16. FAIR VALUE MEASUREMENTS

The Company follows ASC 820 Fair Value Measurements and Disclosures ("ASC 820") to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. This section clarifies that fair value of certain assets and liabilities is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between willing market participants.

ASC 820 specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company's market assumptions. The three levels of the fair value hierarchy under ASC 820 based on these two types of inputs are as follows:

 

The following describes the valuation techniques used by the Company to measure certain financial assets and liabilities recorded at fair value on a recurring basis in the financial statements.

Interest rate swap agreement used for interest rate risk management

Interest rate swaps are recorded at fair value on a recurring basis. The Company utilizes an interest rate swap agreement as part of the management of interest rate risk to modify the repricing characteristics of certain portions of the Company's interest-bearing assets and liabilities. The Company determines the fair value of its interest rate swap using externally developed pricing models based on market observable inputs and therefore classifies such valuation as Level 2. The Company has considered counterparty credit risk in the valuation of its interest rate swap assets and has considered its own credit risk in the valuation of its interest rate swap liabilities.

Securities available for sale

Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2). If the inputs used to provide the evaluation for certain securities are unobservable and/or there is little, if any, market activity then the security would fall to the lowest level of the hierarchy (Level 3). The carrying value of restricted Federal Reserve Bank and FHLB stock approximates fair value based on the redemption provisions of each entity and is therefore excluded from the following table.

 

The following table presents the balances of financial assets and liabilities measured at fair value on a recurring basis at December 31, 2011 and 2010 (dollars in thousands):

 

		Fair Value Measurements at December 31, 2011 using
		Quoted Prices in Active Markets for Identical Assets				Significant Other Observable Inputs				Significant Unobservable Inputs
		Level 1				Level 2				Level 3				Balance
ASSETS
Interest rate swap—loans		$	—			$	66			$	—			$	66
Securities available for sale:
U.S. government and agency securities			—				4,284				—				4,284
Obligations of states and political subdivisions			—				200,207				—				200,207
Corporate and other bonds			—				12,240				—				12,240
Mortgage-backed securities			—				400,318				—				400,318
Other securities			—				3,117				—				3,117
Total		$	—			$	620,232			$	—			$	620,232
LIABILITIES
Interest rate swap—loans		$	—			$	66			$	—			$	66
Cash flow hedge—trust			—				4,293				—				4,293
Total		$	—			$	4,359			$	—			$	4,359

 

		Fair Value Measurements at December 31, 2010 using
		Quoted Prices in Active Markets for Identical Assets				Significant Other Observable  Inputs				Significant Unobservable Inputs
		Level 1				Level 2				Level 3				Balance
ASSETS
Interest rate swap—loans		$	—			$	189			$	—			$	189
Securities available for sale:
U.S. government and agency securities			—				9,961				—				9,961
Obligations of states and political subdivisions			—				175,032				—				175,032
Corporate and other bonds			—				15,065				—				15,065
Mortgage-backed securities			—				344,038				—				344,038
Other securities			—				3,284				—				3,284
Total		$	—			$	547,569			$	—			$	547,569
LIABILITIES
Interest rate swap—loans		$	—			$	189			$	—			$	189
Cash flow hedge—trust			—				1,476				—				1,476
Total		$	—			$	1,665			$	—			$	1,665

Certain financial assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.

The following describes the valuation techniques used by the Company to measure certain assets recorded at fair value on a nonrecurring basis in the financial statements.

 

Loans held for sale

Loans held for sale are carried at the lower of cost or market value. These loans currently consist of residential loans originated for sale in the secondary market. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data which is not materially different than cost due to the short duration between origination and sale (Level 2). As such, the Company records any fair value adjustments on a nonrecurring basis. No nonrecurring fair value adjustments were recorded on loans held for sale during the years ended December 31, 2011 and 2010. Gains and losses on the sale of loans are recorded within income from the mortgage segment on the Consolidated Statements of Income.

Impaired loans

Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreements will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the Company's collateral is real estate. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser using observable market data (Level 2). However, if the collateral is a house or building in the process of construction or if an appraisal of the property is more than two years old, then a Level 3 valuation is considered to measure the fair value. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business's financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Impaired loans allocated to the allowance for loan losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income. At December 31, 2011, the Company's Level 3 loans consisted of nine relationships secured by residential real estate and lots of $13.9 million with a reserve of $1.1 million; four relationships secured by commercial real estate of $7.5 million and a reserve of $911,000; one relationship secured by land of $14.5 million with a reserve of $28,000; and one relationship secured by receivables of $1 million with a reserve $39,000. At December 31, 2010, the Company's Level 3 loans consisted of five relationships secured by commercial real estate of $5.2 million with a $492,000 valuation reserve; four relationships secured by residential real estate and lots of $3.6 million with a valuation reserve of $525,000; and two relationships secured by inventory, receivables or equipment of $305,000 with a $244,000 valuation reserve.

Other real estate owned

Fair values of other real estate owned are carried at the lower of carrying value or fair value less selling costs. Fair value is based upon independent market prices, appraised values of the collateral or management's estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the foreclosed asset as Level 2 valuation. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the foreclosed asset as Level 3 valuation. Total valuation expenses related to OREO properties for the years ended December 31, 2011 and 2010 were $707,000 and $43,000, respectively.

 

The following table summarizes the Company's financial assets that were measured at fair value on a nonrecurring basis at December 31, 2011 and 2010 (dollars in thousands):

 

		Fair Value Measurements at December 31, 2011 using
		Quoted Prices in Active Markets for Identical Assets				Significant Other Observable Inputs				Significant Unobservable Inputs
		Level 1				Level 2				Level 3				Balance
ASSETS
Loans held for sale		$	—			$	74,823			$	—			$	74,823
Impaired loans			—				28,525				34,898				63,423
Other real estate owned			—				—				32,263				32,263
Total		$	—			$	103,348			$	67,161			$	170,509

 

		Fair Value Measurements at December 31, 2010 using
		Quoted Prices in Active Markets for Identical Assets				Significant  Other Observable Inputs				Significant Unobservable Inputs
		Level 1				Level 2				Level 3				Balance
ASSETS
Loans held for sale		$	—			$	73,974			$	—			$	73,974
Impaired loans			—				59,992				7,895				67,887
Other real estate owned			—				—				36,122				36,122
Total		$	—			$	133,966			$	44,017			$	177,983

ASC 825, Financial Instruments requires disclosure about fair value of financial instruments for interim periods and excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.

Cash and cash equivalents

For those short-term instruments, the carrying amount is a reasonable estimate of fair value.

Loans

The fair value of performing loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Fair value for significant nonperforming loans is based on recent external appraisals. If appraisals are not available, estimated cash flows are discounted using a rate commensurate with the risk associated with the estimated cash flows.

Deposits

The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair value of certificates of deposit is estimated by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities.

Borrowings

The carrying value of short-term borrowings is a reasonable estimate of fair value. The fair value of long-term borrowings is estimated based on interest rates currently available for debt with similar terms and remaining maturities.

Accrued interest

The carrying amounts of accrued interest approximate fair value.

 

Commitments to extend credit and standby letters of credit

The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date. At December 31, 2011 and 2010, the fair value of loan commitments and standby letters of credit was immaterial.

The carrying values and estimated fair values of the Company's financial instruments as of December 31, 2011 and 2010 are as follows (dollars in thousands):

 

		December 31, 2011								December 31, 2010
		Carrying				Fair				Carrying				Fair
		Amount				Value				Amount				Value
Financial assets:
Cash and cash equivalents		$	96,659			$	96,659			$	61,153			$	61,153
Securities available for sale			640,827				640,827				572,441				572,441
Loans held for sale			74,823				74,823				73,974				73,974
Net loans			2,779,113				2,794,914				2,798,847				2,811,023
Interest rate swap—loans			66				66				189				189
Accrued interest receivable			16,626				16,626				15,980				15,980
Financial liabilities:
Deposits		$	3,175,105			$	3,191,256			$	3,070,059			$	3,078,130
Borrowings			278,686				277,374				308,169				314,684
Accrued interest payable			1,865				1,865				2,182				2,182
Cash flow hedge—trust			4,293				4,293				1,476				1,476
Interest rate swap—loans			66				66				189				189

The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of the Company's financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company's overall interest rate risk.