UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2020
or
¨TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _______________ to _________________________.
Commission file number: 000-16084
CITIZENS & NORTHERN CORPORATION
(Exact name of Registrant as specified in its charter)
Securities registered pursuant to Section 12(b) of the Act:
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 12 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. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files).
Yes xNo ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See definition of “large accelerated filer,” accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer¨ Accelerated filer x Non-accelerated filer ¨ Smaller reporting company xEmerging growth company ¨
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨No x
Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date.
CITIZENS & NORTHERN CORPORATION – FORM 10-Q
Index
The accompanying notes are an integral part of these unaudited consolidated financial statements.
Consolidated Statements of Changes in Stockholders' Equity
Notes to Unaudited Consolidated Financial Statements
1. BASIS OF INTERIM PRESENTATION AND STATUS OF RECENT ACCOUNTING PRONOUNCEMENTS
The consolidated financial statements include the accounts of Citizens & Northern Corporation and its subsidiaries, Citizens & Northern Bank (“C&N Bank”), Bucktail Life Insurance Company and Citizens & Northern Investment Corporation (collectively, “Corporation”). The consolidated financial statements also include C&N Bank’s wholly-owned subsidiaries, C&N Financial Services Corporation and Northern Tier Holding LLC. C&N Bank is the sole member of Northern Tier Holding LLC. All material intercompany balances and transactions have been eliminated in consolidation.
The consolidated financial information included herein, except the consolidated balance sheet dated December 31, 2019, is unaudited. Such information reflects all adjustments (consisting solely of normal recurring adjustments) that are, in the opinion of management, necessary for a fair presentation of the financial position, results of operations, comprehensive income, cash flows and changes in stockholders’ equity for the interim periods; however, the information does not include all disclosures required by accounting principles generally accepted in the United States of America (“U.S. GAAP”) for a complete set of financial statements. Certain 2019 information has been reclassified for consistency with the 2020 presentation.
Operating results reported for the three-month period ended March 31, 2020 might not be indicative of the results for the year ending December 31, 2020. The Corporation evaluates subsequent events through the date of filing with the Securities and Exchange Commission.
RECENT ACCOUNTING PRONOUNCEMENTS
The Financial Accounting Standards Board (FASB) issues Accounting Standards Updates (ASUs) to the FASB Accounting Standards Codification (ASC). This section provides a summary description of recent ASUs that have significant implications (elected or required) within the consolidated financial statements, or that management expects may have a significant impact on financial statements issued in the near future.
Recent Accounting Pronouncements - Adopted
Effective January 1, 2019, the Corporation adopted ASU 2016-02, Leases (Topic 842), as modified by subsequent ASUs, which changed U.S. GAAP by requiring that lease assets and liabilities arising from operating leases be recognized on the balance sheet. Topic 842, as modified, does not significantly change the recognition, measurement and presentation of expenses and cash flows arising from a lease by a lessee from prior U.S. GAAP. For leases with a term of 12 months or less, the Corporation made an accounting policy election by class of underlying asset not to recognize lease assets and liabilities. The Corporation elected to adopt this pronouncement using an optional transition method resulting in recognition of right-of-use assets and lease liabilities for operating leases of $1,132,000 on its consolidated balance sheets at January 1, 2019, with no adjustment to stockholders’ equity and no material impact to its consolidated statements of income. At December 31, 2019, right-of-use assets of $1,637,000 were included in other assets, and the related liabilities totaling the same amount were included in accrued interest and other liabilities, in the consolidated balance sheets.
Effective December 31, 2019, the Corporation elected early adoption of ASU 2017-04, Intangibles – Goodwill and Other (Topic 350), which simplified accounting for goodwill impairment by removing step 2 of the goodwill impairment test thus eliminating the need to determine the fair value of individual assets and liabilities of the reporting unit. Upon adoption of this ASU, goodwill impairment is the amount by which a reporting unit’s carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. Adoption of this ASU did not have a material impact on the Corporation’s consolidated financial statements.
ASU 2018-13, Fair Value Measurement (Topic 820) modifies disclosure requirements on fair value measurements. This ASU removes requirements to disclose the amount of and reasons for transfers between Level 1 and Level 2 of the fair value hierarchy, the policy for timing of transfers between levels and the valuation processes for Level 3 fair value measurements. ASU 2018-13 clarifies that disclosure regarding measurement uncertainty is intended to communicate information about the uncertainty in measurement as of the reporting date. ASU 2018-13 adds certain disclosure requirements, including disclosure of changes in unrealized gains and losses for the period included in other comprehensive income for recurring Level 3 fair value measurements held at the end of the reporting period and the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements. The amendments in this ASU are effective for the Corporation beginning in the first quarter 2020. The amendments on changes in unrealized gains and losses, the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements and the narrative description of measurement uncertainty should be applied prospectively, while all other amendments should be applied retrospectively for all periods presented. The Corporation does not expect adoption of this ASU to have a material impact on its consolidated financial position or results of operations.
Recently Issued But Not Yet Effective Accounting Pronouncements
ASU 2016-13, Financial Instruments-Credit Losses (Topic 326), as modified by subsequent ASUs, changes accounting for credit losses on loans receivable and debt securities from an incurred loss methodology to an expected credit loss methodology. Among other things, ASU 2016-13 requires the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Accordingly, ASU 2016-13 requires the use of forward-looking information to form credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, though the inputs to those techniques will change to reflect the full amount of expected credit losses. In addition, ASU 2016-13 amends the accounting for credit losses on debt securities and purchased financial assets with credit deterioration. The effect of implementing this ASU is recorded through a cumulative-effect adjustment to retained earnings. The Corporation has formed a cross functional management team and is working with an outside vendor assessing alternative loss estimation methodologies and the Corporation’s data and system needs to evaluate the impact that adoption of this standard will have on the Corporation’s financial condition and results of operations. In November 2019, the FASB approved a delay of the required implementation date of ASU 2016-13 for smaller reporting companies, including the Corporation, resulting in a required implementation date for the Corporation of January 1, 2023.
ASU 2020-04, Reference Rate Reform (Topic 848) provides temporary optional guidance to ease the potential burden in accounting for reference rate reform. The amendments in Update 2020-04 are elective and apply to all entities that have contracts, hedging relationships, and other transactions that reference LIBOR or another reference rate expected to be discontinued. The guidance includes a general principle that permits an entity to consider contract modifications due to reference rate reform to be an event that does not require contract remeasurement at the modification date or reassessment of a previous accounting determination. Some specific optional expedients are as follows:
The amendments in this Update are effective as of March 12, 2020 through December 31, 2022. The Corporation expects to apply the amendments prospectively for applicable loan and other contracts within the effective period of this Update.
2. BUSINESS COMBINATION AND PENDING ACQUISITION
Business Combination – Acquisition of Monument Bancorp, Inc.
On April 1, 2019, the Corporation completed its acquisition of 100% of the common stock of Monument Bancorp, Inc.(“Monument.”) Monument was the parent company of Monument Bank, a commercial bank which operated two community bank offices and one lending office in Bucks County, Pennsylvania. Pursuant to the merger, Monument was merged into Citizens & Northern Corporation and Monument Bank was merged into C&N Bank.
Total purchase consideration was $42.7 million, including cash paid to former Monument shareholders totaling $9.6 million and 1,279,825 shares of Corporation common stock issued with a value of $33.1 million, net of costs directly related to stock issuance of $181,000.
In connection with the transaction, the Corporation recorded goodwill of $16.4 million and a core deposit intangible asset of $1.5 million. Total loans acquired on April 1, 2019 were valued at $259.3 million, while total deposits assumed were valued at $223.3 million, borrowings were valued at $111.6 million and subordinated debt was valued at $12.4 million. The subordinated debt included an instrument with a fair value of $5.4 million that was redeemed on April 1, 2019 with no realized gain or loss. The Corporation acquired available-for-sale debt securities valued at $94.6 million and sold the securities in early April for approximately no realized gain or loss. The assets purchased and liabilities assumed in the merger were recorded at their estimated fair values at the time of closing, subject to refinement for up to one year after the closing date. There were no adjustments to the fair value measurements of assets or liabilities in the first quarter 2020.
Merger-related expenses, including legal and professional expenses and conversion of Monument’s customer accounting data into C&N’s core system, were $311,000 in the first quarter 2019.
Pending Acquisition of Covenant Financial, Inc.
In December 2019, the Corporation announced a plan of merger to acquire Covenant Financial, Inc. (“Covenant”). Covenant is the holding company for Covenant Bank, which operates banking offices in Bucks and Chester Counties of PA. At March 31, 2020, Covenant reported total assets of $522 million, liabilities of $479 million and stockholders’ equity of $43 million. Under the terms of the definitive agreement, the Corporation will pay cash for 25% of the Covenant shares and will convert 75% of Covenant shares to the Corporation’s common stock. The transaction was valued on December 18, 2019 at approximately $77 million. Based on the average closing price of the Corporation’s common stock in the final 10 trading days of March 2020 of $18.87 per share, the value of the transaction would be $60 million. The value used to record the stock-based portion of the merger consideration will be based on the average of the high and low trading price of the Corporation’s common stock on the closing date. The merger is subject to satisfaction of customary closing conditions, including receipt of regulatory approvals and approval of Covenant’s shareholders. The merger is expected to close in the third quarter 2020.
In the first quarter 2020, the Corporation incurred merger-related expenses related to the planned acquisition of Covenant totaling $141,000, In the year ending December 31, 2020, management expects the Corporation to incur significant additional merger-related expenses, including severance and similar expenses, costs associated with termination of data processing contracts, conversion of Covenant’s customer accounting data, legal and professional fees and various other costs. Management estimates pre-tax merger-related expenses associated with the Covenant acquisition will total approximately $7.4 million ($6.0 million, net of tax), with most of the expenses expected to be incurred in the third quarter 2020.
3. PER SHARE DATA
Basic earnings per common share are calculated using the two-class method to determine income attributable to common shareholders. Unvested restricted stock awards that contain nonforfeitable rights to dividends are considered participating securities under the two-class method. Distributed dividends and an allocation of undistributed net income to participating securities reduce the amount of income attributable to common shareholders. Income attributable to common shareholders is then divided by weighted-average common shares outstanding for the period to determine basic earnings per common share.
Diluted earnings per common share are calculated under the more dilutive of either the treasury method or the two-class method. Diluted earnings per common share is computed using weighted-average common shares outstanding, plus weighted-average common shares available from the exercise of all dilutive stock options, less the number of shares that could be repurchased with the proceeds of stock option exercises based on the average share price of the Corporation's common stock during the period.
(In Thousands, Except Share and Per Share Data)
(a) Basic and diluted earnings per share under the two-class method are determined on net income reported on the consolidated statements of income, less earnings allocated to non-vested restricted shares with nonforfeitable dividends (participating securities).
Anti-dilutive stock options are excluded from net income per share calculations. There were no anti-dilutive instruments in the three-month periods ended March 31, 2020 and 2019.
4. COMPREHENSIVE INCOME
Comprehensive income is the total of (1) net income, and (2) all other changes in equity from non-stockholder sources, which are referred to as other comprehensive income (loss). The components of other comprehensive income (loss), and the related tax effects, are as follows:
Changes in the components of accumulated other comprehensive income (loss) are as follows and are presented net of tax:
Items reclassified out of each component of other comprehensive income (loss) are as follows:
5. CASH AND DUE FROM BANKS
Cash and due from banks at March 31, 2020 and December 31, 2019 include the following:
Certificates of deposit are issues by U.S. banks with original maturities greater than three months. Each certificate of deposit is fully FDIC-insured. The Corporation maintains cash and cash equivalents with certain financial institutions in excess of the FDIC insurance limit.
Historically, C&N Bank has been required to maintain reserves against deposit liabilities in the form of cash and balances with the Federal Reserve Bank of Philadelphia. The reserves are based on deposit levels, account activity, and other services provided by the Federal Reserve Bank. In March 2020, the Federal Reserve Board reduced reserve requirements for U.S. banks to 0%. Accordingly, C&N Bank had no required reserves at March 31, 2020. Required reserves were $20,148,000 at December 31, 2019.
6. SECURITIES
Amortized cost and fair value of available-for-sale debt securities at March 31, 2020 and December 31, 2019 are summarized as follows:
The following table presents gross unrealized losses and fair value of available-for-sale debt securities with unrealized loss positions that are not deemed to be other-than-temporarily impaired, aggregated by length of time that individual securities have been in a continuous unrealized loss position at March 31, 2020 and December 31, 2019:
Gross realized gains and losses from available-for-sale securities were as follows:
The amortized cost and fair value of available-for-sale debt securities by contractual maturity are shown in the following table as of March 31, 2020. Actual maturities may differ from contractual maturities because counterparties may have the right to call or prepay obligations with or without call or prepayment penalties.
(In Thousands)
The Corporation’s mortgage-backed securities and collateralized mortgage obligations have stated maturities that may differ from actual maturities due to borrowers’ ability to prepay obligations. Cash flows from such investments are dependent upon the performance of the underlying mortgage loans and are generally influenced by the level of interest rates. In the table above, mortgage-backed securities and collateralized mortgage obligations are shown in one period.
Investment securities carried at $206,718,000 at March 31, 2020 and $215,270,000 at December 31, 2019 were pledged as collateral for public deposits, trusts and certain other deposits as provided by law. See Note 9 for information concerning securities pledged to secure borrowing arrangements.
Management evaluates securities for other-than-temporary impairment (OTTI) at least on a quarterly basis, and more frequently when economic or market conditions warrant such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) whether the Corporation intends to sell the security or more likely than not will be required to sell the security before its anticipated recovery.
A summary of information management considered in evaluating debt and equity securities for other-than-temporary impairment (“OTTI”) at March 31, 2020 is provided below.
Debt Securities
At March 31, 2020 and December 31, 2019, management performed an assessment for possible OTTI of the Corporation’s debt securities on an issue-by-issue basis, relying on information obtained from various sources, including publicly available financial data, ratings by external agencies, brokers and other sources. The extent of individual analysis applied to each security depended on the size of the Corporation’s investment, as well as management’s perception of the credit risk associated with each security. Based on the results of the assessment, management believes impairment of debt securities at March 31, 2020 and December 31, 2019 to be temporary.
Equity Securities
C&N Bank is a member of the Federal Home Loan Bank of Pittsburgh (FHLB-Pittsburgh), which is one of 11 regional Federal Home Loan Banks. As a member, C&N Bank is required to purchase and maintain stock in FHLB-Pittsburgh. There is no active market for FHLB-Pittsburgh stock, and it must ordinarily be redeemed by FHLB-Pittsburgh in order to be liquidated. C&N Bank’s investment in FHLB-Pittsburgh stock, included in Other Assets in the consolidated balance sheet, was $9,206,000 at March 31, 2020 and $10,131,000 at December 31, 2019. The Corporation evaluated its holding of FHLB-Pittsburgh stock for impairment and deemed the stock to not be impaired at March 31, 2020 and December 31, 2019. In making this determination, management concluded that recovery of total outstanding par value, which equals the carrying value, is expected. The decision was based on review of financial information that FHLB-Pittsburgh has made publicly available.
The Corporation’s marketable equity security, with a carrying value of $994,000 at March 31, 2020 and $979,000 at December 31, 2019, consisted exclusively of one mutual fund. There was an unrealized loss on the mutual fund of $6,000 at March 31, 2020 and $21,000 at December 31, 2019. There was a decrease in the unrealized loss of $15,000 in the first quarter 2020 and a decrease in the unrealized loss of $12,000 in the first quarter 2019. Changes in the unrealized losses on this security are included in other noninterest income in the consolidated statements of income.
7. LOANS
The loans receivable portfolio is segmented into residential mortgage, commercial and consumer loans. Loans outstanding at March 31, 2020 and December 31, 2019 are summarized by segment, and by classes within each segment, as follows:
Summary of Loans by Type
In the table above, outstanding loan balances are presented net of deferred loan origination fees, net, of $2,492,000 at March 31, 2020 and $2,482,000 at December 31, 2019.
Effective April 1, 2019, the Corporation acquired loans pursuant to the acquisition of Monument. The loans acquired from Monument were recorded at an initial fair value of $259,295,000. The gross amortized cost of loans acquired from Monument on April 1, 2019 was reduced $1,807,000 based on movements in interest rates (market rate adjustment) and was also reduced $1,914,000 based on a credit fair value adjustment on non-impaired loans and by $318,000 based on a credit fair value adjustment on impaired loans. In the last three quarters of 2019, the Corporation recognized accretion of a portion of the market rate adjustment and credit adjustment on non-impaired loans, and a partial recovery of purchased credit impaired (PCI) loans. In the first quarter 2020, adjustments to the initial market rate and credit fair value adjustments were recognized as follows:
Loans acquired from Monument that were identified as having a deterioration in credit quality (purchased credit impaired, or PCI) were valued at $441,000 at April 1, 2019, which was $318,000 lower than the total outstanding balance of the loans. The fair values of all of the PCI loans were determined based on the estimated realizable value of underlying real estate collateral, net of estimated selling cost. In the first quarter 2020, the Corporation recorded interest income of $112,000 from the excess of proceeds received on the pay-off of PCI loans over their carrying amounts. A summary of PCI loans held at March 31, 2020 and December 31, 2019 is as follows:
The Corporation grants loans to individuals as well as commercial and tax-exempt entities. Commercial, residential and personal loans are made to customers geographically concentrated in northcentral Pennsylvania, the southern tier of New York State and southeastern Pennsylvania. Although the Corporation has a diversified loan portfolio, a significant portion of its debtors’ ability to honor their contracts is dependent on the local economic conditions within the region. There is no concentration of loans to borrowers engaged in similar businesses or activities that exceed 10% of total loans at either March 31, 2020 or December 31, 2019.
The Corporation maintains an allowance for loan losses that represents management’s estimate of the losses inherent in the loan portfolio as of the balance sheet date and recorded as a reduction of the investment in loans. The allowance for loan losses is maintained at a level considered adequate to provide for losses that can be reasonably anticipated. Management performs a quarterly evaluation of the adequacy of the allowance. The allowance is based on the Corporation’s past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant revision as more information becomes available. In the process of evaluating the loan portfolio, management also considers the Corporation’s exposure to losses from unfunded loan commitments. As of March 31, 2020, and December 31, 2019, management determined that no allowance for credit losses related to unfunded loan commitments was required.
Transactions within the allowance for loan losses, summarized by segment and class, for the three-month periods ended March 31, 2020 and 2019 were as follows:
Three Months Ended March 31, 2020
Three Months Ended March 31, 2019
In the evaluation of the loan portfolio, management determines two major components for the allowance for loan losses – (1) a specific component based on an assessment of certain larger relationships, mainly commercial purpose loans, on a loan-by-loan basis; and (2) a general component for the remainder of the portfolio, except for performing loans purchased from Monument, based on a collective evaluation of pools of loans with similar risk characteristics. The general component is assigned to each pool of loans based on both historical net charge-off experience, and an evaluation of certain qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the above methodologies for estimating specific and general losses in the portfolio.
Performing loans acquired from Monument are presented net of a discount for credit losses of $1,011,000 at March 31, 2020 and $1,216,000 at December 31, 2019. This discount reflects an estimate of the present value of credit losses based on market expectations at the date of acquisition of $1,914,000, subsequently reduced as accretion has been recognized based on estimated and actual principal pay-downs. None of the performing loans purchased were found to be impaired at March 31, 2020, and the purchased performing loans were excluded from the loan pools for which the general component of the allowance for loan losses was calculated.
In the first quarter 2020, the provision for loan losses was $1,528,000, up from a credit (reduction in expense) to the provision of $957,000 in the first quarter 2019. In the first quarter 2020, the Corporation recognized a specific allowance of $1,193,000 related to a commercial loan with an outstanding balance of $3.5 million at March 31, 2020. In total, the provision included a charge of $1,210,000 related to specific loans (net increase in specific allowances on loans of $1,176,000 and net charge-offs of $34,000), a charge of $402,000 attributable to increases in qualitative factors and a credit of $67,000 in the net charge-off experience factors used to estimate the allowance, and a net credit of $17,000 from the impact of a reduction in total outstanding loans. In comparison, the Corporation recorded a credit for loan losses (reduction in expense) of $957,000 in the first quarter 2019, as specific allowances totaling $1,365,000 at December 31, 2018 on two commercial loans were eliminated. These two loans were no longer considered impaired at March 31, 2019 and were returned to full accrual status in the first quarter 2019. In total, the first quarter 2019 credit for loan losses included a net credit of $1,011,000 related to changes in specific allowances on loans, adjusted for net charge-offs during the period, partially offset by a net increase of $54,000 in the collectively determined and unallocated portions of the allowance for loan losses.
In determining the larger loan relationships for detailed assessment under the specific allowance component, the Corporation uses an internal risk rating system. Under the risk rating system, the Corporation classifies problem or potential problem loans as “Special Mention,” “Substandard,” or “Doubtful” on the basis of currently existing facts, conditions and values. Substandard loans include those characterized by the distinct possibility that the Corporation will sustain some loss if the deficiencies are not corrected. Loans classified as Doubtful have all the weaknesses inherent in those classified as Substandard with the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. Loans that do not currently expose the Corporation to sufficient risk to warrant classification as Substandard or Doubtful, but possess weaknesses that deserve management’s close attention, are deemed to be Special Mention. Risk ratings are updated any time that conditions or the situation warrants. Loans not classified are included in the “Pass” column in the table that follows.
The following tables summarize the aggregate credit quality classification of outstanding loans by risk rating as of March 31, 2020 and December 31, 2019:
March 31, 2020
December 31, 2019
The general component of the allowance for loan losses covers pools of loans including commercial loans not considered individually impaired, as well as smaller balance homogeneous classes of loans, such as residential real estate, home equity lines of credit and other consumer loans. Accordingly, the Corporation generally does not separately identify individual consumer and residential loans for impairment disclosures, unless such a loan: (1) is subject to a restructuring agreement, or (2) has an outstanding balance of $400,000 or more and a credit grade of Special Mention, Substandard or Doubtful. The pools of loans are evaluated for loss exposure based upon average historical net charge-off rates for each loan class, adjusted for qualitative factors (described in the following paragraphs). The time period used in determining the average historical net charge-off rate for each loan class is based on management’s evaluation of an appropriate time period that captures an historical loss experience relevant to the current portfolio. At March 31, 2020 and December 31, 2019, a five-year average net charge-off rate was used for commercial loans secured by real estate and for multi-family residential loans, while a three-year average net charge-off rate was used for all other loan classes.
Qualitative risk factors are evaluated for the impact on each of the three segments (residential mortgage, commercial and consumer) within the loan portfolio. Each qualitative factor is assigned a value to reflect improving, stable or declining conditions based on management’s judgment using relevant information available at the time of the evaluation. The adjustment for qualitative factors is applied as an increase or decrease to the average net charge-off rate for each loan class within each segment.
The qualitative factors used in the general component calculations are designed to address credit risk characteristics associated with each segment. The Corporation’s credit risk associated with all of the segments is significantly impacted by these factors, which include economic conditions within its market area, the Corporation’s lending policies, changes or trends in the portfolio, risk profile, competition, regulatory requirements and other factors.
Loans are classified as impaired, when, based on current information and events, it is probable that the Corporation will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial loans, by the fair value of the collateral (if the loan is collateral dependent), by future cash flows discounted at the loan’s effective rate or by the loan’s observable market price.
The scope of loans reviewed individually each quarter to determine if they are impaired include all commercial loan relationships greater than $200,000 and any residential mortgage or consumer loans of $400,000 or more for which there is at least one extension of credit graded Special Mention, Substandard or Doubtful. Loans that are individually reviewed, but which are determined to not be impaired, are combined with all remaining loans that are not reviewed on a specific basis, and such loans are included within larger pools of loans based on similar risk and loss characteristics for purposes of determining the general component of the allowance. The loans that have been individually reviewed, but which have been determined to not be impaired, are included in the “Collectively Evaluated” column in the table summarizing the allowance and associated loan balances as of March 31, 2020 and December 31, 2019. All loans classified as troubled debt restructurings (discussed in more detail below) and all commercial loan relationships less than $200,000 or other loan relationships less than $400,000 in the aggregate, but with an estimated loss of $100,000 or more, are individually evaluated for impairment.
The following tables present a summary of loan balances and the related allowance for loan losses summarized by portfolio segment and class for each impairment method used as of March 31, 2020 and December 31, 2019.
Summary information related to impaired loans at March 31, 2020 and December 31, 2019 is provided in the table immediately below. Purchased credit impaired loans are excluded from the table.
In the table immediately above, two loans to one borrower are presented under the Residential mortgage loans – first liens and Residential mortgage loans – junior liens classes. These loans are collateralized by one property, and the allowance associated with these loans was determined based on an analysis of the total amounts of the Corporation’s exposure in comparison to the estimated net proceeds if the Corporation were to sell the property.
The average balance of impaired loans, excluding purchased credit impaired loans, and interest income recognized on these impaired loans is as follows:
Loans are placed on nonaccrual status for all classes of loans when, in the opinion of management, collection of interest is doubtful. Any unpaid interest previously accrued on those loans is reversed from income. Interest income is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest payments received on loans for which the risk of further loss is greater than remote are applied as a reduction of the loan principal balance. Interest income on other nonaccrual loans, including impaired loans, is recognized only to the extent of interest payments received. Generally, loans are restored to accrual status when the obligation is brought current, has performed in accordance with the contractual terms for a reasonable period of time (generally six months) and the ultimate collectability of the total contractual principal and interest is no longer in doubt. The past due status of all classes of loans receivable is determined based on contractual due dates for loan payments. Also, the amortization of deferred loan fees is discontinued when a loan is placed on nonaccrual status.
The breakdown by portfolio segment and class of nonaccrual loans and loans past due ninety days or more and still accruing is as follows:
The amounts shown in the table immediately above include loans classified as troubled debt restructurings (described in more detail below), if such loans are past due ninety days or more or nonaccrual.
The table below presents a summary of the contractual aging of loans as of March 31, 2020 and December 31, 2019:
Nonaccrual loans are included in the contractual aging in the immediately preceding table. A summary of the contractual aging of nonaccrual loans at March 31, 2020 and December 31, 2019 is as follows:
Loans whose terms are modified are classified as Troubled Debt Restructurings (TDRs) if the Corporation grants such borrowers concessions, and it is deemed that those borrowers are experiencing financial difficulty. Loans classified as TDRs are designated as impaired. The outstanding balance of loans subject to TDRs, as well as contractual aging information at March 31, 2020 and December 31, 2019 is as follows:
At March 31, 2020 and December 31, 2019, there were no commitments to loan additional funds to borrowers whose loans have been classified as TDRs.
TDRs that occurred during the three-month periods ended March 31, 2020 and 2019 are as follows:
All of the loans for which TDRs were granted in the table above in the three-month period ended March 31, 2019 are associated with one relationship.
In the three-month periods ended March 31, 2020 and 2019, there were no defaults on loans for which modifications considered to be TDRs were entered into within the previous 12 months.
The carrying amount of foreclosed residential real estate properties held as a result of obtaining physical possession (included in Foreclosed assets held for sale in the unaudited consolidated balance sheets) is as follows:
The recorded investment of consumer mortgage loans secured by residential real properties for which formal foreclosure proceedings were in process is as follows:
8. GOODWILL AND OTHER INTANGIBLE ASSETS, NET
Information related to the core deposit intangibles are as follows:
Amortization expense was $62,000 in the first quarter 2020 and $2,000 in the first quarter 2019.
Goodwill represents the excess of the cost of acquisitions over the fair value of the net assets acquired. At March 31, 2020 and December 31, 2019, the carrying value of goodwill is $28,388,000.
Goodwill is tested at least annually at December 31 for impairment, or more often if events or circumstances indicate there may be impairment. In the first quarter 2020, the coronavirus (COVID-19) pandemic that has impacted the U.S. and most of the world has led to government-imposed emergency restrictions that have substantially limited the operation of non-essential businesses and the activities of individuals. These restrictions have resulted in significant adverse effects on macroeconomic conditions, and stock market valuations have decreased significantly for most companies, including banks. The ultimate effect of COVID-19 on the local or broader economy is not known nor is the ultimate length of the restrictions described and any accompanying effects. In light of the adverse circumstances resulting from COVID-19, management determined it necessary to evaluate goodwill for impairment at March 31, 2020.
The average closing price (trading price) of the Corporation’s common stock was $19.96 per share for the month of March 2020, down from $25.90 in February 2020 and $27.37 in January 2020. The average closing price for the last 10 trading days of the first quarter 2020 (March 18 through March 31, 2020) was $18.87 per share. In comparison, the book value per share of the Corporation’s common stock at March 31, 2020 was $18.22 per share. In testing goodwill for impairment as of March 31, 2020, the Corporation by-passed performing a qualitative assessment and performed a quantitative assessment based on comparison of the Corporation’s market capitalization to its stockholders’ equity, resulting in the determination that the fair value of its reporting unit, its community banking operation, exceeded its carrying value. Accordingly, there was no goodwill impairment at March 31, 2020.
9. BORROWED FUNDS AND SUBORDINATED DEBT
Short-term borrowings (initial maturity within one year) include the following:
Short-term borrowings from FHLB-Pittsburgh are as follows:
Overnight borrowings from FHLB-Pittsburgh had an interest rate of 0.36% at March 31, 2020 and 1.81% at December 31, 2019. At March 31, 2020, other short-term advances included eight advances totaling $18,200,000 with a weighted-average interest rate of 1.68%.
The Corporation had available credit with other correspondent banks totaling $45,000,000 at March 31, 2020 and December 31, 2019. These lines of credit are primarily unsecured. No amounts were outstanding at March 31, 2020 or December 31, 2019.
The Corporation has a line of credit with the Federal Reserve Bank of Philadelphia’s Discount Window. At March 31, 2020, the Corporation had available credit in the amount of $14,364,000 on this line with no outstanding advances. At December 31, 2019, the Corporation had available credit in the amount of $14,244,000 on this line with no outstanding advances. As collateral for this line, the Corporation has pledged available-for-sale securities with a carrying value of $14,815,000 at March 31, 2020 and $14,728,000 at December 31, 2019.
The Corporation engages in repurchase agreements with certain commercial customers. These agreements provide that the Corporation sells specified investment securities to the customers on an overnight basis and repurchases them on the following business day. The weighted average rate paid by the Corporation on customer repurchase agreements was 0.10% at March 31, 2020 and December 31, 2019. The carrying value of the underlying securities was $2,430,000 at March 31, 2020 and $1,951,000 at December 31, 2019.
The FHLB-Pittsburgh loan facility is collateralized by qualifying loans secured by real estate with a book value totaling $783,312,000 at March 31, 2020 and $778,877,000 at December 31, 2019. Also, the FHLB-Pittsburgh loan facility requires the Corporation to invest in established amounts of FHLB-Pittsburgh stock. The carrying values of the Corporation’s holdings of FHLB-Pittsburgh stock (included in Other Assets) were $9,206,000 at March 31, 2020 and $10,131,000 at December 31, 2019. The Corporation’s total credit facility with FHLB-Pittsburgh was $567,606,000 at March 31, 2020, including an unused (available) amount of $459,462,000. At December 31, 2019, the Corporation’s total credit facility with FHLB-Pittsburgh was $552,546,000, including an unused (available) amount of $416,127,000.
LONG-TERM BORROWINGS
Long-term borrowings from FHLB-Pittsburgh are as follows:
At March 31, 2020 and December 31, 2019, the Corporation has outstanding subordinated debt agreements with par values totaling $6,500,000, maturing April 1, 2027, which may be redeemed at par beginning April 1, 2022. The agreements have fixed annual interest rates of 6.50%. At March 31, 2020 and December 31, 2019, the carrying value of the subordinated debt on the consolidated balance sheet is $6,500,000.
10. STOCK-BASED COMPENSATION PLANS
The Corporation has a Stock Incentive Plan for a selected group of officers and an Independent Directors Stock Incentive Plan. In the first quarter 2020, the Corporation awarded 48,284 shares of restricted stock under the Stock Incentive Plan and 7,580 shares of restricted stock under the Independent Directors Stock Incentive Plan. The 2020 restricted stock awards under the Stock Incentive Plan vest ratably over three years, and include 30,381 time-based awards with a total fair value of $801,000 at the date of grant and 17,903 performance-based awards with a total fair value of $343,000 at date of grant. The 2020 restricted stock issued under the Independent Directors Stock Incentive Plan are time-based awards, vesting over one year, with a total fair value of $200,000 at the date of grant.
Compensation cost related to restricted stock is recognized based on the fair value of the stock at the grant date over the vesting period, adjusted for estimated and actual forfeitures. Total annual stock-based compensation for the year ending December 31, 2020 is estimated to total $893,000. Total stock-based compensation expense attributable to restricted stock awards amounted to $194,000 in the first quarter 2020 and $229,000 in the first quarter 2019.
11. CONTINGENCIES
In the normal course of business, the Corporation may be subject to pending and threatened lawsuits in which claims for monetary damages could be asserted. In management’s opinion, the Corporation’s financial position and results of operations would not be materially affected by the outcome of such pending legal proceedings.
12. FAIR VALUE MEASUREMENTS AND FAIR VALUES OF FINANCIAL INSTRUMENTS
The Corporation measures certain assets at fair value. Fair value is defined as the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. FASB Accounting Standards Codification (ASC) topic 820, “Fair Value Measurements and Disclosures” establishes a framework for measuring fair value that includes a hierarchy used to classify the inputs used in measuring fair value. The hierarchy prioritizes the inputs used in determining valuations into three levels. The level in the fair value hierarchy within which the fair value measurement falls is determined based on the lowest level input that is significant to the fair value measurement. The levels of the fair value hierarchy are as follows:
Level 1 – Fair value is based on unadjusted quoted prices in active markets that are accessible to the Corporation for identical assets. These generally provide the most reliable evidence and are used to measure fair value whenever available.
Level 2 – Fair value is based on significant inputs, other than Level 1 inputs, that are observable either directly or indirectly for substantially the full term of the asset through corroboration with observable market data. Level 2 inputs include quoted market prices in active markets for similar assets, quoted market prices in markets that are not active for identical or similar assets and other observable inputs.
Level 3 – Fair value is based on significant unobservable inputs. Examples of valuation methodologies that would result in Level 3 classification include option pricing models, discounted cash flows and other similar techniques.
The Corporation monitors and evaluates available data relating to fair value measurements on an ongoing basis and recognizes transfers among the levels of the fair value hierarchy as of the date of an event or change in circumstances that affects the valuation method chosen. Examples of such changes may include the market for a particular asset becoming active or inactive, changes in the availability of quoted prices, or changes in the availability of other market data.
At March 31, 2020 and December 31, 2019, assets measured at fair value and the valuation methods used are as
follows:
Nonrecurring fair value measurements
Management’s evaluation and selection of valuation techniques and the unobservable inputs used in determining the fair values of assets valued using Level 3 methodologies include sensitive assumptions. Other market participants might use substantially different assumptions, which could result in calculations of fair values that would be substantially different than the amount calculated by management.
At March 31, 2020 and December 31, 2019, quantitative information regarding valuation techniques and the significant unobservable inputs used for assets measured on a recurring basis using unobservable inputs Level 3 methodologies are as follows:
The fair value of servicing rights is affected by expected future interest rates. Increases (decreases) in future expected interest rates tend to increase (decrease) the fair value of the Corporation’s servicing rights because of changes in expected prepayment behavior by the borrowers on the underlying loans. Unrealized gains (losses) in fair value of servicing rights are included in Loan servicing fees, net, in the unaudited consolidated statements of income.
Following is a reconciliation of activity for Level 3 assets measured at fair value on a recurring basis:
Loans are classified as impaired when, based on current information and events, it is probable that the Corporation will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Foreclosed assets held for sale consist of real estate acquired by foreclosure. For impaired commercial loans secured by real estate and foreclosed assets held for sale, estimated fair values are determined primarily using values from third-party appraisals. Appraised values are discounted to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value. The discounts also include estimated costs to sell the property. For commercial and industrial and agricultural loans secured by non-real estate collateral, such as accounts receivable, inventory and equipment, estimated fair values are determined based on the borrower’s financial statements, inventory reports, accounts receivable aging data or equipment appraisals or invoices. Indications of value from these sources are generally discounted based on the age of the financial information or the quality of the assets.
At March 31, 2020 and December 31, 2019, quantitative information regarding valuation techniques and the significant unobservable inputs used for nonrecurring fair value measurements using Level 3 methodologies are as follows:
Certain of the Corporation’s financial instruments are not measured at fair value in the consolidated financial statements. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. Certain financial instruments and all nonfinancial instruments are excluded from disclosure requirements. Therefore, the aggregate fair value amounts presented may not represent the underlying fair value of the Corporation.
The estimated fair values, and related carrying amounts, of the Corporation’s financial instruments that are not recorded at fair value are as follows:
The Corporation has commitments to extend credit and has issued standby letters of credit. Standby letters of credit are conditional guarantees of performance by a customer to a third party. Estimates of the fair value of these off-balance sheet items were not made because of the short-term nature of these arrangements and the credit standing of the counterparties.
13. CORONAVIRUS (COVID-19) OUTBREAK/SUBSEQUENT EVENT
In December 2019, a coronavirus (COVID-19) was reported in China, and, in March 2020, the World Health Organization declared it a pandemic. Since first being reported in China, the coronavirus has spread to additional countries including the United States. In response, many state and local governments, including the Commonwealth of Pennsylvania, have instituted emergency restrictions that have substantially limited the operation of non-essential businesses and the activities of individuals. These restrictions have resulted in significant adverse effects for many businesses and have resulted in a significant number of layoffs and furloughs of employees nationwide and in the regions in which the Corporation operates.
The Corporation’s Pandemic Committee has instituted measures to protect the health of employees and clients, including temporarily operating branch locations on a drive-through only basis and transitioning a significant portion of the Corporation’s employees to remote work.
The ultimate effect of COVID-19 on the local or broader economy is not known nor is the ultimate length of the restrictions described and any accompanying effects. In the first quarter 2020, the Corporation increased the allowance for loan losses $402,000 based on an increase in qualitative factors related to potential deterioration in economic conditions. Because of the significant uncertainties related to the ultimate duration of the COVID-19 pandemic and its economic impact, the total impact on the Corporation’s loan portfolio is not determinable.
To work with clients impacted by COVID-19, the Corporation is offering short-term (typically 90-day) loan modifications on a case-by-case basis to borrowers who were current in their payments at the inception of the loan modification program. These efforts have been designed to assist borrowers as they deal with the current crisis and help the Corporation mitigate credit risk. For loans subject to the program, each borrower is required to resume making regularly scheduled loan payments at the end of the modification period and the deferred amounts will be moved to the end of the loan term. The loans will not be reported as past due or as TDRs during the deferral period. The quantity and balances of modifications under the program through March 31, 2020 and April 30, 2020 are as follows:
On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) was signed into law. The CARES Act is a $2 trillion stimulus package designed to provide relief to U.S. businesses and consumers struggling as a result of the pandemic. A provision in the CARES Act includes creation of the Paycheck Protection Program (“PPP”) through the Small Business Administration (SBA) and Treasury Department. Under the PPP, the Corporation, as an SBA-certified lender, provides SBA-guaranteed loans to small businesses to pay their employees, rent, mortgage interest, and utilities. PPP loans will be forgiven subject to clients’ providing documentation evidencing their compliant use of funds and otherwise complying with the terms of the program.
The maximum term of PPP loans is two years, and the Corporation will be repaid sooner to the extent the loans are forgiven. The interest rate on PPP loans is 1%, and the Corporation will receive fees ranging between 1% and 5% per loan, depending on the size of the loan. Fees on PPP loans, net of origination costs, will be recognized in interest income as a yield adjustment over the term of the loans.
The Corporation began accepting and processing applications for loans under the PPP on April 3, 2020. As of April 30, 2020, the outstanding balance of PPP loans was $84,478,000, and the Corporation had received conditional approval from the SBA for an additional $11,709,000 of PPP loans expected to be funded in May 2020. Fees to be received on PPP loans originated through April 30, 2020 total $3,106,000. Management believes the Corporation has ample availability of funding sources available for PPP loans, including unused borrowing capacity with the FHLB-Pittsburgh. In April 2020, the Federal Reserve instituted the Paycheck Protection Program Liquidity Facility (“PPPLF”), which is intended to facilitate PPP lending. The Corporation is in the process of evaluating whether it will participate in the PPPLF.
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Certain statements in this section and elsewhere in this quarterly report on Form 10-Q are forward-looking statements. Citizens & Northern Corporation and its wholly-owned subsidiaries (collectively, the Corporation) intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Reform Act of 1995. Forward-looking statements, which are not historical facts, are based on certain assumptions and describe future plans, business objectives and expectations, and are generally identifiable by the use of words such as, "should", “likely”, "expect", “plan”, "anticipate", “target”, “forecast”, and “goal”. These forward-looking statements are subject to risks and uncertainties that are difficult to predict, may be beyond management’s control and could cause results to differ materially from those expressed or implied by such forward-looking statements. Factors which could have a material, adverse impact on the operations and future prospects of the Corporation include, but are not limited to, the following:
These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.
CORONAVIRUS (COVID-19) OUTBREAK
The Corporation’s Pandemic Committee has instituted measures to protect the health of employees and clients, including temporarily operating branch locations on a drive-through only basis and transitioning a significant portion of the Corporation’s employees to remote work. No furloughs or layoffs of employees have been made to date. The Pandemic Committee has been very active since March 2020, providing frequent communication with employees and clients by telephone, video conference, email and digital tools, while substantially limiting business travel.
Emergency restrictions on the activities of businesses and individuals have resulted in significant adverse economic effects and a significant number of layoffs and furloughs of employees nationwide and in the regions in which the Corporation operates. The ultimate effect of COVID-19 on the local or broader economy is not known nor is the ultimate length of the restrictions described and any accompanying effects. In the first quarter 2020, the Corporation increased the allowance for loan losses $402,000 based on an increase in qualitative factors related to potential deterioration in economic conditions. Because of the significant uncertainties related to the ultimate duration of the COVID-19 pandemic and its economic impact, the total impact on the Corporation’s loan portfolio is not determinable.
To work with clients impacted by COVID-19, the Corporation is offering short-term (typically 90-day) loan modifications on a case-by-case basis to borrowers who were current in their payments at the inception of the loan modification program. These efforts have been designed to assist borrowers as they deal with the current crisis and help the Corporation mitigate credit risk. For loans subject to the program, each borrower is required to resume making regularly scheduled loan payments at the end of the modification period and the deferred amounts will be moved to the end of the loan term. The loans will not be reported as past due or as TDRs during the deferral period. Through April 30, 2020, 602 loans with a total outstanding balance at the time of modification of $180,178,000 have been modified under this program. As shown in Note 13 to the unaudited consolidated financial statements, 244 of the loans modified through April 30, 2020 with a recorded investment of $136,047,000 were commercial loans. A breakdown of these commercial loans by industry is as follows:
The Corporation began accepting and processing applications for loans under the PPP on April 3, 2020. Under the PPP, the Corporation provides SBA-guaranteed loans to small businesses to pay their employees, rent, mortgage interest, and utilities. PPP loans will be forgiven subject to clients’ providing documentation evidencing their compliant use of funds and otherwise complying with the terms of the program.
As of April 30, 2020, the outstanding balance of PPP loans was $84,478,000, and the Corporation had received conditional approval from the SBA for an additional $11,709,000 of PPP loans expected to be funded in May 2020. Fees to be received on PPP loans originated through April 30, 2020 total $3,106,000. Management believes the Corporation has ample availability of funding sources available for PPP loans, including unused borrowing capacity with the FHLB-Pittsburgh. In April 2020, the Federal Reserve instituted the Paycheck Protection Program Liquidity Facility (“PPPLF”), which is intended to facilitate PPP lending. The Corporation is in the process of evaluating whether it will participate in the PPPLF.
Capital Strength
While it is difficult to estimate the future impact of COVID-19, the Corporation, including the principal subsidiary, C&N Bank, entered the crisis from a position of strength. This is especially apparent in the capital ratios, which are at levels that demonstrate the capacity to absorb the acquisition of Covenant Financial, Inc. as well as significant losses if they arise while continuing to meet the requirements to be considered well capitalized.
C&N Bank’s leverage ratio (Tier 1 capital to average assets) at March 31, 2020 of 12.38% is more than double the well-capitalized threshold of 5%, an excess capital amount of $117.0 million. Similarly, the total capital to risk-weighted assets ratio at March 31, 2020 is 19.18%, which exceeds the well-capitalized threshold of 10%, an excess capital amount of $99.5 million.
Additional details regarding the Corporation’s and C&N Bank’s regulatory capital position are provided in the “Stockholders’ Equity and Capital Adequacy” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”).
PENDING AND COMPLETED BUSINESS COMBINATIONS
EARNINGS OVERVIEW
Net income was $0.30 per diluted share in the first quarter 2020, as compared to $0.41 per share in the first quarter 2019. Highlights related to the Corporation’s earnings results for the first quarters of 2020 and 2019 are presented below.
Net income of $4,166,000 in the first quarter 2020 was down $924,000 (18.2%) from the first quarter 2019 amount. Significant variances were as follows:
More detailed information concerning fluctuations in the Corporation’s earnings results and other financial information are provided in other sections of MD&A.
TABLE I - QUARTERLY FINANCIAL DATA
(Dollars In Thousands, Except Per Share Data)
(Unaudited)
CRITICAL ACCOUNTING POLICIES
The presentation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect many of the reported amounts and disclosures. Actual results could differ from these estimates.
A material estimate that is particularly susceptible to significant change is the determination of the allowance for loan losses. Management believes the allowance for loan losses is adequate and reasonable. Analytical information related to the Corporation’s aggregate loans and the related allowance for loan losses is summarized by loan segment and classes of loans in Note 7 to the unaudited consolidated financial statements. Additional discussion of the Corporation’s allowance for loan losses is provided in a separate section later in MD&A. Given the very subjective nature of identifying and valuing loan losses, it is likely that well-informed individuals could make materially different assumptions, and could, therefore calculate a materially different allowance value. While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation’s allowance for loan losses. Such agencies may require the Corporation to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination.
Another material estimate is the calculation of fair values of the Corporation’s debt securities. For most of the Corporation’s debt securities, the Corporation receives estimated fair values of debt securities from an independent valuation service, or from brokers. In developing fair values, the valuation service and the brokers use estimates of cash flows, based on historical performance of similar instruments in similar interest rate environments. Based on experience, management is aware that estimated fair values of debt securities tend to vary among brokers and other valuation services.
As described in Note 6 to the unaudited consolidated financial statements, management evaluates securities for other-than-temporary impairment (OTTI). In making that evaluation, consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) whether the Corporation intends to sell the security or more likely than not will be required to sell the security before its anticipated recovery. Management’s assessments of the likelihood and potential for recovery in value of securities are subjective and based on sensitive assumptions.
NET INTEREST INCOME
The Corporation’s primary source of operating income is net interest income, which is equal to the difference between the amounts of interest income and interest expense. Tables II, III and IV include information regarding the Corporation’s net interest income for the three-month periods ended March 31, 2020 and 2019. In each of these tables, the amounts of interest income earned on tax-exempt securities and loans have been adjusted to a fully taxable-equivalent basis. Accordingly, the net interest income amounts reflected in these tables exceed the amounts presented in the consolidated financial statements. The discussion that follows is based on amounts in the related Tables.
For the three-month periods, fully taxable equivalent net interest income was $14,506,000 in 2020, which was $2,490,000 (20.7%) higher than in 2019. Interest income was $3,895,000 higher in 2020 as compared to 2019, while interest expense was higher by $1,405,000 in comparing the same periods. As presented in Table III, the Net Interest Margin was 3.83% in 2020 as compared to 4.04% in 2019, and the “Interest Rate Spread” (excess of average rate of return on earning assets over average cost of funds on interest-bearing liabilities) decreased to 3.54% in 2020 from 3.81% in 2019. The average yield on earning assets of 4.55% was 0.06% higher in 2020 as compared to 2019, while the average rate on interest-bearing liabilities increased 0.33% between periods.
Accretion and amortization of purchase accounting-related adjustments from marking financial instruments to fair value had a positive effect on net interest income in the first quarter 2020 of $417,000, including an increase in income on loans of $464,000 partially offset by increases in interest expense on time deposits of $41,000 and on short-term borrowings of $6,000. The net positive impact to the first quarter 2020 net interest margin from accretion and amortization of purchase accounting adjustments was 0.11%.
INTEREST INCOME AND EARNING ASSETS
Interest income totaled $17,261,000 in 2020, an increase of $3,895,000 (29.1%) from 2019. Interest and fees from loans receivable increased $4,378,000, or 41.1%, in 2020 as compared to 2019. Table IV shows the increase in interest on loans includes $4,630,000 attributable to an increase in average volume, partially offset by a decrease of $252,000 related to a decrease in average yield. The average balance of loans receivable increased $344,739,000 (41.9%) to $1,168,485,000 in 2020 from $823,746,000 in 2019, including the effects of loans acquired from Monument as well as additional growth, primarily in commercial loans. The average yield on loans in the first quarter of 2020 was 5.18%, down from 5.25% in the first quarter 2019 as rates on variable rate loans and rates on recent new loan originations have decreased due to decreases in market interest rates that occurred in the latter part of 2019 and first quarter of 2020. Accretion of purchase accounting-related adjustments provided a positive impact of 0.16% to the first quarter 2020 yield on loans.
Interest income from available-for-sale debt securities decreased $450,000 (17.4%) in 2020 from 2019. Total average available-for-sale debt securities (at amortized cost) in 2020 decreased to $335,007,000 from $361,929,000 in 2019. The average yield on available-for-sale debt securities was 2.56% for 2020, down from 2.89% in 2019. The decrease in average yield on available-for-sale debt securities is mainly the result of higher-yielding tax-exempt municipal bonds being called or maturing throughout 2019 and increased amortization on mortgage-backed securities due to accelerated prepayments of principal caused by falling interest rates.
INTEREST EXPENSE AND INTEREST-BEARING LIABILITIES
For the three-month periods, interest expense increased $1,405,000 to $2,755,000 in 2020 from $1,350,000 in 2019. Interest expense on deposits increased $1,102,000, as the average rate on interest-bearing deposits increased to 0.89% in 2020 from 0.56% in 2019. The increase in average rates on deposits includes increases of 0.58% on time deposits, 0.12% on money market accounts and 0.05% on saving accounts. Total average deposits (interest-bearing and noninterest-bearing) amounted to $1,260,245,000 in 2020, an increase of $239,172,000 (23.4%) from 2019. The increase in total average deposits included deposits assumed from Monument. The increase in average rate on interest-bearing liabilities resulted primarily from comparatively higher rates on deposits assumed from Monument.
Further contributing to the increase in average rate on deposits was an increase in higher-cost deposits as a proportion of total deposits. The average balance of time deposits increased $154,306,000 to 39% of total average interest-bearing deposits in the first quarter 2020 from 30% in the first quarter 2019. The growth in time deposits resulted from changes in mix attributable to deposits assumed from Monument, an increase in time deposits within the Corporation’s legacy markets and use of brokered certificates of deposit (CDs) in 2020. The average balance of brokered CDs, included in time deposits in Table III, was $30,266,000 in the first quarter 2020 with no corresponding amount in the first quarter 2019. The balance of brokered CDs at March 31, 2020 was $15,224,000, up from $14,984,000 at December 31, 2019.
Interest expense on total borrowed funds increased $303,000 in 2020 as compared to 2019. The average balance of total borrowed funds increased to $115,447,000 in the first quarter 2020 from $50,623,000 in the first quarter 2019, while the average rate on borrowed funds decreased to 2.09% in the first quarter 2020 from 2.38% in the first quarter 2019.
Interest expense on short-term borrowings increased $119,000 to $198,000 in 2020 from $79,000 in 2019. The average balance of short-term borrowings increased to $44,882,000 in 2020 from $15,935,000 in 2019. The average rate on short-term borrowings decreased to 1.77% in 2020 from 2.01% in 2019, reflecting the impact of lower short-term market rates in the first quarter 2020.
Interest expense on long-term borrowings increased $77,000 to $295,000 in 2020 from $218,000 in 2019. The average balance of long-term borrowings was $64,065,000 in 2020, up from an average balance of $34,688,000 in 2019. Borrowings are classified as long-term within the Tables based on their term at origination. The average balance of long-term borrowings in 2020 and 2019 consisted mainly of FHLB advances with terms longer than 12 months at origination. The average rate on long-term borrowings was 1.85% in 2020 compared to 2.55% in the first quarter of 2019.
Interest expense on subordinated debt assumed from Monument was $107,000 in the first quarter 2020 with no comparative amount in 2019.
TABLE II - ANALYSIS OF INTEREST INCOME AND EXPENSE
Note: Interest income from tax-exempt securities and loans has been adjusted to a fully tax-equivalent basis, using the Corporation’s federal income tax rate of 21%.
(1) Annualized rates of return on tax-exempt securities and loans are presented on a fully taxable-equivalent basis, using the Corporation’s federal income tax rate of 21%.
(2) Nonaccrual loans have been included with loans for the purpose of analyzing net interest earnings.
(3) Rates of return on earning assets and costs of funds are presented on an annualized basis.
(1) Changes in income on tax-exempt securities and loans are presented on a fully tax-equivalent basis, using the Corporation’s federal income tax rate of 21%.
(2) The change in interest due to both volume and rates has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amount of the change in each.
NONINTEREST INCOME
TABLE V - COMPARISON OF NONINTEREST INCOME
Total noninterest income shown in Table V in the first quarter 2020 was up $875,000 from the first quarter 2019 total. Significant variances included the following:
NONINTEREST EXPENSE
As shown in Table VII, total noninterest expense, excluding merger-related expenses, increased $2,216,000 (20.7%) for the three months ended March 31, 2020 over the total for the three months ended March 31, 2019. The most significant variances include the following:
INCOME TAXES
The income tax provision in interim periods is based on the Corporation’s estimate of the effective tax rate expected to be applicable for the full year. The income tax provision for the first three months of 2020 was $816,000, which was $165,000 lower than the provision for the first three months of 2019 of $981,000. The effective tax rate (tax provision as a percentage of pre-tax income) was 16.4% in the first three months of 2020 compared to 16.2% in the first three months of 2019. The Corporation’s effective tax rates differ from the statutory rate of 21% in the first three months of 2020 and 2019 principally because of the effects of tax-exempt interest income.
The Corporation recognizes deferred tax assets and liabilities based on differences between the financial statement carrying amounts and the tax basis of assets and liabilities. The net deferred tax asset at March 31, 2020 and December 31, 2019 represents the following temporary difference components:
At March 31, 2020, the net deferred tax asset was $684,000, down from $2,618,000 at December 31, 2019. The most significant change in temporary difference components was a net increase of $1,521,000 in the deferred tax liability resulting from appreciation in available-for-sale debt securities attributable to lower interest rates.
The Corporation regularly reviews deferred tax assets for recoverability based on history of earnings, expectations for future earnings and expected timing of reversals of temporary differences. Realization of deferred tax assets ultimately depends on the existence of sufficient taxable income, including taxable income in prior carryback years, as well as future taxable income.
Management believes the recorded net deferred tax asset at March 31, 2020 is fully realizable; however, if management determines the Corporation will be unable to realize all or part of the net deferred tax asset, the Corporation would adjust the deferred tax asset, which would negatively impact earnings.
FINANCIAL CONDITION
This section includes information regarding the Corporation’s lending activities or other significant changes or exposures that are not otherwise addressed in MD&A. Significant changes in the average balances of the Corporation’s earning assets and interest-bearing liabilities are described in the “Net Interest Income” section of MD&A. Other significant balance sheet items, including the allowance for loan losses and stockholders’ equity, are discussed in separate sections of MD&A. There are no significant concerns that have arisen related to the Corporation’s off-balance sheet loan commitments or outstanding standby letters of credit at March 31, 2020. Management does not expect capital expenditures to have a material, detrimental effect on the Corporation’s financial condition in 2020.
Net loans outstanding (excluding mortgage loans held for sale) were $1,156,143,000 at March 31, 2020, down from $1,172,386,000 at December 31, 2019 but up 41.5% from $817,136,000 at March 31, 2019. As presented in Table X, total outstanding commercial loans were $9.6 million lower at March 31, 2020 from December 31, 2019, including a reduction in loans to political subdivisions of $10.0 million. The reduction in outstanding loans to political subdivisions in the first quarter 2020 included the impact of a pay-off of one loan of approximately $10 million. Residential mortgage loans were $4.3 million lower at March 31, 2020 as compared to December 31, 2019. In 2019, a significant portion of the Corporation’s loan growth was attributable to the Monument acquisition. In comparing outstanding balances at March 31, 2020 and 2019, total commercial loans increased $218.6 million (62.3%) and total residential mortgage loans increased $124.0 million (27.1%) while total consumer loans decreased $521,000 (3.1%).
While the Corporation’s lending activities are primarily concentrated in its market area, a portion of the Corporation’s commercial loan segment consists of participation loans. Participation loans represent portions of larger commercial transactions for which other institutions are the “lead banks”. Although not the lead bank, the Corporation conducts detailed underwriting and monitoring of participation loan opportunities. Participation loans are included in the “Commercial and industrial,” “Commercial loans secured by real estate”, “Political subdivisions” and “Other commercial” classes in the loan tables presented in this Form 10-Q. Total participation loans outstanding amounted to $62,414,000 at March 31, 2020, down from $64,633,000 at December 31, 2019 and $68,418,000 at March 31, 2019. At March 31, 2020, the balance of participation loans outstanding includes a total of $44,095,000 to businesses located outside of the Corporation’s market area. Also, included within participation loans outstanding are “leveraged loans,” meaning loans to businesses with minimal tangible book equity and for which the extent of collateral available is limited, though typically at the time of origination the businesses have demonstrated strong cash flow performance in their recent histories. Leveraged participation loans outstanding totaled $10,109,000 at March 31, 2020 and $9,947,000 at December 31, 2019.
Since 2009, the Corporation has originated and sold residential mortgage loans to the secondary market through the MPF Xtra program administered by the Federal Home Loan Banks of Pittsburgh and Chicago. Residential mortgages originated and sold through the MPF Xtra program consist primarily of conforming, prime loans sold to the Federal National Mortgage Association (Fannie Mae), a quasi-government entity. In 2014, the Corporation began to originate and sell residential mortgage loans to the secondary market through the MPF Original program, which is also administered by the Federal Home Loan Banks of Pittsburgh and Chicago. Prior to the April 2019 merger, Monument Bank had participated in the MPF Original program. Residential mortgages originated and sold through the MPF Original program consist primarily of conforming, prime loans sold to the Federal Home Loan Bank of Pittsburgh. In late 2019, the Corporation began to originate and sell larger-balance, nonconforming mortgages under the MPF Direct Program, which is also administered by the Federal Home Loan Banks of Pittsburgh and Chicago. The Corporation will not retain servicing rights for loans sold under the MPF Direct Program. Through March 31, 2020, the Corporation’s activity under the MPF Direct Program was minimal.
For loan sales originated under the MPF Xtra and Original programs, the Corporation provides customary representations and warranties to investors that specify, among other things, that the loans have been underwritten to the standards established by the investor. The Corporation may be required to repurchase a loan and reimburse a portion of fees received or reimburse the investor for a credit loss incurred on a loan, if it is determined that the representations and warranties have not been met. Such repurchases or reimbursements generally result from an underwriting or documentation deficiency. At
March 31, 2020, the total outstanding balance of loans the Corporation has repurchased as a result of identified instances of noncompliance amounted to $1,757,000, and the corresponding total outstanding balance repurchased at December 31, 2019 was $1,770,000.
At March 31, 2020, outstanding balances of loans sold and serviced through the two programs totaled $182,410,000, including loans sold through the MPF Xtra program of $106,040,000 and loans sold through the Original program of $76,370,000. In addition, the outstanding balance of loans sold under the MPF Original program by Monument totaled $20,130,000. The loans sold by Monument are not serviced by the Corporation; however, the Corporation has assumed the credit enhancement obligation on these loans (as discussed in the next paragraph). At December 31, 2019, outstanding balances of loans sold and serviced through the two programs totaled $178,446,000, including loans sold through the MPF Xtra program of $104,707,000 and loans sold through the Original program of $73,739,000. Based on the fairly limited volume of required repurchases to date, no allowance has been established for representation and warranty exposures as of March 31, 2020 and December 31, 2019.
For loans sold under the Original program, the Corporation provides a credit enhancement whereby the Corporation would assume credit losses in excess of a defined First Loss Account (“FLA”) balance, up to specified amounts. The FLA is funded by the Federal Home Loan Bank of Pittsburgh based on a percentage of the outstanding balance of loans sold. At March 31, 2020, the Corporation’s maximum credit enhancement obligation under the MPF Original Program was $4,840,000, and the Corporation has recorded a related allowance for credit losses of $303,000 which is included in “Accrued interest and other liabilities” in the accompanying consolidated balance sheets. At December 31, 2019, the Corporation’s maximum credit enhancement obligation under the MPF Original Program was $4,618,000, and the related allowance for credit losses was $333,000. The Corporation does not provide a credit enhancement for loans sold through the Xtra program.
PROVISION AND ALLOWANCE FOR LOAN LOSSES
The Corporation maintains an allowance for loan losses that represents management’s estimate of the losses inherent in the loan portfolio as of the balance sheet date and is recorded as a reduction of the investment in loans. Note 7 to the unaudited consolidated financial statements provides an overview of the process management uses for evaluating and determining the allowance for loan losses.
While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation’s allowance for loan losses. Such agencies may require the Corporation to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination.
The allowance for loan losses was $11,330,000 at March 31, 2020, up from $9,836,000 at December 31, 2019. Table VIII shows total specific allowances on impaired loans increased $1,176,000 to $2,227,000 at March 31, 2020 from $1,051,000 at December 31, 2019. This net increase included the impact of a specific allowance of $1,193,000 on a commercial loan with an outstanding balance of $3,500,000 being recorded in the first quarter 2020. This loan was made on a partially unsecured basis. At March 31, 2020, the specific allowance reflected the Corporation’s estimate that the liquidation value of the related collateral, net of selling costs, would be approximately $1.6 million, and that approximately $700,000 would be recovered from the remainder of the borrower’s net assets.
Loans acquired from Monument that were identified as having a deterioration in credit quality (purchased credit impaired, or PCI), were valued at $441,000 at April 1, 2019 and $305,000 at March 31, 2020. The remainder of the portfolio was deemed to be the performing component of the portfolio. The calculation of the fair value of performing loans included a discount for credit losses of $1,914,000, reflecting an estimate of the present value of credit losses based on market expectations. Cumulatively through March 31, 2020, the Corporation recognized accretion of the discount totaling $903,000, and the balance of the discount at March 31, 2020 was $1,011,000. None of the performing loans purchased were found to be impaired at March 31, 2020, and the purchased performing loans were excluded from the loan pools for which the general component of the allowance for loan losses was calculated. Accordingly, there was no allowance for loan losses at March 31, 2020 on loans purchased from Monument.
The provision (credit) for loan losses by segment in the three-month periods ended March 31, 2020 and 2019 are as follows:
The provision (credit) for loan losses is further detailed as follows:
Consumer segment
For the periods shown in the tables immediately above, the provision related to increases or decreases in specific allowances on impaired loans was affected by changes in the results of management’s assessment of the amount of probable or actual (charged-off) losses associated with a small number of larger, individual loans. This line item also includes net charge-offs or recoveries from smaller loans that had not been individually evaluated for impairment prior to charge-off.
In the tables immediately above, the portion of the net change in the collectively determined allowance attributable to loan growth was determined by applying the historical loss experience and qualitative factors used in the allowance calculation at the end of the preceding period to the net increase or decrease in loans outstanding (excluding loans specifically evaluated for impairment) for the period.
The effect on the provision of changes in historical loss experience and qualitative factors, as shown in the tables above, was determined by: (1) calculating the net change in each factor used in determining the allowance at the end of the period as compared to the preceding period, and (2) applying the net change in each factor to the outstanding balance of loans at the end of the preceding period (excluding loans specifically evaluated for impairment).
Table IX presents information related to past due and impaired loans, and loans that have been modified under terms that are considered troubled debt restructurings (TDRs). Total nonperforming loans as a percentage of outstanding loans was 1.23% at March 31, 2020, up from 0.88% at December 31, 2019, and nonperforming assets as a percentage of total assets was 0.99% at March 31, 2020, up from 0.80% at December 31, 2019. At March 31, 2020, these ratios were affected by classification as nonperforming of the commercial loan noted above with an outstanding balance of $3.5 million that had not been classified as such at December 31, 2019.
Table IX presents data at March 31, 2020 and at the end of each of the years ended December 31, 2015 through 2019. Table IX shows that total nonperforming loans as a percentage of loans of 1.23% at March 31, 2020, though up from December 31, 2019, was lower than the corresponding year-end ratio from 2015 through 2018. Similarly, the March 31, 2020 ratio of total nonperforming assets as a percentage of assets of 0.99% was lower than the corresponding ratio from 2015 through 2018. These improved credit-related ratios reflect the impact of acquired loans from Monument with minimal nonperforming loans at March 31, 2020.
Total impaired loans of $8,290,000 at March 31, 2020 are up $2,804,000 from the corresponding amount at December 31, 2019 of $5,486,000. The increase in impaired loans includes the impact of classification as impaired of the commercial loan referred to above with an outstanding balance of $3.5 million and a specific allowance of $1,193,000 at March 31, 2020.
Total nonperforming assets of $16,087,000 at March 31, 2020 are $2,776,000 higher than the corresponding amount at December 31, 2019, summarized as follows:
Over the period 2015-2019 and the first three months of 2020, each period includes a few large commercial relationships that have required significant monitoring and workout efforts. As a result, a limited number of relationships may significantly impact the total amount of allowance required on impaired loans and may significantly impact the amount of total charge-offs reported in any one period.
Management believes it has been conservative in its decisions concerning identification of impaired loans, estimates of loss, and nonaccrual status; however, the actual losses realized from these relationships could vary materially from the allowances calculated as of March 31, 2020. Management continues to closely monitor its commercial loan relationships for possible credit losses and will adjust its estimates of loss and decisions concerning nonaccrual status, if appropriate.
Tables VII through X present historical data related to loans and the allowance for loan losses.
TABLE VII - ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES
(Dollars In Thousands)
TABLE VIII - COMPONENTS OF THE ALLOWANCE FOR LOAN LOSSES
TABLE IX - PAST DUE AND IMPAIRED LOANS, NONPERFORMING ASSETS
AND TROUBLED DEBT RESTRUCTURINGS (TDRs)
TABLE X - SUMMARY OF LOANS BY TYPE
LIQUIDITY
Liquidity is the ability to quickly raise cash at a reasonable cost. An adequate liquidity position permits the Corporation to pay creditors, compensate for unforeseen deposit fluctuations and fund unexpected loan demand. At March 31, 2020, the Corporation maintained overnight interest-bearing deposits with the Federal Reserve Bank of Philadelphia and other correspondent banks totaling $11,555,000.
The Corporation maintains overnight borrowing facilities with several correspondent banks that provide a source of day-to-day liquidity. Also, the Corporation maintains borrowing facilities with the Federal Home Loan Bank of Pittsburgh, secured by various mortgage loans.
The Corporation has a line of credit with the Federal Reserve Bank of Philadelphia’s Discount Window. Management intends to use this line of credit as a contingency funding source. As collateral for the line, the Corporation has pledged available-for-sale debt securities with a carrying value of $14,815,000 at March 31, 2020.
The Corporation’s outstanding, available, and total credit facilities at March 31, 2020 and December 31, 2019 are as follows:
At March 31, 2020, the Corporation’s outstanding credit facilities with the Federal Home Loan Bank of Pittsburgh consisted of overnight borrowings of $17,000,000, short-term borrowings of $18,200,000 and long-term borrowings of $72,944,000. At December 31, 2019, the Corporation’s outstanding credit facilities with the Federal Home Loan Bank of Pittsburgh consisted of overnight borrowings of $64,000,000, short-term borrowings of $20,297,000 and long-term borrowings with a total amount of $52,127,000. Additional information regarding borrowed funds is included in Note 9 to the unaudited consolidated financial statements.
Additionally, the Corporation uses “RepoSweep” arrangements to borrow funds from commercial banking customers on an overnight basis. If required to raise cash in an emergency situation, the Corporation could sell available-for-sale securities to meet its obligations or use repurchase agreements placed with brokers to borrow funds secured by investment assets. At March 31, 2020, the carrying value of available-for-sale securities in excess of amounts required to meet pledging or repurchase agreement obligations was $182,093,000.
Management believes the Corporation is well-positioned to meet its short-term and long-term obligations, including the impact of additional lending opportunities and other potential cash requirements arising from the Monument merger.
STOCKHOLDERS’ EQUITY AND CAPITAL ADEQUACY
Details concerning capital ratios at March 31, 2020 and December 31, 2019 are presented below. As a small bank holding company, the Corporation is not subject to consolidated capital requirements at March 31, 2020; however, C&N Bank remains subject to regulatory capital requirements administered by the federal banking agencies. Management believes, as of March 31, 2020, that C&N Bank meets all capital adequacy requirements to which it is subject and maintains a capital conservation buffer (described in more detail below) that allows the Bank to avoid limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers. Further, as reflected in the table below, the Corporation’s and C&N Bank’s capital ratios at March 31, 2020 and December 31, 2019 exceed the Corporation’s Board policy threshold levels.
In October 2019, the Federal Reserve Board, FDIC and Office of the Comptroller of the Currency finalized a rule that provides qualifying community banking organizations an option to calculate a simple leverage ratio, rather than multiple measures of capital adequacy. In the first quarter 2020, C&N Bank did not elect the community bank leverage ratio (“CBLR”) framework. The decision to continue to measure capital adequacy using previously existing risk-based and leverage capital requirements reflects concerns that reliance on the leverage ratio as a single measurement could, in certain circumstances, limit the ability to grow or encourage taking excessive risk. C&N Bank could elect the CBLR framework in the future.
While it is difficult to estimate the future impact of COVID-19, the Corporation’s and C&N Bank’s capital ratios at March 31, 2020 are at levels that demonstrate the capacity to absorb the acquisition of Covenant as well as significant losses if they arise while continuing to meet the requirements to be considered well capitalized.
Future dividend payments will depend upon maintenance of a strong financial condition, future earnings and capital and regulatory requirements. As described in more detail below, C&N Bank is subject to restrictions on the amount of dividends that may be paid without approval of banking regulatory authorities. Further, although the Corporation is no longer subject to the specific consolidated capital requirements described herein, the Corporation’s ability to pay dividends, repurchase stock or engage in other activities may be limited by the Federal Reserve if the Corporation fails to hold capital commensurate with its overall risk profile.
To avoid limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers, a banking organization subject to the rule must hold a capital conservation buffer composed of common equity tier 1 capital above its minimum risk-based capital requirements. The buffer is measured relative to risk-weighted assets. At March 31, 2020, the minimum risk-based capital ratios, and the capital ratios including the capital conservation buffer, are as follows:
A banking organization with a buffer greater than 2.5% over the minimum risk-based capital ratios would not be subject to additional limits on dividend payments or discretionary bonus payments; however, a banking organization with a buffer less than 2.5% would be subject to increasingly stringent limitations as the buffer approaches zero. Also, a banking organization is prohibited from making dividend payments or discretionary bonus payments if its eligible retained income is negative in that quarter and its capital conservation buffer ratio was less than 2.5% as of the beginning of that quarter. Eligible net income is defined as net income for the four calendar quarters preceding the current calendar quarter, net of any distributions and associated tax effects not already reflected in net income. A summary of payout restrictions based on the capital conservation buffer is as follows:
At March 31, 2020, C&N Bank’s Capital Conservation Buffer, determined based on the minimum total capital ratio, was 11.02%.
The Corporation’s total stockholders’ equity is affected by fluctuations in the fair values of available-for-sale debt securities. The difference between amortized cost and fair value of available-for-sale debt securities, net of deferred income tax, is included in Accumulated Other Comprehensive Income (Loss) within stockholders’ equity. The balance in Accumulated Other Comprehensive Income (Loss) related to unrealized gains (losses) on available-for-sale debt securities, net of deferred income tax, amounted to $9,230,000 at March 31, 2020 and $3,511,000 at December 31, 2019. Changes in accumulated other comprehensive income (loss) are excluded from earnings and directly increase or decrease stockholders’ equity. If available-for-sale debt securities are deemed to be other-than-temporarily impaired, unrealized losses are recorded as a charge against earnings, and amortized cost for the affected securities is reduced. Note 6 to the unaudited consolidated financial statements provides additional information concerning management’s evaluation of available-for-sale securities for other-than-temporary impairment at March 31, 2020.
Stockholders’ equity is also affected by the underfunded or overfunded status of defined benefit pension and postretirement plans. The balance in Accumulated Other Comprehensive Income related to defined benefit plans, net of deferred income tax, was $244,000 at March 31, 2020 and $180,000 at December 31, 2019.
COMPREHENSIVE INCOME
Comprehensive Income is the total of (1) net income, and (2) all other changes in equity from non-stockholder sources, which are referred to as Other Comprehensive Income. Changes in the components of Accumulated Other Comprehensive Income (Loss) are included in Other Comprehensive Income, and for the Corporation, consist of changes in unrealized gains or losses on available-for-sale debt securities and changes in underfunded or overfunded defined benefit plans. Fluctuations in interest rates significantly affect fair values of available-for-sale debt securities, and accordingly have an effect on Other Comprehensive Income (Loss) in each period.
Comprehensive Income totaled $9,949,000 for the first quarter 2020 as compared to $8,619,000 in the first quarter 2019. For the three months ended March 31, 2020, Comprehensive Income included: (1) Net Income of $4,166,000, which was $924,000 lower than in the first quarter 2019; (2) Other Comprehensive Income from available-for-sale debt securities of $5,719,000 as compared to Other Comprehensive Income of $3,366,000 in the first quarter 2019; and (3) Other Comprehensive Income from defined benefit plans of $64,000 which was lower for the first quarter 2020 as compared to $163,000 for the first quarter 2019.
ITEM 4. CONTROLS AND PROCEDURES
The Corporation’s management, under the supervision of and with the participation of the Corporation’s Chief Executive Officer and Chief Financial Officer, has carried out an evaluation of the design and effectiveness of the Corporation’s disclosure controls and procedures as defined in Rule 13a-15(e) and Rule 15d-15(e) of the Securities Exchange Act of 1934 as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Corporation’s disclosure controls and procedures are effective to ensure that all material information required to be disclosed in reports the Corporation files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms.
PART II – OTHER INFORMATION
Item 1. Legal Proceedings
The Corporation and C&N Bank are involved in various legal proceedings incidental to their business. Management believes the aggregate liability, if any, resulting from such pending and threatened legal proceedings will not have a material, adverse effect on the Corporation’s financial condition or results of operations.
Item 1A. Risk Factors
Except for the risk factor described immediately below, there have been no material changes from the risk factors previously disclosed in Item 1A of the Corporation’s Form 10-K filed February 20, 2020.
Coronavirus Outbreak- In December 2019, a coronavirus (COVID-19) was reported in China, and, in March 2020, the World Health Organization declared it a pandemic. Since first being reported in China, the coronavirus has spread to additional countries including the United States.
In response, many state and local governments, including the Commonwealth of Pennsylvania, have instituted emergency restrictions that have substantially limited the operation of non-essential businesses and the activities of individuals. It has been widely reported that these restrictions have resulted in significant adverse effects for many different types of businesses, particularly those in the travel, hospitality and food and beverage industries, among many others, and has resulted in a significant number of layoffs and furloughs of employees nationwide and in the regions in which the Corporation operates. The ultimate effect of COVID-19 on the local or broader economy is not known nor is the ultimate length of the restrictions described and any accompanying effects. Moreover, the Federal Reserve has taken action to lower the Federal Funds rate, which may negatively affect interest income and, therefore, earnings. Given the ongoing and dynamic nature of the circumstances, it is difficult to predict the impact of the coronavirus outbreak, and there is no guarantee that the Corporation’s efforts to address the adverse impacts of the coronavirus will be effective. The extent of such impact will depend on future developments, which are highly uncertain and cannot be predicted, including new information which may emerge concerning the severity of the coronavirus and actions taken to contain the coronavirus or its impact, among others.
The effect of COVID-19 and related events, including those described above and those not yet known or knowable, could have a negative effect on the Corporation’s business prospects, financial condition and results of operations, as a result of quarantines; market volatility; market downturns; changes in consumer behavior; business closures; deterioration in the credit quality of borrowers or the inability of borrowers to satisfy their obligations (and any related forbearances or restructurings that may be implemented); changes in the value of collateral securing outstanding loans; changes in the value of the investment securities portfolio; effects on key employees, including operational management personnel and those charged with preparing, monitoring and evaluating the Corporation’s financial reporting and internal controls; declines in the demand for loans and other banking services and products; declines in demand resulting from adverse impacts of the disease on businesses deemed to be “non-essential” by governments; and branch or office closures and business interruptions.
As described above, the Corporation has entered into an agreement to acquire Covenant. The COVID-19-related risk factors described in the preceding paragraphs also apply to Covenant. These factors, together or in combination with other events or occurrences not yet known or anticipated, could adversely affect the value of the merger consideration or could delay or prevent the consummation of the merger. Further, if the Corporation or Covenant is unable to recover from a business disruption on a timely basis, the merger and the combined company's business and financial condition and results of operations following the completion of the merger would be adversely affected. The merger and efforts to integrate the businesses of the Corporation and Covenant may also be delayed and adversely affected by the coronavirus outbreak and become more costly, which could adversely affect the Corporation’s financial condition and results of operations.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Issuer Purchases of Equity Securities
The following table sets forth a summary of the purchases by the Corporation of its common stock during the first quarter 2020.
Note to Table: Effective April 21, 2016, the Corporation’s Board of Directors approved a treasury stock repurchase program. Under this stock repurchase program, the Corporation is authorized to repurchase up to 600,000 shares of the Corporation's common stock or slightly less than 5% of the Corporation's issued and outstanding shares at April 19, 2016. The Board of Directors’ April 21, 2016 authorization provides that: (1) the new treasury stock repurchase program shall be effective when publicly announced and shall continue thereafter until suspended or terminated by the Board of Directors, in its sole discretion; and (2) all shares of common stock repurchased pursuant to the new program shall be held as treasury shares and be available for use and reissuance for purposes as and when determined by the Board of Directors including, without limitation, pursuant to the Corporation’s Dividend Reinvestment and Stock Purchase Plan and its equity compensation program. To date, no purchases have been made under this repurchase program.
Item 3. Defaults Upon Senior Securities
None
Item 4. Mine Safety Disclosures
Not applicable
Item 5. Other Information
Item 6. Exhibits
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.