NOTE 3 — FAIR VALUE MEASUREMENTS

Fair Value Measurements

FASB ASU 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (Topic 820),” amends existing guidance regarding the highest and best use and valuation premise by clarifying these concepts are only applicable to measuring the fair value of nonfinancial assets. FASB ASU 2011-4 also clarifies that the fair value measurement of financial assets and financial liabilities which have offsetting market risks or counterparty credit risks that are managed on a portfolio basis, when several criteria are met, can be measured at the net risk position. Additional disclosures about Level 3 fair value measurements are required including a quantitative disclosure of the unobservable inputs and assumptions used in the measurement, a description of the valuation process in place, and discussion of the sensitivity of fair value changes in unobservable inputs and interrelationships about those inputs as well as disclosure of the level of the fair value of items that are not measured at fair value in the financial statements but disclosure of fair value is required. The provisions of FASB ASU 2011-04 are effective for the Company’s reporting period beginning after December 15, 2011 and should be applied prospectively. Our adoption of FASB ASU 2011-04 did not have a significant impact on our financial condition or result of operations.

FASB ASC 820, “Fair Value Measurements and Disclosures,” defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. It also establishes a fair value hierarchy about the assumptions used to measure fair value and clarifies assumptions about risk and the effect of a restriction on the sale or use of an asset. FASB ASC 820 defines fair value 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. FASB ASC 820 also establishes a three-level 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 three levels of inputs that may be used to measure fair value are defined as follows:

 

•    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, 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 assumptions that market participants would use in pricing an asset or liability.

FASB ASC 825, “Financial Instruments,” provides additional guidance for estimating fair value in accordance with FASB ASC 820 when the volume and level of activity for the asset or liability have significantly decreased. It also includes guidance on identifying circumstances that indicate a transaction is not orderly. FASB ASC 825 emphasizes that even if there has been a significant decrease in the volume and level of activity for the asset or liability and regardless of the valuation technique(s) used, the objective of a fair value measurement remains the same. FASB ASC 825 also requires additional disclosures relating to fair value measurement inputs and valuation techniques, as well as disclosures of all debt and equity investment securities by major security types rather than by major security categories that should be based on the nature and risks of the securities during both interim and annual periods. FASB ASC 825 became effective for interim and annual reporting periods ending after June 15, 2009 and did not require disclosures for earlier periods presented for comparative purposes at initial adoption. In periods after initial adoption, FASB ASC 825 requires comparative disclosures only for periods ending after initial adoption. We adopted FASB ASC 825 in the second quarter of 2009. Fair value is used on a recurring basis for certain assets and liabilities in which fair value is the primary basis of accounting. Additionally, fair value is used on a non-recurring basis to evaluate assets or liabilities for impairment or for disclosure purposes in accordance with FASB ASC 825 “Financial Instruments.” The adoption of FASB ASC 825 resulted in additional disclosures that are presented in “Note 4 – Investment Securities.”

We record investment securities available for sale at fair value on a recurring basis. Certain other assets, such as loans held for sale, impaired loans, other real estate owned, and other intangible assets, are recorded at fair value on a non-recurring basis. Non-recurring fair value measurements typically involve assets that are periodically evaluated for impairment and for which any impairment is recorded in the period in which the re-measurement is performed.

We used the following methods and significant assumptions to estimate fair value:

Investment Securities Available for Sale – The fair values of investment securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges. If quoted prices are not available, fair values are measured using matrix pricing, which is a mathematical technique used widely 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, or other model-based valuation techniques requiring observable inputs other than quoted prices such as yield curve, prepayment speeds, and default rates. Level 1 investment securities include U.S. government and agency debentures and equity securities that are traded on an active exchange or by dealers or brokers in active over-the-counter markets. The fair value of these securities is determined by quoted prices on an active exchange or over-the-counter market. Level 2 investment securities primarily include mortgage-backed securities, municipal bonds, collateralized mortgage obligations, and asset-backed securities. In determining the fair value of the securities categorized as Level 2, we obtain reports from nationally recognized broker-dealers detailing the fair value of each investment security held as of each reporting date. The broker-dealers use prices obtained from nationally recognized pricing services to value our fixed income securities. The fair value of the municipal bonds is determined based on a proprietary model maintained by the broker-dealers. We review the prices obtained for reasonableness based on our understanding of the marketplace, and also consider any credit issues related to the bonds. As we have not made any adjustments to the market quotes provided to us and as they are based on observable market data, they have been categorized as Level 2 within the fair value hierarchy. Level 3 investment securities are instruments that are not traded in the market. As such, no observable market data for the instrument is available, which necessitates the use of significant unobservable inputs. As of December 31, 2012, we had a zero coupon tax credit municipal bond of $779,000. This bond was recorded at estimated fair value using a discounted cash flow method, and was measured on a recurring basis with Level 3 inputs. Key assumptions used in measuring the fair value of the tax credit bond as of December 31 were discount rate and cash flows. The discount rate was derived from the term structure of Bank Qualified (“BQ”) “A-” rated municipal bonds, as the tax credit bond’s guarantee had the similar credit strength. The contractual future cash flows were the tax credits to be received for a remaining life of 2.23 years. Even if the discount rate is adjusted down to the term structure of BQ “BBB-” rating municipal bonds, the tax credit bond’s value would decline by 2%. We do not anticipate a significant deterioration of the tax credit bond’s credit quality. Management reviews the discount rate on an ongoing basis based on current market rates.

SBA Loans Held for Sale – Small Business Administration (“SBA”) loans held for sale are carried at the lower of cost or fair value. As of December 31, 2012 and 2011, we had $7.8 million and $5.1 million of SBA loans held for sale, respectively. Management obtains quotes, bids or pricing indication sheets on all or part of these loans directly from the purchasing financial institutions. Premiums received or to be received on the quotes, bids or pricing indication sheets are indicative of the fact that cost is lower than fair value. At December 31, 2012 and 2011, the entire balance of SBA loans held for sale was recorded at its cost. We record SBA loans held for sale on a nonrecurring basis with Level 2 inputs.

Non-Performing Loans Held for Sale – We reclassify certain non-performing loans as held-for-sale when we decide to sell those loans. The fair value of non-performing loans held for sale is generally based upon the quotes, bids or sales contract prices which approximate their fair value. Non-performing loans held for sale are recorded at estimated fair value less anticipated liquidation cost. As of December 31, 2012 and 2011, we had $484,000 and $15.0 million of non-performing loans held for sale, respectively, which are measured on a nonrecurring basis with Level 3 inputs.

Stock Warrants — The Company followed the guidance of FASB ASC Topic 815- 40, “Derivatives and Hedging – Contracts in Entity’s Own Stock” (“ASC 815- 40”), which establishes a framework for determining whether certain freestanding and embedded instruments are indexed to a company’s own stock for purposes of evaluation of the accounting for such instruments under existing accounting literature. Under GAAP, the issuer is required to measure the fair value of the equity instruments in the transaction as of earlier of i) the date at which a commitment for performance by the counterparty to earn the equity instruments is reached or ii) the date at which the counterparty’s performance is complete. The fair value of the warrants was recorded as a liability and a cost of equity, which was determined by the Black-Scholes option pricing modeling and was measured on a recurring basis with Level 3 inputs.

 

Assets and Liabilities Measured at Fair Value on a Recurring Basis

There were no transfers of assets between Level 1 and Level 2 of the fair value hierarchy for the year ended December 31, 2012. As of December 31, 2012 and 2011, assets and liabilities measured at fair value on a recurring basis are as follows:

 

		Level 1				Level 2				Level 3
		Quoted Prices in Active Markets For Identical Assets				Significant Observable Inputs With No Active Market With Identical Characteristics				Significant Unobservable Inputs				Balance
		(In Thousands)
December 31, 2012:
ASSETS:
Debt Securities Available for Sale:
Mortgage-Backed Securities		$	—			$	160,326			$	—			$	160,326
Collateralized Mortgage Obligations			—				100,487				—				100,487
U.S. Government Agency Securities			93,118				—				—				93,118
Municipal Bonds-Tax Exempt			—				12,033				779				12,812
Municipal Bonds-Taxable			—				46,142				—				46,142
Corporate Bonds			—				20,400				—				20,400
SBA Loan Pools Securities			—				14,026				—				14,026
Other Securities			—				3,357				—				3,357
Total Debt Securities Available for Sale			93,118				356,771				779				450,668
Equity Securities Available for Sale:
Financial Services Industry			392				—				—				392
Total Equity Securities Available for Sale			392				—				—				392
Total Securities Available for Sale		$	93,510			$	356,771			$	779			$	451,060
LIABILITIES:
Stock Warrants		$	—			$	—			$	906			$	906
December 31, 2011:
ASSETS:
Debt Securities Available for Sale:
Mortgage-Backed Securities		$	—			$	113,005			$	—			$	113,005
Collateralized Mortgage Obligations			—				162,837				—				162,837
U.S. Government Agency Securities			72,548				—				—				72,548
Municipal Bonds-Tax Exempt			—				3,482				—				3,482
Municipal Bonds-Taxable			—				6,138				—				6,138
Corporate Bonds			—				19,836				—				19,836
Other Securities			—				3,335				—				3,335
Total Debt Securities Available for Sale			72,548				308,633				—				381,181
Equity Securities Available for Sale:
Financial Services Industry			681				—				—				681
Total Equity Securities Available for Sale			681				—				—				681
Total Securities Available for Sale		$	73,229			$	308,633			$	—			$	381,862
LIABILITIES:
Stock Warrants		$	—			$	—			$	883			$	883

 

The table below presents a reconciliation and income statement classification of gains and losses for all assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the year ended December 31, 2012:

 

		Beginning Balance as of January 1, 2012				Purchase, Issuances, Sales and Settlement				Realized Gains or Losses In Earnings				Unrealized Gains or Losses In Other Comprehensive Income				Ending Balance as of December 31, 2012
		(In Thousands)
ASSETS:
Municipal Bonds-Tax Exempt (1)		$	—			$	698			$	—			$	81			$	779
LIABILITIES:
Stock Warrants (2)		$	883			$	—			$	23			$	—			$	906

 

		Beginning Balance as of January 1, 2011				Purchase, Issuances, Sales and Settlement				Realized Gains or Losses In Earnings				Unrealized Gains or Losses In Other Comprehensive Income				Ending Balance as of December 31, 2011
LIABILITIES:
Stock Warrants (2)		$	1,600			$	—			$	(717	)		$	—			$	883

 

(1)

Reflects a zero coupon tax credit municipal bond that was previously classified as a held-to-maturity security, which was reclassified as an available-for-sale security during the year ended December 31, 2012. As the Company was not able to obtain a price from independent external pricing service providers, the discounted cash flow method was used to determine its fair value. The bond carried a par value of $700,000 and an amortized value of $698,000 with a remaining life of 2.2 years at December 31, 2012.

 

(2)

Reflects warrants for our common stock issued in connection with services it provided to us as a placement agent in connection with our best efforts public offering and as our financial adviser in connection with our completed rights offering. The warrants were immediately exercisable when issued at an exercise price of $9.60 per share of our common stock and expire on October 14, 2015. See “Note 13 – Stockholders’ Equity” for more details.

Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis

As of December 31, 2012, assets and liabilities measured at fair value on a non-recurring basis are as follows:

 

		Level 1				Level 2				Level 3
		Quoted Prices in Active Markets For Identical Assets				Significant Observable Inputs With No Active Market With Identical Characteristics				Significant Unobservable Inputs				Loss During The Year Ended December 31, 2012 and 2011
		(In Thousands)
December 31, 2012:
ASSETS:
Non-Performing Loans Held for Sale (1)		$	—			$	484			$	—			$	3,747
Impaired Loans (2)		$	—			$	27,844			$	8,888			$	580
Other Real Estate Owned (3)		$	—			$	774			$	—			$	301
December 31, 2011:
ASSETS:
Non-Performing Loans Held for Sale (4)		$	—			$	17,525			$	—			$	2,903
Impaired Loans (5)		$	—			$	54,784			$	35,835			$	7,364
Other Real Estate Owned (6)		$	—			$	180			$	—			$	488

 

(1)	Includes a SBA loan of $484,000

 

(2)	Includes real estate loans of $8.7 million, commercial and industrial loans of $27.0 million, and consumer loans of $1.0 million

 

(3)	Includes properties from the foreclosure of real estate loans of $774,000

 

(4)	Includes commercial property loans of $11.1 million, commercial term loan of $5.6 million, and SBA loans of $870,500

 

(5)	Includes real estate loans of $35.1 million, commercial and industrial loans of $54.8 million, and consumer loans of $721,000

 

(6)	Includes properties from the foreclosure of real estate loans of $180,000

FASB ASC 825 requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis. The methodologies for estimating the fair value of financial assets and financial liabilities that are measured at fair value on a recurring basis or non-recurring basis are discussed above.

The estimated fair value of financial instruments has been determined by using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data in order to develop estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that we could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.

The estimated fair values of financial instruments were as follows:

 

		December 31, 2012								December 31, 2011
		Carrying or Contract Amount				Estimated Fair Value				Carrying or Contract Amount				Estimated Fair Value
		(In Thousands)
Financial Assets:
Cash and Cash Equivalents		$	268,047			$	268,047			$	201,683			$	201,683
Restricted Cash			5,350				5,350				1,818				1,818
Term Federal Funds			—				—				115,000				115,173
Investment Securities Available for Sale			451,060				451,060				381,862				381,862
Investment Securities Held to Maturity			—				—				59,742				59,363
Loans Receivable, Net of Allowance for Loan Losses			1,986,051				1,981,669				1,849,020				1,802,511
Loans Held for Sale			8,306				8,306				22,587				22,587
Accrued Interest Receivable			7,581				7,581				7,829				7,829
Investment in Federal Home Loan Bank Stock			17,800				17,800				22,854				22,854
Investment in Federal Reserve Bank			12,222				12,222				8,558				8,558
Financial Liabilities:
Noninterest-Bearing Deposits			720,931				720,931				634,466				634,466
Interest-Bearing Deposits			1,675,032				1,680,211				1,710,444				1,710,878
Borrowings			85,341				85,414				85,709				83,853
Accrued Interest Payable			11,775				11,775				16,032				16,032
Off-Balance Sheet Items:
Commitments to Extend Credit			182,746				146				158,748				194
Standby Letters of Credit			10,588				24				12,742				26

 

The methods and assumptions used to estimate the fair value of each class of financial instruments for which it was practicable to estimate that value are explained below:

Cash and Cash Equivalents – The carrying amounts of cash and cash equivalents approximate fair value due to the short-term nature of these instruments (Level 1).

Restricted Cash – The carrying amount of restricted cash approximates its fair value (Level 1).

Term Federal Funds – The fair value of term federal funds with original maturities of more than 90 days is estimated by discounting the cash flows based on expected maturities or repricing dates utilizing estimated market discount rates (Level 2).

Investment Securities – The fair value of investment securities, consisting of investment securities available for sale, is generally obtained from market bids for similar or identical securities, from independent securities brokers or dealers, or from other model-based valuation techniques described above (Level 1, 2 and 3).

Loans Receivable, Net of Allowance for Loan Losses – The fair value for loans receivable is estimated based on the discounted cash flow approach. The discount rate was derived from the associated yield curve plus spreads and reflects the offering rates offered by the Bank for loans with similar financial characteristics. Yield curves are constructed by product type using the Bank’s loan pricing model for like-quality credits. The discount rates used in the Bank’s model represent the rates the Bank would offer to current borrowers for like-quality credits. These rates could be different from what other financial institutions could offer for these loans. No adjustments have been made for changes in credit within the loan portfolio. It is our opinion that the allowance for loan losses relating to performing and nonperforming loans results in a fair valuation of such loans. Additionally, the fair value of our loans may differ significantly from the values that would have been used had a ready market existed for such loans and may differ materially from the values that we may ultimately realize (Level 3).

Loans Held for Sale – Loans held for sale are carried at the lower of aggregate cost or fair market value, as determined based upon quotes, bids or sales contract prices or may be assessed based upon the fair value of the collateral which is obtained from recent real estate appraisals (Level 2). Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustment is typically significant and result in Level 3 classification of the inputs for determining fair value.

Accrued Interest Receivable – The carrying amount of accrued interest receivable approximates its fair value (Level 1).

Investment in Federal Home Loan Bank and Federal Reserve Bank Stock – The carrying amounts of investment in Federal Home Loan Bank (“FHLB”) and Federal Reserve Bank (“FRB”) stock approximate fair value as such stock may be resold to the issuer at carrying value (Level 1).

Non-Interest-Bearing Deposits – The fair value of non-interest-bearing deposits is the amount payable on demand at the reporting date (Level 2).

Interest-Bearing Deposits – The fair value of interest-bearing deposits, such as savings accounts, money market checking, and certificates of deposit, is estimated based on discounted cash flows. The cash flows for non-maturity deposits, including savings accounts and money market checking, are estimated based on their historical decaying experiences. The discount rate used for fair valuation is based on interest rates currently being offered by the Bank on comparable deposits as to amount and term (Level 3).

Borrowings – Borrowings consist of FHLB advances, junior subordinated debentures and other borrowings. Discounted cash flows based on current market rates for borrowings with similar remaining maturities are used to estimate the fair value of borrowings (Level 3).

Accrued Interest Payable – The carrying amount of accrued interest payable approximates its fair value (Level 1).

Stock Warrants – The fair value of stock warrants is determined by the Black-Scholes option pricing model. The expected stock volatility is based on historical volatility of our common stock over expected term of the warrants. The expected life assumption is based on the contract term. The dividend yield of zero is based on the fact that we have no present intention to pay cash dividends. The risk free rate used for the warrant is equal to the zero coupon rate in effect at the time of the grant (Level 3).

Commitments to Extend Credit and Standby Letters of Credit – The fair values of commitments to extend credit and standby letters of credit are based upon the difference between the current value of similar loans and the price at which the Bank has committed to make the loans (Level 3).