UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended September 30, 2016
or
For the transition period from ______________ to ______________
Commission File Number: 0-23636
HAWTHORN BANCSHARES, INC.
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
132 East High Street, Box 688, Jefferson City, Missouri 65102
(Address of principal executive offices) (Zip Code)
(573) 761-6100
(Registrant’s telephone number, including area code)
N/A
(Former name, former address and former fiscal year, if changed since last report.)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes ¨ 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). x Yes ¨ 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.:
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ¨ Yes x No
As of November 09, 2016, the registrant had 5,624,310 shares of common stock, par value $1.00 per share, outstanding
Part I - Financial Information
Item 1. Financial Statements
HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES
Consolidated Balance Sheets (unaudited)
See accompanying notes to the consolidated financial statements(unaudited).
Consolidated Statements of Income (unaudited)
Consolidated Statements of Comprehensive Income (unaudited)
Consolidated Statements of Stockholders' Equity (unaudited)
Consolidated Statements of Cash Flows (unaudited)
Consolidated Statements of Cash Flows (continued) (unaudited)
Hawthorn Bancshares, Inc.and subsidiaries
Notes to the Consolidated Financial Statements
(Unaudited)
Hawthorn Bancshares, Inc. (the Company) through its subsidiary, Hawthorn Bank (the Bank), provides a broad range of banking services to individual and corporate customers located within the communities in and surrounding Jefferson City, Columbia, Clinton, Warsaw, Springfield, Branson, and the greater Kansas City metropolitan area. The Company is subject to competition from other financial and nonfinancial institutions providing financial products. Additionally, the Company and its subsidiaries are subject to the regulations of certain regulatory agencies and undergo periodic examinations by those regulatory agencies.
The accompanying unaudited consolidated financial statements of the Company have been prepared in conformity with U.S. generally accepted accounting principles (U.S. GAAP) for interim financial information and with the instructions to Form10-Q, and Rule 10-01 of Regulation S-X. Accordingly, the unaudited consolidated financial statements do not include all of the information and disclosures required by U.S. GAAP for complete financial statements and should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015. Certain amounts in the 2015 condensed consolidated financial statements have been reclassified to conform to the 2016 condensed consolidated presentation. Such reclassifications have no effect on previously reported net income or stockholders’ equity.
The preparation of the consolidated financial statements includes all adjustments that, in the opinion of management, are necessary in order to make those statements not misleading. Management is required to make estimates and assumptions, including the determination of the allowance for loan losses, real estate acquired in connection with foreclosure or in satisfaction of loans, and fair values of investment securities available-for-sale that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The Company’s management has evaluated and did not identify any subsequent events or transactions requiring recognition or disclosure in the consolidated financial statements.
Stock DividendOn July 1, 2016, the Company paid a special stock dividend of four percent to shareholders of record at the close of business on June 15, 2016. For all periods presented, share information, including basic and diluted earnings per share, has been adjusted retroactively to reflect this change.
The following represents significant new accounting principles adopted in 2016:
Consolidation The FASB issued ASU No. 2015-02, Amendments to the Consolidation Analysis, in February 2015. The amendment substantially changes the way reporting entities are required to evaluate whether they should consolidate certain legal entities. All legal entities are subject to reevaluation under the new amendment. Specifically, the amendments modify the evaluation of whether limited partnerships and similar legal entities are variable interest entities (VIEs) or voting interest entities, eliminate the presumption that a general partner should consolidate a limited partnership, and affect the consolidation analysis of reporting entities that are involved with VIEs. The amendments were effective for interim and annual periods beginning January 1, 2016. The adoption did not have a significant effect on the Company’s consolidated financial statements.
Intangible Assets The FASB issued ASU 2015-05, Customer's Accounting for Fees Paid in a Cloud Computing Arrangement, in April 2015. The amendments provide guidance to customers about whether a cloud computing arrangement includes a software license. Arrangements containing a license should be recorded as consistent with the acquisition of software licenses, whereas arrangements that do not include a software license should be recorded as consistent with the accounting for service contracts. These amendments were effective for interim and annual periods beginning January 1, 2016. The adoption did not have a significant effect on the Company's consolidated financial statements.
Loans
A summary of loans, by major class within the Company’s loan portfolio, at September 30, 2016 and December 31, 2015 is as follows:
The Bank grants real estate, commercial, installment, and other consumer loans to customers located within the communities surrounding Jefferson City, Columbia, Clinton, Warsaw, Springfield, Branson and the greater Kansas City metropolitan area. As such, the Bank is susceptible to changes in the economic environment in these communities. The Bank does not have a concentration of credit in any one economic sector. Installment and other consumer loans consist primarily of automobile financing. At September 30, 2016, loans with a carrying value of $472.9 million, or $388.3 million fair value, were pledged to the Federal Home Loan Bank as collateral for borrowings and letters of credit.
Allowance for Loan Losses
The following is a summary of the allowance for loan losses during the periods indicated.
Loans, or portions of loans, are charged off to the extent deemed uncollectible or a loss is confirmed. Loan charge-offs reduce the allowance for loan losses, and recoveries of loans previously charged off are added back to the allowance. If management determines that it is probable that all amounts due on a loan will not be collected under the original terms of the loan agreement, the loan is considered to be impaired. These loans are evaluated individually for impairment and specific reserves are estimated as further discussed below. Loans not individually evaluated are aggregated by risk characteristics and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type, delinquencies, current economic conditions, loan risk ratings and industry concentration.
Beginning in the first quarter of 2016, the Company began to lengthen its look-back period with the intent to increase such period from three to five years over the next two years. The Company believes that the five-year look-back period, which is consistent with the Company’s practices prior to the start of the economic recession in 2008, provides a representative historical loss period in the current economic environment.
The following table provides the balance in the allowance for loan losses at September 30, 2016 and December 31, 2015, and the related loan balance by impairment methodology.
Impaired Loans
Loans evaluated under ASC 310-10-35 include loans which are individually evaluated for impairment. All other loans are collectively evaluated for impairment under ASC 450-20. Impaired loans individually evaluated for impairment totaled $9.2 million and $10.3 million at September 30, 2016 and December 31, 2015, respectively, and are comprised of loans on non-accrual status and loans which have been classified as troubled debt restructurings (TDRs).
The net carrying value of impaired loans is generally based on the fair values of collateral obtained through independent appraisals or internal evaluations, less selling costs, or by discounting the total expected future cash flows. At September 30, 2016 and December 31, 2015, $4.7 million and $6.4 million, respectively, of impaired loans were evaluated based on the fair value less estimated selling costs of the loan’s collateral. Once the impairment amount is calculated a specific reserve allocation is recorded. At September 30, 2016, $1.3 million of the Company’s allowance for loan losses was allocated to impaired loans totaling $9.2 million compared to $1.5 million of the Company's allowance for loan losses allocated to impaired loans totaling $10.3 million at December 31, 2015. Management determined that $2.1 million, or 23%, of total impaired loans required no reserve allocation at September 30, 2016 compared to $4.5 million, or 44%, at December 31, 2015 primarily due to adequate collateral values, acceptable payment history and adequate cash flow ability.
The categories of impaired loans at September 30, 2016 and December 31, 2015 are as follows:
The following tables provide additional information about impaired loans at September 30, 2016 and December 31, 2015, respectively, segregated between loans for which an allowance has been provided and loans for which no allowance has been provided.
The following table presents by class, information related to the average recorded investment and interest income recognized on impaired loans during the periods indicated.
The recorded investment varies from the unpaid principal balance primarily due to partial charge-offs taken resulting from current appraisals received. The amount recognized as interest income on impaired loans continuing to accrue interest, primarily related to troubled debt restructurings, was $55,000 and $246,000, for the three months and nine months ended September 30, 2016, respectively, compared to $63,000 and $261,000 for the three and nine months ended September 30, 2015, respectively. The average recorded investment in impaired loans is calculated on a monthly basis during the periods reported.
Delinquent and Non-Accrual Loans
The delinquency status of loans is determined based on the contractual terms of the notes. Borrowers are generally classified as delinquent once payments become 30 days or more past due. The Company’s policy is to discontinue the accrual of interest income on any loan when, in the opinion of management, the ultimate collectibility of interest or principal is no longer probable. In general, loans are placed on non-accrual when they become 90 days or more past due. However, management considers many factors before placing a loan on non-accrual, including the delinquency status of the loan, the overall financial condition of the borrower, the progress of management’s collection efforts and the value of the underlying collateral. Non-accrual loans are returned to accrual status when, in the opinion of management, the financial condition of the borrower indicates that the timely collectibility of interest and principal is probable and the borrower demonstrates the ability to pay under the terms of the note through a sustained period of repayment performance, which is generally six months.
The following table provides aging information for the Company’s past due and non-accrual loans at September 30, 2016 and December 31, 2015.
Credit Quality
The Company categorizes loans into risk categories based upon an internal rating system reflecting management’s risk assessment. Loans are placed on watch status when one or more weaknesses that may result in the deterioration of the repayment exits or the Company’s credit position at some future date. Loans classified as substandard are inadequately protected by the current sound worth and paying capacity of the obligor or by the collateral pledged, if any. Loans so classified may have a well-defined weakness or weaknesses that jeopardize the repayment of the debt. Such loans are characterized by the distinct possibility that the Company may sustain some loss if the deficiencies are not corrected. A loan is classified as a troubled debt restructuring (TDR) when a borrower is experiencing financial difficulties that lead to the restructuring of a loan, where the Company grants concessions to the borrower in the restructuring that it would not otherwise consider. Loans classified as TDRs which continue to accrue interest are classified as performing TDRs. Loans classified as TDRs which are not accruing interest are classified as nonperforming TDRs and are included with all other nonaccrual loans for presentation purposes. It is the Company’s policy to discontinue the accrual of interest income on loans when management believes that the collection of interest or principal is doubtful. Loans are placed on non-accrual status when (1) deterioration in the financial condition of the borrower exists for which payment of full principal and interest is not expected, or (2) payment of principal or interest has been in default for a period of 90 days or more and the asset is not both well secured and in the process of collection. Subsequent interest payments received on such loans are applied to principal if any doubt exists as to the collectability of such principal; otherwise, such receipts are recorded as interest income on a cash basis.
The following table presents the risk categories by class at September 30, 2016 and December 31, 2015.
Troubled Debt Restructurings
At September 30, 2016, loans classified as TDRs totaled $6.3 million, of which $597,000 were classified as nonperforming TDRs and included in non-accrual loans and $5.7 million were classified as performing TDRs. At December 31, 2015, loans classified as TDRs totaled $6.4 million, of which $527,000 were classified as nonperforming TDRs and included in non-accrual loans and $5.9 million were classified as performing TDRs. Both performing and nonperforming TDRs are considered impaired loans. When an individual loan is determined to be a TDR, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the underlying collateral less applicable selling costs. Accordingly, specific reserves of $445,000 and $910,000 related to TDRs were allocated to the allowance for loan losses at September 30, 2016 and December 31, 2015, respectively.
The following table summarizes loans that were modified as TDRs during the periods indicated.
(1) The amounts reported post-modification are inclusive of all partial pay-downs and charge-offs, and no portion of the debt was forgiven. Loans modified as a TDR that were fully paid down, charged-off or foreclosed upon during the period ended are not reported.
The Company’s portfolio of loans classified as TDRs include concessions for the borrower given financial condition such as interest rates below the current market rate, deferring principal payments, and extending maturity dates. There were six loans and seven loans meeting the TDR criteria during the three and nine months ended September 30, 2016, respectively, compared to no loans and ten loans during the three and nine months ended September 30, 2015, respectively.
Upon default of a TDR, which is considered to be 90 days or more past due under the modified terms, impairment is measured based on the fair value of the underlying collateral less applicable selling costs. The impairment amount is either charged off as a reduction to the allowance for loan losses, provided for as a specific reserve within the allowance for loan losses, or in the process of foreclosure. There was one TDR that defaulted during the three and nine months ended September 30, 2016 and is in the process of foreclosure within twelve months of its modification date and no TDR’s defaulted during 2015. See Lending and Credit Management section for further information.
Changes in the net carrying amount of other real estate and repossessed assets were as follows for the periods indicated:
At September 30, 2016, $141,000 of consumer mortgage loans secured by residential real estate properties were in the process of foreclosure compared to $390,000 at December 31, 2015.
Activity in the valuation allowance for other real estate owned was as follows for the periods indicated:
The amortized cost, contractual maturity, gross unrealized gains and losses, and fair value of debt securities classified as available-for-sale at September 30, 2016 and December 31, 2015 are shown below:
* Expected maturities may differ from contractual maturities because borrowers have the right to call or prepay obligations with or without prepayment penalties.
All of the Company’s investment securities are classified as available for sale. Agency bonds and notes, small business administration guaranteed loan certificates (SBA), residential and commercial agency mortgage-backed securities, and agency collateralized mortgage obligations (CMO) include securities issued by the Government National Mortgage Association (GNMA), a U.S. government agency, and the Federal National Mortgage Association (FNMA), the Federal Home Loan Mortgage Corporation (FHLMC) and the Federal Home Loan Bank (FHLB), which are U.S. government-sponsored enterprises.
Other investments and securities primarily consist of Federal Home Loan Bank stock and the Company’s interest in statutory trusts. These securities are reported at cost in the amount of $9.2 million and $8.0 million as of September 30, 2016 and December 31, 2015, respectively.
Debt securities with carrying values aggregating approximately $183.2 million and $182.7 million at September 30, 2016 and December 31, 2015, respectively, were pledged to secure public funds, securities sold under agreements to repurchase, and for other purposes as required or permitted by law.
Gross unrealized losses on debt securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2016 and December 31, 2015 were as follows:
The total available for sale portfolio consisted of approximately 282 securities at September 30, 2016. The portfolio included 76 securities having an aggregate fair value of $71.0 million that were in a loss position at September 30, 2016. Securities identified as temporarily impaired which had been in a loss position for 12 months or longer had a fair value of $3.4 million at September 30, 2016. The $390,000 aggregate unrealized loss included in accumulated other comprehensive income at September 30, 2016 was caused by interest rate fluctuations.
The total available for sale portfolio consisted of approximately 316 securities at December 31, 2015. The portfolio included 111 securities having an aggregate fair value of $147.5 million that were in a loss position at December 31, 2015. Securities identified as temporarily impaired which had been in a loss position for 12 months or longer had a fair value of $45.3 million at December 31, 2015. The $2.0 million aggregate unrealized loss included in accumulated other comprehensive income at December 31, 2015 was caused by interest rate fluctuations.
Because the decline in fair value is attributable to changes in interest rates and not credit quality, these investments were not considered other-than-temporarily impaired at September 30, 2016 and December 31, 2015, respectively. In the absence of changes in credit quality of these investments, the fair value is expected to recover on all debt securities as they approach their maturity date, or re-pricing date or if market yields for such investments decline. In addition, the Company does not have the intent to sell these investments over the period of recovery, and it is not more likely than not that the Company will be required to sell such investment securities.
The following table presents the components of investment securities gains and losses, which have been recognized in earnings.
Mortgage Servicing Rights
At September 30, 2016, the Company was servicing approximately $299.7 million of loans sold to the secondary market compared to $312.1 million at December 31, 2015, and $311.8 million at September 30, 2015. Mortgage loan servicing fees, reported as non-interest income, earned on loans sold were $233,000 and $654,000 for the three and nine months ended September 30, 2016, respectively, compared to $206,000 and $648,000 for the three and nine months ended September 30, 2015, respectively.
The table below presents changes in mortgage servicing rights (MSRs) for the periods indicated.
(1) The change in fair value resulting from changes in valuation inputs or assumptions used in the valuation model reflects the change in discount rates and prepayment speed assumptions primarily due to changes in interest rates.
(2) Other changes in fair value reflect changes due to customer payments and passage of time.
The following key data and assumptions were used in estimating the fair value of the Company’s MSRs as of the nine months ended September 30, 2016 and 2015:
The Company offers a sweep account program whereby amounts in excess of an established limit are “swept” from the customer’s demand deposit account on a daily basis into retail repurchase agreements pursuant to individual repurchase agreements between the Company and its customers.Repurchase agreements are agreements to sell securities subject to an obligation to repurchase the same or similar securities. They are accounted for as secured borrowings, not as sales and purchases of the securities portfolio. The securities collateral pledged for the repurchase agreements with customers is maintained by a designated third party custodian. The collateral amounts pledged to repurchase agreements by remaining maturity in the table below are limited to the outstanding balances of the related asset or liability; thus amounts of excess collateral are not shown.
Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 34.7% for the three months ended September 30, 2016 compared to 35.2% for the three months ended September 30, 2015. Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 33.8% for the nine months ended September 30, 2016 compared to 34.6% for the nine months ended September 30, 2015. The decrease in tax rates year over year is primarily due to an immaterial return to provision adjustment recorded in the first quarter of 2016.
The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income of the appropriate character during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, taxable income available in carryback years, and tax planning strategies in making this assessment. With the exception of certain capital losses generated during 2013 and 2014, it is management’s opinion that the Company will more likely than not realize the benefits of these temporary differences as of September 30, 2016 and, therefore, only established a valuation reserve against the Company’s capital loss carry forward. Management arrived at this conclusion based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible. As indicated above, the Company generated approximately $219,000 of capital losses during 2013 and 2014 as a result of disposing of certain limited partnership interests. The capital losses will expire between 2019 and 2020, and it is management’s opinion that the Company will not more likely than not generate the capital gain income necessary to utilize the capital loss carry forwards before the capital losses expire. As such, the Company has established an $83,000 valuation reserve against its capital loss carry forward deferred tax asset.
Accumulated Other Comprehensive Loss
The following details the change in the components of the Company’s accumulated other comprehensive income (loss) for the nine months ended September 30, 2016 and 2015:
(1) The pre-tax amounts reclassified from accumulated other comprehensive income (loss) are included in gain on sale of investment securities in the consolidated statements of income.
(2) The pre-tax amounts reclassified from accumulated other comprehensive income (loss) are included in the computation of net periodic pension cost.
Employee Benefits
Employee benefits charged to operating expenses are summarized in the table below for the periods indicated.
The Company’s profit-sharing plan includes a matching 401k portion, in which the Company matches the first 3% of eligible employee contributions. The Company made annual contributions in an amount up to 6% of income before income taxes and before contributions to the profit-sharing and pension plans for all participants, limited to the maximum amount deductible for federal income tax purposes, for each of the periods shown. In addition, employees were able to make additional tax-deferred contributions.
Pension
The Company provides a noncontributory defined benefit pension plan for all full-time employees. An employer is required to recognize the funded status of a defined benefit postretirement plan as an asset or liability in its balance sheet and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. Under the Company’s funding policy for the defined benefit pension plan, contributions are made to a trust as necessary to provide for current service and for any unfunded accrued actuarial liabilities over a reasonable period. To the extent that these requirements are fully covered by assets in the trust, a contribution might not be made in a particular year. A pension contribution in the amount of $772,000 was made on April 15, 2016.
Components of Net Pension Cost and Other Amounts Recognized in Accumulated Other Comprehensive Income
The following items are components of net pension cost for the periods indicated:
The Company’s stock option plan provides for the grant of options to purchase up to 553,361 shares of the Company’s common stock to officers and other key employees of the Company and its subsidiaries. All options have been granted at exercise prices equal to fair value and vest over periods ranging from four to five years.
The following table summarizes the Company’s stock option activity:
Options have been adjusted to reflect a 4% stock dividend paid on July 1, 2016.
Total stock-based compensation expense was $5,000 and $16,000 for the three and nine months ended September 30, 2016, respectively, compared to $1,000 and $5,000 for both the three and nine months ended September 30, 2015, respectively. As of September 30, 2016, the total unrecognized compensation expense related to non-vested stock awards was $4,000 and the related weighted average period over which it is expected to be recognized is approximately 0.51 years.
Stock Dividend On July 1, 2016, the Company paid a special stock dividend of 4% to common shareholders of record at the close of business on June 15, 2016. For all periods presented, share information, including basic and diluted earnings per share, has been adjusted retroactively to reflect this change.
Basic earnings per share is computed by dividing income available to shareholders by the weighted average number of shares outstanding during the year. Diluted earnings per share gives effect to all dilutive potential shares that were outstanding during the year. The calculations of basic and diluted earnings per share are as follows for the periods indicated:
Under the treasury stock method, outstanding stock options are dilutive when the average market price of the Company’s common stock, when combined with the effect of any unamortized compensation expense, exceeds the option price during the period, except when the Company has a loss from continuing operations available to shareholders. In addition, proceeds from the assumed exercise of dilutive options along with the related tax benefit are assumed to be used to repurchase common shares at the average market price of such stock during the period.
Options to purchase 44,458 and 69,106 shares during the three and nine months ended September 30, 2016 and 2015, respectively, were not included in the respective computations of diluted earnings per share because the exercise price of the option, when combined with the effect of the unamortized compensation expense, was greater than the average market price of the common shares and were considered anti-dilutive.
Repurchase ProgramOn August 6, 2015, the Board of Directors authorized a share repurchase plan to purchase through open market transactions $2.0 million market value of the Company’s common stock. During 2016, the Company repurchased 30,033 shares of common stock pursuant to the plan at an average price of $14.50 per share. At September 30, 2016, approximately $1.5 million may be used to purchase shares under the plan.
The table below shows activity in the outstanding shares of the Company's common stock during the periods presented in the table. Shares in the table below are presented on a historical basis and have not been restated for the annual 4% stock dividends.
Except as noted in the above table, all share and per share amounts in this note have been restated for the 4% common stock dividend distributed July 1, 2016.
The Company uses fair value measurements to record fair value adjustments to certain financial and nonfinancial assets and liabilities. The FASB ASC Topic 820, Fair Value Measurements and Disclosures, defines fair value, establishes a framework for the measurement of fair value, and enhances disclosures about fair value measurements. The standard applies whenever other standards require (permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. In this standard, FASB clarified the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability. In support of this principle, the standard establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. As of September 30, 2016 and December 31, 2015, respectively, there were no transfers into or out of Levels 1-3.
The fair value hierarchy is as follows:
Level 1 – Inputs are unadjusted quoted prices for identical assets or liabilities in active markets.
Level 2 – Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets and liabilities in active markets, such as interest rates and yield curves that are observable at commonly quoted intervals.
Level 3 – Inputs are unobservable inputs for the asset or liability and significant to the fair value. These may be internally developed using the Company’s best information and assumptions that a market participant would consider.
ASC Topic 820 also provides guidance on determining fair value when the volume and level of activity for the asset or liability have significantly decreased and on identifying circumstances when a transaction may not be considered orderly.
The Company is required to disclose assets and liabilities measured at fair value on a recurring basis separate from those measured at fair value on a nonrecurring basis. Nonfinancial assets measured at fair value on a nonrecurring basis would include foreclosed real estate, long-lived assets, and core deposit intangible assets, which are reviewed when circumstances or other events indicate that impairment may have occurred.
Valuation Methods for Instruments Measured at Fair Value on a Recurring Basis
Following is a description of the Company’s valuation methodologies used for assets and liabilities recorded at fair value on a recurring basis:
Available-for-Sale Securities
The fair value measurements of the Company’s investment securities are determined by a third party pricing service which considers observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things. The fair value measurements are subject to independent verification to another pricing source by management each quarter for reasonableness. Securities classified as available-for-sale are reported at fair value utilizing Level 2 inputs.
The fair value of mortgage servicing rights is based on the discounted value of estimated future cash flows utilizing contractual cash flows, servicing rate, constant prepayment rate, servicing cost, and discount rate factors. Accordingly, the fair value is estimated based on a valuation model that calculates the present value of estimated future net servicing income. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, market discount rates, cost to service, float earnings rates, and other ancillary income, including late fees. The valuation models estimate the present value of estimated future net servicing income. The Company classifies its servicing rights as Level 3.
The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows:
The change in valuation of mortgage servicing rights arising from inputs and assumptions decreased $52,000 and $197,000, compared to an increase of $136,000 and $223,000 for the three and nine months ended September 30, 2016 and 2015, respectively. MSR values have been falling steadily throughout 2016. The lower values are primarily related to faster prepay speed assumptions, consistent with lower long term interest rates.
Valuation methods for instruments measured at fair value on a nonrecurring basis
Following is a description of the Company’s valuation methodologies used for assets and liabilities recorded at fair value on a nonrecurring basis:
The Company does not record loans at fair value on a recurring basis other than loans that are considered impaired. The net carrying value of impaired loans is generally based on fair values of the underlying collateral obtained through independent appraisals or internal evaluations less estimated selling costs, or by discounting the total expected future cash flows. Once the fair value of the collateral less estimated selling costs has been determined and any impairment amount calculated, a specific reserve allocation is made. Because many of these inputs are not observable, the measurements are classified as Level 3. As of September 30, 2016, the Company identified $7.1 million in impaired loans that had specific allowances for losses aggregating $1.3 million. Related to these loans, there was $153,000 and $920,000 in charge-offs recorded during the three and nine months ended September 30, 2016, respectively. As of September 30, 2015, the Company identified $6.8 million in impaired loans that had specific allowances for losses aggregating $2.0 million. Related to these loans, there was $695,000 and $1.0 million in charge-offs recorded during the three and nine months ended September 30, 2015, respectively.
Other Real Estate and Foreclosed Assets
Other real estate and foreclosed assets consisted of loan collateral that has been repossessed through foreclosure. This collateral is comprised of commercial and residential real estate and other non-real estate property, including autos, manufactured homes, and construction equipment. Other real estate assets are recorded as held for sale initially at the lower of the loan balance or fair value of the collateral less estimated selling costs. The Company relies on external appraisals and assessment of property values by internal staff. In the case of non-real estate collateral, reliance is placed on a variety of sources, including external estimates of value and judgment based on experience and expertise of internal specialists. Subsequent to foreclosure, valuations are updated periodically, and the assets may be written down to reflect a new cost basis. Because many of these inputs are not observable, the measurements are classified as Level 3.
* Total gains (losses) reported for other real estate and foreclosed assets includes charge-offs, valuation write downs, and net losses taken during the periods reported.
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate such value:
The fair values of loans are estimated by discounting the expected future cash flows using the current rates at which similar loans could be made to borrowers with similar credit ratings and for the same remaining maturities. The net carrying amount of impaired loans is generally based on the fair values of collateral obtained through independent appraisals or internal evaluations, or by discounting the total expected future cash flows. This method of estimating fair value does not incorporate the exit-price concept of fair value prescribed by ASC Topic 820.
Investment Securities
A detailed description of the fair value measurement of the debt instruments in the available-for-sale sections of the investment security portfolio is provided in the Fair Value Measurement section above. A schedule of investment securities by category and maturity is provided in the notes on Investment Securities.
Federal Home Loan Bank (FHLB) Stock
Ownership of equity securities of FHLB is restricted and there is no established market for their resale. The carrying amount is a reasonable estimate of fair value.
Federal Funds Sold, Cash, and Due from Banks
The carrying amounts of short-term federal funds sold and securities purchased under agreements to resell, interest earning deposits with banks, and cash and due from banks approximate fair value. Federal funds sold and securities purchased under agreements to resell classified as short-term generally mature in 90 days or less.
The fair value of mortgage servicing rights is based on the discounted value of estimated future cash flows utilizing contractual cash flows, servicing rate, constant prepayment rate, servicing cost, and discount rate factors. Accordingly, the fair value is estimated based on a valuation model that calculates the present value of estimated future net servicing income. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, market discount rates, cost to service, float earnings rates, and other ancillary income, including late fees.
Cash Surrender Value - Life Insurance
The fair value of Bank owned life insurance (BOLI) approximates the carrying amount. Upon liquidation of these investments, the Company would receive the cash surrender value which equals the carrying amount.
Accrued Interest Receivable and Payable
For accrued interest receivable and payable, the carrying amount is a reasonable estimate of fair value because of the short maturity for these financial instruments.
Deposits
The fair value of deposits with no stated maturity, such as noninterest-bearing demand, NOW accounts, savings, and money market, is equal to the amount payable on demand. The fair value of time deposits is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.
Securities Sold under Agreements to Repurchase and Interest-bearing Demand Notes to U.S. Treasury
For securities sold under agreements to repurchase and interest-bearing demand notes to U.S. Treasury, the carrying amount is a reasonable estimate of fair value, as such instruments reprice in a short time period.
Subordinated Notes and Other Borrowings
The fair value of subordinated notes and other borrowings is based on the discounted value of contractual cashflows. The discount rate is estimated using the rates currently offered for other borrowed money of similar remaining maturities.
A summary of the carrying amounts and fair values of the Company’s financial instruments at September 30, 2016 and December 31, 2015 is as follows:
Off-Balance Sheet Financial Instruments
The fair value of commitments to extend credit and standby letters of credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements, the likelihood of the counterparties drawing on such financial instruments, and the present creditworthiness of such counterparties. The Company believes such commitments have been made on terms that are competitive in the markets in which it operates.
Limitations
The fair value estimates provided are made at a point in time based on market information and information about the financial instruments. Because no market exists for a portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the fair value estimates.
The Company’s repurchase reserve liability for estimated losses incurred on sold loans was $160,000 at both September 30, 2016 and December 31, 2015. This liability represents management’s estimate of the potential repurchase or make-whole liability for residential mortgage loans originated for sale that may arise from representation and warranty claims that could relate to a variety of issues, including but not limited to, misrepresentation of facts, appraisal issues, or program requirements that may not meet investor guidelines. At September 30, 2016, the Company accrued $2,000 for the reimbursement of expenses incurred on one repurchase loss remitted in April 2016 compared to $40,000 accrued for the expenses on one repurchase loss remitted in April 2015 of the prior year. At September 30, 2016, the Company was servicing 2,909 loans sold to the secondary market with a balance of approximately $299.7 million compared to 3,024 loans sold with a balance of approximately $312.1 million at December 31, 2015.
The Company issues financial instruments with off-balance-sheet risk in the normal course of business of meeting the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments may involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the consolidated balance sheets.
The Company’s extent of involvement and maximum potential exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for financial instruments included on its consolidated balance sheets. At September 30, 2016, no amounts have been accrued for any estimated losses for these financial instruments.
The contractual amount of off-balance-sheet financial instruments were as follows as of the dates indicated:
Commitments
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since certain of the commitments and letters of credit are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the customer. Collateral held varies, but may include accounts receivable, inventory, furniture and equipment, and real estate.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. These standby letters of credit are primarily issued to support contractual obligations of the Company’s customers. The approximate remaining term of standby letters of credit range from one month to five years at September 30, 2016.
Pending Litigation
The Company and its subsidiaries are defendants in various legal actions incidental to the Company’s past and current business activities. Based on the Company’s analysis, and considering the inherent uncertainties associated with litigation, management does not believe that it is reasonably possible that these legal actions will materially adversely affect the Company’s consolidated financial condition or results of operations in the near term. The Company records a loss accrual for all legal matters for which it deems a loss is probable and can be reasonably estimated. Some legal matters, which are at early stages in the legal process, have not yet progressed to the point where a loss is deemed probable or an amount can be estimated.
Item 2 - Management’s Discussion and Analysis of Financial Condition
And Results of Operations
This report contains certain forward-looking statements with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company, Hawthorn Bancshares, Inc., and its subsidiaries, including, without limitation:
Forward-looking statements are not guarantees of future performance or results. They involve risks, uncertainties and assumptions. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors:
We have described under the caption Risk Factors in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015, and in other reports filed with the SEC from time to time, additional factors that could cause actual results to be materially different from those described in the forward-looking statements. Other factors that have not been identified in this report could also have this effect. You are cautioned not to put undue reliance on any forward-looking statement, which speak only as of the date they were made.
Overview
Crucial to the Company’s community banking strategy is growth in its commercial banking services, retail mortgage lending and retail banking services. Through the branch network of its subsidiary bank, the Company, with $1.2 billion in assets at September 30, 2016, provides a broad range of commercial and personal banking services. The Bank’s specialties include commercial banking for small and mid-sized businesses, including equipment, operating, commercial real estate, Small Business (SBA) loans, and personal banking services including real estate mortgage lending, installment and consumer loans, certificates of deposit, individual retirement and other time deposit accounts, checking accounts, savings accounts, and money market accounts. Other financial services that the Company provides include trust services that include estate planning, investment and asset management services and a comprehensive suite of cash management services. The geographic areas in which the Company provides products and services include the communities in and surrounding Jefferson City, Columbia, Clinton, Warsaw, Springfield, Branson, and the greater Kansas City metropolitan area.
The Company's primary source of revenue is net interest income derived primarily from lending and deposit taking activities. Much of the Company's business is commercial, commercial real estate development, and mortgage lending. The Company's income from mortgage brokerage activities is directly dependent on mortgage rates and the level of home purchases and refinancings.
The success of the Company's growth strategy depends primarily on the ability of its banking subsidiary to generate an increasing level of loans and deposits at acceptable risk levels and on acceptable terms without significant increases in non-interest expenses relative to revenues generated. The Company's financial performance also depends, in part, on its ability to manage various portfolios and to successfully introduce additional financial products and services by expanding new and existing customer relationships, utilizing improved technology, and enhancing customer satisfaction. Furthermore, the success
of the Company's growth strategy depends on its ability to maintain sufficient regulatory capital levels during periods in which general economic conditions are unfavorable and despite economic conditions being beyond its control.
The Company’s subsidiary bank is a full-service bank conducting a general banking business, offering its customers checking and savings accounts, debit cards, certificates of deposit, safety deposit boxes and a wide range of lending services, including commercial and industrial loans, residential real estate loans, single payment personal loans, installment loans and credit card accounts. In addition, the Bank provides trust services.
The deposit accounts of the Bank are insured by the Federal Deposit Insurance Corporation (FDIC) to the extent provided by law. The operations of the Bank are supervised and regulated by the FDIC and the Missouri Division of Finance. Periodic examinations of the Bank are conducted by representatives of the FDIC and the Missouri Division of Finance. Such regulations, supervision and examinations are principally for the benefit of depositors, rather than for the benefit of shareholders. The Company is subject to supervision and examination by the Board of Governors of the Federal Reserve System.
CRITICAL ACCOUNTING POLICIES
The following accounting policies are considered most critical to the understanding of the Company’s financial condition and results of operations. These critical accounting policies require management’s most difficult, subjective and complex judgments about matters that are inherently uncertain. Because these estimates and judgments are based on current circumstances, they may change over time or prove to be inaccurate based on actual experiences. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of a materially different financial condition and/or results of operations could reasonably be expected. The impact and any associated risks related to the critical accounting policies on the business operations are discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations, where such policies affect the reported and expected financial results.
Management has identified the accounting policy related to the allowance for loan losses as critical to the understanding of the Company's results of operations, since the application of this policy requires significant management assumptions and estimates that could result in materially different amounts to be reported if conditions or underlying circumstances were to change. Further discussion of the methodology used in establishing the allowance and the impact of any associated risks related to these policies on the Company’s business operations is provided in note 1 to the Company’s unaudited consolidated financial statements and is also discussed in theLending and Credit Management section below. Many of the loans are deemed collateral dependent for purposes of the measurement of the impairment loss, thus the fair value of the underlying collateral and sensitivity of such fair values due to changing market conditions, supply and demand, condition of the collateral and other factors can be volatile over periods of time. Such volatility can have an impact on the financial performance of the Company.
Other Real Estate and Repossessed Assets
Other real estate and repossessed assets consist of loan collateral that has been repossessed through foreclosure. This collateral is comprised of commercial and residential real estate and other non-real estate property, including autos, manufactured homes, and construction equipment. Other real estate assets are initially recorded as held for sale at the fair value of the collateral less estimated selling costs. Any adjustment is recorded as a charge-off against the allowance for loan losses. The Company relies on external appraisals and assessment of property values by internal staff. In the case of non-real estate collateral, reliance is placed on a variety of sources, including external estimates of value and judgment based on experience and expertise of internal specialists. Subsequent to foreclosure, valuations are updated periodically, and the assets may be written down to reflect a new cost basis. The write-downs are recorded as other real estate expense, net. The Company establishes a valuation allowance related to other real estate owned on an asset-by-asset basis. The valuation allowance is created during the holding period when the fair value less cost to sell is lower than the cost of the property.
SELECTED CONSOLIDATED FINANCIAL DATA
The following table presents selected consolidated financial information for the Company as of and for each of the three and nine months ended September 30, 2016 and 2015, respectively. The selected consolidated financial data should be read in conjunction with the unaudited consolidated financial statements of the Company, including the related notes, presented elsewhere herein.
Selected Financial Data
RESULTS OF OPERATIONS ANALYSIS
The Company has prepared all of the consolidated financial information in this report in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP). In preparing the consolidated financial statements in accordance with U.S. GAAP, the Company makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurances that actual results will not differ from those estimates.
Consolidated net income decreased $655,000 to $1.9 million, or $0.33 per diluted share, for the three months ended September 30, 2016 compared to $2.5 million, or $0.45 per diluted share, for the three months ended September 30, 2015. For the three months ended September 30, 2016, the return on average assets was 0.59%, the return on average stockholders’ equity was 8.09%, and the efficiency ratio was 74.03%.
Consolidated net income decreased $1.3 million to $5.3 million, or $0.94 per diluted share, for the nine months ended September 30, 2016 compared to $6.6 million, or $1.17 per diluted share, for the nine months ended September 30, 2015. For the nine months ended September 30, 2016, the return on average assets was 0.94%, the return on average stockholders’ equity was 7.78%, and the efficiency ratio was 75.43%.
Net interest incomewas $10.1 million and $30.0 million for the three and nine months ended September 30, 2016, respectively, compared to $10.6 million and $30.5 million for the three and nine months end September 30, 2015, respectively. The net interest margin (expressed on a fully taxable equivalent basis) decreased to 3.44% for the three months ended September 30, 2016, compared to 3.78% for the three months ended September 30, 2015, and decreased to 3.47% for the nine months ended September 30, 2016 compared to 3.71% for the nine months ended September 30, 2015. These changes are discussed in greater detail under the Average Balance Sheets and Rate and Volume Analysis section below.
A $300,000 and $975,000provision for loan losses was recorded for the three and nine months ended September 30, 2016, respectively, compared to no provision and $250,000 provision for the three and nine months ended September 30, 2015.
The Company’s net charge-offs were $222,000, or 0.02% of average loans, for the three months ended September 30, 2016 compared to net charge-offs of $740,000, or 0.08% of average loans, for the three months ended September 30, 2015. For the nine months ended September 30, 2016, the Company’s net charge-offs were $109,000, or 0.01% of average loans compared to net charge-offs of $103,000, or 0.01% of average loans for the nine months ended September 30, 2015.
Non-performing loans totaled $9.3 million, or 0.98% of total loans, at September 30, 2016 compared to $10.3 million, or 1.19% of total loans, at December 31, 2015, and $14.6 million, or 1.66% of total loans, at September 30, 2015. These changes are discussed in greater detail under the Lending and Credit Management section below.
Non-interest income decreased $211,000, or 9.0%, to $2.1 million for the three months ended September 30, 2016 compared to $2.3 million for the three months ended September 30, 2015, and decreased $263,000, or 3.9%, to $6.5 million for the nine months ended September 30, 2016 compared to $6.8 million for the nine months ended September 30, 2015. These changes are discussed in greater detail below under Non-interest Income.
Non-interest expense increased $108,000, or 1.2%, to $9.1 million for the three months ended September 30, 2016 compared to $9.0 million for the three months ended September 30, 2015, and increased $569,000, or 2.1%, to $27.5 million for the nine months ended September 30, 2016 compared to $27.0 million for the nine months ended September 30, 2015. These changes are discussed in greater detail below under Non-interest Expense.
Average Balance Sheets
Net interest income is the largest source of revenue resulting from the Company’s lending, investing, borrowing, and deposit gathering activities. It is affected by both changes in the level of interest rates and changes in the amounts and mix of interest earning assets and interest bearing liabilities. The following table presents average balance sheets, net interest income, average yields of earning assets, average costs of interest bearing liabilities, net interest spread and net interest margin on a fully taxable equivalent basis for each of the periods ended September 30, 2016 and 2015, respectively.
Rate and Volume Analysis
The following table summarizes the changes in net interest income on a fully taxable equivalent basis, by major category of interest earning assets and interest bearing liabilities, identifying changes related to volumes and rates for the three and nine months ended September 30, 2016 compared to the three and nine months ended September 30, 2015. The change in interest due to the combined rate/volume variance has been allocated to rate and volume changes in proportion to the absolute dollar amounts of change in each.
Financial results for the three months ended September 30, 2016 compared to the three months ended September 30, 2015, reflected a decrease in net interest income, on a tax equivalent basis, of $438,000, or 4.10%, and financial results for the nine months ended September 30, 2016 compared to the nine months ended September 30, 2015 reflected a decrease of $628,000, or 2.03%.
Measured as a percentage of average earning assets, the net interest margin (expressed on a fully taxable equivalent basis) decreased to 3.44% for the three months ended September 30, 2016 compared to 3.78% for the three months ended September 30, 2015, and decreased to 3.47% for the nine months ended September 30, 2016 compared to 3.71% for the nine months ended September 30, 2015. The decrease in net interest income and the net
interest margin was due to a contraction in the net interest spread caused primarily by a decrease in the yield on investment securities maturing at higher historical rates and new replacement securities yielding lower current market rates.
Average interest-earning assets increased $62.4 million, or 5.56%, to $1.19 billion for the three months ended September 30, 2016 compared to $1.12 billion for the three months ended September 30, 2015, and average interest bearing liabilities increased $35.9 million, or 3.97%, to $941.7 million for the three months ended September 30, 2016 compared to $905.7 million for the three months ended September 30, 2015.
Average interest-earning assets increased $47.6 million, or 4.26%, to $1.16 billion for the nine months ended September 30, 2016 compared to $1.12 billion for the nine months ended September 30, 2015, and average interest bearing liabilities increased $27.9 million, or 3.09%, to $931.3 million for the nine months ended September 30, 2016 compared to $903.4 million for the nine months ended September 30, 2015.
Total interest income (expressed on a fully taxable equivalent basis) decreased to $11.7 million and $34.5 million for the three and nine months ended September 30, 2016, respectively, compared to $12.0 million and $34.7 million for the three and nine months ended September 30, 2015, respectively. The Company’s rates earned on interest earning assets were 3.93% and 3.95% for the three and nine months ended September 30, 2016, respectively, compared to 4.23% and 4.15% for the three and nine months ended September 30, 2015, respectively.
Interest income on loans was $10.7 million and $31.1 million for the three and nine months ended September 30, 2016, respectively, compared to $10.8 million and $31.0 million for the three and nine months ended September 30, 2015, respectively.
Average loans outstanding increased $59.3 million, or 6.81%, to $930.8 million for the three months ended September 30, 2016 compared to $871.5 million for the three months ended September 30, 2015. The average yield on loans receivable decreased to 4.57% for the three months ended September 30, 2016 compared to 4.90% for the three months ended September 30, 2015.
For the nine months ended September 30, 2016, average loans outstanding increased $34.7 million, or 4.02%, to $897.9 million compared to $863.3 million for the nine months ended September 30, 2015. The average yield on loans receivable decreased to 4.61% for the nine months ended September 30, 2016 compared to 4.81% for the nine months ended September 30, 2015.
Total interest expense was $1.5 million and $4.2 million for the three and nine months ended September 30, 2016, respectively, compared to $1.3 million and $3.7 million for the three and nine months ended September 30, 2015, respectively. The Company’s rates paid on interest bearing liabilities were 0.62% and 0.60% for the three and nine months ended September 30, 2016 compared to 0.56% and 0.55% for the three and nine months ended September 30, 2015, respectively. See the Liquidity Management section for further discussion.
Interest expense on deposits increased to $789,000 and $2.3 million for the three and nine months ended September 30, 2016, respectively, compared to $732,000 and $2.2 million for the three and nine months ended September 30, 2015, respectively.
Average time deposits increased $18.0 million, or 2.33%, to $786.7 million for the three months ended September 30, 2016 compared to $768.7 million for the three months ended September 30, 2015. The average cost of deposits increased to 0.40% for the three months ended September 30, 2016 compared to 0.38% for the three months ended September 30, 2015.
For the nine months ended September 30, 2016, average time deposits decreased $2.4 million, or 0.31%, to $780.9 million for the nine months ended September 30, 2015 compared to $783.3 million for the nine months ended September 30, 2015. The average cost of deposits increased to 0.39% for the nine months ended September 30, 2016 compared to 0.38% for the nine months ended September 30, 2015 primarily as a result of higher market interest rates.
Interest expense on borrowings increased to $670,000 and $1.9 million for the three and nine months ended September 30, 2016, respectively, compared to $539,000 and $1.5 million for the three and nine months ended September 30, 2015, respectively.
Average borrowings increased $18.0 million, or 13.14%, to $155.0 million for the three months ended September 30, 2016 compared to $137.0 million for the three months ended September 30, 2015. The average cost of borrowings increased to 1.72% for the three months ended September 30, 2016 compared to 1.56% for the three months ended September 30, 2015.
For the nine months ended September 30, 2016, average borrowings increased $30.4 million, or 25.31%, to $150.4 million for the nine months ended September 30, 2015 compared to $120.0 million for the nine months ended September 30, 2015. The average cost of borrowings decreased to 1.66% for the nine months ended September 30, 2016 compared to 1.67% for the nine months ended September 30, 2015. See the Liquidity Management section for further discussion.
Non-interest Income and Expense
Non-interest income for the periods indicated was as follows:
* Total revenue is calculated as net interest income plus non-interest income.
NM - not meaningful
Total non-interest income decreased $211,000, or 9.0%, to $2.1 million for the quarter ended September 30, 2016 compared to $2.3 million for the quarter ended September 30, 2015, and decreased $263,000, or 3.9%, to $6.5 million for the nine months ended September 30, 2016 compared to $6.8 million for the nine months ended September 30, 2015.
Real estate servicing fees, net of the change in valuation of mortgage serving rights decreased $181,000, or 102.3%, to $(4,000) for the quarter ended September 30, 2016 compared to $177,000 for the quarter ended September 30, 2015, and decreased $393,000, or 110.1%, to $(36,000) for the nine months ended September 30, 2016 compared to $357,000 for the nine months ended September 30, 2015.
Mortgage loan servicing fees earned on loans sold were $233,000 for the quarter ended September 30, 2016 compared to $206,000 for the quarter ended September 30, 2015. Total realized losses included in earnings attributable to the change in unrealized gains or losses related to assets still held were $237,000 for the quarter ended September 30, 2016 compared to $29,000 for the quarter ended September 30, 2015.
Mortgage loan servicing fees earned on loans sold were $654,000 for the nine months ended September 30, 2016 compared to $648,000 for the nine months ended September 30, 2015. Total realized losses included in earnings attributable to the change in unrealized gains or losses related to assets still held were $690,000 for the nine months ended September 30, 2016 compared to $291,000 for the nine months ended September 30, 2015. The Company was servicing $299.7 million of mortgage loans at September 30, 2015 compared to $312.1 million and $311.8 million at December 31, 2015 and September 30, 2015, respectively.
Gain on sales of mortgage loans decreased $56,000, or 17.4%, to $266,000 for the quarter ended September 30, 2016 compared to $322,000 for the quarter ended September 30, 2015, and decreased $450,000, or 40.8%, to $653,000 for the nine months ended September 30, 2016 compared to $1.1 million for the nine months ended September 30, 2015. The Company sold loans of $11.2 million for both the quarters ended September 30, 2016 and 2015, and $28.8 million for the nine months ended September 30, 2016 compared to $40.1 million for the nine months ended September 30, 2015.
Gain on sale of investment securities During the nine months ended September 30, 2016 the Company received $60.7 million from proceeds on sales of available-for-sale debt securities and recognized gains of $602,000. These transactions were the result of bond sales and purchases to replace several smaller holdings with fewer, larger investments without materially changing the duration or yield of the investment portfolio.
Non-interest expense for the periods indicated was as follows:
* Efficiency ratio is calculated as non-interest expense as a percent of total revenue. Total revenue includes net interest income and non-interest income.
Total non-interest expense increased $108,000, or 1.2%, to $9.1 million for the quarter ended September 30, 2016 compared to $9.0 million for the quarter ended September 30, 2015, and increased $569,000, or 2.1%, to $27.5 million for the nine months ended September 30, 2016 compared to $27.0 million for the nine months ended September 30, 2015.
Salariesdecreased $106,000, or 2.7%, to $3.8 million for the quarter ended September 30, 2016 compared to $3.9 million for the quarter ended September 30, 2015, and increased $185,000, or 1.6%, to $11.8 million for the nine months ended September 30, 2016 compared to $11.6 million for the nine months ended September 30, 2015. The decrease quarter over quarter was primarily due to a decrease in employees and the increase year over year was primarily due to annual salary increases granted at the beginning of each year.
Employee benefits decreased $151,000, or 10.9%, to $1.2 million for the quarter ended September 30, 2016 compared to $1.4 million for the quarter ended September 30, 2015, and decreased $265,000, or 6.3%, to $3.9 million for the nine months ended September 30, 2016 compared to $4.2 million for the nine months ended September 30, 2015. The decreases in both quarter over quarter and year over year were primarily due to decreases in the 401(k) profit-sharing plan expense, pension plan expense, and medical insurance premiums which was due to a change in the Company’s health insurance plan effective July 1, 2016.
FDIC insurance assessment increased $21,000, or 12.0%, to $196,000 for the quarter ended September 30, 2016 compared to $175,000 for the quarter ended September 30, 2015, and decreased $113,000, or 16.8%, to $560,000 for the nine months ended September 30, 2016 compared to $673,000 for the nine months ended September 30, 2015. The decrease year over year was primarily due to a decrease in the 2016 assessment. This decrease was not reflected quarter over quarter primarily due to an adjustment for the second quarter 2015 estimate that was made in the third quarter of 2015. As required by the Dodd-Frank Act, the FDIC finalized a rule in March 2016 to increase the deposit insurance fund from 1.15 percent of insured deposits to 1.35 percent by 2020. Under a rule adopted in 2011, assessment rates for all banks will decline by 2 or more basis points the quarter after the fund reaches 1.15 percent, which is anticipated for the second quarter of 2016. Under the current rule, starting that same quarter, banks under $10 billion will accrue credits for the portion of their assessments that contribute to growth of the fund above 1.15 percent.
Real estate foreclosure expense and (gains), net increased $378,000, or 114.9%, to $49,000 for the quarter ended September 30, 2016 compared to $(329,000) for the quarter ended September 30, 2015, and increased $584,000, or 165.9%, to $232,000 for the nine months ended September 30, 2016 compared to $(352,000) for the nine months ended September 30, 2015. Net gains recognized on other real estate owned were $17,000 for the quarter ended September 30, 2016 compared to $435,000 for the quarter ended September 30, 2015, and $64,000 for the nine months ended September 30, 2016 compared to $690,000 for the nine months ended September 30, 2015. Expenses to maintain foreclosed properties were $66,000 for the quarter ended September 30, 2016 compared to $107,000 for the quarter ended September 30, 2015, and $296,000 for the nine months ended September 30, 2016 compared to $338,000 for the nine months ended September 30, 2015.
Other non-interest expensedecreased $74,000, or 7.4%, to $927,000 for the quarter ended September 30, 2016 compared to $1.0 million for the quarter ended September 30, 2015, and increased $281,000, or 11.4%, to $2.8 million for the nine months ended September 30, 2016 compared to $2.5 million for the nine months ended September 30, 2015. The decrease quarter
over quarter was primarily related to an impairment write-down on a building held for sale in 2015. The increase year over year was primarily due to an increase in debit card charge offs due to fraudulent transactions, an increase in donations, and an increase in employee training, education, and travel expenses, partially offset by the impairment write-down on a building held for sale in 2015.
Income taxes
Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 34.7% for the quarter ended September 30, 2016 compared to 35.2% for the quarter ended September 30, 2015. Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 33.8% for the nine months ended September 30, 2016 compared to 34.6% for the nine months ended September 30, 2015. The decrease in tax rates year over year is primarily due to an immaterial return to provision adjustment recorded during the first quarter of 2016.
Lending and Credit Management
Interest earned on the loan portfolio is a primary source of interest income for the Company. Net loans represented 73.4% of total assets as of September 30, 2016 compared to 71.3% as of December 31, 2015.
Lending activities are conducted pursuant to an established loan policy approved by the Bank’s Board of Directors. The Bank’s credit review process is overseen by regional loan committees with established loan approval limits. In addition, a senior loan committee reviews all credit relationships in aggregate over an established dollar amount. The senior loan committee meets weekly and is comprised of senior managers of the Bank.
A summary of loans, by major class within the Company’s loan portfolio as of the dates indicated is as follows:
The Company extends credit to its local community market through traditional real estate mortgage products. The Company does not participate in extending credit to sub-prime residential real estate markets. The Company does not lend funds for the type of transactions defined as “highly leveraged” by bank regulatory authorities or for foreign loans. Additionally, the Company does not have any concentrations of loans exceeding 10% of total loans that are not otherwise disclosed in the loan portfolio composition table. The Company does not have any interest-earning assets that would have been included in nonaccrual, past due, or restructured loans if such assets were loans.
The Company generally does not retain long-term fixed rate residential mortgage loans in its portfolio. Fixed rate loans conforming to standards required by the secondary market are offered to qualified borrowers, but are not funded until the Company has a non-recourse purchase commitment from the secondary market at a predetermined price. The Company sold loans of $11.2 million and $28.8 million to investors for the three and nine months ended September 30, 2016, respectively, compared to $11.2 million and $40.1 million for the three and nine months ended September 30, 2015, respectively. At September 30, 2016, the Company was servicing approximately $299.7 million of loans sold to the secondary market compared to $312.1 million at December 31, 2015, and $311.8 million at September 30, 2015.
Risk Elements of the Loan Portfolio
Management, the senior loan committee, and internal loan review, formally review all loans in excess of certain dollar amounts (periodically established) at least annually. Currently, loans in excess of $2.0 million in aggregate and all adversely classified credits identified by management are reviewed. In addition, all other loans are reviewed on a sample basis. The senior loan committee reviews and reports to the board of directors, on a monthly basis, past due, classified, and watch list
loans in order to classify or reclassify loans as loans requiring attention, substandard, doubtful, or loss. During this review, management also determines which loans should be considered impaired. Management follows the guidance provided in the FASB’s ASC Topic 310, Accounting by Creditors for Impairment of a Loan, in identifying and measuring loan impairment. If management determines that it is probable that all amounts due on a loan will not be collected under the original terms of the loan agreement, the loan is considered to be impaired. These loans are evaluated individually for impairment, and in conjunction with current economic conditions and loss experience, specific reserves are estimated as further discussed below. Loans not individually evaluated are aggregated and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type, delinquencies, current economic conditions, loan risk ratings and industry concentration. Management believes, but there can be no assurance, that these procedures keep management informed of potential problem loans. Based upon these procedures, both the allowance and provision for loan losses are adjusted to maintain the allowance at a level considered adequate by management to provide for probable losses inherent in the loan portfolio.
Nonperforming Assets
The following table summarizes nonperforming assets at the dates indicated:
Total nonperforming assets totaled $23.7 million at September 30, 2016 compared to $26.3 million at December 31, 2015. Nonperforming loans, defined as loans on nonaccrual status, loans 90 days or more past due and still accruing, and TDRs totaled $9.3 million, or 0.98% of total loans, at September 30, 2016 compared to $10.3 million, or 1.19% of total loans, at December 31, 2015, and $14.6 million, or 1.66% of total loans, at September 30, 2015. Non-accrual loans included $597,000 and $527,000 of loans classified as TDRs at September 30, 2016 and December 31, 2015, respectively.
As of September 30, 2016 and December 31, 2015, approximately $1.8 million and $5.7 million, respectively, of loans classified as substandard, not included in the nonperforming asset table, were identified as potential problem loans having more than a normal risk which raised doubts as to the ability of the borrower to comply with present loan repayment terms. Even though borrowers are experiencing moderate cash flow problems as well as some deterioration in collateral value, management believes the general allowance was sufficient to cover the risks and probable losses related to such loans at September 30, 2016 and December 31, 2015, respectively.
Total non-accrual loans at September 30, 2016 decreased $831,000, or 19.0%, to $3.6 million compared to $4.4 million at December 31, 2015. This decrease primarily consisted of decreases in real estate mortgage residential and commercial loans, partially offset by an increase in commercial, financial, and agricultural loans. The decrease in non-accrual loans primarily resulted from the sale of a piece of collateral and transfers of impaired loans to other real estate owned and repossessed assets.
Loans past due 90 days and still accruing interest at September 30, 2016, were $61,000 compared to $6,000 at December 31, 2015. Other real estate and repossessed assets at September 30, 2016 were $14.4 million compared to $16.0 million at December 31, 2015. During the nine months ended September 30, 2016, $2.0 million of nonaccrual loans, net of charge-offs taken, moved to other real estate owned and repossessed assets compared to $1.5 million during the nine months ended September 30, 2015.
The following table summarizes the Company’s TDRs at the dates indicated:
At September 30, 2016, loans classified as TDRs totaled $6.3 million, with $445,000 of specific reserves, of which $597,000 were classified as nonperforming TDRs and $5.7 million were classified as performing TDRs. This compared to $6.4 million of loans classified as TDRs, with $910,000 of specific reserves, of which $527,000 were classified as nonperforming TDRs and $5.9 million were classified as performing TDRs at December 31, 2015. Both performing and nonperforming TDRs are considered impaired loans. When an individual loan is determined to be a TDR, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the underlying collateral less applicable selling costs. The net decrease in total TDRs from December 31, 2015 to September 30, 2016 was primarily due to approximately $531,000 of payments received, partially offset by $406,000 of new loans designated as TDRs during the nine months ended September 30, 2016.
Allowance for Loan Losses and Provision
The following table is a summary of the allocation of the allowance for loan losses:
The allowance for loan losses (ALL) was $9.5 million, or 1.00% of loans outstanding, at September 30, 2016 compared to $8.6 million, or 0.99% of loans outstanding, at December 31, 2015, and $9.2 million, or 1.05% of loans outstanding, at September 30, 2015. The ratio of the allowance for loan losses to nonperforming loans, excluding performing TDR’s, was 259.59% at September 30, 2016, compared to 194.48% at December 31, 2015.
The following table is a summary of the general and specific allocations of the allowance for loan losses:
The specific reserve component applies to loans evaluated individually for impairment. The net carrying value of impaired loans is generally based on the fair values of collateral obtained through independent appraisals and/or internal evaluations, less costs to sell, or by discounting the total expected future cash flows. Once the impairment amount is calculated, a specific reserve allocation is recorded. At September 30, 2016, $1.3 million of the Company’s ALL was allocated to impaired loans totaling approximately $9.2 million compared to $1.5 million of the Company’s ALL allocated to impaired loans totaling approximately $10.3 million at December 31, 2015. Management determined that $2.1 million, or 23%, of total impaired loans required no reserve allocation at September 30, 2016 compared to $4.5 million, or 44%, at December 31, 2015 primarily due to adequate collateral values, acceptable payment history and adequate cash flow ability.
The incurred loss component of the general reserve, or loans collectively evaluated for impairment, is determined by applying loss rates to pools of loans by asset type. Loans not individually evaluated are aggregated by risk characteristics and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type. Beginning in the first quarter of 2016, the Company began to lengthen its look-back period with the intent to increase such period from three to five years over the next two years. The Company believes that the five-year look-back period, which is consistent with the Company’s practices prior to the start of the economic recession in 2008, provides a representative historical loss period in the current economic environment. These historical loss rates for each risk group are used as the starting point to determine loss rates for measurement purposes. The historical loan loss rates are multiplied by loss emergence periods (LEP) which represent the estimated time period between a borrower first experiencing financial difficulty and the recognition of a loss.
The Company’s methodology includes qualitative risk factors that allow management to adjust its estimates of losses based on the most recent information available and to address other limitations in the quantitative component that is based on historical loss rates. Such risk factors are generally reviewed and updated quarterly, as appropriate, and are adjusted to reflect changes in national and local economic conditions and developments, the nature, volume and terms of loans in the portfolio, including changes in volume and severity of past due loans, the volume of nonaccrual loans, and the volume and severity of adversely classified or graded loans, loan concentrations, assessment of trends in collateral values, assessment of changes in the quality of the Company’s internal loan review department, and changes in lending policies and procedures, including underwriting standards and collections, charge-off and recovery practices.
The specific and general reserve allocations represent management’s best estimate of probable losses inherent in the loan portfolio at the evaluation date. Although the allowance for loan losses is comprised of specific and general allocations, the entire allowance is available to absorb any credit losses.
Provision
The provision for loan losses was $300,000 and $975,000 for the three and nine months ended September 30, 2016, respectively, compared to no provision and $250,000 for the three and nine months ended September 30, 2015, respectively. The increase was primarily due to using a fifteen quarter look-back period compared to twelve quarters, as discussed above, in addition to an increase in loans.
The following table summarizes loan loss experience for the periods indicated:
Net Loan Charge-offs
The Company’s net loan charge-offs were $222,000, or 0.02% of average loans, for the three months ended September 30, 2016, compared to net loan charge-offs of $740,000, or 0.08% of average loans, for the three months ended September 30, 2015. The decrease in charge-offs quarter over quarter primarily related to one commercial loan relationship recorded during the third quarter of 2015.
The Company’s net loan charge-offs were $109,000, or 0.01% of average loans, for the nine months ended September 30, 2016, compared to net loan charge-offs of $103,000, or 0.01% of average loans, for the nine months ended September 30, 2015. Although loan charge-offs decreased year over year, loan recoveries also decreased from the prior year. One commercial loan and one real estate residential construction loan recovery were received during the first and second quarters of 2015 compared to a significant commercial real estate construction loan recovery received from the sale of collateral during the second quarter of 2016.
Liquidity and Capital Resources
Liquidity Management
The role of liquidity management is to ensure funds are available to meet depositors' withdrawal and borrowers' credit demands while at the same time maximizing profitability. This is accomplished by balancing changes in demand for funds with changes in the supply of those funds. Liquidity to meet the demands is provided by maturing assets, short-term liquid assets that can be converted to cash and the ability to attract funds from external sources, principally depositors. Due to the nature of services offered by the Company, management prefers to focus on transaction accounts and full service relationships with customers.
The Company’s Asset/Liability Committee (ALCO), primarily made up of senior management, has direct oversight responsibility for the Company's liquidity position and profile. A combination of daily, weekly, and monthly reports provided to management detail the following: internal liquidity metrics, composition and level of the liquid asset portfolio, timing differences in short-term cash flow obligations, available pricing and market access to the financial markets for capital, and exposure to contingent draws on the Company's liquidity.
The Company has a number of sources of funds to meet liquidity needs on a daily basis. The Company’s most liquid assets are comprised of available for sale investment securities, federal funds sold, and excess reserves held at the Federal Reserve.
Federal funds sold and resale agreements normally have overnight maturities and are used for general daily liquidity purposes. The fair value of the available-for-sale investment portfolio was $221.8 million at September 30, 2016 and included an unrealized net gain of $1.3 million. The portfolio includes projected maturities and mortgage backed securities pay-downs of approximately $20.9 million over the next twelve months, which offer resources to meet either new loan demand or reductions in the Company’s deposit base.
The Company pledges portions of its investment securities portfolio to secure public fund deposits, federal funds purchase lines, securities sold under agreements to repurchase, borrowing capacity at the Federal Reserve Bank, and for other purposes required by law. At September 30, 2016 and December 31, 2015, the Company’s unpledged securities in the available for sale portfolio totaled approximately $38.6 million and $52.4 million, respectively.
Total investment securities pledged for these purposes were as follows:
Liquidity is available from the Company’s base of core customer deposits, defined as demand, interest checking, savings, and money market deposit accounts. At September 30, 2016, such deposits totaled $707.9 million and represented 69.5% of the Company’s total deposits. These core deposits are normally less volatile and are often tied to other products of the Company through long lasting relationships. Time deposits and certificates of deposit of $100,000 and over totaled $310.1 million at September 30, 2016. These accounts are normally considered more volatile and higher costing representing 30.5% of total deposits at September 30, 2016.
Core deposits at September 30, 2016 and December 31, 2015 were as follows:
Other components of liquidity are the level of borrowings from third party sources and the availability of future credit. The Company’s outside borrowings are comprised of securities sold under agreements to repurchase, Federal Home Loan Bank advances, and subordinated notes. Federal funds purchased are overnight borrowings obtained mainly from upstream correspondent banks with which the Company maintains approved credit lines. As of September 30, 2016, under agreements with these unaffiliated banks, the Bank may borrow up to $40.0 million in federal funds on an unsecured basis and $17.4 million on a secured basis. There were no federal funds purchased outstanding at September 30, 2016. Securities sold under agreements to repurchase are generally borrowed overnight and are secured by a portion of the Company’s investment portfolio. At September 30, 2016, there was $28.5 million in repurchase agreements. The Company may periodically borrow additional short-term funds from the Federal Reserve Bank through the discount window; although no such borrowings were outstanding at September 30, 2016.
The Bank is a member of the Federal Home Loan Bank of Des Moines (FHLB). As a member of the FHLB, the Bank has access to credit products of the FHLB. As of September 30, 2016, the Bank had $79.0 million in outstanding borrowings with the FHLB. In addition, the Company has $49.5 million in outstanding subordinated notes issued to wholly-owned grantor trusts, funded by preferred securities issued by the trusts.
Borrowings outstanding at September 30, 2016 and December 31, 2015 were as follows:
The Company pledges certain assets, including loans and investment securities to the Federal Reserve Bank, FHLB, and other correspondent banks as security to establish lines of credit and borrow from these entities. Based on the type and value of collateral pledged, the Company may draw advances against this collateral.
The following table reflects the advance equivalent of the assets pledged, borrowings, and letters of credit outstanding in addition to the estimated future funding capacity available to the Company as follows:
At September 30, 2016, loans with a market value of $388.3 million were pledged at the Federal Home Loan Bank as collateral for borrowings and letters of credit. At September 30, 2016, investments with a market value of $19.5 million were pledged to secure federal funds purchase lines and borrowing capacity at the Federal Reserve Bank.
Sources and Uses of Funds
Cash and cash equivalents were $38.9 million at September 30, 2016 compared to $28.4 million at December 31, 2015. The $8.6 million increase resulted from changes in the various cash flows produced by operating, investing, and financing activities of the Company, as shown in the accompanying consolidated statement of cash flows for the nine months ended September 30, 2016. Cash flow provided from operating activities consists mainly of net income adjusted for certain non-cash items. Operating activities provided cash flow of $9.1 million for the nine months ended September 30, 2016.
Investing activities consisting mainly of purchases, sales and maturities of available-for-sale securities, and changes in the level of the loan portfolio used total cash of $68.8 million. The cash outflow primarily consisted of $102.0 million purchases of investment securities, and $85.1 million net increase in loans, partially offset by $60.7 million proceeds from sales of investment securities, and $56.0 from maturities, calls, and pay-downs of investment securities.
Financing activities provided cash of $70.3 million, resulting primarily from a $36.9 million increase in interest bearing transaction accounts, $29.0 million increase in net FHLB advances, and $22.0 million increase in time deposits, partially offset by a $28.3 million decrease in federal funds purchased and securities sold under agreements to repurchase. Future short-term liquidity needs arising from daily operations are not expected to vary significantly during 2016.
In the normal course of business, the Company enters into certain forms of off-balance sheet transactions, including unfunded loan commitments and letters of credit. These transactions are managed through the Company's various risk management processes. Management considers both on-balance sheet and off-balance sheet transactions in its evaluation of the Company's liquidity. The Company had $237.9 million in unused loan commitments and standby letters of credit as of September 30, 2016. Although the Company's current liquidity resources are adequate to fund this commitment level the nature of these commitments is such that the likelihood of such a funding demand is very low.
The Company is a legal entity, separate and distinct from the Bank, which must provide its own liquidity to meet its operating needs. The Company’s ongoing liquidity needs primarily include funding its operating expenses and paying cash dividends to its shareholders. The Company paid cash dividends to its shareholders totaling approximately $815,000 and $785,000 for the nine months ended September 30, 2016 and 2015, respectively. A large portion of the Company’s liquidity is obtained from the Bank in the form of dividends. The Bank did not declare or pay dividends to the Company during the nine months ended September 30, 2016. At September 30, 2016 and December 31, 2015, the Company had cash and cash equivalents totaling $2.1 million and $5.0 million, respectively.
Capital Management
The Company and the Bank are subject to various regulatory capital requirements administered by federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements. Under capital adequacy guidelines, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification of the Company and the Bank are subject to qualitative judgments by the regulators about components, risk-weightings, and other factors.
In July 2013, the federal banking agencies issued final rules to implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act. The phase-in period for the Company began on January 1, 2015. The Federal Reserve System’s (FRB) capital adequacy guidelines require that bank holding companies maintain a Common Equity Tier 1 risk-based capital ratio equal to at least 4.5% of its risk-weighted assets, a Tier 1 risk-based capital ratio equal to at least 6% of its risk-weighted assets and a total risk-based capital ratio equal to at least 8% of its risk-weighted assets. In addition, bank holding companies generally are required to maintain a Tier 1 leverage ratio of at least 4%.
In addition, the final rules establish a common equity tier 1 capital conservation buffer of 2.5% of risk-weighted assets applicable to all banking organizations. Institutions that do not maintain the required capital buffer will become subject to progressively more stringent limitations on the percentage of earnings that can be paid out in dividends or used for stock repurchases and on the payment of discretionary bonuses to senior executive management. The capital conservation buffer requirement will be phased in over four years beginning in 2016. The capital conservation buffer requirement effectively raises the minimum required risk-based capital ratios to 7% Common Equity Tier 1 Capital, 8.5% Tier 1 Capital and 10.5% Total Capital on a fully phased-in basis.
Under the Basel III requirements, at September 30, 2016 and December 31, 2015, the Company met all capital adequacy requirements and had regulatory capital ratios in excess of the levels established for well-capitalized institutions, as shown in the following table as of periods indicated:
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Interest Sensitivity
Market risk arises from exposure to changes in interest rates and other relevant market rate or price risk. The Company faces market risk in the form of interest rate risk through transactions other than trading activities. The Company uses financial modeling techniques to measure interest rate risk. These techniques measure the sensitivity of future earnings due to changing interest rate environments. Guidelines established by the Company's Asset/Liability Committee and approved by the board of directors are used to monitor exposure of earnings at risk. General interest rate movements are used to develop sensitivity as the Company feels it has no primary exposure to specific points on the yield curve. For the nine months ended September 30, 2016, our Company utilized a 400 basis point immediate and gradual move in interest rates (both upward and downward) applied to both a parallel and proportional yield curve. However, there are no assurances that the change will not be more or less than this estimate.
The following table represents estimated interest rate sensitivity and periodic and cumulative gap positions calculated as of September 30, 2016. Significant assumptions used for this table included: loans will repay at historic repayment rates; certain interest-bearing demand accounts are interest sensitive due to immediate repricing, and fixed maturity deposits will not be withdrawn prior to maturity. A significant variance in actual results from one or more of these assumptions could materially affect the results reflected in the table.
Effects of Inflation
The effects of inflation on financial institutions are different from the effects on other commercial enterprises since financial institutions make few significant capital or inventory expenditures, which are directly affected by changing prices. Because bank assets and liabilities are virtually all monetary in nature, inflation does not affect a financial institution as much as do changes in interest rates. The general level of inflation does underlie the general level of most interest rates, but interest rates do not increase at the rate of inflation as do prices of goods and services. Rather, interest rates react more to changes in the expected rate of inflation and to changes in monetary and fiscal policy.
Inflation does have an impact on the growth of total assets in the banking industry, often resulting in a need to increase capital at higher than normal rates to maintain an appropriate capital to asset ratio. In the opinion of management, inflation did not have a significant effect on the Company's operations for the three months ended September 30, 2016.
Item 4. Controls and Procedures
Our Company's management has evaluated, with the participation of our principal executive and principal financial officers, the effectiveness of our disclosure controls and procedures as defined in Rules 13a – 15(e) or 15d – 15(e) of the Securities Exchange Act of 1934 as of September 30, 2016. Based upon and as of the date of that evaluation, our principal executive and principal financial officers concluded that our disclosure controls and procedures were effective to ensure that information required to be disclosed in the reports we file and submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported as and when required. It should be noted that any system of disclosure controls and procedures, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met. In addition, the design of any system of disclosure controls and procedures is based in part upon assumptions about the likelihood of future events. Because of these and other inherent limitations of any such system, there can be no assurance that any design will always succeed in achieving its stated goals under all potential future conditions, regardless of how remote.
There has been no change in our Company's internal control over financial reporting that occurred during the three months ended September 30, 2016 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Impact of New Accounting Standards
Revenue from Contracts with CustomersThe FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606), in May 2014. The ASU supersedes revenue recognition requirements in Topic 605, Revenue Recognition, including most industry-specific revenue recognition guidance in the FASB Accounting Standards Codification. The core principle of the new guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance identifies specific steps that entities should apply in order to achieve this principle. The amendments are effective for interim and annual periods beginning January 1, 2018 and must be applied retrospectively.
In March 2016, the FASB began to issue targeted guidance to clarify specific implementation issues of ASU 2014-09. The FASB issued ASU 2016-08, Principal versus Agent Considerations (Reporting Revenue Gross versus Net), which provides guidance on determining an entity's role in providing goods and services as a principal versus an agent, and whether it controls each specified good or service before it is transferred to the customer. In April 2016, ASU 2016-10, Identifying Performance Obligations and Licensing, was issued, which clarifies the guidance related to whether goods or services are distinct within the contract and therefore are a performance obligation, and clarifies the timing and pattern of revenue recognition for licenses of intellectual property. The effective date and transition requirements of these ASUs are the same as those of ASU 2014-09.
In May 2016, the FASB issued ASU 2016-12, Revenue from Contracts with Customers: Narrow-Scope Improvements and Practical Expedients. The amendments in this update address narrow-scope improvements to the accounting guidance on collectability, noncash consideration, and completed contracts at transition. Additionally, the amendments in this Update provide a practical expedient for contract modifications at transition and an accounting policy election related to the presentation of sales taxes and other similar taxes collected from customers. The amendments also included a rescission issued in May 2016, ASU 2016-11, Revenue Recognition and Derivatives and Hedging: Rescission of SEC Guidance Because of ASU 2014-09 and 2014-16 Pursuant to Staff Announcements at the March 3, 2016 Emerging Task Force meeting, and relates to revenue and expense recognition for freight services in process, accounting for shipping and handling fees and costs, and accounting for consideration given by a vendor to a customer. These amendments are effective upon the adoption of ASU 2014-09. The Company continues to assess the impact of the ASU's adoption on the Company’s consolidated financial statements and disclosures.
Debt Instruments The FASB issued ASU 2016-06, Contingent Put and Call Options in Debt Instruments, in March 2016. The ASU clarifies the requirements for assessing whether contingent call (put) options that can accelerate the payment of principal on debt instruments are clearly and closely related to their debt hosts. Under the new guidance, the embedded options should be assessed solely in accordance with a four-step decision sequence, with no additional assessment of whether the triggering event is indexed to interest rates or credit risk. The amendments are effective January 1, 2017 and are not expected to have a significant effect on the Company's consolidated financial statements.
Financial Instruments The FASB issued ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities, in January 2016. The amendments require all equity investments to be measured at fair value with changes in the fair value recognized through net income, other than those accounted for under the equity method of accounting or those that
result in the consolidation of the investee. Additionally, these amendments require presentation in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk for those liabilities measured at fair value. The amendments also require use of the exit price notion when measuring the fair value of financial instruments for disclosure purposes. These amendments are effective for interim and annual periods beginning January 1, 2018. The Company is in the process of evaluating the impact of the ASU's adoption on the Company's consolidated financial statements, including potential changes to the Company's note disclosure of the fair value of its loan portfolio.
In June 2016, the FASB issued ASU 2016-13,Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The revised accounting guidance will remove all recognition thresholds and will require a company to recognize an allowance for credit losses for the difference between the amortized cost basis of a financial instrument and the amount of amortized cost that the company expects to collect over the instrument's contractual life. It also amends the credit loss measurement guidance for available-for-sale debt securities and beneficial interests in securitized financial assets. This new accounting guidance will be effective for interim and annual reporting periods beginning after December 15, 2019. The Company is currently evaluating the impact of the ASU's adoption on the Company's consolidated financial statements.
Leases In February 2016, the FASB issued ASU 2016-02, Leases, in order to increase transparency and comparability by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The ASU primarily affects lessee accounting, which requires the lessee to recognize a right-of-use asset and a liability to make lease payments for those leases classified as operating leases under previous GAAP. For leases with a term of 12 months or less, an election by class of underlying asset not to recognize lease assets and lease liabilities is permitted. The ASU also provides additional guidance as to the definition of a lease, identification of lease components, and sale and leaseback transactions. The amendments in the ASU are effective for interim and annual periods beginning January 1, 2019. The Company is in the process of evaluating the impact of the ASU's adoption on the Company's consolidated financial statements.
Liabilities The FASB issued ASU 2016-04, Recognition of Breakage for Certain Prepaid Store-Value Products, in March 2016, in order to address current and potential future diversity in practice related to the derecognition of a prepaid store-value product liability. Such products include prepaid gift cards issued on a specific payment network and redeemable at network-accepting merchant locations, prepaid telecommunication cards, and traveler's checks. The amendments require that the portion of the dollar value of prepaid stored-value products that is ultimately unredeemed (that is, the breakage) be accounted for consistent with the breakage guidance for stored-value product transactions provided in ASC Topic 606 - Revenue from Contracts with Customers. These amendments are effective for interim and annual periods beginning January 1, 2018. The Company is in the process of evaluating the impact of the ASU's adoption on the Company's consolidated financial statements.
Stock Compensation The FASB issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting, in March 2016, in order to reduce complexity in this area and improve the usefulness of information provided to users. Amendments which will affect public companies include the recognition of excess tax benefits and deficiencies in income tax expense or benefit in the income statement, guidance as to the classification of excess tax benefits on the statement of cash flows, an election to account for award forfeitures as they occur, and the ability to withhold taxes up to the maximum statutory rate in the applicable jurisdictions without triggering liability classification of the award. The amendments are effective January 1, 2017. The Company is in the process of evaluating the impact of the ASU's adoption on the Company's consolidated financial statements.
Statement of Cash Flows The FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, in August 2016, in order to address concerns regarding diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows. In particular, this ASU addresses eight specific cash flow issues in an effort to reduce this diversity in practice: (1) debt prepayment or debt extinguishment costs; (2) settlement of zero-coupon bonds; (3) contingent consideration payments made after a business combination; (4) proceeds from the settlement of insurance claims; (5) proceeds from the settlement of corporate-owned life insurance policies, including bank-owned life insurance policies; (6) distributions received from equity method investees; (7) beneficial interests in securitization transactions; and (8) separately identifiable cash flows and application of the predominance principle. The amendments are effective for annual periods beginning after December 15, 2017, and for interim periods within those annual periods. The Company is in the process of evaluating the impact of the ASU's adoption on the Company's consolidated financial statements.
PART II - OTHER INFORMATION
The information required by this Item is set forth inCommitments and Contingencies, Pending Litigation, in our Company’s Notes to Consolidated Financial Statements (unaudited).
The following table summarizes the purchases made by or on behalf of the Company or certain affiliated purchasers of shares of the Company's common stock during the three months ended September 30, 2016:
* On August 6, 2015, the Company announced that its Board of Directors authorized the purchase, through open market transactions, of up to $2,000,000 market value of the Company's common stock. Management was given discretion to determine the number and pricing of the shares to be purchased, as well as, the timing of any such purchases.
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.
INDEX TO EXHIBITS
September 30, 2016 Form 10-Q
Specimen certificate representing shares of our Company’s $1.00 par value common stock (filed as Exhibit 4.1 to our Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 1999 (Commission file number 0-23636) and incorporated herein by reference).
*As provided in Rule 406T of Regulation S-T, this information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933, as amended, and Section 18 of the Securities Exchange Act of 1934, as amended.
**Incorporated by reference.