Note 11 - Fair Values of Financial Instruments

A fair value hierarchy that prioritizes the inputs to valuation methods is 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 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair market hierarchy are as follows:

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

Level 2: 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.

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

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

The following information should not be interpreted as an estimate of the fair value of Bancorp since a fair value calculation is only provided for a limited portion of Bancorp’s assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between Bancorp’s disclosures and those of other companies may not be meaningful. The following methods and assumptions were used to estimate the fair values of Bancorp’s financial instruments at September 30, 2014 and December 31, 2013.

Impaired Loans:

Impaired loans are carried at the lower of cost or the present value of expected future cash flows of the loan. If it is determined that the repayment of the loan will be provided solely by the underlying collateral, and there are no other available and reliable sources of repayment, the loan is considered collateral dependent. Impaired loans that are considered collateral dependent are carried at the lower of cost or the fair value of the underlying collateral. Collateral may be in the form of real estate or business assets including equipment, inventory and accounts receivable. The use of independent appraisals and management’s best judgment are significant inputs in arriving at the fair value measure of the underlying collateral and impaired loans are therefore classified within level 3 of the fair value hierarchy.

For such loans that are classified as impaired, an allowance is established when the present value of the expected future cash flows of the impaired loan is lower than the carrying value of that loan. For such loans that are classified as collateral dependent impaired loans, an allowance is established when the current market value of the underlying collateral less its estimated disposal costs has not been finalized, but management determines that it is likely that the value is lower than the carrying value of that loan. Once the net collateral value has been determined, a charge-off is taken for the difference between the net collateral value and the carrying value of the loan.

Impaired loans are those for which Bancorp has measured impairment based on the present value of expected future cash flows or on the fair value of the loan’s collateral. Fair value is generally determined based upon independent third-party appraisals of the properties, or discounted cash flows based upon the expected proceeds. These assets are included as Level 3 fair values, based upon the lowest level of input that is significant to the fair value measurements. The fair value consisted of the loan balances of $17,357,000 and $19,856,000 at September 30, 2014 and December 31, 2013, respectively, less their valuation allowances of $2,464,000 and $3,303,000 at September 30, 2014 and December 31, 2013, respectively.

Foreclosed Real Estate:

Real estate acquired through foreclosure is included in the following disclosure at the lower of carrying value or fair value less estimated disposal costs. Management periodically evaluates the recoverability of the carrying value of the real estate acquired through foreclosure using current estimates of fair value. In the event of a subsequent decline, management provides a specific allowance to reduce real estate acquired through foreclosure to fair value less estimated disposal cost. Expenses incurred on foreclosed real estate prior to disposition are charged to expense. Gains or losses on the sale of foreclosed real estate are recognized upon disposition of the property.

The following table sets forth financial assets that were accounted for at fair value on a nonrecurring and recurring basis by level within the fair value hierarchy as of September 30, 2014 and December 31, 2013:

			September 30, 2014 Fair Value Measurement Using:
	September 30, 2014		Quoted Prices in Active Markets For Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(dollars in thousands)
Nonrecurring fair value measurements
Impaired loans	$	14,893	$	-	$	-	$	14,893
Foreclosed real estate		1,157		-		-		1,157
Total nonrecurring fair value measurements	$	16,050	$	-	$	-	$	16,050

Recurring fair value measurements
Mortgage servicing rights	$	708	$	-	$	-		708
Rate lock commitments		277		-		277		-
Mandatory forward contracts		63		-		63		-
Total recurring fair value measurements	$	1,048	$	-	$	340	$	708
			December 31, 2013 Fair Value Measurement Using:
	December 31, 2013		Quoted Prices in Active Markets For Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(dollars in thousands)
Nonrecurring fair value measurements
Impaired loans	$	16,553	$	-	$	-	$	16,553
Foreclosed real estate		8,972		-		-		8,972
Total nonrecurring fair value measurements	$	25,525	$	-	$	-	$	25,525
Recurring fair value measurements
Mortgage servicing rights	$	723	$	-	$	-	$	723

There were no liabilities that were required to be re-measured on a nonrecurring basis at September 30, 2014 or December 31, 2013.

The following table presents additional quantitative information about assets measured at fair value on a recurring basis and for which Bancorp has utilized Level 3 inputs to determine fair value:

	Quantitative Information about Level 3 Fair Value Measurements
	Fair Value Estimate		Valuation Techniques	Unobservable Input	Range (Weighted Average)
September 30, 2014
Mortgage servicing rights	$	708	Market approach	Weighted average prepayment speed		8.81	%

December 31, 2013
Mortgage servicing rights	$	723	Market approach	Weighted average prepayment speed		8.30	%

All appraisals are reviewed by the credit department; however, no modifications or adjustments are made to the appraisals received.

The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis and for which Bancorp has utilized Level 3 inputs to determine fair value:

	Quantitative Information about Level 3 Fair Value Measurements
	Fair Value Estimate		Valuation Techniques	Unobservable Input	Range (Weighted Average)
September 30, 2014
Impaired loans	$	14,893	Present value of future cash flows (1)	Discount rate		-6.00	%

Foreclosed real estate	$	1,157	Appraisal of collateral (2),(4)	Appraisal adjustments (3)	-6.00% to -24.83% (-15.43%)

December 31, 2013
Impaired loans	$	15,942	Present value of future cash flows (1)	Discount rate		-6.00	%
	$	611	Appraisal of collateral (2)	Liquidation expenses (3)		-6.00	%

Foreclosed real estate	$	8,972	Appraisal of collateral (2),(4)	Appraisal adjustments (3)	-6.00% to -44.08% (-12.69%)

(1)

Cash flow which generally include various level 3 inputs which are not identifiable.

(2)

Fair value is generally determined through independent appraisals for the underlying collateral, which generally include various level 3 inputs which are not identifiable.

(3)

Appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated liquidation expenses. The range and weighted average of liquidation expenses and other appraisal adjustments are presented as a percent of the appraisal.

(4)

Includes qualitative adjustments by management and estimated liquidation expenses.

The estimated fair values of Bancorp's financial instruments as of September 30, 2014 and December 31, 2013 were as follows:

					Fair Value Measurement at September 30, 2014
	Carrying Amount		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	(dollars in thousands)
Cash and cash equivalents	$	31,618	$	31,618	$	31,618	$	-	$	-
Investment securities (HTM)		62,297		62,746		-		62,746		-
Loans held for sale		9,601		9,857		-		9,857		-
Loans receivable, net		620,060		634,676		-		-		634,676
FHLB stock		5,936		5,936		-		5,936		-
Accrued interest receivable		2,392		2,392		-		2,392		-
Mortgage servicing rights		708		708		-		-		708
Rate lock commitments		277		277		-		277		-
Mandatory forward contracts		63		63		-		63		-

Financial Liabilities
Deposits	$	537,743	$	538,664		-		538,664		-
FHLB advances		115,000		108,744		-		108,744		-
Subordinated debentures		24,119		24,119		-		-		24,119
Accrued interest payable		1,886		1,886		-		1,886		-

Off Balance Sheet Commitments	$	-	$	-	$	-	$	-	$	-

					Fair Value Measurement At December 31, 2013
	Carrying Amount		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	(dollars in thousands)
Cash and cash equivalents	$	98,376	$	98,376	$	98,376	$	-	$	-
Investment securities (HTM)		44,661		45,213		-		45,213		-
Loans held for sale		3,726		3,825		-		3,825		-
Loans receivable, net		602,813		610,335		-		-		610,335
FHLB stock		6,190		6,190		-		6,190		-
Accrued interest receivable		2,353		2,353		-		2,353		-
Mortgage servicing rights		723		723		-		-		723

Financial Liabilities
Deposits	$	571,249	$	573,371		-		573,371		-
FHLB advances		115,000		106,876		-		106,876		-
Subordinated debentures		24,119		24,119		-		-		24,119
Accrued interest payable		1,375		1,375		-		1,375		-

Off Balance Sheet Commitments	$	-	$	-	$	-	$	-	$	-

The following methods and assumptions were used to measure the fair value of financial instruments recorded at cost on Bancorp’s consolidated balance sheet:

Cash and cash equivalents:

The carrying amount reported in the consolidated statements of financial condition for cash and cash equivalents approximate those assets’ fair values.

Investment Securities:

Bancorp utilizes a third party source to determine the fair value of its securities. The methodology consists of pricing models based on asset class and includes available trade, bid, other market information, broker quotes, proprietary models, various databases and trading desk quotes. All Bancorp’s investments are considered Level 2.

Loans held for sale:

The fair value of loans held for sale is based primarily on investor quotes.

Loans receivable:

The fair values of loans receivable were estimated using discounted cash flow analyses, using market interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. These rates were used for each aggregated category of loans as reported on the Office of the Comptroller of the Currency Quarterly Report.

FHLB stock:

The carrying amount of FHLB stock approximates fair value based on the redemption provisions of the FHLB. There have been no identified events or changes in circumstances that may have a significant adverse effect on the FHLB stock. Based on our evaluation, we have concluded that our FHLB stock was not impaired at September 30, 2014 and December 31, 2013.

Accrued interest receivable and payable:

The carrying amounts of accrued interest receivable and accrued interest payable approximates their fair values.

Derivative Instruments:

Mortgage banking derivatives used in the ordinary course of business primarily consist of mandatory forward sales contracts (“forward contract”) and rate lock commitments. The fair value of Bancorp’s derivative instruments is primarily measured by obtaining pricing from broker-dealers recognized to be market participants. The pricing is derived from market observable inputs that can generally be verified and do not typically involve significant judgment by Bancorp. Forward contracts and rate lock loan commitments are classified as Level 2 in the fair value hierarchy.

Mortgage servicing rights:

The fair value of mortgage servicing rights is determined using a valuation model administered by a third party that calculates the present value of estimated future net servicing income. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, discount rate, default rates, cost to service (including delinquency and foreclosure costs), escrow account earnings, contractual servicing fee income and other ancillary income such as late fees. Management reviews all significant assumptions on a monthly basis. Mortgage loan prepayment speed, a key assumption in the model, is the annual rate at which borrowers are forecasted to repay their mortgage loan principal. The discount rate used to determine the present value of estimated future net servicing income, another key assumption in the model, is an estimate of the required rate of return investors in the market would require for an asset with similar risk. Both assumptions can, and generally will, change as market conditions and interest rates change.

Deposit liabilities:

The fair values disclosed for demand deposit accounts, savings accounts and money market deposits are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies market interest rates currently being offered in the market on certificates to a schedule of aggregated expected monthly maturities on time deposits.

FHLB advances:

Fair values of long-term debt are estimated using discounted cash flow analysis, based on rates currently available for advances from the FHLB with similar terms and remaining maturities.

Subordinated debentures:

Current economic conditions have rendered the market for this liability inactive. As such, Bancorp is unable to determine a good estimate of fair value. Since the rate paid on the debentures held is lower than what would be required to secure an interest in the same debt at year end and we are unable to obtain a current fair value, Bancorp has disclosed that the carrying value approximates the fair value.

Off-balance sheet financial instruments:

Fair values for Bancorp’s off-balance sheet financial instruments (lending commitments and letters of credit) are not significant and are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing