SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
For the quarterly period March 31, 2016
or
For the transition period from to
Commission File Number 0-14492
FARMERS & MERCHANTS BANCORP, INC.
(Exact name of registrant as specified in its charter)
(419) 446-2501
Registrant’s telephone number, including area code
(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 Section 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.
Indicated 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 of each of the issuers’ classes of common stock, as of the latest practicable date:
Common Stock, No Par Value
4,605,534
Class
Washington, D.C. 20549
FORM 10Q
INDEX
Form 10-Q Items
2
ITEM 1 FINANCIAL STATEMENTS
FARMERS & MERCHANTS BANCORP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
Assets
Cash and due from banks
Federal funds sold
Total cash and cash equivalents
Interest-bearing time deposits
Securities - available-for-sale
Other securities, at cost
Loans, net
Premises and equipment
Goodwill
Mortgage servicing rights
Other real estate owned
Other assets
Total Assets
Liabilities and Stockholders’ Equity
Liabilities
Deposits
Noninterest-bearing
Interest-bearing
NOW accounts
Savings
Time
Total deposits
Federal Funds purchased and securities sold under agreements to repurchase
Federal Home Loan Bank (FHLB) advances
Dividend payable
Accrued expenses and other liabilities
Total liabilities
Commitments and Contingencies
Stockholders’ Equity
Common stock - No par value - 6,500,000 shares authorized 5,200,000 shares issued and outstanding
Treasury Stock - 594,466 shares 2016, 587,466 shares 2015
Retained earnings
Accumulated other comprehensive income
Total stockholders’ equity
Total Liabilities and Stockholders’ Equity
See Notes to Condensed Consolidated Unaudited Financial Statements.
Note: The December 31, 2015, Condensed Consolidated Balance Sheet has been derived from the audited Consolidated Balance Sheet as of that date.
3
CONDENSED CONSOLIDATED STATEMENTS OF INCOME & COMPREHENSIVE INCOME
(Unaudited)
Condensed Consolidated Statements of Income & Comprehensive Income
(in thousands of dollars, except per share data)
Interest Income
Loans, including fees
Debt securities:
U.S. Treasury and government agencies
Municipalities
Dividends
Other
Total interest income
Interest Expense
Federal funds purchased and securities sold under agreements to repurchase
Borrowed funds
Total interest expense
Net Interest Income - Before Provision for Loan Losses
Provision for Loan Losses
Net Interest Income After Provision
For Loan Losses
Noninterest Income
Customer service fees
Other service charges and fees
Net gain on sale of loans
Net gain on sale of available for sale securities
Total noninterest income
Noninterest Expense
Salaries and Wages
Employee benefits
Net occupancy expense
Furniture and equipment
Data processing
Franchise taxes
Net loss on sale of other assets owned
FDIC Assessment
Mortgage servicing rights amortization
Other general and administrative
Total other operating expenses
Income Before Income Taxes
Income Taxes
Net Income
Other Comprehensive Income (Net of Tax):
Net unrealized gain on available for sale securities
Reclassification adjustment for gain on sale of available for sale securities
Tax expense
Other comprehensive income
Comprehensive Income
Earnings Per Share - Basic and Diluted
Dividends Declared
See Notes to Condensed Consolidated Unaudited Financial Statements
4
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash Flows from Operating Activities
Net income
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation
Accretion and amortization of available for sale securities, net
Amortization of servicing rights
Amortization of core deposit intangible
Compensation expense related to stock awards
Provision for loan loss
Gain on sale of loans held for sale
Originations of loans held for sale
Proceeds from sale of loans held for sale
Loss on sale of other assets
Gain on sales of securities available for sale
Change in other assets and other liabilities, net
Net cash provided by operating activities
Cash Flows from Investing Activities
Activity in securities:
Maturities, prepayments and calls
Sales
Purchases
Net change in interest-bearing time deposits
Proceeds from sales of assets
Additions to premises and equipment
Loan originations and principal collections, net
Net cash provided by (used in) investing activities
Cash Flows from Financing Activities
Net change in deposits
Net change in federal funds purchased and securities sold under agreements to repurchase
Purchase of Treasury Stock
Cash dividends paid on common stock
Net cash provided by financing activities
Net Increase in Cash and Cash Equivalents
Cash and cash equivalents - Beginning of year
Cash and cash equivalents - End of period
Supplemental Information
Cash paid during the year for:
Interest
Income taxes
Noncash investing activities:
Transfer of loans to other real estate owned
5
NOTE 1 BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions for Form 10Q and Rule 10-01 of Regulation S-X; accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2016 are not necessarily indicative of the results that are expected for the year ended December 31, 2016. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2015.
NOTE 2 ASSET PURCHASES
The Company recognized core deposit intangible assets of $1.09 million with the purchase of the Hicksville office on July 9, 2010. These are being amortized over an estimated remaining economic useful life of the deposits of 7 years on a straight line basis.
An office was purchased on December 13, 2013 in Custar, Ohio. Core deposit intangible assets of $1.17 million were recognized and are being amortized over its remaining economic useful life of the deposits of 7 years on a straight line basis.
The amortization expense for the year ended December 31, 2015 was $323 thousand. Of the $322 thousand to be expensed in 2016, $81 thousand has been expensed for the three months ended March 31, 2016. $81 thousand was also expensed for the three months ended March 31, 2015.
2016
2017
2018
2019
2020
Thereafter
6
NOTE 3 SECURITIES
The amortized cost and fair value of securities, with gross unrealized gains and losses, follows:
Available-for-Sale:
U.S. Treasury
U.S. Government agencies
Mortgage-backed securities
State and local governments
Total available-for-sale securities
Investment securities will at times depreciate to an unrealized loss position. The Company utilizes the following criteria to assess whether impairment is other than temporary. No one item by itself will necessarily signal that a security should be recognized as an other than temporary impairment.
If the impairment is judged to be other than temporary, the cost basis of the individual security shall be written down to fair value, thereby establishing a new cost basis. The new cost basis shall not be changed for subsequent recoveries in fair value. The amount of the write down shall be included in current earnings as a realized loss. The recovery in fair value, if any, shall be recognized in earnings when the security is sold. The table below is presented by category of security and length of time in a continuous loss position. The Company currently does not hold any securities with other than temporary impairment.
7
NOTE 3 SECURITIES (Continued)
Information pertaining to securities with gross unrealized losses at March 31, 2016 and December 31, 2015, aggregated by investment category and length of time that individual securities have been in a continuous loss position follows:
Unrealized losses on securities have not been recognized into income because the issuers’ bonds are of high credit quality, values have only been impacted by rate changes, and the Company has the intent and ability to hold the securities for the foreseeable future. Additionally, the decline in value is primarily due to changes in interest rates since the securities were purchased. The fair value is expected to recover as the bonds approach the maturity date.
Below are the gross realized gains and losses as of March 31 for each of the years presented.
Gross realized gains
Gross realized losses
Net realized gains
Tax expense related to net realized gain
The net realized gain on sales and related tax expense is a reclassification out of accumulated other comprehensive income (loss). The net realized gain is included in net gain on sale of securities available-for-sale and the related tax expense is included in income tax expense in the condensed consolidated statements of income and comprehensive income.
8
The amortized cost and fair value of debt securities at March 31, 2016, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
One year or less
After one year through five years
After five years through ten years
After ten years
Total
Investments with a carrying value of $197.1 million and $189.3 million at March 31, 2016 and December 31, 2015, respectively, were pledged to secure public deposits and securities sold under repurchase agreements.
Other securities include Federal Home Loan Bank of Cincinnati and Farmer Mac stock as of March 31, 2016 and December 31, 2015.
NOTE 4 LOANS
The Company had $1.1 million in loans held for sale at March 31, 2016 as compared to $1.2 million in loans held for sale at December 31, 2015. Due to materiality, these loans are included in the Consumer Real Estate and Agricultural Real Estate loan numbers.
Loan balances as of March 31, 2016 and December 31, 2015:
Loans:
Consumer Real Estate
Agricultural Real Estate
Agricultural
Commercial Real Estate
Commercial and Industrial
Consumer
Industrial Development Bonds
Less: Net deferred loan fees and costs
Less: Allowance for loan losses
Loans - Net
9
NOTE 4 LOANS (Continued)
The following is a maturity schedule by major category of loans as of March 31, 2016:
The distribution of fixed rate loans and variable rate loans by major loan category is as follows as of March 31, 2016. Variable rate loans whose current rates are equal to their floor or ceiling are classified as fixed in this table.
As of March 31, 2016 and December 31, 2015 one to four family residential mortgage loans amounting to $18.8 and $20.0 million, respectively, have been pledged as security for future loans the Bank has received from the Federal Home Loan Bank.
Unless listed separately, Industrial Development Bonds are included in the commercial and industrial category for the remainder of the tables in this Note 4.
10
The following table represents the contractual aging of the recorded investment in past due loans by portfolio classification of loans as of March 31, 2016 and December 31, 2015, net of deferred loan fees and costs:
11
The following table presents the recorded investment in nonaccrual loans by class of loans as of March 31, 2016 and December 31, 2015:
Commercial
Following are the characteristics and underwriting criteria for each major type of loan the Bank offers:
Commercial Real Estate – Construction, purchase, and refinance of business purpose real estate. Risks discussed during the approval process include construction delays and overruns, vacancies, collateral value subject to market value fluctuations, interest rate, market demands, borrower’s ability to repay in a timely fashion, and others. The Bank does employ stress testing on higher balance loans to mitigate risk by ensuring the customer’s ability to repay in a changing rate environment.
Agricultural Real Estate – Purchase of farm real estate or for permanent improvements to the farm real estate. Cash flow from the farm operation is the repayment source and is therefore subject to the financial success of the farm operation.
Consumer Real Estate – Purchase, refinance, or equity financing of one to four family owner occupied dwelling. Success in repayment is subject to borrower’s income, debt level, character in fulfilling payment obligations, employment, and others.
Commercial and Industrial – Loans to proprietorships, partnerships, or corporations to provide temporary working capital and seasonal loans as well as long term loans for capital asset acquisition. Risks include adequacy of cash flow, reasonableness of projections, financial leverage, economic trends, management ability and estimated capital expenditures during the fiscal year. The Bank does employ stress testing on higher balance loans to mitigate risk by ensuring the customer’s ability to repay in a changing rate environment before granting loan approval.
Agricultural – Loans for the production and housing of crops, fruits, vegetables, and livestock or to fund the purchase or re-finance of capital assets such as machinery and equipment and livestock. The production of crops and livestock is especially vulnerable to commodity prices and weather. The vulnerability to commodity prices is offset by the farmer’s ability to hedge their position by the use of the future contracts. The risk related to weather is often mitigated by requiring federal crop insurance.
Consumer – Funding for individual and family purposes. Success in repayment is subject to borrower’s income, debt level, character in fulfilling payment obligations, employment, and others.
Industrial Development Bonds – Funds for public improvements in the Bank’s service area. Repayment ability is based on the continuance of the taxation revenue as the source of repayment.
12
The Bank uses a nine tier risk rating system to grade its loans. The grade of a loan may change during the life of the loan.
The risk ratings are described as follows.
Loans may be graded 3 when there is no recent information on which to base a current risk evaluation and the following conditions apply:
At inception, the loan was properly underwritten and did not possess an unwarranted level of credit risk:
13
14
The following table represents the risk category of loans by portfolio class, net of deferred fees and costs, based on the most recent analysis performed as of March 31, 2016 and December 31, 2015:
March 31, 2016
1-2
December 31, 2015
15
For consumer residential real estate, and other, the Company also evaluates credit quality based on the aging status of the loan, which was previously stated, and by payment activity. The following tables present the recorded investment in those classes based on payment activity and assigned risk grading as of March 31, 2016 and December 31, 2015.
Grade
Pass
Special Mention (5)
Substandard (6)
Doubtful (7)
Performing
Nonperforming
Information about impaired loans as of March 31, 2016, December 31, 2015 and March 31, 2015 are as follows:
Impaired loans without a valuation allowance
Impaired loans with a valuation allowance
Total impaired loans
Valuation allowance related to impaired loans
Total non-accrual loans
Total loans past-due ninety days or more and still accruing
Quarter ended average investment in impaired loans
Year to date average investment in impaired loans
No additional funds are committed to be advanced in connection with impaired loans.
16
The Bank had approximately $1.1 million of its impaired loans classified as troubled debt restructured (TDR) as of March 31, 2016, $1.1 million as of December 31, 2015 and $1.3 million as of March 31, 2015. During the first quarter 2016, one new loan was considered TDR. This loan is making interest-only payments.
The following table represents three months ended March 31, 2016.
Three Months
Troubled Debt Restructurings
The following table represents three months ended March 31, 2015.
March 31, 2015
For the three month period ended March 31, 2016 and 2015, there were no TDRs that subsequently defaulted after modification.
For the majority of the Bank’s impaired loans, the Bank will apply the fair value of collateral or use a measurement incorporating the present value of expected future cash flows discounted at the loan’s effective rate of interest. To determine fair value of collateral, collateral asset values securing an impaired loan are periodically evaluated. Maximum time of re-evaluation is every 12 months for chattels and titled vehicles and every two years for real estate. In this process, third party evaluations are obtained. Until such time that updated appraisals are received, the Bank may discount the collateral value used.
The Bank uses the following guidelines as stated in policy to determine when to realize a charge-off, whether a partial or full loan balance. A charge-off in whole or in part is realized when unsecured consumer loans, credit card credits and overdraft lines of credit reach 90 days delinquency. At 120 days delinquent, secured consumer loans are charged down to the value of the collateral, if repossession of the collateral is assured and/or in the process of repossession. Consumer mortgage loan deficiencies are charged down upon the sale of the collateral or sooner upon the recognition of collateral deficiency. Commercial and agricultural credits are charged down at 120 days delinquency, unless an established and approved work-out plan is in place or litigation of the credit will likely result in recovery of the loan balance. Upon notification of bankruptcy, unsecured debt is charged off. Additional charge-off may be realized as further unsecured positions are recognized.
17
The following tables present loans individually evaluated for impairment by class of loans for three months ended March 31, 2016 and March 31, 2015.
With no related allowance recorded:
With a specific allowance recorded:
Totals:
18
As of March 31, 2016, the Company had $456 thousand of foreclosed residential real estate property obtained by physical possession and $568 thousand of consumer mortgage loans secured by residential real estate properties for which foreclosure proceedings are in process according to local jurisdictions.
The Allowance for Loan and Lease Losses (ALLL) has a direct impact on the provision expense. An increase in the ALLL is funded through recoveries and provision expense. The following tables summarize the activities in the allowance for credit losses.
Allowance for Loan & Lease Losses
Balance at beginning of year
Loans charged off
Recoveries
Allowance for Unfunded Loan Commitments & Letters of Credit
Total Allowance for Credit Losses
19
The Company segregates its ALLL into two reserves: The ALLL and the Allowance for Unfunded Loan Commitments and Letters of Credit (AULC). When combined, these reserves constitute the total Allowance for Credit Losses (ACL).
The AULC is reported within other liabilities on the balance sheet while the ALLL is netted within the loans, net asset line. The ACL presented above represents the full amount of reserves available to absorb possible credit losses.
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20
The following table breaks down the activity within ACL for each loan portfolio classification and shows the contribution provided by both the recoveries and the provision along with the reduction of the allowance caused by charge-offs.
Additional analysis related to the allowance for credit losses for three months ended March 31, 2016 and March 31, 2015 is as follows:
Three Months Ended March 31, 2016
ALLOWANCE FOR CREDIT LOSSES:
Beginning balance
Charge Offs
Provision (Credit)
Other Non-interest expense related to unfunded
Ending Balance
Ending balance: individually evaluated for impairment
Ending balance: collectively evaluated for impairment
Ending balance: loans acquired with deteriorated credit quality
FINANCING RECEIVABLES:
Ending balance
21
Three Months Ended March 31, 2015
22
NOTE 5 EARNINGS PER SHARE
Basic earnings per share are calculated using the two-class method. The two-class method is an earnings allocation formula under which earnings per share is calculated from common stock and participating securities according to dividends declared and participation rights in undistributed earnings. Under this method, all earnings distributed and undistributed, are allocated to participating securities and common shares based on their respective rights to receive dividends. Unvested share-based payment awards that contain non-forfeitable rights to dividends are considered participating securities (i.e. unvested restricted stock), not subject to performance based measures. Basic earnings per share is calculated by dividing net income available to common shareholders by the weighted average number of common shares outstanding. Application of the two-class method for participating securities results a more dilutive basic earnings per share as the participating securities are allocated the same amount of income as if they are outstanding for purposes of basic earnings per share. There is no additional potential dilution in calculating diluted earnings per share, therefore basic and diluted earnings per share are the same amounts. Other than the restricted stock plan, the Company has no other stock based compensation plans.
Earnings per share
Less: distributed earnings allocated to participating securities
Less: undistributed earnings allocated to participating securities
Net earnings available to common shareholders
Weighted average common shares outstanding including participating securities
Less: average unvested restricted shares
Weighted average common shares outstanding
Basic earnings and diluted per share
NOTE 6 FAIR VALUE OF INSTRUMENTS
FAIR VALUE OF FINANCIAL INSTRUMENTS
Fair values of financial instruments are management’s estimate of the values at which the instruments could be exchanged in a transaction between willing parties. These estimates are subjective and may vary significantly from amounts that would be realized in actual transactions. In addition, other significant assets are not considered financial assets including deferred tax assets, premises, equipment and intangibles. Further, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on the fair value estimates and have not been considered in any of the estimates.
The following assumptions and methods were used in estimating the fair value for financial instruments.
Cash and Cash Equivalents
The carrying amounts reported in the balance sheet for cash, cash equivalents and federal funds sold approximate their fair values. Also included in this line item are the carrying amounts of interest-bearing deposits maturing within ninety days which approximate their fair values. Fair values of other interest-bearing deposits are estimated using discounted cash flow analyses based on current rates for similar types of deposits.
23
NOTE 6 FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)
Interest Bearing Time Deposits
Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow analysis that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.
Securities – Available-for-sale
Fair values for securities, excluding Federal Home Loan Bank and Farmer Mac stock, are based on quoted market price, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments.
Other Securities
The carrying value of Federal Home Loan Bank and Farmer Mac stock, listed as “other securities”, approximates fair value based on the redemption provisions of the Federal Home Loan Bank.
For those variable-rate loans that re-price frequently, and with no significant change in credit risk, fair values are based on carrying values. The fair values of the fixed rate and all other loans are estimated using discounted cash flow analysis, using interest rates currently being offered for loans with similar terms to borrowers with similar credit quality.
The fair values disclosed for deposits with no defined maturities are equal to their carrying amounts, which represent the amount payable on demand. The carrying amounts for variable-rate, fixed term money market accounts and certificates of deposit approximate their fair value at the reporting date. Fair value for fixed-rate certificates of deposit are estimated using a discounted cash flow analysis that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.
Federal Funds Purchased and Securities Sold Under Agreements to Repurchase
The carrying value of federal funds purchased and securities sold under agreements to repurchase approximates fair values.
Accrued Interest Receivable and Payable
The carrying amounts of accrued interest approximate their fair values.
Dividends Payable
The carrying amounts of dividends payable approximate their fair values and are generally paid within forty days of declaration.
Off Balance Sheet Financial Instruments
Fair values for off-balance sheet, credit related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counter-parties’ credit standing.
24
The estimated fair values, and related carrying or notional amounts, for on and off-balance sheet financial instruments as of March 31, 2016 and December 31, 2015 are reflected below.
Financial Assets:
Interest receivable
Financial Liabilities:
Interest bearing Deposits
Non-interest bearing Deposits
Time Deposits
Total Deposits
Fed Funds purchased and Securities sold under agreement to repurchase
Federal Home Loan Bank advances
Interest payable
25
Securities—available-for-sale
Federal Funds Purchased and Securities Sold Under Agreement to Repurchase
Fair Value Measurements
In general, fair values determined by Level 1 inputs use quoted prices in active markets for identical assets or liabilities in active markets that the Company has the ability to access.
Available-for-sale securities, when quoted prices are available in an active market, securities are valued using the quoted price and are classified as Level 1.
Fair values determined by Level 2 inputs use other inputs that are observable, either directly or indirectly. These Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals.
Available-for-sale securities classified as Level 2 are valued using the prices obtained from an independent pricing service. The prices are not adjusted. Securities of obligations of state and political subdivisions are valued using a type of matrix, or grid, pricing in which securities are benchmarked against the treasury rate based on credit rating. Substantially all assumptions used by the independent pricing service are observable in the marketplace, can be derived from observable data, or are supported by observable levels at which transactions are executed in the marketplace.
Level 3 inputs are unobservable inputs, including inputs that are available in situations where there is little, if any, market activity for the related asset or liability. The Bank holds some local municipals that the Bank evaluates based on the credit strength of the underlying project such as hospital or retirement housing. The fair value is determined by valuing similar credit payment streams at similar rates.
26
In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest level input that is significant to the valuation. The Company’s assessment of the significance of particular inputs to these fair value measurements requires judgment and considers factors specific to each asset.
The following summarizes financial assets measured at fair value on a recurring basis as of March 31, 2016 and December 31, 2015, segregated by level or the valuation inputs within the fair value hierarchy utilized to measure fair value:
Assets and Liabilities Measured at Fair Value on a Recurring Basis (In Thousands)
Assets—(Securities Available-for-Sale)
Total Securities Available-for-Sale
27
The following table represents the changes in the Level 3 fair-value category of which unobservable inputs are relied upon as of March 31, 2016 and March 31, 2015.
Balance at January 1, 2016
Change in Market Value
Payments & Maturities
Balance at March 31, 2016
Balance at January 1, 2015
Balance at March 31, 2015
Most of the Company’s available-for-sale securities, including any bonds issued by local municipalities, have CUSIP numbers or have similar characteristics of those in the municipal markets, making them marketable and comparable as Level 2.
The Company also has assets that, under certain conditions, are subject to measurement at fair value on a non-recurring basis. At March 31, 2016 and December 31, 2015, such assets consist primarily of collateral dependent impaired loans. Collateral dependent impaired loans categorized as Level 3 assets consist of non-homogeneous loans that are considered impaired. The Company estimates the fair value of the loans based on the present value of expected future cash flows using management’s best estimate of key assumptions. These assumptions include future payment ability, timing of payment streams, and estimated realizable values of available collateral (typically based on outside appraisals.)
28
At March 31, 2016 and December 31, 2015, fair value of collateral dependent impaired loans categorized as Level 3 were $0.7 and $0.5 million, respectively. The specific allocation for impaired loans was $426 and $330 thousand as of March 31, 2016 and December 31, 2015, respectively, which are accounted for in the allowance for loan losses (see Note 4).
Other real estate is reported at either the lower of the fair value of the real estate minus the estimated costs to sell the asset or the cost of the asset. The determination of fair value of the real estate relies primarily on appraisals from third parties. If the fair value of the real estate, minus the estimated costs to sell the asset, is less than the asset’s cost, the deficiency is recognized as a valuation allowance against the asset through a charge to expense. The valuation allowance is therefore increased or decreased, through charges or credits to expense, for changes in the asset’s fair value or estimated selling costs.
The following table presents quantitative information about unobservable inputs used in recurring and nonrecurring Level 3 fair value measurements:
Valuation Technique
Unobservable Inputs
State and local government
Collateral dependent Impaired loans
Other real estate owned—commercial
29
The following table presents impaired loans and other real estate owned as recorded at fair value on March 31, 2016 and December 31, 2015:
Collateral dependent impaired loans
Total change in fair value
The Company also has other assets, which under certain conditions, are subject to measurement at fair value. These assets include loans held for sale, bank owned life insurance, and mortgage servicing rights. The Company estimated the fair values of these assets utilizing Level 3 inputs, including, the discounted present value of expected future cash flows. At March 31, 2016 and December 31, 2015, the Company estimates that there is no impairment of these assets.
30
The Company had $9 million and $22 million in Federal Funds Purchased as of March 31, 2016, and December 31, 2015, respectively. During the same time periods the company also had $60 million and $57 million in securities sold under agreement to repurchase.
Federal funds purchased
Repurchase Agreements
US Treasury & agency securities
OVERVIEW
The momentum of 2015 loan growth continued through the first quarter of 2016. Higher loan balances drove the improvement in net interest income along with overall net income. Competition remains challenging, especially for the well performing larger balance customers.
The agricultural market is facing a tougher environment this season with lower commodity prices, higher input prices and currently wet fields. Many are working with decreasing working capital which is both beneficial and slightly worrisome for the Bank. Important to note, the observation is decreasing, not insufficient capital. At this time it is felt, tighter profit margins may impact equipment valuations, purchases and sales. Land prices have decreased slightly with the greater fluctuations in the lower quality land.
Unemployment rates continue to improve throughout the Company’s market area. Manufacturing activity remains similar to last year and car dealerships are reporting strong sales. Low gas prices continue to help the local economies.
Overall, the 1-4 family business has improved with increased activity in the first quarter. New regulatory rules which became effective in 2015 continue to constrain the offering of construction loans. While some community banks are leaving this market, F&M is working to design products that comply with the regulatory requirements and meet our customer’s needs. The construction loan products should be ready for bank-wide implementation in the second quarter.
31
Loan growth drove the improvement in net interest income as compared to last year and was the driving factor for the increased loan loss provision. Noninterest income also strengthened and net income after taxes ended the first quarter 2016 5.5% above first quarter 2015. The 7.2% increase in net interest income after provision for loan losses, and a 4.4% increase in noninterest income, partially offset by a 6.4% increase in noninterest expense resulted in a 5.9% increase in earnings per share for the 2016 quarter as compared to 2015’s first quarter.
NATURE OF ACTIVITIES
Farmers & Merchants Bancorp, Inc. (Company) is a financial holding company incorporated under the laws of Ohio in 1985. Our subsidiaries are, The Farmers & Merchants State Bank (Bank), a community bank operating in Northwest Ohio since 1897 and Farmers & Merchants Risk Management, Inc., a captive insurance company formed in December 2014 and is located in Nevada. We report our financial condition and net income on a consolidated basis and we have only one segment.
Our executive offices are located at 307 North Defiance Street, Archbold, Ohio 43502, and our telephone number is (419) 446-2501.
The Bank opened an additional office during April of 2016 in Fort Wayne, Indiana. The office is located within the corporation limits of Huntertown, with a Fort Wayne address. The Bank has continued its expansion strategy and the new office is expected to provide new growth opportunities. The doors officially opened on April 7th.
The Farmers & Merchants State Bank engages in general commercial banking and savings business including commercial, agricultural and residential mortgage, consumer and credit card lending activities. The largest segment of the lending business relates to commercial, both real estate and non-real estate. The type of commercial business ranges from small business to multi-million dollar companies. The loans are a reflection of business located within the Banks’ market area. Because the Bank’s offices are located in Northwest Ohio and Northeast Indiana, a substantial amount of the loan portfolio is comprised of loans made to customers in the farming industry for such items as farm land, farm equipment, livestock and operating loans for seed, fertilizer, and feed. Other types of lending activities include loans for home improvements, and loans for the purchase of autos, trucks, recreational vehicles, motorcycles, and other consumer goods.
The Bank also provides checking account services, as well as savings and time deposit services such as certificates of deposits. In addition. Automated Teller Machines (ATMs) are provided at most branch locations along with other independent locations such as major employers and hospitals in the market area. The Bank has custodial services for Individual Retirement Accounts (IRAs) and Health Savings Accounts (HSAs) . The Bank provides on-line banking access for consumer and business customers. For consumers, this includes bill-pay, on-line statement opportunities and mobile banking. For business customers, it provides the option of electronic transaction origination such as wire and Automated Clearing House (ACH) file transmittal. In addition, the Bank offers remote deposit capture or electronic deposit processing and merchant credit card services. Mobile banking was added in 2012 and has been widely accepted and used by consumers. Over the past couple of years, the Bank has updated its consumer offerings with “Secure” and “Pure” checking in 2014 and with KASASA Cash Bank in 2015. Upgrades to our digital products and services continue to occur in both retail and business lines.
The Bank has established underwriting policies and procedures which facilitate operating in a safe and sound manner in accordance with supervisory and regulatory guidance. Within this sphere of safety and soundness, the Bank’s practice has been to not promote innovative, unproven credit products which may not be in the best interest of the Bank or its customers. The Bank does offer a hybrid mortgage loan. Hybrid loans are loans that start out as a fixed rate mortgage but after a set number of years automatically adjust to an adjustable rate mortgage. The Bank offers a three year fixed rate mortgage after which the interest rate will adjust annually. The majority of the Bank’s adjustable rate mortgages are of this type. In order to offer longer term fixed rate mortgages, the Bank does participate in the Freddie Mac, Farmer
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Mac and Small Business Lending programs. The Bank also normally retains the servicing rights on these partially or 100% sold loans. In order for the customer to participate in these programs they must meet the requirements established by those agencies. In addition, the Bank does sell some of its longer term fixed rate agricultural mortgages into the secondary market with the aid of a broker.
The Bank does not have a program to fund sub-prime loans. Sub-prime loans are characterized as a lending program or strategy that targets borrowers who pose a significantly higher risk of default than traditional retail banking customers.
All loan requests are reviewed as to credit worthiness and are subject to the Bank’s underwriting guidelines as to secured versus unsecured credit. Secured loans are in turn subject to loan to value (LTV) requirements based on collateral types as set forth in the Bank’s Loan Policy. In addition, credit scores of principal borrowers are reviewed and an approved exception from an additional officer is required should a credit score not meet the Bank’s Loan Policy guidelines.
Consumer Loans:
Commercial/Agriculture/Real Estate:
Inventory:
Livestock and grain up to 80% LTV, crops (insured) up to 75% and Warehouse Receipts up to 87%.
Maximum LTV of 50% on raw and finished goods.
Equipment:
F&M Investment Services, the brokerage department of the Bank, opened for business in April, 1999. Securities are offered through Raymond James Financial Services, Inc.
In December of 2014, the Company became a financial holding company within the meaning of the Bank Holding Company Act of 1956 as amended (the “Act”), in order to provide the flexibility to take advantage of the expanded powers available to a financial holding company under the Act. Our subsidiary bank is in turn regulated and examined by the Ohio Division of Financial Institutions and the Federal Deposit Insurance Corporation. The activities of our bank subsidiary are also subject to other federal and state laws and regulations. The Company also formed a captive insurance company (the “captive”) in December 2014 which is located in Nevada and regulated by the State of Nevada Division of Insurance. To enable the formation of the captive, the Company’s status was changed to a financial holding company from a bank holding company.
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The Bank’s primary market includes communities located in the Ohio counties of Defiance, Fulton, Henry, Lucas, Williams, Wood and in the Indiana counties of DeKalb and Steuben. In the first half of 2016 the Bank will add the Indiana county of Allen to its service area with the opening of its newly constructed office in Fort Wayne. The commercial banking business in this market is highly competitive, with approximately 17 other depository institutions currently doing business in the Bank’s primary market. In our banking activities, we compete directly with other commercial banks, credit unions, farm credit services, and savings and loan institutions in each of our operating localities. In a number of our locations, we compete against entities which are much larger than us. The primary factors in competing for loans and deposits are the rates charged as well as location and quality of the services provided.
At March 31, 2016, we had 264 full time equivalent employees. The employees are not represented by a collective bargaining unit. We provide our employees with a comprehensive benefit program, some of which are contributory. We consider our employee relations to be good.
REGULATORY DEVELOPMENTS
The Bank has been attentive to the significant final mortgage rules, revisions to the rules, and additional guidance issued by the Consumer Financial Protection Bureau to implement the Dodd-Frank Wall Street Reform and Consumer Protection Act provisions. Effective in January 2014, these rules have altered the landscape for the entire mortgage lending industry. The Bank continues to test, train, validate results, and review the applicable requirements of these new mortgage rules to enhance knowledge and understanding. The TILA-RESPA Integrated Disclosure (TRID) rules which were originally to be effective on August 1, 2015 were subsequently postponed until October 3, 2015. Bank staff worked closely with the Mortgage Loan Origination software vendor and diligently strived to achieve TRID compliance as of the October 2015 effective date. The vendor has been attentive to the key regulatory requirements and receptive to its individual clients’ needs. Further changes and enhancements to the loan origination software have served to better accommodate documentation needs and compliance strategies. Bank staff has continued outreach efforts with real estate agents, attorneys, and closing agents to further cultivate collaboration and attain TRID compliance, and thus minimize the impact of these regulatory changes on home loan borrowers. Due to the complexities of the new TRID rules, the lack of clarity or guidance involving various provisions, and the lingering uncertainties regarding liability, remaining attentive to industry questions and concerns to ensure full compliance remains an ongoing priority. The Bank has committed to make good faith efforts in compliance with the technical requirements of the TRID rules.
The Company has implemented Basel III capital rules which began to be phased in for the Company on January 1, 2015. These rules may impact the ability of some financial institutions to pay dividends, though the Company believes itself to be able to maintain its strong capital position and not be limited in that regard.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, and the Company follows general practices within the financial services industry in which it operates. At times the application of these principles requires management to make assumptions, estimates and judgments that affect the amounts reported in the financial statements and accompanying notes.
These assumptions, estimates and judgments are based on information available as of the date of the financial statements. As this information changes, the financial statements could reflect different assumptions, estimates and judgments. Certain policies inherently have a greater reliance on assumptions, estimates and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Examples of critical assumptions, estimates and judgments are when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not required to be recorded at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability must be recorded contingent upon a future event.
These policies, along with the disclosures presented in the notes to the condensed consolidated financial statements and in the management discussion and analysis of the financial condition and results of operations, provide information on how significant assets and liabilities are valued and how those values are determined for the financial statements. Based on the valuation techniques used and the sensitivity of financial statement amounts to assumptions, estimates, and judgments underlying those amounts, management has identified the determination of the Allowance for Loan and Lease Losses (ALLL), the valuation of its Mortgage Servicing Rights and OREO as the accounting areas that require the most subjective or complex judgments, and as such could be the most subject to revision as new information becomes available.
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Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at fair value at the date of foreclosure. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell.
Foreclosed real estate for sale is carried at the lower of fair value minus estimated costs to sell, or cost. Costs of holding foreclosed real estate are charged to expense in the current period, except for significant property improvements, which are capitalized. Valuations are periodically performed by management and a write-down is recorded by a charge to non-interest expense if the carrying value exceeds the fair value minus estimated costs to sell. Foreclosed real estate is classified as OREO. The net income from operations of foreclosed real estate held for sale is reported in non-interest income or non-interest expense determined by whether in a gain or loss position overall. At March 31, 2016, holdings were $1.1 million and were $1.2 million as of December 31, 2015 and $1.1 million as of March 31, 2015.
The ALLL and ACL represents management’s estimate of probable credit losses inherent in the Bank’s loan portfolio, unfunded loan commitments, and letters of credit at the report date. The ALLL methodology is regularly reviewed for its appropriateness and is approved annually by the Board of Directors. This written methodology is consistent with Generally Accepted Accounting Principles which provides for a consistently applied analysis.
The Bank’s methodology provides an estimate of the probable credit losses either by calculating a specific loss per credit or by applying a composite of historical factors over a relevant period of time with current internal and external factors which may affect credit collectability. Such factors which may influence estimated losses are the conditions of the local and national economy, local unemployment trends, and abilities of lending staff, valuation trends of fixed assets, and trends in credit delinquency, classified credits, and credit losses.
Inherent in most estimates is imprecision. The Bank’s ALLL provides a margin for imprecision with an unallocated portion. Bank regulatory agencies and external auditors periodically review the Bank’s methodology and adequacy of the ALLL. Any required changes in the ALLL or loan charge-offs by these agencies or auditors may have a material effect on the ALLL.
The Company is required to estimate the value of its Mortgage Servicing Rights. The Company recognizes as separate assets rights to service fixed rate single-family mortgage loans that it has sold without recourse but services for others for a fee. Mortgage servicing assets are initially recorded at cost, based upon pricing multiples as determined by the purchaser, when the loans are sold. Mortgage servicing assets are carried at the lower of the initial carrying value, adjusted for amortization, or estimated fair value. Amortization is determined in proportion to and over the period of estimated net servicing income using the level yield method. For purposes of determining impairment, the mortgage servicing assets are stratified into like groups based on loan type, term, new versus seasoned and interest rate. The valuation is completed by an independent third party.
The expected and actual rates of mortgage loan prepayments are the most significant factors driving the potential for the impairment of the value of mortgage servicing assets. Increases in mortgage loan prepayments reduce estimated future net servicing cash flows because the life of the underlying loan is reduced.
The Company’s mortgage servicing rights relating to loans serviced for others represent an asset of the company. This asset is initially capitalized and included in other assets on the Company’s consolidated balance sheet. The mortgage servicing rights are then amortized against noninterest income in proportion to, and over the period of the estimated future net servicing income of the underlying mortgage servicing rights. The amortization thereof is recorded in non-interest expense. There are a number of factors, however, that can affect the ultimate value of the mortgage servicing rights to the Company, including the estimated prepayment speed of the loan and the discount rate used to present value the servicing right. For example, if the mortgage loan is prepaid, the Company will receive fewer servicing fees, meaning that the present value of the mortgage servicing rights is less than the carrying value of those rights on the Company’s balance sheet. Therefore, in an attempt to reflect an accurate expected value to the Company of the mortgage servicing rights, the Company receives a valuation of its mortgage servicing rights from an independent third party. The independent third party’s valuation of the mortgage servicing rights is based on relevant characteristics of the Company’s loan servicing portfolio, such as loan terms, interest rates and recent national prepayment experience, as
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well as current national market interest rate levels, market forecasts and other economic conditions. Management, with the advice from its third party valuation firm, reviewed the assumptions related to prepayment speeds, discount rates, and capitalized mortgage servicing income on a quarterly basis. Changes are reflected in the following quarter’s analysis
related to the mortgage servicing asset. In addition, based upon the independent third party’s valuation of the Company’s mortgage servicing rights, management then establishes a valuation allowance by each strata, if necessary, to quantify the likely impairment of the value of the mortgage servicing rights to the Company. The estimates of prepayment speeds and discount rates are inherently uncertain, and different estimates could have a material impact on the Company’s net income and results of operations. The valuation allowance is evaluated and adjusted quarterly by management to reflect changes in the fair value of the underlying mortgage servicing rights based on market conditions. The accuracy of these estimates and assumptions by management and its third party valuation specialist can be directly tied back to the fact that management has only been required to record minor valuation allowances through its income statement over time based upon the valuation of each stratum of servicing rights. For more information regarding the estimates and calculations used to establish the ALLL and the value of Mortgage Servicing Rights, please see Note 1 to the consolidated financial statements provided herewith.
MATERIAL CHANGES IN FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
The Company ended March 31, 2016 with its total asset balance over a billion dollars. It represents a new record high in the Company’s 119 year history. The Company plans to continue in its growth mode with the addition of the Bank’s 23rd office which opened April 7, 2016 in Indiana, making it the fourth office in the state.
Liquidity in terms of cash and cash equivalents ended almost $4.9 million higher as of March 31, 2016 than it was at yearend December 31, 2015. Decreased securities along with increased deposits funded the $21.6 million in increase in net loans for the quarter. Loan growth occurred in commercial real estate, commercial and industrial, agricultural real estate and agricultural and consumer portfolios. These were slightly offset by the decrease in consumer real estate.
In comparing to the same period, prior year, the March 31, 2016 record loan balances of $707.6 million increased 15.1% compared to $614.7 million. The year over year improvement was made up of a 27.1% increase in commercial real estate loans, a 15.7% increase in agricultural real estate loans, a 9.0% increase in non-real estate agricultural loans and an 8.2% increase in commercial and industrial loans. The only portfolio which experienced a reduction was consumer real estate by 9.0%. The Company credits the growth to a strong team of lenders focused on providing customers valuable localized services and thereby increasing our market share.
The chart below shows the breakdown of the loan portfolio by category as of March 31 for the last three years, net of deferred fees and costs.
Total Loans, net
As mentioned previously, the security portfolio was utilized to fund loan growth in both 2015 and the first quarter 2016. The security portfolio decreased $8.6 million in the first quarter 2016 from yearend 2015 and is lower by $19.6 million from March 31, 2015. The current portfolio is in a net unrealized gain position of $2.2 million. With the exception of stock, which is shown as other securities, all of the Company’s security portfolio is categorized as “available for sale” and as such is recorded at fair value.
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Management feels confident that liquidity needs for future growth can be met through additional run-off and/or sales from the security portfolio, increased deposits and additional borrowings. For short term needs, the Bank has $104.2 million of unsecured borrowing capacity through its correspondent banks.
Overall assets grew 2.0% since yearend 2015 and 6.1% since March 31, 2015. The largest growth was in the targeted loan portfolios.
Deposits accounted for the largest growth within liabilities, up 3.5% or $26.8 million since yearend and 2.8% or $21.4 million over March 31, 2015 balances. Core deposits continue to drive the increase which provide the greatest benefit for both lower cost of funds and the opportunity to generate additional noninterest income. When comparing to a year ago, other borrowed money increased $10 million as the borrowings took place during the fourth quarter of 2015.
Federal Funds purchased and securities sold under agreement to repurchase increased $17.6 million when comparing March 31, 2016 balances to March 31, 2015. This category decreased by $9.4 million when comparing March 31, 2016 to December 31, 2015. Borrowings from FHLB aided in the quarter decrease as these replaced $10 million of Fed Funds purchased.
Capital increased $2.6 million during the first quarter of 2016, as earnings exceeded dividend declarations. Accumulated other comprehensive income increased in gain position $1.2 million which encompassed the shift of $113 thousand from unrealized gain to realized gain with the sale of securities since yearend 2015. Dividends paid year-to-date differed by $42 thousand from the same period last year.
The beginning of the Basel III capital rule applies in 2016. The Bank and Company include a capital conservation buffer as a part of the transition provision. For calendar year 2016, the applicable required capital conservation buffer percentage of 0.625% is the base above which institutions avoid limitations on distributions and certain discretionary bonus payments. The total buffer requirement will increase to 2.5% for calendar year 2019. As of March 31, 2016, the Company and the Bank are both positioned well above the 2019 requirement.
The Company continues to be well-capitalized in accordance with Federal regulatory capital requirements as the capital ratios below show:
Tier I Leverage Ratio
Risk Based Capital Tier I
Total Risk Based Capital
Stockholders’ Equity/Total Assets
Capital Conservation Buffer
MATERIAL CHANGES IN RESULTS OF OPERATIONS
Comparison of Results of Operation for three month periods ended March 31, 2016 and 2015, and December 31, 2015.
Higher loan balances created the improvement in the interest income for the first quarter 2016 as compared to first quarter 2015. Interest income rose 10% or $820 thousand while loans accounted for a $912 thousand increase. Offsetting the improvement from loans was a decrease in securities income of $92 thousand. The change in the balance sheet mix along with the loan growth caused the asset yield to improve by 12 basis points to 3.97% for the first quarter 2016 compared to first quarter 2015’s 3.85%.
In terms of dollars, $271 thousand additional interest income was earned in first quarter 2016 than in fourth quarter 2015. As a percentage, the 3.1% increase for first quarter is also attributed to higher loan balances during the quarter. 2016 is off to a strong start in interest income generation.
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The average interest earning asset base was $47.5 million higher in first quarter 2016 than for first quarter 2015 or up 5.4%.
The yields on tax-exempt securities and the portion of the tax-exempt IDB loans included in loans have been tax adjusted based on a 34% tax rate in the charts to follow.
Loans
Taxable Investment Securities
Tax-exempt Investment Securities
Fed Funds Sold & Interest Bearing Deposits
Total Interest Earning Assets
Change in Quarter to Date March 31, 2016 Interest Income Compared to March 31, 2015 (In Thousands)
Interest expense for the quarter was also higher for first quarter 2016 compared to the fourth quarter 2015 and first quarter 2015. At $996 thousand, first quarter 2016 was up $73 thousand as compared to fourth quarter 2015 and $138 thousand as compared to same time period 2015.
The average balance of interest-bearing liabilities was higher by $34.3 million in 2016 than first quarter 2015. $10 million of the increase is attributed to the FHLB borrowings. The higher balance coupled with the slight variation of the balance sheet mix, resulted in a 5 basis points increase in the cost of funds at 0.58% for first quarter 2016 as compared to 2015’s 0.53%.
The Federal Funds and prime rate increase of 25 basis points in December 2015 had only a marginal effect on the Bank’s pricing methodologies. Rates, both loan and deposit, remain at low levels.
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Savings Deposits
Other Time Deposits
Other Borrowed Money
Fed Funds Purchased & Securities Sold under Agreement to Repurch.
Total Interest Bearing Liabilities
Change in Quarter to Date March 31, 2016 Interest Expense Compared to March 31, 2015 (In Thousands)
Net Interest Income
Overall, net interest spread and net interest margin figures for the first quarter 2016 have improved over the last two years. As the chart below illustrates, both higher yields on interest and dividend income, even offset by higher interest expense resulted with total net interest margin up 9 basis points since the first quarter of 2015 and over first quarter 2014 by 20 basis points.
Interest/Dividend income/yield
Interest Expense / yield
Net Interest Spread
Net Interest Margin
Net interest income was up $682 thousand in the first quarter 2016 over the same time frame in 2015 due to the increase in loan income even with higher interest expense, as previously mentioned. There has been a $198 thousand increase in net interest income over fourth quarter 2015. New loans added in 2015 and 2016 will continue to generate more income; the benefits of the Company’s strategy of repositioning the balance sheet will continue to grow.
The discussion will now be separated into two distinct quarter discussions – first quarter comparisons and the two most recent quarter comparisons.
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Comparison of Noninterest Results of Operation – First Quarter 2016 to First Quarter 2015
Provision Expense
Provision for loan losses was almost 2.5 times higher for first quarter 2016 as the Bank sought to provide coverage for the much higher total loan balances as compared to first quarter 2015. The provision of $277 thousand was partially due to net-charge offs of $49 thousand during the quarter. First quarter 2015 had net charge-offs of $42 thousand and $114 thousand of provision expense. Strong asset quality for both periods is reflected in the low past dues (30 days+ past due/total loans) percentages of 0.29% for March 31, 2016 and 0.43% for March 31, 2015.
In the immediate future, the Bank expects to fund the loan loss reserve for any loan growth that may occur.
The Bank uses the following guidelines as stated in policy to determine when to realize a charge-off of a loan, whether partial loan balance or full loan balance. A charge down in whole or in part is realized when unsecured consumer loans, credit card credits and overdraft lines of credit reach 90 days delinquency. At 120 days delinquent, secured consumer loans are charged down to the value of the collateral, if repossession of the collateral is assured and/or in the process of repossession. Consumer mortgage loan deficiencies are charged down upon the sale of the collateral or sooner upon the recognition of collateral deficiency. Commercial and agricultural credits are charged down at 120 days delinquency, unless an established and approved work-out plan is in place or litigation of the credit will likely result in recovery of the loan balance. Upon notification of bankruptcy, unsecured debt is charged off. Additional charge-offs may be realized as further unsecured positions are recognized.
Loans classified as nonaccrual were lower as of March 31, 2016 at $2.0 million compared to $2.4 million as of March 31, 2015. One new loan was categorized as TDR during the first quarter 2016.
In determining the allocation for impaired loans the Bank applies the appraised market value of the collateral securing the asset, reduced by applying a discount for estimated costs of collateral liquidation. In some instances where the discounted market value is less than the loan amount, a specific impairment allocation is assigned, which may be reduced or eliminated by the write down of the credit’s active principal outstanding balance.
For the majority of the Bank’s impaired loans, including all collateral dependent loans, the Bank will apply the appraised market value methodology. However, the Bank may also utilize a measurement incorporating the present value of expected future cash flows discounted at the loan’s effective rate of interest. To determine appraised market value, collateral asset values securing an impaired loan are periodically evaluated. Maximum time of re-evaluation is every 12 months for chattels and titled vehicles and every two years for real estate. In this process, third party evaluations are obtained and heavily relied upon. Until such time that updated appraisals are received, the Bank may discount the collateral value used.
The ALLL has a direct impact on the provision expense. The increase in the ALLL is funded through recoveries and provision expense. The following tables both deal with the allowance for credit losses. The first table breaks down the activity within ALLL for each loan portfolio class and shows the contribution provided by both the recoveries and the provision along with the reduction of the allowance caused by charge-offs. The second table discloses how much of the ALLL is attributed to each class of the loan portfolio, as well as the percent that each particular class of the loan portfolio represents to the entire loan portfolio in the aggregate. The consumer loan portfolio and industrial loans accounted for the largest component of charge-offs and recoveries through first three months of 2016. As was mentioned in previous discussion, the commercial real estate portfolio is currently having a major impact on the ALLL due to the loan growth.
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MATERIAL CHANGES IN RESULTS OF OPERATIONS (Continued)
Daily average of outstanding loans
Allowance for Loan & Lease Losses—January 1
Loans Charged off:
Loan Recoveries
Net Charge Offs
Allowance for Loan & Lease Losses—March 31
Allowance for Unfunded Loan Commitments & Letters of Credit—March 31
Total Allowance for Credit Losses—March 31
Ratio of net charge-offs to average Loans outstanding
Ratio of Allowance for Loan Loss to Nonperforming Loans
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The following table presents the balances for allowance of loan losses by loan type for three months ended March 31, 2016 and March 31, 2015.
Balance at End of Period Applicable To:
Unallocated
Off Balance Sheet Commitments
Noninterest income was up $113 thousand in the first quarter 2016 over the same time frame in 2015. The bulk of this increase came from an increase in customer service fees. Customer service fees were positively impacted by the structural changes made to the Bank’s bill pay program and checking accounts. All other categories of noninterest income showed only slight variations when comparing the two quarters.
$17.5 million in sales of investment securities were conducted so far in 2016 to capture the benefit of movement in market interest rates. The sales resulted in a gain of $113 thousand. The same time period 2015 had similar sales of $16.3 million resulting in gains of $109 thousand. The difference between 2016 and 2015 sales was the utilization of the funds. 2016 went to fund loan growth while only a portion did in 2015 with the balances held in cash and reinvested in securities beginning in the second quarter.
The impact of mortgage servicing rights, both to income and expense, is shown in the following table which reconciles the value of mortgage servicing rights. The capitalization runs through non-interest income while the amortization thereof is included in non-interest expense. For first quarter 2016, mortgage servicing rights caused a net $52 thousand more in income. This is a reversal of 2015’s first quarter net expense cost of $7 thousand. The higher capitalized additions for 2016 are attributed to a higher loan origination level of 1-4 families in 2016 as compared to 2015. The carrying value is well below the market value of $3.0 million which indicates any large expense to fund the valuation allowance to be unlikely in 2016.
Beginning Balance, January 1
Capitalized Additions
Amortization
Ending Balance, March 31
Valuation Allowance
Mortgage Servicing Rights, net March 31
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For the first quarter 2016, noninterest expenses were $421 thousand higher than in 2015. An increase of $185 thousand in salaries and wages was overshadowed by a decrease of $202 thousand in employee benefits. The decrease in employee benefits was derived from lower costs related to medical claims for the quarter and lower pension costs due to an adjustment in first quarter 2015 for the accrual.
Data processing fees were $82 thousand higher than last year due to the increased number of customers, accounts and updated services.
The largest increase for the 2016 first quarter was in other general and administrative. This line item on the income statement was up by $266 thousand over 2015. Audit and exam fees were higher by $140 thousand so far in 2016 than for 2015. This related to an accrual adjustment in 2015 which lowered the expense for that time period. Marketing expenses were up $52 thousand as advertising for the new office and KASASA Cash Back went full swing in the first quarter 2016.
Overall, net income in the first quarter of 2016 was up $130 thousand as compared to the same quarter last year. The Company has done an exceptional job of growing loans while keeping past dues low. The Company remains strong, stable, and well capitalized and has the capacity to continue to cover the increased costs of doing business in a tough economy while seeking good loans to improve profitability. The opening of the new office may create a slight drag in the short run; however, the Company remains focused on the long term.
The Company continues to look for new opportunities to generate and protect revenue and provide additional channels through which to serve our customers and maintain our high level of customer satisfaction.
Comparison of Noninterest Results of Operations – First Quarter 2016 to Fourth Quarter 2015
In comparing the provision expense of first quarter 2016 to fourth quarter 2015, an increase of $191.1 thousand was realized. The increased provision was for the continued loan growth experienced throughout the first quarter. The ratio of loans past due 30 and more days to total loans stood at 0.32% as of December 31, 2015 and 0.29% as of March 31, 2016. The average percentage for all of 2015 was 0.44%. The Bank continues to keep a tight watch and works to maintain its strong asset quality position. Increases to the ACL were for loan growth as net charge-offs remain at low levels also. Nonaccruals decreased slightly from yearend 2015, lower by $38 thousand at first quarter end 2016.
Noninterest income for the first quarter 2016 shows under the fourth quarter by $35 thousand. A decrease in other customer service fees accounted for $198 thousand. First quarter 2016, however, had increases of over $80 thousand in both other service charges and net gain on sale of securities line items.
Noninterest expense was higher by $377 thousand in comparison in the first quarter 2016. Medical claims were higher in the fourth quarter 2015 which is typical of yearend when deductibles have been met for the year so more elective procedures are performed. A decrease in the number of full time equivalent employees from 265 as of December 31, 2015, to 264 as of March 31, 2016 is representative of turnover and the number may increase as positions are filled with the addition of another office. Loan production offset the increase in base salaries with the establishment of deferred costs as related to personnel expense. Behind the increased cost of first quarter is the other general and administrative mentioned in the earlier first quarter comparisons discussion, mainly accounting and data processing, up $42.4 and $78.1 thousand respectively. ATM expense was also higher in the first quarter by $62.1 thousand as the cost of card replacement is higher coupled with the fact the reissue time frame has been accelerated due to “chip” acceptance.
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Overall in comparing fourth quarter 2015 to first quarter 2016, the fourth quarter generated $292 thousand more in net income. The higher interest income of 2016 was outweighed by the higher loan provision and noninterest expense. The Company recognizes the additional cost of its expansion strategy and is pleased with the strong loan growth seen so far in 2016.
A revitalized service and product was introduced in the fourth quarter of 2015. Overdraft privilege was renamed Courtesy Pay and utilizes new dynamic limits based on customer behavior in their checking account, and KASASA Cash Back was added to the KASASA product offerings. Courtesy pay has generated an additional $24.1 thousand in net revenue and KASASA Cash Back has added 463 accounts with 85% of those being new relationships as of the first quarter end. The Company is focused on continuing to strengthen our core earnings through loan growth and improvement to the net interest margin.
FORWARD LOOKING STATEMENTS
Statements contained in this portion of the Company’s report may be forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements may be identified by the use of words such as “intend,” “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” and “potential.” Such forward-looking statements are based on current expectations, but actual results may differ materially from those currently anticipated due to a number of factors, which include, but are not limited to, factors discussed in documents filed by the Company with the Securities and Exchange Commission from time to time. Other factors which could have a material adverse effect on the operations of the Company and its subsidiaries include, but are not limited to, changes in interest rates, general economic conditions, legislative and regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality and composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Bank’s market area, changes in relevant accounting principles and guidelines and other factors over which management has no control. The forward-looking statements are made as of the date of this report, and the Company assumes no obligation to update the forward-looking statements or to update the reasons why actual results differ from those projected in the forward-looking statements.
Market risk is the exposure to loss resulting from changes in interest rates and equity prices. The primary market risk to which the Company is subject is interest rate risk. The majority of our interest rate risk arises from the instruments, positions and transactions entered into for purposes other than trading such as loans, available for sale securities, interest bearing deposits, short term borrowings and long term borrowings. Interest rate risk occurs when interest bearing assets and liabilities re-price at different times as market interest rates change. For example, if fixed rate assets are funded with variable rate debt, the spread between asset and liability rates will decline or turn negative if rates increase.
Interest rate risk is managed within an overall asset/liability framework. The principal objectives of asset/liability management are to manage sensitivity of net interest spreads and net income to potential changes in interest rates.
Funding positions are kept within predetermined limits designed to ensure that risk-taking is not excessive and that liquidity is properly managed. In the event that our asset/liabilities management strategies are unsuccessful, our profitably may be adversely affected. The Company employs a sensitivity analysis utilizing interest rate shocks to help in this analysis.
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The shocks presented below assume an immediate change of rate in the percentages and directions shown covering a twelve month period:
Margin (Ratio)
3.07%
3.15%
3.25%
3.33%
2.82%
The net interest margin represents the forecasted twelve month margin. The Company also reviews shocks with a 4.0% fluctuation with a delayed time frame of 10 months and over a 24 month time frame. It also shows what effect rate changes will have on both the margin and net interest income. The goal of the Company is to lengthen some of the liabilities or sources of funds to decrease the exposure to a rising rate environment. The Bank has offered higher rates on certificates of deposits for longer periods since 2011. Of course, customer desires also drive the ability to capture longer term deposits. Currently, the majority of customers look for terms twelve months and under while the Bank would prefer 24 months and longer. Some movement into the longer term time deposits has occurred. What the Bank has experienced is a decrease in the time balances of our deposit portfolio, therefore a loss of term funding
The shock chart currently shows a slight tightening in net interest margin over the next twelve months in an increasing rate environment with an even lower tightening in a falling rate environment. Due to the length and existence of such a low rate environment, the model does not predict expansion of net interest income in any falling category except the first one. Cost of funds are below 0.50% so at even the lowest shock of 100 basis points, the Bank cannot take full advantage and reprice funds to match the level of shock. Since the average duration of the majority of the assets is outside the 12 month shock period, the rising rate environment does not show improvement. The majority of the newer loans added to the commercial real estate portfolio begin with an initial fixed rate period of three to five years whose variable adjustment is outside of the current shock time frame. The Bank enhanced its use of the software model during 2012 by including decay rates and key rate ties on certain deposit accounts and continues to review and modify those rates as updated data is compiled. Both enhancements were based on historical performance data of the Bank. Both directional changes are within risk exposure guidelines at the 200 basis point level. The effect of the rate shocks may be mitigated to the extent that not all lines of business are directly tied to an external index and actual balance sheet composition may differ from prediction.
Overall, what the chart shows is that the Company must concentrate on increasing loan spreads on variable loans and extend the duration on cost of funds where possible. Changes in portfolio and/or balance sheet composition are needed for the margin to improve regardless of any rate shock.
As of March 31, 2016, an evaluation was performed under the supervision and with the participation of the Company’s management including the CEO and CFO, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on that evaluation, the Company’s management, including the CEO and CFO, concluded that the Company’s disclosure controls and procedures were effective as of March 31, 2016. There have been no changes in the Company’s internal control over financial reporting that occurred during the quarter ended March 31, 2016 that have materially affected, or are reasonably likely to materially affect, the registrant’s internal control over financial reporting.
PART II OTHER INFORMATION
ITEM 1 LEGAL PROCEEDINGS
None
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There have been no material changes in the risk factors disclosed by Registrant in its Report on Form 10-K for the fiscal year ended December 31, 2015.
Treasury stock repurchased the quarter ended March 31, 2016 (1).
Period
1/1/2016 to
1/31/2016
2/1/2016 to
2/29/2016
3/1/2016 to
3/31/2016
Not applicable
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
/s/ Paul S. Siebenmorgen
/s/ Barbara J. Britenriker
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