Note 15.

Fair Value of Financial Instruments

Under FASB ASC Topic 820 “Fair Value Measurements” (“ASC Topic 820”), fair values are based on 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. When available, management uses quoted market prices to determine fair value. If quoted prices are not available, fair value is based upon valuation techniques such as matrix pricing or other models that use, where possible, current market-based or independently sourced market parameters, such as interest rates. If observable market-based inputs are not available, the Company uses unobservable inputs to determine appropriate valuation adjustments using discounted cash flow methodologies.

Management uses its best judgment in estimating the fair value of the Company’s financial instruments; however, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts the Company could have realized in a sales transaction on the dates indicated. The estimated fair value amounts have been measured as of their respective period end and have not been re-evaluated or updated for purposes of these financial statements subsequent to those respective dates. As such, the estimated fair values of these financial instruments subsequent to the respective reporting dates may be different than the amounts reported at each period-end.

ASC Topic 820 provides guidance for estimating fair value when the volume and level of activity for an asset or liability has significantly declined and for identifying circumstances when a transaction is not orderly. ASC Topic 820 establishes a fair value hierarchy that prioritizes the inputs to valuation methods 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 value hierarchy under ASC Topic 820 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 2 includes debt securities with quoted prices that are traded less frequently then exchange-traded instruments. Valuation techniques include matrix pricing which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices.

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).

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. The Company did not have transfers of financial instruments within the fair value hierarchy during the quarters ended March 31, 2014 and 2013.

Items Measured on a Recurring Basis

The Company’s available for sale investment securities are recorded at fair value on a recurring basis.

Fair value for Level 1 securities are determined by obtaining quoted market prices on nationally recognized securities exchanges. Level 1 securities include common stocks.

Level 2 securities include obligations of U.S. government-sponsored agencies and debt securities with quoted prices, which are traded less frequently than exchange-traded instruments, whose value is determined using matrix pricing with inputs that are observable in the market or can be derived principally from or corroborated by observable market data. The prices were obtained from third party vendors. This category generally includes the Company’s mortgage-backed securities and CMOs issued by U.S. government and government-sponsored agencies, non-agency CMOs, and corporate and municipal bonds.

Level 3 securities include investments in seven private equity funds which are predominantly invested in real estate. The value of the private equity funds are derived from the funds’ financials and K-1 filings. The Company also reviews the funds’ asset values and its near-term projections.

For financial assets measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy used at March 31, 2014 and December 31, 2013 are as follows:

	Fair Value Measurements Using:
As of March 31, 2014	Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
(In thousands)	Level 1		Level 2		Level 3		Fair Value
Investment securities available-for-sale
U.S. government agencies	$	-	$	63,059	$	-	$	63,059
Mortgage-backed securities-residential		-		31,538		-		31,538
Collateralized mortgage obligations:
Issued or guaranteed by U.S. government agencies		-		189,786		-		189,786
Non-agency		-		4,342		-		4,342
Corporate bonds		-		9,555		-		9,555
Municipal bonds		-		9,103		-		9,103
Other securities		-		-		4,780		4,780
Common stocks		49		-		-		49
Total investment securities available-for-sale	$	49	$	307,383	$	4,780	$	312,212

	Fair Value Measurements Using:
As of December 31, 2013	Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
(In thousands)	Level 1		Level 2		Level 3		Fair Value
Investment securities available-for-sale
U.S. government agencies	$	-	$	62,036	$	-	$	62,036
Mortgage-backed securities-residential		-		32,097		-		32,097
Collateralized mortgage obligations:
Issued or guaranteed by U.S. government agencies		-		189,103		-		189,103
Non-agency		-		4,479		-		4,479
Corporate bonds		-		9,438		-		9,438
Municipal bonds		-		6,900		-		6,900
Other securities		-		-		4,625		4,625
Common stocks		49		-		-		49
Total investment securities available-for-sale	$	49	$	304,053	$	4,625	$	308,727

The following tables present additional information about assets measured at fair value on a recurring basis and for which the Company has utilized Level 3 inputs to determine fair value for the three months ended March 31, 2014 and 2013:

(In thousands)	Other securities
Investment Securities Available for Sale	2014			2013
Beginning balance January 1,	$	4,625		$	4,164
Total gains/(losses) - (realized/unrealized):
Included in earnings		-			5
Included in other comprehensive income		284			140
Purchases		-			-
Sales and calls		(129	)		(84	)
Transfers in and/or out of Level 3		-			-
Ending balance March 31,	$	4,780		$	4,225

Items Measured on a Nonrecurring Basis

Non-accrual loans and TDRs are evaluated for impairment on an individual basis under FASB ASC Topic 310 “Receivables”. The impairment analysis includes current collateral values, known relevant factors that may affect loan collectability, and risks inherent in different kinds of lending. When the collateral value or discounted cash flows less costs to sell is less than the carrying value of the loan a specific reserve (valuation allowance) is established. Loans held for sale are carried at the lower of cost or fair value. OREO is carried at the lower of cost or fair value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the real estate. Additionally, for collateral acquired from tax liens, fair value may be established using brokers opinions due to their lower carrying value. These assets are included as Level 3 fair values, based upon the lowest level of input that is significant to the fair value measurements.

For financial assets measured at fair value on a nonrecurring basis, the fair value measurements by level within the fair value hierarchy used at March 31, 2014 and December 31, 2013 are as follows:

	Fair Value Measurements Using:
As of March 31, 2014	Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
(In thousands)	Level 1		Level 2		Level 3		Fair Value
Assets
Impaired loans and leases	$	-	$	-	$	3,253	$	3,253
Other real estate owned		-		-		8,112		8,112

	Fair Value Measurements Using:
As of December 31, 2013	Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
(In thousands)	Level 1		Level 2		Level 3		Fair Value
Assets
Impaired loans and leases	$	-	$	-	$	4,073	$	4,073
Other real estate owned		-		-		9,182		9,182
Loans and leases held for sale		-		-		1,446		1,446

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

	Qualitative Information about Level 3 Fair Value Measurements
As of March 31, 2014 (In thousands)	Fair Value		Valuation Techniques	Unobservable Input	Range (Weighted Average)
Impaired loans and leases	$	3,253	Appraisal of	Appraisal adjustments	0.0% to -20% (-0.68%)
			collateral (1)	Liquidation expenses	0.0% to -26.99% (-10.26%)

Other real estate owned		8,112	Appraisal of	Appraisal adjustments	0.0% to -55.9% (-7.4%)
			collateral (1)	Liquidation expenses	-14.7%

(1)

Appraisals may be adjusted for qualitative factors such as interior condition of the property and liquidation expenses.

The following methods and assumptions were used to estimate the fair values of the Company’s financial instruments at March 31, 2014 and December 31, 2013. The following information should not be interpreted as an estimate of the fair value of the entire Company since a fair value calculation is only provided for a limited portion of the Company’s assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between the Company’s disclosures and those of other companies may not be meaningful. The methodologies for estimating the fair value of financial instruments that are measured on a recurring or nonrecurring basis are discussed above.

Cash and cash equivalents (carried at cost):

The carrying amounts reported in the balance sheet for cash and short-term instruments approximate those assets’ fair values.

Securities:

Management uses quoted market prices to determine fair value of securities (level 1). If quoted prices are not available, fair value is based upon valuation techniques such as matrix pricing or other models that use, where possible, current market-based or independently sourced market parameters, such as interest rates (level 2). If observable market-based inputs are not available, the Company uses unobservable inputs to determine appropriate valuation adjustments by reviewing the private equities funds’ financials and K-1 filings (level 3).

Other Investment (carried at cost):

This investment includes the Solomon Hess SBA Loan Fund, which the Company invested in to partially satisfy its community reinvestment requirement. Shares in this fund are not publicly traded and therefore have no readily determinable fair market value. An investor can have their investment in the Fund redeemed for the balance of their capital account at any quarter end with 60 days notice to the Fund. The investment in this Fund is recorded at cost. The Company does not record this investment at fair value on a recurring basis, as this investment’s carrying amount approximates fair value.

Restricted investment in bank stock (carried at cost):

The carrying amount of restricted investment in bank stock approximates fair value, and considers the limited marketability of such securities.

Loans held for sale (carried at lower of cost or fair value):

The fair values of loans held for sale are based upon appraised values of the collateral less costs to sell, management’s estimation of the value of the collateral or expected net sales 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.

Loans receivable (carried at cost):

The fair values of loans are estimated using discounted cash flow analyses, using market rates at the balance sheet date that reflect the credit and interest rate-risk inherent in the loans. Projected future cash flows are calculated based upon contractual maturity or call dates, projected repayments and prepayments of principal. Generally, for variable rate loans that re-price frequently and with no significant change in credit risk, fair values are based on carrying values.

Impaired loans (generally carried at fair value):

Impaired loans are accounted for under ASC Topic 310. Impaired loans are those in which the Company has measured impairment generally based 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 on 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.

Accrued interest receivable and payable (carried at cost):

The carrying amount of accrued interest receivable and accrued interest payable approximates its fair value.

Deposit liabilities (carried at cost):

The fair values disclosed for demand deposits (e.g., interest and noninterest checking, passbook savings and money market accounts) 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 interest rates currently being offered in the market on certificates to a schedule of aggregated expected monthly maturities on time deposits.

Short-term borrowings (carried at cost):

The carrying amounts of short-term borrowings approximate their fair values.

Long-term debt (carried at cost):

Fair values of FHLB advances and other long-term borrowings are estimated using discounted cash flow analysis, based on quoted prices for new FHLB advances with similar credit risk characteristics, terms and remaining maturity. These prices obtained from this active market represent a market value that is deemed to represent the transfer price if the liability were assumed by a third party.

Subordinated debt (carried at cost):

Fair values of junior subordinated debt are estimated using discounted cash flow analysis, based on market rates currently offered on such debt with similar credit risk characteristics, terms and remaining maturity.

Off-balance sheet financial instruments (disclosed at cost):

Fair values for the Company’s off-balance sheet financial instruments (lending commitments and letters of credit) are based on fees currently charged in the market to enter into similar agreements, taking into account, the remaining terms of the agreements and the counterparties’ credit standing. They are not shown in the table because the amounts are immaterial.

The tables below indicate the fair value of the Company’s financial instruments at March 31, 2014 and December 31, 2013.

					Fair Value Measurements
					At March 31, 2014
(In thousands)	Carrying amount		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 cash equivalents	$	23,890	$	23,890	$	23,890	$	-	$	-
Investment securities available-for-sale		312,212		312,212		49		307,383		4,780
Other investment		2,250		2,250		-		-		2,250
Federal Home Loan Bank stock		4,004		4,004		-		-		4,004
Loans, net		346,792		346,145		-		-		346,145
Accrued interest receivable		6,675		6,675		-		6,675		-
Financial Liabilities:
Demand deposits		70,560		70,560		-		70,560		-
NOW and money markets		211,758		211,758		-		211,758		-
Savings		18,449		18,449		-		18,449		-
Time deposits		231,865		230,106		-		230,106		-
Short-term borrowings		5,000		5,000		5,000		-		-
Long-term borrowings		97,767		94,837		-		94,837		-
Subordinated debt		25,774		27,914		-		27,914		-
Accrued interest payable		1,435		1,435		-		1,435		-

					Fair Value Measurements
					At December 31, 2013
(In thousands)	Carrying amount		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 cash equivalents	$	16,844	$	16,844	$	16,844	$	-	$	-
Investment securities available-for-sale		308,727		308,727		49		304,053		4,625
Other investment		2,250		2,250		-		-		2,250
Federal Home Loan Bank stock		4,204		4,204		-		-		4,204
Loans held for sale		1,446		1,446		-		-		1,446
Loans, net		352,810		349,336		-		-		349,336
Accrued interest receivable		7,054		7,054		-		7,054		-
Financial Liabilities:
Demand deposits		60,473		60,473		-		60,473		-
NOW and money markets		210,053		210,053		-		210,053		-
Savings		17,593		17,593		-		17,593		-
Time deposits		240,845		239,102		-		239,102		-
Short-term borrowings		10,000		10,000		10,000		-		-
Long-term borrowings		97,881		94,896		-		94,896		-
Subordinated debt		25,774		26,000		-		26,000		-
Accrued interest payable		965		965		-		965		-

Limitations

The fair value estimates are made at a discrete point in time based on relevant market information and information about 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 factors.

These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Further, the foregoing estimates may not reflect the actual amount that could be realized if all or substantially all of the financial instruments were offered for sale. This is due to the fact that no market exists for a sizable portion of the loan, deposit and off balance sheet instruments.

In addition, the fair value estimates are based on existing on-and-off balance sheet financial instruments without attempting to value anticipated future business and the value of assets and liabilities that are not considered financial instruments. Other significant assets that are not considered financial assets include premises and equipment. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of the estimates.

Finally, reasonable comparability between financial institutions may not be likely due to the wide range of permitted valuation techniques and numerous estimates which must be made given the absence of active secondary markets for many of the financial instruments. This lack of uniform valuation methodologies introduces a greater degree of subjectivity to these estimated fair values.