United States
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For quarterly period ended September 30, 2012
For the transition period from to .
Commission file number 001-35021
EVANS BANCORP, INC.
(Exact name of registrant as specified in its charter)
(State or other jurisdiction
of incorporation or organization)
(I.R.S. Employer
Identification No.)
14 -16 North Main Street,
Angola, New York
(716) 926-2000 .
(Registrant’s telephone number, including area code)
Not applicable .
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically 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 (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:
Common Stock, $.50 par value: 4,157,422 shares as of October 30, 2012
INDEX
EVANS BANCORP, INC. AND SUBSIDIARIES
Financial Statements
Unaudited Consolidated Balance Sheets — September 30, 2012 and December 31, 2011
Unaudited Consolidated Statements of Income — Three months ended September 30, 2012 and 2011
Unaudited Consolidated Statements of Income — Nine months ended September 30, 2012 and 2011
Unaudited Statements of Consolidated Comprehensive Income — Three months ended September 30, 2012 and 2011
Unaudited Statements of Consolidated Comprehensive Income — Nine months ended September 30, 2012 and 2011
Unaudited Consolidated Statements of Stockholders’ Equity — Nine months ended September 30, 2012 and 2011
Unaudited Consolidated Statements of Cash Flows — Nine months ended September 30, 2012 and 2011
Notes to Unaudited Consolidated Financial Statements
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Quantitative and Qualitative Disclosures About Market Risk
Controls and Procedures
PART II. OTHER INFORMATION
Item 6. Exhibits
SIGNATURES
PART I—FINANCIAL INFORMATION
ITEM I—FINANCIAL STATEMENTS
UNAUDITED CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, 2012 AND DECEMBER 31, 2011
(in thousands, except share and per share amounts)
ASSETS
Cash and due from banks
Interest-bearing deposits at banks
Securities:
Available for sale, at fair value (cost: $87,330 at September 30, 2012; $95,848 at December 31, 2011)
Held to maturity, at amortized cost (fair value: $4,022 at September 30, 2012; $3,811 at December 31, 2011)
Federal Home Loan Bank common stock, at amortized cost
Federal Reserve Bank common stock, at amortized cost
Loans and leases, net of allowance for loan and lease losses of $10,208 at September 30, 2012 and $11,495 at December 31, 2011
Properties and equipment, net of depreciation of $13,961 at September 30, 2012 and $13,145 at December 31, 2011
Goodwill
Intangible assets
Bank-owned life insurance
Other assets
TOTAL ASSETS
LIABILITIES AND STOCKHOLDERS’ EQUITY
LIABILITIES
Deposits:
Demand
NOW
Regular savings
Time
Total deposits
Securities sold under agreement to repurchase
Other borrowings
Other liabilities
Junior subordinated debentures
Total liabilities
CONTINGENT LIABILITIES AND COMMITMENTS
STOCKHOLDERS’ EQUITY:
Common stock, $.50 par value, 10,000,000 shares authorized;4,153,332 and 4,125,272 shares issued at September 30, 2012 and December 31, 2011, respectively, and 4,151,985 and 4,124,892 shares outstanding, at September 30, 2012 and December 31, 2011, respectively
Capital surplus
Retained earnings
Accumulated other comprehensive gain, net of tax
Total stockholders’ equity
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
See Notes to Unaudited Consolidated Financial Statements
1
UNAUDITED CONSOLIDATED STATEMENTS OF INCOME
THREE MONTHS ENDED SEPTEMBER 30, 2012 AND 2011
INTEREST INCOME
Loans and leases
Interest bearing deposits at banks
Taxable
Non-taxable
Total interest income
INTEREST EXPENSE
Deposits
Total interest expense
NET INTEREST INCOME
PROVISION FOR LOAN AND LEASE LOSSES
NET INTEREST INCOME AFTER
NON-INTEREST INCOME
Bank charges
Insurance service and fees
Data center income
Net gain on sales of securities
Gain on loans sold
Other
Total non-interest income
NON-INTEREST EXPENSE
Salaries and employee benefits
Occupancy
Repairs and maintenance
Advertising and public relations
Professional services
Technology and communications
Amortization of intangibles
FDIC insurance
Total non-interest expense
INCOME BEFORE INCOME TAXES
INCOME TAX PROVISION
NET INCOME
Net income per common share-basic
Net income per common share-diluted
Cash dividends per common share
Weighted average number of common shares outstanding
Weighted average number of diluted shares outstanding
2
NINE MONTHS ENDED SEPTEMBER 30, 2012 AND 2011
Net gain on sales and calls of securities
FDIC Insurance
3
UNAUDITED STATEMENTS OF CONSOLIDATED COMPREHENSIVE INCOME
OTHER COMPREHENSIVE INCOME, NET OF TAX:
Unrealized gain on available-for-sale securities:
Unrealized gain on available-for-sale securities
Reclassification of gain on sale of securities
Defined benefit pension plans:
Amortization of prior service cost
Amortization of actuarial loss
Total
OTHER COMPREHENSIVE INCOME, NET OF TAX
COMPREHENSIVE INCOME
4
5
PART 1—FINANCIAL INFORMATION
ITEM 1—FINANCIAL STATEMENTS
UNAUDITED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
Balance, December 31, 2010
Net Income
Other comprehensive gain
Cash dividends ($0.40 per common share)
Stock options expense
Excess tax benefit from stock-based compensation
Issued 11,090 restricted shares, net of forffeitures of 1,388 shares
Issued 7,784 shares under ESPP
Issued 6,172 shares in DRIP
Balance, September 30, 2011
Balance, December 31, 2011
Cash dividends ($0.44 per common share)
Issued 11,493 restricted shares
Issued 10,267 shares under ESPP
Issued 6,680 shares in DRIP
Balance, September 30, 2012
6
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
OPERATING ACTIVITIES:
Interest received
Fees received
Interest paid
Cash paid to employees and vendors
Cash contributed to pension plan
Income taxes paid
Proceeds from sale of loans held for resale
Originations of loans held for resale
Net cash provided by operating activities
INVESTING ACTIVITIES:
Available for sales securities:
Purchases
Proceeds from sales
Proceeds from maturities, calls, and payments
Held to maturity securities:
Cash paid for bank owned life insurance
Additions to properties and equipment
Net increase in loans
Net cash used in investing activities
FINANCING ACTIVITIES:
Repayments of borrowings
Net increase in deposits
Dividends paid
Issuance of common stock
Net cash provided by financing activities
Net increase in cash and equivalents
CASH AND CASH EQUIVALENTS:
Beginning of period
End of period
(continued)
7
RECONCILIATION OF NET INCOME TO NET CASH PROVIDED BY OPERATING ACTIVITIES:
Net income
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
Deferred tax expense
Provision for loan and lease losses
Premium on loans sold
Changes in assets and liabilities affecting cash flow:
NET CASH PROVIDED BY OPERATING ACTIVITIES
8
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2012 AND 2011
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accounting and reporting policies followed by Evans Bancorp, Inc. (the “Company”), a financial holding company, and its two direct, wholly-owned subsidiaries: (i) Evans Bank, National Association (the “Bank”), and the Bank’s subsidiaries, Evans National Leasing, Inc. (“ENL”), Evans National Holding Corp. (“ENHC”) and Suchak Data Systems, LLC (“SDS”); and (ii) Evans National Financial Services, LLC (“ENFS”), and ENFS’s subsidiary, The Evans Agency, LLC (“TEA”), and TEA’s subsidiaries, Frontier Claims Services, Inc. (“FCS”) and ENB Associates Inc. (“ENBA”), in the preparation of the accompanying interim unaudited consolidated financial statements conform with U.S. generally accepted accounting principles (“GAAP”) and with general practice within the industries in which it operates. Except as the context otherwise requires, the Company and its direct and indirect subsidiaries are collectively referred to in this report as the “Company.”
The accompanying consolidated financial statements are unaudited. In the opinion of management, all adjustments necessary for a fair presentation of the Company’s financial position and results of operations for the interim periods have been made. Certain reclassifications have been made to the 2011 unaudited consolidated financial statements to conform to the presentation used in 2012.
The results of operations for the three and nine month periods ended September 30, 2012 are not necessarily indicative of the results to be expected for the full year. The accompanying unaudited consolidated financial statements should be read in conjunction with the Audited Consolidated Financial Statements and the Notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2011. The Company has evaluated subsequent events for potential recognition and/or disclosure through the date of filing.
9
2. SECURITIES
The amortized cost of securities and their approximate fair value at September 30, 2012 and December 31, 2011 were as follows:
Available for Sale:
Debt securities:
U.S. government agencies
States and political subdivisions
Total debt securities
Mortgage-backed securities:
FNMA
FHLMC
GNMA
CMO
Total mortgage-backed securities
Total securities designated as available for sale
Held to Maturity:
Debt securities
Total securities designated as held to maturity
Total securities
U.S. Treasury and other U.S. government agencies
Available for sale securities with a total fair value of $74.9 million and $76.7 million at September 30, 2012 and December 31, 2011, respectively, were pledged as collateral to secure public deposits and for other purposes required or permitted by law.
10
The Company uses the Federal Home Loan Bank of New York (“FHLBNY”) as its primary source of overnight funds and also has several long-term advances with FHLBNY. The Company had a total of $19.0 million and $22.0 million in borrowed funds with FHLBNY at September 30, 2012 and December 31, 2011, respectively. The Company has placed sufficient collateral in the form of residential and commercial real estate loans at FHLBNY that meet FHLB collateral requirements. As a member of the Federal Home Loan Bank (“FHLB”) System, the Bank is required to hold stock in FHLBNY. The Bank held $1.8 million in FHLBNY stock as of September 30, 2012 and December 31, 2011 at amortized cost.
The scheduled maturities of debt and mortgage-backed securities at September 30, 2012 and December 31, 2011 are summarized below. All maturity amounts are contractual maturities. Actual maturities may differ from contractual maturities because certain issuers have the right to call or prepay obligations with or without call premiums.
Debt securities available for sale:
Due in one year or less
Due after one year through five years
Due after five years through ten years
Due after ten years
Mortgage-backed securities available for sale
Total available for sale securities
Debt securities held to maturity:
Total held to maturity securities
Information regarding unrealized losses within the Company’s available for sale securities at September 30, 2012 and December 31, 2011, is summarized below. The securities are primarily U.S. government-guaranteed agency securities or municipal securities. All unrealized losses are considered temporary and related to market interest rate fluctuations.
11
CMO’S
Held To Maturity:
Total temporarily impaired securities
In regard to municipal securities, the Company’s general investment policy is that in-state securities must be rated at least Moody’s Baa (or equivalent) at the time of purchase. The Company reviews the ratings report and municipality financial statements and prepares a pre-purchase analysis report before the purchase of any municipal securities. Out-of-state issues must be rated by Moody’s at least Aa (or equivalent) at the time of purchase. The Company did not own any out-of-state municipal bonds at September 30, 2012 or December 31, 2011. Bonds rated below A are reviewed periodically to ensure their continued credit worthiness. While purchase of non-rated municipal securities is permitted under the Company’s investment policy, such purchases are limited to bonds issued by municipalities in the Company’s general market area. Those municipalities are typically customers of the Bank whose financial situation is familiar to management. The financial statements of the issuers of non-rated securities are reviewed by the Bank and a credit file of the issuers is kept on each non-rated municipal security with relevant financial information.
12
Although concerns have been raised in the marketplace recently about the health of municipal bonds, the Company has not experienced any significant credit troubles in this portfolio and does not believe any credit troubles are imminent with respect to its portfolio. Aside from the non-rated municipal securities to local municipalities discussed above that are considered held-to-maturity, all of the Company’s available-for-sale municipal bonds are investment-grade government obligation (“G.O.”) bonds. G.O. bonds are generally considered safer than revenue bonds because they are backed by the full faith and credit of the government while revenue bonds rely on the revenue produced by a particular project. All of the Company’s municipal bonds are issued by municipalities in New York State. To the Company’s knowledge, there has never been a default of a NY G.O. in the history of the state. The Company believes that its risk of loss on default of a G.O. municipal bond for the Company is relatively low. However, historical performance does not guarantee future performance.
Management has assessed the securities available for sale in an unrealized loss position at September 30, 2012 and December 31, 2011 and determined the decline in fair value below amortized cost to be temporary. In making this determination, management considered the period of time the securities were in a loss position, the percentage decline in comparison to the securities’ amortized cost, and the financial condition of the issuer (primarily government or government-sponsored enterprises). In addition, management does not intend to sell these securities and it is not more likely than not that the Company will be required to sell these securities before recovery of their amortized cost. Management believes the decline in fair value is primarily related to market interest rate fluctuations and not to the credit deterioration of the individual issuers.
The Company has not recorded any other-than-temporary impairment charges in 2012 or 2011, with the gross unrealized losses at an immaterial level, amounting to less than 0.1% of the total fair value of the securities portfolio at September 30, 2012 and December 31, 2011. Nevertheless, it remains possible that there could be deterioration in the asset quality of the securities portfolio in the future. The credit worthiness of the Company’s portfolio is largely reliant on the ability of U.S. government sponsored agencies such as FHLB, Federal National Mortgage Association (“FNMA”), Government National Mortgage Association (“GNMA”), and Federal Home Loan Mortgage Corporation (“FHLMC”), and municipalities throughout New York State to meet their obligations. In addition, dysfunctional markets could materially alter the liquidity, interest rate, and pricing risk of the portfolio. The relatively stable past performance is not a guarantee for similar performance of the Company’s securities portfolio going forward.
3. FAIR VALUE MEASUREMENTS
The Company follows the provisions of ASC Topic 820, “Fair Value Measurements and Disclosures.” Those provisions relate to financial assets and liabilities carried at fair value and fair value disclosures related to financial assets and liabilities. ASC Topic 820 defines fair value and specifies a hierarchy of valuation techniques based on the nature of the inputs used to develop the fair value measures. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
There are three levels of inputs to fair value measurements:
Observable market data should be used when available.
13
FINANCIAL INSTRUMENTS MEASURED AT FAIR VALUE ON A RECURRING BASIS
The following table presents for each of the fair-value hierarchy levels as defined in this footnote, those financial instruments which are measured at fair value on a recurring basis at September 30, 2012 and December 31, 2011:
September 30, 2012
Securities available-for-sale:
Mortgage-backed securities
Mortgage servicing rights
December 31, 2011
Securities available for sale
Fair values for securities are determined using independent pricing services and market-participating brokers. The Company’s independent pricing service utilizes evaluated pricing models that vary by asset class and incorporate available trade, bid and other market information for structured securities, cash flow and, when available, loan performance data. Because many fixed income securities do not trade on a daily basis, the evaluated pricing applications apply information as applicable through processes, such as benchmarking of like securities, sector groupings, and matrix pricing, to prepare evaluations. In addition, model processes, such as the Option Adjusted Spread model, are used to assess interest rate impact and develop prepayment scenarios. The models and the process take into account market convention. For each asset class, a team of evaluators gathers information from market sources and integrates relevant credit information, perceived market movements and sector news into the evaluated pricing applications and models. The company’s service provider may occasionally determine that it does have not sufficient verifiable information to value a particular security. In these cases the Company will utilize valuations from another pricing service.
Management believes that it has a sufficient understanding of the third party service’s valuation models, assumptions and inputs used in determining the fair value of securities to enable management to maintain an appropriate system of internal control. On a quarterly basis the Company reviews changes in the market value of its security portfolio. Individual changes in valuations are reviewed for consistency with general interest rate movements and any known credit concerns for specific securities. Additionally, on an annual basis the Company has its entire security portfolio priced by a second pricing service to determine consistency with another market evaluator. If, on the Company’s review or in comparing with another servicer, a material difference between pricing evaluations were to exist, the Company may submit an inquiry to the service provider regarding the data used to value a particular security. If the Company determines it has market information that would support a different valuation than the initial evaluation it can submit a challenge for a change to that security’s valuation. There were no material differences in valuations noted in 2012 or 2011.
Securities available for sale are classified as Level 2 in the fair value hierarchy as the valuation provided by the third-party provider uses observable market data.
Mortgage servicing rights (“MSRs”) do not trade in an active, open market with readily observable prices. Accordingly, the Company obtains the fair value of the MSRs using a third-party pricing provider. The provider determines the fair value by discounting projected net servicing cash flows of the remaining servicing portfolio. The valuation model used by the provider considers market loan prepayment predictions and other economic factors which management considers to be significant unobservable inputs. The fair value of MSRs is mostly affected by changes in mortgage interest rates since rate changes cause the loan prepayment acceleration factors to increase or decrease. All assumptions are market driven. Management has a sufficient understanding of the third party service’s valuation models, assumptions and inputs used in determining the fair value of MSRs to enable management to maintain an appropriate system of internal control. Mortgage servicing rights are classified within Level 3 of the fair value hierarchy as the valuation is model driven and primarily based on unobservable inputs.
14
The following table summarizes the changes in fair value for mortgage servicing rights during the three and nine month periods ended September 30, 2012 and 2011, respectively:
Beginning balance, June 30
Losses included in earnings
Additions from loan sales
Ending balance, September 30
Beginning balance, December 31
Quantitative information about the significant unobservable inputs used in the fair value measurement of MSRs at the respective dates is as follows:
Servicing fees
Discount rate
Prepayment rate (CPR)
FINANCIAL INSTRUMENTS MEASURED AT FAIR VALUE ON A NONRECURRING BASIS
The Company is required, on a nonrecurring basis, to adjust the carrying value of certain assets or provide valuation allowances related to certain assets using fair value measurements. The following table presents for each of the fair-value hierarchy levels as defined in this footnote, those financial instruments which are measured at fair value on a nonrecurring basis at September 30, 2012 and December 31, 2011:
Impaired loans
The Company evaluates and values impaired loans at the time the loan is identified as impaired, and the fair values of such loans are estimated using Level 3 inputs in the fair value hierarchy. Each loan’s collateral has a unique appraisal and management’s discount of the value is based on factors unique to each impaired loan. The significant unobservable input in determining the fair value is management’s subjective discount on appraisals of the collateral securing the loan, which ranges from 10%-50%. Collateral may consist of real estate and/or business assets including equipment, inventory and/or accounts receivable and the value of these assets is determined based on appraisals by qualified licensed appraisers hired by the Company. Appraised and reported values may be discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, estimated costs to sell, and/or management’s expertise and knowledge of the client and the client’s business.
15
The Company has an appraisal policy in which appraisals are obtained upon a commercial loan being downgraded on the Company internal loan rating scale to a 5 (special mention) or a 6 (substandard) depending on the amount of the loan, the type of loan and the type of collateral. All impaired commercial loans are either graded a 6 or 7 on the internal loan rating scale. For consumer loans, the Company obtains appraisals when a loan becomes 90 days past due or is determined to be impaired, whichever occurs first. Subsequent to the downgrade or reaching 90 days past due, if the loan remains outstanding and impaired for at least one year more, management may require another follow-up appraisal. Between receipts of updated appraisals, if necessary, management may perform an internal valuation based on any known changing conditions in the marketplace such as sales of similar properties, a change in the condition of the collateral, or feedback from local appraisers. Impaired loans had a gross value of $12.9 million, with a valuation allowance of $1.4 million, at September 30, 2012, compared to a gross value for impaired loans of $11.9 million, with a valuation allowance of $1.6 million, at December 31, 2011.
FAIR VALUE OF FINANCIAL INSTRUMENTS
At September 30, 2012 and December 31, 2011, the estimated fair values of the Company’s financial instruments, including those that are not measured and reported at fair value on a recurring basis or nonrecurring basis, were as follows:
Financial assets:
Level 1:
Cash and cash equivalents
Level 2:
Available for sale securities
FHLB and FRB stock
Level 3:
Held to maturity securities
Loans and leases, net
Financial liabilities:
Demand deposits
NOW deposits
Regular savings deposits
Commitments to extend credit
Other borrowed funds
Time deposits
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practical to estimate that value.
Cash and Cash Equivalents. For these short-term instruments, the carrying amount is a reasonable estimate of fair value. “Cash and Cash Equivalents” includes interest-bearing deposits at other banks.
FHLB and FRB stock. The carrying value of FHLB and FRB stock approximate fair value.
16
Securities held to maturity. The Company holds certain municipal bonds as held-to-maturity. These bonds are generally small in dollar amount and are issued only by certain local municipalities within the Company’s market area. The original terms are negotiated directly and on an individual basis consistent with our loan and credit guidelines. These bonds are not traded on the open market and management intends to hold the bonds to maturity. The fair value of held-to-maturity securities is estimated by discounting the future cash flows using the current rates at which similar agreements would be made with municipalities with similar credit ratings and for the same remaining maturities.
Loans and Leases, net. The fair value of fixed rate loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities, net of the appropriate portion of the allowance for loan losses. For variable rate loans, the carrying amount is a reasonable estimate of fair value. This fair value calculation is not necessarily indicative of the exit price, as defined in ASC 820.
Deposits. The fair value of demand deposits, NOW accounts, muni-vest accounts and regular savings accounts is the amount payable on demand at the reporting date. The fair value of time deposits is estimated using the rates currently offered for deposits of similar remaining maturities.
Junior Subordinated Debentures. The carrying amount of Junior Subordinated Debentures is a reasonable estimate of fair value due to the fact that they bear a floating interest rate that adjusts on a quarterly basis.
Commitments to extend credit and standby letters of credit. As described in Note 8—“Contingent Liabilities and Commitments” to these Unaudited Consolidated Financial Statements, the Company was a party to financial instruments with off-balance sheet risk at September 30, 2012 and December 31, 2011. Such financial instruments consist of commitments to extend permanent financing and letters of credit. If the options are exercised by the prospective borrowers, these financial instruments will become interest-earning assets of the Company. If the options expire, the Company retains any fees paid by the counterparty in order to obtain the commitment or guarantee. The fees collected for these commitments are recorded as “unearned commitment fees” in Other Liabilities. The carrying value approximates the fair value.
Securities Sold Under Agreement to Repurchase.The fair value of the securities sold under agreement to repurchase approximates its carrying value.
Other Borrowed Funds. The fair value of the short-term portion of other borrowed funds approximates its carrying value. The fair value of the long-term portion of other borrowed funds is estimated using a discounted cash flow analysis based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.
17
4. LOANS, LEASES, AND THE ALLOWANCE FOR LOAN AND LEASE LOSSES
Loan and Lease Portfolio Composition
The following table presents selected information on the composition of the Company’s loan and lease portfolio as of the dates indicated:
Mortgage loans on real estate:
Residential Mortgages
Commercial and multi-family
Construction-Residential
Construction-Commercial
Home equities
Total real estate loans
Direct financing leases
Commercial and industrial loans
Consumer loans
Net deferred loan origination costs
Total gross loans
Allowance for loan losses
Loans, net
18
The Bank sells certain fixed rate residential mortgages to FNMA, while maintaining the servicing rights for those mortgages. During the three and nine month periods ended September 30, 2012, the Bank sold mortgages to FNMA totaling $6.0 million and $17.1 million, respectively as compared with $2.6 million and $15.8 million sold during the three and nine month periods ended September 30, 2011, respectively. At September 30, 2012, the Bank had a loan servicing portfolio principal balance of $70.5 million upon which it earns servicing fees, as compared with $62.4 million at December 31, 2011. The value of the mortgage servicing rights for that portfolio was $0.4 million at September 30, 2012 and December 31, 2011. Residential mortgage loans held-for-sale were $2.7 million at September 30, 2012, compared with $3.6 million at December 31, 2011. The Company has never been contacted by FNMA to repurchase any loans due to improper documentation or fraud.
As noted in Note 1, these financial statements should be read in conjunction with the Audited Consolidated Financial Statements and the Notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2011. Disclosures related to the basis for accounting for loans and leases, the method for recognizing interest income on loans and leases, the policy for placing loans and leases on nonaccrual status and the subsequent recording of payments and resuming accrual of interest, the policy for determining past due status, a description of the Company’s accounting policies and methodology used to estimate the allowance for loan and lease losses, the policy for charging off loans and leases, the accounting policies for impaired loans, and more descriptive information on the Company’s credit risk ratings are all contained in the Notes to the Audited Consolidated Financial Statements in the Annual Report on Form 10-K for the year ended December 31, 2011. Unless otherwise noted in this Form 10-Q, the policies and methodology described in the Annual Report for the year ended December 31, 2011 are consistent with those utilized in the nine months ended September 30, 2012.
Credit Quality Indicators
The Bank monitors the credit risk in its loan portfolio by reviewing certain credit quality indicators (“CQI”). The primary CQI for its commercial mortgage and commercial and industrial (“C&I”) portfolios is the individual loan’s credit risk rating. The following list provides a description of the credit risk ratings that are used internally by the Bank when assessing the adequacy of its allowance for loan and lease losses:
1-3-Pass
4-Watch
5-O.A.E.M. (Other Assets Especially Mentioned) or Special Mention
6-Substandard
7-Doubtful
8-Loss
The Company’s consumer loans, including residential mortgages and home equities, and commercial leases are not individually risk rated or reviewed in the Company’s loan review process. Consumers are not required to provide the Company with updated financial information as is a commercial customer. Consumer loans also carry smaller balances. Given the lack of updated information since the initial underwriting of the loan and small size of individual loans, the Company uses delinquency status as the credit quality indicator for consumer loans.
In the first quarter of 2012, the Company changed its methodology for reserving for non-accruing residential mortgages and home equities in response to the Interagency Supervisory Guidance issued by federal banking regulators in January 2012. Previously, estimated loss percentages were applied to pools of non-accruing residential mortgages and home equity loans. The Company now evaluates required loss reserves on an individual loan basis. This change resulted from the Company’s successful efforts to obtain more information about the financial status of borrowers and the fair value of loan collateral. The change from reserving for non-accruing residential mortgages and home equities on an individual basis versus a pooled approach resulted in a reduction of allowance for loan and lease losses of $0.1 million.
There were no other changes in the Company’s allowance for loan and lease loss methodology in the nine month period ended September 30, 2012.
19
The following tables provide data, at the class level, of credit quality indicators of certain loans and leases for the dates specified:
Corporate Credit
Exposure – By
Credit Rating
20
Past Due Loans and Leases
The following tables provide an analysis of the age of the recorded investment in loans and leases that are past due as of the dates indicated:
Commercial and industrial
Residential real estate:
Residential
Construction
Commercial real estate:
Commercial
Consumer
Total Loans
21
Allowance for loan and lease losses
The following tables present the activity in the allowance for loan and lease losses according to portfolio segment, for the nine month periods ended September 30, 2012 and September 30, 2011:
Allowance for loan and lease losses:
Beginning balance
Charge-offs
Recoveries
Provision
Ending balance
Individually evaluated for impairment
Collectively evaluated for impairment
Loans acquired with deteriorated credit quality
Loans and leases:
Ending balance:
22
September 30, 2011
The following tables present the activity in the allowance for loan and lease losses according to portfolio segment, for the three month periods ended September 30, 2012 and September 30, 2011:
23
24
Impaired Loans and Leases
The following tables provide data, at the class level, of impaired loans and leases as of the dates indicated:
With no related allowance recorded:
Total impaired loans and leases
With a related allowance recorded:
25
26
27
Non-performing loans and leases
The following table sets forth information regarding non-performing loans and leases as of the dates specified:
Non-accruing loans and leases:
Total non-accruing loans and leases
Accruing loans 90+ days past due
Total non-performing loans and leases
Total non-performing loans and leases to total assets
Total non-performing loans and leases to total loans and leases
28
Troubled debt restructurings
The Company had $10.5 million in loans and leases that were restructured in a troubled debt restructuring (“TDR”) at September 30, 2012, compared with $7.7 million at December 31, 2011. $6.6 million and $7.1 million of those balances were in non-accrual status at September 30, 2012 and December 31, 2011, respectively. Any TDR that is placed on non-accrual is not reverted back to accruing status until the borrower makes timely payments as contracted for at least six months. Those loans and leases that are in accruing status have shown evidence of performance for at least six months as of September 30, 2012 and December 31, 2011. One of the restructurings was made under a government assistance program in the third quarter of 2012. Two commercial mortgages with a combined balance of $0.3 million restructured in 2011 and one residential mortgage with a balance of $44 thousand restructured in the second quarter of 2012 are covered under the Bank’s loss-sharing arrangement with the FDIC. All of the Company’s restructurings were allowed in an effort to maximize its ability to collect on loans and leases where borrowers were experiencing financial difficulty. Modifications made to loans in a troubled debt restructuring did not have a material impact on the Company’s net income for the three and nine month periods ended September 30, 2012 and 2011. The reserve for a TDR is based upon the present value of the future expected cash flows discounted at the loan’s original effective rate or upon the fair value of the collateral less costs to sell, if the loan is deemed collateral dependent. This reserve methodology is used because all TDR loans are considered impaired. As of September 30, 2012, there were no commitments to lend additional funds to debtors owing loans or leases whose terms have been modified in TDRs. The Company’s TDRs involve interest only payments and lengthening of terms as concessions to try and maximize the collectability of the loans.
The OCC recently clarified the categorization of loans of borrowers who are in Chapter 7 bankruptcy in which the bankruptcy court discharges the borrower’s obligation to the bank and the borrower does not reaffirm the debt. The release of the borrower’s personal liability as order by the court is considered a concession and the loan would become a TDR. This guidance did not cause any loans in the Company’s portfolio to become a TDR.
The following tables summarize the loans and leases that were classified as troubled debt restructurings as of the dates indicated:
Commercial and multi family
Total troubled restructured loans and leases
29
The following table shows the data for TDR activity for the three and nine month periods ended September 30, 2012:
Troubled Debt Restructurings
Commercial and Industrial
Residential Real Estate:
Commercial Real Estate:
Commercial & Multi-Family
Home Equities
The general practice of the Bank is to work with borrowers so that they are able to pay back their loan or lease in full. If a borrower continues to be delinquent or cannot meet the terms of a TDR and the loan or lease is determined to be uncollectible, the loan or lease will be charged off. The following table presents loans and leases which were classified as TDR’s during the previous 12 months which have defaulted during the three and nine month periods ended September 30, 2012:
30
That Subsequently Defaulted
Commercial and Multi-Family
Covered Loans and the Related Allowance
On July 24, 2009, the Bank entered into a definitive purchase and assumption agreement with the FDIC under which the Bank assumed approximately $51.0 million in liabilities, consisting almost entirely of deposits, and purchased substantially all of the assets of Waterford Village Bank. The loan portfolio acquired in the transaction totaled $42.0 million. The loans acquired in that acquisition are referred to as “covered” loans because they are “covered” by a loss sharing agreement with the FDIC. The agreement calls for the FDIC to reimburse the Bank for 80% of losses up to $5.6 million and 95% of losses beyond that threshold. At acquisition, the Company marked the covered loan portfolio to its market value and the allowance for loan and lease losses related to the covered loans was zero. Since acquisition, management has provisioned for any incremental increases in estimated credit losses due to deterioration in specific loans or increased risk factors on pools of loans. As a result of the FDIC guarantees, the provision for loan and lease losses and the allowance for loan and lease losses at September 30, 2012 and December 31, 2011 are presented net of FDIC guarantees related to covered loans. The following table depicts the allowance for loan and lease losses related to covered loans as of September 30, 2012 and December 31, 2011:
Covered loans
Incremental estimated credit losses since acquisition
FDIC guarantee
Allowance for loan and lease losses, covered loans
5. PER SHARE DATA
The common stock per share information is based upon the weighted average number of shares outstanding during each period. For the three and nine month periods ended September 30, 2012 the Company had 24,321 and 13,436 average dilutive shares, respectively. The Company had 1,767 and 6,331 average dilutive shares for the three and nine month periods ended September 30, 2011, respectively.
31
Potential common shares that would have the effect of increasing diluted earnings per share are considered to be anti-dilutive and not included in calculating diluted earnings per share. For the three and nine month periods ended September 30, 2012 there were approximately 71,234 and 161,596 average shares, respectively, that were not included in calculating diluted earnings per share because their effect was anti-dilutive. There were 157,054 and 166,155 potentially anti-dilutive average shares for the three and nine month periods ended September 30, 2011.
6. OTHER COMPREHENSIVE INCOME
The following tables display the components of other comprehensive income (loss):
Unrealized gain on investment securities
Other Comprehensive Income
Unrealized gain on investment securities:
32
7. SEGMENT INFORMATION
The Company is comprised of two primary business segments, banking and insurance agency activities. The following tables set forth information regarding these segments for the three and nine month periods ended September 30, 2012 and 2011.
Three Months Ended September 30, 2012
Net interest income (expense)
Net interest income (expense) after provision for loan and lease losses
Non-interest income
Non-interest expense
Income before income taxes
Income tax provision
33
Three Months Ended September 30, 2011
Nine Months Ended September 30, 2012
34
Nine Months Ended September 30, 2011
8. CONTINGENT LIABILITIES AND COMMITMENTS
The unaudited consolidated financial statements do not reflect various commitments and contingent liabilities, which arise in the normal course of business, and which involve elements of credit risk, interest rate risk and liquidity risk. These commitments and contingent liabilities consist of commitments to extend credit and standby letters of credit. A summary of the Bank’s commitments and contingent liabilities is as follows:
Standby letters of credit
Commitments to extend credit and standby letters of credit include some exposure to credit loss in the event of nonperformance of the customer. The Bank’s credit policies and procedures for credit commitments and financial guarantees are the same as those for extensions of credit that are recorded on the Company’s unaudited consolidated balance sheets. Because these instruments have fixed maturity dates, and because they may expire without being drawn upon, they do not necessarily represent cash requirements of the Bank. The Bank has not incurred any losses on its commitments and has not recorded a reserve for its commitments during 2011 and 2012.
Certain lending commitments for construction residential mortgage loans are considered derivative instruments under the guidelines of GAAP. The changes in the fair value of these commitments, due to interest rate risk, are not recorded on the consolidated balance sheets as the fair value of these derivatives is not considered material.
The Company is subject to possible litigation proceedings in the normal course of business. As of September 30, 2012 and December 31, 2011, there were no claims pending against the Company that management considered material.
35
9. NET PERIODIC BENEFIT COSTS
On January 31, 2008, the Bank froze its defined benefit pension plan. The plan covered substantially all Company employees. The plan provides benefits that are based on the employees’ compensation and years of service. Under the freeze, eligible employees will receive at retirement the benefits already earned through January 31, 2008, but have not accrued any additional benefits since then. As a result, service cost is no longer incurred.
The Bank used an actuarial method of amortizing prior service cost and unrecognized net gains or losses which result from actual expense and assumptions being different than those that are projected. The amortization method the Bank used recognized the prior service cost and net gains or losses over the average remaining service period of active employees.
The Bank also maintains a nonqualified supplemental executive retirement plan covering certain members of the Company’s senior management. The Bank uses an actuarial method of amortizing unrecognized net gains or losses which result from actual expense and assumptions being different than those that are projected. The amortization method the Bank uses recognizes the net gains or losses over the average remaining service period of active employees.
The Bank contributed $340 thousand to the defined benefit pension plan in the first nine months of 2012 and plans to contribute an additional $30 thousand before the end of the year.
The following table presents the net periodic cost for the Bank’s defined benefit pension plan and supplemental executive retirement plan for the three and nine month periods ended September 30, 2012 and 2011:
Three months ended September 30,
Service cost
Interest cost
Expected return on plan assets
Amortization of the net loss
Net periodic cost
36
Nine months ended September 30,
10. RECENT ACCOUNTING PRONOUNCEMENTS
Accounting Standards Update (“ASU”) 2011-03, Reconsideration of Effective Control for Repurchase Agreements. This ASU relates to accounting for repurchase agreements (“repos”) and other agreements that both entitle and obligate a transferor to repurchase or redeem financial assets before their maturity. During the global economic crisis, capital market participants questioned the necessity and usefulness of the collateral maintenance guidance for the transferor’s ability criterion when determining whether a repo should be accounted for as a sale or as a secured borrowing. The amendments in this ASU remove from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (2) the collateral maintenance implementation guidance related to that criterion. The new guidance is effective for interim and annual periods beginning after December 15, 2011. The Company adopted this ASU effective January 1, 2012, which did not have a significant impact on the Company’s repo accounting.
ASU 2011-04,Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards (“IFRS”). This ASU was issued to provide largely identical guidance about fair value measurement and disclosure requirements for IFRS and U.S. GAAP. The new guidance clarifies that the application of the highest and best use and valuation premise concepts are not relevant when measuring the fair value of financial assets or liabilities. This ASU also requires new and enhanced disclosures on the quantification and valuation process for significant unobservable inputs, transfers between Levels 1 and 2 and the categorization of all fair value measurements in the fair value hierarchy, even when those measurements are only for disclosure purposes. The Company adopted this ASU effective January 1, 2012. The enhanced disclosures are included in Note 3, “Fair Value Measurements.”
ASU 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. The objective of this ASU is to improve the comparability, consistency, and transparency of financial reporting and to increase the prominence of items reported in other comprehensive income. To increase the prominence of items reported in other comprehensive income and to facilitate the convergence of U.S. GAAP and IFRS, the Financial Accounting Standards Board (“FASB”) decided to eliminate the option to present components of other comprehensive income as part of the statement of changes in shareholders’ equity. The amendments require that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In the two-statement approach, the first statement should present total net income and its components followed consecutively by a second statement that should present total other comprehensive income, the components of other comprehensive income, and the total of comprehensive income. The amendments in this ASU will be applied retrospectively. The amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. In the interim period ended March 31, 2012, the Company adopted this ASU and elected to use the two-statement approach.
37
ASU No. 2011-08, Intangibles-Goodwill and Other (Topic 350): Testing Goodwill for Impairment. This ASU permits an entity to make a qualitative assessment of whether it is more likely than not that a reporting unit’s fair value is less than its carrying amount before applying the two-step goodwill impairment test. If an entity concludes it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, it need not perform the two-step impairment test. The ASU is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The Company adopted this ASU effective January 1, 2012. The Company will evaluate the need for a two-step goodwill impairment test each period subsequent to adoption. The Company typically performs its goodwill impairment test as of December 31st on an annual basis. As there were no triggering events in the quarter ended September 30, 2012, management did not test goodwill for impairment. The Company does not expect adoption of this ASU to have a material effect on its financial statements.
ASU No. 2011-12, Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05. ASU No. 2011-12 defers the effective date of the requirement to present separate line items on the income statement for reclassification adjustments of items out of accumulated other comprehensive income into net income for all periods presented. The ASU does not change the other requirements of FASB ASU No. 2011-05, Presentation of Comprehensive Income. Entities are still required to present reclassification adjustments within other comprehensive income either on the face of the statement that reports other comprehensive income or in the notes to the financial statements. The requirement to present comprehensive income in either a single continuous statement or two consecutive condensed statements remains for both annual and interim reporting. The deferral of the requirement for the presentation of reclassification adjustments is intended to be temporary until the FASB reconsiders the operational concerns and needs of financial statement users.
The Company adopted the amendments in this Update at the same time as ASU 2011-05, which became effective beginning in the interim period ended March 31, 2012. As the Company had no reclassifications adjustments within other comprehensive income, this Update had no impact on the Company’s financial statements.
38
ITEM 2—MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This Quarterly Report on Form 10-Q may contain certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), that involve substantial risks and uncertainties. When used in this report, or in the documents incorporated by reference herein, the words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “may,” “plan,” “seek,” and similar expressions identify such forward-looking statements. These forward-looking statements include statements regarding the Company’s business plans, prospects, growth and operating strategies, statements regarding the asset quality of the Company’s loan and investment portfolios, and estimates of the Company’s risks and future costs and benefits.
These forward-looking statements are based largely on the expectations of the Company’s management and are subject to a number of risks and uncertainties, including but not limited to general economic conditions, either nationally or in the Company’s market areas, that are worse than expected; increased competition among depository or other financial institutions; inflation and changes in the interest rate environment that reduce the Company’s margins or reduce the fair value of financial instruments; changes in laws or government regulations affecting financial institutions, including changes in regulatory fees, monetary policy, and capital requirements; the Company’s ability to enter new markets successfully and capitalize on growth opportunities; the Company’s ability to successfully integrate acquired entities; changes in accounting pronouncements and practices, as adopted by financial institution regulatory agencies, the Financial Accounting Standards Board and the Public Company Accounting Oversight Board; changes in consumer spending, borrowing and saving habits; changes in the Company’s organization, compensation and benefit plans; and other factors discussed elsewhere in this Quarterly Report on Form 10-Q, as well as in the Company’s periodic reports filed with the SEC, in particular the “Risk Factors” discussed in Item 1A of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2011. Many of these factors are beyond the Company’s control and are difficult to predict.
Because of these and other uncertainties, the Company’s actual results, performance or achievements could differ materially from those contemplated, expressed or implied by the forward-looking statements contained herein. Forward-looking statements speak only as of the date they are made. The Company undertakes no obligation to publicly update or revise forward-looking information, whether as a result of new, updated information, future events or otherwise.
APPLICATION OF CRITICAL ACCOUNTING ESTIMATES
The Company’s Unaudited Consolidated Financial Statements included in this Quarterly Report on Form 10-Q are prepared in accordance with U.S. GAAP and follow general practices within the industries in which it operates. Application of these principles requires management to make estimates, assumptions and judgments that affect the amounts reported in the Company’s Unaudited Consolidated Financial Statements and Notes. These estimates, assumptions and judgments are based on information available as of the date of the Unaudited Consolidated Financial Statements. Accordingly, as this information changes, the Unaudited Consolidated Financial Statements could reflect different estimates, assumptions and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments, and as such, have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available. When third-party information is not available, valuation adjustments are estimated in good faith by management primarily through the use of internal cash flow modeling techniques. Refer to Note 3 — “Fair Value Measurements” to the Company’s Unaudited Consolidated Financial Statements included in Item 1 of this Quarterly Report on Form 10-Q for further detail on fair value measurement.
39
Significant accounting policies followed by the Company are presented in Note 1 — “Organization and Summary of Significant Accounting Policies” to the Audited Consolidated Financial Statements included in Item 8 in its Annual Report on Form 10-K for the year ended December 31, 2011. These policies, along with the disclosures presented in the other Notes to the Company's Audited Consolidated Financial Statements contained in its Annual Report on Form 10-K and in this financial review, provide information on how significant assets and liabilities are presented in the Company’s Unaudited Consolidated Financial Statements and how those values are determined.
Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions and estimates underlying those amounts, management has identified the determination of the allowance for loan and lease losses and valuation of goodwill to be the accounting areas that require the most subjective or complex judgments, and as such, could be most subject to revision as new information becomes available.
Allowance for Loan and Lease Losses
The allowance for loan and lease losses represents management’s estimate of probable losses in the Company’s loan and lease portfolio. Determining the amount of the allowance for loan and lease losses is considered a critical accounting estimate because it requires significant judgment on the part of management and the use of estimates related to the amount and timing of expected future cash flows on impaired loans and leases, estimated losses on pools of homogeneous loans and leases based on historical loss experience and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan and lease portfolio also represents the largest asset type on the Company’s Unaudited Consolidated Balance Sheets. Note 1 to the Audited Consolidated Financial Statements included in Item 8 in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, describes the methodology used to determine the allowance for loan and lease losses.
The amount of goodwill reflected in the Company’s Unaudited Consolidated Financial Statements is required to be tested by management for impairment on at least an annual basis. The test for impairment of goodwill on the identified reporting unit is considered a critical accounting estimate because it requires judgment on the part of management and the use of estimates related to the growth assumptions and market multiples used in the valuation model. The goodwill impairment testing is typically performed annually on December 31st. No impairment charges were incurred in the most recent test and the fair value of the tested reporting unit substantially exceeded its fair value. There were no triggering events in the three and nine month periods ended September 30, 2012 that resulted in an interim impairment test.
ANALYSIS OF FINANCIAL CONDITION
Loan and Lease Activity
Total loans and leases grew to $598.6 million at September 30, 2012, reflecting a $0.7 million or 0.1% increase from June 30, 2012 and a $15.2 million or 2.6% increase from December 31, 2011. The national direct financing lease portfolio declined $0.9 million during the third quarter to $2.4 million at September 30, 2012 as the Company had ceased lease originations in the second quarter of 2009 and is winding down the portfolio and exiting this business line.
Core loans, defined as total loans less leases, were $596.2 million at September 30, 2012, a $1.6 million, or 0.3% increase from $594.6 million at June 30, 2012 and an $18.8 million, or 3.3% increase from December 31, 2011. The large amount of loans closed in the fourth quarter of 2011 left the Company’s loan pipeline relatively lighter to start 2012. The Company re-filled the pipeline in the first quarter and early second quarter and was able to generate significant loan closings in the second quarter, with the highest level of growth driven by commercial and multi-family real estate loans. Loan balances in the third quarter were relatively flat as demand has been relatively soft and the marketplace remains extremely competitive. Compared with core loan balances of $560.8 million at September 30, 2011, the growth rate over the past twelve months has been 6.3%.
Loans secured by real estate were $485.3 million at September 30, 2012, an increase of $2.8 million or 0.6% from June 30, 2012, and $20.1 million or 4.3% from December 31, 2011. The strongest growth was in commercial real estate construction loans, which increased $3.8 million or 11.9% in the third quarter of 2012. Year-to-date, growth in commercial real estate construction was $7.7 million, or 27.6%. Commercial real estate lending has long been an area of strength of the Bank and its loan officers and the historical strong performance has continued in 2012.
40
Residential mortgages increased to $70.4 million at September 30, 2012 from $69.3 million at June 30, 2012, but decreased from $73.6 million at December 31, 2011. The Company has sold the majority of its originated residential mortgage loans as long-term fixed rate mortgage loan rates remain near all-time historic lows. This, along with prepayments from existing customers re-financing their homes, has resulted in the decrease in residential mortgage balances in 2012. Residential mortgage originations increased to $9.0 million and $24.1 million in the three and nine month periods ended September 30, 2012, respectively, compared with $6.0 million and $23.6 million in the three and nine month periods ended September 30, 2011, respectively.
The Bank sells certain fixed rate residential mortgages to FNMA, while maintaining the servicing rights for those mortgages. During the three and nine month periods ended September 30, 2012, the Bank sold mortgages to FNMA totaling $6.0 million and $17.1 million, respectively, as compared with $2.6 million and $15.8 million sold during the three and nine month periods ended September 30, 2011, respectively. At September 30, 2012, the Bank had a loan servicing portfolio principal balance of $70.5 million upon which it earns servicing fees, as compared with $68.4 million at June 30, 2012 and $62.4 million at December 31, 2011. The value of the mortgage servicing rights for that portfolio was $0.4 million at September 30, 2012, June 30, 2012 and December 31, 2011. Residential mortgage loans held-for-sale were $2.7 million at September 30, 2012, compared with $1.0 million at June 30, 2012 and $3.6 million at December 31, 2011. The Company has never been contacted by FNMA to repurchase any loans due to improper documentation or fraud.
The Company continues to focus on commercial and industrial (“C&I”) lending as a way to diversify its loan portfolio, which has historically experienced strong growth rates in real estate loans. However, the Company faces the headwinds of a low growth economy and a very competitive local market. Line of credit commitments and line of credit usage decreased in the third quarter, resulting in C&I balances declining to $106.8 million at September 30, 2012, compared with $107.8 million at June 30, 2012, and $109.5 million at December 31, 2011.
Leasing Portfolio
As noted above, management made the strategic decision in April 2009 to exit the national direct financing lease business and market the portfolio for sale. This decision resulted in the classification of the leasing portfolio as held-for-sale and the portfolio being marked to its market value at September 30, 2009. The mark-to-market adjustment was $7.2 million. At September 30, 2009, management determined to keep the lease portfolio and service it to maturity, terminated its plans to actively market the portfolio for sale, and the portfolio was placed back into held-for-investment at the revised carrying amount as of September 30, 2009. The difference between the principal value and the carrying value, initially created by the mark-to-market adjustment at September 30, 2009, reduces over time as individual leases deteriorate, become uncollectible, and are written off. The allowance for lease losses was zero at September 30, 2009 when the portfolio was classified as held-for-sale and reported at its fair market value. With the portfolio classified as held-for-investment at September 30, 2012, the portfolio has been evaluated in accordance with the Company’s normal credit review policies in determining the appropriate allowance for lease losses. During the third quarter of 2012, a net of $4 thousand in leases were written off and the difference between the principal value and carrying value of the leasing portfolio remained the same at $0.1 million at September 30, 2012 when compared with June 30, 2012. Non-performing leases of $0.3 million at September 30, 2012 declined from $0.4 million at June 30, 2012 and $1.2 million at December 31, 2011. There were no new leases placed in nonaccrual in the third quarter. With both performing and non-performing lease balances declining, management determined that the allowance for leasing losses should decrease by $0.1 million in the third quarter of 2012, following a $0.2 million decrease in the second quarter of 2012 and a $0.4 million decrease in the first quarter of 2012. The following table illustrates the write-off and allowance activity related to the leasing portfolio over the past five quarters.
41
Leasing Principal Balance
Mark
Leasing Carrying Value
Mark-to-Market Adjustment
Net Write-Offs
Remaining Mark
Allowance for lease losses
Provision for leases
Leasing net charge-offs
Total mark plus allowance
Mark + allowance/leasing principal balance
Credit Quality of Loan Portfolio
Total non-performing loans and leases, defined as accruing loans and leases greater than 90 days past due and non-accrual loans and leases, totaled $9.4 million, or 1.57% of total loans and leases outstanding, at September 30, 2012, compared with $11.0 million, or 1.84%, at June 30, 2012 and $15.2 million, or 2.60% of total loans and leases outstanding at December 31, 2011. There were several reasons for the decline in non-performing loans and leases during the past three quarters.
In the first six months of 2012, certain construction loans that were formerly more than 90 days past their maturity dates were converted to permanent loans and remain performing as of September 30, 2012 ($1.4 million). The non-performing leasing portfolio continued to improve and run off ($0.7 million). Other reasons for the decline in non-performing loans and leases included charge-offs ($0.6 million), pay-offs and pay-downs ($0.9 million), and improved performance justifying a return to performing status ($0.5 million).
In the third quarter of 2012, non-performing loans and leases continued to decline. The Company had two non-accruing loans pay off, including two commercial real estate loans for $0.5 million and $0.3 million. The Company partially charged off $0.4 million of a $2.1 million commercial and industrial relationship that was risk rated a 7 on the Company internal risk rating scale and had previously been reserved for. The Company also charged off $0.1 million of a home equity loan. The leasing portfolio continued its run-off in the third quarter with non-accruing leases declining by $0.2 million. The remaining net $0.2 million decrease is from payments on non-accruing loans that remain in the portfolio.
The allowance for loan and lease losses totaled $10.2 million, or 1.71% of total loans and leases outstanding as of September 30, 2012, compared with $10.7 million or 1.78% at June 30, 2012, and $11.5 million or 1.97% at December 31, 2011. The decrease in the allowance over the prior year end resulted from a $0.8 million release of reserves on the leasing portfolio and net charge-offs of $1.4 million in the nine month period ended September 30, 2012, partially offset by a $0.8 million provision for loan losses. The provision for loan losses resulted from the charge-off of three loans that exceeded the reserve associated with those loans at the time of the charge-offs, as well as the loan growth through the first nine months of 2012. The $0.5 million in net charge-offs in the third quarter of 2012 equates to a 0.31% annualized ratio as a percentage of average net loans and leases. This compares with a 0.30% ratio in the second quarter of 2012 and 0.09% in the third quarter of 2011. For the nine months ended September 30, 2012, the $1.4 million in net charge-offs equated to 0.31% of average net loans and leases, compared with $1.4 million in net charge-offs for a ratio of 0.35% in the first nine months of 2011.
42
The coverage ratio of the allowance for loan and lease losses to non-performing loans and leases increased from 76% at December 31, 2011 to 97% at June 30, 2012 and 108% at September 30, 2012. There are two factors that significantly influence these ratios. The first factor is the covered loan portfolio acquired in the Waterford transaction which are covered by an FDIC loss-sharing agreement that guarantees 80% of any losses incurred in the portfolio up to $5.6 million, and 95% of losses beyond that threshold. The second factor is the leasing portfolio, which carries significantly higher risk, but also has the remaining mark to consider as depicted in the table above. The following table depicts the allowance and non-performing ratios by segregating the covered and non-covered loan portfolios and the leasing portfolio as of the following dates:
Non-covered loans
Leases
Investing Activities
Total securities were $95.9 million at September 30, 2012, compared with $96.8 million at June 30, 2012 and $103.8 million at December 31, 2011. Interest-bearing deposits at other banks, which consist of overnight funds kept at correspondent banks, increased from $3.2 million at December 31, 2011 to $31.4 million at June 30, 2012 and $52.7 million at September 30, 2012. Interest-bearing cash has increased as deposit growth outpaced loan growth. Securities and interest-bearing deposits at correspondent banks made up 20.0 % of the Bank’s total average interest earning assets in the third quarter of 2012, compared with 19.6% in the second quarter of 2012.
The Company’s highest concentration in its securities portfolio is in tax-advantaged debt securities issued by state and political subdivisions with 33.1% at September 30, 2012, compared with 31.1% at December 31, 2011. The concentration in U.S. government-sponsored agency bonds was 25.6% of the portfolio at September 30, 2012, compared with 29.1% of the portfolio at December 31, 2011.
The credit quality of the securities portfolio as a whole is believed to be strong as the portfolio has no individual securities in a significant unrealized loss position. Despite interest rates remaining near historic lows, the net unrealized gain position of the investment portfolio increased from $4.1 million at December 31, 2011 and $4.0 million at June 30, 2012 to $4.6 million at September 30, 2012.
43
The Company monitors extension and prepayment risk in the securities portfolio to limit potential exposures. Available-for-sale securities with a total fair value of $74.9 million at September 30, 2012, as compared with $76.7 million at December 31, 2011, were pledged as collateral to secure public deposits and for other purposes required or permitted by law. The Company has no direct exposure to subprime mortgages, nor does the Company hold private mortgage-backed securities, credit default swaps, or FNMA or FHLMC preferred stock investments in its investment portfolio.
Funding Activities
Total deposits at September 30, 2012 were $672.7 million, reflecting an $18.8 million or 2.9% increase from June 30, 2012 and a $56.5 million, or 9.2%, increase from December 31, 2011. Total demand deposits at September 30, 2012 were $126.3 million, reflecting a $10.0 million or 8.6% increase from June 30, 2012, and an $8.2 million or 7.0% increase from December 31, 2011. Demand deposit balances fluctuate day-to-day based on the high volume of transactions normally associated with the demand product, and therefore average demand deposit growth is a valuable measure of sustained growth. Average demand deposits of $124.6 million during the three month period ended September 30, 2012 was 8.3% higher than the second quarter of 2012, and 12.2% higher than the prior year’s third quarter. Most of the Company’s growth in the past year in demand deposits has come from commercial customers.
The Company’s retail deposit growth vehicle continues to be the complementary Better Checking and Better Savings products, which are included in the NOW and regular savings deposit categories, respectively, on the Company’s balance sheet. The Better Checking product is unique in the Bank’s Western New York footprint as it pays a premium interest rate as a reward to customers who demonstrate a deep relationship with the Bank as evidenced by regular use of their debit card, use of direct deposit, and electronic statements. Overall, Better Checking deposits increased $3.4 million, or 7.4%, during the third quarter of 2012 and $9.8 million, or 24.6%, during the first nine months of the year. Regular savings deposits increased $8.6 million, or 2.5%, during the third quarter of 2012 and $37.8 million, or 12.1% during the first nine months of the year. That growth is mostly a result of an increase in Better Savings deposits, offset by decreases in legacy savings products. Growth in NOW and savings deposits slowed in the third quarter as the Company lowered rates on selected deposit products given the Company’s current excess liquidity and declining net interest margin in this extended low rate environment.
Time deposits were $107.7 million at September 30, 2012, a decrease of $0.6 million, or 0.6%, from June 30, 2012, and a $5.8 million, or 5.1%, decrease from December 31, 2011. Time deposit rates remain near historic lows. As a result, customers have continued to show a preference for liquid savings products over time deposits.
Other borrowings, which typically include the Bank’s overnight line of credit and other advances with the FHLBNY, were $19.0 million at September 30, 2012 and June 30, 2012, and $22.0 million at December 31, 2011 as a $3.0 million advance with FHLBNY matured and was not replaced. Because the Company’s deposit growth has outpaced its loan growth this year, the Bank has not needed to add to its wholesale borrowings.
44
ANALYSIS OF RESULTS OF OPERATIONS
Average Balance Sheet
The following tables present the significant categories of the assets and liabilities of the Company, interest income and interest expense, and the corresponding yields earned and rates paid for the periods indicated. The assets and liabilities are presented as daily averages. The average loan and lease balances include both performing and non-performing loans and leases. Investments are included at amortized cost. Yields are presented on a non-tax-equivalent basis.
Interest-earning assets:
Taxable securities
Tax-exempt securities
Total interest-earning assets
Non interest-earning assets:
Premises and equipment, net
Total Assets
LIABILITIES & STOCKHOLDERS’ EQUITY
Interest-bearing liabilities:
Securities sold U/A to repurchase
Total interest-bearing liabilities
Noninterest-bearing liabilities:
Stockholders’ equity
Total Liabilities and Equity
Net interest earnings
Net interest margin
Interest rate spread
45
Net income grew to $2.1 million in the third quarter of 2012, up 10.9% from net income of $1.9 million in the third quarter of 2011. The improvement in net income reflected a combination of higher net interest income and a $0.2 million year-over-year reduction in the provision for loan and lease losses. Return on average equity was 11.60% for the third quarter of 2012 compared with 11.37% in the third quarter of 2011.
For the nine months ended September 30, 2012, the Company recorded net income of $6.0 million, or $1.45 per diluted share, a 26% increase over net income of $4.8 million, or $1.16 per diluted share, in the same period in 2011. The return on average equity was 11.15% for the nine-month period ended September 30, 2012, compared with 9.66% in the same period in 2011.
46
Other Results of Operations — Quarterly Comparison
Net interest income was $6.9 million for the 2012 third quarter, up 6.6% when compared with the third quarter of 2011 and comparable to the second quarter of 2012. Growth in interest-earning assets drove the increase from the third quarter of 2011 and offset net interest margin contraction relative to the same period. Core loans, which are defined as total loans and leases less leases, were $596.2 million at September 30, 2012, an increase of 6.3% from $560.8 million at September 30, 2011, and up 0.3% (1.1% annualized) from $594.6 million at June 30, 2012. The majority of the loan growth since the third quarter of 2011 was in the commercial mortgage loan portfolio.
The Company’s net interest margin decreased to 3.76% for the third quarter of 2012, down from the second quarter rate of 3.85% and down from 3.97% in the third quarter of 2011. As compared with last year’s third quarter the decrease in the net interest margin is a result of the continued declining interest rate environment. The Company has been able to partially offset the 47 basis point decrease in yield on interest-earning assets through re-pricing its interest bearing liabilities by 33 basis points. The contribution of interest-free funds declined by 7 basis points when compared with the third quarter 2011.
The Company’s loan and investment portfolios continue to re-price into lower yields, as evidenced by a decrease in yield on interest-earning assets of 14 basis points from the second quarter of 2012.
The provision for loan and lease losses decreased to $9 thousand in the third quarter of 2012 from a provision of $0.2 million in the prior year’s third quarter, and decreased from a provision of $0.3 million in the linked second quarter of 2012. The third quarter of 2012 benefitted from a release of $0.1 million in leasing provision after continued improvement in the leasing portfolio’s performance, which offset an increased specific reserve of $0.1 million on a commercial real estate loan. With no other significant deterioration in credit quality and relatively low loan growth rate of 0.3% in the quarter, provision for loan and lease losses was near zero.
Non-interest income, which represented 31.7% of total revenue in the third quarter of 2012, increased 1.0%, or $32 thousand, to $3.2 million when compared with the third quarter of 2011. Insurance agency revenue of $1.8 million was down $75 thousand, or 4.0%, when compared with the 2011 third quarter due mostly to decreases in personal lines revenue. Premiums on residential mortgages sold to Fannie Mae increased from $33 thousand in last year’s third quarter to $129 thousand in this year’s third quarter, a 291% increase. The Company was able to achieve better execution and improved margins on loan sales in 2012 when compared with 2011. Compared with the second quarter of 2012, total non-interest income was up $0.2 million due mainly to TEA’s increase in revenue of $0.1 million, reflecting the typical revenue cycle seasonality, and an increase in deposit service charges of $50 thousand, reflecting increased overdraft activity.
Total non-interest expense was $7.4 million in the third quarter of 2012, an increase of 8.1%, from $6.8 million in the third quarter of 2011. The largest component of the increase was salaries and employee benefits, which was up $0.7 million, or 17.3%, when compared with the third quarter of 2011. This rise is due in part to merit increases awarded for 2011 performance, higher health care costs, and increased staff. However, $0.5 million is a non-routine expense related to the severance costs incurred due to the departure of an executive from the Company.
As a result of the increase in non-interest expense, the efficiency ratio increased to 71.64% for the third quarter of 2012 from 69.10% for the third quarter of 2011.
Income tax expense for the quarter ended September 30, 2012, was $0.7 million, representing an effective tax rate of 23.6% compared with an effective tax rate of 29.6% in the third quarter of 2011. The decrease in tax rate in the third quarter was primarily due to a previously unrecognized tax benefit of $220 thousand related to the expiration of a statute from the 2008 tax year. Excluding the non-routine item, the effective tax rate would have been 31.5%. The increase in the normalized tax rate is a reflection of tax-exempt income being a lower portion of overall pre-tax income.
47
Other Results of Operations — Year-to-Date Comparison
Net interest income was $20.7 million for the nine months ended September 30, 2012, an 8.3% increase from the first nine months of 2011. Growth in interest-earning assets, particularly loans, and a reduction in the rate paid on interest-bearing deposits drove the increase from 2011 and offset the net interest margin contraction relative to the same period.
The Company’s net interest margin decreased to 3.76% for the nine month period ended September 30, 2012, down from 3.97% in the first nine months of 2011. As the low interest rate cycle continues, the Company’s loan and investment portfolios re-price into lower yields as evidenced by a decrease in yield on interest-earning assets of 47 basis points in the first nine months of 2012 when compared with the same period in 2011. The Company benefited from re-pricing its interest-bearing liabilities earlier in the interest rate cycle so these rates have fallen less than the yield on interest-earning assets in the past year. Correspondingly, the cost of interest-bearing liabilities for the first nine months of 2012 declined only 33 basis points when compared with the same period in 2011.
The provision for loan and lease losses decreased to $0.1 million in the nine month period ended September 30, 2012 from a provision of $1.7 million in the nine month period ended September 30, 2011. With the continuing improvement in the performance of the leasing portfolio, including a steep decrease in non-performing leases, the Company released $0.8 million in leasing reserves in the first nine months of 2012 compared with a release of leasing reserves of $0.2 million in the first nine months of 2011. The provision for loan losses (not including leases) decreased from $1.9 million in the nine month period ended September 30, 2011 to $0.8 million in the first nine months of 2012. In the prior year period there was deterioration in several commercial loan relationships that drove the higher provision. In contrast, in 2012, the percentage of total loans and leases that are non-performing has decreased from 2.60% at December 31, 2011 to 1.57% at September 30, 2012.
Non-interest income, which represented 31.7% of total revenue in the first nine months of 2012, decreased 0.3%, or $27 thousand, to $9.5 million when compared with the first nine months of 2011. Data center income, which declined $0.2 million from the prior year’s first nine months, is from the Bank’s wholly-owned subsidiary, Suchak Data Systems, LLC (“SDS”). SDS is a data processing company which was acquired by the Bank on December 31, 2008. The original contracted revenue generated by service agreements with other banks is expiring as expected. The Company is focusing on the original purpose for the purchase of SDS, which was to provide resources for its own internal bank processing needs. Insurance agency revenue of $5.4 million for the nine month period ended September 30, 2012 was down $0.1 million, or 3.2%, when compared with the nine month period ended September 30, 2011 due mostly to a decrease in profit sharing revenue from the insurance carriers. The lower profit sharing is driven by higher loss ratios related to lower premium levels. These negative trends were somewhat offset by increased deposit service charges, premiums on loans sold, bank-owned life insurance (“BOLI”) income and other income. Deposit service charges increased $59 thousand, or 4.5%, compared with the first nine months of 2011, primarily due to increases in fee rates to be more in-line with market competition. Premiums on loans sold increased $152 thousand year over year due to more disciplined pricing and improved execution on loan sales to FNMA. BOLI income increased $39 thousand, or 11.8%, due to an increased investment in BOLI. Other income was up $136 thousand in the first nine months of 2012 when compared to the prior year mostly from higher interchange and ATM fees ($76 thousand), merchant services fees ($41 thousand), and FNMA servicing fees ($30 thousand).
Total non-interest expense was $21.6 million in the nine month period ended September 30, 2012, an increase of $1.4 million, or 7.0%, from $20.2 million in the third quarter of 2011. The largest component of the increase was salaries and employee benefits, which was up $1.3 million, or 11.2%, from the first nine months of 2011 to $13.2 million in the first nine months of 2012. Part of the increase reflected merit increases awarded for 2011 performance, higher health care costs and increased staff levels, with the rest coming from a $0.5 million severance payment to a former executive. Professional services expenses increased $0.2 million from $1.3 million in the nine month period ended September 30, 2011 to $1.5 million in the first nine months of 2012. The increase is due mainly to higher legal expenses, particularly those related to resolving and collecting impaired loans.
As a result of the increase in non-interest expense, the efficiency ratio increased to 70.48% for the nine month period ended September 30, 2012 from 69.11% in the corresponding period in 2011.
Income tax expense for the nine months ended September 30, 2012, was $2.6 million, representing an effective tax rate of 29.9% compared with an effective tax rate of 30.2% in the nine month period ended September 30, 2011. Excluding the non-routine tax benefit of $0.2 million described above under “Other Results of Operations — Quarterly Comparison,” the effective tax rate the first nine months of 2012 would have been 32.5%. The normalized effective tax rate increased as tax-exempt income, such as interest income from municipal bonds and the increase in the cash surrender value of bank-owned life insurance, comprised a smaller percentage of total income.
48
CAPITAL
The Company consistently maintains regulatory capital ratios measurably above the federal “well capitalized” standard, including a Tier 1 leverage ratio of 9.71% at September 30, 2012 and December 31, 2011. Book value per share of the Company’s common stock was $17.82 at September 30, 2012, compared with $16.72 at December 31, 2011. Tangible book value per share (a non-GAAP measure) at September 30, 2012 was $15.77, compared with $14.60 at December 31, 2011. The increase in both book value and tangible book value per share is a result of the Company’s $6.0 million in net income, somewhat offset by the $1.8 million in dividends declared in 2012.
Tangible book value per share is a non-GAAP measure. The Company uses this measure to provide information for investors to effectively analyze financial trends and to enhance comparability with peers. A detailed reconciliation of the Company’s GAAP to non-GAAP measure follows:
Stockholders’ equity (“book value”)
Tangible book value
Number of common shares outstanding
Tangible book value per share
On August 21, 2012, the Company declared a semi-annual cash dividend of $0.22 per share on the Company’s outstanding common stock. The dividend was paid on October 9, 2012 to shareholders of record as of September 11, 2012. The dividend was consistent with the previous semi-annual dividend of $0.22 paid on April 10, 2012.
LIQUIDITY
The Bank utilizes cash flows from the investment portfolio and federal funds sold balances to manage the liquidity requirements related to loan demand and deposit fluctuations. The Bank also has many borrowing options. As a member of the FHLB the Bank is able to borrow funds at competitive rates. Advances of up to $132.8 million can be drawn on the FHLB via an Overnight Line of Credit Agreement between the Bank and the FHLB. An amount equal to 25% of the Bank’s total assets could be borrowed through the advance programs under certain qualifying circumstances. The Bank also has the ability to purchase up to $14.0 million in federal funds from its correspondent banks. By placing sufficient collateral in safekeeping at the Federal Reserve Bank, the Bank could borrow at the discount window. The Bank’s liquidity needs also can be met by more aggressively pursuing time deposits, or accessing the brokered time deposit market, including the Certificate of Deposit Account Registry Service (“CDARS”) network. The Company’s primary source of liquidity is dividends from the Bank. Additionally, the Company has access to capital markets as a funding source. In May 2010, the Company raised $13.4 million in net proceeds in connection with a registered offering and sale of 1.2 million shares of common stock.
Cash flows from the Bank’s investment portfolio are laddered, so that securities mature at regular intervals, to provide funds from principal and interest payments at various times as liquidity needs may arise. Contractual maturities are also laddered, with consideration as to the volatility of market prices. At September 30, 2012, approximately 4.9% of the Bank’s securities had contractual maturity dates of one year or less and approximately 23.1% had maturity dates of five years or less.
49
Management, on an ongoing basis, closely monitors the Company’s liquidity position for compliance with internal policies, and believes that available sources of liquidity are adequate to meet funding needs in the normal course of business. As part of that monitoring process, management calculates the 90-day liquidity each month by analyzing the cash needs of the Bank. Included in the calculation are liquid assets and potential liabilities. Management stresses the potential liabilities calculation to ensure a strong liquidity position. Included in the calculation are assumptions of some significant deposit run-off as well as funds needed for loan closings and investment purchases. At September 30, 2012, in the Company’s internal stress test, the Company had net short-term liquidity of $139.1 million as compared with $82.6 million at December 31, 2011. Available assets of $151.5 million, divided by public and purchased funds of $114.1 million, resulted in a long-term liquidity ratio of 133% at September 30, 2012, compared with 99% at December 31, 2011.
Management does not anticipate engaging in any activities, either currently or in the long term, for which adequate funding would not be available and which would therefore result in significant pressure on liquidity. However, continued economic recession could negatively impact the Company’s liquidity.
The Company believes that the Bank maintains a sufficient level of U.S. government and government agency securities and New York State municipal bonds that can be pledged as collateral for municipal deposits.
ITEM 3—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Additional information responsive to this Item is contained in the Liquidity section of Management’s Discussion and Analysis of Financial Condition and Results of Operations, which information is incorporated herein by reference.
Market risk is the risk of loss from adverse changes in market prices and/or interest rates of the Bank’s financial instruments. The primary market risk the Company is exposed to is interest rate risk. The core banking activities of lending and deposit-taking expose the Bank to interest rate risk, which occurs when assets and liabilities reprice at different times and by different amounts as interest rates change. As a result, net interest income earned by the Bank is subject to the effects of changing interest rates. The Bank measures interest rate risk by calculating the variability of net interest income in future periods under various interest rate scenarios using projected balances for interest-earning assets and interest-bearing liabilities. Management’s philosophy toward interest rate risk management is to limit the variability of net interest income to changes in net interest rates. The balances of financial instruments used in the projections are based on expected growth from forecasted business opportunities, anticipated prepayments of loans, and expected maturities of investment securities, loans and deposits. Management supplements the modeling technique described above with analysis of market values of the Bank’s financial instruments and changes to such market values given changes in the interest rates.
The Bank’s Asset-Liability Committee, which includes members of senior management, monitors the Bank’s interest rate sensitivity with the aid of a model that considers the impact of ongoing lending and deposit taking activities, as well as interrelationships in the magnitude and timing of the repricing of financial instruments, including the effect of changing interest rates on expected prepayments and maturities. When deemed prudent, management has taken actions, and intends to do so in the future, to mitigate exposure to interest rate risk through the use of on- or off-balance sheet financial instruments. Possible actions include, but are not limited to, changing the pricing of loan and deposit products, and modifying the composition of interest-earning assets and interest-bearing liabilities, and other financial instruments used for interest rate risk management purposes.
50
The following table demonstrates the possible impact of changes in interest rates on the Bank’s net interest income over a 12-month period of time:
SENSITIVITY OF NET INTEREST INCOME TO CHANGES IN INTEREST RATES
Calculated increase
in projected annual net interest income
Changes in interest rates
+200 basis points
+100 basis points
-100 basis points
-200 basis points
Many assumptions were utilized by management to calculate the impact that changes in interest rates may have on the Bank’s net interest income. The more significant assumptions related to the rate of prepayments of mortgage-related assets, loan and deposit volumes and pricing, and deposit maturities. The Bank assumed immediate changes in rates including 200 basis point rate changes. In the event that the 200 basis point rate changes cannot be achieved, the applicable rate changes are limited to lesser amounts such that interest rates cannot be less than zero. These assumptions are inherently uncertain and, as a result, the Bank cannot precisely predict the impact of changes in interest rates on net interest income. Actual results may differ significantly due to the timing, magnitude, and frequency of interest rate changes in market conditions and interest rate differentials (spreads) between maturity/repricing categories, as well as any actions such as those previously described, which management may take to counter such changes. In light of the uncertainties and assumptions associated with the process, the amounts presented in the table and changes in such amounts are not considered significant to the Bank’s projected net interest income.
ITEM 4—CONTROLS AND PROCEDURES
DISCLOSURE CONTROLS AND PROCEDURES
The Company’s management, with the participation of the Company’s principal executive officer and principal financial officer, evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of September 30, 2012 (the end of the period covered by this Report). Based on that evaluation, the Company’s principal executive and principal financial officers concluded that as of September 30, 2012 the Company’s disclosure controls and procedures were effective.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
No changes in the Company’s internal control over financial reporting were identified in connection with the evaluation required by paragraph (d) of Rule 13a-15 or Rule 15d-15 under the Exchange Act that occurred during the fiscal quarter ended September 30, 2012 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART II—OTHER INFORMATION
ITEM 6 — EXHIBITS
The information called for by this item is incorporated herein by reference to the Exhibit Index included immediately following the signature page to this Quarterly Report on Form 10-Q.
51
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.
52
EXHIBIT INDEX
53