Note 9 – Fair Value Disclosures and Reporting, the Fair Value Option and Fair Value Measurements

FASB’s standards on financial instruments, and on fair value measurements and disclosures, require all entities to disclose the estimated fair value of all financial instruments for which it is practicable to estimate fair values. In addition to those footnote disclosure requirements, FASB’s standard on investments requires that our debt securities, which are classified as available for sale, and our equity securities that have readily determinable fair values, be measured and reported at fair value in our statement of financial position. Certain impaired loans are also reported at fair value, as explained in greater detail below, and foreclosed assets are carried at the lower of cost or fair value. While the fair value option outlined under FASB’s standard on financial instruments permits companies to report certain other financial assets and liabilities at fair value, we have not elected the fair value option for any additional financial assets or liabilities.

Fair value measurements and disclosure standards also establish a framework for measuring fair value. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an 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. Further, they establish a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standards describe 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 observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a company’s own assumptions about the factors that market participants would likely consider in pricing an asset or liability.

Fair value estimates are made at a specific point in time based on relevant market data and information about the financial instruments. The estimates do not reflect any premium or discount that could result from offering the Company’s entire holdings of a particular financial instrument for sale at one time, nor do they attempt to estimate the value of anticipated future business related to the instruments. In addition, the tax ramifications related to realized gains and losses could have a significant effect on fair value estimates but have not been considered in any estimates. Because no market exists for a significant portion of the Company’s financial instruments, fair value disclosures are based on judgments regarding current economic conditions, risk characteristics of various financial instruments and other factors. The estimates are subjective and involve uncertainties and matters of significant judgment, and therefore cannot be determined with precision. Changes in assumptions could significantly affect the fair values presented. The following methods and assumptions were used by the Company to estimate the fair value of its financial instruments disclosed at June 30, 2012 and December 31, 2011:

Cash and cash equivalents and short-term borrowings: For cash and cash equivalents and short-term borrowings, the carrying amount is estimated to be fair value.

Investment securities: The fair values of investment securities are determined by obtaining quoted prices on nationally recognized securities exchanges or by matrix pricing, which is a mathematical technique used widely in the industry to value debt securities by relying on their relationship to other benchmark quoted securities when quoted prices for specific securities are not readily available.

Loans and leases: For variable-rate loans and leases that re-price frequently with no significant change in credit risk or interest rate spread, fair values are based on carrying values. Fair values for other loans and leases are estimated by discounting projected cash flows at interest rates being offered at each reporting date for loans and leases with similar terms, to borrowers of comparable creditworthiness. The carrying amount of accrued interest receivable approximates its fair value.

Loans held for sale: Since loans designated by the Company as available-for-sale are typically sold shortly after making the decision to sell them, realized gains or losses are usually recognized within the same period and fluctuations in fair values are thus not relevant for reporting purposes. If available-for-sale loans stay on our books for an extended period of time, the fair value of those loans is determined using quoted secondary-market prices.

Collateral dependent impaired loans: Impaired loans carried at fair value are those for which it is probable that the bank will be unable to collect all amounts due (including both interest and principal) according to the contractual terms of the original loan agreement, and the carrying value has been written down to the fair value of the loan. The carrying value is equivalent to the fair value of the collateral, net of expected disposition costs where applicable, for collateral-dependent loans.

Cash surrender value of life insurance policies: The fair values are based on net cash surrender values at each reporting date.

Investments in, and capital commitments to, limited partnerships: The fair values of our investments in WNC Institutional Tax Credit Fund Limited Partnerships and any other limited partnerships are estimated using quarterly indications of value provided by the general partner. The fair values of undisbursed capital commitments are assumed to be the same as their book values.

Other investments: Certain long-term investments for which no secondary market exists are carried at cost, and the carrying amount for those investments approximates their estimated fair value.

Deposits: Fair values for demand deposits and other non-maturity deposits are equal to the amount payable on demand at the reporting date, which is the carrying amount. Fair values for fixed-rate certificates of deposit are estimated using a cash flow analysis, discounted at interest rates being offered at each reporting date by the Bank for certificates with similar remaining maturities. The carrying amount of accrued interest payable approximates its fair value.

Short-term borrowings: The carrying amounts approximate fair values for federal funds purchased, overnight FHLB advances, borrowings under repurchase agreements, and other short-term borrowings maturing within ninety days of the reporting dates. Fair values of other short-term borrowings are estimated by discounting projected cash flows at the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

Long-term borrowings: The fair values of the Company’s long-term borrowings are estimated using projected cash flows discounted at the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

Subordinated debentures: The fair values of subordinated debentures are determined based on the current market value for like instruments of a similar maturity and structure.

Commitments to extend credit and letters of credit: If funded, the carrying amounts for currently unused commitments would approximate fair values for the newly created financial assets at the funding date. However, because of the high degree of uncertainty with regard to whether or not those commitments will ultimately be funded, fair values for loan commitments and letters of credit in their current undisbursed state cannot reasonably be estimated, and only notional values are disclosed in the table below.

Estimated fair values for the Company’s financial instruments at the periods noted are as follows:

Fair Value of Financial Instruments
(dollars in thousands, unaudited)	June 30, 2012
			Estimated Fair Value
	Carrying Amount		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Financial Assets:			(Dollars in thousands)
Cash and cash equivalents	$	48,926	$	48,926	$	-	$	-	$	48,926
Investment securities available for sale		422,196		1,809		420,387		-		422,196
Loans and leases, net		784,644		-		829,825		-		829,825
Collateral dependent impaired loans		19,980		-		15,212		307		15,519
Loans held-for-sale		250		250		-		-		250
Cash surrender value of life insurance policies		38,518		-		38,518		-		38,518
Other investments		6,406		-		6,406		-		6,406
Investment in limited partnership		10,622		-		10,622		-		10,622
Accrued interest receivable		5,177		-		5,177		-		5,177

Financial Liabilities:
Deposits:
Noninterest-bearing	$	327,224	$	327,224	$	-	$	-	$	327,224
Interest-bearing		822,311		-		822,756		-		822,756
Fed funds purchased and repurchase agreements		2,890		-		2,890		-		2,890
Short-term borrowings		24,640		-		24,640		-		24,640
Long-term borrowings		5,000		-		5,000		-		5,000
Subordinated debentures		30,928		-		12,229		-		12,229
Limited partnership capital commitment		1,185		-		1,185		-		1,185
Accrued interest payable		346		-		346		-		346

		Notional Amount
Off-balance-sheet financial instruments:
Commitments to extend credit	$	194,916
Standby letters of credit		11,321
Commercial lines of credit		8,982

	December 31, 2011
			Estimated Fair Value
	Carrying Amount		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Financial Assets:			(Dollars in thousands)
Cash and cash equivalents	$	63,036	$	63,036	$	-	$	-	$	63,036
Investment securities available for sale		406,471		1,347		405,124		-		406,471
Loans and leases, net		726,302		-		771,192		-		771,192
Collateral dependent impaired loans		14,627		-		11,016		285		11,301
Loans held-for-sale		1,354		1,354		-		-		1,354
Cash surrender value of life insurance policies		37,657		-		37,657		-		37,657
Other investments		7,040		-		7,040		-		7,040
Investment in limited partnership		9,927		-		9,927		-		9,927
Accrued interest receivable		5,368		-		5,368		-		5,368

Financial Liabilities:
Deposits:
Noninterest-bearing	$	300,045	$	300,045	$	-	$	-	$	300,045
Interest-bearing		786,223		-		702,270		-		702,270
Fed funds purchased and repurchase agreements		3,037		-		3,037		-		3,037
Short-term borrowings		17,120		-		17,120		-		17,120
Long-term borrowings		15,000		-		15,000		-		15,000
Subordinated debentures		30,928		-		12,262		-		12,262
Limited partnership capital commitment		353		-		353		-		353
Accrued interest payable		514		-		514		-		514

		Notional Amount
Off-balance-sheet financial instruments:
Commitments to extend credit	$	154,323
Standby letters of credit		11,113
Commercial lines of credit		8,991

For each financial asset category that was actually reported at fair value at June 30, 2012, the Company used the following methods and significant assumptions:

Investment Securities: The fair values of securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges or by matrix pricing, which is a mathematical technique used widely in the industry to value debt securities by relying on the their relationship to other benchmark quoted securities.

Impaired loans: Impaired loans carried at fair value are those for which it is probable that the bank will be unable to collect all amounts due (including both interest and principal) according to the contractual terms of the original loan agreement, and the carrying value has been written down to the fair value of the loan. The carrying value is equivalent to the fair value of the collateral, net of expected disposition costs where applicable, for collateral-dependent loans.

Foreclosed assets: Repossessed real estate (OREO) and other assets are carried at the lower of cost or fair value. Fair value is the appraised value less expected selling costs for OREO and some other assets such as mobile homes, and for all other assets fair value is represented by the estimated sales proceeds as determined using reasonably available sources. Foreclosed assets for which appraisals can be feasibly obtained are periodically measured for impairment using updated appraisals. Fair values for other foreclosed assets are adjusted as necessary, subsequent to a periodic re-evaluation of expected cash flows and the timing of resolution. If impairment is determined to exist, the book value of a foreclosed asset is immediately written down to its estimated impaired value through the income statement, thus the carrying amount is equal to the fair value and there is no valuation allowance.

Assets reported at fair value on a recurring basis are summarized below:

Fair Value Measurements - Recurring
(dollars in thousands, unaudited)
	Fair Value Measurements at June 30, 2012, Using

	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total		Realized Gain/(Loss)
Investment Securities
U.S. Government agencies	$	-	$	1,288	$	-	$	1,288	$	-
Obligations of states and
political subdivisions		-		80,769		-		80,769		-
U.S. Government agencies
collateralized by mortgage
obligations		-		338,330		-		338,330		-
Other Securities		1,809		-		-		1,809		-

Total available-for-sale securities	$	1,809	$	420,387	$	-	$	422,196	$	-

	Fair Value Measurements at December 31, 2011, Using

	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total		Realized Gain/(Loss)
Investment Securities
U.S. Government agencies	$	-	$	2,026	$	-	$	2,026	$	-
Obligations of states and								-
political subdivisions		-		71,340		-		71,340		-
U.S. Government agencies
collateralized by mortgage
obligations		-		331,758		-		331,758		-
Other Securities		1,347		-		-		1,347		(1,370	)

Total available-for-sale securities	$	1,347	$	405,124	$	-	$	406,471	$	(1,370	)

Assets reported at fair value on a nonrecurring basis are summarized below:

Fair Value Measurements - Nonrecurring
(dollars in thousands, unaudited)
	Fair Value Measurements at June 30, 2012, Using

	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Collateral dependent impaired loans	$	-	$	15,212	$	307	$	15,519
Foreclosed assets	$	-	$	14,423	$	-	$	14,423

	Fair Value Measurements at December 31, 2011, Using

	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Collateral dependent impaired loans	$	-	$	11,016	$	285	$	11,301
Foreclosed assets	$	-	$	14,777	$	587	$	15,364

The table above only includes impaired loan balances for which a specific reserve has been established or on which a write-down has been taken. Information on the Company’s total impaired loan balances, and specific loss reserves associated with those balances, is included in Note 11 below, and in Management’s Discussion and Analysis of Financial Condition and Results of Operation in the “Nonperforming Assets” and “Allowance for Loan and Lease Losses” sections.

The table below presents additional valuation information for impaired loan balances which are measured within Level 3 of the fair value hierarchy, as of June 30, 2012:

Quantitative Information about Level 3 Fair Value measurements

(dollars in thousands, unaudited)

Asset	Fair Value Amount	Valuation Technique	Unobservable Input	Range (Wtd Ave.)

Real Estate Secured loans	$ 307	Adjusted Appraised Value	Selling Costs ⁽¹⁾	15.00% - 25.00% (15.14%)

⁽¹⁾ Represents the range of estimated selling and closing costs that might be incurred through escrow at the time of sale.

The unobservable inputs are based on management’s best estimates of appropriate discounts in arriving at fair market value. Significant increases or decreases in any of those inputs could result in a significantly lower or higher fair value measurement. For example, a change in either direction of actual loss rates would have a directionally opposite change in the calculation of the fair value of impaired unsecured loans.