UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended June 30, 2016
or
For the transition period from _______________ to _________________________.
Commission file number: 000-16084
CITIZENS & NORTHERN CORPORATION
(Exact name of Registrant as specified in its charter)
90-92 MAIN STREET, WELLSBORO, PA 16901
(Address of principal executive offices) (Zip code)
570-724-3411
(Registrant's telephone number including area code)
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.
Yesx No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes xNo ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer ¨Accelerated filer xNon-accelerated filer ¨Smaller reporting company ¨
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.
Notes to Unaudited Consolidated Financial Statements
1. BASIS OF INTERIM PRESENTATION
The consolidated financial information included herein, with the exception of the consolidated balance sheet dated December 31, 2015, 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 2015 information has been reclassified for consistency with the 2016 presentation.
Operating results reported for the three-month and six-month periods ended June 30, 2016 might not be indicative of the results for the year ending December 31, 2016. The Corporation evaluates subsequent events through the date of filing with the Securities and Exchange Commission.
2. PER SHARE DATA
Net income per share is based on the weighted-average number of shares of common stock outstanding. The following data show the amounts used in computing basic and diluted net income per share. As shown in the table that follows, diluted earnings per 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.
Stock options that were anti-dilutive were excluded from net income per share calculations. Weighted-average common shares available from anti-dilutive instruments totaled 47,224 shares in the six-month period ended June 30, 2016, 75,539 shares in the six-month period ended June 30, 2015, 47,139 shares in the second quarter 2016 and 47,974 shares in the second quarter 2015.
3. 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. The components of other comprehensive income, and the related tax effects, are as follows:
Changes in the components of accumulated other comprehensive income are as follows and are presented net of tax:
Items reclassified out of each component of other comprehensive income are as follows:
4. CASH AND DUE FROM BANKS
Cash and due from banks at June 30, 2016 and December 31, 2015 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.
The Corporation is 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. Required reserves were $12,532,000 at June 30, 2016 and $15,327,000 at December 31, 2015.
5. 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 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 June 30, 2016 and December 31, 2015, assets measured at fair value and the valuation methods used are as follows:
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 June 30, 2016 and December 31, 2015, quantitative information regarding significant techniques and 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.
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.
At June 30, 2016 and December 31, 2015, quantitative information regarding significant techniques and inputs used for nonrecurring fair value measurements using unobservable inputs (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 Corporation used the following methods and assumptions in estimating fair value disclosures for financial instruments:
CASH AND CASH EQUIVALENTS - The carrying amounts of cash and short-term instruments approximate fair values.
CERTIFICATES OF DEPOSIT - Fair values for certificates of deposit, included in cash and due from banks in the consolidated balance sheet, are based on quoted market prices for certificates of similar remaining maturities.
SECURITIES - Fair values for securities, excluding restricted equity securities, are based on quoted market prices or other methods as described above. The carrying value of restricted equity securities approximates fair value based on applicable redemption provisions.
LOANS HELD FOR SALE - Fair values of loans held for sale are determined based on applicable sale prices available under the Federal Home Loan Banks’ MPF Xtra and MPF Original programs.
LOANS - Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, commercial real estate, residential mortgage and other consumer. Each loan category is further segmented into fixed and adjustable rate interest terms and by performing and nonperforming categories. The fair value of performing loans is calculated by discounting contractual cash flows, adjusted for estimated prepayments based on historical experience, using estimated market discount rates that reflect the credit and interest rate risk inherent in the loans. Fair value of nonperforming loans is based on recent appraisals or estimates prepared by the Corporation’s lending officers.
SERVICING RIGHTS - The fair value of servicing rights, included in other assets in the consolidated balance sheet, is determined through a discounted cash flow valuation. Significant inputs include expected net servicing income, the discount rate and the expected prepayment speeds of the underlying loans.
DEPOSITS - The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits, savings, money market and interest checking accounts, is (by definition) equal to the amount payable on demand at June 30, 2016 and December 31, 2015. The fair value of time deposits, such as certificates of deposit and Individual Retirement Accounts, is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered
for deposits of similar remaining maturities. The fair value estimates of deposits do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market, commonly referred to as the core deposit intangible.
BORROWED FUNDS - The fair value of borrowings is estimated using discounted cash flow analyses based on rates currently available to the Corporation for similar types of borrowing arrangements.
ACCRUED INTEREST - The carrying amounts of accrued interest receivable and payable approximate fair values.
OFF-BALANCE SHEET COMMITMENTS - 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.
The estimated fair values, and related carrying amounts, of the Corporation’s financial instruments are as follows:
6. SECURITIES
Amortized cost and fair value of available-for-sale securities at June 30, 2016 and December 31, 2015 are summarized as follows:
The following table presents gross unrealized losses and fair value of available-for-sale 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 June 30, 2016 and December 31, 2015:
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 June 30, 2016. 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.
The Corporation’s mortgage-backed securities 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 $203,791,000 at June 30, 2016 and $228,616,000 at December 31, 2015 were pledged as collateral for public deposits, trusts and certain other deposits as provided by law. See Note 8 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 OTTI at June 30, 2016 is provided below.
Debt Securities
At June 30, 2016, 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 June 30, 2016 to be temporary.
Equity Securities
The Corporation’s marketable equity securities at June 30, 2016 and December 31, 2015 consisted exclusively of stocks of banking companies. At June 30, 2016, the Corporation held no stocks with an unrealized loss.
The Corporation realized gains from sales of bank stocks totaling $28,000 in the three-month period ended June 30, 2016 and $277,000 during the first six months of 2016. Realized gains from sales of bank stocks totaled $476,000 in the three-month and six-month periods ended June 30, 2015.
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 $3,485,000 at June 30, 2016 and $4,527,000 at December 31, 2015. The Corporation evaluated its holding of FHLB-Pittsburgh stock for impairment and deemed the stock to not be impaired at June 30, 2016 and December 31, 2015. 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.
7. LOANS
The loans receivable portfolio is segmented into residential mortgage, commercial and consumer loans. Loans outstanding at June 30, 2016 and December 31, 2015 are summarized by segment, and by classes within each segment, 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 the Pennsylvania and New York counties that comprise the market serviced by Citizens & Northern Bank. 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 June 30, 2016 or December 31, 2015.
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 June 30, 2016 and December 31, 2015, 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 and six-month periods ended June 30, 2016 and 2015 were as follows:
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 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.
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 below.
The following tables summarize the aggregate credit quality classification of outstanding loans by risk rating as of June 30, 2016 and December 31, 2015:
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 loans are subject to a restructuring agreement. The pools of loans are evaluated for loss exposure based upon three-year average historical net charge-off rates for each loan class, adjusted for qualitative factors. Qualitative risk factors (described in the following paragraph) 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 three-year average net charge-off rate to 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. Further, the residential mortgage segment is significantly affected by the values of residential real estate that provide collateral for the loans. The majority of the Corporation’s commercial segment loans (approximately 56% at June 30, 2016) is secured by real estate, and accordingly, the Corporation’s risk for the commercial segment is significantly affected by commercial real estate values. The consumer segment includes a wide mix of loans for different purposes, primarily secured loans, including loans secured by motor vehicles, manufactured housing and other types of collateral.
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 evaluated individually for impairment include all loan relationships greater than $200,000 for which there is at least one extension of credit graded Special Mention, Substandard or Doubtful. Also, all loans classified as troubled debt restructurings (discussed in more detail below) and all loan relationships less than $200,000 in the aggregate, but with an estimated loss of $100,000 or more, are individually evaluated for impairment. Loans that are individually evaluated for impairment, but which are not determined to 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 evaluated, but which have not been determined to be impaired, are included in the “Collectively Evaluated” column in the tables summarizing the allowance and associated loan balances as of June 30, 2016 and December 31, 2015.
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 June 30, 2016 and December 31, 2015:
Summary information related to impaired loans at June 30, 2016 and December 31, 2015 is as follows:
The average balance of impaired loans and interest income recognized on 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 June 30, 2016 and December 31, 2015:
Nonaccrual loans are included in the contractual aging in the immediately preceding table. A summary of the contractual aging of nonaccrual loans at June 30, 2016 and December 31, 2015 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 June 30, 2016 and December 31, 2015 is as follows:
The TDR that occurred during the three-month period ended June 30, 2016 is as follows:
There were no TDRs that occurred during the three-month period ended June 30, 2015.
The TDR in the three-month period ended June 30, 2016 resulted from an extension of a final maturity date and a lowered interest rate. There was a $30,000 allowance for loan losses on this loan at June 30, 2016 as compared to no allowance for loan losses on the loan prior to the second quarter 2016.
TDRs that occurred during the six-month periods ended June 30, 2016 and 2015 were as follows:
The TDRs in the six-month period ended June 30, 2016 included an extension of a final maturity date and a lowered interest rate on one contract and an extension of a final maturity date on one contract. There was a $30,000 allowance for loan losses on the commercial and industrial loan that included an extension of a final maturity date and a lowered interest rate at June 30, 2016 as compared to no allowance for loan losses on the loan at December 31, 2015. There was no allowance for loan losses at June 30, 2016 on the other commercial and industrial loan (TDR), and no change in the allowance for loan losses resulting from that TDR in the six-month period ended June 30, 2016.
The TDRs in the six-month period ended June 30, 2015 included an extended maturity date and a reduction in interest rate on a residential mortgage – first lien, a lowered interest rate and reduced payment amount on a residential mortgage – junior lien and a lowered interest rate and reduced payment amount on the consumer loan. There was no allowance for loan losses on these loans at June 30, 2015, and no change in the allowance for loan losses resulting from these TDRs.
In the three-month period ended June 30, 2016, defaults on loans for which modifications considered to be TDRs were entered into within the previous 12 months were as follows:
There were no defaults on loans for which modification considered to be TDRs were entered into within the previous 12 months in the three-month period ended June 30, 2015.
In the six-month period ended June 30, 2016, the events of default in the table listed above resulted from a borrower’s failure to pay in a timely manner after reduced payment amounts for six months expired on the Residential mortgage – first lien and a borrower’s failure to pay in a timely manner after lowered interest rates and reduced payment amounts on the Residential mortgage – junior lien and on the Consumer loan. There was no allowance for loan losses recorded on these loans at June 30, 2016.
In the six-month periods ended June 30, 2016 and 2015, defaults on loans for which modifications considered to be TDRs were entered into within the previous 12 months were as follows:
In the six-month period ended June 30, 2016, the events of default in the table listed above resulted from the borrowers’ failure to make timely payments under the following circumstances: (1) for one customer relationship included in the Residential first lien mortgage class, timely payment was missed after payment amounts were reduced for six months; (2) for the other customer relationship in the Residential first lien mortgage class, payment was missed after the monthly payment amount was reduced for six months; (3) for the customer relationships in the Residential junior lien mortgage class and the consumer class, timely payments were missed after interest rates and payment amounts were reduced on both loans; and (4) for the Commercial and industrial loan, the borrower failed to pay off the loan at the extended maturity date.
In the six-month period ended June 30, 2015, the events of default in the table listed above resulted from the borrowers’ failure to make timely payments under the following circumstances: (1) for one customer relationship included in the Residential first lien mortgage class, payment was missed after the interest rate and monthly payment amount had been reduced; (2) for the other customer relationship included in the Residential first lien class, monthly payments were missed after reducing the monthly payments to interest only payments; (3) for the Commercial loan secured by real estate, monthly payments were missed after reducing the monthly payments to interest only; and (4) for the Commercial construction and land loan, monthly payments were missed after extending the term of maturity. There were no allowances for loan losses recorded on these loans at June 30, 2015.
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 Sheet) 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. BORROWED FUNDS
Short-term borrowings include the following:
Short-term borrowings from FHLB-Pittsburgh are as follows:
The FHLB-Pittsburgh loan facilities are collateralized by qualifying loans secured by real estate with a book value totaling $454,935,000 at June 30, 2016 and $450,883,000 at December 31, 2015. Also, the FHLB-Pittsburgh loan facilities require 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 $3,485,000 at June 30, 2016 and $4,527,000 at December 31, 2015.
At June 30, 2016, short-term borrowings from the FHLB-Pittsburgh include 6 advances of approximately $2,090,000 each, maturing monthly throughout the remainder of the year ending December 31, 2016, with a weighted average interest rate of 0.99% and rates ranging from 0.92% to 1.052%. In the first six months 2016, the Corporation repaid six advances of approximately $2,090,000 each, with a weighted average rate of 0.72%.
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 interest rate paid by the Corporation on customer repurchase agreements was 0.10% at June 30, 2016 and December 31, 2015. The carrying value of the underlying securities was $17,218,000 at June 30, 2016 and $12,613,000 at December 31, 2015.
Long-term borrowings are as follows:
Long-term borrowings from FHLB-Pittsburgh are as follows:
The repurchase agreement included in long-term borrowings has an interest rate of 3.595% and an effective maturity date in December 2017.
The “Repurchase Date,” as defined in the Master Repurchase Agreement between the Corporation and the broker-dealer, occurs quarterly on or about the 20th of each March, June, September and December until the “Final Repurchase Date” (as defined) on December 20, 2017. The Corporation pays interest, and the borrowing is putable by the issuer, on each Repurchase Date. The Final Repurchase Date is the effective maturity date of the borrowing.
Securities sold under repurchase agreements were delivered to the broker-dealer who is the counter-party to the transactions. The broker-dealer may have sold, loaned or otherwise disposed of such securities to other parties in the normal course of their operations, and has agreed to resell to the Corporation substantially identical securities at the maturities of the agreements. The Master Repurchase Agreement provides that the Agreement constitutes a “netting contract,” as defined; however, the Corporation and the broker-dealer have no other obligations to one another and accordingly, no netting has occurred.
The carrying value of the underlying securities was $36,117,000 at June 30, 2016 and $33,780,000 at December 31, 2015, detailed in the following table:
Two of the more significant risks associated with the repurchase agreement with the broker-dealer are as follows:
The Corporation manages these risks by maintaining sufficient available assets of acceptable credit quality, as well as maintaining other borrowing facilities, to meet ongoing collateral maintenance requirements or pay off the borrowing if required. In particular, the Corporation had unused borrowing capacity available from the FHLB-Pittsburgh of $294,373,000 at June 30, 2016.
9. DEFINED BENEFIT PLANS
The Corporation sponsors a defined benefit health care plan that provides postretirement medical benefits and life insurance to employees who meet certain age and length of service requirements. Full-time employees no longer accrue service time toward the Corporation-subsidized portion of the medical benefits. This plan contains a cost-sharing feature, which causes participants to pay for all future increases in costs related to benefit coverage. Accordingly, actuarial assumptions related to health care cost trend rates do not significantly affect the liability balance at June 30, 2016 and December 31, 2015, and are not expected to significantly affect the Corporation's future expenses. The Corporation uses a December 31 measurement date for the postretirement plan.
In an acquisition in 2007, the Corporation assumed the Citizens Trust Company Retirement Plan, a defined benefit pension plan. This plan covers certain employees who were employed by Citizens Trust Company on December 31, 2002, when the plan was amended to discontinue admittance of any future participant and to freeze benefit accruals. Information related to the Citizens Trust Company Retirement Plan has been included in the tables that follow. The Corporation uses a December 31 measurement date for this plan.
The components of net periodic benefit costs from these defined benefit plans are as follows:
In the first six months of 2016, the Corporation funded postretirement contributions totaling $31,000, with estimated annual postretirement contributions of $68,000 expected in 2016 for the full year. Based upon the related actuarial reports, no defined benefit pension contributions are required in 2016, though the Corporation may make discretionary contributions.
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 three-month periods ended March 31, 2016 and 2015, the Corporation issued restricted stock under each of the Plans.
In the first quarter 2016, the Corporation awarded a total of 34,199 shares of restricted stock under the Stock Incentive and Independent Directors Stock Incentive Plans. Restricted stock awards in the first quarter 2016 included the following: (1) a total of 17,289 shares to employees, vesting over a three-year term, with vesting contingent upon the Corporation meeting an annual return on average equity (“ROAE”) performance ratio, as defined; (2) a total of 10,304 shares to employees, vesting over a three-year term, with vesting dependent on satisfactory performance; and (3) a total of 6,606 shares under the Independent Directors Incentive Plan, vesting over a term of one year.
In the second quarter 2016, the Corporation awarded a total of 1,228 shares of restricted stock under the Independent Directors Stock Incentive Plan. The restricted stock was awarded to two new directors, with each award vesting over a term of one year.
In the first quarter 2015, a total of 34,800 shares of restricted stock were awarded under the Plans. Restricted stock awards in 2015 included the following: (1) a total of 20,298 shares to employees, vesting over a four-year term, with vesting contingent upon the Corporation meeting an annual ROAE performance ratio, as defined; (2) a total of 2,198 shares to employees, vesting over a four-year term, with vesting dependent on satisfactory performance; (3) an award to the Chief Executive Officer of 5,174 shares, vesting over a three-year term, with vesting dependent on satisfactory performance; and (4) a total of 7,130 shares under the Independent Directors Incentive Plan, vesting over a term of one year.
Compensation cost related to restricted stock is recognized based on the market price of the stock at the grant date over the vesting period. Management has estimated restricted stock expense in the first six months of 2016 based on an assumption that the ROAE target for 2016 will be met.
Total stock-based compensation expense is as follows:
11. INCOME TAXES
The net deferred tax asset at June 30, 2016 and December 31, 2015 represents the following temporary difference components:
The provision for income tax for the three-month and six month periods ended June 30, 2016 and 2015 is based on the Corporation’s estimate of the effective tax rate expected to be applicable for the full year. The effective tax rates for the Corporation are as follows:
The effective tax rate for each period presented differs from the statutory rate of 35% principally because of the effects of tax-exempt interest income.
The Corporation has investments in three limited partnerships that manage affordable housing projects that have qualified for the federal low-income housing tax credit. The Corporation’s expected return from these investments is based on the receipt of tax credits and tax benefits from deductions of operating losses. The Corporation uses the effective yield method to account for these investments, with the benefits recognized as a reduction of the provision for income taxes. For two of the three limited partnership investments, the tax credits have been received in full in prior years, and the Corporation has fully realized the benefits of the credits and amortized its initial investments in the partnerships. The most recent affordable housing project was completed in 2013, and the Corporation received tax credits in 2013, 2014 and 2015 and expects to continue to receive tax credits annually through 2022. The carrying amount of the Corporation’s investment is $762,000 at June 30, 2016 and $812,000 at December 31, 2015 (included in Other Assets in the consolidated balance sheets). For the year ending December 31, 2016, the estimated amount of tax credits and other tax benefits to be received is $158,000 and the estimated amount to be recognized as a reduction of the provision for income taxes is $76,000. For the year ended December 31, 2015, tax credits and other tax benefits totaled $158,000 and the amount recognized as a reduction of the provision for income taxes for 2015 was $80,000. The total reduction in the provision for income taxes resulting from this investment is $19,000 in the second quarter 2016, and $38,000 for the six months ended June 30, 2016, and $20,000 in the second quarter 2015, and $41,000 for the six months ended June 30, 2015.
The Corporation has no unrecognized tax benefits, nor pending examination issues related to tax positions taken in preparation of its income tax returns. With limited exceptions, the Corporation is no longer subject to examination by the Internal Revenue Service for years prior to 2012.
12. 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.
13. RECENT ACCOUNTING PRONOUNCEMENTS
The 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.
In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers, which provides a principles-based framework for revenue recognition that supersedes virtually all previously issued revenue recognition guidance under U.S. GAAP. Additionally, the ASU requires improved disclosures to help users of financial statements better understand the nature, amount, timing, and uncertainty of revenue that is recognized. The core principle of the five-step revenue recognition framework is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In April 2016, the FASB issued ASU 2016-10, which provides clarifying information related to identifying performance obligations and licensing. In May 2016, the FASB issued ASU 2016-12, which provides clarifying guidance in a few narrow areas and adds some practical expedients to the guidance. In August 2015 the FASB issued ASU 2015-14, which deferred the effective date of the revenue recognition standard by a year, making it applicable for the Corporation in the first quarter 2018 and for the annual period ending December 31, 2018. The amendments should be applied either retrospectively to each prior reporting period presented or retrospectively with the cumulative effect of initially applying the amendments recognized at the date of initial application. The Corporation is in the process of evaluating the potential impact of adopting the amendments, including determining which transition method to apply.
In January 2016, the FASB issued ASU 2016-01, Recognition and Measurement of Financial Assets and Liabilities. This makes significant changes in U.S. GAAP related to certain aspects of recognition, measurement, presentation and disclosure of financial instruments. The changes provided for in this Update that are applicable to the Corporation are as follows: (1) require equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income; however, an entity may choose to measure equity investments that do not have readily determinable fair values at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer; (2) for equity investments without readily determinable fair values, require a qualitative assessment to identify impairment, and if a qualitative assessment indicates that impairment exists, requiring an entity to measure the investment at fair value; (3) eliminate the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet; (4) require public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; (5) require an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments (at March 31, 2016 and December 31, 2015, the Corporation has no liabilities for which the fair value measurement option has been elected); (6) require separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (that is, securities or loans and receivables) on the balance sheet or the accompanying notes to the financial statements; and (7) clarify that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets. The amendments in this Update will become effective for the Corporation for annual and interim periods beginning in the first quarter 2018. With limited exceptions, early adoption of the amendments in this Update is not permitted. Amendments are to be applied by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. The amendments related to equity securities without readily determinable fair values should be applied prospectively.
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The core principle of Topic 842 is that a lessee should recognize the assets and liabilities that arise from leases. Specifically, a lessee should recognize on the balance sheet a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term. For leases with a term of 12 months or less, a lessee would be permitted to make an accounting policy election by class of underlying asset not to recognize lease assets and liabilities. Topic 842 would not significantly change the recognition, measurement and presentation of expenses and cash flows arising from a lease by a lessee from current U.S. GAAP; however, the principal change from current GAAP is that lease assets and liabilities arising from operating leases would be recognized on the balance sheet. Topic 842 provides several other changes or clarifications to existing GAAP, and will require qualitative disclosures, along with quantitative disclosures, so that financial statement users can understand more about the nature of an entity’s leasing activities. In transition, Topic 842 provides that lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach, including optional practical expedients. An entity that elects to apply the practical expedients will, in effect, continue to account for leases that commence before the effective date in accordance with previous GAAP unless the lease is modified, except that lessees will be required to recognize a right-of-use asset and a lease liability for all operating leases at each reporting date based on the present value of the remaining minimum rental payments that were tracked and disclosed under previous GAAP. Topic 842 will become effective for the Corporation for annual and interim periods beginning in the first quarter 2019.
In March 2016, the FASB issued ASU No. 2016-07, Investments – Equity Method and Joint Ventures. This ASU eliminates the requirement that when an investment qualifies for the equity method as a result of an increase in the level of ownership interest or influence, an investor must adjust the investment, results of operations and retained earnings retroactively as if the equity method had been in effect during all previous periods the investment had been held. The ASU requires the equity method investor to add the cost of acquiring an additional interest in the investee to the basis of the investor’s previously held interest and adopt the equity method of accounting as of the date the investment becomes qualified for the equity method. The ASU further requires that an entity that has an available-for-sale equity security that becomes qualified for the equity method recognize through earnings the unrealized gain or loss in accumulated other comprehensive income at the date the investment becomes qualified for use of the equity method. The amendments in this Update are effective for the Corporation for annual and interim periods beginning in the first quarter 2017, with earlier application permitted. The amendments should be applied prospectively upon their effective date.
In March 2016, the FASB issued ASU No. 2016-09, Compensation – Stock Compensation. This ASU changes several aspects of accounting for share-based payment transactions, and includes some changes that apply only to nonpublic companies. This Update includes amendments that currently apply, or may apply in the future, to the Corporation related to the following: (1) accounting for the difference between the deduction for tax purposes and the amount of compensation cost recognized for financial reporting purposes; (2) classification of excess tax benefits on the statement of cash flows; (3) accounting for forfeitures; (4) accounting for awards partially settled in cash in excess of the employer’s minimum statutory tax withholding requirements; and (5) classification of employee taxes paid on the statement of cash flows when an employer withholds shares for tax-withholding purposes. The amendments in this Update are effective for the Corporation for annual and interim periods beginning in the first quarter 2017, with earlier adoption permitted. The ASU provides separate transition provisions for each of the amendments. The Corporation is in the process of evaluating the potential impact of adopting the amendments.
In June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326). This ASU will result in significant changes in the Corporation’s accounting for credit losses related to loans receivable and investment securities. A summary of significant provisions of this ASU is as follows:
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.
EARNINGS OVERVIEW
Second quarter 2016 net income was $0.32 per basic and diluted share, as compared to $0.29 in the first quarter 2016 and $0.36 in the second quarter 2015. For the six months ended June 30, 2016, net income per basic and diluted share was $0.61 as compared to $0.67 per basic and diluted share for the first six months of 2015. The return on average assets for the first six months of 2016 was 1.22%, and the return on average equity was 7.94%.
Some of the more significant fluctuations in revenues and expenses between the three-month period ended June 30, 2016 and the corresponding period in 2015 were as follows:
Some of the more significant fluctuations in revenues and expenses between the six-month period ended June 30, 2016 and the corresponding period in 2015 were as follows:
More detailed information concerning fluctuations in the Corporation’s earnings results and other financial information are provided in other sections of Management’s Discussion and Analysis.
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 Management’s Discussion and Analysis. 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 and six-month periods ended June 30, 2016 and June 30, 2015. 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.
Six-Month Periods Ended June 30, 2016 and 2015
For the six-month periods, fully taxable equivalent net interest income was $21,428,000 in 2016, $11,000 (0.1%) higher than in 2015. Interest income was $549,000 lower in 2016 as compared to 2015; however, interest expense was lower by $560,000 in comparing the same periods. As presented in Table III, the Net Interest Margin was 3.79% in 2016 as compared to 3.71% in 2015, and the “Interest Rate Spread” (excess of average rate of return on earning assets over average cost of funds on interest-bearing liabilities) was 3.66% in 2016 as compared to 3.55% in 2015.
INTEREST INCOME AND EARNING ASSETS
Interest income totaled $23,257,000 in 2016, a decrease of 2.3% from 2015. Interest and fees on loans receivable increased $844,000, or 5.1%. The average balance of gross loans receivable increased $73,894,000, or 11.7%, to $706,759,000 in 2016 from $632,865,000 in 2015. The Corporation experienced significant growth in both commercial and mortgage loans outstanding. Growth in commercial loans included an increase of approximately $25 million in the average outstanding balance of participation loans in the first six months of 2016 as compared to the first six months of 2015. The Corporation’s average rate of return on loans receivable declined to 4.96% in 2016 from 5.29% in 2015 as average interest rates on new loans are lower, reflecting recent market conditions.
As indicated in Table III, average available-for-sale securities (at amortized cost) totaled $408,773,000 in 2016, a decrease of $97,180,000 (19.2%) from 2015. The net decrease in the Corporation’s available-for-sale securities portfolio consisted of decreases in all categories of securities with the exception of commercial mortgage-backed securities. The Corporation’s yield on securities was slightly lower in 2016 than in 2015, primarily because of lower market interest rates. The average rate of return on available-for-sale securities was 2.83% in 2016 and 2.85% in 2015.
INTEREST EXPENSE AND INTEREST-BEARING LIABILITIES
Interest expense fell $560,000, or 23.4%, to $1,829,000 in 2016 from $2,389,000 in 2015. Table III shows that the overall cost of funds on interest-bearing liabilities fell to 0.45% in 2016 from 0.58% in 2015.
Total average deposits (interest-bearing and noninterest-bearing) decreased 1.7%, to $956,602,000 in 2016 from $973,631,000 in 2015. Decreases in the average balances of demand deposits, certificates of deposit and Individual Retirement Accounts were partially offset by increases in interest checking, money market accounts and savings accounts.
Total average borrowed funds decreased $10,574,000 to $68,141,000 in 2016 from $78,715,000 in 2015. The average rate on borrowed funds was 2.44% in 2016 compared to 3.65% in 2015, reflecting a $32,418,000 reduction in the average balance of higher-rate, long-term borrowings resulting from prepayment in the second and fourth quarters of 2015 of a long-term repurchase agreement borrowing with an interest rate of 4.265%. The average balance of short-term borrowings increased $21,844,000 in 2016 over 2015, as average overnight borrowings were higher in 2016 and the Corporation funded the pay-off of the long-term repurchase agreement with a series of short-term advances from the FHLB-Pittsburgh.
Three-Month Periods Ended June 30, 2016 and 2015
For the three-month periods, fully taxable equivalent net interest income was $10,684,000 in 2016, which was $65,000 (0.6%) lower than in 2015. Interest income was $316,000 lower in 2016 as compared to 2015, while interest expense was lower by $251,000 in comparing the same periods. As presented in Table III, the Net Interest Margin was 3.76% in 2016 as compared to 3.69% in 2015, and the “Interest Rate Spread” (excess of average rate of return on earning assets over average cost of funds on interest-bearing liabilities) was 3.63% in 2016 as compared to 3.53% in 2015.
Interest income totaled $11,609,000 in 2016, a decrease of $316,000 (2.6%) from 2015. Interest and fees from loans receivable increased $426,000, or 5.1%, in 2016 as compared to 2015, while income from available-for-sale securities decreased $758,000 (21.4%). As indicated in Table III, for the three-month periods, the average balance of gross loans receivable increased 11.0% to $711,882,000 in 2016 from $641,214,000 in 2015. The average rate of return on loans was 4.96% in 2016, down from 5.22% in 2015. Total average available-for-sale securities (at amortized cost) in 2016 decreased to $406,260,000 from $506,126,000 in 2015. The average rate of return on available-for-sale securities was 2.76% for 2016, down from 2.81% in 2015.
For the three-month periods, interest expense fell $251,000, or 21.3%, to $925,000 in 2016 from $1,176,000 in 2015. Total average deposits (interest-bearing and noninterest-bearing) amounted to $968,605,000 in the second quarter 2016, a decrease of $12,547,000 (1.3%) from the second quarter 2015 total. Total average borrowed funds decreased to
$61,874,000 in the second quarter 2016 from $78,396,000 in the second quarter 2015, while the average rate on borrowed funds fell to 2.62% in the second quarter 2016 from 3.57% in the second quarter 2015. The net change in average borrowed funds included an increase of $14,040,000 in short-term borrowings and a decrease of $30,562,000 in long-term borrowings. In total, the average interest rate on interest-bearing liabilities was 0.46% in the second quarter 2016 as compared to 0.56% in the second quarter 2015. The reduction in average rate on interest-bearing liabilities in 2016 was mainly caused by the pay-off (prepayment) of the higher-cost borrowing in 2015, as described above.
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 marginal federal income tax rate of 35%.
TABLE III - ANALYSIS OF AVERAGE DAILY BALANCES AND RATES
(Dollars in Thousands)
(1) Annualized rates of return on tax-exempt securities and loans are presented on a fully taxable-equivalent basis, using the Corporation’s marginal federal income tax rate of 35%.
(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.
TABLE IV - ANALYSIS OF VOLUME AND RATE CHANGES
(1) Changes in income on tax-exempt securities and loans are presented on a fully tax-equivalent basis, using the Corporation’s marginal federal income tax rate of 35%.
(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.
TABLE V - COMPARISON OF NONINTEREST INCOME
(In Thousands)
Table V excludes realized gains on available-for-sale securities, which are discussed in the “Earnings Overview” section of Management’s Discussion and Analysis. Total noninterest income shown in Table V increased $78,000 or 1.0%, in the first six months of 2016 as compared to the first six months of 2015. The most significant variances include the following:
TABLE VI - COMPARISON OF NONINTEREST INCOME
Table VI excludes realized gains on available-for-sale securities, which are discussed in the “Earnings Overview” section of Management’s Discussion and Analysis. Total noninterest income shown in Table VI decreased $56,000 or 1.4%, in the three months ended June 30, 2016 as compared to the three months ended June 30, 2015. The most significant variances include the following:
TABLE VII - COMPARISON OF NONINTEREST EXPENSE
As shown in Table VII, total noninterest expense increased $200,000 or 1.1% in the first six months of 2016 as compared to the first six months of 2015. Excluding the $910,000 loss on prepayment of debt in 2015, total noninterest expense increased $1,110,000, or 6.7%. Other significant variances include the following:
TABLE VIII - COMPARISON OF NONINTEREST EXPENSE
As shown in Table VIII, total noninterest expense decreased $339,000 or 3.8% in the three months ended June 30, 2016 as compared to the same period of 2015. Excluding the $910,000 loss on prepayment of debt in 2015, total noninterest expense increased $571,000, or 7.2%.Significant variances include the following:
FINANCIAL CONDITION
Gross loans outstanding (excluding mortgage loans held for sale) were $727,842,000 at June 30, 2016, up 3.3% from $704,880,000 at December 31, 2015 and up 9.6% from $663,818,000 at June 30, 2015. The total outstanding balances of residential mortgage segment loans at June 30, 2016 increased $12,555,000 (3.3%) as compared to December 31, 2015 and increased $23,374,000 (6.2%) as compared to June 30, 2015. The total outstanding balances of commercial segment loans at June 30, 2016 increased $8,929,000 (2.9%) as compared to December 31, 2015 and increased $63,168,000 (13.9%) as compared to June 30, 2015. These increases in loans outstanding included significant increases in commercial participation loans and commercial real estate secured 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” and “Political subdivisions” classes in the loan tables presented in this Form 10-Q. Total participation loans outstanding amounted to $35,940,000 at June 30, 2016, up from $33,059,000 at December 31, 2015 and up significantly from $10,354,000 at June 30, 2015. At June 30, 2016, the balance of participation loans outstanding includes $7,320,000 to a business based in the Corporation’s market area, $10,000,000 to an entity located outside of the Corporation’s market area and $11,089,000 from participations in loans originated through the Corporation’s membership in a network that originates loans throughout the U.S. The Corporation’s participation loans originated through the network consist of loans to businesses that are larger than the Corporation’s typical commercial customer base. The loans originated through the network are considered “leveraged loans,” meaning the businesses typically have minimal tangible book equity and the extent of collateral available is limited, though the businesses have demonstrated strong cash flow performance in their recent histories.
Other 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 Management’s Discussion and Analysis. Other significant balance sheet items, including the allowance for loan losses and stockholders’ equity, are discussed in separate sections of Management’s Discussion and Analysis.
Management does not expect capital expenditures to have a material, detrimental effect on the Corporation’s financial condition in 2016.
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 government agency. 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. 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. 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 June 30, 2016, the Corporation has recorded an allowance in the amount of $155,000 for credit losses on loans sold under the MPF Original Program which is included in “Accrued interest and other liabilities” in the accompanying balance sheet. There was no allowance recorded at December 31, 2015. The Corporation does not provide a credit enhancement for loans sold through the Xtra program.
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 June 30, 2016, the total outstanding balance of loans the Corporation has repurchased as a result of identified instances of noncompliance amounted to $1,939,000, and the corresponding total outstanding balance repurchased at December 31, 2015 was $1,968,000.
At June 30, 2016, outstanding balances of loans sold and serviced through the two programs totaled $156,417,000, including loans sold through the MPF Xtra program of $120,225,000 and loans sold through the Original program of $36,192,000. At December 31, 2015, outstanding balances of loans sold and serviced through the two programs totaled $152,448,000, including loans sold through the MPF Xtra program of $125,571,000 and loans sold through the Original program of $26,877,000. Based on the fairly limited volume of required repurchases to date, no allowance had been established for representation and warranty exposures as of June 30, 2016 and December 31, 2015.
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 $7,929,000 at June 30, 2016, up slightly from $7,889,000 at December 31, 2015. As shown in Table X, the specific allowance on impaired loans totaled $253,000 at June 30, 2016, which was $567,000 lower than the total specific allowance at December 31, 2015 primarily as a result of a $595,000 partial charge-off on one commercial loan. Table X also shows the collectively determined component of the allowance for commercial loans was $387,000 higher at June 30, 2016 than at December 31, 2015, reflecting the effects of growth in outstanding loans and increases in the average net charge-offs experience and qualitative factors used to estimate the required allowance. The collectively determined component of the allowance for residential mortgages was $233,000 higher at June 30, 2016 than at December 31, 2015, reflecting growth in outstanding loans and the use of slightly higher qualitative factors to estimate the required allowance.
The provision (credit) for loan losses by segment in the three-month and six-month period ended June 30, 2016 and 2015 is as follows:
The increases in the provision for loan losses for the second quarter and first six months of 2016 as compared to the corresponding periods of 2015 reflect, in part, increases in the collectively determined allowance for loan losses resulting from growth in outstanding loans and from slight increases in qualitative factors used to estimate the required allowance. In 2016, the provision for the commercial segment also includes the effects of an increase in average net charge-offs as a percentage of outstanding loans (based on historical experience over the previous thirty-six months) used to estimate a portion of the collectively determined allowance.
Table XI presents information related to past due and impaired loans, and loans that have been modified under terms that are considered troubled debt restructurings (TDRs). Table XI shows total impaired loans of $9,330,000 at June 30, 2016, down $644,000 from the corresponding amount at December 31, 2015 of $9,974,000. As also shown in Table XI, loans classified as TDRs totaled $6,149,000 at June 30, 2016 down slightly from $6,364,000 at December 31, 2015, and nonaccrual loans totaled $10,504,000 at June 30, 2016 as compared to $11,517,000 at December 31, 2015.
The outstanding balances of impaired loans without a valuation allowance, nonaccrual loans and nonperforming TDRs at June 30, 2016, include an outstanding balance of $4,925,000 from loans to one commercial entity. In 2014, the Corporation entered into a forbearance agreement with this commercial borrower which included a reduction in monthly payment amounts over a fifteen-month period. At the end of the fifteen-month period, the monthly payment amounts would revert to the original amounts, unless the forbearance agreement was extended or the payment requirements otherwise modified. The forbearance agreement has been extended for two additional twelve-month periods, most recently in July 2016. The Corporation recorded a charge-off of $1,486,000 in the second quarter 2014 as a result of these modifications, as the payment amounts based on the forbearance agreement are not sufficient to fully amortize the contractual amount of principal outstanding on the loans. The borrower has made all required payments on the loans in accordance with the terms of the forbearance agreement, as extended.
As also shown in Table XI total loans past due 90 days or more and still accruing interest increased to $4,654,000 at June 30, 2016 from $3,229,000 at December 31, 2015. This category includes first lien residential mortgages with a total outstanding balance of $3,663,000 at June 30, 2016. The Corporation reviews the status of loans past due 90 days or more each quarter to determine if it is appropriate to continue to accrue interest, and has determined the loans included in this category are well secured and that ultimate collection of all principal and interest is probable.
Each period presented in Table XI 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 June 30, 2016. 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 IX through XII present historical data related to loans and the allowance for loan losses.
TABLE IX - ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES
TABLE X - COMPONENTS OF THE ALLOWANCE FOR LOAN LOSSES
The above allocation is based on estimates and subjective judgments and is not necessarily indicative of the specific amounts or loan categories in which losses may occur.
TABLE XI - PAST DUE AND IMPAIRED LOANS, NONPERFORMING ASSETS AND TROUBLED DEBT RESTRUCTURINGS (TDRs)
TABLE XII - SUMMARY OF LOANS BY TYPE
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 June 30, 2016, the Corporation maintained overnight interest-bearing deposits with the Federal Reserve Bank of Philadelphia and other correspondent banks totaling $9,401,000.
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 securities with a carrying value of $19,031,000 at June 30, 2016.
The Corporation’s outstanding, available, and total credit facilities at June 30, 2016 and December 31, 2015 are as follows:
At June 30, 2016, the Corporation’s outstanding credit facilities with the Federal Home Loan Bank of Pittsburgh consisted of overnight borrowings of $7,500,000, short-term borrowings of $12,541,000, and long-term borrowings with a total amount of $11,615,000. At December 31, 2015, the Corporation’s outstanding credit facilities with the Federal Home Loan Bank of Pittsburgh consisted of overnight borrowings of $23,500,000, short-term borrowings of $25,081,000, and long-term borrowings with a total amount of $11,767,000. Additional information regarding borrowed funds is included in Note 8 of the unaudited consolidated financial statements.
Additionally, the Corporation uses repurchase agreements placed with brokers to borrow funds secured by investment assets and “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. At June 30, 2016, the carrying value of available-for-sale securities in excess of amounts required to meet pledging or repurchase agreement obligations was $224,393,000.
Management believes the Corporation is well-positioned to meet its short-term and long-term obligations.
STOCKHOLDERS’ EQUITY AND CAPITAL ADEQUACY
The Corporation and C&N Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Details concerning capital ratios at June 30, 2016 and December 31, 2015 are presented below. Management believes, as of June 30, 2016 and December 31, 2015, that the Corporation and C&N Bank meet all capital adequacy requirements to which they are subject and maintain capital conservation buffers (described in more detail in the “New Capital Rule” section below) that allow the Corporation and C&N 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 June 30, 2016 and December 31, 2015 exceed the Corporation’s policy threshold levels.
Management expects the Corporation and C&N Bank to maintain capital levels that exceed the regulatory standards for well-capitalized institutions and the applicable capital conservation buffers for the next 12 months and for the foreseeable future.
Future dividend payments will depend upon maintenance of a strong financial condition, future earnings and capital and regulatory requirements. As described in more detail in the section below titled “New Capital Rule," the Corporation and C&N Bank are subject to restrictions on the amount of dividends that may be paid without approval of banking regulatory authorities.
NEW CAPITAL RULE
In July 2013, the federal regulatory authorities issued a new capital rule based, in part, on revisions developed by the Basel Committee on Banking Supervision to the Basel capital framework (Basel III). The Corporation and C&N Bank became subject to the new rule effective January 1, 2015. Generally, the new rule implemented higher minimum capital requirements, revised the definition of regulatory capital components and related calculations, added a new common equity tier 1 capital ratio, implemented a new capital conservation buffer, increased the risk weighting for past due loans and provided a transition period for several aspects of the new rule.
The current (new) capital rule provides that, in order to avoid limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers, a banking organization 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. Phase-in of the capital conservation buffer requirements began January 1, 2016. The transition schedule for new ratios, including the capital conservation buffer, is as follows:
As fully phased in, a banking organization with a buffer greater than 2.5% 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. The new rule also prohibits a banking organization 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 June 30, 2016, the Corporation’s Capital Conservation Buffer, determined based on the minimum total capital ratio, was 15.47%. C&N Bank’s Capital Conservation Buffer (also determined based on the minimum total capital ratio) was 13.01%.
The Corporation’s total stockholders’ equity is affected by fluctuations in the fair values of available-for-sale securities. The difference between amortized cost and fair value of available-for-sale securities, net of deferred income tax, is included in Accumulated Other Comprehensive Income within stockholders’ equity. The balance in Accumulated Other Comprehensive Income related to unrealized gains on available-for-sale securities, net of deferred income tax, amounted to $6,849,000 at June 30, 2016 and $2,493,000 at December 31, 2015. Changes in accumulated other comprehensive income are excluded from earnings and directly increase or decrease stockholders’ equity. If available-for-sale 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 June 30, 2016.
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 $45,000 at June 30, 2016 and $35,000 at December 31, 2015.
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 securities and changes in underfunded or overfunded defined benefit plans. Fluctuations in interest rates significantly affect fair values of available-for-sale securities, and accordingly have an effect on Other Comprehensive Income (Loss) in each period.
Comprehensive Income totaled $5,369,000 for the three months ended June 30, 2016 as compared to $777,000 in the second quarter 2015. For the three months ended June 30, 2016, Comprehensive Income included: (1) Net Income of $3,871,000, which was $486,000 lower than in the second quarter 2015; (2) Other Comprehensive Income from an increase in net unrealized gains on available-for-sale securities of $1,502,000 as compared to Other Comprehensive Loss of ($3,577,000) from a decrease in net unrealized gains on available-for-sale securities in the second quarter 2015; and (3) Other Comprehensive Loss from defined benefit plans of ($4,000) for the second quarter 2016 and ($3,000) for the second quarter 2015.
Comprehensive Income totaled $11,810,000 for the six months ended June 30, 2016 as compared to $6,898,000 for the six months ended June 30, 2015. In the six months ended June 30, 2016, Comprehensive Income included: (1) Net Income of $7,444,000, which was $728,000 lower than in the first six months of 2015; (2) Other Comprehensive Income from an increase in net unrealized gains on available-for-sale securities, net of deferred income tax, of $4,356,000 as compared to Other Comprehensive Loss of ($1,204,000) in the first six months of 2015; and (3) Other Comprehensive Income from defined benefit plans of $10,000 as compared to Other Comprehensive Loss of ($70,000) in the first six months of 2015.
INCOME TAXES
The effective income tax rate ranged from 24.35% to 25.18% of pre-tax income for the three-month and six-month periods ended June 30, 2016 and 2015. The provision for income tax for interim periods is based on the Corporation’s estimate of the effective tax rate expected to be applicable for the full year. The Corporation’s effective tax rates differ from the statutory rate of 35% 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. At June 30, 2016, the net deferred tax asset was $425,000, down from $3,115,000 at December 31, 2015. The most significant change in temporary difference components was an increase of $2,344,000 in the deferred tax liability associated with unrealized gains on available-for-sale securities.
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 June 30, 2016 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.
Additional information related to income taxes is presented in Note 11 to the unaudited, consolidated financial statements.
INFLATION
The Corporation is significantly affected by the Federal Reserve Board’s efforts to control inflation through changes in short-term interest rates. Beginning in September 2007, in response to concerns about weakness in the U.S. economy, the Federal Reserve lowered the fed funds target rate numerous times; in December 2008, it established a target range of 0% to 0.25%, which it maintained through mid-December 2015. On December 16, 2015, the Federal Reserve raised their target for the federal funds rate to 0.25% to 0.50%. This decision was based on data available that suggested economic activity had been expanding at a moderate pace. This included an increase in household spending, business fixed investments increasing, and an improvement in labor market conditions. Also, throughout this period, the Federal Reserve has injected massive amounts of liquidity into the nation’s monetary system through a variety of programs. The Federal Reserve has purchased large amounts of securities in an effort to keep interest rates low and stimulate economic growth. Beginning in late 2013, the Federal Reserve began reducing the amount of securities purchased under its asset purchase program and then ended the program in October 2014, though still reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and continued to roll over maturing Treasury securities at auction. The Federal Reserve maintained their commitment to this policy in their June 15, 2016 statement and anticipates doing so until normalization of the level of the federal funds rate is well under way.
Despite the current low short-term rate environment, inflation statistics indicate that the overall rate of inflation is unlikely to significantly affect the Corporation’s operations within the near future. Although management cannot predict future changes in the rates of inflation, management monitors the impact of economic trends, including any indicators of inflationary pressures, in managing interest rate and other financial risks.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK
Market risk is the risk of loss arising from adverse changes in market rates and prices of the Corporation’s financial instruments. In addition to the effects of interest rates, the market prices of the Corporation’s debt securities within the available-for-sale securities portfolio are affected by fluctuations in the risk premiums (amounts of spread over risk-free rates) demanded by investors. Management attempts to limit the risk that economic conditions would force the Corporation to sell securities for realized losses by maintaining a strong capital position (discussed in the “Stockholders’ Equity and Capital Adequacy” section of Management’s Discussion and Analysis) and ample sources of liquidity (discussed in the “Liquidity” section of Management’s Discussion and Analysis).
The Corporation’s two major categories of market risk are interest rate risk and equity securities risk, which are discussed in the following sections.
INTEREST RATE RISK
Business risk arising from changes in interest rates is an inherent factor in operating a bank. The Corporation’s assets are predominantly long-term, fixed-rate loans and debt securities. Funding for these assets comes principally from shorter-term deposits and borrowed funds. Accordingly, there is an inherent risk of lower future earnings or decline in fair value of the Corporation’s financial instruments when interest rates change.
The Corporation uses a simulation model to calculate the potential effects of interest rate fluctuations on net interest income and the market value of portfolio equity. For purposes of these calculations, the market value of portfolio equity includes the fair values of financial instruments, such as securities, loans, deposits and borrowed funds, and the book values of nonfinancial assets and liabilities, such as premises and equipment and accrued expenses. The model measures and projects the amount of potential changes in net interest income, and calculates the discounted present value of anticipated cash flows of financial instruments, assuming an immediate increase or decrease in interest rates. Management ordinarily runs a variety of scenarios within a range of plus or minus 100-400 basis points of current rates.
The model makes estimates, at each level of interest rate change, regarding cash flows from principal repayments on loans and mortgage-backed securities and call activity on other investment securities. Actual results could vary significantly from these estimates, which could result in significant differences in the calculations of projected changes in net interest income and market value of portfolio equity. Also, the model does not make estimates related to changes in the composition of the deposit portfolio that could occur due to rate competition, and the table does not necessarily reflect changes that management would make to realign the portfolio as a result of changes in interest rates.
The Corporation’s Board of Directors has established policy guidelines for acceptable levels of interest rate risk, based on an immediate increase or decrease in interest rates. The policy limits acceptable fluctuations in net interest income from the baseline (flat rates) one-year scenario and variances in the market value of portfolio equity from the baseline values based on current rates.
Table XIII, which follows this discussion, is based on the results of calculations performed using the simulation model as of April 30, 2016 and December 31, 2015. The table shows that as of the respective dates, the changes in net interest income and changes in market value were within the policy limits in all scenarios.
TABLE XIII - THE EFFECT OF HYPOTHETICAL CHANGES IN INTEREST RATES
EQUITY SECURITIES RISK
The Corporation’s equity securities portfolio consists of investments in stocks of banks and bank holding companies. Investments in bank stocks are subject to risk factors that affect the banking industry in general, including credit risk, competition from non-bank entities, interest rate risk and other factors, which could result in a decline in market prices. Also, losses could occur in individual stocks held by the Corporation because of specific circumstances related to each bank.
Equity securities held as of June 30, 2016 and December 31, 2015 are presented in Table XIV. Table XIV presents quantitative data concerning the effects of a decline in fair value of the Corporation’s equity securities of 10% or 20%. The data in Table XIV does not reflect the effects of any appreciation in value that may occur, nor does it present the Corporation’s maximum exposure to loss on equity securities, which would be 100% of their fair value as of June 30, 2016.
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.
There were no significant changes in the Corporation’s internal control over financial reporting that occurred during the period covered by this report that have materially affected, or that are reasonably likely to affect, our internal control over financial reporting.
PART II – OTHER INFORMATION
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.
There have been no material changes from the risk factors previously disclosed in Item 1A of the Corporation’s Form 10-K filed February 18, 2016.
Issuer Purchases of Equity Securities
The following table sets forth a summary of the purchases by the Corporation, on the open market, of its equity securities during the second quarter 2016:
Notes to Table:
In April 2016, the Corporation repurchased the remainder of the shares authorized under the program. In total, 622,500 shares were repurchased for a total cost of $12,140,000, at an average price of $19.50 per share.
None
Not applicable
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.