UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2013
Commission File Number 0-15572
FIRST BANCORP
(Exact Name of Registrant as Specified in its Charter)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. ýYES oNO
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). ýYES oNO
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one)
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). oYES ýNO
The number of shares of the registrant's Common Stock outstanding on July 31, 2013 was 19,679,659.
INDEX
FIRST BANCORP AND SUBSIDIARIES
FORWARD-LOOKING STATEMENTS
Part I of this report contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and the Private Securities Litigation Reform Act of 1995, which statements are inherently subject to risks and uncertainties. Forward-looking statements are statements that include projections, predictions, expectations or beliefs about future events or results or otherwise are not statements of historical fact. Further, forward-looking statements are intended to speak only as of the date made. Such statements are often characterized by the use of qualifying words (and their derivatives) such as “expect,” “believe,” “estimate,” “plan,” “project,” or other statements concerning our opinions or judgment about future events. Our actual results may differ materially from those anticipated in any forward-looking statements, as they will depend on many factors about which we are unsure, including many factors which are beyond our control. Factors that could influence the accuracy of such forward-looking statements include, but are not limited to, the financial success or changing strategies of our customers, our level of success in integrating acquisitions, actions of government regulators, the level of market interest rates, and general economic conditions. For additional information about factors that could affect the matters discussed in this paragraph, see the “Risk Factors” section of our 2012 Annual Report on Form 10-K.
Part I. Financial Information
Item 1 - Financial Statements
First Bancorp and Subsidiaries
Consolidated Balance Sheets
($ in thousands-unaudited)
See accompanying notes to consolidated financial statements.
Consolidated Statements of Income (Loss)
Consolidated Statements of Comprehensive Income (Loss)
Consolidated Statements of Shareholders’ Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Note 1 - Basis of Presentation
In the opinion of the Company, the accompanying unaudited consolidated financial statements contain all adjustments necessary to present fairly the consolidated financial position of the Company as of June 30, 2013 and 2012 and the consolidated results of operations and consolidated cash flows for the periods ended June 30, 2013 and 2012. All such adjustments were of a normal, recurring nature. Reference is made to the 2012 Annual Report on Form 10-K filed with the SEC for a discussion of accounting policies and other relevant information with respect to the financial statements. The results of operations for the periods ended June 30, 2013 and 2012 are not necessarily indicative of the results to be expected for the full year. The Company has evaluated all subsequent events through the date the financial statements were issued.
Note 2 – Accounting Policies
Note 1 to the 2012 Annual Report on Form 10-K filed with the SEC contains a description of the accounting policies followed by the Company and discussion of recent accounting pronouncements. The following paragraphs update that information as necessary.
The Comprehensive Income topic was amended in June 2011. The amendment eliminated the option to present other comprehensive income as a part of the statement of changes in stockholders’ equity and required consecutive presentation of the statement of net income and other comprehensive income. The amendments were applicable to the Company commencing on January 1, 2012 and have been applied retrospectively. In December 2011, the topic was further amended to defer the effective date of presenting reclassification adjustments from other comprehensive income to net income on the face of the financial statements while the Financial Accounting Standards Board (FASB) redeliberated the presentation requirements for the reclassification adjustments. In February 2013, the FASB further amended the Comprehensive Income topic clarifying the conclusions from such redeliberations. Specifically, the amendments do not change the current requirements for reporting net income or other comprehensive income in financial statements. However, the amendments do require an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, in certain circumstances an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income. The amendments were effective for the Company on a prospective basis for reporting periods beginning after December 15, 2012. These amendments did not have a material effect on the Company’s financial statements.
In October 2012, the Business Combinations topic was amended to address the subsequent accounting for an indemnification asset resulting from a government-assisted acquisition of a financial institution. The guidance indicates that when a reporting entity records an indemnification asset as a result of a government-assisted acquisition of a financial institution involving an indemnification agreement, the indemnification asset should be subsequently measured on the same basis as the asset subject to indemnification. Any amortization of changes in value should be limited to any contractual limitations on the amount and the term of the indemnification agreement. The amendments should be applied prospectively to any new indemnification assets acquired and to changes in expected cash flows of existing indemnification assets occurring on or after the date of adoption. Prior periods would not be adjusted. The amendments were effective for 2013 and did not have a material effect on the Company’s financial statements.
Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.
Note 3 – Reclassifications
Certain amounts reported for the periods ended June 30, 2012 have been reclassified to conform to the presentation for June 30, 2013. These reclassifications had no effect on net income or shareholders’ equity for the periods presented, nor did they materially impact trends in financial information.
Note 4 – Acquisition
On March 22, 2013, the Company completed the purchase of two branches from Four Oaks Bank & Trust Company located in Southern Pines and Rockingham, North Carolina. The Company acquired $57 million in deposits and $16 million in loans in the acquisition. The Company purchased the Rockingham branch building, but did not purchase the Southern Pines branch building and instead transferred the acquired accounts to one of the Company’s nearby existing branches. The primary reason for this acquisition was to increase the Company’s presence in existing market areas. The Company paid a deposit premium for the branches of approximately $586,000, which is the amount of the identifiable intangible asset associated with the fair value of the core deposit base. The intangible asset is being amortized as expense on a straight-line basis over a seven year period. The operations of the two branches are included in the accompanying Consolidated Statements of Income (Loss) beginning on the acquisition date of March 22, 2013. Historical pro forma information is not presented due to the immateriality of the transaction.
Note 5 – Equity-Based Compensation Plans
At June 30, 2013, the Company had the following equity-based compensation plans: the First Bancorp 2007 Equity Plan, the First Bancorp 2004 Stock Option Plan, and the First Bancorp 1994 Stock Option Plan. The Company’s shareholders approved all equity-based compensation plans. The First Bancorp 2007 Equity Plan became effective upon the approval of shareholders on May 2, 2007. As of June 30, 2013, the First Bancorp 2007 Equity Plan was the only plan that had shares available for future grants.
The First Bancorp 2007 Equity Plan is intended to serve as a means to attract, retain and motivate key employees and directors and to associate the interests of the plans’ participants with those of the Company and its shareholders. The First Bancorp 2007 Equity Plan allows for both grants of stock options and other types of equity-based compensation, including stock appreciation rights, restricted stock, restricted performance stock, unrestricted stock, and performance units.
Recent equity grants to employees have either had performance vesting conditions, service vesting conditions, or both. Compensation expense for these grants is recorded over the various service periods based on the estimated number of equity grants that are probable to vest. No compensation cost is recognized for grants that do not vest and any previously recognized compensation cost will be reversed. As it relates to director equity grants, the Company grants common shares, valued at approximately $16,000, to each non-employee director (currently 12 in total) in June of each year. Compensation expense associated with these director grants is recognized on the date of grant since there are no vesting conditions.
Pursuant to an employment agreement, the Company granted the chief executive officer 75,000 non-qualified stock options and 40,000 shares of restricted stock during the third quarter of 2012. The option award and the restricted stock award will vest in full on December 31, 2014 and December 31, 2015, respectively, if the Company achieves certain earnings targets for those years, and will be forfeited if the applicable targets are not achieved. Compensation expense for this grant will be recorded over the various periods based on the estimated number of options and restricted stock that are probable to vest. If the awards do not vest, no compensation cost will be recognized and any previously recognized compensation cost will be reversed. Based on current conditions, the Company has concluded that it is not probable that these awards will vest, and thus no compensation expense has been recorded.
The Company granted long-term restricted shares of common stock to certain senior executives on February 23, 2012 with a two year minimum vesting period. The total compensation expense associated with this grant was $89,700 and the grant will fully vest on February 23, 2014. The Company recorded $19,000 and $14,900 in stock option expense during the six months ended June 30, 2013 and 2012, respectively, and expects to record $1,000 in stock option expense each quarter thereafter until the awards vest.
The Company granted long-term restricted shares of common stock to certain senior executives on February 24, 2011 with a two year minimum vesting period. The total compensation expense associated with this grant was $105,500 and the grant fully vested on February 24, 2013. The Company recorded $6,500 and $22,000 in stock option expense during the six months ended June 30, 2013 and 2012, respectively.
Under the terms of the Predecessor Plans and the First Bancorp 2007 Equity Plan, options can have a term of no longer than ten years, and all options granted thus far under these plans have had a term of ten years. The Company’s options provide for immediate vesting if there is a change in control (as defined in the plans).
At June 30, 2013, there were 466,813 options outstanding related to the three First Bancorp plans, with exercise prices ranging from $9.76 to $22.12. At June 30, 2013, there were 761,538 shares remaining available for grant under the First Bancorp 2007 Equity Plan.
The Company issues new shares of common stock when options are exercised.
The Company measures the fair value of each option award on the date of grant using the Black-Scholes option-pricing model. The Company determines the assumptions used in the Black-Scholes option pricing model as follows: the risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of the grant; the dividend yield is based on the Company’s dividend yield at the time of the grant (subject to adjustment if the dividend yield on the grant date is not expected to approximate the dividend yield over the expected life of the option); the volatility factor is based on the historical volatility of the Company’s stock (subject to adjustment if future volatility is reasonably expected to differ from the past); and the weighted-average expected life is based on the historical behavior of employees related to exercises, forfeitures and cancellations.
The Company’s equity grants for the six months ended June 30, 2013 were the issuance of 13,164 shares of common stock to non-employee directors on June 3, 2013 (1,097 shares per director), at a fair market value of $14.68 per share, which was the closing price of the Company’s common stock on that date.
The Company’s equity grants for the six months ended June 30, 2012 were the issuance of 1) 9,559 shares of long-term restricted stock to certain senior executives on February 23, 2012, at a fair market value of $10.96 per share, which was the closing price of the Company’s common stock on that date, and 2) 25,452 shares of common stock to non-employee directors on June 1, 2012 (1,818 shares per director), at a fair market value of $8.86 per share, which was the closing price of the Company’s common stock on that date.
The Company recorded total stock-based compensation expense of $220,000 and $263,000 for the six-month periods ended June 30, 2013 and 2012, respectively. Of the $220,000 in expense that was recorded in 2013, approximately $193,000 related to the June 3, 2013 director grants, which is classified as “other operating expenses” in the Consolidated Statements of Income (Loss). The remaining $27,000 in expense relates to the employee grants discussed above and is recorded as “salaries expense.” Stock based compensation is reflected as an adjustment to cash flows from operating activities on the Company’s Consolidated Statement of Cash Flows. The Company recognized $86,000 and $103,000 of income tax benefits related to stock based compensation expense in the income statement for the six months ended June 30, 2013 and 2012, respectively.
As noted above, certain of the Company’s stock option grants contain terms that provide for a graded vesting schedule whereby portions of the award vest in increments over the requisite service period. The Company has elected to recognize compensation expense for awards with graded vesting schedules on a straight-line basis over the requisite service period for the entire award. Compensation expense is based on the estimated number of stock options and awards that will ultimately vest. Over the past five years, there have only been minimal amounts of forfeitures, and therefore the Company assumes that all options granted without performance conditions will become vested.
The following table presents information regarding the activity for the first six months of 2013 related to all of the Company’s stock options outstanding:
The Company did not have any stock option exercises during the six months ended June 30, 2013 or 2012. The Company recorded no tax benefits from the exercise of nonqualified stock options during the six months ended June 30, 2013 or 2012.
Note 6 – Earnings Per Common Share
Basic Earnings Per Common Share is calculated by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted Earnings Per Common Share is computed by assuming the issuance of common shares for all potentially dilutive common shares outstanding during the reporting period. Currently, the Company’s potentially dilutive common stock issuances relate to stock option grants under the Company’s equity-based compensation plans and the Company’s Series C Preferred Stock, which is convertible into common stock on a one-for-one ratio.
In computing Diluted Earnings Per Common Share, adjustments are made to the computation of Basic Earnings Per Common shares, as follows. As it relates to stock options, it is assumed that all dilutive stock options are exercised during the reporting period at their respective exercise prices, with the proceeds from the exercises used by the Company to buy back stock in the open market at the average market price in effect during the reporting period. The difference between the number of shares assumed to be exercised and the number of shares bought back is included in the calculation of dilutive securities. As it relates to the Series C Preferred Stock, it is assumed that the preferred stock was converted to common stock during the reporting period. Dividends on the preferred stock are added back to net income and the shares assumed to be converted are included in the number of shares outstanding.
If any of the potentially dilutive common stock issuances have an anti-dilutive effect, which is the case when a net loss is reported, the potentially dilutive common stock issuance is disregarded.
The following is a reconciliation of the numerators and denominators used in computing Basic and Diluted Earnings Per Common Share:
For both the three and six months ended June 30, 2013, there were 391,813 options that were antidilutive because the exercise price exceeded the average market price for the period. For both the three and six months ended June 30, 2012, there were 386,662 options that were antidilutive. Antidilutive options have been omitted from the calculation of diluted earnings per share for the respective periods.
Note 7 – Securities
The book values and approximate fair values of investment securities at June 30, 2013 and December 31, 2012 are summarized as follows:
Included in mortgage-backed securities at June 30, 2013 were collateralized mortgage obligations with an amortized cost of $251,000 and a fair value of $261,000. Included in mortgage-backed securities at December 31, 2012 were collateralized mortgage obligations with an amortized cost of $381,000 and a fair value of $396,000. All of the Company’s mortgage-backed securities, including collateralized mortgage obligations, were issued by government-sponsored corporations.
The Company owned Federal Home Loan Bank (FHLB) stock with a cost and fair value of $3,894,000 at June 30, 2013 and $4,934,000 at December 31, 2012, which is included in equity securities above and serves as part of the collateral for the Company’s line of credit with the FHLB. The investment in this stock is a requirement for membership in the FHLB system. Periodically the FHLB recalculates the Company’s required level of holdings, and the Company either buys more stock or the FHLB redeems a portion of the stock at cost.
The following table presents information regarding securities with unrealized losses at June 30, 2013:
($ in thousands)
The following table presents information regarding securities with unrealized losses at December 31, 2012:
In the above tables, all of the non-equity securities that were in an unrealized loss position at June 30, 2013 and December 31, 2012 are bonds that the Company has determined are in a loss position due to interest rate factors, the overall economic downturn in the financial sector, and the broader economy in general. The Company has evaluated the collectability of each of these bonds and has concluded that there is no other-than-temporary impairment. The Company does not intend to sell these securities, and it is more likely than not that the Company will not be required to sell these securities before recovery of the amortized cost. The Company has also concluded that each of the equity securities in an unrealized loss position at June 30, 2013 and December 31, 2012 was in such a position due to temporary fluctuations in the market prices of the securities. The Company’s policy is to record an impairment charge for any of these equity securities that remains in an unrealized loss position for twelve consecutive months unless the amount is insignificant.
The aggregate carrying amount of cost-method investments was $3,894,000 and $4,934,000 at June 30, 2013 and December 31, 2012, respectively, which was the FHLB stock discussed above. The Company determined that none of its cost-method investments were impaired at either period end.
The book values and approximate fair values of investment securities at June 30, 2013, by contractual maturity, are summarized in the table below. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
At June 30, 2013 and December 31, 2012 investment securities with carrying values of $100,418,000 and $78,519,000, respectively, were pledged as collateral for public and private deposits.
The Company did not sell any securities during the six months ended June 30, 2013. There were $9,641,000 in sales of securities during the six months ended June 30, 2012, which resulted in a net gain of $439,000. During the six months ended June 30, 2013 and 2012, the Company recorded a net gain of $7,000 and $11,000, respectively, related to the call of several municipal and bond securities. Also, during the six months ended June 30, 2013 and 2012, the Company recorded a net loss of $0 and $1,000, respectively, related to write-downs of the Company's equity portfolio.
Note 8 – Loans and Asset Quality Information
The loans and foreclosed real estate that were acquired in FDIC-assisted transactions are covered by loss share agreements between the FDIC and the Company’s banking subsidiary, First Bank, which afford First Bank significant loss protection - see Note 2 to the financial statements included in the Company’s 2011 Annual Report on Form 10-K for detailed information regarding these transactions. Because of the loss protection provided by the FDIC, the risk of the loans and foreclosed real estate that are covered by loss share agreements are significantly different from those assets not covered under the loss share agreements. Accordingly, the Company presents separately loans subject to the loss share agreements as “covered loans” in the information below and loans that are not subject to the loss share agreements as “non-covered loans.”
The following is a summary of the major categories of total loans outstanding:
As of June 30, 2013, December 31, 2012 and June 30, 2012, net loans include unamortized premiums of $252,000, $485,000, and $717,000, respectively, related to acquired loans.
At December 31, 2012, the Company also had $30 million classified as “loans held for sale” that are not included in the loan balances disclosed above or in the disclosures presented in the remainder of Note 8. In the fourth quarter of 2012, the Company identified approximately $68 million of non-covered higher risk loans that it targeted for sale to a third-party investor. Based on an offer to purchase these loans received prior to year-end, the Company wrote the loans down by approximately $38 million to their estimated liquidation value of approximately $30 million and reclassified them as “loans held for sale.” The sale of the loans was completed in January 2013 with the Company receiving sales proceeds of approximately $30 million.
The following is a summary of the major categories of non-covered loans outstanding:
The carrying amount of the covered loans at June 30, 2013 consisted of impaired and nonimpaired purchased loans (as determined on the date of acquisition), as follows:
The carrying amount of the covered loans at December 31, 2012 consisted of impaired and nonimpaired purchased loans (as determined on the date of acquisition), as follows:
The following table presents information regarding covered purchased nonimpaired loans since December 31, 2011. The amounts include principal only and do not reflect accrued interest as of the date of the acquisition or beyond.
As reflected in the table above, the Company accreted $10,270,000 of the loan discount on purchased nonimpaired loans into interest income during the first six months of 2013. As of June 30, 2013, there was remaining loan discount of $36,068,000 related to purchased performing loans. If these loans continue to be repaid by the borrowers, the Company will accrete the remaining loan discount into interest income over the covered lives of the respective loans. In such circumstances, a corresponding entry to reduce the indemnification asset will be recorded amounting to 80% of the loan discount accretion, which reduces noninterest income. At June 30, 2013, the Company also had $17,262,000 of loan discount related to purchased nonperforming loans. It is not expected that a significant amount of this discount will be accreted, as it represents estimated losses on these loans.
The following table presents information regarding all purchased impaired loans since December 31, 2011, substantially all of which are covered loans. The Company has applied the cost recovery method to all purchased impaired loans at their respective acquisition dates due to the uncertainty as to the timing of expected cash flows, as reflected in the following table.
Purchased Impaired Loans
Each of the purchased impaired loans is on nonaccrual status and considered to be impaired. Because of the uncertainty of the expected cash flows, the Company is accounting for each purchased impaired loan under the cost recovery method, in which all cash payments are applied to principal. Thus, there is no accretable yield associated with the above loans. During the first six months of 2013 and 2012, the Company received $38,000 and $0, respectively, in payments that exceeded the initial carrying amount of the purchased impaired loans, which is included in the loan discount accretion amount discussed previously.
Nonperforming assets are defined as nonaccrual loans, restructured loans, loans past due 90 or more days and still accruing interest, nonperforming loans held for sale, and foreclosed real estate. Nonperforming assets are summarized as follows:
ASSET QUALITY DATA ($ in thousands)
(1) At June 30, 2013, December 31, 2012, and June 30, 2012, the contractual balance of the nonaccrual loans covered by FDIC loss share agreements was $89.3 million, $64.4 million, and $60.4 million, respectively.
The following table presents information related to the Company’s impaired loans.
The remaining tables in this note present information derived from the Company’s allowance for loan loss model. Relevant accounting guidance requires certain disclosures to be disaggregated based on how the Company develops its allowance for loan losses and manages its credit exposure. This model combines loan types in a different manner than the tables previously presented.
The following table presents the Company’s nonaccrual loans as of June 30, 2013.
The following table presents the Company’s nonaccrual loans as of December 31, 2012.
The following table presents an analysis of the payment status of the Company’s loans as of June 30, 2013.
The Company had no non-covered or covered loans that were past due greater than 90 days and accruing interest at June 30, 2013.
The following table presents an analysis of the payment status of the Company’s loans as of December 31, 2012.
The Company had no non-covered or covered loans that were past due greater than 90 days and accruing interest at December 31, 2012.
The following table presents the activity in the allowance for loan losses for non-covered loans for the three and six months ended June 30, 2013.
The following table presents the activity in the allowance for loan losses for non-covered loans for the year ended December 31, 2012.
The following table presents the activity in the allowance for loan losses for non-covered loans for the three and six months ended June 30, 2012.
The following table presents the activity in the allowance for loan losses for covered loans for the three and six months ended June 30, 2013.
The following table presents the activity in the allowance for loan losses for covered loans for the year ended December 31, 2012.
The following table presents the activity in the allowance for loan losses for covered loans for the three and six months ended June 30, 2012.
The following table presents the Company’s impaired loans as of June 30, 2013.
Interest income recorded on non-covered and covered impaired loans during the six months ended June 30, 2013 is considered insignificant.
The related allowance listed above includes both reserves on loans specifically reviewed for impairment and general reserves on impaired loans that were not specifically reviewed for impairment.
The following table presents the Company’s impaired loans as of December 31, 2012.
Interest income recorded on non-covered and covered impaired loans during the year ended December 31, 2012 is considered insignificant.
The Company tracks credit quality based on its internal risk ratings. Upon origination a loan is assigned an initial risk grade, which is generally based on several factors such as the borrower’s credit score, the loan-to-value ratio, the debt-to-income ratio, etc. Loans that are risk-graded as substandard during the origination process are declined. After loans are initially graded, they are monitored monthly for credit quality based on many factors, such as payment history, the borrower’s financial status, and changes in collateral value. Loans can be downgraded or upgraded depending on management’s evaluation of these factors. Internal risk-grading policies are consistent throughout each loan type.
The following describes the Company’s internal risk grades in ascending order of likelihood of loss:
The following table presents the Company’s recorded investment in loans by credit quality indicators as of June 30, 2013.
At June 30, 2013, there was an insignificant amount of loans that were graded “8” with an accruing status.
The following table presents the Company’s recorded investment in loans by credit quality indicators as of December 31, 2012.
At December 31, 2012, there was an insignificant amount of loans that were graded “8” with an accruing status.
Troubled Debt Restructurings
The restructuring of a loan is considered a “troubled debt restructuring” if both (i) the borrower is experiencing financial difficulties and (ii) the creditor has granted a concession. Concessions may include interest rate reductions or below market interest rates, principal forgiveness, restructuring amortization schedules and other actions intended to minimize potential losses.
The vast majority of the Company’s troubled debt restructurings modified during the three and six months ended June 30, 2013 related to interest rate reductions combined with restructured amortization schedules. The Company does not generally grant principal forgiveness.
All loans classified as troubled debt restructurings are considered to be impaired and are evaluated as such for determination of the allowance for loan losses. The Company’s troubled debt restructurings can be classified as either nonaccrual or accruing based on the loan’s payment status. The troubled debt restructurings that are nonaccrual are reported within the nonaccrual loan totals presented previously.
The following table presents information related to loans modified in a troubled debt restructuring during the three and six months ended June 30, 2013.
The following table presents information related to loans modified in a troubled debt restructuring during the three and six months ended June 30, 2012.
Accruing restructured loans that were modified in the previous 12 months and that defaulted during the three and six months ended June 30, 2013 are presented in the table below. The Company considers a loan to have defaulted when it becomes 90 or more days delinquent under the modified terms, has been transferred to nonaccrual status, or has been transferred to foreclosed real estate.
Accruing restructured loans that were modified in the previous 12 months and that defaulted during the three and six months ended June 30, 2012 are presented in the table below.
Note 9 – Deferred Loan Costs
The amount of loans shown on the Consolidated Balance Sheets includes net deferred loan costs of approximately $1,168,000, $1,324,000, and $1,376,000 at June 30, 2013, December 31, 2012, and June 30, 2012, respectively.
Note 10 – FDIC Indemnification Asset
The FDIC indemnification asset is the estimated amount that the Company will receive from the FDIC under loss share agreements associated with two FDIC-assisted failed bank acquisitions. See page 40 of the Company’s 2012 Annual Report on Form 10-K for a detailed explanation of this asset.
The FDIC indemnification asset was comprised of the following components as of the dates shown:
The following presents a rollforward of the FDIC indemnification asset since December 31, 2012.
Note 11 – Goodwill and Other Intangible Assets
The following is a summary of the gross carrying amount and accumulated amortization of amortizable intangible assets as of June 30, 2013, December 31, 2012, and June 30, 2012 and the carrying amount of unamortized intangible assets as of those same dates. In the first quarter of 2013, the Company recorded a core deposit premium intangible of $586,000 in connection with the acquisition of two branches, which is being amortized on a straight-line basis over the estimated life of the related deposits of seven years.
Amortization expense totaled $220,000 and $223,000 for the three months ended June 30, 2013 and 2012, respectively. Amortization expense totaled $419,000 and $446,000 for the six months ended June 30, 2013 and 2012, respectively.
The following table presents the estimated amortization expense for the last two quarters of calendar year 2013 and for each of the four calendar years ending December 31, 2017 and the estimated amount amortizable thereafter. These estimates are subject to change in future periods to the extent management determines it is necessary to make adjustments to the carrying value or estimated useful lives of amortized intangible assets.
Note 12 – Pension Plans
The Company has historically sponsored two defined benefit pension plans – a qualified retirement plan (the “Pension Plan”) which was generally available to all employees, and a Supplemental Executive Retirement Plan (the “SERP”), which was for the benefit of certain senior management executives of the Company. Effective December 31, 2012, the Company froze both plans for all participants. Although no previously accrued benefits were lost, employees no longer accrue benefits for service subsequent to 2012.
The Company recorded pension income totaling $190,000 for the three months ended June 30, 2013, which primarily related to investment income from the Pension Plan’s assets. For the three months ended June 30, 2012, the Company recorded pension expense totaling $619,000 related to the Pension Plan and the SERP. The following table contains the components of the pension (income) expense.
The Company recorded pension income totaling $327,000 for the six months ended June 30, 2013, which primarily related to investment income from the Pension Plan’s assets. For the six months ended June 30, 2012, the Company recorded pension expense totaling $1,658,000 related to the Pension Plan and the SERP. The following table contains the components of the pension (income) expense.
The Company’s contributions to the Pension Plan are based on computations by independent actuarial consultants and are intended to be deductible for income tax purposes. The contributions are invested to provide for benefits under the Pension Plan. The Company expects that it will contribute $1,500,000 to the Pension Plan in 2013.
The Company’s funding policy with respect to the SERP is to fund the related benefits from the operating cash flow of the Company.
Note 13 – Comprehensive Income (Loss)
Comprehensive income (loss) is defined as the change in equity during a period for non-owner transactions and is divided into net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) includes revenues, expenses, gains, and losses that are excluded from earnings under current accounting standards. The components of accumulated other comprehensive income (loss) for the Company are as follows:
The following table discloses the changes in accumulated other comprehensive income (loss) for the six months ended June 30, 2013 (all amounts are net of tax).
Note 14 – Fair Value
Relevant accounting guidance establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The guidance describes three levels of inputs that may be used to measure fair value:
Level 1: Quoted prices (unadjusted) of 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; or other inputs that are observable or can be corroborated by observable market data.
Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
The following table summarizes the Company’s financial instruments that were measured at fair value on a recurring and nonrecurring basis at June 30, 2013. The impaired loans shown below are those in which the value is based on the underlying collateral value.
The following table summarizes the Company’s financial instruments that were measured at fair value on a recurring and nonrecurring basis at December 31, 2012.
The following is a description of the valuation methodologies used for instruments measured at fair value.
Securities Available for Sale — When quoted market prices are available in an active market, the securities are classified as Level 1 in the valuation hierarchy. If quoted market prices are not available, but fair values can be estimated by observing quoted prices of securities with similar characteristics, the securities are classified as Level 2 on the valuation hierarchy. Most of the fair values for the Company’s Level 2 securities are determined by our third-party securities portfolio manager using matrix pricing. Matrix pricing is a mathematical technique widely used 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. For the Company, Level 2 securities include mortgage-backed securities, collateralized mortgage obligations, government-sponsored enterprise securities, and corporate bonds. In cases where Level 1 or Level 2 inputs are not available, securities are classified within Level 3 of the hierarchy.
The Company reviews the pricing methodologies utilized by the portfolio manager to ensure the fair value determination is consistent with the applicable accounting guidance and that the investments are properly classified in the fair value hierarchy. Further, the Company validates the fair values for a sample of securities in the portfolio by comparing the fair values provided by the portfolio manager to prices from other independent sources for the same or similar securities. The Company analyzes unusual or significant variances and conducts additional research with the portfolio manager, if necessary, and takes appropriate action based on its findings.
Impaired loans — Fair values for impaired loans in the above table are generally collateral dependent and are estimated based on underlying collateral values securing the loans. Collateral may be in the form of real estate or business assets including equipment, inventory and accounts receivable. The vast majority of the collateral is real estate. The value of real estate collateral is determined using an income or market valuation approach based on an appraisal conducted by an independent, licensed third party appraiser (Level 3). The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable borrower’s financial statements if not considered significant. Likewise, values for inventory and accounts receivable collateral are based on borrower financial statement balances or aging reports on a discounted basis as appropriate (Level 3). Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income (Loss).
Foreclosed real estate – Foreclosed real estate, consisting of properties obtained through foreclosure or in satisfaction of loans, is reported at the lower of cost or fair value, based on a current appraisal that is generally prepared using an income or market valuation approach and conducted by an independent, licensed third party appraiser, adjusted for estimated selling costs (Level 3). At the time of foreclosure, any excess of the loan balance over the fair value of the real estate held as collateral is treated as a charge against the allowance for loan losses. For any real estate valuations subsequent to foreclosure, any excess of the real estate recorded value over the fair value of the real estate is treated as a foreclosed real estate write-down on the Consolidated Statements of Income (Loss). In December 2012, the Company recorded a write-down of $10.6 million related to its non-covered foreclosed properties. This write-down reduced the carrying value of these properties by approximately 29% beyond their standard carrying value as described above. This write-down was recorded because of management’s intent to dispose of these properties in an expedited manner and accept sales prices lower than prior practice.
For Level 3 assets and liabilities measured at fair value on a recurring or non-recurring basis as of June 30, 2013, the significant unobservable inputs used in the fair value measurements were as follows:
For Level 3 assets and liabilities measured at fair value on a recurring or non-recurring basis as of December 31, 2012, the significant unobservable inputs used in the fair value measurements were as follows:
Transfers of assets or liabilities between levels within the fair value hierarchy are recognized when an event or change in circumstances occurs. There were no transfers between Level 1 and Level 2 for assets or liabilities measured on a recurring basis during the three or six months ended June 30, 2013 or 2012.
For the six months ended June 30, 2013, the decrease in the fair value of securities available for sale was $2,166,000, which is included in other comprehensive income (net of tax benefit of $844,000). For the six months ended June 30, 2012, the increase in the fair value of securities available for sale was $452,000, which is included in other comprehensive loss (net of tax expense of $175,000). Fair value measurement methods at June 30, 2013 and 2012 are consistent with those used in prior reporting periods.
The carrying amounts and estimated fair values of financial instruments at June 30, 2013 and December 31, 2012 are as follows:
Fair value methods and assumptions are set forth below for the Company’s financial instruments.
Cash and Amounts Due from Banks, Federal Funds Sold, Presold Mortgages in Process of Settlement, Accrued Interest Receivable, and Accrued Interest Payable - The carrying amounts approximate their fair value because of the short maturity of these financial instruments.
Available for Sale and Held to Maturity Securities -Fair values are provided by a third-party and 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 or matrix pricing.
Loans -For nonimpaired loans, fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, financial and agricultural, real estate construction, real estate mortgages and installment loans to individuals. Each loan category is further segmented into fixed and variable interest rate terms. The fair value for each category is determined by discounting scheduled future cash flows using current interest rates offered on loans with similar risk characteristics. Fair values for impaired loans are primarily based on estimated proceeds expected upon liquidation of the collateral.
FDIC Indemnification Asset – Fair value is equal to the FDIC reimbursement rate of the expected losses to be incurred and reimbursed by the FDIC and then discounted over the estimated period of receipt.
Bank-Owned Life Insurance – The carrying value of life insurance approximates fair value because this investment is carried at cash surrender value, as determined by the issuer.
Deposits- The fair value of deposits with no stated maturity, such as noninterest-bearing checking accounts, savings accounts, interest-bearing checking accounts, and money market accounts, is equal to the amount payable on demand as of the valuation date. The fair value of certificates of deposit is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.
Borrowings- The fair value of borrowings is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered by the Company’s lenders for debt of similar remaining maturities.
Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. 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 highly liquid market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected 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 on- and off-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. Significant assets and liabilities that are not considered financial assets or liabilities include net premises and equipment, intangible and other assets such as deferred income taxes, prepaid expense accounts, income taxes currently payable and other various accrued expenses. In addition, the income tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of the estimates.
Note 15 – Shareholders’ Equity Transactions
Small Business Lending Fund
On September 1, 2011, the Company completed the sale of $63.5 million of Series B preferred stock to the Secretary of the Treasury under the Small Business Lending Fund (SBLF). The fund was established under the Small Business Jobs Act of 2010 that was created to encourage lending to small businesses by providing capital to qualified community banks with assets less than $10 billion.
Under the terms of the stock purchase agreement, the Treasury received 63,500 shares of non-cumulative perpetual preferred stock with a liquidation value of $1,000 per share, in exchange for $63.5 million.
The Series B preferred stock qualifies as Tier 1 capital. The dividend rate, as a percentage of the liquidation amount, can fluctuate on a quarterly basis during the first 10 quarters during which the Series B preferred stock is outstanding, based upon changes in the level of “Qualified Small Business Lending” or “QSBL”. For the first nine quarters after issuance, the dividend rate can range from one percent (1%) to five percent (5%) per annum based upon the increase in QSBL as compared to the baseline. For quarters subsequent to the issuance in 2011, the Company has paid a dividend rate ranging from 3.0% to 5.0%. Based upon an increase in the level of QSBL over the baseline level calculated under the terms of the related purchase agreement, the dividend rate for the next dividend period (which will end on September 30, 2013) is expected to be 1.0%, subject to confirmation by Treasury. For the tenth calendar quarter through four and one half years after issuance, the dividend rate will be fixed at between one percent (1%) and seven percent (7%) based upon the level of QSBL compared to the baseline. After four and one half years from the issuance, the dividend rate will increase to nine percent (9%). Subject to regulatory approval, the Company is generally permitted to redeem the Series B preferred shares at par plus unpaid dividends.
For the first six months of 2013 and 2012, the Company accrued approximately $345,000 and $1,589,000 in preferred dividend payments for the Series B Preferred Stock, respectively. This amount is deducted from net income in computing “Net income available to common shareholders.”
Stock Issuance
On December 21, 2012, the Company issued 2,656,294 shares of its common stock and 728,706 shares of the Company’s Series C Preferred Stock to certain accredited investors, each at the price of $10.00 per share, pursuant to a private placement transaction. Net proceeds from this sale of common and preferred stock were $33.8 million and were used to strengthen and remove risk from the Company’s balance sheet in anticipation of a planned disposition of certain classified loans and write-down of foreclosed real estate.
The Series C Preferred Stock qualifies as Tier 1 capital and is Convertible Perpetual Preferred Stock, with dividend rights equal to the Company’s Common Stock. Each share of Series C Preferred Stock will automatically convert into one share of Common Stock on the date the holder of Series C Preferred Stock transfers any shares of Series C Preferred Stock to a non-affiliate of the holder in certain permissible transfers. The Series C Preferred Stock is non-voting, except in limited circumstances.
During the first six months of 2013, the Company accrued approximately $117,000 in preferred dividend payments for the Series C Preferred Stock.
Item 2 - Management's Discussion and Analysis of Consolidated Results of Operations and Financial Condition
Critical Accounting Policies
The accounting principles we follow and our methods of applying these principles conform with accounting principles generally accepted in the United States of America and with general practices followed by the banking industry. Certain of these principles involve a significant amount of judgment and may involve the use of estimates based on our best assumptions at the time of the estimation. The allowance for loan losses, intangible assets, and the fair value and discount accretion of loans acquired in FDIC-assisted transactions are three policies we have identified as being more sensitive in terms of judgments and estimates, taking into account their overall potential impact to our consolidated financial statements.
Allowance for Loan Losses
Due to the estimation process and the potential materiality of the amounts involved, we have identified the accounting for the allowance for loan losses and the related provision for loan losses as an accounting policy critical to our consolidated financial statements. The provision for loan losses charged to operations is an amount sufficient to bring the allowance for loan losses to an estimated balance considered adequate to absorb losses inherent in the portfolio.
Our determination of the adequacy of the allowance is based primarily on a mathematical model that estimates the appropriate allowance for loan losses. This model has two components. The first component involves the estimation of losses on “impaired loans” that are individually evaluated. A loan is considered to be impaired when, based on current information and events, it is probable we will be unable to collect all amounts due according to the contractual terms of the loan agreement. A loan is individually evaluated for an appropriate valuation allowance if the loan balance is above a prescribed evaluation threshold (which varies based on credit quality, accruing status, and type of collateral) and the loan is determined to be impaired. The estimated valuation allowance is the difference, if any, between the loan balance outstanding and the value of the impaired loan as determined by either 1) an estimate of the cash flows that we expect to receive from the borrower discounted at the loan’s effective rate, or 2) in the case of a collateral-dependent loan, the fair value of the collateral.
The second component of the allowance model is an estimate of losses for impaired loans collectively evaluated and all loans not considered to be impaired loans. Impaired loans collectively evaluated and loans not considered to be impaired are segregated by loan type, and estimated loss percentages are assigned to each loan type, based on the historical losses, current economic conditions, and operational conditions specific to each loan type. For impaired loans collectively evaluated and loans with more than standard risk but not considered to be impaired, loss percentages are based on a multiple of the estimated loss rate for loans of a similar loan type with normal risk. The multiples assigned vary by type of loan, depending on risk, and we have consulted with an external credit review firm in assigning those multiples.
The reserve estimated for impaired loans is then added to the reserve estimated for all other loans. This becomes our “allocated allowance.” In addition to the allocated allowance derived from the model, we also evaluate other data such as the ratio of the allowance for loan losses to total loans, net loan growth information, nonperforming asset levels and trends in such data. Based on this additional analysis, we may determine that an additional amount of allowance for loan losses is necessary to reserve for probable losses. This additional amount, if any, is our “unallocated allowance.” The sum of the allocated allowance and the unallocated allowance is compared to the actual allowance for loan losses recorded on our books and any adjustment necessary for the recorded allowance to equal the computed allowance is recorded as a provision for loan losses. The provision for loan losses is a direct charge to earnings in the period recorded.
Loans covered under loss share agreements are recorded at fair value at acquisition date. Therefore, amounts deemed uncollectible at acquisition date become a part of the fair value calculation and are excluded from the allowance for loan losses. Subsequent decreases in the amount expected to be collected result in a provision for loan losses with a corresponding increase in the allowance for loan losses. Subsequent increases in the amount expected to be collected are accreted into income over the life of the loan. Proportional adjustments are also recorded to the FDIC indemnification asset.
Although we use the best information available to make evaluations, future material adjustments may be necessary if economic, operational, or other conditions change. In addition, various regulatory agencies, as an integral part of their examination process, periodically review our allowance for loan losses. Such agencies may require us to recognize additions to the allowance based on the examiners’ judgment about information available to them at the time of their examinations.
For further discussion, see “Nonperforming Assets” and “Summary of Loan Loss Experience” below.
Intangible Assets
Due to the estimation process and the potential materiality of the amounts involved, we have also identified the accounting for intangible assets as an accounting policy critical to our consolidated financial statements.
When we complete an acquisition transaction, the excess of the purchase price over the amount by which the fair market value of assets acquired exceeds the fair market value of liabilities assumed represents an intangible asset. We must then determine the identifiable portions of the intangible asset, with any remaining amount classified as goodwill. Identifiable intangible assets associated with these acquisitions are generally amortized over the estimated life of the related asset, whereas goodwill is tested annually for impairment, but not systematically amortized. Assuming no goodwill impairment, it is beneficial to our future earnings to have a lower amount assigned to identifiable intangible assets and higher amount of goodwill as opposed to having a higher amount considered to be identifiable intangible assets and a lower amount classified as goodwill.
The primary identifiable intangible asset we typically record in connection with a whole bank or bank branch acquisition is the value of the core deposit intangible, whereas when we acquire an insurance agency, the primary identifiable intangible asset is the value of the acquired customer list. Determining the amount of identifiable intangible assets and their average lives involves multiple assumptions and estimates and is typically determined by performing a discounted cash flow analysis, which involves a combination of any or all of the following assumptions: customer attrition/runoff, alternative funding costs, deposit servicing costs, and discount rates. We typically engage a third party consultant to assist in each analysis. For the whole bank and bank branch transactions recorded to date, the core deposit intangibles have generally been estimated to have a life ranging from seven to ten years, with an accelerated rate of amortization. For insurance agency acquisitions, the identifiable intangible assets related to the customer lists were determined to have a life of ten to fifteen years, with amortization occurring on a straight-line basis.
Subsequent to the initial recording of the identifiable intangible assets and goodwill, we amortize the identifiable intangible assets over their estimated average lives, as discussed above. In addition, on at least an annual basis, goodwill is evaluated for impairment by comparing the fair value of our reporting units to their related carrying value, including goodwill (our community banking operation is our only material reporting unit). If the carrying value of a reporting unit were ever to exceed its fair value, we would determine whether the implied fair value of the goodwill, using a discounted cash flow analysis, exceeded the carrying value of the goodwill. If the carrying value of the goodwill exceeded the implied fair value of the goodwill, an impairment loss would be recorded in an amount equal to that excess. Performing such a discounted cash flow analysis would involve the significant use of estimates and assumptions.
In our October 2012 goodwill impairment evaluation, we determined the fair value of our community banking operation was approximately $17.20 per common share, or 5% higher, than the $16.43 stated book value of our common stock at the date of valuation. To assist us in computing the fair value of our community banking operation, we engaged a consulting firm that used various valuation techniques as part of its analysis, which resulted in the conclusion of the $17.20 value.
We review identifiable intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Our policy is that an impairment loss is recognized, equal to the difference between the asset’s carrying amount and its fair value, if the sum of the expected undiscounted future cash flows is less than the carrying amount of the asset. Estimating future cash flows involves the use of multiple estimates and assumptions, such as those listed above.
Fair Value and Discount Accretion of Loans Acquired in FDIC-Assisted Transactions
We consider the determination of the initial fair value of loans acquired in FDIC-assisted transactions, the initial fair value of the related FDIC indemnification asset, and the subsequent discount accretion of the purchased loans to involve a high degree of judgment and complexity. We determine fair value accounting estimates of newly assumed assets and liabilities in accordance with relevant accounting guidance. However, the amount that we realize on these assets could differ materially from the carrying value reflected in our financial statements, based upon the timing of collections on the acquired loans in future periods. To the extent the actual values realized for the acquired loans are different from the estimates, the FDIC indemnification asset will generally be impacted in an offsetting manner due to the loss-sharing support from the FDIC.
Because of the inherent credit losses associated with the acquired loans in a failed bank acquisition, the amount that we record as the fair values for the loans is generally less than the contractual unpaid principal balance due from the borrowers, with the difference being referred to as the “discount” on the acquired loans. We have applied the cost recovery method of accounting to all purchased impaired loans due to the uncertainty as to the timing of expected cash flows. This will result in the recognition of interest income on these impaired loans only when the cash payments received from the borrower exceed the recorded net book value of the related loans.
For nonimpaired purchased loans, we accrete the discount over the lives of the loans in a manner consistent with the guidance for accounting for loan origination fees and costs.
FDIC Indemnification Asset
The following table presents additional information regarding our covered loans, loan discounts, allowances for loan losses and the corresponding FDIC indemnification asset:
As noted in the table above, our commercial loss share agreement related to Cooperative Bank’s non-single family loans expires in June 2014. As it relates to that portion of covered loans, we expect accelerated amounts of loan discount accretion and corresponding indemnification asset expense until the expiration date as the loss share attributes of the loan portfolio are resolved.
Current Accounting Matters
See Note 2 to the Consolidated Financial Statements above for information about accounting standards that we have recently adopted.
RESULTS OF OPERATIONS
Overview
Net income available to common shareholders amounted to $5.4 million, or $0.27 per diluted common share, for the three months ended June 30, 2013 compared to $2.5 million, or $0.15 per diluted common share, recorded in the second quarter of 2012. For the six months ended June 30, 2013, the Company recorded net income available to common shareholders of $8.2 million, or $0.41 per diluted common share, compared to a net loss of $3.5 million, or ($0.21) per diluted common share, for the six months ended June 30, 2012. The higher earnings were primarily a result of lower provisions for loan losses and lower foreclosed property losses and write-downs recorded during 2013, as well as higher net interest income.
Net Interest Income and Net Interest Margin
Net interest income for the second quarter of 2013 amounted to $35.6 million, an 8.0% increase from the $33.0 million recorded in the second quarter of 2012. Net interest income for the six months ended June 30, 2013 amounted to $67.5 million, a 3.8% increase from the $65.0 million recorded in the comparable period of 2012.
Our net interest margin (tax-equivalent net interest income divided by average earning assets) in the second quarter of 2013 was 5.10% compared to 4.68% for the second quarter of 2012. For the six month period ended June 30, 2013, our net interest margin was 4.90% compared to 4.64% for the same period in 2012. The 5.10% margin realized in the second quarter of 2013 was a 41 basis point increase from the 4.69% net interest margin realized in the first quarter of 2013. The higher margins were primarily a result of higher amounts of discount accretion on loans purchased in failed-bank acquisitions recognized during the respective periods, as well as lower overall funding costs. Loan discount accretion amounted to $6.6 million in the second quarter of 2013 compared to $3.3 million in the second quarter of 2012. Loan discount accretion amounted to $10.3 million for the six months ended June 30, 2013 compared to $5.9 million for the six months ended June 30, 2012. The higher loan discount accretion was primarily due to continued resolution of the commercial loan portfolio assumed in the 2009 failed-bank acquisition of Cooperative Bank.
Our cost of funds has steadily declined from 0.62% in the second quarter of 2012 to 0.41% in the second quarter of 2013.
Provision for Loan Losses and Asset Quality
We recorded total provisions for loan losses of $5.6 million in the second quarter of 2013 compared to $6.5 million for the second quarter of 2012. For the six months ended June 30, 2013, we recorded total provisions for loans losses of $16.7 million compared to $28.0 million for the same period of 2012. The decrease in 2013 was primarily the result of an elevated provision for loan losses on non-covered loans recorded in the first quarter of 2012 – see explanation of the terms “covered” and “non-covered” in the section below entitled “Note Regarding Components of Earnings.”
Total non-covered nonperforming assets amounted to $79.1 million at June 30, 2013 (2.66% of total non-covered assets), which compares to $106.1 million at December 31, 2012 and $132.5 million at June 30, 2012. The decrease in 2013 compared to both periods in 2012 was due primarily to a combination of loan sales and foreclosed property write-downs that occurred in the fourth quarter of 2012 and the first quarter of 2013, as discussed in the following paragraph.
In the fourth quarter of 2012, we identified approximately $68 million of non-covered higher-risk loans that we targeted for sale to a third-party investor. Based on an offer to purchase these loans that was received in December, we wrote the loans down by approximately $38 million in the fourth quarter of 2012 to their estimated liquidation value of approximately $30 million and reclassified them as “loans held for sale.” The sale of these loans was completed on January 23, 2013. Of the $68 million in loans targeted for sale, approximately $38.2 million had been classified as nonaccrual loans, and $10.5 million had been classified as accruing troubled-debt-restructurings. Additionally, in the fourth quarter of 2012, we recorded write-downs totaling $10.6 million on substantially all of our non-covered foreclosed properties in connection with efforts to accelerate the sale of these assets.
Non-covered nonaccrual loans increased from $33.0 million at December 31, 2012 to $42.3 million at June 30, 2013, due primarily to several larger credits that deteriorated during the first and second quarters of 2013. Non-covered foreclosed real estate decreased from $26.3 million at December 31, 2012 to $15.4 million at June 30, 2013 as a result of strong sales activity during the first half of 2013, which was consistent with our intent discussed above to accelerate the disposition of foreclosed properties.
Total covered nonperforming assets have steadily declined in the past year, amounting to $89.1 million at June 30, 2013 compared to $96.2 million at December 31, 2012 and $129.0 million at June 30, 2012. Within this category, foreclosed real estate declined from $70.9 million at June 30, 2012 to $32.0 million at June 30, 2013. The Company is experiencing increased property sales activity, particularly along the North Carolina coast, which is where most of the Company’s covered foreclosed properties are located. Covered nonaccrual loans increased from $33.5 million at December 31, 2012 to $50.3 million at June 30, 2013, due primarily to several large loans that deteriorated during the first quarter of 2013.
Noninterest Income
Total noninterest income for the second quarter of 2013 was $4.5 million compared to $1.8 million for the same period of 2012. For the six months ended June 30, 2013, noninterest income amounted to $11.6 million compared to $7.1 million for the six months ended June 30, 2012.
Core noninterest income for the second quarter of 2013 was $7.2 million, an increase of 15.9% over the $6.2 million reported for the second quarter of 2012. For the first six months of 2013, core noninterest income amounted to $13.7 million, a 13.3% increase from the $12.1 million recorded in the comparable period of 2012. Core noninterest income includes i) service charges on deposit accounts, ii) other service charges, commissions, and fees, iii) fees from presold mortgages, iv) commissions from sales of insurance and financial products, and v) bank-owned life insurance income. The largest component of the increases in core noninterest income was in the amount of fees from presold mortgages we recorded. The increase in these fees was due to high mortgage loan refinancing activity, as well as increased volume resulting from additional mortgage loan personnel added in recent quarters.
Noncore components of noninterest income resulted in net losses of $2.7 million in the second quarter of 2013 compared to net losses of $4.4 million in the second quarter of 2012. For the six months ended June 30, 2013 and 2012, we recorded net losses of $2.1 million and $4.9 million, respectively, related to the noncore components of noninterest income. The largest variances related to foreclosed property gains/losses and indemnification asset income (expense).
Noninterest Expenses
Noninterest expenses amounted to $25.8 million in the second quarter of 2013 compared to $23.4 million recorded in the second quarter of 2012. Noninterest expenses for the six months ended June 30, 2013 amounted to $49.0 million compared to $47.8 million recorded in the first half of 2012.
During the second quarter of 2013, we accrued approximately $1.6 million in severance expenses (included in “other operating expenses”) due to the separation from service of several employees during the quarter, including the Company’s former chief executive officer.
We also experienced declines in employee benefit expense as a result of freezing two defined benefit pension plans on December 31, 2012. We recorded pension income of $0.2 million and $0.3 million for the three and six months ended June 30, 2013, respectively, compared to pension expense of $0.6 million and $1.7 million for the three and six months ended June 30, 2012, respectively.
Balance Sheet and Capital
Total assets at June 30, 2013 amounted to $3.2 billion, a 2.4% decrease from a year earlier. Total loans at June 30, 2013 amounted to $2.4 billion, a 0.3% decrease from a year earlier, and total deposits amounted to $2.8 billion at June 30, 2013, a 0.7% decrease from a year earlier.
The decrease in loans over the past year was a result of the loan sale previously discussed, as well as the progressive decline in the amount of covered loans. Partially offsetting the decrease was internal loan growth, as well as $16 million in loans added in a branch acquisition discussed below. Excluding the acquired loans, the Company’s non-covered loans have increased by $80 million since December 31, 2012, representing annualized growth of 7.7%. We are seeing improved loan demand as the economy in our market areas improves.
The overall decrease in deposits over the past year was a result of declines in all time deposit categories, including brokered deposits, internet deposits, and all other time deposits. The decrease in loans and strong growth in transaction deposit accounts allowed us to lessen our reliance on time deposits, which is typically our highest cost of funds.
As previously reported, during the first quarter of 2013, we completed the acquisition of two branches from Four Oaks Bank & Trust Company, which resulted in the addition of $16 million in loans and $57 million in deposits.
We remain well-capitalized by all regulatory standards, with a Total Risk-Based Capital Ratio at June 30, 2013 of 16.58% compared to the 10.00% minimum required to be considered well-capitalized. Our tangible common equity to tangible assets ratio was 6.93% at June 30, 2013, an increase of 57 basis points from a year earlier, which is primarily due to the Company’s capital raise that occurred in the fourth quarter of 2012.
Note Regarding Components of Earnings
Our results of operation are significantly affected by the on-going accounting for two FDIC-assisted failed bank acquisitions. In the discussion above and elsewhere in this document, the term “covered” is used to describe assets included as part of FDIC loss share agreements, which generally result in the FDIC reimbursing the Company for 80% of losses incurred on those assets. The term “non-covered” refers to the Company’s legacy assets, which are not included in any type of loss share arrangement.
For covered loans that deteriorate in terms of repayment expectations, we record immediate allowances through the provision for loan losses. For covered loans that experience favorable changes in credit quality compared to what was expected at the acquisition date, including loans that payoff, we record positive adjustments to interest income over the life of the respective loan – also referred to as loan discount accretion. For covered foreclosed properties that are sold at gains or losses or that are written down to lower values, we record the gains/losses within noninterest income.
The adjustments discussed above are recorded within the income statement line items noted without consideration of the FDIC loss share agreements. Because favorable changes in covered assets result in lower expected FDIC claims, and unfavorable changes in covered assets result in higher expected FDIC claims, the FDIC indemnification asset is adjusted to reflect those expectations. The net increase or decrease in the indemnification asset is reflected within noninterest income.
The adjustments noted above can result in volatility within individual income statement line items. Because of the FDIC loss share agreements and the associated indemnification asset, pretax income resulting from amounts recorded as provisions for loan losses on covered loans, discount accretion, and losses from covered foreclosed properties is generally only impacted by 20% of these amounts due to the corresponding adjustments made to the indemnification asset.
Components of Earnings
Net interest income is the largest component of earnings, representing the difference between interest and fees generated from earning assets and the interest costs of deposits and other funds needed to support those assets. Net interest income for the three month period ended June 30, 2013 amounted to $35.6 million, an increase of $2.7 million, or 8.0%, from the $33.0 million recorded in the second quarter of 2012. Net interest income on a tax-equivalent basis for the three month period ended June 30, 2013 amounted to $36.0 million, an increase of $2.6 million, or 7.9%, from the $33.3 million recorded in the second quarter of 2012. We believe that analysis of net interest income on a tax-equivalent basis is useful and appropriate because it allows a comparison of net interest income amounts in different periods without taking into account the different mix of taxable versus non-taxable investments that may have existed during those periods.
Net interest income for the six month period ended June 30, 2013 amounted to $67.5 million, an increase of $2.5 million, or 3.8%, from the $65.0 million recorded in the first half of 2012. Net interest income on a tax-equivalent basis for the six month period ended June 30, 2013 amounted to $68.3 million, an increase of $2.5 million, or 3.7%, from the $65.8 million recorded in the comparable period of 2012.
There are two primary factors that cause changes in the amount of net interest income we record - 1) changes in our loans and deposits balances, and 2) our net interest margin (tax-equivalent net interest income divided by average interest-earning assets).
For the three and six months ended June 30, 2013, the higher net interest income compared to the same periods of 2012 was due to higher net interest margins (see discussion below), which was partially offset by declines in interest-earning assets (primarily average loan balances) for the periods presented.
The following tables presents net interest income analysis on a tax-equivalent basis for the periods indicated.
Average loans outstanding for the second quarter of 2013 were $2.409 billion, which was 1.2% less than the average loans outstanding for the second quarter of 2012 ($2.438 billion). Average loans outstanding for the six months ended June 30, 2013 were $2.396 billion, which was 1.6% less than the average loans outstanding for the six months ended June 30, 2012 ($2.435 billion). The lower amount of average loans outstanding in 2013 is primarily due to 1) the sale of approximately $68 million in non-covered higher-risk loans during January 2013 and 2) the resolution of $83 million in covered loans within our “covered loan” portfolio since June 30, 2012. Resolution of covered loans includes foreclosure, charge-off, or repayment. Partially offsetting these decreases was internal loan growth, as well as loans added in a branch acquisition.
The mix of our loan portfolio remained substantially the same at June 30, 2013 compared to December 31, 2012, with approximately 90% of our loans being real estate loans, 7% being commercial, financial, and agricultural loans, and the remaining 3% being consumer installment loans. The majority of our real estate loans are personal and commercial loans where real estate provides additional security for the loan.
Average total deposits outstanding for the second quarter of 2013 were $2.818 billion, which was 0.2% greater than the average deposits outstanding for the second quarter of 2012 ($2.812 billion). Average deposits outstanding for the six months ended June 30, 2013 were $2.811 billion, which was 0.5% greater than the average deposits outstanding for the six months ended June 30, 2012 ($2.796 billion). We experienced strong growth in our transaction deposit accounts, which we define as noninterest bearing checking, interest bearing checking, money market and savings accounts. Average transaction deposit accounts increased from $1.52 billion for the quarter ended June 30, 2012, to $1.70 billion for the quarter ended June 30, 2013, representing growth of $181 million, or 11.9%. With the lower amount of loans and the growth of our transaction deposit accounts, we were able to lessen our reliance on higher cost sources of funding, including time deposits and borrowings. Average time deposits declined from $1.29 billion for the quarter ended June 30, 2012, to $1.12 billion for the quarter ended June 30, 2013, a decrease of $175 million, or 13.5%. Average borrowings decreased from $127.9 million in the second quarter of 2012 to $46.4 million in the second quarter of 2013. The favorable change in the funding mix resulted in our average cost of interest bearing liabilities decreasing from 0.70% in the second quarter of 2012 to 0.48% in the second quarter of 2013. Our total cost of funds, which includes noninterest bearing checking accounts at a zero percent cost, was 0.41% in the second quarter of 2013 compared to 0.62% in the second quarter of 2012.
See additional information regarding changes in the Company’s loans and deposits in the section below entitled “Financial Condition.”
Our net interest margin (tax-equivalent net interest income divided by average earning assets) for the second quarter of 2013 was 5.10% compared to 4.68% for the second quarter of 2012. For the six month period ended June 30, 2013, our net interest margin was 4.90% compared to 4.64% for the same period in 2012. The higher margins were primarily a result of higher amounts of discount accretion on loans purchased in failed bank acquisitions (see discussion below), as well as the lower overall funding costs just discussed.
Our net interest margin benefitted from net accretion of purchase accounting premiums/discounts associated with the Cooperative acquisition in June 2009 and, to a lesser degree, the acquisition of The Bank of Asheville in January 2011. For the three months ended June 30, 2013 and 2012, we recorded $6,504,000 and $3,196,000, respectively, in net accretion of purchase accounting premiums/discounts, which increased net interest income. For the six months ended June 30, 2013 and 2012, we recorded $10,055,000 and $5,721,000, respectively, in net accretion of purchase accounting premiums/discounts. The following table presents the detail of the purchase accounting adjustments that impacted net interest income.
See additional information regarding net interest income in the section entitled “Interest Rate Risk.”
We recorded total provisions for loan losses of $5.6 million in the second quarter of 2013 compared to $6.5 million in the second quarter of 2012. For the six months ended June 30, 2013, we recorded total provisions for loans losses of $16.7 million compared to $28.0 million in the same period of 2012. As discussed below, the decrease in 2013 was primarily the result of an elevated provision for loan losses on non-covered loans recorded in the first quarter of 2012.
The provision for loan losses on non-covered loans amounted to $4.0 million in the second quarter of 2013 compared to $5.2 million in the second quarter of 2012. For the first six months of 2013, the provision for loan losses on non-covered loans amounted to $9.8 million compared to $23.8 million for the same period of 2012. The decrease for the six month period was primarily due to a high provision for loan losses recorded in the first quarter of 2012 that resulted from an internal review that applied more conservative assumptions to estimate the probable losses associated with some of our nonperforming loan relationships, which we believed could lead to a more timely resolution of the related credits. Many of these same loans were sold to a third party investor in January 2013, as discussed earlier.
The provision for loan losses on covered loans amounted to $1.5 million in the second quarter of 2013 compared to $1.3 million in the second quarter of 2012. For the six months ended June 30, 2013, the provision for loan losses on covered loans amounted to $6.9 million compared to $4.3 million for the same period of 2012. The increase for the six month period in 2013 was primarily the result of several large credits that deteriorated during the first quarter of 2013 and were placed on nonaccrual status.
Total noninterest income was $4.5 million in the second quarter of 2013 compared to $1.8 million for the second quarter of 2012. Total noninterest income was $11.6 million for the first six months of 2013 compared to $7.1 million for the same period in 2012.
As presented in the table below, core noninterest income for the second quarter of 2013 was $7.2 million, an increase of 15.9% over the $6.2 million reported for the second quarter of 2012. Core noninterest income for the six months ended June 30, 2013 was $13.7 million, an increase of 13.3% over the $12.1 million reported for the comparable period in 2012. Core noninterest income includes i) service charges on deposit accounts, ii) other service charges, commissions, and fees, iii) fees from presold mortgages, iv) commissions from sales of insurance and financial products, and v) bank-owned life insurance income.
The following table presents our core noninterest income for the three and six month periods ending June 30, 2013 and 2012, respectively.
In the table above, service charges on deposit accounts have increased in 2013 compared to 2012 primarily as a result of increases in transaction deposit accounts, which have either monthly service charges or activity-based fees associated with them.
Other service charges, commissions, and fees have increased in 2013 compared to 2012 primarily as a result of higher debit card interchange fees. We earn a small fee each time a customer uses a debit card to make a purchase. Due to the growth in checking accounts and increased customer usage of debit cards, we have experienced increases in this line item.
Among the core noninterest income categories, fees from presold mortgages experienced the most significant increase. The increase in these fees was due to high mortgage loan refinancing activity, as well as increased volume from additional mortgage loan personnel we have added in recent quarters.
Commissions from sales of insurance and financial products have increased in 2013 compared to 2012 as a result of increased sales volume generated by additional personnel hired in our wealth management division over the past two years.
Bank-owned life insurance income increased in 2013 due to two large purchases. We purchased $25 million of bank-owned life insurance in April 2012 and another $15 million in June 2013.
Within the noncore components of noninterest income, we recorded net gains on non-covered foreclosed property of $0.8 million and $1.5 million for the three and six months ended June 30, 2013, respectively, compared to net losses of $1.3 million and $2.0 million for the same periods of 2012. Stabilization in real estate market values and lower carrying values following the December 2012 write-down discussed above impacted these variances.
We experienced lower losses on covered foreclosed properties during the three and six month periods ended June 30, 2013, amounting to $0.5 million and $5.1 million, respectively, compared to $6.6 million and $11.1 million during the comparable periods of 2012. The lower losses in 2013 were primarily a result of lower levels of covered foreclosed properties, as well as stabilization in real estate market values, particularly along the North Carolina coast, which is where most of our covered foreclosed properties are located.
As previously discussed, indemnification asset income (expense) is recorded to reflect additional (decreased) amounts expected to be received from the FDIC due to covered loan and foreclosed property losses arising during the period. In the second quarter of 2013, higher loan discount accretion and relatively low levels of loan and foreclosed property losses on covered assets resulted in a net reduction in the indemnification asset, which resulted in $3.4 million of indemnification asset expense compared to $3.6 million in indemnification asset income recorded in the second quarter of 2012. For the six months ended June 30, 2013, indemnification asset income amounted to $1.5 million compared to income of $7.7 million for the same period of 2012.
During the first half of 2012, we recorded $0.4 million in gains on sales of approximately $9.6 million in available for sale securities. We recorded negligible gains on securities during the first six months of 2013.
Noninterest expenses amounted to $25.8 million in the second quarter of 2013 compared to $23.4 million recorded in the same period of 2012. Noninterest expenses for the six months ended June 30, 2013 amounted to $49.0 million compared to $47.8 million recorded in the first half of 2012.
Salaries expense was $11.0 million for the second quarter of 2013 compared to $10.2 million in the second quarter of 2012. Salaries expense amounted to $21.7 million for the first half of 2013 compared to $20.3 million for the comparable period of 2012. These increases are primarily associated with the hiring of additional employees in the mortgage and wealth management divisions and in order to build our infrastructure to prepare for future growth.
Employee benefits expense was $2.5 million in the second quarter of 2013 compared to $2.8 million in the second quarter of 2012. For the first six months of 2013, employee benefits expense was $5.2 million compared to $6.7 million for the same period in 2012. The decreases in 2013 primarily relate to declines in pension expense as a result of freezing the Company’s two defined benefit plans on December 31, 2012. We recorded pension income of $0.2 million and $0.3 million for the three and six months ended June 30, 2013, respectively, compared to pension expense of $0.6 million and $1.7 million for the three and six months ended June 30, 2012, respectively. The pension income we recorded in 2013 relates to investment income from the pension plan’s assets.
Occupancy expense and equipment expense did not vary materially when comparing the three and six month periods ended June 30, 2013 to the comparable periods of 2012.
Other noninterest expenses amounted to $9.1 million and $7.5 million for the second quarters of 2013 and 2012, respectively, and $16.1 million and $14.7 million for the six month periods ended June 30, 2013 and 2012, respectively. The primary reason for the increases in both periods relates to higher severance expenses. In the second quarter of 2013, we accrued approximately $1.6 million in severance expenses due to separation of service of several employees during the quarter, including the Company’s former chief executive officer. In 2012, severance expense amounted to $0.4 million, which was recorded in the first quarter of 2012.
For the second quarter of 2013, the provision for income taxes was $3.2 million, an effective tax rate of 36.1%, compared to $1.5 million for the same period of 2012, which was an effective tax rate of 31.5%. The higher effective tax rate in 2013 was due to lower tax-exempt interest income in relation to taxable income.
For the first six months of 2013, the provision for income taxes was $4.7 million, an effective tax rate of 35.2%. We recorded an income tax benefit of $1.8 million for the first six months of 2012 due to the net loss reported for the period.
We accrued preferred stock dividends of $0.2 million and $0.8 million for the three months ended June 30, 2013 and 2012, respectively. For the first six months of 2013 and 2012, we accrued preferred stock dividends of $0.5 million and $1.6 million, respectively. These amounts are deducted from net income in computing “net income available to common shareholders.” The decrease in preferred dividends in 2013 is a result of a favorable dividend rate variance related to the SBLF preferred stock that was issued in September 2011. The dividend rate can range from 1% to 5% per anum based upon changes in our level of “Qualified Small Business Lending” (“QSBL”). We have been able to continually increase our levels of QSBL since 2011 and as a result, our dividend rate has steadily decreased from 5.0% in the first half of 2012 to 1.0% in the second quarter of 2013. We expect our preferred stock dividend rate to remain at an annualized rate of 1.0% for the remainder of 2013.
The Consolidated Statements of Comprehensive Income (Loss) reflect other comprehensive losses of $1,125,000 and $1,311,000 during the three and six months ended June 30, 2013, respectively, compared to other comprehensive income of $171,000 and $521,000 during the three and six months ended June 30, 2012, respectively. The primary component of other comprehensive income (loss) for the periods presented was changes in unrealized holding gains (losses) of our available for sale securities. Our available for sale securities portfolio is predominantly comprised of fixed rate bonds that generally increase in value when market yields for fixed rate bonds decrease and decline in value when market yields for fixed rate bonds increase. The market yields for fixed rate bonds increased in June 2013, which had an unfavorable impact on a substantial portion of our available for sale securities portfolio. Management has evaluated any unrealized losses on individual securities at each period end and determined that there is no other-than-temporary impairment.
FINANCIAL CONDITION
Total assets at June 30, 2013 amounted to $3.25 billion, 2.4% lower than a year earlier. Total loans at June 30, 2013 amounted to $2.43 billion, a 0.3% decrease from a year earlier, and total deposits amounted to $2.82 billion, a 0.7% decrease from a year earlier.
The following table presents information regarding the nature of our growth for the twelve months ended June 30, 2013 and for the first six months of 2013.
As derived from the table above, for the twelve months preceding June 30, 2013, our total loans declined $7 million, or 0.3%. Over that period, we experienced internal growth in our non-covered loan portfolio of $127 million, or 6.0%. Also impacting growth was the March 2013 acquisition of two branches with approximately $16 million in loans (see Note 4 to the consolidated financial statements for more information). Partially offsetting the growth in non-covered loans was the write-down and reclassification of approximately $68 million in non-covered higher-risk loans to “loans held for sale” during the fourth quarter of 2012. Also offsetting growth in total loans were normal loan pay-downs, foreclosures, and loan charge-offs of our covered loans, which declined by $83 million at June 30, 2013 compared to a year earlier. We continue to pursue lending opportunities in order to improve our asset yields.
For the first six months of 2013, we experienced internal growth in our non-covered loan portfolio of $80 million, or 3.8%. As noted above, we also acquired $16 million in loan growth during the first quarter from the purchase of two branches. These increases were partially offset by a decline in our covered loans of $42 million.
The mix of our loan portfolio remains substantially the same at June 30, 2013 compared to December 31, 2012. The majority of our real estate loans are personal and commercial loans where real estate provides additional security for the loan.
Note 8 to the consolidated financial statements presents additional detailed information regarding our mix of loans, including a break-out between loans covered by FDIC loss share agreements and non-covered loans.
For the three and twelve month periods ended June 30, 2013, we experienced strong internal growth in transaction deposit accounts, which has allowed us to reduce our reliance on higher cost time deposits. Our level of deposits was also impacted by the August 2012 purchase of a branch with $9 million in deposits and the March 2013 purchase of two branches with $57 million in deposits.
Nonperforming Assets
Nonperforming assets include nonaccrual loans, troubled debt restructurings, loans past due 90 or more days and still accruing interest, nonperforming loans held for sale, and foreclosed real estate. As previously discussed, as a result of two FDIC-assisted transactions, we entered into loss share agreements that afford us significant protection from losses from all loans and foreclosed real estate acquired in those acquisitions.
Because of the loss protection provided by the FDIC, the financial risk of the acquired loans and foreclosed real estate is significantly different from the risk associated with assets not covered under the loss share agreements. Accordingly, we present separately nonperforming assets subject to the loss share agreements as “covered” nonperforming assets, and nonperforming assets that are not subject to the loss share agreements as “non-covered.”
Nonperforming assets are summarized as follows:
We have reviewed the collateral for our nonperforming assets, including nonaccrual loans, and have included this review among the factors considered in the evaluation of the allowance for loan losses discussed below.
Consistent with the weak economy in our market area, we have experienced high levels of loan losses, delinquencies and nonperforming assets compared to our historical averages.
The following is the composition, by loan type, of all of our nonaccrual loans (covered and non-covered) at each period end, as classified for regulatory purposes:
The following segregates our nonaccrual loans at June 30, 2013 into covered and non-covered loans, as classified for regulatory purposes:
The following segregates our nonaccrual loans at December 31, 2012 into covered and non-covered loans, as classified for regulatory purposes:
Troubled debt restructurings (TDRs) are accruing loans for which we have granted concessions to the borrower as a result of the borrower’s financial difficulties. At June 30, 2013, total TDRs (covered and non-covered) amounted to $28.1 million, compared to $40.3 million at December 31, 2012, and $39.7 million at June 30, 2012. The decline from December 31, 2012 to June 30, 2013 is primarily a result of covered TDRs that re-defaulted during the first six months of 2013 and were placed on nonaccrual status.
Non-covered TDRs amounted to $21.3 million at June 30, 2013, compared to $24.8 million at December 31, 2012, and $20.7 million at June 30, 2012. As part of a routine regulatory exam that concluded in the third quarter of 2012, we reclassified approximately $30 million of performing loans to TDR status during the second and third quarters of 2012. Other than reclassifying these loans to a nonperforming asset category for disclosure purposes, the reclassifications did not impact our financial statements. Also, in December 2012, the Company reclassified approximately $10.5 million (written down to a liquidation value of $5.0 million) of accruing TDRs to the “nonperforming loans held for sale” category as discussed earlier.
Covered TDRs amounted to $6.8 million at June 30, 2013, compared to $15.5 million at December 31, 2012, and $19.1 million at June 30, 2012. The decrease in 2013 was primarily due to several large TDRs that deteriorated during the period and were placed on nonaccrual status.
Non-covered foreclosed real estate has decreased over the past year, amounting to $15.4 million at June 30, 2013, $26.3 million at December 31, 2012, and $37.9 million at June 30, 2012. The decrease from June 30, 2012 to December 31, 2012 was due to write-downs of $10.6 million that we recorded in the fourth quarter of 2012. We recorded write-downs on substantially all of our non-covered foreclosed properties in connection with efforts to accelerate the sale of these assets. The $10.6 million in write-downs represented approximately 29% of the total carrying value of the properties. The decrease from December 31, 2012 to June 30, 2013 was the result of strong sales activity during the first half of 2013, which was consistent with our intent to accelerate the disposition of foreclosed properties.
At June 30, 2013, we also held $32.0 million in foreclosed real estate that is subject to the loss share agreements with the FDIC, which is a decrease from $47.3 million at December 31, 2012 and $70.9 million at June 30, 2012. The decreases are due to increased property sales activity, particularly along the North Carolina coast, which is where most of our covered foreclosed properties are located.
We believe that the fair values of the items of foreclosed real estate, less estimated costs to sell, equal or exceed their respective carrying values at the dates presented.
The following table presents the detail of all of our foreclosed real estate at each period end (covered and non-covered):
The following segregates our foreclosed real estate at June 30, 2013 into covered and non-covered:
The following segregates our foreclosed real estate at December 31, 2012 into covered and non-covered:
The following table presents geographical information regarding our nonperforming assets at June 30, 2013.
Summary of Loan Loss Experience
The allowance for loan losses is created by direct charges to operations. Losses on loans are charged against the allowance in the period in which such loans, in management’s opinion, become uncollectible. The recoveries realized during the period are credited to this allowance.
We have no foreign loans, few agricultural loans and do not engage in significant lease financing or highly leveraged transactions. Commercial loans are diversified among a variety of industries. The majority of our real estate loans are primarily personal and commercial loans where real estate provides additional security for the loan. Collateral for virtually all of these loans is located within our principal market area.
The weak economic environment since 2009 has resulted in elevated levels of classified and nonperforming assets, which has led to higher provisions for loan losses compared to historical averages. Our total provision for loan losses was $5.6 million for the second quarter of 2013 compared to $6.5 million in the second quarter of 2012. Our total provision for loan losses for the first six months of 2013 and 2012 was $16.7 million and $28.0 million, respectively. The total provision for loan losses is comprised of provision for loan losses for non-covered loans and provision for loan losses for covered loans, as discussed in the following paragraphs.
The provision for loan losses on non-covered loans amounted to $4.0 million and $5.2 million in the second quarters of 2013 and 2012, respectively, and $9.8 million and $23.8 million for the first half of 2013 and 2012, respectively. The decrease for the six-month period was primarily due to a high provision for loan losses recorded in the first quarter of 2012 attributable to refinements to our loan loss model and internal control changes that resulted in a realignment of departmental responsibilities for determining our allowance for loan losses. As a result of the changes, an internal review of selected nonperforming loan relationships was conducted, which applied more conservative assumptions to estimate the probable losses. We believed that the additional reserves established could lead to a more timely resolution of the related credits. Many of these same loans were sold to a third party investor in January 2013, as discussed earlier.
The $9.8 million provision for loan losses on non-covered loans recorded in the first half of 2013 was impacted by higher levels of loans classified as special mention or classified at June 30, 2013 compared to December 31, 2012 – see Note 8 to the consolidated financial statements for detail. During the first six months of 2013, non-covered loans classified as special mention increased from $61 million to $81 million, while classified loans increased from $41 million to $61 million. We believe those increases were primarily due to more conservative judgments being applied to loan grading than was the prior practice, as opposed to any significant deterioration in overall loan quality. As reflected in Note 8, the amount of non-covered loans that were past due 30-59 days has decreased from $17.1 million at December 31, 2012 to $11.9 million at June 30, 2013, and the amount of loans 60-89 days past due has decreased from $4.7 million at December 31, 2012 to $2.8 million at June 30, 2013.
The provision for loan losses on covered loans amounted to $1.5 million in the second quarter of 2013 compared to $1.3 million in the second quarter of 2012. For the six months ended June 30, 2013, the provision for loan losses on covered loans amounted to $6.9 million compared to $4.3 million for the same period of 2012. The increase in the six month period was primarily the result of several large credits that deteriorated during the first quarter of 2013 and were placed on nonaccrual status. Because of the FDIC loss share agreements in place for these loans, the FDIC indemnification asset was adjusted upwards by 80% for the amount of the provision.
For the first six months of 2013, we recorded $12.3 million in net charge-offs, compared to $16.0 million for the comparable period of 2012. The net charge-offs in 2013 included $5.7 million of covered loans and $6.6 million of non-covered loans, whereas in 2012 net charge-offs included $4.1 million of covered loans and $11.8 million of non-covered loans. The charge-offs in 2013 continue a trend that began in 2010, with charge-offs being concentrated in the construction and land development and commercial real estate categories. These types of loans have been impacted the most by the recession and decline in new housing.
The allowance for loan losses amounted to $50.9 million at June 30, 2013, compared to $46.4 million at December 31, 2012 and $53.5 million at June 30, 2012. At June 30, 2013, December 31, 2012, and June 30, 2012, the allowance for loan losses attributable to covered loans was $6.0 million, $4.8 million, and $5.9 million, respectively. The allowance for loan losses for covered loans is attributable to covered loans that have exhibited credit quality deterioration due to lower collateral valuations. The allowance for loan losses for non-covered loans amounted to $44.8 million, $41.6 million, and $47.5 million at June 30, 2013, December 31, 2012, and June 30, 2012, respectively. The increase in the allowance for losses for non-covered loans at June 30, 2013 compared to December 31, 2012 is primarily the result of higher levels of classified loans.
We believe our reserve levels are adequate to cover probable loan losses on the loans outstanding as of each reporting date. It must be emphasized, however, that the determination of the reserve using our procedures and methods rests upon various judgments and assumptions about economic conditions and other factors affecting loans. No assurance can be given that we will not in any particular period sustain loan losses that are sizable in relation to the amounts reserved or that subsequent evaluations of the loan portfolio, in light of conditions and factors then prevailing, will not require significant changes in the allowance for loan losses or future charges to earnings. See “Critical Accounting Policies – Allowance for Loan Losses” above.
In addition, various regulatory agencies, as an integral part of their examination process, periodically review our allowance for loan losses and value of other real estate. Such agencies may require us to recognize adjustments to the allowance or the carrying value of other real estate based on their judgments about information available at the time of their examinations.
For the periods indicated, the following table summarizes our balances of loans outstanding, average loans outstanding, changes in the allowance for loan losses arising from charge-offs and recoveries, and additions to the allowance for loan losses that have been charged to expense.
The following table discloses the activity in the allowance for loan losses for the six months ended June 30, 2013, segregated into covered and non-covered.
The following table discloses the activity in the allowance for loan losses for the six months ended June 30, 2012, segregated into covered and non-covered.
Based on the results of our loan analysis and grading program and our evaluation of the allowance for loan losses at June 30, 2013, there have been no material changes to the allocation of the allowance for loan losses among the various categories of loans since December 31, 2012.
Liquidity, Commitments, and Contingencies
Our liquidity is determined by our ability to convert assets to cash or acquire alternative sources of funds to meet the needs of our customers who are withdrawing or borrowing funds, and to maintain required reserve levels, pay expenses and operate the Company on an ongoing basis. Our primary liquidity sources are net income from operations, cash and due from banks, federal funds sold and other short-term investments. Our securities portfolio is comprised almost entirely of readily marketable securities, which could also be sold to provide cash.
In addition to internally generated liquidity sources, we have the ability to obtain borrowings from the following three sources - 1) an approximately $339 million line of credit with the Federal Home Loan Bank (of which none was outstanding at June 30, 2013), 2) a $50 million overnight federal funds line of credit with a correspondent bank (none of which was outstanding at June 30, 2013), and 3) an approximately $86 million line of credit through the Federal Reserve Bank of Richmond’s discount window (none of which was outstanding at June 30, 2013). In addition to the outstanding borrowings from the FHLB that reduce the available borrowing capacity of that line of credit, our borrowing capacity was reduced by $143 million at June 30, 2013 and 2012, as a result of our pledging letters of credit for public deposits at each of those dates. Unused and available lines of credit amounted to $332 million at June 30, 2013 compared to $367 million at December 31, 2012.
Our overall liquidity has remained stable since June 30, 2012. Our liquid assets (cash and securities) as a percentage of our total deposits and borrowings increased from 16.6% at June 30, 2012 to 16.7% at June 30, 2013.
We believe our liquidity sources, including unused lines of credit, are at an acceptable level and remain adequate to meet our operating needs in the foreseeable future. We will continue to monitor our liquidity position carefully and will explore and implement strategies to increase liquidity if deemed appropriate.
The amount and timing of our contractual obligations and commercial commitments has not changed materially since December 31, 2012, detail of which is presented in Table 18 on page 85 of our 2012 Annual Report on Form 10-K.
We are not involved in any legal proceedings that, in our opinion, could have a material effect on our consolidated financial position.
Off-Balance Sheet Arrangements and Derivative Financial Instruments
Off-balance sheet arrangements include transactions, agreements, or other contractual arrangements pursuant to which we have obligations or provide guarantees on behalf of an unconsolidated entity. We have no off-balance sheet arrangements of this kind other than letters of credit and repayment guarantees associated with our trust preferred securities.
Derivative financial instruments include futures, forwards, interest rate swaps, options contracts, and other financial instruments with similar characteristics. We have not engaged in derivative activities through June 30, 2013, and have no current plans to do so.
Capital Resources
We are regulated by the Board of Governors of the Federal Reserve Board (FED) and are subject to the securities registration and public reporting regulations of the Securities and Exchange Commission. Our banking subsidiary is regulated by the Federal Deposit Insurance Corporation (FDIC) and the North Carolina Office of the Commissioner of Banks. We are not aware of any recommendations of regulatory authorities or otherwise which, if they were to be implemented, would have a material effect on our liquidity, capital resources, or operations.
We must comply with regulatory capital requirements established by the FED and FDIC. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. Our capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. These capital standards require us to maintain minimum ratios of “Tier 1” capital to total risk-weighted assets and total capital to risk-weighted assets of 4.00% and 8.00%, respectively. Tier 1 capital is comprised of total shareholders’ equity calculated in accordance with generally accepted accounting principles, excluding accumulated other comprehensive income (loss), less intangible assets, and total capital is comprised of Tier 1 capital plus certain adjustments, the largest of which is our allowance for loan losses. Risk-weighted assets refer to our on- and off-balance sheet exposures, adjusted for their related risk levels using formulas set forth in FED and FDIC regulations.
In addition to the risk-based capital requirements described above, we are subject to a leverage capital requirement, which calls for a minimum ratio of Tier 1 capital (as defined above) to quarterly average total assets of 3.00% to 5.00%, depending upon the institution’s composite ratings as determined by its regulators. The FED has not advised us of any requirement specifically applicable to us.
At June 30, 2013, our capital ratios exceeded the regulatory minimum ratios discussed above. The following table presents our capital ratios and the regulatory minimums discussed above for the periods indicated.
Our bank subsidiary is also subject to capital requirements similar to those discussed above. The bank subsidiary’s capital ratios do not vary materially from our capital ratios presented above. At June 30, 2013, our bank subsidiary exceeded the minimum ratios established by the FED and FDIC.
In addition to regulatory capital ratios, we also closely monitor our ratio of tangible common equity to tangible assets (“TCE Ratio”). Our TCE ratio was 6.93% at June 30, 2013 compared to 6.81% at December 31, 2012 and 6.36% at June 30, 2012.
BUSINESS DEVELOPMENT MATTERS
The following is a list of business development and other miscellaneous matters affecting First Bancorp and First Bank, our bank subsidiary.
SHARE REPURCHASES
We did not repurchase any shares of our common stock during the first six months of 2013. At June 30, 2013, we had approximately 214,000 shares available for repurchase under existing authority from our board of directors. We may repurchase these shares in open market and privately negotiated transactions, as market conditions and our liquidity warrants, subject to compliance with applicable regulations. See also Part II, Item 2 “Unregistered Sales of Equity Securities and Use of Proceeds.”
Item 3 – Quantitative and Qualitative Disclosures About Market Risk
INTEREST RATE RISK (INCLUDING QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK)
Net interest income is our most significant component of earnings. Notwithstanding changes in volumes of loans and deposits, our level of net interest income is continually at risk due to the effect that changes in general market interest rate trends have on interest yields earned and paid with respect to our various categories of earning assets and interest-bearing liabilities. It is our policy to maintain portfolios of earning assets and interest-bearing liabilities with maturities and repricing opportunities that will afford protection, to the extent practical, against wide interest rate fluctuations. Our exposure to interest rate risk is analyzed on a regular basis by management using standard GAP reports, maturity reports, and an asset/liability software model that simulates future levels of interest income and expense based on current interest rates, expected future interest rates, and various intervals of “shock” interest rates. Over the years, we have been able to maintain a fairly consistent yield on average earning assets (net interest margin). Over the past five calendar years, our net interest margin has ranged from a low of 3.74% (realized in 2008) to a high of 4.78% (realized in 2012). During that five year period, the prime rate of interest has ranged from a low of 3.25% (which was the rate as of June 30, 2013) to a high of 6.25% (which was the rate as of June 30, 2008). The consistency of the net interest margin is aided by the relatively low level of long-term interest rate exposure that we maintain. At June 30, 2013, approximately 73% of our interest-earning assets are subject to repricing within five years (because they are either adjustable rate assets or they are fixed rate assets that mature) and substantially all of our interest-bearing liabilities reprice within five years.
Using stated maturities for all fixed rate instruments except mortgage-backed securities (which are allocated in the periods of their expected payback) and securities and borrowings with call features that are expected to be called (which are shown in the period of their expected call), at June 30, 2013, we had approximately $823 million more in interest-bearing liabilities than earning assets that are subject to interest rate changes within one year. This generally would indicate that net interest income would experience downward pressure in a rising interest rate environment and would benefit from a declining interest rate environment. However, this method of analyzing interest sensitivity only measures the magnitude of the timing differences and does not address earnings, market value, or management actions. Also, interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. In addition to the effects of “when” various rate-sensitive products reprice, market rate changes may not result in uniform changes in rates among all products. For example, included in interest-bearing liabilities subject to interest rate changes within one year at June 30, 2013 are deposits totaling $1.3 billion comprised of checking, savings, and certain types of money market deposits with interest rates set by management. These types of deposits historically have not repriced with, or in the same proportion, as general market indicators.
Overall, we believe that in the near term (twelve months), net interest income will not likely experience significant downward pressure from rising interest rates. Similarly, we would not expect a significant increase in near term net interest income from falling interest rates. Generally, when rates change, our interest-sensitive assets that are subject to adjustment reprice immediately at the full amount of the change, while our interest-sensitive liabilities that are subject to adjustment reprice at a lag to the rate change and typically not to the full extent of the rate change. In the short-term (less than six months), this results in us being asset-sensitive, meaning that our net interest income benefits from an increase in interest rates and is negatively impacted by a decrease in interest rates. However, in the twelve-month horizon, the impact of having a higher level of interest-sensitive liabilities lessens the short-term effects of changes in interest rates.
The general discussion in the foregoing paragraph applies most directly in a “normal” interest rate environment in which longer-term maturity instruments carry higher interest rates than short-term maturity instruments, and is less applicable in periods in which there is a “flat” interest rate curve. A “flat yield curve” means that short-term interest rates are substantially the same as long-term interest rates. As a result of the prolonged negative economic environment that continued through most of 2012 and into 2013, the Federal Reserve took steps to suppress long-term interest rates in an effort to boost the housing market, increase employment, and stimulate the economy, which resulted in a flat interest rate curve. A flat interest rate curve is an unfavorable interest rate environment for many banks, including the Company, as short-term interest rates generally drive our deposit pricing and longer-term interest rates generally drive loan pricing. When these rates converge, the profit spread we realize between loan yields and deposit rates narrows, which pressures our net interest margin.
In June 2013, the economy began to show tangible signs of improvement and the Federal Reserve suggested that they may lessen their involvement in the economic recovery process in the near future, which should result in a rise in interest rates, especially longer-term interest rates. The marketplace began to anticipate that result and accordingly, longer-term interest rates increased in June 2013, while short-term rates have remained stable. For example, from December 31, 2012 to June 30, 2013, the interest rate on three-month Treasury bills remained stable, but the interest rate for seven-year Treasury notes increased by 78 basis points. This results in a “steepening” of the yield curve and is a more favorable interest rate environment for many banks, including the Company, because as noted above, short-term interest rates generally drive our deposit pricing and longer-term interest rates generally drive loan pricing. However, intense competition for high-quality loans in our market areas has thus far negated the impact of the higher long-term market rates by limiting our ability to charge higher rates on loans, and thus we continue to experience downward pressure on our loan yields and net interest margin.
As it relates to deposits, the Federal Reserve has made no changes to the short term interest rates it sets directly since 2008, and since that time we have been able to reprice many of our maturing time deposits at lower interest rates. We were also able to generally decrease the rates we paid on other categories of deposits as a result of declining short-term interest rates in the marketplace and an increase in liquidity that lessened our need to offer premium interest rates. However, as short-term rates are already near zero, it is unlikely that we will be able to continue the trend of reducing our funding costs in the same proportion as experienced in recent quarters.
As previously discussed in the section “Net Interest Income,” our net interest income was impacted by certain purchase accounting adjustments related primarily to our acquisitions of Cooperative Bank and The Bank of Asheville. The purchase accounting adjustments related to the premium amortization on loans, deposits and borrowings are based on amortization schedules and are thus systematic and predictable. The accretion of the loan discount on loans acquired from Cooperative Bank and The Bank of Asheville, which amounted to $10.3 million and $5.9 million for the first six months of 2013 and 2012, respectively, is less predictable and could be materially different among periods. This is because of the magnitude of the discounts that were initially recorded ($280 million in total) and the fact that the accretion being recorded is dependent on both the credit quality of the acquired loans and the impact of any accelerated loan repayments, including payoffs. If the credit quality of the loans declines, some, or all, of the remaining discount will cease to be accreted into income. If the underlying loans experience accelerated paydowns or improved performance expectations, the remaining discount will be accreted into income on an accelerated basis. In the event of total payoff, the remaining discount will be entirely accreted into income in the period of the payoff. Each of these factors is difficult to predict and susceptible to volatility.
Based on our most recent interest rate modeling, which assumes no changes in interest rates for 2013 (federal funds rate = 0.25%, prime = 3.25%), we project that our net interest margin for the remainder of 2013 will experience some compression. We expect loan yields to continue to trend downwards, while many of our deposit products already have interest rates near zero.
We have no market risk sensitive instruments held for trading purposes, nor do we maintain any foreign currency positions.
See additional discussion regarding net interest income, as well as discussion of the changes in the annual net interest margin, in the section entitled “Net Interest Income” above.
Item 4 – Controls and Procedures
As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures, which are our controls and other procedures that are designed to ensure that information required to be disclosed in our periodic reports with the SEC is recorded, processed, summarized and reported within the required time periods. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed is communicated to our management to allow timely decisions regarding required disclosure. Based on the evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures are effective in allowing timely decisions regarding disclosure to be made about material information required to be included in our periodic reports with the SEC. In addition, no change in our internal control over financial reporting has occurred during, or subsequent to, the period covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Part II. Other Information
Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds
Footnotes to the Above Table
There were no unregistered sales of our securities during the three months ended June 30, 2013.
Item 6 - Exhibits
The following exhibits are filed with this report or, as noted, are incorporated by reference. Management contracts, compensatory plans and arrangements are marked with an asterisk (*).
Copies of exhibits are available upon written request to: First Bancorp, Anna G. Hollers, Executive Vice President, P.O. Box 508, Troy, NC 27371
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.