UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
(Mark One)
OR
For the transition period from ___________________________ to ___________________________
Commission file number 0-17706
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þNo ¨
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). Yesþ 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 definition 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 ¨No þ
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
QNB CORP. AND SUBSIDIARY
QUARTER ENDED MARCH 31, 2013
INDEX
The accompanying notes are an integral part of the consolidated financial statements.
The accompanying notes are an integral part of the consolidated financial statements
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements include the accounts of QNB Corp. and its wholly-owned subsidiary, QNB Bank (the “Bank”). The consolidated entity is referred to herein as “QNB” or the “Company”. All significant intercompany accounts and transactions are eliminated in the consolidated financial statements.
These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in QNB's 2012 Annual Report incorporated in the Form 10-K. Operating results for the three month period ended March 31, 2013 are not necessarily indicative of the results that may be expected for the year ending December 31, 2013.
The unaudited consolidated financial statements reflect all adjustments which, in the opinion of management, are necessary for a fair presentation of the results of operations for the interim period and are of a normal and recurring nature.
Tabular information, other than share and per share data, is presented in thousands of dollars.
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities at the dates of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from such estimates.
The Company has evaluated events and transactions occurring subsequent to the balance sheet date of March 31, 2013, for items that should potentially be recognized or disclosed in these financial statements.
2. RECENT ACCOUNTING PRONOUNCEMENTS
In February 2013, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2013-02, Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. The amendments in this guidance require an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required under U.S. generally accepted accounting principles (GAAP) to be reclassified in its entirety to net income. For other amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income, an entity is required to cross-reference other disclosures required under U.S. GAAP that provide additional detail about those amounts. This amendment is effective prospectively for reporting periods beginning after December 15, 2012 for public companies. The application of this standard did not have a material impact on the Company’s financial statements, but it did result in additional required disclosures that can be found in Note 6.
3. STOCK-BASED COMPENSATION AND SHAREHOLDERS’ EQUITY
QNB sponsors stock-based compensation plans, administered by a Board Committee, under which both qualified and non-qualified stock options may be granted periodically to certain employees. Compensation cost has been measured using the fair value of an award on the grant date and is recognized over the service period, which is usually the vesting period.
Stock-based compensation expense was approximately $6,000 and $16,000 for the three months ended March 31, 2013 and 2012, respectively. As of March 31, 2013, there was approximately $139,000 of unrecognized compensation cost related to unvested share-based compensation award grants that is expected to be recognized over the next 34 months.
Options are granted to certain employees at prices equal to the market value of the stock on the date the options are granted. The 1998 Plan authorized the issuance of 220,500 shares. The time period during which any option is exercisable under the Plan is determined by the Committee but shall not commence before the expiration of six months after the date of grant or continue beyond the expiration of ten years after the date the option is awarded. The granted options vest ratably over a three-year period. As of March 31, 2013, there were 225,058 options granted, 30,444 options forfeited, 164,814 options exercised and 29,800 options outstanding under this Plan. The 1998 Plan expired on March 10, 2008.
The 2005 Plan authorizes the issuance of 200,000 shares. The terms of the 2005 Plan are identical to the 1998 Plan, except options expire five years after the grant date. As of March 31, 2013, there were 143,200 options granted, 45,000 options forfeited, 11,100 options exercised, and 87,100 options outstanding under this Plan. The 2005 Plan expires March 15, 2015.
The fair value of each option is amortized into compensation expense on a straight-line basis between the grant date for the option and each vesting date. QNB estimated the fair value of stock options on the date of the grant using the Black-Scholes option pricing model. The model requires the use of numerous assumptions, many of which are highly subjective in nature.
The following assumptions were used in the option pricing model in determining the fair value of options granted during the period:
The risk-free interest rate was selected based upon yields of U.S. Treasury issues with a term approximating the expected life of the option being valued. Historical information was the primary basis for the selection of the expected dividend yield, expected volatility and expected lives of the options.
The fair market value of options granted in the first three months of 2013 and 2012 was $4.52 and $3.81, respectively.
3. STOCK-BASED COMPENSATION AND SHAREHOLDERS’ EQUITY (continued)
Stock option activity during the three months ended March 31, 2013 is as follows:
4. SHARE REPURCHASE PLAN
The Board of Directors has authorized the repurchase of up to 100,000 shares of its common stock in open market or privately negotiated transactions. The repurchase authorization does not bear a termination date. There were no shares repurchased during the three months ended March 31, 2013. As of March 31, 2013, 57,883 shares were repurchased under this authorization at an average price of $16.97 and a total cost of $982,000.
5. EARNINGS PER SHARE
The following sets forth the computation of basic and diluted earnings per share:
There were 52,300 stock options that were anti-dilutive for the three-month periods ended March 31, 2013 and 2012. These stock options were not included in the above calculation.
6. COMPREHENSIVE INCOME
The following shows the components of accumulated other comprehensive income at March 31, 2013 and December 31, 2012:
The following table presents amounts reclassified out of accumulated other comprehensive income for the three months ended March 31, 2013:
7. INVESTMENT SECURITIES
The amortized cost and estimated fair values of investment securities available-for-sale at March 31, 2013 and December 31, 2012 were as follows:
7. INVESTMENT SECURITIES (continued)
The amortized cost and estimated fair value of securities available-for-sale by contractual maturity at March 31, 2013 are shown in the following table. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities are assigned to categories based on contractual maturity except for mortgage-backed securities and CMOs which are based on the estimated average life of these securities and municipal securities that have been pre-refunded.
Proceeds from sales of investment securities available-for-sale were approximately $4,097,000 and $6,185,000 for the three months ended March 31, 2013 and 2012, respectively.
At March 31, 2013 and December 31, 2012, investment securities available-for-sale totaling approximately $162,673,000 and $170,433,000, respectively, were pledged as collateral for repurchase agreements and deposits of public funds.
The following table presents information related to the Company’s gains and losses on the sales of equity and debt securities, and losses recognized for the other-than-temporary impairment of these investments. Gains and losses on available-for-sale securities are computed on the specific identification method and included in non-interest income. Gross realized losses on equity and debt securities are net of other-than-temporary impairment charges:
The tax expense applicable to the net realized gains for the three-month periods ended March 31, 2013 and 2012 amounted to approximately $144,000 and $132,000, respectively.
QNB recognizes OTTI for debt securities classified as available-for-sale in accordance with FASB ASC 320, Investments – Debt and Equity Securities, which requires that we assess whether we intend to sell or it is more likely than not that the Company will be required to sell a security before recovery of its amortized cost basis less any current-period credit losses. For debt securities that are considered other-than-temporarily impaired and that we do not intend to sell and will not be required to sell prior to recovery of our amortized cost basis, the amount of the impairment is separated into the amount that is credit related (credit loss component) and the amount due to all other factors. The credit loss component is recognized in earnings and is the difference between the security’s amortized cost basis and the present value of its expected future cash flows discounted at the security’s effective yield. The remaining difference between the security’s fair value and the present value of future expected cash flows is due to factors that are not credit related and, therefore, is not required to be recognized as a loss in the income statement, but is recognized in other comprehensive income. For equity securities, once a decline in value is determined to be other-than-temporary, the value of the equity security is reduced to fair value and a corresponding charge to earnings is recognized. QNB believes that we will fully collect the carrying value of securities on which we have recorded a non-credit related impairment in other comprehensive income.
The following table presents a rollforward of the credit loss component recognized in earnings. The credit loss component of the amortized cost represents the difference between the present value of expected future cash flows and the amortized cost basis of the security prior to considering credit losses. The beginning balance represents the credit loss component for debt securities for which OTTI occurred prior to the beginning of the year. Credit-impaired debt securities must be presented in two components based upon whether the current period is the first time the debt security was credit-impaired (initial credit impairment) or is not the first time the debt security was credit-impaired (subsequent credit impairments). No credit impairments were recognized in the first quarter of 2013 or 2012.
The following table presents a summary of the cumulative credit-related other-than-temporary impairment charges recognized as components of earnings for debt securities still held by QNB:
The amortized cost and estimated fair values of investment securities held-to-maturity at March 31, 2013 and December 31, 2012 were as follows:
The amortized cost and estimated fair value of securities held-to-maturity by contractual maturity at March 31, 2013 are shown in the following table. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
There were no sales of investment securities classified as held-to-maturity during the three months ended March 31, 2013 or 2012.
The following table indicates the length of time individual securities have been in a continuous unrealized loss position at March 31, 2013 and December 31, 2012:
Management evaluates debt securities, which are comprised of U.S. Government agencies, state and municipalities, mortgage-backed securities, CMOs and corporate debt securities, for other-than-temporary impairment and considers the current economic conditions, the length of time and the extent to which the fair value has been less than cost, interest rates and the bond rating of each security. The unrealized losses at March 31, 2013 in U.S. Government securities, state and municipal securities, mortgage-backed securities, CMOs and corporate debt securities are primarily the result of interest rate fluctuations. If held to maturity, these bonds will mature at par, and QNB will not realize a loss. The Company has the intent to hold the securities and does not believe it will be required to sell the securities before recovery occurs.
QNB holds seven pooled trust preferred securities as of March 31, 2013. These securities have a total amortized cost of approximately $3,519,000 and a fair value of $1,999,000. Five of the seven securities have been in an unrealized loss position for more than twelve months. All of the pooled trust preferred securities are available-for-sale securities and are carried at fair value.
The following table provides additional information related to pooled trust preferred securities (PreTSLs) as of March 31, 2013:
Mezzanine* - only class of bonds still outstanding (represents the senior-most obligation of the trust)
The market for these securities at March 31, 2013 is not active and markets for similar securities also are not active. The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which pooled trust preferred securities trade and then by a significant decrease in the volume of trades relative to historical levels. The new issue market is also inactive and the market values for these securities (and any securities other than those issued or guaranteed by U.S. Government agencies) are depressed relative to historical levels. In today’s market, a low market price for a particular bond may only provide evidence of a recent widening of corporate spreads in general versus being an indicator of credit problems with a particular issuer. Lack of liquidity in the market for trust preferred collateralized debt obligations, credit rating downgrades and market uncertainties related to the financial industry are all factors contributing to the temporary impairment of these securities. Although these securities are classified as available-for-sale, the Company has the intent to hold the securities and does not believe it will be required to sell the securities before recovery occurs. As illustrated in the table above, these securities are comprised mainly of securities issued by banks, and to a lesser degree, insurance companies. QNB owns the mezzanine tranches of these securities.
On a quarterly basis we evaluate our debt securities for other-than-temporary impairment (OTTI), which involves the use of a third-party valuation firm to assist management with the valuation. When evaluating these investments a credit-related portion and a non-credit related portion of OTTI are determined. The credit related portion is recognized in earnings and represents the expected shortfall in future cash flows. The non-credit related portion is recognized in other comprehensive income and represents the difference between the book value and the fair value of the security less any current quarter credit related impairment. For the three months ended March 31, 2013, no other-than-temporary impairment charges representing credit impairment were recognized on our pooled trust preferred collateralized debt obligations. A discounted cash flow analysis provides the best estimate of credit related OTTI for these securities. Additional information related to this analysis follows:
All of the pooled trust preferred collateralized debt obligations held by QNB are rated lower than AA and are measured for OTTI within the scope of ASC 325 (formerly known as EITF 99-20), Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to be Held by a Transferor in Securitized Financial Assets, and Amendments to the Impairment Guidance of EITF Issue No. 99-20 (formerly known as EITF 99-20-1). QNB performs a discounted cash flow analysis on all of its impaired debt securities to determine if the amortized cost basis of an impaired security will be recovered. In determining whether a credit loss exists, QNB uses its best estimate of the present value of cash flows expected to be collected from the debt security and discounts them at the effective yield implicit in the security at the date of acquisition or the prospective yield for those securities with prior OTTI charges. The discounted cash flow analysis is considered to be the primary evidence when determining whether credit related other-than-temporary impairment exists.
Results of a discounted cash flow test are significantly affected by other variables such as the estimate of future cash flows (including prepayments), credit worthiness of the underlying banks and insurance companies and determination of probability and severity of default of the underlying collateral. The following provides additional information for each of these variables:
In addition to the above factors, the evaluation of impairment also includes a stress test analysis which provides an estimate of future risk for each tranche. This stressed breakpoint is then compared to the level of assets with credit concerns in each tranche. This comparison allows management to identify those pools that are at a greater risk for a future adverse change in cash flows so the asset quality in those pools can be monitored more closely for potential deterioration of credit quality.
Based upon the analysis performed by management as of March 31, 2013, it is probable that we will collect all contractual principal and interest payments on one of our seven pooled trust preferred securities, PreTSL XIX. The expected principal shortfall on the remaining pooled trust preferred securities has resulted in credit related other-than-temporary impairment charges in previous years. All of these pooled trust preferred securities held by QNB could be subject to additional writedowns in the future if additional deferrals and defaults occur.
8. LOANS & ALLOWANCE FOR LOAN LOSSES
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are stated at the principal amount outstanding, net of deferred loan fees and costs. Interest income is accrued on the principal amount outstanding. Loan origination and commitment fees and related direct costs are deferred and amortized to income over the term of the respective loan and loan commitment period as a yield adjustment.
Loans held-for-sale consists of residential mortgage loans that are carried at the lower of aggregate cost or fair value. Net unrealized losses, if any, are recognized through a valuation allowance charged to income. Gains and losses on residential mortgages held-for-sale are included in non-interest income.
QNB maintains an allowance for loan losses, which is intended to absorb probable known and inherent losses in the outstanding loan portfolio. The allowance is reduced by actual credit losses and is increased by the provision for loan losses and recoveries of previous losses. The provisions for loan losses are charged to earnings to bring the total allowance for loan losses to a level considered necessary by management.
The allowance for loan losses is based on management’s continuing review and evaluation of the loan portfolio. The level of the allowance is determined by assigning specific reserves to individually identified problem credits and general reserves to all other loans. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value) of the impaired loan is lower than the carrying value of that loan. The portion of the allowance that is allocated to internally criticized and non-accrual loans is determined by estimating the inherent loss on each credit after giving consideration to the value of underlying collateral. The general component covers pools of loans by loan class including commercial loans not considered impaired, as well as smaller balance homogeneous loans, such as residential real estate, home equity and other consumer loans. These pools of loans are evaluated for loss exposure based upon historical loss rates. These loss rates are based on a three year history of charge-offs and are more heavily weighted for recent experience for each of these categories of loans, adjusted for qualitative factors. These qualitative risk factors include:
8. LOANS & ALLOWANCE FOR LOAN LOSSES (continued)
Each factor is assigned a value to reflect improving, stable or declining conditions based on management’s best judgment using relevant information available at the time of the evaluation.
An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
Management emphasizes loan quality and close monitoring of potential problem credits. Credit risk identification and review processes are utilized in order to assess and monitor the degree of risk in the loan portfolio. QNB’s lending and credit administration staff are charged with reviewing the loan portfolio and identifying changes in the economy or in a borrower’s circumstances which may affect the ability to repay debt or the value of pledged collateral. A loan classification and review system exists that identifies those loans with a higher than normal risk of uncollectibility. Each commercial loan is assigned a grade based upon an assessment of the borrower’s financial capacity to service the debt and the presence and value of collateral for the loan. An independent loan review group tests risk assessments and evaluates the adequacy of the allowance for loan losses. Management meets monthly to review the credit quality of the loan portfolio and quarterly to review the allowance for loan losses.
In addition, various regulatory agencies, as an integral part of their examination process, periodically review QNB’s allowance for loan losses. Such agencies may require QNB to recognize additions to the allowance based on their judgments using information available to them at the time of their examination.
Management believes that it uses the best information available to make determinations about the adequacy of the allowance and that it has established its existing allowance for loan losses in accordance with GAAP. If circumstances differ substantially from the assumptions used in making determinations, future adjustments to the allowance for loan losses may be necessary and results of operations could be affected. Because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that increases to the allowance will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above.
Major classes of loans are as follows:
Loans secured by commercial real estate include all loans collateralized at least in part by commercial real estate. These loans may not be for the expressed purpose of conducting commercial real estate transactions.
Overdrafts are reclassified as loans and are included in consumer loans above and total loans on the balance sheet. At March 31, 2013 and December 31, 2012, overdrafts were approximately $79,000 and $103,000, respectively.
QNB generally lends in its trade area which is comprised of Quakertown and the surrounding communities. To a large extent, QNB makes loans collateralized at least in part by real estate. Its lending activities could be affected by changes in the general economy, the regional economy, or real estate values. Other than disclosed in the table above, at March 31, 2013, there were no concentrations of loans exceeding 10% of total loans.
The Company engages in a variety of lending activities, including commercial, residential real estate and consumer transactions. The Company focuses its lending activities on individuals, professionals and small to medium sized businesses. Risks associated with lending activities include economic conditions and changes in interest rates, which can adversely impact both the ability of borrowers to repay their loans and the value of the associated collateral.
Commercial and industrial loans, commercial real estate loans, construction loans and residential real estate loans with a business purpose are generally perceived as having more risk of default than residential real estate loans with a personal purpose and consumer loans. These types of loans involve larger loan balances to a single borrower or groups of related borrowers and are more susceptible to a risk of loss during a downturn in the business cycle. These loans may involve greater risk because the availability of funds to repay these loans depends on the successful operation of the borrower’s business. The assets financed are used within the business for its ongoing operation. Repayment of these kinds of loans generally comes from the cash flow of the business or the ongoing conversions of assets, such as accounts receivable and inventory, to cash. Typical collateral for commercial and industrial loans includes the borrower’s accounts receivable, inventory and machinery and equipment. Commercial real estate and residential real estate loans secured for a business purpose are originated primarily within the eastern Pennsylvania market area at conservative loan-to-value ratios and often backed by the individual guarantees of the borrowers or owners. Repayment of this kind of loan is dependent upon either the ongoing cash flow of the borrowing entity or the resale of or lease of the subject property. Commercial real estate loans may be affected to a greater extent than residential loans by adverse conditions in real estate markets or the economy because commercial real estate borrowers’ ability to repay their loans depends on successful development of their properties, as well as the factors affecting residential real estate borrowers.
Loans to state and political subdivisions are tax-exempt or taxable loans to municipalities, school districts and housing and industrial development authorities. These loans can be general obligations of the municipality or school district repaid through their taxing authority, revenue obligations repaid through the income generated by the operations of the authority, such as a water or sewer authority, or loans issued to a housing and industrial development agency, for which a private corporation is responsible for payments on the loans.
Loans to depository institutions consist of a loan to a commercial bank in Lehigh County, Pennsylvania. This loan is secured by shares of common stock of the borrowing institution.
Indirect lease financing receivables represent loans to small businesses that are collateralized by equipment. These loans tend to have higher risk characteristics but generally provide higher rates of return. These loans are originated by a third party and purchased by QNB based on criteria specified by QNB. The criteria include minimum credit scores of the borrower, term of the lease, type and age of equipment financed and geographic area. The geographic area primarily represents states contiguous to Pennsylvania. QNB is not the lessor and does not service these loans.
The Company originates fixed-rate and adjustable-rate real estate-residential mortgage loans for personal purposes that are secured by first liens on the underlying 1-4 family residential properties. Credit risk exposure in this area of lending is minimized by the evaluation of the credit worthiness of the borrower, including debt-to-income ratios, credit scores and adherence to underwriting policies that emphasize conservative loan-to-value ratios of generally no more than 80%. Residential mortgage loans granted in excess of the 80% loan-to-value ratio criterion are generally insured by private mortgage insurance.
The real estate-home equity portfolio consists of fixed-rate home equity loans and variable-rate home equity lines of credit. Risks associated with loans secured by residential properties are generally lower than commercial loans and include general economic risks, such as the strength of the job market, employment stability and the strength of the housing market. Since most loans are secured by a primary or secondary residence, the borrower’s continued employment is the greatest risk to repayment.
The Company offers a variety of loans to individuals for personal and household purposes. Consumer loans are generally considered to have greater risk than first or second mortgages on real estate because they may be unsecured, or, if they are secured, the value of the collateral may be difficult to assess and is more likely to decrease in value than real estate. Credit risk in this portfolio is controlled by conservative underwriting standards that consider debt-to-income levels and the creditworthiness of the borrower and, if secured, collateral values.
The Company employs an eight (8) grade risk rating system related to the credit quality of commercial loans, loans to state and political subdivisions and indirect lease financing of which the first four categories are pass categories (credits not adversely rated). The following is a description of the internal risk ratings and the likelihood of loss related to each risk rating.
1 - Excellent - no apparent risk
2 - Good - minimal risk
3 - Acceptable - average risk
4 - Watch List - greater than average risk
5 - Special Mention - potential weaknesses
6 - Substandard - well defined weaknesses
7 - Doubtful - full collection unlikely
8 - Loss - considered uncollectible
The Company maintains a loan review system, which allows for a periodic review of our loan portfolio and the early identification of potential problem loans. Each loan officer assigns a rating to all loans in the portfolio at the time the loan is originated. Loans with risk ratings of one through three are reviewed annually based on the borrower’s fiscal year. Loans with risk ratings of four are reviewed every six to twelve months based on the dollar amount of the relationship with the borrower. Loans with risk ratings of five through eight are reviewed at least quarterly, and as often as monthly, at management’s discretion. The Company also utilizes an outside loan review firm to review the portfolio on a semi-annual basis to provide the Board of Directors and senior management an independent review of the Bank’s loan portfolio on an ongoing basis. These reviews are designed to recognize deteriorating credits in their earliest stages in an effort to reduce and control risk in the lending function as well as identifying potential shifts in the quality of the loan portfolio. The examinations by the outside loan review firm include the review of lending activities with respect to underwriting and processing new loans, monitoring the risk of existing loans and to provide timely follow-up and corrective action for loans showing signs of deterioration in quality. In addition, the outside firm reviews the methodology for the allowance for loan losses to determine compliance to policy and regulatory guidance.
The following tables present the classes of the loan portfolio summarized by the aggregate pass rating and the classified ratings of special mention, substandard and doubtful within the Company’s internal risk rating system as of March 31, 2013 and December 31, 2012:
For retail loans, the Company evaluates credit quality based on the performance of the individual credits. The following tables present the recorded investment in the retail classes of the loan portfolio based on payment activity as of March 31, 2013 and December 31, 2012:
The performance and credit quality of the loan portfolio is also monitored by analyzing the age of the loans receivable as determined by the length of time a recorded payment is past due. The following table presents the classes of the loan portfolio summarized by the past due status as of March 31, 2013 and December 31, 2012:
The following tables disclose the recorded investment in loans receivable that are either on non-accrual status or past due 90 days or more and still accruing interest as of March 31, 2013 and December 31, 2012:
90 days
or more past due (still accruing)
Activity in the allowance for loan losses for the three months ended March 31, 2013 and 2012 are as follows:
As previously discussed, the Company maintains a loan review system, which includes a continuous review of the loan portfolio by internal and external parties to aid in the early identification of potential impaired loans. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial loans, loans to state and political subdivisions and indirect lease financing loans by using either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral if the loan is collateral dependent.
Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential mortgage loans for impairment disclosures, unless such loans are part of a larger relationship that is impaired, or are classified as a troubled debt restructuring.
An allowance for loan losses is established for an impaired loan if its carrying value exceeds its estimated fair value. The estimated fair values of the majority of the Company’s impaired loans are measured based on the estimated fair value of the loan’s collateral.
For commercial loans secured by real estate, estimated fair values are determined primarily through third-party appraisals. When a real estate secured loan becomes impaired, a decision is made regarding whether an updated certified appraisal of the real estate is necessary. This decision is based on various considerations, including the age of the most recent appraisal, the loan-to-value ratio based on the original appraisal and the condition of the property. Appraised values are discounted to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value. The discounts also include estimated costs to sell the property.
For commercial loans secured by non-real estate collateral, such as accounts receivable, inventory and equipment, estimated fair values are determined based on the borrower’s financial statements, inventory reports, accounts receivable agings or equipment appraisals or invoices. Indications of value from these sources are generally discounted based on the age of the financial information or the quality of the assets.
From time to time, QNB may extend, restructure, or otherwise modify the terms of existing loans, on a case-by-case basis, to remain competitive and retain certain customers, as well as assist other customers that may be experiencing financial difficulties. A loan is considered to be a troubled debt restructuring (“TDR”) loan when the Company grants a concession to the borrower because of the borrower’s financial condition that it would not otherwise consider. Such concessions include the reduction of interest rates, forgiveness of principal or interest, or other modifications of interest rates to less than the current market rate for new obligations with similar risk. Loans classified as TDRs are considered non-performing and are also designated as impaired.
The concessions made for TDRs involve lowering the monthly payments on loans through periods of interest only payments, a reduction in interest rate below a market rate or an extension of the term of the loan without a corresponding adjustment to the risk premium reflected in the interest rate, or a combination of these three methods. The restructurings rarely result in the forgiveness of principal or accrued interest. If the borrower has demonstrated performance under the previous terms and our underwriting process shows the borrower has the capacity to continue to perform under the restructured terms, the loan will continue to accrue interest. Non-accruing restructured loans may be returned to accrual status when there has been a sustained period of repayment performance (generally six consecutive months of payments) and both principal and interest are deemed collectible. TDR loans that are in compliance with their modified terms and that yield a market rate may be removed from the TDR status after a period of performance.
QNB assesses all loan restructurings under the guidance of ASU 2011-02. Performing TDRs (not reported as non-accrual or past due 90 days or more and still accruing) totaled $4,346,000 and $2,578,000 as of March 31, 2013 and December 31, 2012, respectively. Non-performing TDRs totaled $3,251,000 and $3,299,000 as of March 31, 2013 and December 31, 2012, respectively. All TDRs are included in impaired loans presented in the section above.
The following table presents loans by loan class modified as TDRs during the three months ended March 31, 2013 and 2012. The pre-modification and post-modification outstanding recorded investments disclosed in the tables below, represent carrying amounts immediately prior to the modification and at March 31, 2013 and 2012.
The TDR concessions made during the three months ended March 31, 2013 involved an interest only repayment period on the loan. There was no specific reserve for loan losses allocated to the loans modified as TDRs during the three months ended March 31, 2013. Any required specific reserves are included in the allowance for loan losses for loans individually evaluated for impairment. There were no charge-offs resulting from loans modified as TDRs during the three months ended March 31, 2013 or 2012.
There were no loans modified as TDRs within 12 months prior to March 31, 2013 for which there was a payment default (30 days or more past due) during the three months ended March 31, 2013.
The following tables present the balance in the allowance for loan losses at March 31, 2013 and December 31, 2012 disaggregated on the basis of the Company’s impairment method by class of loans receivable along with the balance of loans receivable by class, excluding unearned fees and costs, disaggregated on the basis of the Company’s impairment methodology:
The following tables summarize additional information in regards to impaired loans by loan portfolio class as of March 31, 2013 and December 31, 2012:
9. FAIR VALUE MEASUREMENTS AND DISCLOSURES
Financial Accounting Standards Board (FASB) ASC 820, Fair Value Measurements and Disclosures, defines fair value as an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (fair values are not adjusted for transaction costs). ASC 820 also establishes a framework (fair value hierarchy) for measuring fair value under GAAP, and expands disclosures about fair value measurements.
ASC 820 establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are as follows:
An asset’s or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.
The measurement of fair value should be consistent with one of the following valuation techniques: market approach, income approach, and/or cost approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities (including a business). For example, valuation techniques consistent with the market approach often use market multiples derived from a set of comparables. Multiples might lie in ranges with a different multiple for each comparable. The selection of where within the range the appropriate multiple falls requires judgment, considering factors specific to the measurement (qualitative and quantitative). Valuation techniques consistent with the market approach include matrix pricing. Matrix pricing is a mathematical technique used principally to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the security’s relationship to other benchmark quoted securities.
9. FAIR VALUE MEASUREMENTS AND DISCLOSURES (continued)
The following table sets forth QNB’s financial assets measured at fair value on a recurring and nonrecurring basis and the fair value measurements by level within the fair value hierarchy as of March 31, 2013:
There were no transfers in and out of Level 1 and Level 2 fair value measurements during the three months ended March 31, 2013. There were also no transfers in or out of level 3 for the same period. There were no losses included in earnings attributable to the change in unrealized gains or losses relating to the available-for-sale securities above with fair value measurements utilizing significant unobservable inputs for the three-month periods ended March 31, 2013 and 2012, respectively.
The following table sets forth QNB’s financial assets measured at fair value on a recurring and nonrecurring basis, the fair value measurements by level within the fair value hierarchy as of December 31, 2012:
The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis and for which QNB has utilized Level 3 inputs to determine fair value:
The following table presents additional information about the securities available-for-sale measured at fair value on a recurring basis and for which QNB utilized significant unobservable inputs (Level 3 inputs) to determine fair value for the three months ended March 31, 2013:
The Level 3 securities consist of seven collateralized debt obligation securities, PreTSL securities, which are backed by trust preferred securities issued by banks, thrifts, and insurance companies. The market for these securities at March 31, 2013 is not active and markets for similar securities also are not active. The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which PreTSLs trade and then by a significant decrease in the volume of trades relative to historical levels. The new issue market is also inactive and there are currently very few market participants who are willing and or able to transact for these securities.
Given conditions in the debt markets today and the absence of observable transactions in the secondary and new issue markets, we determined:
The Bank is aware of several factors indicating that recent transactions of PreTSL securities are not orderly including an increased spread between bid/ask prices, lower sales transaction volumes for these types of securities, and a lack of new issuances. As a result, the Bank engaged an independent third party to value the securities using a discounted cash flow analysis. The estimated cash flows are based on specific assumptions about defaults, deferrals and prepayments of the trust preferred securities underlying each PreTSL. The resulting collateral cash flows are allocated to the bond waterfall using the INTEX desktop valuation model.
The estimates for the conditional default rates (CDR) are based on the payment characteristics of the trust preferred securities themselves (e.g. current, deferred, or defaulted) as well as the financial condition of the trust preferred issuers in the pool. A near-term CDR for each issuer in the pool is estimated based on their financial condition using key financial ratios relating to the financial institution’s capitalization, asset quality, profitability and liquidity. In addition to the specific bank default assumptions, overall deal default rates are modeled. In 2013 and beyond, the CDR rate is calculated based upon a comparison of key financial ratios of active individual issuers without a short-term probability of default compared to all FDIC insured banks. To derive this long-term default rate, a comparison of certain key financial ratios of the active issuers in the security to all FDIC insured banks is reviewed. The active issuers are summarized by creating a weighted average based on issue size, then divided into categories based upon their status of deferral and whether or not a specific default assumption has been assigned to the issuer. To ensure an accurate comparison, the standard deviation across the issuers for each ratio is calculated and any issuer that falls more than three standard deviations above or below the average for that ratio is removed.
The base loss severity assumption and long-term loss severity assumptions are modeled at 95%. The severity factor for near-term CDRs is vectored to reflect the relative expected performance of the institutions modeled to default, with lower forecasted severities used for the higher quality institutions.
Prepayments are modeled to take into account the disruption in the asset-backed securities marketplace and the lack of new pooled trust preferred issuances. For purposes of the cash flow analysis, relatively modest rates of prepayment were forecasted (ranging from 0-1%). In addition to the base prepayment assumption, due to the recent enactment of the Dodd-Frank financial legislation additional prepayment analysis was performed. First, all fixed rate trust preferred securities issued by banks with more than $15 billion in total assets at December 31, 2009 were identified. The current credit rating of these institutions was reviewed and it was assumed that any issuer with an investment grade credit rating would prepay their issuance as soon as possible, or July 1, 2015 for bank holding company subsidiaries of foreign banking organizations that have relied on Supervision and Regulation Letter SR-01-1. For those institutions rated below investment grade the holding companies’ approximate cost of long-term funding given their rating and marketplace interest rate was estimated. The following assumption was made; any holding company that could refinance for a cost savings of more than 2% will refinance and will do so as soon as possible, or July 1, 2015. Finally, for issuers not impacted by the Tier 1 regulatory capital legislation enacted by the Dodd-Frank Act, the issuers that have shown a recent history of prepayment of both floating rate and fixed rate issues were identified and it was assumed these issuers will prepay as soon as possible.
The internal rate of return is the pre-tax yield used to discount the best estimate of future cash flows after credit losses. The cash flows have been discounted using estimated market discount rates of 3-month LIBOR plus spreads ranging from 4.10% to 9.28%. The determination of appropriate market discount rates involved the consideration of the following:
The analysis of discount rates involved the review of corporate bond spreads for banks, U.S. Treasury yields, credit default swap rates for financial companies (utilized as a proxy for credit), the swap/LIBOR yield curve and the characteristics of the individual securities being valued.
The following information should not be interpreted as an estimate of the fair value of the entire Company since a fair value calculation is only provided for a limited portion of QNB’s assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between QNB’s disclosures and those of other companies may not be meaningful.
The following methods and assumptions were used to estimate the fair values of each major classification of financial instrument and non-financial asset at March 31, 2013 and December 31, 2012:
Cash and cash equivalents, accrued interest receivable and accrued interest payable (carried at cost): The carrying amounts reported in the balance sheet approximate those assets’ fair value.
Investment securities available for sale (carried at fair value) and held-to-maturity (carried at amortized cost): The fair value of securities are determined by obtaining quoted market prices on nationally recognized securities exchanges (Level 1), or matrix pricing (Level 2), which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices. Level 2 debt securities are valued by a third-party pricing service commonly used in the banking industry. Level 2 fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution date, market consensus prepayment speeds, credit information and the security’s terms and conditions, among other things. For certain securities which are not traded in active markets or are subject to transfer restrictions, valuations are adjusted to reflect illiquidity and/or non-transferability, and such adjustments are generally based on available market evidence (Level 3). In the absence of such evidence, management’s best estimate is used. Management’s best estimate consists of both internal and external support on certain Level 3 investments. Cash flow models using a present value formula that includes assumptions market participants would use along with indicative exit pricing obtained from broker/dealers (where available) were used to support fair values of certain Level 3 investments.
Restricted investment in bank stocks (carried at cost): The fair value of stock in Atlantic Central Bankers Bank and the Federal Home Loan Bank is the carrying amount, based on redemption provisions, and considers the limited marketability of such securities.
Loans Held for Sale (carried at lower of cost or fair value): The fair value of loans held for sale is determined, when possible, using quoted secondary market prices. If no such quoted prices exist, the fair value of a loan is determined using quoted prices for a similar loan or loans, adjusted for the specific attributes of that loan.
Loans Receivable (carried at cost): The fair values of loans are estimated using discounted cash flow analyses, using market rates at the balance sheet date that reflect the credit and interest rate-risk inherent in the loans. Projected future cash flows are calculated based upon contractual maturity or call dates, projected repayments and prepayments of principal. Generally, for variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values.
Impaired Loans (generally carried at fair value): Impaired loans are loans, in which the Company has measured impairment generally based on the fair value of the loan’s collateral. Fair value is generally determined based upon independent third-party appraisals of the properties, or discounted cash flows based upon the expected proceeds. These assets are included as Level 3 fair values, based upon the lowest level of input that is significant to the fair value measurements.
Mortgage Servicing Rights (carried at lower of cost or fair value): The fair value of mortgage servicing rights is based on a valuation model that calculates the present value of estimated net servicing income. The mortgage servicing rights are stratified into tranches based on predominant characteristics, such as interest rate, loan type and investor type. The valuation incorporates assumptions that market participants would use in estimating future net servicing income.
Foreclosed assets (other real estate owned and repossessed assets): Foreclosed assets are the only non-financial assets valued on a non-recurring basis which are held by the Company at fair value, less cost to sell. At foreclosure or repossession, if the fair value, less estimated costs to sell, of the collateral acquired (real estate, vehicles, equipment) is less than the Company’s recorded investment in the related loan, a write-down is recognized through a charge to the allowance for loan losses. Additionally, valuations are periodically performed by management and any subsequent reduction in value is recognized by a charge to income. The fair value of foreclosed assets held-for-sale is estimated using Level 3 inputs based on observable market data.
Deposit liabilities (carried at cost): The fair value of deposits with no stated maturity (e.g. demand deposits, interest-bearing demand accounts, money market accounts and savings accounts) are by definition, equal to the amount payable on demand at the reporting date (i.e. their carrying amounts). This approach to estimating fair value excludes the significant benefit that results from the low-cost funding provided by such deposit liabilities, as compared to alternative sources of funding. Deposits with a stated maturity (time deposits) have been valued using the present value of cash flows discounted at rates approximating the current market for similar deposits.
Short-term borrowings (carried at cost): The carrying amount of short-term borrowings approximates their fair values.
Long-term debt (carried at cost): The fair values of FHLB advances and securities sold under agreements to repurchase are estimated using discounted cash flow analysis, based on quoted prices for new long-term debt with similar credit risk characteristics, terms and remaining maturity. These prices obtained from this active market represent a fair value that is deemed to represent the transfer price if the liability were assumed by a third party.
Off-balance-sheet instruments (disclosed at cost): The fair values for the Bank’s off-balance sheet instruments (lending commitments and letters of credit) are based on fees currently charged in the market to enter into similar agreements, taking into account, the remaining terms of the agreements and the counterparties’ credit standing.
Management uses its best judgment in estimating the fair value of the Company’s financial instruments; however, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts the Company could have realized in a sales transaction on the dates indicated. The estimated fair value amounts have been measured as of the respective period ends and have not been re-evaluated or updated for purposes of these financial statements subsequent to those respective dates. As such, the estimated fair values of these financial instruments subsequent to the respective reporting dates may be different than the amounts reported at each period end.
The estimated fair values and carrying amounts of the Company’s financial and off-balance sheet instruments are summarized as follows:
10. OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS AND GUARANTEES
In the normal course of business there are various legal proceedings, commitments, and contingent liabilities which are not reflected in the financial statements. Management does not anticipate any material losses as a result of these transactions and activities. They include, among other things, commitments to extend credit and standby letters of credit. The maximum exposure to credit loss, which represents the possibility of sustaining a loss due to the failure of the other parties to a financial instrument to perform according to the terms of the contract, is represented by the contractual amount of these instruments. QNB uses the same lending standards and policies in making credit commitments as it does for on-balance sheet instruments. The activity is controlled through credit approvals, control limits, and monitoring procedures.
A summary of the Bank's financial instrument commitments is as follows:
10. OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS AND GUARANTEES (continued)
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 the payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. QNB evaluates each customer’s creditworthiness on a case-by-case basis.
Standby letters of credit are conditional commitments issued by the Bank to guarantee the financial or performance obligation of a customer to a third party. QNB’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making conditional obligations as it does for on-balance sheet instruments. These standby letters of credit expire within three years. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending other loan commitments. The Bank requires collateral and personal guarantees supporting these letters of credit as deemed necessary. Management believes that the proceeds obtained through a liquidation of such collateral and the enforcement of personal guarantees would be sufficient to cover the maximum potential amount of future payments required under the corresponding guarantees. The amount of the liability as of March 31, 2013 and December 31, 2012 for guarantees under standby letters of credit issued is not material.
The amount of collateral obtained for letters of credit and commitments to extend credit is based on management’s credit evaluation of the customer. Collateral varies, but may include real estate, accounts receivable, marketable securities, pledged deposits, inventory or equipment.
11. REGULATORY RESTRICTIONS
Dividends payable by the Company and the Bank are subject to various limitations imposed by statutes, regulations and policies adopted by bank regulatory agencies. Under Pennsylvania banking law, the Bank is subject to certain restrictions on the amount of dividends that it may declare without prior regulatory approval. Under Federal Reserve regulations, the Bank is limited as to the amount it may lend affiliates, including QNB Corp., unless such loans are collateralized by specific obligations.
Both the Company and the Bank are subject to regulatory capital requirements administered by Federal banking agencies. Failure to meet minimum capital requirements can initiate actions by regulators that could have an effect on the financial statements. Under the framework for prompt corrective action, both the Company and the Bank must meet capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance-sheet items. The capital amounts and classification are also subject to qualitative judgments by the regulators. Management believes, as of March 31, 2013, that the Company and the Bank met capital adequacy requirements to which they were subject.
As of the most recent notification, the primary regulator of the Bank considered it to be “well capitalized” under the regulatory framework. There are no conditions or events since that notification that management believes have changed the classification. To be categorized as well capitalized, the Company and the Bank must maintain minimum ratios as set forth in the following table.
11. REGULATORY RESTRICTIONS (continued)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
QNB Corp. (herein referred to as QNB or the Company) is a bank holding company headquartered in Quakertown, Pennsylvania. The Company, through its wholly-owned subsidiary, QNB Bank (the Bank), has been serving the residents and businesses of upper Bucks, northern Montgomery and southern Lehigh counties in Pennsylvania since 1877. The Bank is a locally managed community bank that provides a full range of commercial and retail banking and retail brokerage services.
Tabular information presented throughout management’s discussion and analysis, other than share and per share data, is presented in thousands of dollars.
FORWARD-LOOKING STATEMENTS
In addition to historical information, this document contains forward-looking statements. Forward-looking statements are typically identified by words or phrases such as “believe,” “expect,” “anticipate,” “intend,” “estimate,” “project” and variations of such words and similar expressions, or future or conditional verbs such as “will,” “would,” “should,” “could,” “may” or similar expressions. The U.S. Private Securities Litigation Reform Act of 1995 provides safe harbor in regard to the inclusion of forward-looking statements in this document and documents incorporated by reference.
Shareholders should note that many factors, some of which are discussed elsewhere in this document and in the documents that are incorporated by reference, and including the risk factors identified in Item 1A of QNB’s 2012 Form 10-K, could affect the future financial results of the Company and its subsidiary and could cause those results to differ materially from those expressed in the forward-looking statements contained or incorporated by reference in this document. These factors include, but are not limited, to the following:
QNB cautions that these forward-looking statements are subject to numerous assumptions, risks and uncertainties, all of which change over time, and QNB assumes no duty to update forward-looking statements. Management cautions readers not to place undue reliance on any forward-looking statements. These statements speak only as of the date of this report on Form 10-Q, even if subsequently made available by QNB on its website or otherwise, and they advise readers that various factors, including those described above, could affect QNB’s financial performance and could cause actual results or circumstances for future periods to differ materially from those anticipated or projected. Except as required by law, QNB does not undertake, and specifically disclaims any obligation, to publicly release any revisions to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The discussion and analysis of the financial condition and results of operations are based on the consolidated financial statements of QNB, which are prepared in accordance with U.S. generally accepted accounting principles (GAAP) and predominant practices within the banking industry. The preparation of these consolidated financial statements requires QNB to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. QNB evaluates estimates on an on-going basis, including those related to the determination of the allowance for loan losses, the determination of the valuation of other real estate owned and foreclosed assets, other-than-temporary impairments on investment securities, the valuation of deferred tax assets, stock-based compensation and income taxes. QNB bases its estimates on historical experience and various other factors and assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Other-Than-Temporary Investment Security Impairment
Securities are evaluated periodically to determine whether a decline in their value is other-than-temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other-than-temporary. The term “other-than-temporary” is not intended to indicate that the decline is permanent, but indicates that the prospect for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. For equity securities, once a decline in value is determined to be other-than-temporary, the value of the equity security is reduced and a corresponding charge to earnings is recognized.
The Company follows accounting guidance related to the recognition and presentation of other-than-temporary impairment that specifies (a) if a company does not have the intent to sell a debt security prior to recovery and (b) it is more likely than not that it will not have to sell the debt security prior to recovery, the security would not be considered other-than-temporarily impaired unless there is a credit loss. When an entity does not intend to sell the security, and it is more likely than not, the entity will not have to sell the security before recovery of its cost basis, it will recognize the credit component of an other-than-temporary impairment of a debt security in earnings and the remaining portion in other comprehensive income. For held-to-maturity debt securities, the amount of an other-than-temporary impairment recorded in other comprehensive income for the noncredit portion of a previous other-than-temporary impairment is amortized prospectively over the remaining life of the security on the basis of the timing of future estimated cash flows of the security.
There were no credit-related other-than-temporary impairment charges in the first quarter of 2013 or 2012.
Allowance for Loan Losses
QNB considers that the determination of the allowance for loan losses involves a higher degree of judgment and complexity than its other significant accounting policies. The allowance for loan losses is calculated with the objective of maintaining a level believed by management to be sufficient to absorb probable known and inherent losses in the outstanding loan portfolio. The allowance is reduced by actual credit losses and is increased by the provision for loan losses and recoveries of previous losses. The provisions for loan losses are charged to earnings to bring the total allowance for loan losses to a level considered necessary by management.
The allowance for loan losses is based on management’s continual review and evaluation of the loan portfolio. The level of the allowance is determined by assigning specific reserves to individually identified problem credits and general reserves to all other loans. The portion of the allowance that is allocated to impaired loans is determined by estimating the inherent loss on each credit after giving consideration to the value of underlying collateral. The general reserves are based on the composition and risk characteristics of the loan portfolio, including the nature of the loan portfolio, credit concentration trends, delinquency and loss experience, as well as other qualitative factors such as current economic trends.
In addition, various regulatory agencies, as an integral part of their examination process, periodically review QNB’s allowance for loan losses. Such agencies may require QNB to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.
Management believes that it uses the best information available to make determinations about the adequacy of the allowance and that it has established its existing allowance for loan losses in accordance with GAAP. If circumstances differ substantially from the assumptions used in making determinations, future adjustments to the allowance for loan losses may be necessary and results of operations could be affected. Because future events affecting borrowers and collateral cannot be predicted with certainty, increases to the allowance may be necessary should the quality of any loans deteriorate as a result of the factors discussed above.
Foreclosed Assets
Assets acquired through, or in lieu of, loan foreclosure are held-for-sale and are initially recorded at fair value less cost to sell at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses and changes in the valuation allowance are included in net expenses from foreclosed assets.
Stock-Based Compensation
QNB sponsors stock-based compensation plans, administered by a board committee, under which both qualified and non-qualified stock options may be granted periodically to certain employees. QNB accounts for all awards granted under stock-based compensation plans in accordance with ASC 718, Compensation-Stock Compensation. Compensation cost has been measured using the fair value of an award on the grant date and is recognized over the service period, which is usually the vesting period. The fair value of each option is amortized into compensation expense on a straight-line basis between the grant date for the option and each vesting date. QNB estimates the fair value of stock options on the date of the grant using the Black-Scholes option pricing model. The model requires the use of numerous assumptions, many of which are highly subjective in nature.
Income Taxes
QNB accounts for income taxes under the asset/liability method in accordance with income tax accounting guidance, ASC 740, Income Taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is established against deferred tax assets when, in the judgment of management, it is more likely than not that such deferred tax assets will not become available. Because the judgment about the level of future taxable income is dependent to a great extent on matters that may, at least in part, be beyond QNB’s control, it is at least reasonably possible that management’s judgment about the need for a valuation allowance for deferred tax assets could change in the near term.
RESULTS OF OPERATIONS - OVERVIEW
QNB reported net income for the first quarter of 2013 of $2,408,000, or $0.74 per share on a diluted basis. This represents a slight decrease compared to net income of $2,471,000, or $0.77 per share on a diluted basis, for the same period in 2012.
Net income expressed as an annualized rate of return on average assets and average shareholders’ equity was 1.08% and 13.10%, respectively, for the quarter ended March 31, 2013 compared with 1.15% and 14.71%, respectively, for the quarter ended March 31, 2012.
Total assets as of March 31, 2013 were $918,780,000, compared with $919,874,000 at December 31, 2012. Total loans at March 31, 2013 were $477,402,000, compared with $477,733,000 at December 31, 2012, and total deposits at March 31, 2013 were $799,814,000, compared with $801,638,000 at December 31, 2012.
Net Interest Income and Net Interest Margin
Net interest income for the quarter ended March 31, 2013 totaled $6,333,000, a decrease of $473,000, or 6.9%, over the same period in 2012. Average earning assets for the first quarter of 2013 were $873,240,000, an increase of $37,089,000, or 4.4%, from the first quarter of 2012, with average investment securities increasing $51,907,000, or 15.3%, and average loans decreasing $10,817,000, or 2.2%, over the same period. On the funding side, average deposits increased $40,832,000, or 5.4%, to $794,780,000 for the first quarter of 2013 with growth occurring in average non-interest and interest bearing checking accounts, municipal deposits and savings accounts. During this same time period average borrowed funds decreased $8,137,000 to $33,059,000.
The prolonged low interest rate environment has continued to exert pressure on asset yields and the net interest margin as longer term assets reprice to lower interest rate levels while funding costs are near their implied floors. In addition, the change in the mix of earning assets with investment securities representing a larger proportion of earning assets has also impacted the average yield on earning assets and the net interest margin. The net interest margin for the first quarter of 2013 was 3.17% compared to 3.53% for the first quarter of 2012 and 3.19% for the fourth quarter of 2012. The average rate earned on earning assets declined 61 basis points from 4.41% for the first quarter of 2012 to 3.80% for the first quarter of 2013. When comparing the change in the yield on earning assets between the two first quarter periods, loans and investment securities declined from 5.37% and 3.20%, respectively, for the first quarter of 2012 to 4.91% and 2.51%, respectively, for the first quarter of 2013, a decline of 46 basis points and 69 basis points, respectively. In comparison, the cost of interest-bearing liabilities declined 28 basis points from 1.00% to 0.72% over the same time periods. The interest rate paid on interest-bearing deposits declined by 21 basis points to 0.70% for the first quarter of 2013 compared to the first quarter of 2012.
Asset Quality, Provision for Loan Loss and Allowance for Loan Loss
QNB closely monitors the quality of its loan portfolio and considers many factors when performing a quarterly analysis of the appropriateness of the allowance for loan losses and calculating the required provision for loan losses. This analysis considers a number of relevant factors including: specific impairment reserves, historical loan loss experience, general economic conditions, levels of and trends in delinquent and non-performing loans, levels of classified loans, trends in the growth rate of loans and concentrations of credit.
Total non-performing assets were $25,265,000 at March 31, 2013 compared with $24,273,000 as of December 31, 2012 and $23,234,000 as of March 31, 2012. Included in this classification are non-performing loans, other real estate owned (OREO) and repossessed assets, and non-performing pooled trust preferred securities. Total non-performing loans, which represent loans on non-accrual status, loans past due more than 90 days and still accruing interest, and restructured loans were $22,113,000, or 4.63% of total loans, at March 31, 2013 compared with $21,150,000, or 4.41% of total loans, at December 31, 2012 and $19,903,000, or 4.15% of total loans, at March 31, 2012. The main contributor to the increase compared to both of these periods is the level of restructured loans. Loans on non-accrual status were $17,465,000 at March 31, 2013 compared with $18,572,000 at December 31, 2012 and $17,064,000 at March 31, 2012. In cases where there is a collateral shortfall on non-accrual loans, specific impairment reserves have been established based on updated collateral values even if the borrower continues to pay in accordance with the terms of the agreement. Of the total amount of non-accrual loans at March 31, 2013, there were $9,369,000, or 53.6%, that were current at the end of the quarter.
QNB had OREO and other repossessed assets of $1,153,000 as of March 31, 2013 compared with $1,161,000 at December 31, 2012 and $1,277,000 at March 31, 2012. Non-performing pooled trust preferred securities are carried at fair value which was $1,999,000, $1,962,000, and $2,054,000 at March 31, 2013, December 31, 2012 and March 31, 2012, respectively. The increase in the balance of non-performing pooled trust preferred securities compared to year end reflects an improvement in the fair value of these securities and not the purchase of additional securities.
QNB recorded no provision for loan losses in the first quarter of 2013 compared with $300,000 in the first quarter of 2012 and $300,000 in the fourth quarter of 2012. Net loan charge-offs were $421,000, or 0.36% annualized of total average loans, for the first quarter of 2013, compared with $85,000, or 0.07% annualized of total average loans, for the first quarter of 2012 and $245,000, or 0.20% annualized of total average loans, for the fourth quarter of 2012.
QNB's allowance for loan losses of $9,351,000 represents 1.96% of total loans at March 31, 2013 compared to an allowance for loan losses of $9,772,000, or 2.04% of total loans at December 31, 2012 and $9,456,000, or 1.97% of total loans at March 31, 2012.
Non-Interest Income
Total non-interest income was $1,748,000 for the first quarter of 2013, an increase of $182,000, or 11.6%, compared with the same period in 2012. Net gains on the sale of investment securities accounts for $34,000 of this total increase. QNB recorded $423,000 of net gains on the sale of investment securities during the first quarter of 2013 compared to net gains of $389,000 recognized in the first quarter of 2012. Included in the first quarter 2013 securities gains were $262,000 recorded on the sale of equity securities and $161,000 on sales of bonds, primarily mortgage-backed securities and collateralized mortgage obligations (CMOs). With the excellent performance of the U.S. equity markets in the first quarter of 2013, similar to the first quarter of 2012, QNB elected to sell some equity holdings and recognize gains. In the first quarter of 2012, QNB recorded gains of $386,000 on the sale of equity securities.
There was a $143,000 increase in other non-interest income related to improved mortgage servicing income, title company income and mutual fund and annuity income. During the fourth quarter of 2012, QNB changed vendors related to the mutual fund and annuity income and now provides securities and advisory services under the name of QNB Financial Services through Investment Professionals, Inc., a registered Broker/Dealer and Registered Investment Advisor. There has been a significant increase in revenue as a result of the change which contributed an additional $84,000 to the quarter. Mortgage servicing fees were $33,000 higher quarter over quarter primarily related to the reversal of a portion of the valuation allowance related to the fair value of mortgage servicing rights as calculated by an independent third-party. Title company income also increased $29,000 when comparing the first quarter of 2013 to 2012.
Non-Interest Expense
Total non-interest expense was $4,940,000 for the first quarter of 2013, an increase of $89,000, or 1.8% as compared to $4,851,000 for the first quarter of 2012. Much of the increase was related to the opening of two new branch locations in the first quarter of 2013. Net occupancy as well as furniture and fixtures expense increased $95,000, or 12.6%. The majority of this increase was attributable to higher depreciation expense, building repairs and maintenance and equipment maintenance costs. Also contributing to the change in non-interest expense was a $38,000, or 18.9%, increase in marketing expense as a result of advertising, public relations, sales promotions and donations costs. Partially offsetting these items was a reduction in salaries and benefits expense of $67,000, or 2.6%. The first quarter of 2012 included an accrual for incentive compensation. In addition, medical and dental benefit premiums and claims decreased approximately $19,000 comparing the first quarter of 2013 to 2012. Other non-interest expense also declined by $45,000, primarily due to lower costs related to OREO, comparing the three months ended March 31, 2013 to the same period in prior year.
These items noted in the foregoing overview, as well as others, will be discussed and analyzed more thoroughly in the next sections.
Average Balances, Rate, and Interest Income and Expense Summary (Tax-Equivalent Basis)
Tax-exempt securities and loans were adjusted to a tax-equivalent basis and are based on the marginal Federal corporate tax rate of 34 percent.
Non-accrual loans and investment securities are included in earning assets.
* Includes loans held-for-sale.
Rate/Volume Analysis. The following table shows the fully taxable equivalent effect of changes in volumes and rates on interest income and interest expense. Changes in net interest income that could not be specifically identified as either a rate or volume change were allocated to changes in volume.
NET INTEREST INCOME
The following table presents the adjustment to convert net interest income to net interest income on a fully taxable-equivalent basis for the three-month periods ended March 31, 2013 and 2012.
Net interest income is the primary source of operating income for QNB. Net interest income is interest income, dividends, and fees on earning assets, less interest expense incurred for funding sources. Earning assets primarily include loans, investment securities, interest bearing balances at the Federal Reserve Bank (Fed) and Federal funds sold. Sources used to fund these assets include deposits and borrowed funds. Net interest income is affected by changes in interest rates, the volume and mix of earning assets and interest-bearing liabilities, and the amount of earning assets funded by non-interest bearing deposits.
For purposes of this discussion, interest income and the average yield earned on loans and investment securities are adjusted to a tax-equivalent basis as detailed in the tables that appear above. This adjustment to interest income is made for analysis purposes only. Interest income is increased by the amount of savings of Federal income taxes, which QNB realizes by investing in certain tax-exempt state and municipal securities and by making loans to certain tax-exempt organizations. In this way, the ultimate economic impact of earnings from various assets can be more easily compared.
The net interest rate spread is the difference between average rates received on earning assets and average rates paid on interest-bearing liabilities, while the net interest rate margin, which includes interest-free sources of funds, is net interest income expressed as a percentage of average interest-earning assets. The Asset/Liability and Investment Management Committee works to manage and maximize the net interest margin for the Company.
Net interest income decreased $473,000, or 6.9%, to $6,333,000 for the quarter ended March 31, 2013 as compared to the quarter ended March 31, 2012. On a tax-equivalent basis, net interest income decreased $504,000, or 6.9%, from $7,338,000 for the three months ended March 31, 2012 to $6,834,000 for the same period ended March 31, 2013.
When comparing the two quarters, growth in deposits and the investment of these deposits into the securities portfolio was offset by a reduction in the net interest margin resulting in lower net interest income. Average earning assets grew by $37,089,000, or 4.4%, when comparing the first quarter of 2013 to the same period in 2012, with average investment securities increasing $51,907,000, or 15.3%, offset by average loans decreasing $10,817,000, or 2.2%. On the funding side, average deposits increased $40,832,000, or 5.4%, with average transaction accounts increasing $59,552,000, or 12.7%. The growth in transaction accounts was broad based across all product lines and all customer types with the largest increases centered in QNB's Online eSavings product and the deposits of several local school districts and municipalities. Offsetting a portion of this growth was a decline in average time deposits of $18,720,000 when comparing the first quarter 2013 with the same period in 2012.
With the growth in earning assets occurring in the investment portfolio, the mix of earning assets changed which contributed to a decline in the net interest margin, as investment securities generally earn a lower yield than loans. The economy has shown signs of improvement, however many businesses and consumers are continuing to deleverage and remain reluctant to borrow. A low level of interest rates has been in place since 2008 and has resulted in lower yields earned on both loans and investment securities as well as lower rates paid on deposits and borrowed funds. During the beginning of this interest rate cycle, funding costs declined at a faster pace and to a greater degree than rates on earning assets resulting in an increasing net interest margin. However, since the second quarter of 2011 this trend has reversed as funding costs have approached bottom while yields on earning assets continue to reprice lower resulting in a lower net interest margin.
As a result of these historically low interest rates, over the past year, a significant amount of higher yielding bonds with call features were called and prepayments on mortgage-related securities increased, with these proceeds being reinvested in lower yielding investment securities. In addition, new loans are being originated at significantly lower rates, variable rate loans are repricing lower and many customers with fixed rates are requesting that their rates be modified lower. The net interest margin for the first quarter of 2013 was 3.17% compared to 3.53% for the first quarter of 2012 and 3.19% for the fourth quarter of 2012. Also negatively impacting both the yield on earning assets and the net interest margin are nonaccrual loans which remained relatively flat from $17,064,000 at March 31, 2012 to $17,465,000 at March 31, 2013.
The Rate-Volume Analysis tables, as presented on a tax-equivalent basis, highlight the impact of changing rates and volumes on interest income and interest expense. Total interest income on a tax-equivalent basis decreased $988,000, or 10.8%, to $8,177,000 for the first quarter of 2013, while total interest expense decreased $484,000, or 26.5%, to $1,343,000. Volume growth in earning assets contributed an additional $118,000 of interest income but was offset by a decline in interest income of $1,106,000 resulting from lower interest rates. With regard to interest expense, lower funding costs (interest rates paid) resulted in a decline in interest expense of $317,000 which was coupled with a $167,000 decrease in interest expense resulting from the decline in the volume of long-term debt.
The yield on earning assets on a tax-equivalent basis decreased 61 basis points from 4.41% for the first quarter of 2012 to 3.80% for the first quarter of 2013 and also declined by 31 basis points from the 4.11% reported for the fourth quarter of 2012. In comparison, the rate paid on interest-bearing liabilities decreased 28 basis points from 1.00% for the first quarter of 2012 to 0.72% for the first quarter of 2013 and decreased 14 basis points when compared to 0.86% reported in the fourth quarter of 2012.
Interest income on investment securities decreased $259,000 when comparing the two quarters as the increase in average balances could not offset the 69 basis point decline in the average yield of the portfolio. The average yield on the investment portfolio was 2.51% for the first quarter of 2013 compared with 3.20% for the first quarter of 2012. As noted previously, the decline in the yield on the investment portfolio is primarily the result of the extended period of low interest rates which has resulted in an increase in cash flow from the investment portfolio as prepayments speeds on mortgage-backed securities and CMOs accelerated as did the amount of calls of agency and municipal securities. The reinvestment of these funds was in securities that had lower yields than what they replaced. The growth in the investment portfolio was primarily in high-quality U.S. Government agency and agency issued mortgage-backed and CMO securities as well as in tax-exempt state and municipal bonds.
Income on Government agency securities decreased $16,000, as the 49.6% growth in average balances was offset by a 68 basis point decline in the yield from 1.85% for the first quarter of 2012 to 1.17% for the same period in 2013. Most of the bonds in the agency portfolio have call features ranging from three months to three years, many of which were exercised as a result of the low interest rate environment. The proceeds from these called bonds as well as liquidity from deposit growth were reinvested in securities with significantly lower yields.
Interest income on tax-exempt municipal securities decreased only $7,000 as the 10.3% growth in average balances stabilized the decrease in yield. The municipal securities sector of the portfolio had a yield decline of 56 basis points from 5.58% at March 31, 2012 to 5.02% at March 31, 2013.
Interest income on mortgage-backed securities and CMOs decreased $222,000 with an increase in average balances offsetting in part the significant impact of lower rates. Average balances increased $11,488,000, or 6.1%, to $199,988,000 when comparing the two periods and contributed $79,000 in additional income. The yield on the mortgage-backed and CMO portfolio decreased 60 basis points from 2.73% for the first quarter of 2012 to 2.13% for the first quarter of 2013, resulting in a $301,000 reduction in interest income. This portfolio was expanded because it provides higher yields relative to agency bonds and also provides monthly cash flow which can be used for liquidity purposes or can be reinvested when interest rates eventually increase. With the historically low interest rate environment mortgage refinancing activity over the past three years was significant resulting in an increase in prepayments on these securities. Since most of these securities were purchased at a premium, prepayments result in a shorter amortization period of this premium and therefore a reduction in income.
Income on loans decreased $728,000 to $5,710,000 when comparing the first quarters of 2013 and 2012 with the decline in the portfolio yield being the major reason. The yield on the loan portfolio decreased 46 basis points to 4.91% when comparing the same periods, resulting in a reduction in interest income of $510,000. When comparing the two quarters average balances decreased 2.2% resulting in a decrease of $218,000 in interest income. As a result of the decline in market rates and an increase in competition for quality loans, QNB lowered the rates offered on new loans and reduced rates on some existing loans.
The largest category of the loan portfolio is commercial real estate loans. This category of loans includes commercial purpose loans secured by either commercial properties such as office buildings, factories, warehouses, medical facilities and retail establishments, or residential real estate, usually the residence of the business owner. The category also includes construction and land development loans. Income on commercial real estate loans decreased $390,000 and was impacted by both the decline in yield and a decrease in average balances. The yield on commercial real estate loans was 5.03% for the first quarter of 2013, a decrease of 40 basis points from the 5.43% reported for the first quarter of 2012. Average balances decreased $8,992,000, or 3.5%, to $247,728,000, for the three months ended March 31, 2013 compared with the same quarter in 2012.
Income on commercial and industrial loans, the second largest category, decreased $117,000 and was impacted by a decline in yield though the average balance increased. Average commercial and industrial loans increased $2,389,000, or 2.5%, to $99,664,000 for the first quarter of 2013. The average yield on these loans decreased 55 basis points to 4.43% resulting in a decrease in income of $137,000. Many of the loans in this category are indexed to the prime interest rate and have floors.
Income on home equity loans declined by $60,000 when comparing the first quarter of 2013 and 2012. During this same time period average home equity loans decreased $1,134,000, or 2.2%, to $50,702,000, while the yield on the home equity portfolio decreased 34 basis points to 4.26%. The demand for home equity loans has declined as home values have fallen preventing some homeowners from having equity in their homes to borrow against while others have taken advantage of the low interest rates on mortgages and refinanced their home equity loans into a new mortgage. During the second quarter of 2013, QNB began to offer very attractive rates on both variable rate and fixed rate home equity loans in an attempt to increase demand.
Given the low yields on investment securities, management decided to retain some 15 year mortgages to borrowers with high credit scores and low loan to value ratios. As a result, average residential mortgage loans secured by first lien 1-4 family residential mortgages increased by $1,357,000, or 5.0%, to $28,511,000 for the first quarter of 2013. During this same period the average yield on the portfolio declined by 40 basis points to 4.67% for the first quarter of 2013 as mortgage rates continue to remain at historic lows. The net result was a slight decrease in interest income of $11,000.
For the most part, earning assets are funded by deposits, which increased on average by $40,832,000, or 5.4%, to $794,780,000, when comparing the first quarters of 2013 and 2012. Total income on earning assets on a tax-equivalent basis decreased $988,000 when comparing the first quarter of 2013 to the first quarter of 2012 while total interest expense declined $484,000. Interest expense on total deposits decreased $302,000 while interest expense on borrowed funds decreased $182,000 when comparing the two quarters. The rate paid on interest-bearing liabilities decreased 28 basis points from 1.00% for the first quarter of 2012 to 0.72% for the first quarter of 2013. During this same period, the rate paid on interest-bearing deposits decreased 21 basis points from 0.91% to 0.70%. The reduction in the cost of funds reflects the prolonged exceptionally low interest rate environment over the past two years and the historic lows reached by Treasury rates.
The growth in deposits when comparing the first quarter of 2013 with the first quarter of 2012 was in accounts with greater liquidity, such as interest-bearing demand, interest-bearing municipal accounts, and savings deposits. Average interest-bearing demand accounts increased $11,913,000, or 12.4%, to $107,743,000 for the first quarter of 2013 compared to the first quarter of 2012; however, interest expense on interest-bearing demand accounts decreased $18,000 to $62,000 for the first quarter of 2013 as the average rate paid decreased from 0.34% for the first quarter of 2012 to 0.24% for the first quarter of 2013. Included in this category is QNB-Rewards checking, a higher-rate checking account product. The decrease in interest expense and the average rate paid on interest-bearing demand accounts is primarily the result of a reduction in the rate paid on QNB-Rewards checking. The rate paid on this account for the first quarter of 2012 was 1.25% on balances up to $25,000 and 0.50% for balances over $25,000 compared to 1.00% on balances up to $25,000 and 0.25% for balances over $25,000 during the first quarter of 2013. In order to receive the high rate a customer must receive an electronic statement, have one direct deposit or other ACH transaction and have at least 12 check card purchase transactions post and clear per statement cycle. For the first quarter of 2013, the average balance in this product was $29,878,000 and the related interest expense was $52,000 for an average yield of 0.70%. In comparison, the average balance of the QNB-Rewards accounts for the first quarter of 2012 was $28,998,000 with a related interest expense of $72,000 and an average rate paid of 0.99%. Even with the reduction in the rates paid on the QNB-Rewards product, the yield of 1.00% for the first $25,000 and 0.25% on balances over $25,000, assuming qualifications are met, is still an attractive rate relative to competitors’ offerings as well as other QNB products. This product also generates fee income through the use of the check card. The average balance of other interest-bearing demand accounts included in this category increased from $66,832,000 for the first quarter of 2012 to $77,865,000 for the first quarter of 2013. The average rate paid on these balances also increased slightly from 0.05% to 0.06% for the three month periods March 31, 2012 and 2013, respectively.
Interest expense on municipal interest-bearing demand accounts decreased $3,000 to $84,000 for the first quarter of 2013. The average balance of municipal interest-bearing demand accounts increased $25,161,000, or 46.3%, while the average interest rate paid on these accounts decreased from 0.64% for the first quarter of 2012 to 0.43% for the first quarter of 2013. Most of these accounts are tied directly to the Federal funds rate with most having rate floors between 0.25% and 0.75%. QNB was successful in increasing their relationships with several of these customers over the past year, accounting for the increase in balances.
Average money market accounts decreased $3,826,000, or 4.9%, to $74,308,000 for the first quarter of 2013 compared with the same period in 2012. When comparing these same periods interest expense on money market accounts decreased $33,000 to $38,000 and the average interest rate paid declined 15 basis points to 0.21% for the first quarter of 2013. The decline in interest expense and the rate paid is a function of the overall decline in market rates.
The QNB online eSavings account, introduced approximately three years ago, has been extremely successful and is the main reason for the growth of savings accounts to $197,942,000 at March 31, 2013. As market rates declined, the eSavings interest rate paid was also reduced and declined from 0.90% at March 31, 2012 to 0.50% at March 31, 2013. The average yield paid on these accounts was 0.56% for the first quarter of 2013 compared with a yield of 0.90% for the first quarter of 2012. The average balance of this product was $150,011,000 for the first quarter of 2013 compared to $127,642,000 for the first quarter of 2012 and contributed to the $20,911,000, or 11.8%, increase in total average savings accounts when comparing the two quarters. Traditional statement savings accounts, passbook savings and club accounts are also included in the savings category; however, decreased $1,458,000, or 3.0%, when comparing the first quarter 2013 average to the same 2012 quarter. The average rate paid on total savings accounts decreased 26 basis points from 0.72% for the first quarter of 2012 to 0.46% for the first quarter of 2013 and interest expense decreased 28.9% from $315,000 to $224,000 over the same period.
The repricing of time deposits at lower rates has had the greatest impact on total interest expense when comparing the two quarters. Total interest expense on time deposits decreased $157,000, or 15.7%, to $846,000 for the first quarter of 2013. Average total time deposits decreased by $18,720,000, or 6.6%, to $266,574,000 for the first quarter of 2013. Similar to fixed-rate loans and investment securities, time deposits reprice over time and, therefore, have less of an immediate impact on costs in either a rising or falling rate environment. Unlike loans and investment securities, however, the maturity and repricing characteristics of time deposits tend to be shorter. Over the course of 2012 and the first three months of 2013 a significant amount of time deposits have continued to reprice lower as rates have declined. The average rate paid on time deposits decreased from 1.41% to 1.29% when comparing the first quarter of 2012 to the same period in 2013.
Approximately $150,472,000, or 56.6%, of time deposits at March 31, 2013 will reprice or mature over the next 12 months. The average rate paid on these time deposits is approximately 0.85%. Given the short-term nature of QNB’s time deposit portfolio and the current rates being offered, it is likely that the average rate paid on time deposits may continue to decline slightly in the near term as higher costing time deposits are repriced lower. However, given the short-term nature of these deposits interest expense could increase if short-term time deposit rates were to increase suddenly.
Short-term borrowings are primarily comprised of sweep accounts structured as repurchase agreements with our commercial customers. Interest expense on short-term borrowings decreased minimally from $27,000 for the first quarter of 2012 to $26,000 for the first quarter of 2013. When comparing these same periods average balances increased from $20,899,000 to $27,772,000 while the average rate paid declined from 0.52% to 0.38%.
QNB had approximately $5,300,000 of average long-term debt at an average rate of 4.75% for the first quarter of 2013 and $20,300,000 for the first quarter of and 2012. In April 2012, $15,000,000 of debt at a rate of 4.75% matured and was repaid. This resulted in a reduction of interest expense of $181,000 between the two periods.
To continue to attract and retain deposits, QNB plans to be competitive with respect to rates and to continue to deliver products with terms and features that appeal to customers. The QNB Rewards checking and online eSavings accounts are examples of such products.
PROVISION FOR LOAN LOSSES AND ALLOWANCE FOR LOAN LOSSES
The provision for loan losses represents management's determination of the amount necessary to be charged to operations to bring the allowance for loan losses to a level that represents management’s best estimate of the known and inherent losses in the existing loan portfolio. Management believes that it uses the best information available to make determinations about the adequacy of the allowance and that it has established its existing allowance for loan losses in accordance with U.S. generally accepted accounting principles (GAAP). The determination of an appropriate level for the allowance for loan losses is based upon an analysis of the risks inherent in QNB’s loan portfolio. Management, in determining the allowance for loan losses, makes significant estimates and assumptions. Since the allowance for loan losses is dependent, to a great extent, on conditions that may be beyond QNB’s control, it is at least reasonably possible that management’s estimates of the allowance for loan losses and actual results could differ. In addition, various regulatory agencies, as an integral part of their examination process, periodically review QNB’s allowance for losses on loans. Such agencies may require QNB to recognize changes to the allowance based on their judgments about information available to them at the time of their examination. Actual loan losses, net of recoveries, serve to reduce the allowance.
Management closely monitors the quality of its loan portfolio and performs a quarterly analysis of the appropriateness of the allowance for loan losses. This analysis considers a number of relevant factors including: specific impairment reserves, historical loan loss experience, general economic conditions, levels of and trends in delinquent and non-performing loans, levels of classified loans, trends in the growth rate of loans and concentrations of credit.
Economic conditions over the past four years have contributed to high rates of unemployment and a softening of the residential and commercial real estate markets. These factors have had a negative impact on both consumers and small businesses and have contributed to higher than historical levels of net charge-offs and increases in specific reserves and in non-performing, impaired and classified loans. These factors and continued concerns related to economic conditions have resulted in elevated levels of the provision for loan losses and the allowance for loan losses. Since December 31, 2008, the start of the financial crisis, QNB has increased its allowance for loan losses from $3,836,000, or 0.95% of total loans, to $9,351,000, or 1.96% of total loans at March 31, 2013. Over the past year the allowance for loan losses has been relatively stable representing $9,772,000, or 2.05% of total loans at December 31, 2012, and $9,456,000, or 1.97% of total loans at March 31, 2012. The allowance for loan losses at March 31, 2013 is at a level that QNB management believes is adequate as of that date based on its analysis of known and inherent losses in the portfolio.
QNB recorded no provision for loan losses in the first quarter of 2013. This compares to provisions of $300,000 for the quarter ended March 31, 2012 and $300,000 for the quarter ended December 31, 2012. The lack of a provision for the first quarter reflects a slight decrease in total loans and the overall results of the analysis of the adequacy of the allowance for loan losses. Net loan charge-offs were $421,000, or 0.36% (annualized) of average total loans for the first quarter of 2013 compared with $85,000, or 0.07% (annualized) of average total loans for the first quarter of 2012 and $245,000, or 0.20% (annualized) of average total loans for the fourth quarter of 2012. Of the $421,000 in net charge-offs during the first quarter of 2013 almost 70% were fully reserved at December 31, 2012.
At March 31, 2013, non-performing loans totaled $22,113,000, as compared to $21,150,000 at December 31, 2012 and $19,903,000 at March 31, 2012. Non-performing loans have risen somewhat from 4.15% of total loans at March 31, 2012 to 4.63% at March 31, 2013. This increase was primarily the result of a $1,822,000 loan that was restructured to allow for a period of interest only payments during the first quarter of 2013. Loans on non-accrual status were $17,465,000 at March 31, 2013 compared with $18,572,000 at December 31, 2012 and $17,064,000 at March 31, 2012. Loans are placed on non-accrual status immediately if, in the opinion of management, collection is doubtful, or when principal or interest is past due 90 days or more and collateral is insufficient to cover principal and interest. In cases where there is a collateral shortfall on non-accrual loans, specific impairment reserves have been established based on the updated collateral values even if the borrower continues to pay in accordance with the terms of the agreement. Of the total amount of non-accrual loans at March 31, 2013, $9,369,000, or 53.6%, were current or past due less than 30 days at quarter end. While total non-performing loans have increased when comparing the first quarter of 2013 with the first quarter of the prior year, loans classified as substandard or doubtful, which includes non-performing loans, continues to improve. At March 31, 2013 substandard or doubtful loans totaled $44,408,000, a reduction of $9,653,000 from $54,061,000 as of March 31, 2012.
QNB had $302,000 of loans past due 90 days or more and still accruing interest at March 31, 2013 compared to none at December 31, 2012 and $171,000 at March 31, 2012. Total loans 30 days or more past due represented 2.52% of total loans at March 31, 2013 compared with 1.50% at December 31, 2012 and 1.81% at March 31, 2012.
A loan is considered impaired, based on current information and events, if it is probable that QNB will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and shortfalls on a case-by-case basis, taking into consideration all the circumstances surrounding the loan and the borrower, including length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial loans and indirect lease financing loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral, if the loan is collateral dependent. At March 31, 2013 and December 31, 2012, the recorded investment in loans for which impairment has been identified totaled $31,917,000 and $32,304,000 of which $24,245,000 and $23,771,000, respectively, required no specific allowance for loan loss. The recorded investment in impaired loans requiring an allowance for loan losses was $7,672,000 and $8,533,000 at March 31, 2013 and December 31, 2012, respectively. At March 31, 2013 and December 31, 2012, the related allowance for loan losses associated with these loans was $2,146,000 and $2,701,000, respectively. Most of the loans that have been identified as impaired are collateral-dependent. See Note 8 to the Notes to Consolidated Financial Statements for additional detail of impaired loans.
The following table shows detailed information and ratios pertaining to the Company’s loan and asset quality:
An analysis of loan charge-offs for the three months ended March 31, 2013 compared to 2012 is as follows:
NON-INTEREST INCOME
QNB, through its core banking business, generates various fees and service charges. Total non-interest income includes service charges on deposit accounts, ATM and check card income, income on bank-owned life insurance, merchant income and gains and losses on the sale of investment securities and residential mortgage loans. Total non-interest income for the first quarter of 2013 was $1,748,000, an increase of $182,000, compared to $1,566,000 for the first quarter of 2012.
The fixed-income securities portfolio represents a significant portion of QNB’s earning assets and is also a primary tool in liquidity and asset/liability management. QNB actively manages its fixed income portfolio in an effort to take advantage of changes in the shape of the yield curve and changes in spread relationships in different sectors and for liquidity purposes. Management continually reviews strategies that will result in an increase in the yield or improvement in the structure of the investment portfolio, including monitoring credit and concentration risk in the portfolio. Net investment securities gains were $423,000 for the quarter ended March 31, 2013 compared to $389,000 for the comparable quarter in 2012. Included in the first quarter of 2013 securities gains were $262,000 recorded on the sale of equity securities and $161,000 on sales of bonds, primarily mortgaged-backed securities and collateralized mortgage obligations. With the excellent performance of the U.S. equity markets in the first quarter of 2013, QNB elected to sell some equity holdings and recognize gains. In the first quarter of 2012, QNB recorded gains of $386,000 on the sale of equity securities as the U.S. equity markets had strong performance. There were no credit-related OTTI charges during the first quarter of 2013 or 2012.
Fees for services to customers were $366,000 for the first quarter of 2013, a $27,000, or 8.0%, increase from the same period in 2012. Overdraft income, representing approximately 67% of total fees for services to customers during the first quarter of 2013, increased by $26,000. The increase in overdraft income primarily reflects the positive impact of the introduction of an overdraft protection program on net overdraft income as the program reduced the amount of overdraft fees forgiven.
The net gain on residential mortgage sales is directly related to the volume of mortgages sold and the timing of the sales relative to the interest rate environment. Residential mortgage loans to be sold are identified at origination. The net gain on the sale of residential mortgage loans was virtually the same as last year at $225,000 for the quarter ended March 31, 2013. Although the overall gain was similar to prior year; the gain per loan was lower than prior year due to the impact of the interest rate environment at the time of sale. Proceeds from the sale of residential mortgages were $6,575,000 and $5,491,000 for the first quarters of 2013 and 2012, respectively.
There was a $143,000 increase in other non-interest income related to improved mortgage servicing income, title company income and mutual fund and annuity income. During the fourth quarter of 2012, QNB changed vendors related to the mutual fund and annuity income and now provides securities and advisory services under the name of QNB Financial Services through Investment Professionals, Inc., a registered Broker/Dealer and Registered Investment Advisor. There has been a significant increase in revenue as a result of the change which contributed an additional $84,000 to the quarter. Mortgage servicing fees were $33,000 higher quarter over quarter primarily related to the reversal of a portion of the valuation allowance related to the fair value of mortgage servicing rights as calculated by an independent third-party. When QNB sells its residential mortgages in the secondary market, it retains servicing rights. A normal servicing fee is retained on all mortgage loans sold and serviced. QNB recognizes its obligation to service financial assets that are retained in a transfer of assets in the form of a servicing asset. The servicing asset is amortized in proportion to, and over, the period of net servicing income or loss. On a quarterly basis, servicing assets are assessed for impairment based on their fair value. The timing of mortgage payments and delinquencies also impacts the amount of servicing fees recorded.
QNB also provides title insurance as a member of Laurel Abstract Company LLC. Title company income also increased $29,000 when comparing the first quarter of 2013 to 2012.
NON-INTEREST EXPENSE
Non-interest expense is comprised of costs related to salaries and employee benefits, net occupancy, furniture and equipment, marketing, third party services, FDIC insurance premiums, regulatory assessments and taxes and various other operating expenses. Total non-interest expense was $4,940,000 for the first quarter of 2013, an increase of $89,000, or 1.8%, compared to the first quarter of 2012. QNB’s overhead efficiency ratio, which represents the percentage of each dollar of revenue that is used for non-interest expense, is calculated by taking non-interest expense divided by net operating revenue on a tax-equivalent basis. The Bank’s efficiency ratios were 62.5% and 60.1% for the three months ended March 31, 2013 and 2012, respectively, and compare favorably with Pennsylvania commercial banks with assets between $500 million and $1 billion which had an average efficiency ratio of 72.4% for the fourth quarter of 2012, the most recent period available.
Salaries and benefits is the largest component of non-interest expense. QNB monitors, through the use of various surveys, the competitive salary and benefit information in its markets and makes adjustments when appropriate. Salaries and benefits expense for the first quarter of 2013 were $2,559,000, a decrease of $67,000, or 2.6%, from the $2,626,000 reported in the first quarter of 2012. The first quarter of 2012 included an accrual for incentive compensation of approximately $96,000. In addition, medical and dental benefit premiums and claims decreased approximately $19,000 comparing the first quarter of 2013 to 2012. Partially offsetting some of these declines were promotion and merit increases.
Net occupancy as well as furniture and fixtures expense increased $95,000, or 12.6%. The majority of this increase was attributable to higher depreciation expense, building repairs and maintenance and equipment maintenance costs. Much of the increase was related to the opening of two new locations during the first quarter, a full-service branch in Colmar, PA and a business office in Warminster, PA.
Marketing expense increased $38,000, or 18.9%, to $239,000 for the quarter ended March 31, 2013. Increases in advertising, public relations, sales promotions which were higher in large part as a result of the two new locations mentioned previously that opened in the first quarter. Donations costs were also higher when compared to the first quarter of 2012. QNB contributes to many not-for-profit organizations and clubs and sponsors many local events in the communities it serves.
Third party services are comprised of professional services, including legal, accounting, auditing and consulting services, as well as fees paid to outside vendors for support services of day-to-day operations. These support services include correspondent banking services, statement printing and mailing, investment security safekeeping and supply management services. Third party services expense increased $35,000, or 10.3%, to $374,000 for the three months ended March 31, 2013 when compared to the same period in 2012.
State tax expense represents the accrual of the Pennsylvania shares tax, which is based on the equity of the Bank, Pennsylvania sales and use tax and the Pennsylvania capital stock tax. State tax expense was $172,000 for the first quarter of 2013, an increase of $12,000 compared to the same period in 2012. The Bank’s Pennsylvania Shares Tax was $172,000 for the first quarter of 2013, an increase of $14,000 resulting from an increase in the Bank’s equity.
Other non-interest expense declined $45,000, or 10.2%, to $396,000 for the first quarter of 2013. The majority of the decrease relates to expenses associated with other real estate owned. These expenses include taxes, insurance and maintenance costs related to the properties held by the Bank.
INCOME TAXES
QNB utilizes an asset and liability approach for financial accounting and reporting of income taxes. As of March 31, 2013, QNB’s net deferred tax asset was $2,001,000. The primary components of deferred taxes are a deferred tax asset of $3,179,000 relating to the allowance for loan losses, a deferred tax asset of $169,000 generated by OTTI charges on equity securities and a deferred tax asset of $432,000 related to OTTI charges on trust preferred securities. Partially offsetting these deferred tax assets was a deferred tax liability of $1,791,000 resulting from unrealized gains on available-for-sale securities. As of March 31, 2012, QNB’s net deferred tax asset was $1,172,000. The primary components of deferred taxes are a deferred tax asset of $3,215,000 relating to the allowance for loan losses, a deferred tax asset of $134,000 generated by OTTI charges on equity securities and a deferred tax asset of $435,000 related to OTTI charges on trust preferred securities. Partially offsetting these deferred tax assets was a deferred tax liability of $2,304,000 resulting from unrealized gains on available-for-sale securities.
The realizability of deferred tax assets is dependent upon a variety of factors, including the generation of future taxable income, the existence of taxes paid and recoverable, the reversal of deferred tax liabilities and tax planning strategies. Based upon these and other factors, management believes it is more likely than not that QNB will realize the benefits of these remaining deferred tax assets. The net deferred tax asset is included in other assets on the consolidated balance sheet.
Applicable income tax expense was $733,000 for the three-month period ended March 31, 2013 compared to $750,000 for the three-month period ended March 31, 2012. The effective tax rate for 2013 was unchanged at 23.3% when comparing the first quarter of 2013 to the first quarter of 2012.
FINANCIAL CONDITION ANALYSIS
The following balance sheet analysis compares average balance sheet data for the three months ended March 31, 2013 and 2012, as well as the period ended balances as of March 31, 2013 and December 31, 2012.
Average earning assets for the three-month period ended March 31, 2013 increased $37,089,000, or 4.4%, to $873,240,000 from $836,151,000 for the three months ended March 31, 2012. The mix of earning assets has changed somewhat when comparing the two periods. Average loans decreased $10,817,000, or 2.2%, while average investment securities increased $51,907,000, or 15.3%. Average loans represented 54.0% of earning assets for the first three months of 2013, while average investment securities represented 44.9% of earning assets for the same period. This compares to 57.7% and 40.7%, respectively, for the first three months of 2012. Average other earning assets, which includes Federal Reserve deposits, decreased $4,001,000, or 28.7%, when comparing these same periods. Given the slow-down in loan growth and the relatively low yield of 0.25% on interest-bearing deposits at the Federal Reserve Bank, the decision was made to try and stay as fully invested as possible, while still retaining adequate liquidity.
QNB’s primary business is accepting deposits and making loans to meet the credit needs of the communities it serves. Loans are the most significant component of earning assets and growth in loans to small businesses and residents of these communities has been a primary focus of QNB. Inherent within the lending function is the evaluation and acceptance of credit risk and interest rate risk. QNB manages credit risk associated with its lending activities through portfolio diversification, underwriting policies and procedures and loan monitoring practices. Loan growth over the past 12 months has remained relatively flat. Businesses and consumers appear to be holding off investing in new equipment or any other type of financing and are paying down their lines with excess cash. Despite the lack of demand QNB is committed to make credit available to its customers.
Average total commercial loans decreased $6,603,000 when comparing the first three months of 2013 to the first three months of 2012. Commercial and industrial loans increased $2,389,000, or 2.5%, to $99,664,000. Commercial and industrial loans represent commercial purpose loans that are either secured by collateral other than real estate or unsecured. Many of these loans are for operating lines of credit. Average loans secured by real estate, either commercial or residential properties decreased $8,992,000, or 3.5%, when comparing the average balances for the three month periods while average tax-exempt loans to state and municipal organizations decreased $2,159,000, or 6.2%, over the same time period.
Average home equity loans declined from $51,836,000 for the first quarter of 2012 to $50,702,000 for the first three months of 2013. As mortgage interest rates remain at historic lows, customers continue to pay down their home equity loans when they refinance their first mortgage. The Bank began a home equity loan promotion as of March 1, 2013 and has initially received a strong response to the product offering.
Total investment securities were $398,447,000 at March 31, 2013 and $401,648,000 at December 31, 2012. The composition of the portfolio is little changed since December 31, 2012.
QNB does own CDOs in the form of pooled trust preferred securities. These securities are comprised mainly of securities issued by banks or bank holding companies, and to a lesser degree, insurance companies. QNB owns the mezzanine tranches of these securities. These securities are structured so that the senior and mezzanine tranches are protected from defaults by over-collateralization and cash flow default protection provided by subordinated tranches. QNB holds seven of these securities with an amortized cost of $3,519,000 and a fair value of $1,999,000 at March 31, 2013. There was no credit-related other-than-temporary impairment charge in the first quarter of 2013 or 2012. It is possible that future calculations could require recording additional other-than-temporary impairment charges through earnings. For additional detail on these securities see Note 7 Investment Securities and Note 9 Fair Value Measurements and Disclosures.
For the most part, earning assets are funded by deposits. Total average deposits increased $40,832,000, or 5.4%, to $794,780,000 for the first three months of 2013 compared to the first three months of 2012. Customers are continuing to look for the safety and stability of a strong local community bank as opposed to the volatility of the equity markets and the uncertainty of the larger regional and national banks.
Average interest-bearing demand and municipal accounts increased $ 11,913,000, or 12.4%, and $25,161,000, or 46.3%, respectively, when comparing the first three months of 2013 and 2012. Business accounts are the primary factor behind the growth of the interest-bearing demand accounts while the growth in relationships with a couple of school districts contributed to the increase in municipal balances. Savings accounts increased $20,911,000, or 11.8%, to $197,942,000 for the first quarter of 2013 due to the continued success of QNB’s Online eSavings. Average non-interest bearing demand accounts increased $5,393,000 or 8.5%, when comparing the three month periods. Total average time deposits decreased $18,720,000 , or 6.6%, when comparing the two quarters as customers continue to look for the liquidity of transaction accounts and are hesitant to lock in longer term deposits at low rates.
Total assets at March 31, 2013 were $918,780,000 compared with $919,874,000 at December 31, 2012, relatively unchanged between the periods. Interest-bearing deposits in banks increased $10,640,000 when comparing December 31, 2012 to March 31, 2013. Total loans also remained relatively unchanged when compared to December 31, 2012 and were $477,402,000 at March 31, 2013. As discussed previously the demand for loans by businesses and consumers continues to be low.
On the liability side, total deposits decreased marginally to $799,814,000 at March 31, 2013 compared to the December 31, 2012 balances. Similar to prior periods, the growth was centered in lower-cost core deposits, including savings accounts which increased $10,999,000, or 5.7%, to $202,336,000. This increase was partially offset as money market accounts, primarily business accounts, decreased $7,594,000, or 10.0%, from $76,047,000 at December 31, 2012 to $68,453,000 at March 31, 2013. These deposits can be volatile depending on the timing of deposits and withdrawals. Time deposits decreased $3,332,000, or 1.2%, from $269,234,000 at December 31, 2012 to $265,902,000 at March 31, 2013 as customers continue to look for liquidity in anticipation of rising interest rates.
Short-term borrowings declined $3,615,000 from $32,488,000 at December 31, 2012 to $28,873,000 at March 31, 2013. The majority of these balances are commercial sweep accounts which are also volatile based on businesses receipt and disbursement of funds.
LIQUIDITY
Liquidity represents an institution’s ability to generate cash or otherwise obtain funds at reasonable rates to satisfy demand for loans and deposit withdrawals. QNB attempts to manage its mix of cash and interest-bearing balances, Federal funds sold and investment securities in an attempt to match the volatility, seasonality, interest sensitivity and growth trends of its loans and deposits. The Company manages its liquidity risk by measuring and monitoring its liquidity sources and estimated funding needs. Liquidity is provided from asset sources through repayments and maturities of loans and investment securities. The portfolio of investment securities classified as available for sale and QNB's policy of selling certain residential mortgage originations in the secondary market also provide sources of liquidity. Core deposits and cash management repurchase agreements have historically been the most significant funding source for QNB. These deposits and repurchase agreements are generated from a base of consumers, businesses and public funds primarily located in the Company’s market area.
Additional sources of liquidity are provided by the Bank’s membership in the FHLB. At March 31, 2013, the Bank had a maximum borrowing capacity with the FHLB of approximately $216,838,000. The maximum borrowing capacity changes as a function of qualifying collateral assets. QNB has no outstanding borrowings with the FHLB at March 31, 2013. In addition, the Bank maintains two unsecured Federal funds lines with two correspondent banks totaling $18,000,000. At March 31, 2013, there were no outstanding borrowings under these lines. Future availability under these lines is subject to the policies of the granting banks and may be withdrawn. As part of its contingency funding plan, QNB successfully tested its ability to borrow from these sources during the fourth quarter of 2012.
Total cash and cash equivalents, available-for-sale investment securities and loans held-for-sale totaled $419,425,000 and $418,571,000 at March 31, 2013 and December 31, 2012, respectively. The sources and level of liquidity maintained should be adequate to meet normal fluctuations in loan demand or deposit withdrawals. With the current low interest rate environment, it is anticipated that the investment portfolio will continue to provide significant liquidity as agency and municipal bonds are called and as cash flow on mortgage-backed and CMO securities continues to be steady. In the event that interest rates would increase the cash flow available from the investment portfolio could decrease.
Approximately $162,673,000 and $170,433,000 of available-for-sale securities at March 31, 2013 and December 31, 2012, respectively, were pledged as collateral for repurchase agreements and deposits of public funds.
As an additional source of liquidity, QNB is a member of the Certificate of Deposit Account Registry Service (CDARS) program offered by the Promontory Interfinancial Network, LLC. CDARS is a funding and liquidity management tool used by banks to access funds and manage their balance sheet. It enables financial institutions to provide customers with full FDIC insurance on time deposits over $250,000 that are placed in the program. During the third quarter of 2011, QNB began offering Insured Cash Sweep (ICS), a product similar to CDARS, but one that provides liquidity like a money market or savings account.
CAPITAL ADEQUACY
A strong capital position is fundamental to support continued growth and profitability and to serve the needs of depositors. QNB's shareholders' equity at March 31, 2013 was $78,450,000, or 8.54% of total assets, compared to shareholders' equity of $77,623,000, or 8.44% of total assets, at December 31, 2012. Shareholders’ equity at March 31, 2013 and December 31, 2012 included a positive adjustment of $3,477,000 and $4,456,000, respectively, related to unrealized holding gains, net of taxes, on investment securities available-for-sale. Without these adjustments, shareholders' equity to total assets would have been 8.16% and 7.95% at March 31, 2013 and December 31, 2012, respectively.
Average shareholders' equity and average total assets were $74,527,000 and $905,388,000 for the first three months of 2013, an increase of 6.2% and 1.3%, respectively, from the averages for the year ended December 31, 2012. The ratio of average total equity to average total assets was 8.23% for the first three months of 2013 compared to 7.86% for all of 2012.
QNB is subject to various regulatory capital requirements as issued by Federal regulatory authorities. Regulatory capital is defined in terms of Tier I capital (shareholders’ equity excluding unrealized gains or losses on available-for-sale debt securities and disallowed intangible assets), Tier II capital, which includes the allowable portion of the allowance for loan losses which is limited to 1.25% of risk-weighted assets and a portion of the unrealized gains on equity securities, and total capital (Tier I plus Tier II). Risk-based capital ratios are expressed as a percentage of risk-weighted assets. Risk-weighted assets are determined by assigning various weights to all assets and off-balance sheet arrangements, such as letters of credit and loan commitments, based on associated risk. Regulators have also adopted minimum Tier I leverage ratio standards, which measure the ratio of Tier I capital to total quarterly average assets.
The following table sets forth consolidated information for QNB Corp.:
The minimum regulatory capital ratios are 4.00% for Tier I, 8.00% for the total risk-based capital and 4.00% for leverage. All capital ratios have improved from December 31, 2012 as the Tier I and total risk based capital levels have increased while the risk-weighted assets and quarterly average assets have declined since year end.
During the first quarter of 2010, QNB began offering a Dividend Reinvestment and Stock Purchase Plan (the “Plan”) to provide participants a convenient and economical method for investing cash dividends paid on the Company’s common stock in additional shares at a discount. The Plan also allows participants to make additional cash purchases of stock at a discount. Stock purchases under the Plan contributed $250,000 to capital during first three months of 2013.
The Board of Directors has authorized the repurchase of up to 100,000 shares of its common stock in open market or privately negotiated transactions. The repurchase authorization does not bear a termination date. As of March 31, 2013, 57,883 shares were repurchased under this authorization at an average price of $16.97 and a total cost of $982,000. There has been no additional shares repurchased under the plan since the first quarter of 2009.
Continuing to impact risk-weighted assets is the $25,319,000 of risk-weighted assets due to mezzanine tranches of pooled trust preferred securities that were downgraded below investment grade during the first quarter of 2009. Although the amortized cost of these securities was only $3,519,000 at March 31, 2013, regulatory guidance required an additional $25,319,000 to be included in risk-weighted assets. The Bank utilized the method as outlined in the Call Report Instructions for an available-for-sale bond that has not triggered the Low Level Exposure (LLE) rule. The mezzanine tranches of CDOs that utilized this method of risk-weighting are five out of seven pooled trust preferred securities (PreTSLs) held by the Bank as of March 31, 2013. The other two pooled trust preferred securities have only one tranche remaining so the treatment noted above does not apply.
The Federal Deposit Insurance Corporation Improvement Act of 1991 established five capital level designations ranging from "well capitalized" to "critically undercapitalized." At March 31, 2013 and December 31, 2012, management believes that the Company and the Bank met all capital adequacy requirements to which they are subject and have met the "well capitalized" criteria which requires minimum Tier I and total risk-based capital ratios of 6.00% and 10.00%, respectively, and a leverage ratio of 5.00%.
The information required in response to this item is set forth in Item 2, above.
We maintain a system of controls and procedures designed to provide reasonable assurance as to the reliability of the consolidated financial statements and other disclosures included in this report, as well as to safeguard assets from unauthorized use or disposition. We evaluated the effectiveness of the design and operation of our disclosure controls and procedures under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective as of the end of the period covered by this report. No changes were made to our internal control over financial reporting during the fiscal quarter covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
MARCH 31, 2013
None.
There were no material changes to the Risk Factors described in Item 1A in QNB’s Annual Report on Form 10-K for the period ended December 31, 2012.
The following Exhibits are being furnished* as part of this report:
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.