Note 16 - Fair Value of Financial Instruments

Fair values of financial instruments are management’s estimate of the values at which the instruments could be exchanged in a transaction between willing parties. These estimates are subjective and may vary significantly from amounts that would be realized in actual transactions. In addition, other significant assets are not considered financial assets including deferred tax assets, premises, equipment and intangibles. Further, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on the fair value estimates and have not been considered in any of the estimates.

The following assumptions and methods were used in estimating the fair value for financial instruments:

Cash and Cash Equivalents

The carrying amounts reported in the balance sheet for cash, cash equivalents and federal funds sold approximate their fair values. Also included in this line item are the carrying amounts of interest-bearing deposits maturing within ninety days which approximate their fair values. Fair values of other interest-bearing deposits are estimated using discounted cash flow analyses based on current rates for similar types of deposits.

Securities and Other Securities

Fair values for securities, excluding Federal Home Loan Bank stock, are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. The carrying value of Federal Home Loan Bank stock approximates fair value based on the redemption provisions of the Federal Home Loan Bank. The Bank acquired stock in the Federal Home Loan Bank of Indianapolis at a cost of $231.4 thousand through its acquisition of Knisely Bank. There were no borrowings at the time of acquisition associated with Federal Home Loan Bank of Indianapolis. The Bank had requested Federal Home Loan Bank of Indianapolis to buy back its stock when the acquisition of Knisely was completed in January 2008. A five year waiting period was imposed and the stock was ultimately redeemed in full during 2013. An early redemption of 42,000 shares occurred in 2010 with another 41,000 shares redeemed in 2011. These decreased the aggregate holdings to a value of $148.4 thousand which was redeemed in 2013.

Loans

For those variable-rate loans that re-price frequently, and with no significant change in credit risk, fair values are based on carrying values. The fair values of the fixed rate and all other loans are estimated using discounted cash flow analysis, using interest rates currently being offered for loans with similar terms to borrowers with similar credit quality.

Deposits

The fair values disclosed for deposits with no defined maturities are equal to their carrying amounts, which represent the amount payable on demand. The carrying amounts for variable-rate, fixed-term money market accounts and certificates of deposit approximate their fair value at the reporting date. Fair value for fixed-rate certificates of deposit are estimated using a discounted cash flow analysis that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.

Short-Term Borrowings

The carrying value of short-term borrowings approximates fair values.

FHLB Advances

Fair values or FHLB advances are estimated using discounted cash flow analysis based on the Company’s current incremental borrowing rates for similar types or borrowing arrangements.

Accrued Interest Receivable and Payable

The carrying amounts of accrued interest approximate fair values.

Dividends Payable

The carrying amounts of dividends payable approximate their fair values and are generally paid within forty days of declaration.

Off Balance Sheet Financial 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.

[Remainder of this page intentionally left blank.]

The estimated fair values, and related carrying or notional amounts, for on and off-balance sheet financial instruments as of December 31, 2013 and 2012, are reflected below. The aggregate fair values in the table below do not represent the total market value of the Bank’s assets and liabilities. The table excludes the following:

Bank Premises and Equipment, Goodwill, Mortgage Servicing Rights, Other Real Estate Owned, Other Assets, Other Liabilities and Accrued Expenses.


	(In Thousands)
	December 2013										December 2012
	Carrying		Fair								Carrying		Fair
	Amount		Value		Level 1		Level 2		Level 3		Amount		Value		Level 1		Level 2		Level 3
Financial Assets:
Cash and Cash Equivalents	$	19,263	$	19,263	$	19,263	$	—	$	—	$	44,092	$	44,092	$	44,092	$	—	$	—
Securities - available for sale		324,509		324,509		25,272		288,891		10,346		355,905		355,905		10,568		328,929		16,408
Other Securities		4,216		4,216		—		—		4,216		4,365		4,365		—		—		4,365
Loans, net		570,919		579,992		—		—		579,992		496,178		501,260		—		—		501,260
Interest receivable		3,694		3,694		—		—		3,694		3,603		3,603		—		—		3,603

Total Assets	$	922,601	$	931,674	$	44,535	$	288,891	$	598,248	$	904,143	$	909,225	$	54,660	$	328,929	$	525,636

Financial Liabilities:
Interest bearing Deposits	$	429,652	$	429,750	$	—	$	—	$	429,750	$	389,779	$	390,066	$	—	$	—	$	390,066
Non-interest bearing Deposits		110,452		111,239		—		111,239		—		103,966		104,529		—		104,529		—
Time Deposits		236,360		236,027		—		—		236,027		269,507		272,591		—		—		272,591

Total Deposits	$	776,464	$	777,016	$	—	$	111,239	$	665,777	$	763,252	$	767,186	$	—	$	104,529	$	662,657
Short-term debt		69,756		69,756		—		—		69,756		51,312		51,312		—		—		51,312
Federal Home Loan Bank advances		4,500		4,570		—		—		4,570		11,600		11,012		—		—		11,012
Interest payable		223		223		—		—		223		288		288		—		—		288
Dividends payable		967		967		—		967		—		931		931		—		931		—

Total Liabilities	$	851,910	$	852,532	$	—	$	112,206	$	740,326	$	827,383	$	830,729	$	—	$	105,460	$	725,269

Fair Value Measurements

The following table presents information about the Company’s assets and liabilities measured at fair value on a recurring basis at December 31, 2013 and 2012, and the valuation techniques used by the Company to determine those fair values.

In general, fair values determined by Level 1 inputs use quoted prices in active markets for identical assets or liabilities in active markets that the Company has the ability to access.

Available-for-sale securities - When quoted prices are available in an active market, securities are valued using the quoted price and are classified as Level 1. The quoted prices are not adjusted.

Fair values determined by Level 2 inputs use other inputs that are observable, either directly or indirectly. These Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals.

Available-for-sale securities classified as Level 2 are valued using the prices obtained from an independent pricing service. The prices are not adjusted. Securities of obligations of state and political subdivisions are valued using a type of matrix, or grid, pricing in which securities are benchmarked against the treasury rate based on credit rating. Substantially all assumptions used by the independent pricing service are observable in the marketplace, can be derived from observable data, or are supported by observable levels at which transactions are executed in the marketplace.

Level 3 inputs are unobservable inputs, including inputs that are available in situations where there is little, if any, market activity for the related asset or liability. The Bank holds some local municipals that the Bank evaluates based on the credit strength of the underlying project such as hospital or retirement housing. The fair value is determined by valuing similar credit payment streams at similar rates.

In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest level input that is significant to the valuation. The Company’s assessment of the significance of particular inputs to these fair value measurements requires judgment and considers factors specific to each asset.

The following summarizes financial assets measured at fair value on a recurring basis as of December 31, 2013 and December 31, 2012 segregated by level or the valuation inputs within the fair value hierarchy utilized to measure fair value:


($ in Thousands)	Quoted Prices in Active		Significant		Significant
	Active Markets		Observable		Observable
	for Identical		Inputs		Inputs
December 31, 2013	Assets (Level 1)		(Level 2)		(Level 3)
Assets-(Securities Available for Sale)
U.S. Treasury	$	25,272	$	—	$	—
U.S. Government agency		—		172,972		—
Mortgage-backed securities		—		44,792		—
State and local governments		—		71,127		10,346

Total Securities Available for Sale	$	25,272	$	288,891	$	10,346


($ in Thousands)	Quoted Prices in Active		Significant		Significant
	Active Markets		Observable		Observable
	for Identical		Inputs		Inputs
December 31, 2012	Assets (Level 1)		(Level 2)		(Level 3)
Assets-(Securities Available for Sale)
U.S. Treasury	$	10,568	$	—	$	—
U.S. Government agency		—		220,200		—
Mortgage-backed securities		—		53,006		—
State and local governments		—		55,723		16,408

Total Securities Available for Sale	$	10,568	$	328,929	$	16,408

Most of the Company’s available for sale securities, including any bonds issued by local municipalities, have CUSIP numbers or have similar characteristics of those in the municipal markets, making them marketable and comparable as Level 2.

The Company also has assets that, under certain conditions, are subject to measurement at fair value on a non-recurring basis. At December 31, 2013 and 2012, such assets consist primarily of impaired loans. Impaired loans categorized as Level 3 assets consist of non-homogeneous loans that are considered impaired. The Company estimates the fair value of the loans based on the present value of expected future cash flows using management’s best estimate of key assumptions. These assumptions include future payment ability, timing of payment streams, and estimated realizable values of available collateral (typically based on outside appraisals).

At December 31, 2013 and 2012, impaired loans categorized as Level 3 were $1.9 and $3.7 million, respectively. The specific allocation for impaired loans was $516.1 thousand as of December 31, 2013 and $864.9 thousand as of December 31, 2012, respectively, which are accounted for in the allowance for loan losses (see Note 4).

Other real estate is reported at the lower of either the fair value of the real estate, minus the estimated costs to sell the asset, or the cost of the asset. The determination of the fair value of the real estate relies primarily on appraisals from third parties. If the fair value of the real estate, minus the estimated costs to sell the asset, is less than the asset’s cost, the deficiency is recognized as a valuation allowance against the asset through a charge to expense. The valuation allowance is therefore increased or decreased, through charges or credits to expense, for changes in the asset’s fair value or estimated selling costs.

The following table presents impaired loans and other real estate owned as recorded at fair value:


	Assets Measured at Fair Value on a Nonrecurring Basis at December 31, 2013
	Quoted Prices in Active								Change in
($ in Thousands)			Markets for		Significant		Significant		fair value for
	Balance at		Identical		Observable Inputs		Unobservable Inputs		twelve-month period
	December 31, 2013		Assets (Level 1)		(Level 2)		(Level 3)		ended Dec. 31, 2013
Impaired loans	$	1,924	$	—	$	—	$	1,924	$	(525	)
Other real estate owned - residential mortgages		964		—		—		964		—
Other real estate owned - commercial		1,127		—		—		1,127		(64	)

Total change in fair value									$	(589	)


	Assets Measured at Fair Value on a Nonrecurring Basis at December 31, 2012
			Quoted Prices in Active						Change in
($ in Thousands)			Markets for		Significant		Significant		fair value for
	Balance at		Identical		Observable Inputs		Unobservable Inputs		twelve-month period
	December 31, 2012		Assets (Level 1)		(Level 2)		(Level 3)		ended Dec. 31, 2012
Impaired loans	$	3,726	$	—	$	—	$	3,726	$	(820	)
Other real estate owned - residential mortgages		783		—		—		783		(62	)
Other real estate owned - commercial		1,526		—		—		1,526		(214	)

Total change in fair value									$	(1,096	)

The Company also has other assets, which under certain conditions, are subject to measurement at fair value. These assets include loans held for sale, bank owned life insurance, and mortgage servicing rights. The Company estimated the fair values of these assets utilizing Level 3 inputs, including, the discounted present value of expected future cash flows. At December 31, 2013, the Company estimates that there is no impairment of these assets and therefore, no impairment charge to other expense was required to adjust these assets to their estimated fair values.