(15) Fair Value Measurements

Bancorp follows the provisions of the authoritative guidance for fair value measurements. This guidance is definitional and disclosure oriented and addresses how companies should approach measuring fair value when required by US GAAP. The guidance prescribes various disclosures about financial statement categories and amounts which are measured at fair value, if such disclosures are not already specified elsewhere in US GAAP.

The authoritative guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between participants at the measurement date. The guidance also establishes a hierarchy to group assets and liabilities carried at fair value in three levels based upon the markets in which the assets and liabilities trade and the reliability of assumptions used to determine fair value. These levels are:

· Level 1: Valuation is based upon quoted prices for identical instruments traded in active markets.

· Level 2: Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

· Level 3: Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions would reflect internal estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques could include pricing models, discounted cash flows and other similar techniques.

Authoritative guidance requires maximization of use of observable inputs and minimization of use of unobservable inputs in fair value measurements. Where there exists limited or no observable market data, Bancorp uses its own estimates generally considering characteristics of the asset/liability, the current economic and competitive environment and other factors. For this reason, results cannot be determined with precision and may not be realized on an actual sale or immediate settlement of the asset or liability.

Bancorp’s investment securities available for sale and interest rate swaps are recorded at fair value on a recurring basis. Other accounts including mortgage loans held for sale, mortgage servicing rights, impaired loans and other real estate owned may be recorded at fair value on a non-recurring basis, generally in the application of lower of cost or market adjustments or write-downs of specific assets.

The portfolio of investment securities available for sale is comprised of U.S. Treasury and other U.S government obligations, debt securities of U.S. government-sponsored corporations, mortgage-backed securities, obligations of state and political subdivisions and corporate equity securities. Corporate equity securities, included in the 2014 table, are priced using quoted prices of identical securities in an active market. These measurements are classified as Level 1 in the hierarchy above. All other securities are priced using standard industry models or matrices with various assumptions such as yield curves, volatility, prepayment speeds, default rates, time value, credit rating and market prices for the instruments. These assumptions are generally observable in the market place and can be derived from or supported by observable data. These measurements are classified as Level 2 in the hierarchy above.

Interest rate swaps are valued using primarily Level 2 inputs. Fair value measurements are obtained from an outside pricing service. Prices obtained are generally based on dealer quotes, benchmark forward yield curves, and other relevant observable market data. For purposes of potential valuation adjustments to derivative positions, Bancorp evaluates the credit risk of its counterparties as well as its own credit risk. To date, Bancorp has not realized any losses due to a counterparty’s inability to perform and the change in value of derivative assets and liabilities attributable to credit risk was not significant during 2014.

Below are the carrying values of assets measured at fair value on a recurring basis.

	Fair value at March 31, 2014
(in thousands)	Total		Level 1		Level 2		Level 3
Assets
Investment securities available for sale
U.S. Treasury and other U.S. government obligations	$	40,000	$	—	$	40,000	$	—
Government sponsored enterprise obligations	156,357		—		$	156,357	—
Mortgage-backed securities - government agencies	173,280		—		173,280		—
Obligations of states and political subdivisions	69,505		—		69,505		—
Corporate equity securities	1,042		1,042		—		—

Total investment securities available for sale	440,184		1,042		439,142		—

Interest rate swaps	379		—		379		—

Total assets	$	440,563	$	1,042	$	439,521	$	—

Liabilities

Interest rate swaps	$	322	$	—	$	322	$	—

	Fair value at December 31, 2013
(in thousands)	Total		Level 1		Level 2		Level 3
Assets
Investment securities available for sale
U.S. Treasury and other U.S. government obligations	$	110,000	$	—	$	110,000	$	—
Government sponsored enterprise obligations	137,845		—		$	137,845	—
Mortgage-backed securities - government agencies	172,693		—		172,693		—
Obligations of states and political subdivisions	69,493		—		69,493		—

Total investment securities available for sale	490,031		—		490,031		—

Interest rate swaps	299		—		299		—

Total assets	$	490,330	$	—	$	490,330	$	—

Liabilities

Interest rate swaps	$	275	$	—	$	275	$	—

Bancorp did not have any financial instruments classified within Level 3 of the valuation hierarchy for assets and liabilities measured at fair value on a recurring basis at March 31, 2014 or December 31, 2013.

MSRs are recorded at fair value upon capitalization, are amortized to correspond with estimated servicing income, and are periodically assessed for impairment based on fair value at the reporting date. Fair value is based on a valuation model that calculates the present value of estimated net servicing income. The model incorporates assumptions that market participants would use in estimating future net servicing income. These measurements are classified as Level 3. At March 31, 2014 and December 31, 2013 there was no valuation allowance for the mortgage servicing rights, as the fair value exceeded the cost. Accordingly, the MSRs are not included in either table below for March 31, 2014 or December 31, 2013.

Mortgage loans held for sale are recorded at the lower of cost or market value. The portfolio is comprised of residential real estate loans and fair value is based on specific prices of underlying contracts for sales to investors. These measurements are classified as Level 2. Because the fair value of the loans held for sale exceeded carrying value, mortgage loans held for sale are not included in either table below for March 31, 2014 or December 31, 2013.

Other real estate owned, which is carried at the lower of cost or fair value, is periodically assessed for impairment based on fair value at the reporting date. Fair value is determined from external appraisals using judgments and estimates of external professionals. Many of these inputs are not observable and, accordingly, these measurements are classified as Level 3. At March 31, 2014 and December 31, 2013, the carrying value of other real estate owned was $2,933,000 and $5,590,000, respectively. Other real estate owned is not included in either table below, as the fair value of the properties exceeded their carrying value at March 31, 2014 and December 31, 2013.

For impaired loans in the table below, the fair value is calculated as the carrying value of only loans with a specific valuation allowance, less the specific allowance. As of March 31, 2014, total impaired loans with a valuation allowance were $8.4 million, and the specific allowance totaled $1.3 million, resulting in a fair value of $7.1 million, compared to total impaired loans with a valuation allowance of $10.6 million, and the specific allowance allocation totaling $1.5 million, resulting in a fair value of $9.1 million at December 31, 2013. The losses represent the change in the specific allowances for the period indicated.

Below are the carrying values of assets measured at fair value on a non-recurring basis.

									Losses for 3 month
	Fair value at March 31, 2014								period ended
(in thousands)	Total		Level 1		Level 2		Level 3		March 31, 2014
Impaired loans	$	7,102	$	—	$	—	$	7,102	$	(180	)

									Losses for 3 month
	Fair value at December 31, 2013								period ended
(in thousands)	Total		Level 1		Level 2		Level 3		March 31, 2013
Impaired loans	$	9,128	$	—	$	—	$	9,128	$	(928	)

In the case of the securities portfolio, Bancorp monitors the valuation technique utilized by pricing agencies to ascertain when transfers between levels have occurred. The nature of the remaining assets and liabilities is such that transfers in and out of any level are expected to be rare. For the three months ended March 31, 2014, there were no transfers between Levels 1, 2, or 3.