First Mid Bancshares - 10-Q quarterly report FY

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 is a large accelerated filer, an accelerated filer, 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 Act).  [  ] Yes  [X] No

As of August 7, 2008, 6,233,185 common shares, $4.00 par value, were outstanding.

PART I

Notes to Consolidated Financial Statements

(unaudited)

Basis of Accounting and Consolidation

The unaudited condensed consolidated financial statements include the accounts of First Mid-Illinois Bancshares, Inc. (“Company”) and the following wholly-owned subsidiaries: Mid-Illinois Data Services, Inc. (“MIDS”), The Checkley Agency, Inc. (“Checkley”), and First Mid-Illinois Bank & Trust, N.A. (“First Mid Bank”).  All significant intercompany balances and transactions have been eliminated in consolidation.  The financial information reflects all adjustments which, in the opinion of management, are necessary for a fair presentation of the results of the interim periods ended June 30, 2008 and 2007, and all such adjustments are of a normal recurring nature.  Certain amounts in the prior year’s consolidated financial statements have been reclassified to conform to the June 30, 2008 presentation and there was no impact on net income or stockholders’ equity.  The results of the interim period ended June 30, 2008 are not necessarily indicative of the results expected for the year ending December 31, 2008. The Company operates as a one-segment entity for financial reporting purposes.

The 2007 year-end consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles.

The unaudited condensed consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X and do not include all of the information required by U.S. generally accepted accounting principles for complete financial statements and related footnote disclosures although the Company believes that the disclosures made are adequate to make the information not misleading.  These financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s 2007 Annual Report on Form 10-K.

Stock Plans

At the Annual Meeting of Stockholders held May 23, 2007, the stockholders approved the First Mid-Illinois Bancshares, Inc. 2007 Stock Incentive Plan (“SI Plan”).  The SI Plan was implemented to succeed the Company’s 1997 Stock Incentive Plan, which had a ten-year term that expired October 21, 2007. The SI Plan is intended to provide a means whereby directors, employees, consultants and advisors of the Company and its subsidiaries may sustain a sense of proprietorship and personal involvement in the continued development and financial success of the Company and its subsidiaries, thereby advancing the interests of the Company and its stockholders.  Accordingly, directors and selected employees, consultants and advisors may be provided the opportunity to acquire shares of common stock of the Company on the terms and conditions established herein in the SI Plan.

A maximum of 300,000 shares of common stock may be issued under the SI Plan.  As of December 31, 2007, the Company had awarded 32,000 shares under the plan. There were no shares awarded during the first six months of 2008.

Stock Split

On June 29, 2007, the Company effected a three-for-two stock split in the form of a 50% stock dividend for all shareholders of record as of June 18, 2007. Accordingly, an entry was made for $9,493,000 to increase the common stock account and decrease the retained earnings account. Par value remained at $4 per share.  All current and prior period share and per share amounts have been restated giving retroactive recognition to the stock split.

Treasury Stock

On May 23, 2007, the Company retired 1,500,000 shares of its treasury stock (after adjustment for stock split), the cost of which was determined using the first-in, first-out method.  Accordingly, an entry was made to decrease the treasury stock account for $21,021,000, the common stock account for $4,000,000 and the retained earnings account for $17,021,000.

Website

The Company maintains a website at www.firstmid.com. All periodic and current reports of the Company and amendments to these reports filed with the Securities and Exchange Commission (“SEC”) can be accessed, free of charge, through this website as soon as reasonably practicable after these materials are filed with the SEC.

Comprehensive Income (Loss)

The Company’s comprehensive income (loss) for the three and six-month periods ended June 30, 2008 and 2007 was as follows (in thousands):

 

New Accounting Pronouncements

In March 2008, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 161 (FAS 161), “Disclosures About Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133.” FAS 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements.  FAS 161 is effective for fiscal years beginning after November 15, 2008.  The Company does not expect the implementation of FAS 161 to have a material impact on its consolidated financial statements.

In December 2007, the FASB issued Statement of Financial Accounting Standards No. 160 (FAS 160), “Noncontrolling Interests in Consolidated Financial Statements -- an amendment of ARB No.51.”  FAS 160 requires that a noncontrolling interest in a subsidiary be reported separately within equity and the amount of consolidated net income specifically attributable to the noncontrolling interest be identified in the consolidated financial statements.  It also calls for consistency in the manner of reporting changes in the parent’s ownership interest and requires fair value measurement of any noncontrolling equity investment retained in deconsolidation.  FAS 160 is effective for fiscal years beginning after December 15, 2008. The Company does not expect the implementation of FAS 160 to have a material impact on its consolidated financial statements.

In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141(R) (FAS 141(R)), “Business Combinations.”  FAS 141(R) will significantly change the financial accounting and reporting of business combination transactions.  FAS 141(R) establishes principles for how an acquirer recognizes and measures the identifiable assets acquired, liabilities assumed, and any noncontrolling interest in the acquiree; recognizes and measures goodwill acquired in the business combination or a gain from a bargain purchase; and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination.  FAS 141(R) is effective for acquisition dates in fiscal years beginning after December 15, 2008.  The Company does not expect the implementation of FAS 141(R) to have a material impact on its consolidated financial statements.

Earnings Per Share

A three-for-two common stock split was effected on June 29, 2007, in the form of a 50% stock dividend for the stockholders of record at the close of business on June 18, 2007.  Accordingly, information with respect to shares of common stock and earnings per share has been restated for current and prior periods presented to fully reflect the stock split. Basic earnings per share (“EPS”) is calculated as net income divided by the weighted average number of common shares outstanding.  Diluted EPS is computed using the weighted average number of common shares outstanding, increased by the assumed conversion of the Company’s stock options, unless anti-dilutive.

The components of basic and diluted earnings per common share for the three and six-month periods ended June 30, 2008 and 2007 were as follows:

Stock options for 124,813 shares of common stock were not considered in computing diluted earnings per share for the six-month period ended June 30, 2008, because they were anti-dilutive.

Goodwill and Intangible Assets

The Company has goodwill from business combinations, intangible assets from branch acquisitions, and identifiable intangible assets assigned to core deposit relationships and customer lists of Checkley.

The following table presents gross carrying value and accumulated amortization by major intangible asset class as of June 30, 2008 and December 31, 2007 (in thousands):

Total amortization expense for the six months ended June 30, 2008 and 2007 was as follows (in thousands):

Aggregate amortization expense for the current year and estimated amortization expense for each of the five succeeding years is shown in the table below (in thousands):

In accordance with the provisions of SFAS 142, the Company performed testing of goodwill for impairment as of September 30, 2007 and determined that, as of that date, goodwill was not impaired.  Management also concluded that the remaining amounts and amortization periods were appropriate for all intangible assets.

Other Assets

The Company owns approximately $3.7 million of Federal Home Loan Bank stock included in other assets. During the third quarter of 2007, the Federal Home Loan Bank of Chicago received a Cease and Desist Order from its regulator, the Federal Housing Finance Board. The Federal Home Loan Bank will continue to provide liquidity and funding through advances; however, the draft order prohibits capital stock repurchases and redemptions until a time to be determined by the Federal Housing Finance Board and requires Federal Housing Finance Board approval for dividends. On July 24, 2008, the Federal Housing Finance Board amended the order to allow the Federal Home Loan Bank to repurchase or redeem any capital stock issued to support new advances after the repayment of those new advances if certain conditions are met.  The amended order, however, provides that the Director of the Office of Supervision of the Federal Housing Finance Board may direct the Federal Home Loan Bank of Chicago to halt the repurchase of redemption of capital stock if, in his sole discretion, the continuation of such transactions would be inconsistent with maintaining the capital adequacy of the Federal Home Loan Bank of Chicago and its safe and sound operations. With regard to dividends, the Federal Home Loan Bank continues to assess its dividend capacity each quarter and make appropriate request for approval. There were no dividends paid by the Federal Home Loan Bank of Chicago during the first six months of 2008.

Repurchase Agreements and Other Borrowings

Securities sold under agreements to repurchase had seasonal declines of $12.8 million during the first six months of 2008. Other borrowings decreased $8 million during the six-month period ended June 30, 2008. This decrease was primarily due to a decrease of $10 million in Federal Home Loan Bank advances partially offset by an increase in borrowing on the Company’s revolving credit line with The Northern Trust Company.

Fair Value of Assets and Liabilities

Effective January 1, 2008, the Company adopted Statement of Financial Accounting Standards No. 157 (FAS 157), “Fair Value Measurements.” FAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements.  FAS 157 has been applied prospectively as of the beginning of the period.

FAS 157 defines fair value 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.  FAS 157 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

In accordance with FAS 157, the Company groups its financial assets and financial liabilities measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.  These levels are:

 

Following is a description of the valuation methodologies used for instruments measured at fair value on a recurring basis and recognized in the accompanying balance sheet.

Available-for-Sale Securities

The fair value of available-for-sale securities are determined by various valuation methodologies.  Where quoted market prices are available in an active market, securities are classified within Level 1. Level 1 securities include exchange traded equities. If quoted market prices are not available, then fair values are estimated by using pricing models or quoted prices of securities with similar characteristics.  Level 2 securities include U.S. Treasury securities, obligations of U.S. government corporations and agencies, obligations of states and political subdivisions, mortgage-backed securities, collateralized mortgage obligations and corporate bonds. In certain cases where Level 1 or Level 2 inputs are not available, securities are classified within Level 3 of the hierarchy and include subordinated tranches of collateralized mortgage obligations and investments in financial institution trust preferred securities.

The following table presents the Company’s assets that are measured at fair value on a recurring basis and the level within the FAS 157 hierarchy in which the fair value measurements fall as of June 30, 2008 (in thousands):

The change in fair value of assets measured on a recurring basis using significant unobservable inputs (Level 3) for the three and six-month periods ended June 30, 2008 is summarized as follows (in thousands):

 

The Company may be required, from time to time, to measure certain other financial assets and liabilities at fair value on a nonrecurring basis.  These adjustments to fair value usually result from application of lower-of-cost-or-market accounting or write-downs of individual assets.  For assets measured at fair value on a nonrecurring basis in the first six months of 2008 that were still held in the balance sheet at June 30, 2008, the following table provides the level of valuation assumptions used to determine each adjustment and the fair value of the assets at June 30, 2008 (in thousands).

 

 

 

Loans for which it is probable that the Company will not collect all principal and interest due according to contractual terms are measured for impairment in accordance with the provisions of Financial Accounting Standard No. 114 (“FAS 114”) “Accounting by Creditors for Impairment of a Loan.”  Allowable methods for estimating fair value include using the fair value of the collateral for collateral dependent loans or, where a loan is determined not to be collateral dependent, using the discounted cash flow method.

If the impaired loan is identified as collateral dependent, then the fair value method of measuring the amount of impairment is utilized. This method requires obtaining a current independent appraisal of the collateral and applying a discount factor to the value based on First Mid’s loan review policy and procedures.

If the impaired loan is determined not to be collateral dependent, then the discounted cash flow method is used.  This method requires the impaired loan to be recorded at the present value of expected future cash flows discounted at the loan’s effective interest rate. The effective interest rate of a loan is the contractual interest rate adjusted for any net deferred loan fees or costs, premiums, or discount existing at origination or acquisition of the loan.

Management establishes a specific reserve for loans that have an estimated fair value that is below the carrying value. Impaired loans for which the specific reserve was adjusted in accordance with FAS 114 had a carrying amount of $1.6 million with specific loss exposures of $332,000 as of June 30, 2008, a decrease of $380,000 from March 31, 2008 and an increase of $112,000 from December 31, 2007. The decrease in specific loss exposures during the second quarter of 2008 was primarily the result approximately $1.3 million of loans foreclosed on and moved to other real estate owned and approximately $917,000 of loans charged-off to the allowance for loan losses to more accurately reflect the Company’s expectation for liquidation of the real estate.

When there is little prospect of collecting either principal or interest, loans, or portions of loans, may be charged-off to the allowance for loan losses.  Losses are recognized in the period an obligation becomes uncollectible.  The recognition of a loss does not mean that the loan has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off the loan even though partial recovery may be effected in the future.

New Accounting Principles

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159 (FAS 159), “The Fair Value Option for Financial Assets and Financial Liabilities – Including amendment of FASB Statement No. 115.” FAS 159 allows companies to report selected financial assets and liabilities at fair value.  The changes in fair value are recognized in earnings and the assets and liabilities measured under this methodology are required to be displayed separately in the balance sheet.  The main intent of FAS 159 is to mitigate the difficulty in determining reported earnings caused by a “mixed-attribute model” (that is, reporting some assets at fair value and others using a different valuation method such as amortized cost). The project is separated into two phases. This first phase addresses the creation of a fair value option for financial assets and liabilities.  A second phase will address creating a fair value option for selected non-financial items. FAS 159 is effective for all financial statements issued for fiscal years beginning after November 15, 2007.  The Company has not elected the fair value option for any financial assets or liabilities at June 30, 2008.

ITEM 2.                      MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis is intended to provide a better understanding of the consolidated financial condition and results of operations of the Company and its subsidiaries as of, and for the six month periods ended, June 30, 2008 and 2007.  This discussion and analysis should be read in conjunction with the consolidated financial statements, related notes and selected financial data appearing elsewhere in this report.

Forward-Looking Statements

This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), such as discussions of the Company’s pricing and fee trends, credit quality and outlook, liquidity, new business results, expansion plans, anticipated expenses and planned schedules.  The Company intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and is including this statement for purposes of these safe harbor provisions.  Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Company, are identified by use of the words “believe”, “expect”, “intend”, “anticipate”, “estimate”, “project”, or similar expressions.  Actual results could differ materially from the results indicated by these statements because the realization of those results is subject to many risks and uncertainties including: changes in interest rates, general economic conditions, legislative/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 or composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Company’s market area and accounting principles, policies and guidelines.  These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.  Further information concerning the Company and its business, including  a discussion of these and additional factors that could materially affect the Company’s financial results, is included in the Company’s 2007 Annual Report on Form 10-K under the headings ”Item 1. Business” and “Item 1A. Risk Factors."

New Accounting Standards Adopted

The Company adopted the provisions of FAS 157 on January 1, 2008. The implementation of FAS 157 did not have a material impact on the Company’s financial statements. FAS 157 has been applied prospectively as of the beginning of the period.  See “Fair Value of Assets and Liabilities” in the notes to consolidated financial statements for more detailed information regarding the adoption of FAS 157.

Properties

On September 29, 2007, the Company closed its facilities located at 435 South Hamilton, Sullivan, Illinois in the IGA and at 220 North Highway Avenue, DeLand, Illinois. The customers and operations of both of these facilities were moved to other facilities in Sullivan and Monticello, Illinois. These actions did not have a material impact on the Company’s consolidated financial statements.

During the first quarter of 2008, the Company obtained an independent appraisal of the DeLand property in anticipation of possibly donating or selling this property.  Subsequently, the Company adjusted its carrying value of the property to the appraised value which resulted in a loss of $132,000 in the consolidated financial statements.

Overview

This overview of management’s discussion and analysis highlights selected information in this document and may not contain all of the information that is important to you. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources, and critical accounting estimates which have an impact on the Company’s financial condition and results of operations you should carefully read this entire document.

Net income was $5,616,000 and $5,001,000 and diluted earnings per share was $.88 and $.77 for the six months ended June 30, 2008 and 2007, respectively. The following table shows the Company’s annualized performance ratios for the six months ended June 30, 2008 and 2007, compared to the performance ratios for the year ended December 31, 2007:

Total assets at June 30, 2008 and December 31, 2007 were $1,019.9 million and $1,016.3 million, respectively. The increase in net assets was primarily due to an increase in interest-bearing deposits and federal funds sold, offset by decreases in available-for-sale securities and net loans.  Available-for-sale securities decreased by $17.3 million during the first six months of 2008 due to securities that were called or matured and were not immediately replaced. Net loan balances were $733.9 million at June 30, 2008, a decrease of $6.2 million, or .8%, from $740.1 million at December 31, 2007 due to seasonal pay downs on agricultural operating loans. Total deposit balances increased to $796 million at June 30, 2008 from $770.6 million at December 31, 2007 due to increased balances in certificates of deposit.

Net interest margin, defined as net interest income divided by average interest-earning assets, was 3.62% for the six months ended June 30, 2008, up from 3.39% for the same period in 2007. The increase in the net interest margin is attributable to a greater decrease in borrowing and deposit rates compared to the decrease in interest-earning asset rates.  Net interest income before the provision for loan losses was $17.3 million compared to net interest income of $15.3 million for the same period in 2007. The increase was due to improvement in the net interest margin and growth in average earning assets of $47.9 million for the six months ended June 30, 2008 compared to the same period in 2007.

Noninterest income increased $.6 million or 9.1%, to $8 million for the six months ended June 30, 2008 compared to $7.4 million for the six months ended June 30, 2007. The increase in noninterest income was due to increases in fees received on ATM and debit cards and approximately $291,000 in proceeds on life insurance the Company maintained on former executive officer and director, Daniel E. Marvin, Jr., who died in April of 2008.

Noninterest expense increased 5.6%, or $.8 million, to $15.7 million for the six months ended June 30, 2008 compared to $14.9 million during the same period in 2007.  The increase in noninterest expense was due to the write down of the DeLand property during the first quarter and increases in loan collection expenses.

Following is a summary of the factors that contributed to the changes in net income (in thousands):

Credit quality is an area of importance to the Company. Total nonperforming loans were $5.6 million at June 30, 2008, compared to $7.6 million at June 30, 2007 and $7.5 million at December 31, 2007.  The decrease from year-end 2007 was primarily due to $765,000 of charge-offs and $1.3 million moved to other real estate owned, relating to commercial real estate loans to one borrower. There was also $150,000 of charge-offs of commercial loans of another borrower. This was partially offset by the addition to non-performing loans of $700,000 of a residential construction loan to one borrower due to insufficient cash flow. The Company’s provision for loan losses for the six months ended June 30, 2008 and 2007 was $1,059,000 and $395,000, respectively.  At June 30, 2008, the composition of the loan portfolio remained similar to the same period last year. Loans secured by both commercial and residential real estate comprised 70% of the loan portfolio as of June 30, 2008 and 2007. During the six months ended June 30, 2008, annualized net charge-offs were .27% of average loans compared to ..03% for the same period in 2007.

The Company owns approximately $3.7 million of Federal Home Loan Bank stock included in other assets. During the third quarter of 2007, the Federal Home Loan Bank of Chicago received a Cease and Desist Order from their regulator, the Federal Housing Finance Board. The Federal Home Loan Bank will continue to provide liquidity and funding through advances; however, the draft order prohibits capital stock repurchases and redemptions until a time to be determined by the Federal Housing Finance Board and requires Federal Housing Finance Board approval for dividends. With regard to dividends, the Federal Home Loan Bank continues to assess its dividend capacity each quarter and make appropriate request for approval. There were no dividends paid by the Federal Home Loan Bank of Chicago during the first six months of 2008.

The Company’s capital position remains strong and the Company has consistently maintained regulatory capital ratios above the “well-capitalized” standards. The Company’s Tier 1 capital to risk weighted assets ratio calculated under the regulatory risk-based capital requirements at June 30, 2008 and 2007 was 10.8% and 10.4%, respectively. The Company’s total capital to risk weighted assets ratio calculated under the regulatory risk-based capital requirements at June 30, 2008 and 2007 was 11.6% and 11.2%, respectively.

The Company’s liquidity position remains sufficient to fund operations and meet the requirements of borrowers, depositors, and creditors. The Company maintains various sources of liquidity to fund its cash needs. See discussion under the heading “Liquidity” for a full listing of sources and anticipated significant contractual obligations. The Company enters into financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include lines of credit, letters of credit and other commitments to extend credit.  The total outstanding commitments at June 30, 2008 and 2007 were $160.5 million and $159.4 million, respectively.  The increase is primarily attributable to increases in commercial operating lines of credit offset by decreases in commercial real estate lines of credit.

Critical Accounting Policies

The Company has established various accounting policies that govern the application of U.S. generally accepted accounting principles in the preparation of the Company’s financial statements. The significant accounting policies of the Company are described in the footnotes to the consolidated financial statements included in the Company’s 2007 Annual Report on Form 10-K. Certain accounting policies involve significant judgments and assumptions by management that have a material impact on the carrying value of certain assets and liabilities; management considers such accounting policies to be critical accounting policies. The judgments and assumptions used by management are based on historical experience and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions made by management, actual results could differ from these judgments and assumptions, which could have a material impact on the carrying values of assets and liabilities and the results of operations of the Company.

The Company believes the allowance for loan losses is the critical accounting policy that requires the most significant judgments and assumptions used in the preparation of its consolidated financial statements. In estimating the allowance for loan losses, management utilizes historical experience, as well as other factors, including the effect of changes in the local real estate market on collateral values, the effect on the loan portfolio of current economic indicators and their probable impact on borrowers, and increases or decreases in nonperforming and impaired loans. Changes in these factors may cause management’s estimate of the allowance for loan losses to increase or decrease and result in adjustments to the Company’s provision for loan losses. See heading “Loan Quality and Allowance for Loan Losses” for a more detailed description of the Company’s estimation process and methodology related to the allowance for loan losses.

Results of Operations

Net Interest Income

The largest source of revenue for the Company is net interest income. Net interest income represents the difference between total interest income earned on earning assets and total interest expense paid on interest-bearing liabilities.  The amount of interest income is dependent upon many factors, including the volume and mix of earning assets, the general level of interest rates and the dynamics of changes in interest rates.  The cost of funds necessary to support earning assets varies with the volume and mix of interest-bearing liabilities and the rates paid to attract and retain such funds.  The Company’s average balances, interest income and expense and rates earned or paid for major balance sheet categories are set forth in the following table (dollars in thousands):

Changes in net interest income may also be analyzed by segregating the volume and rate components of interest income and interest expense.  The following table summarizes the approximate relative contribution of changes in average volume and interest rates to changes in net interest income for the six months ended June 30, 2008, compared to the same period in 2007 (in thousands):

Net interest income increased $2 million, or 12.8%, to $17.3 million for the six months ended June 30, 2008, from $15.3 million for the same period in 2007. The increase in net interest income was due to improvement in the Company’s net interest margin and growth in earning assets.

For the six months ended June 30, 2008, average earning assets increased by $47.9 million, or 5.3%, and average interest-bearing liabilities increased $35.4 million, or 4.6%, compared with average balances for the same period in 2007. The changes in average balances for these periods are shown below:

 

 

 

 

 

 

 

To compare the tax-exempt yields on interest-earning assets to taxable yields, the Company also computes non-GAAP net interest income on a tax equivalent basis (TE) where the interest earned on tax-exempt securities is adjusted to an amount comparable to interest subject to normal income taxes assuming a federal tax rate of 34% (referred to as the tax equivalent adjustment). The net yield on interest-earning assets (TE) was 3.70% for the first six months of 2008 and 3.46% for the first six months of 2007. The TE adjustments to net interest income for June 30, 2008 and 2007 were $199,000 and $177,000, respectively.

Provision for Loan Losses

The provision for loan losses for the six months ended June 30, 2008 and 2007 was $1,059,000 and $395,000, respectively.  Nonperforming loans were $5.6 million and $7.6 million as of June 30, 2008 and 2007, respectively.  Net charge-offs were $1,004,000 for the six months ended June 30, 2008 compared to $113,000 during the same period in 2007.  For information on loan loss experience and nonperforming loans, see discussion under the “Nonperforming Loans” and “Loan Quality and Allowance for Loan Losses” sections below.

Other Income

An important source of the Company’s revenue is derived from other income.  The following table sets forth the major components of other income for the three and six months ended June 30, 2008 and 2007 (in thousands):

Following are explanations of the changes in these other income categories for the three months ended June 30, 2008 compared to the same period in 2007:

First Mid Bank generally releases the servicing rights on loans sold into the secondary market.

Following are explanations of the changes in these other income categories for the six months ended June 30, 2008 compared to the same period in 2007:

First Mid Bank generally releases the servicing rights on loans sold into the secondary market.

Other Expense

The major categories of other expense include salaries and employee benefits, occupancy and equipment expenses and other operating expenses associated with day-to-day operations.  The following table sets forth the major components of other expense for the three and six months ended June 30, 2008 and 2007 (in thousands):

Following are explanations for the changes in these other expense categories for the three months ended June 30, 2008 compared to the same period in 2007:

 

Following are explanations for the changes in these other expense categories for the six months ended June 30, 2008 compared to the same period in 2007:

Income Taxes

Total income tax expense amounted to $2,964,000 (34.6% effective tax rate) for the six months ended June 30, 2008, compared to $2,434,000 (32.7% effective tax rate) for the same period in 2007. The change in effective rate from 2007 to 2008 is primarily due to a $142,000 reduction in the state tax expense accrual during 2007 as a result of amending the 2003 and 2002 state income tax returns for a greater deduction in enterprise zone interest. This resulted in a $93,000 net reduction in tax expense for 2007 that did not occur in 2008.

Analysis of Balance Sheets

Loans

The loan portfolio (net of unearned interest) is the largest category of the Company’s earning assets.  The following table summarizes the composition of the loan portfolio, including loans held for sale, as of June 30, 2008 and December 31, 2007 (in thousands):

Overall loans decreased $1.8 million, or .3%.  The decrease was primarily a result of decreases in commercial and agricultural operating loans offset by increases in residential real estate loans. Total real estate mortgage loans have averaged approximately 70% of the Company’s total loan portfolio for the past several years.  This is the result of the Company’s focus on commercial real estate lending and long-term commitment to residential real estate lending.  The balance of real estate loans held for sale amounted to $6,277,000 and 1,974,000 as of June 30, 2008 and December 31, 2007, respectively.

At June 30, 2008, the Company had loan concentrations in agricultural industries of $107 million, or 14.3%, of outstanding loans and $114.2 million, or 15.3%, at December 31, 2007.  In addition, the Company had loan concentrations in the following industries as of June 30, 2008 compared to December 31, 2007 (dollars in thousands):

The Company had no further loan concentrations in excess of 25% of total risk-based capital.

The following table presents the balance of loans outstanding as of June 30, 2008, by maturities (in thousands):

As of June 30, 2008, loans with maturities over one year consisted of approximately $338.7 million in fixed rate loans and $44.6 million in variable rate loans. The loan maturities noted above are based on the contractual provisions of the individual loans.  Rollovers and borrower requests are handled on a case-by-case basis.

Nonperforming Loans

Nonperforming loans are defined as: (a) loans accounted for on a nonaccrual basis; (b) accruing loans contractually past due ninety days or more as to interest or principal payments; and (c) loans not included in (a) and (b) above which are defined as "renegotiated loans".  The Company’s policy is to cease accrual of interest on all loans that become ninety days past due as to principal or interest.  Nonaccrual loans are returned to accrual status when, in the opinion of management, the financial position of the borrower indicates there is no longer any reasonable doubt as to the timely collection of interest or principal.

The following table presents information concerning the aggregate amount of nonperforming loans at June 30, 2008 and December 31, 2007 (in thousands):

The $1,904,000 decrease in nonaccrual loans during the six months ended June 30, 2008 resulted from the net of $1,944,000 of additional loans put on nonaccrual status, $1,330,000 of loans brought current or paid-off, $1,488,000 of loans transferred to other real estate owned and $1,030,000 of loans charged-off.

Interest income that would have been reported if nonaccrual and renegotiated loans had been performing totaled $190,500 and $199,000 for the six-month periods ended June 30, 2008 and 2007, respectively.

Loan Quality and Allowance for Loan Losses

The allowance for loan losses represents management’s estimate of the reserve necessary to adequately account for probable losses attributable to current loan exposures. The provision for loan losses is the charge against current earnings that is determined by management as the amount needed to maintain an adequate allowance for loan losses.  In determining the adequacy of the allowance for loan losses, and therefore the provision to be charged to current earnings, management relies predominantly on a disciplined credit review and approval process that extends to the full range of the Company’s credit exposure.  The review process is directed by overall lending policy and is intended to identify, at the earliest possible stage, borrowers who might be facing financial difficulty.  Once identified, the magnitude of exposure to individual borrowers is quantified in the form of specific allocations of the allowance for loan losses.  Management considers collateral values and guarantees in the determination of such specific allocations.  Additional factors considered by management in evaluating the overall adequacy of the allowance include historical net loan losses, the level and composition of nonaccrual, past due and renegotiated loans, trends in volumes and terms of loans, effects of changes in risk selection and underwriting standards or lending practices, lending staff changes, concentrations of credit, industry conditions and the current economic conditions in the region where the Company operates.  Management considers the allowance for loan losses a critical accounting policy.

Management recognizes there are risk factors that are inherent in the Company’s loan portfolio.  All financial institutions face risk factors in their loan portfolios because risk exposure is a function of the business.  The Company’s operations (and therefore its loans) are concentrated in east central Illinois, an area where agriculture is the dominant industry.  Accordingly, lending and other business relationships with agriculture-based businesses are critical to the Company’s success.  At June 30, 2008, the Company’s loan portfolio included $107 million of loans to borrowers whose businesses are directly related to agriculture.  The balance decreased $7.2 million from $114.2 million at December 31, 2007.  While the Company adheres to sound underwriting practices, including collateralization of loans, any extended period of low commodity prices, significantly reduced yields on crops and/or reduced levels of government assistance to the agricultural industry could result in an increase in the level of problem agriculture loans and potentially result in loan losses within the agricultural portfolio.

In addition, the Company has $39.1 million of loans to motels, hotels and tourist courts.  The performance of these loans is dependent on borrower specific issues as well as the general level of business and personal travel within the region.  While the Company adheres to sound underwriting standards, a prolonged period of reduced business or personal travel could result in an increase in nonperforming loans to this business segment and potentially in loan losses. The Company also has $71.1 million of loans to lessors of non-residential buildings and $52.7 million of loans to lessors of residential buildings and dwellings. A significant widespread decline in real estate values could result in an increase in nonperforming loans to this segment and potentially in loan losses.

Analysis of the allowance for loan losses as of June 30, 2008 and 2007, and of changes in the allowance for the three and six-month periods ended June 30, 2008 and 2007, is as follows (dollars in thousands):

The ratio of the allowance for loan losses to nonperforming loans is 110.8% as of June 30, 2008 compared to 80.7% as of June 30, 2007.  The decrease in total nonperforming loans is the primary factor in the increase in the ratio. The decrease in nonperforming loans is primarily due to $765,000 of charge-offs and $1.3 million moved to other real estate owned, relating to several commercial real estate loans to one borrower, and $150,000 of charge-offs of commercial loans to another borrower during the second quarter of 2008. This was partially offset by the addition to non-performing loans during the first quarter of 2008 of $700,000 to a residential construction borrower experiencing insufficient cash flow.  Based upon market real estate comparable information, the Company estimates that the probable remaining collateral shortfall on non-performing loans is not material and management believes that the overall estimate of the allowance for loan losses adequately accounts for probable losses attributable to current exposures.

During the second quarter, the Company took possession of several commercial real estate properties for one borrower that had an outstanding loan balance of $2.9 million. This loan had previously been identified as having cash flow difficulties and had been placed on non-accrual status. In connection with the foreclosure process, we received updated appraisal information and wrote the asset values down to their appraised values. As a result, net charge-offs increased to $1,004,000 for the first six months of 2008 compared to $113,000 for the same period last year and the provision for loan losses increased to $1,059,000 in 2008 compared to $395,000 for 2007 as the Company replenished the allowance for loan and lease losses.

The Company minimizes credit risk by adhering to sound underwriting and credit review policies.  Management and the board of directors of the Company review these policies at least annually.  Senior management is actively involved in business development efforts and the maintenance and monitoring of credit underwriting and approval.  The loan review system and controls are designed to identify, monitor and address asset quality problems in an accurate and timely manner.  On a quarterly basis, the board of directors and management review the status of problem loans and determine a best estimate of the allowance.  In addition to internal policies and controls, regulatory authorities periodically review asset quality and the overall adequacy of the allowance for loan losses.

Securities

The Company’s overall investment objectives are to insulate the investment portfolio from undue credit risk, maintain adequate liquidity, insulate capital against changes in market value and control excessive changes in earnings while optimizing investment performance.  The types and maturities of securities purchased are primarily based on the Company’s current and projected liquidity and interest rate sensitivity positions.

The following table sets forth the amortized cost of the securities as of June 30, 2008 and December 31, 2007 (dollars in thousands):

At June 30, 2008, the Company’s investment portfolio showed a decrease of $13.2 million from December 31, 2007 primarily due to U.S. Treasury and obligations of U.S. government corporations and agencies securities that matured and were not replaced offset by additional purchases of mortgage-backed securities.  The amortized cost, gross unrealized gains and losses and estimated fair values for available-for-sale and held-to-maturity securities by major security type at June 30, 2008 and December 31, 2007 were as follows (in thousands):

Other securities consist of trust preferred securities and corporate bonds. The increase in unrealized losses of these securities, which have maturities ranging from 4 years to 30 years, is primarily due to their long-term nature. Many fund managers have sold these longer-term securities to provide current cash flow.  This has led to increased supply in the market, while demand has decreased, causing a devaluation of the securities. The Company believes the decline in market valuation is primarily liquidity related and the impairment of these securities is not considered other than temporary.

At June 30, 2008, there was one obligation of a U.S. government agency with a fair value of $5,947,000 and an unrealized loss of $11,832, in a continuous unrealized loss position for twelve months or more.  At June 30, 2007, there were five obligations of states and political subdivisions with a fair value of $1,559,000 and an unrealized loss of $44,000, six mortgage-backed securities with a fair value of $11,632,000 and an unrealized loss of $458,000, and ten obligations of U.S. government agencies with a fair value of $52,594,000 and an unrealized loss of $677,000, in a continuous unrealized loss position for twelve months or more. This position was due to short-term and intermediate rates increasing since the purchase of these securities resulting in the market value of the security being lower than book value. Management does not believe any individual unrealized loss as of June 30, 2008 or 2007 represents an other than temporary impairment.

The following table indicates the expected maturities of investment securities classified as available-for-sale and held-to-maturity, presented at amortized cost, at June 30, 2008 and the weighted average yield for each range of maturities.  Mortgage-backed securities are included based on their weighted average life.  All other securities are shown at their contractual maturity (dollars in thousands).