9. 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 value.

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the Corporation has the ability to access at 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 the Corporation’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

An asset or liability’s level is based on the lowest level of input that is significant to the fair value measurement.

The Corporation used the following methods and significant assumptions to estimate fair value:

Cash and cash equivalents – The carrying value of cash, due from banks and interest bearing deposits approximates fair value and are classified as Level 1.

Securities available for sale – The fair value of all investment securities are based upon the assumptions market participants would use in pricing the security. If available, investment securities are determined by quoted market prices (Level 1). Level 1 includes U.S. Treasury, federal agency securities and certain equity securities. For investment securities where quoted market prices are not available, fair values are calculated based on market prices on similar securities (Level 2). Level 2 includes U.S. Government sponsored entities and agencies, mortgage-backed securities, collateralized mortgage obligations, state and political subdivision securities and corporate debt securities. For investment securities where quoted prices or market prices of similar securities are not available, fair values are calculated by using unobservable inputs (Level 3) and may include certain equity securities held by the Corporation. The Level 3 equity security valuations were supported by an analysis prepared by the Corporation which relies on inputs such as the security issuer’s publicly attainable financial information, multiples derived from prices in observed transactions involving comparable businesses and other market, financial and nonfinancial factors.

Loans – The fair value of loans receivable was estimated based on the discounted value of the future cash flows using the current rates being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification.

Impaired loans – At the time a loan is considered impaired, it is valued at the lower of cost or fair value. Impaired loans carried at fair value generally receive a specific allowance for loan losses. For collateral dependent loans, 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 for determining fair 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 client’s business, resulting in a Level 3 classification. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly. As of September 30, 2013, the fair value of impaired loans consists of loan balances of $2.8 million, net of a valuation allowance of $230,000, compared to loan balances of $4.1 million, net of a valuation allowance of $1.4 million, at December 31, 2012. There was no additional provision for loan losses and $21,000 of additional provision for loan losses recorded for impaired loans during the three and nine month periods ended September 30, 2013, respectively. There was $1.4 million and $1.5 million of additional provision for loan losses recorded for impaired loans during the three and nine month periods ended September 30, 2012.

Other Real estate owned (OREO) – Assets acquired through or instead of foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals. Management’s ongoing review of appraisal information may result in additional discounts or adjustments to the valuation based upon more recent market sales activity or more current appraisal information derived from properties of similar type and/or locale. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. As of September 30, 2013, OREO measured at fair value less costs to sell had a net carrying amount of $35,000, which was made up of the outstanding balance of $50,000 and write-downs of $15,000, compared to a net carrying amount of $45,000, which was made up of the outstanding balance of $50,000 and write-downs of $5,000 at December 31, 2012.

Appraisals for both collateral-dependent impaired loans and OREO are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed by the Corporation. Once received, management 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. On an annual basis, the Corporation compares the actual selling price of OREO that has been sold to the most recent appraisal to determine what additional adjustment should be made to the appraisal value to arrive at fair value. The most recent analysis performed indicated that a discount of 10% should be applied.

Federal bank stock – It is not practical to determine the fair value of federal bank stocks due to restrictions placed on its transferability.

Deposits – The fair value of deposits with no stated maturity, such as non-interest bearing demand deposits, checking with interest, savings and money market accounts, is equal to the amount payable on demand resulting in either a Level 1 or Level 2 classification. The fair values of time deposits are based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar maturities resulting in a Level 2 classification.

Borrowings – The fair value of borrowings with the FHLB is estimated using discounted cash flows based on current incremental borrowing rates for similar types of borrowing arrangements resulting in a Level 2 classification.

Accrued interest receivable and payable – The carrying value of accrued interest receivable and payable approximates fair value. The fair value classification is consistent with the related financial instrument.

For assets measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy are as follows:

(Dollar amounts in thousands)			(Level 1)		(Level 2)
			Quoted Prices in		Significant		(Level 3)
			Active Markets		Other		Significant
			for Identical		Observable		Unobservable
Description	Total		Assets		Inputs		Inputs
September 30, 2013:
U.S. Treasury and federal agency	$	4,248	$	4,248	$	-	$	-
U.S. government sponsored entities and agencies		23,044		-		23,044		-
Mortgage-backed securities: residential		12,859		-		12,859		-
Collateralized mortgage obligations: residential		42,552		-		42,552		-
State and political subdivision		39,935		-		39,935		-
Corporate debt securities		240		-		240		-
Equity securities		2,447		1,795		-		652
	$	125,325	$	6,043	$	118,630	$	652

December 31, 2012:
U.S. Treasury and federal agency	$	3,967	$	3,967	$	-	$	-
U.S. government sponsored entities and agencies		28,162		-		28,162		-
Mortgage-backed securities: residential		22,724		-		22,724		-
Collateralized mortgage obligations: residential		22,475		-		22,475		-
State and political subdivision		36,765		-		36,765		-
Corporate debt securities		3,761		-		3,761		-
Equity securities		2,352		1,699		-		653
	$	120,206	$	5,666	$	113,887	$	653

The Corporation’s policy is to transfer assets or liabilities from one level to another when the methodology to obtain the fair value changes such that there are more or fewer unobservable inputs as of the end of the reporting period. During the three and nine month periods ended September 30, 2013, the Corporation had no transfers between levels. The following table presents changes in Level 3 assets measured on a recurring basis for the three and nine month periods ended September 30, 2013 and 2012:

(Dollar amounts in thousands)	Three months ended				Nine months ended
	September 30,				September 30,
	2013		2012		2013		2012
Balance at the beginning of the period	$	653	$	-	$	653	$	-
Total gains or losses (realized/unrealized):		-		-		-		-
Included in earnings		-		-		-		-
Included in other comprehensive income		(1)		-		(1)		-
Issuances		-		-		-		-
Transfers in and/or out of Level 3		-		653		-		653
Balance at the end of the period	$	652	$	653	$	652	$	653

For assets measured at fair value on a non-recurring basis, the fair value measurements by level within the fair value hierarchy are as follows:

(Dollar amounts in thousands)			(Level 1)		(Level 2)
			Quoted Prices in		Significant		(Level 3)
			Active Markets		Other		Significant
			for Identical		Observable		Unobservable
Description	Total		Assets		Inputs		Inputs
September 30, 2013:
Impaired commercial real estate loans	$	2,483	$	-	$	-	$	2,483
Other residential real estate owned		35		-		-		35
	$	2,518	$	-	$	-	$	2,518
December 31, 2012:
Impaired commercial real estate loans	$	2,620	$	-	$	-	$	2,620
Other residential real estate owned		45		-		-		45
	$	2,665	$	-	$	-	$	2,665

The following table presents quantitative information about Level 3 fair value measurements for assets measured at fair value on a non-recurring basis:

(Dollar amounts in thousands)

Valuation

Unobservable

Techniques(s)

Input (s)

Range

September 30, 2013:

Impaired commercial real estate loans

2,483

Sales comparison approach/

Adjustment for differences

0% - 10%

Contractual provision of USDA loan

between comparable sales

Other residential real estate owned

Sales comparison approach

Adjustment for differences

10%

between comparable sales

December 31, 2012:

Impaired commercial real estate loans

2,620

Sales comparison approach/

Adjustment for differences

10% - 25%

Contractual provision of USDA loan

between comparable sales

Other residential real estate owned

Sales comparison approach

Adjustment for differences

10%

between comparable sales

The two tables above exclude a $61,000 impaired residential mortgage loan classified as a troubled debt restructure which was measured at fair value using a discounted cash flow methodology at September 30, 2013.

Included in impaired commercial real estate loans is a loan guaranteed by the United States Department of Agriculture (USDA) with balances of $350,000 and $354,000, respectively, as of September 30, 2013 and December 31, 2012. The guarantee covers 90% of the principal balance outstanding. In determining the fair value of this loan, the Corporation considered the contractual provisions of the loan and did not rely on the fair value of the underlying collateral. As such, the Corporation applied a 10% discount to the loan which represents the portion of the loan at risk. The weighted average discount on impaired loans as of September 30, 2013 and December 31, 2012 was 2% and 11%, respectively.

The following table sets forth the carrying amount and estimated fair values of the Corporation’s financial instruments included in the consolidated balance sheet as of September 30, 2013 and December 31, 2012:

(Dollar amounts in thousands)
	Carrying		Fair Value Measurements using:
Description	Amount		Total		Level 1		Level 2		Level 3
September 30, 2013:
Financial Assets:
Cash and cash equivalents	$	14,636	$	14,636	$	14,636	$	-	$	-
Securities available for sale		125,325		125,325		6,043		118,630		652
Loans, net		347,729		352,256		-		-		352,256
Federal bank stock		3,707		N/A		N/A		N/A		N/A
Accrued interest receivable		1,607		1,607		33		484		1,090
		493,004		493,824		20,712		119,114		353,998
Financial Liabilities:
Deposits		429,442		431,120		321,797		109,323		-
Borrowed funds		46,650		47,834		-		47,834		-
Accrued interest payable		305		305		4		301		-
		476,397		479,259		321,801		157,458		-

	Carrying		Fair Value Measurements using:
	Amount		Total		Level 1		Level 2		Level 3
December 31, 2012:
Financial Assets:
Cash and cash equivalents	$	20,424	$	20,424	$	20,424	$	-	$	-
Securities available for sale		120,206		120,206		5,666		113,887		653
Loans, net		333,801		340,840		-		-		340,840
Federal bank stock		2,885		N/A		N/A		N/A		N/A
Accrued interest receivable		1,533		1,533		23		383		1,127
		478,849		483,003		26,113		114,270		342,620
Financial Liabilities:
Deposits		432,459		436,279		300,805		135,474		-
FHLB advances		20,000		22,613		-		22,613		-
Accrued interest payable		442		442		55		387		-
		452,901		459,334		300,860		158,474		-