NOTE 17 - DISCLOSURES ABOUT FAIR VALUE

Accounting guidance establishes 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 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; or other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

Investment Securities: The fair values of securities available-for-sale are determined by matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs). One corporate security is valued using Level 3 inputs as there is no readily observable market activity. Management determines the value of this security based on expected cash flows, the credit quality of the security and current market interest rates.

Derivatives: The Bank’s derivative instruments consist of over-the-counter interest-rate swaps that trade in liquid markets. The fair value of the 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 the Bank. This valuation method is classified as Level 2 in the fair value hierarchy.

Impaired Loans: At the time a loan is considered impaired, it is recorded at the lower of cost or fair value. Impaired loans carried at fair value generally receive specific allocations of the allowance for loan losses. For collateral dependent loans, fair value is commonly based on recent 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 fair value classification. The standard discount on equipment, accounts receivable, and inventory is 50%. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly.

Other Real Estate Owned: Assets acquired through or instead of loan 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 the lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent 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.

Loans Held For Sale: Loans held for sale are carried at the lower of cost or fair value, which is evaluated on a pool-level basis. The fair value of loans held for sale is determined using quoted prices for similar assets, adjusted for specific attributes of that loan or other observable market data, such as outstanding commitments from third party investors (Level 2).

Assets and Liabilities Measured on a Recurring Basis

Assets and liabilities measured at fair value on a recurring basis are summarized below (in thousands):

			Fair Value Measurements at
			December 31, 2013 Using:
					Significant
			Quoted Prices in		Other		Significant
	Total		Active Markets for		Observable		Unobservable
	December 31,		Identical Assets		Inputs		Inputs
	2013		(Level 1)		(Level 2)		(Level 3)
Assets
Investment securities available-for-sale
U.S. government sponsored entities and agencies	$	120,139	$	-	$	120,139	$	-
U.S. government agency mortgage backed		220,059		-		220,059		-
Corporate		925		-		-		925
Derivatives		1,915		-		1,915		-

Total	$	343,038	$		$	342,113	$	925

Liabilities
Derivatives	$	1,915	$	-	$	1,915	$	-

Total	$	1,915	$	-	$	1,915	$	-

			Fair Value Measurements at
			December 31, 2012 Using:
					Significant
			Quoted Prices in		Other		Significant
	Total		Active Markets for		Observable		Unobservable
	December 31,		Identical Assets		Inputs		Inputs
	2012		(Level 1)		(Level 2)		(Level 3)
Assets
Investment securities available-for-sale
U.S. government sponsored entities and agencies	$	128,477	$	-	$	128,477	$	-
U.S. government agency mortgage backed		184,907		-		184,907		-
Corporate		1,060		-		-		1,060
Derivatives		1,926		-		1,926		-

Total	$	316,370	$	-	$	315,310	$	1,060

Liabilities
Derivatives	$	1,926	$	-	$	1,926	$	-

Total	$	1,926	$	-	$	1,926	$	-

There were no transfers between Level 1 and Level 2 during 2013 or 2012.

There were no gains or losses for assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the year ended December 31, 2013.

There were no changes in unrealized gains and losses recorded in earnings for the year ended December 31, 2013 for Level 3 assets and liabilities that are still held at December 31, 2013.

The table below presents a reconciliation of all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the period ended December 31 (in thousands):

	Corporate Securities
	12/31/13		12/31/12

Balance of recurring Level 3 assets at January 1	$	1,060	$	1,060
Total gains or losses for the period:
Included in earnings		-		-
Included in other comprehensive income		-		-
Purchases		-		-
Sales		-		-
Issuances		-		-
Settlements		(135)		-
Transfers into Level 3		-		-
Transfers out of Level 3		-		-

Balance of recurring Level 3 assets at December 31	$	925	$	1,060

The following table presents quantitative information about recurring Level 3 fair value measurements at December 31, 2013 (in thousands):

			Valuation
	Fair value		Technique(s)	Unobservable Input(s)	Value

Corporate security	$	925	Discounted cash flow	Probability of default	0	%

The following table presents quantitative information about recurring Level 3 fair value measurements at December 31, 2012 (in thousands):

			Valuation
	Fair value		Technique(s)	Unobservable Input(s)	Value

Corporate security	$	1,060	Discounted cash flow	Probability of default	0	%

The interest rate on this security is based on interest rates paid for securities with similar credit characteristics, but the probability of default is determined through a credit quality review rather than formal ratings or other observable inputs. The interest rate adjusts to reflect current market conditions of highly rated investments, if probability of default changed significantly, the interest rate would adjust accordingly and the fair value would be updated. Management reviews this interest rate and the security’s credit quality quarterly and a market value adjustment is made if necessary pursuant to this review.

Assets and Liabilities Measured on a Non-Recurring Basis

Assets and liabilities measured at fair value on a non-recurring basis are summarized below:

			Fair Value Measurements at
			December 31, 2013 Using:
					Significant
				Quoted Prices in		Other		Significant
		Total		Active Markets for		Observable		Unobservable
		December 31,		Identical Assets		Inputs		Inputs
		2013		(Level 1)		(Level 2)		(Level 3)
Assets
Impaired loans
Commercial	$	2,215	$	-	$	-	$	2,215
Nonresidential real estate
Owner occupied properties		5,673		-		-		5,673
Non owner occupied properties		942		-		-		942
Residential real estate
Home equity lines of credit		218		-		-		218
Multifamily properties		1,245		-		-		1,245
Other		2,013		-		-		2,013
Construction		1,875		-		-		1,875
Other real estate owned
Residential		-		-		-		-
Non-Residential		2,772		-		-		2,772

Total	$	16,953	$	-	$	-	$	16,953

			Fair Value Measurements at
			December 31, 2012 Using:
						Significant
				Quoted Prices in		Other		Significant
		Total		Active Markets for		Observable		Unobservable
		December 31,		Identical Assets		Inputs		Inputs
		2012		(Level 1)		(Level 2)		(Level 3)
Assets
Impaired loans
Commercial	$	546	$	-	$	-	$	546
Nonresidential real estate		-
Owner occupied properties		6,346		-		-		6,346
Non owner occupied properties		2,788		-		-		2,788
Residential real estate
Home equity lines of credit		354		-		-		354
Multifamily properties		1,072		-		-		1,072
Other		4,541		-		-		4,541
Construction		2,657		-		-		2,657
Other real estate owned
Residential		396		-		-		396
Non-Residential		2,683		-		-		2,683

Total	$	21,383	$	-	$	-	$	21,383

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a gross carrying amount of $17,600 with a valuation allowance of $3,419, resulting in a decrease in provision for loan losses of $2,846 for 2013. As of December 31, 2012, impaired loans had a gross carrying amount of $27,548, with a valuation allowance of $6,265, resulting in an decrease in provision for loan losses of $1,178.

Other real estate owned measured at fair value less costs to sell, had a net carrying amount of $2,772, which is made up of the outstanding balance of $3,287, net of a valuation allowance of $515 at December 31, 2013 resulting in a write-down of $263, for the year ended December 31, 2013. At December 31, 2012, other real estate owned had a net carrying amount of $3,079, made up of the outstanding balance of $3,728, net of a valuation allowance of $649, resulting in a write-down of $369 for the year ended December 31, 2012.

Values for collateral dependent loans and other real estate owned are generally based on appraisals obtained from licensed real estate appraisers and in certain circumstances consideration of offers obtained to purchase properties prior to foreclosure or other factors management deems relevant to arrive at a representative fair value. Appraisals for commercial real estate generally use three methods to derive value: cost, sales or market comparison and income approach. The cost method bases value on the cost to replace the current property. The market comparison approach evaluates the sales price of similar properties in the same market area. The income approach considers net operating income generated by the property and an investor’s required return. The final fair value is based on a reconciliation of these three approaches. Values for non real estate collateral, such as business equipment, are based on the licensed real estate appraisals valuation or the customer’s financial statements. Values for the non real estate collateral use much higher discounts than does real estate collateral. This is reflected in the high discount rate used on Commercial loans which have a much higher percentage of equipment collateral than other loan types have.

The following table presents quantitative information about recurring Level 3 fair value measurements at December 31, 2013 (in thousands):

					Discount Range
		Fair Value	Valuation Technique(s)	Unobservable Input(s)	(Avg discount)
Assets
Impaired Loans:
Commercial	$	2,215	Cost, sales, income approach	Adjustment for comparable properties, market conditions	6-25%
					(11%)
Nonresidential real estate
Owner occupied properties		5,673	Cost, sales, income approach	Adjustment for comparable properties, market conditions	6-76%
					(17%)
Non owner occupied properties		942	Cost, sales, income approach	Adjustment for comparable properties, market conditions	3-66%
					(15%)
Residential real estate
Home equity lines of credit		218	Cost, sales, income approach	Adjustment for comparable properties, market conditions	6-26%
					(8%)
Multifamily properties		1,245	Cost, sales, income approach	Adjustment for comparable properties, market conditions	6%
					(6%)

Other		2,013	Cost, sales, income approach	Adjustment for comparable properties, market conditions	0-100%
					(36%)
Construction		1,875	Cost, sales, income approach	Adjustment for comparable properties, market conditions	6-16%
					(14%)
Other real estate owned
Residential		-	sales approach	Adjustment for comparable properties, market conditions	0-0%
					(0%)
Non-residential		2,772	sales approach	Adjustment for comparable properties, market conditions	0-0%
					(0%)

Total	$	16,953

The following table presents quantitative information about recurring Level 3 fair value measurements at December 31, 2012 (in thousands):

					Discount Range
		Fair Value	Valuation Technique(s)	Unobservable Input(s)	(Avg discount)
Assets
Impaired Loans:
Commercial	$	546	Cost, sales, income approach	Adjustment for comparable propertiesor equipment, market conditions	0-100% (62%)
Nonresidential real estate
Owner occupied properties		6,346	Cost, sales, income approach	Adjustment for comparable properties, market conditions	0-80% (6%)
Non owner occupied properties		2,788	Cost, sales, income approach	Adjustment for comparable properties, market conditions	0-80% (10%)
Residential real estate
Home equity lines of credit		354	Cost, sales, income approach	Adjustment for comparable properties, market conditions	0-100% (27%)
Multifamily properties		1,072	Cost, sales, income approach	Adjustment for comparable properties, market conditions	0% (0%)
Other		4,541	Cost, sales, income approach	Adjustment for comparable properties, market conditions	0-100% (10%)
Construction		2,657	Cost, sales, income approach	Adjustment for comparable properties, market conditions	0-80% (14%)
Other real estate owned
Residential		396	sales approach	Adjustment for comparable properties, market conditions	0-0% (0%)
Non-residential		2,683	sales approach	Adjustment for comparable properties, market conditions	0-0% (0%)
Total	$	21,383

The carrying amounts and estimated fair values of financial instruments at December 31, 2013 and December 31, 2012 are as follows (in thousands):

			Fair Value Measurements at December 31, 2013 Using:
	Carrying Value		Level 1		Level 2		Level 3		Total
Financial assets
Cash and cash equivalents	$	78,621	$	78,621	$	-	$	-	$	78,621
Interest-bearing deposits with banks		252		252		-		-		252
Securities available-for-sale		341,123		-		340,198		925		341,123
Securities held-to-maturity		77,010		-		76,457		-		76,457
Federal Home Loan Bank stock		5,099		N/A		N/A		N/A		N/A
Loans held for sale		3,214		-		3,214		-		3,214
Loans, net		1,233,339		-		-		1,236,112		1,236,112
Accrued interest receivable		4,123		-		1,420		2,703		4,123
Derivative assets		1,915		-		1,915		-		1,915
Financial liabilities
Deposits	$	(1,587,585)	$	(1,286,733)	$	(302,701)	$	-	$	(1,589,434)
Short-term borrowings		(27,643)		-		(27,643)		-		(27,643)
Notes payable		(45,577)		-		(20,083)		(17,414)		(37,497)
Accrued interest payable		(693)		-		(680)		(13)		(693)
Standby letters of credit		(415)		-		-		(415)		(415)
Derivative liabilities		(1,915)		-		(1,915)		-		(1,915)

			Fair Value Measurements at
			December 31, 2012 Using:
	Carrying Value		Level 1		Level 2		Level 3		Total
Financial assets
Cash and cash equivalents	$	151,832	$	151,832	$	-	$	-	$	151,832
Interest-bearing deposits with banks		250		250		-		-		250
Securities available-for-sale		314,444		-		313,384		1,060		314,444
Securities held-to-maturity		66,843		-		68,504		-		68,504
Federal Home Loan Bank stock		5,099		N/A		N/A		N/A		N/A
Loans held for sale		16,324		-		16,324		-		16,324
Loans, net		1,178,841		-		-		1,182,273		1,182,273
Accrued interest receivable		4,259		-		1,447		2,812		4,259
Derivative assets		1,926		-		1,926		-		1,926
Financial liabilities
Deposits	$	(1,570,007)	$	(1,210,925)	$	(360,671)	$	-	$	(1,571,596)
Short-term borrowings		(41,408)		-		(41,408)		-		(41,408)
Notes payable		(48,721)		-		(22,392)		(17,192)		(39,584)
Accrued interest payable		(1,031)		-		(1,018)		(13)		(1,031)
Standby letters of credit		(271)		-		-		(271)		(271)
Derivative liabilities		(1,926)		-		(1,926)		-		(1,926)

The estimated fair value approximates carrying amounts for all items except those described below. The carrying amounts of cash and short-term instruments approximate fair values and are classified as either Level 1 or Level 2. Estimated fair value for both securities available-for-sale and held-to-maturity is as previously described for securities available-for-sale. It is not practicable to determine the fair value of Federal Home Loan Bank stock due to restrictions placed on its transferability. Fair values of loans, excluding loans held for sale, are estimated as set forth below:

The methods and assumptions, not previously presented, used to estimate fair values are described as follows:

Cash and cash equivalents: The carrying amounts of cash and cash equivalents approximate fair values and are classified as Level 1.

Interest-bearing deposits with banks: The carrying amount of interest-bearing deposits equivalents approximate fair value and are classified a Level 1.

Federal Home Loan Bank stock: It is not practicable to determine the fair value of Federal Home Loan Bank stock due to restrictions placed on its transferability.

Loans held for sale: The fair value of loans held for sale is estimated based upon binding contracts and quotes from third party investors resulting in a Level 2 classification.

Loans, net: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

Accrued interest receivable/payable: The carrying amounts of accrued interest approximate fair value resulting in a Level 1, Level 2 or Level 3 classification consistent with the classification of the asset/liability with which they are associated.

Deposits: The fair values disclosed for demand deposits (e.g., interest and non-interest checking, passbook savings and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amount) resulting in a Level 1 classification. The carrying amounts of variable rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date resulting in a Level 2 classification. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

Short-term borrowings: The carrying amounts of short-term borrowings, generally maturing within ninety days, approximate their fair values resulting in a Level 2 classification.

Notes payable: The carrying amounts of borrowings under repurchase agreements approximate their fair values resulting in a Level 2 classification. The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 2 classification. The fair values of the Company’s

subordinated debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 3 classification.

Standby letters of credit and off-balance sheet instruments: Fair values for off-balance sheet, credit-related financial instruments 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, which results in a level 3 classification. The fair value of commitments is not material. Estimated fair value of standby letters of credit are based on their current unearned fee balance. Estimated fair value for commitments to make loans and unused lines of credit are considered nominal.