		0
Mortgage-backed securities		322,362		0		322,362		0
Available-for-sale securities	$	497,606	$	0	$	497,606	$	0

December 31, 2011
(In thousands)
	Carrying Value in Balance Sheet		Quoted Prices In Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
U.S. Treasury securities	$	513	$	0	$	513	$	0
Obligations of U.S. Government sponsored enterprises		181,620		0		181,620		0
Obligations of states and political subdivisions		1,329		0		1,329		0
Mortgage-backed securities		333,751		0		333,751		0
Available-for-sale securities	$	517,213	$	0	$	517,213	$	0

Assets and Liabilities Measured on a Nonrecurring Basis:

Assets and liabilities measured at fair value on a nonrecurring basis are summarized below.

September 30, 2012
(In thousands)
	Carrying Value in Balance Sheet		Quoted Prices In Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Impaired loans	$	60,916	$	0	$	0	$	60,916
Other real estate owned	$	53,750	$	0	$	0	$	53,750

December 31, 2011
(In thousands)
	Carrying Value in Balance Sheet		Quoted Prices In Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Impaired loans	$	23,234	$	0	$	0	$	23,234
Other real estate owned	$	57,387	$	0	$	0	$	57,387

Loans considered impaired are loans for which, based on current information and events, it is probable that the creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement.  Impaired loans are subject to nonrecurring fair value adjustments to reflect write-downs that are based on the market price or current appraised value of the collateral, adjusted to reflect local market conditions or other economic factors.  After evaluating the underlying collateral, the fair value of the impaired loans is determined and specific reserves are allocated from the allowance for loan and lease losses.  The recorded fair value reflects the loan balance less the specifically allocated reserve.  Impaired loans for which no reserve has been specifically allocated are not included in the table above.

Other real estate owned (“OREO”) is initially accounted for at fair value, less estimated costs to dispose of the property. Any excess of the recorded investment over fair value, less costs to dispose, is charged to the allowance for loan and lease losses at the time of foreclosure. Updated appraisals or evaluations are obtained at least annually for all OREO properties. These appraisals are used to update fair value estimates.  A provision is charged to earnings for subsequent losses on OREO when these updates indicate such losses have occurred. The ability of the Company to recover the carrying value of OREO is based upon future sales of the real estate. The ability to effect such sales is subject to market conditions and other factors beyond the Company’s control, and future declines in the value of the real estate could result in a charge to earnings.  The recognition of sales and sales gains is dependent upon whether the nature and terms of the sales, including possible future involvement of the Company, if any, meet certain defined requirements.  If those requirements are not met, sale and gain recognition is deferred.

Fair value measurements for impaired loans and other real estate owned include the use of external appraisals obtained annually for impaired loans and other real estate owned over $1 million.  Impaired loans and other real estate owned under $1 million require a current internal property evaluation and external appraisals are obtained biannually.  This process was implemented during the first quarter of 2012, will be completed by the end of 2012, and will be continued on an ongoing basis.  Once an appraisal has been obtained, the fair value is determined based on appraised value less estimated costs to sell.  For impaired loans that have not yet received a current appraisal, discounted appraisals less estimated costs to sell have been used to determine fair value.  Discounts have predominantly been in the range of 0% to 25%, with isolated instances up to 60%.

Accounting standards require disclosure of fair value information about financial instruments, whether or not recognized in the Statements of Condition, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair value is based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. Also, the fair value estimates presented herein are based on pertinent information available to Management as of September 30, 2012 and December 31, 2011.

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

CASH, DUE FROM BANKS, FEDERAL FUNDS SOLD AND INTEREST-BEARING DEPOSITS - For those short-term instruments, the carrying amount is a reasonable estimate of fair value.

SECURITIES AVAILABLE FOR SALE - Fair value for securities available for sale is primarily estimated using market prices for similar securities. For any Level 3 securities, the Company generally uses a discounted cash flow methodology. There were no Level 3 securities at September 30, 2012 or December 31, 2011.

LOANS AND LEASES - For equity lines and other loans or leases with short-term or variable rate characteristics, the carrying value reduced by an estimate for credit losses inherent in the portfolio is a reasonable estimate of fair value. The fair value of all other loans and leases is estimated by discounting their future cash flows using interest rates currently being offered for loans and leases with similar terms, reduced by an estimate of credit losses inherent in the portfolio. The discount rates used are commensurate with the interest rate and prepayment risks involved for the various types of loans. The estimated fair value also includes an estimate of certain liquidity risk.

DEPOSITS - The fair value disclosed for demand deposits (i.e., interest- and non-interest-bearing demand, savings and money market savings) is equal to the amounts payable on demand at the reporting date (i.e., their carrying amounts). Fair value for certificates of deposit is estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates of deposit to a schedule of aggregated monthly maturities.

SHORT-TERM BORROWINGS - The fair value for these short-term liabilities is estimated using a discounted cash flow calculation that applies interest rates currently being offered on similar borrowings.

FHLB ADVANCES AND LONG-TERM DEBT - The fair value of the Company's fixed rate borrowings is estimated using discounted cash flows, based on the Company's current incremental borrowing rates for similar borrowing arrangements.

 COMMITMENTS TO EXTEND CREDIT AND STANDBY LETTERS OF CREDIT - The value of these unrecognized financial instruments is estimated based on the fee income associated with the commitments which, in the absence of credit exposure, is considered to approximate their settlement value. Since no significant credit exposure existed, and because such fee income is not material to the Company's financial statements at September 30, 2012 and December 31, 2011, the fair value of these commitments is not presented.

Many of the Company's assets and liabilities are short-term financial instruments whose carrying amounts reported in the Statement of Condition approximate fair value. These items include cash and due from banks, interest-bearing bank balances, federal funds sold, other short-term borrowings and accrued interest receivable and payable balances. The estimated fair value of the Company's remaining on-balance sheet financial instruments as of September 30, 2012 and December 31, 2011 is summarized below.

	September 30, 2012
(In thousands)
	Carrying Value		Estimated Fair Value		Quoted Prices In Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Financial assets:
Cash and due from banks	$	37,349	$	37,349	$	37,349	$	0	$	0
Interest-bearing deposits		123,408		123,408		123,408		0		0
Securities available for sale		497,606		497,606		0		497,606		0
Loans and leases, net		1,127,006		1,108,278		0		0		1,108,278
Accrued interest receivable		5,703		5,703		0		0		5,703
Financial liabilities:
Deposits	$	1,780,495	$	1,783,403	$	0	$	0	$	1,783,403
Short-term borrowings		20,000		20,433		0		0		20,433
FHLB advances and long-term debt		45,326		29,005		0		0		29,005
Accrued interest payable		2,857		2,857		0		0		2,857

(In thousands)	December 31, 2011
	Carrying Value		Estimated Fair Value
Financial assets:
Cash, due from banks and federal funds sold	$	37,911	$	37,911
Interest-bearing deposits		61,942		61,942
Securities available for sale		517,213		517,213
Loans and leases, net		1,234,893		1,213,983
Accrued interest receivable		6,227		6,227
Financial liabilities:
Deposits	$	1,811,673	$	1,815,613
Short-term borrowings		20,000		20,676
FHLB advances and long-term debt		70,539		54,096
Accrued interest payable		2,916		2,916

Certain financial instruments and all non-financial instruments are excluded from fair value disclosure requirements. The disclosures also do not include certain intangible assets, such as customer relationships and deposit base intangibles. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.