6.	Fair Value of Financial Instruments and Fair Value Measurements

The Company follows the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 820 “Fair Value Measurements and Disclosures,” which defines fair value, establishes a framework for measuring fair value and expands the disclosures about fair value measurements. ASC Topic 820-10-55 requires the use of a hierarchy of fair value techniques based upon whether the inputs to those fair values reflect assumptions other market participants would use based upon market data obtained from independent sources or reflect the Company’s own assumptions of market participant valuation. The Company applies FASB ASC 820 to certain nonfinancial assets and liabilities, which include foreclosed real estate, long-lived assets, goodwill, mortgage servicing rights and core deposit premium, which are recorded at fair value only upon impairment. The fair value hierarchy is 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 for similar assets in active markets or quoted prices that contain observable inputs such as yield curves, volatilities, prepayment speeds and other inputs derived from market data.

• Level 3: Quoted prices in markets that are not active or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable.

Fair value estimates of the Company’s financial instruments as of March 31, 2014 and December 31, 2013, including methods and assumptions utilized, are set forth below:

(Dollars in thousands)	As of March 31,				As of December 31,
	2014				2013
	Carrying		Estimated		Carrying		Estimated
	amount		fair value		amount		fair value
Financial assets:
Cash and cash equivalents	$	26,337	$	26,337	$	29,735	$	29,735
Investment securities:
Available-for-sale		301,892		301,892		300,246		300,246
Other securities		4,660		4,660		5,271		5,271
Loans, net		411,551		418,241		414,016		420,475
Loans held for sale, net		9,247		9,247		7,864		7,864
Mortgage servicing rights		2,321		3,381		2,377		3,491
Derivative financial instruments		462		462		265		265
Accrued interest receivable		3,391		3,391		2,581		2,581

Financial liabilities:
Non-maturity deposits	$	497,267	$	497,267	$	501,291	$	501,291
Time deposits		180,915		180,782		186,195		186,222
FHLB borrowings		35,680		37,981		35,689		38,087
Other borrowings		35,863		32,913		33,055		29,351
Derivative financial instruments		47		47		78		78
Accrued interest payable		316		316		335		335

Methods and Assumptions Utilized

The carrying amount of cash and cash equivalents is considered to approximate fair value.

The Company’s investment securities classified as available-for-sale include U.S. federal agency securities, municipal obligations, mortgage-backed securities, certificates of deposits and common stocks. Quoted exchange prices are available for the Company’s U.S treasury securities and common stock investments, which are classified as Level 1. U.S. federal agency securities and mortgage-backed obligations are priced utilizing industry-standard models that consider various assumptions, including time value, yield curves, volatility factors, prepayment speeds, default rates, loss severity, current market and contractual prices for the underlying financial instruments, as well as other relevant economic measures. Substantially all of these assumptions 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. These measurements are classified as Level 2. Municipal securities are valued using a type of matrix, or grid, pricing in which securities are benchmarked against U.S. treasury rates based on credit rating. These model and matrix measurements are classified as Level 2 in the fair value hierarchy. The Company’s investments in FDIC-insured, fixed-rate certificates of deposits are valued using a net present value model that discounts the future cash flows at the current market rates and are classified as Level 2.

The Company’s other investment securities include investments in FHLB and FRB stock, which are held for regulatory purposes. These investments generally have restrictions on the sale and/or liquidation of stock and the carrying value is approximately equal to fair value. Fair value measurements for these securities are classified as Level 3 based on the restrictions on sale and/or liquidation and related credit risk.

The estimated fair value of the Company’s loan portfolio is based on the segregation of loans by collateral type, interest terms, and maturities. The fair value is estimated based on discounting scheduled and estimated cash flows through maturity using an appropriate risk-adjusted yield curve to approximate current interest rates for each category. No adjustment was made to the interest rates for changes in credit risk of performing loans where there are no known credit concerns. Management segregates loans in appropriate risk categories. Management believes that the risk factor embedded in the interest rates along with the allowance for loan losses applicable to the performing loan portfolio results in a fair valuation of such loans. The fair values of impaired loans are generally based on market prices for similar assets determined through independent appraisals or discounted values of independent appraisals and brokers’ opinions of value. This method of estimating fair value does not incorporate the exit-price concept of fair value prescribed by ASC Topic 820.

Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated fair value, determined on an aggregate basis. The mortgage loan valuations are based on quoted secondary market prices for similar loans and are classified as Level 2.

The Company measures its mortgage servicing rights at the lower of amortized cost or fair value. Periodic impairment assessments are performed based on fair value estimates at the reporting date. The fair value of mortgage servicing rights are estimated based on a valuation model which calculates the present value of estimated future cash flows associated with servicing the underlying loans. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimated prepayment speeds, market discount rates, cost to service, and other servicing income, including late fees. The fair value measurements are classified as Level 3.

The carrying amount of accrued interest receivable and payable are considered to approximate fair value.

The estimated fair value of deposits with no stated maturity, such as non-interest-bearing demand deposits, savings, money market accounts, and NOW accounts, is equal to the amount payable on demand. The fair value of interest-bearing time deposits is based on the discounted value of contractual cash flows of such deposits. The discount rate is tied to the FHLB yield curve plus an appropriate servicing spread. Fair value measurements based on discounted cash flows are classified as Level 2. These fair values do not incorporate the value of core deposit intangibles which may be associated with the deposit base.

The fair value of advances from the FHLB and other borrowings is estimated using current yield curves for similar borrowings adjusted for the Company’s current credit spread and classified as Level 2.

The Company’s derivative financial instruments consist of interest rate lock commitments and corresponding forward sales contracts on mortgage loans held for sale. The fair values of these derivatives are based on quoted prices for similar loans in the secondary market. The market prices are adjusted by a factor, based on the Company’s historical data and its judgment about future economic trends, which considers the likelihood that a commitment will ultimately result in a closed loan. These instruments are classified as Level 2. The amounts are included in other assets or other liabilities on the consolidated balance sheets and gains on sale of loans, net in the consolidated statements of earnings.

The Company also includes interest rate swaps in derivative financial instruments. The fair values of these derivatives are based on valuation models that utilize readily observable market inputs. These instruments are classified as Level 2. The amounts are included in other assets or other liabilities on the consolidated balance sheets.

Off-Balance-Sheet Financial Instruments

The fair value of letters of credit and commitments to extend credit is based on the fees currently charged to enter into similar agreements. The aggregate of these fees is not material.

Transfers

The Company did not transfer any assets or liabilities among levels during the three months ended March 31, 2014 or during the year ended December 31, 2013.

Limitations

Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instruments. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future 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. Fair value estimates are based on existing balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments.

Valuation Methods for Instruments Measured at Fair Value on a Recurring Basis

The following table represents the Company’s financial instruments that are measured at fair value on a recurring basis at March 31, 2014 and December 31, 2013, allocated to the appropriate fair value hierarchy:

(Dollars in thousands)			As of March 31, 2014
			Fair value hierarchy
	Total		Level 1		Level 2		Level 3
Assets:
Available-for-sale securities
U. S. treasury securities	$	500	$	500	$	-	$	-
U. S. federal agency obligations		18,768		-		18,768		-
Municipal obligations, tax exempt		92,209		-		92,209		-
Municipal obligations, taxable		53,595		-		53,595		-
Mortgage-backed securities		127,298		-		127,298		-
Common stocks		1,099		1,099		-		-
Certificates of deposit		8,423		-		8,423		-
Other securities		4,660		-		-		4,660
Derivative financial instruments		462		-		462		-
Liabilities:
Derivative financial instruments	$	47	$	-	$	47	$	-

(Dollars in thousands)			As of December 31, 2013
			Fair value hierarchy
	Total		Level 1		Level 2		Level 3
Assets:
Available-for-sale securities
U. S. treasury securities	$	500	$	500	$	-	$	-
U. S. federal agency obligations		19,643		-		19,643		-
Municipal obligations, tax exempt		91,793		-		91,793		-
Municipal obligations, taxable		52,472		-		52,472		-
Mortgage-backed securities		125,593		-		125,593		-
Common stocks		1,103		1,103		-		-
Certificates of deposit		9,142		-		9,142		-
Other securities		5,271		-		-		5,271
Derivative financial instruments		265		-		265		-
Liabilities:
Derivative financial instruments	$	187	$	-	$	187	$	-

Changes in the fair value of available-for-sale securities are included in other comprehensive income to the extent the changes are not considered other-than-temporary impairments. Other-than-temporary impairment tests are performed on a quarterly basis and any decline in the fair value of an individual security below its cost that is deemed to be other-than-temporary results in a write-down of that security’s cost basis.

Valuation Methods for Instruments Measured at Fair Value on a Nonrecurring Basis

The Company does not value its loan portfolio at fair value. However, adjustments are recorded on certain loans to reflect the impaired value on the underlying collateral. Collateral values are reviewed on a loan-by-loan basis through independent appraisals. Appraised values may be discounted based on management’s historical knowledge, changes in market conditions and/or management’s expertise and knowledge of the client and the client’s business. Because many of these inputs are unobservable, the valuations are classified as Level 3. The carrying value of the Company’s impaired loans was $15.4 million and $16.8 million, with an allocated allowance of $1.0 million and $951,000, at March 31, 2014 and December 31, 2013, respectively.

The Company’s measure of its goodwill is based on the Company’s market capitalization with appropriate control premiums and valuation multiples as compared to recent similar financial industry acquisition multiples to estimate the fair value of the Company’s single reporting unit. The fair value measurements are classified as Level 3. Core deposit intangibles are recognized when core deposits are acquired, using valuation techniques which calculate the present value of the estimated net cost savings relative to the Company’s alternative costs of funds over the expected remaining economic life of the deposits. Subsequent evaluations are made when facts or circumstances indicate potential impairment may have occurred. The models incorporate market discount rates, estimated average core deposit lives and alternative funding rates. The fair value measurements are classified as Level 3.

Real estate owned includes assets acquired through, or in lieu of, foreclosure and land previously acquired for expansion. Real estate owned is initially recorded at the fair value of the collateral less estimated selling costs. Subsequent valuations are updated periodically and are based upon independent appraisals, third party price opinions or internal pricing models and are classified as Level 3.

The following table represents the Company’s financial instruments that are measured at fair value on a non-recurring basis as of March 31, 2014 and December 31, 2013 allocated to the appropriate fair value hierarchy:

(Dollars in thousands)
			As of March 31, 2014						Total
			Fair value hierarchy						(losses)/
	Total		Level 1		Level 2		Level 3		gains
Assets:
Impaired loans	$	14,372	$	-	$	-	$	14,372	$	(104)
Loans held for sale, net		9,247		-		9,247		-		(22)
Mortgage servicing rights		3,381		-		-		3,381		-
Real estate owned, net	$	245	$	-	$	-	$	245	$	-

			As of December 31, 2013						Total
			Fair value hierarchy						(losses)/
	Total		Level 1		Level 2		Level 3		gains
Assets:
Impaired loans	$	15,805	$	-	$	-	$	15,805	$	(564)
Loans held for sale, net		7,864		-		7,864		-		(41)
Mortgage servicing rights		3,491		-		-		3,491		212
Real estate owned, net	$	400	$	-	$	-	$	400	$	(135)