UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
(Mark One)
☒
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2015
OR
☐
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 0-17706
QNB Corp.
(Exact Name of Registrant as Specified in Its Charter)
Pennsylvania
23-2318082
( State or Other Jurisdiction of Incorporation or Organization)
(I.R.S. Employer Identification No.)
15 North Third Street, P.O. Box 9005 Quakertown, PA
18951-9005
(Address of Principal Executive Offices)
(Zip Code)
Registrant's Telephone Number, Including Area Code
(215) 538-5600
Not Applicable
Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report.
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☑ No_____
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☑ 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.
Large accelerated filer ____
Accelerated filer ☑
Non-accelerated filer ____
Smaller Reporting Company
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ____ No ☑
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
Class
Outstanding at October 30, 2015
Common Stock, par value $0.625
3,350,577
QNB CORP. AND SUBSIDIARY
QUARTER ENDED SEPTEMBER 30, 2015
INDEX
PART I - FINANCIAL INFORMATION
ITEM 1.
CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
Notes to Consolidated Financial Statements
ITEM 2.
ITEM 3.
ITEM 4.
69
LEGAL PROCEEDINGS
70
ITEM 1A.
RISK FACTORS
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
DEFAULTS UPON SENIOR SECURITIES
MINE SAFETY DISCLOSURES
ITEM 5.
OTHER INFORMATION
ITEM 6.
EXHIBITS
71
SIGNATURES
CERTIFICATIONS
QNB Corp. and Subsidiary
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
(unaudited)
September 30,
2015
December 31,
2014
Assets
Cash and due from banks
Interest-bearing deposits in banks
Total cash and cash equivalents
Investment securities
Trading
Available-for-sale (amortized cost $360,660 and $373,844)
Held-to-maturity (fair value $153 and $156)
Restricted investment in bank stocks
Loans held-for-sale
Loans receivable
Allowance for loan losses
Net loans
Bank-owned life insurance
Premises and equipment, net
Accrued interest receivable
Other real estate owned
Net deferred tax assets
Other assets
Total assets
Liabilities
Deposits
Demand, non-interest bearing
Interest-bearing demand
Money market
Savings
Time
Time of $100 or more
Total deposits
Short-term borrowings
Accrued interest payable
Other liabilities
Total liabilities
Shareholders' Equity
Common stock, par value $0.625 per share; authorized 10,000,000 shares; 3,515,046 shares and 3,481,227 shares issued; 3,350,477 and 3,316,658 shares outstanding
Surplus
Retained earnings
Accumulated other comprehensive income, net of tax
Treasury stock, at cost; 164,569 shares
Total shareholders' equity
Total liabilities and shareholders' equity
The accompanying notes are an integral part of the consolidated financial statements.
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share data - unaudited)
Three Months
Ended September 30,
Nine Months
Interest income
Interest and fees on loans
Interest and dividends on investment securities (AFS & HTM):
Taxable
Tax-exempt
Interest on trading securities
Interest on interest-bearing balances and other interest income
Total interest income
Interest expense
Interest on deposits
Interest on short-term borrowings
Interest on long-term debt
Total interest expense
Net interest income
Provision for loan losses
Net interest income after provision for loan losses
Non-interest income
Net gain on sale of investment securities
Net gain on trading activities
Fees for services to customers
ATM and debit card
Retail brokerage and advisory income
Merchant Income
Net gain on sale of loans
Other
Total non-interest income
Non-interest expense
Salaries and employee benefits
Net occupancy
Furniture and equipment
Marketing
Third party services
Telephone, postage and supplies
State taxes
FDIC insurance premiums
Total non-interest expense
Income before income taxes
Provision for income taxes
Net income
Earnings per share - basic
Earnings per share - diluted
Cash dividends per share
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands - unaudited)
Three months ended September 30,
Before
tax
amount
Tax
expense
(benefit)
Net of
Other comprehensive income:
Net unrealized holding gains on securities:
Unrealized holding gains arising during the period
Reclassification adjustment for gains included in net income
Other comprehensive income
Total comprehensive income
Nine months ended September 30,
The accompanying notes are an integral part of the consolidated financial statements
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
Accumulated
Number of
Shares
Common
Retained
Comprehensive
Treasury
(in thousands, except share and per share data)
Outstanding
Stock
Earnings
Income
Total
Balance, December 31, 2014
Other comprehensive income, net of tax
Cash dividends declared ($0.87 per share)
Stock issued in connection with dividend reinvestment and stock purchase plan
Stock issued for employee stock purchase plan
Stock issued for options exercised
Tax benefit of stock options exercised
Stock-based compensation expense
Balance, September 30, 2015
Income (Loss)
Balance, December 31, 2013
Cash dividends declared ($0.84 per share)
Balance, September 30, 2014
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands, unaudited)
Operating Activities
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
Net gain on investment securities available-for-sale
Net loss on sale of repossessed assets and other real estate owned
Proceeds from sales of residential mortgages held-for-sale
Origination of residential mortgages held-for-sale
Income on bank-owned life insurance
Net decrease (increase) in trading securities
Deferred income tax provision
Net increase (decrease) in income taxes payable
Net decrease (increase) in accrued interest receivable
Amortization of mortgage servicing rights and change in valuation allowance
Net amortization of premiums and discounts on investment securities
Net decrease in accrued interest payable
Increase in other assets
Decrease in other liabilities
Net cash provided by operating activities
Investing Activities
Proceeds from payments, maturities and calls of investment securities available-for-sale
Proceeds from the sale of investment securities available-for-sale
Purchases of investment securities available-for-sale
Proceeds from redemption of investment in restricted bank stock
Purchase of restricted bank stock
Net increase in loans
Net purchases of premises and equipment
Proceeds from sales of repossessed assets and other real estate owned
Net cash used in investing activities
Financing Activities
Net increase in non-interest bearing deposits
Net increase in interest-bearing deposits
Net decrease in short-term borrowings
Repayments of long-term debt
Tax benefit from exercise of stock options
Cash dividends paid, net of reinvestment
Proceeds from issuance of common stock
Net cash provided by financing activities
Increase in cash and cash equivalents
Cash and cash equivalents at beginning of year
Cash and cash equivalents at end of period
Supplemental Cash Flow Disclosures
Interest paid
Income taxes paid
Non-cash transactions:
Transfer of loans to repossessed assets or other real estate owned
Unsettled trades to purchase securities
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 2014 Annual Report incorporated in the Form 10-K. Operating results for the three and nine month periods ended September 30, 2015 are not necessarily indicative of the results that may be expected for the year ending December 31, 2015.
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 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 September 30, 2015, for items that should potentially be recognized or disclosed in these financial statements.
2. RECENT ACCOUNTING PRONOUNCEMENTS
In May 2014, the FASB issued Accounting Standard Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606). This ASU was issued to help improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets. The ASU’s core principle is that a company will recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In addition, this update specifies the accounting for certain costs to obtain or fulfill a contract with a customer and expands disclosure requirements for revenue recognition. This ASU is effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. QNB is evaluating the effect of adopting this new ASU.
In August 2014, the FASB issued ASU 2014-14, Receivables – Troubled Debt Restructurings by Creditors (Subtopic 310-40). The amendments in this Update require that a mortgage loan be derecognized and that a separate other receivable be recognized upon foreclosure if the following conditions are met: (1) the loan has a government guarantee that is not separable from the loan before foreclosure, (2) at the time of foreclosure, the creditor has the intent to convey the real estate property to the guarantor and make a claim on the guarantee, and the creditor has the ability to recover under that claim, and (3) at the time of foreclosure, any amount of the claim that is determined on the basis of the fair value of the real estate is fixed. Upon foreclosure, the separate other receivable should be measured based on the amount of the loan balance (principal and interest) expected to be recovered from the guarantor. The provisions in this ASU are effective for public business entities for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. The adoption of this guidance did not have a material impact on QNB’s financial statements but may result in expanded disclosures.
2. RECENT ACCOUNTING PRONOUNCEMENTS (continued)
On January 9, 2015, the FASB issued ASU 2015-01 Extraordinary and Unusual Items (Subtopic 225-20) which eliminates from U.S. GAAP the concept of an extraordinary item. The Board released the new guidance as part of its simplification initiative, which, as explained in the ASU, is intended to “identify, evaluate, and improve areas of U.S. GAAP for which cost and complexity can be reduced while maintaining or improving the usefulness of the information provided to the users of financial statements.” To be considered an extraordinary item under existing U.S. GAAP, an event or transaction must be unusual in nature and must occur infrequently. Stakeholders often questioned the decision-usefulness of labeling a transaction or event as extraordinary and indicated that it is difficult to ascertain whether an event or transaction satisfies both criteria. In light of this feedback and in a manner consistent with its simplification initiative, the FASB decided to eliminate the concept of an extraordinary item. As a result, an entity will no longer (1) segregate an extraordinary item from the results of ordinary operations; (2) separately present an extraordinary item on its income statement, net of tax, after income from continuing operations; and (3) disclose income taxes and earnings-per-share data applicable to an extraordinary item. However, the ASU does not affect the reporting and disclosure requirements for an event that is unusual in nature or that occurs infrequently. For all entities, the ASU is effective for annual periods beginning after December 15, 2015, and interim periods within those annual periods. Entities may apply the guidance prospectively or retrospectively to all prior periods presented in the financial statements. If an entity chooses to apply the guidance prospectively, it must disclose whether amounts included in income from continuing operations after adoption of the ASU are related to events and transactions previously recognized and classified as extraordinary items before the date of adoption. Early adoption is permitted if the guidance is applied as of the beginning of the annual period of adoption. QNB is evaluating the effect of adopting this new ASU.
On February 18, 2015, the FASB issued ASU 2015-02, Consolidation (Topic 810): Amendments to the Consolidation Analysis, which amends the consolidation requirements in ASC 810 and significantly changes the consolidation analysis required under U.S. GAAP. The amendments include the following:
●
Limited partnerships will be variable interest entities (VIEs), unless the limited partners have either substantive kick-out or participating rights. Although more partnerships will be VIEs, it is less likely that a general partner will consolidate a limited partnership.
The ASU changes the effect that fees paid to a decision maker or service provider have on the consolidation analysis. Specifically, it is less likely that the fees themselves will be considered a variable interest, that an entity will be a VIE, or that consolidation will result.
The ASU significantly amends how variable interests held by a reporting entity’s related parties or de facto agents affect its consolidation conclusion. Specifically, the ASU will result in less frequent performance of the related-party tiebreaker test (and mandatory consolidation by one of the related parties) than under current U.S. GAAP.
For entities other than limited partnerships, the ASU clarifies how to determine whether the equity holders (as a group) have power over the entity (this will most likely result in a change to current practice). The clarification could affect whether the entity is a VIE.
This ASU will be effective for periods beginning after December 15, 2015, for public companies. Early adoption is permitted, including adoption in an interim period. QNB does not anticipate the adoption of this guidance will have a material impact on its financial statements.
On April 7, 2015, the FASB issued ASU 2015-03, Interest—Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs, which changes the presentation of debt issuance costs in financial statements. Under the ASU, an entity presents such costs in the balance sheet as a direct deduction from the related debt liability rather than as an asset. Amortization of the costs is reported as interest expense. For public business entities, the guidance in the ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is allowed for all entities for financial statements that have not been previously issued. Entities would apply the new guidance retrospectively to all prior periods (i.e., the balance sheet for each period is adjusted). QNB is evaluating the effect of adopting this new ASU.
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 $18,000 and $17,000 for the three months ended September 30, 2015 and 2014, respectively. Stock-based compensation expense was $64,000 and $60,000 for the nine months ended September 30, 2015 and 2014, respectively. As of September 30, 2015, there was approximately $90,000 of unrecognized compensation cost related to unvested share-based compensation award grants that is expected to be recognized over the next 28 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 September 30, 2015, there were 225,058 options granted, 60,244 options forfeited, 164,814 options exercised and no remaining options outstanding under this Plan. The 1998 Plan expired on March 10, 2008.
The 2005 Plan authorized 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 September 30, 2015, there were 184,200 options granted, 55,225 options forfeited, 44,400 options exercised, and 84,575 options outstanding under this Plan. The 2005 Plan expired March 15, 2015.
The QNB Corp. 2015 Stock Incentive Plan authorizing the issuance of 300,000 shares was approved at the Company’s 2015 Annual Meeting of Shareholders. The terms of the 2015 Plan are identical to the 2005 plan. There were no options granted, forfeited, exercised or outstanding under this Plan as of September 30, 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:
Risk free interest rate
Dividend yield
Volatility
Expected life (years)
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 nine months of 2015 and 2014 was $4.38 and $3.81, respectively.
3. STOCK-BASED COMPENSATION AND SHAREHOLDERS’ EQUITY (continued)
Stock option activity during the nine months ended September 30, 2015 and 2014 is as follows:
Number
of options
Weighted
average
exercise price
remaining
contractual term
(in years)
Aggregate
intrinsic value
Outstanding at December 31, 2014
Granted
Exercised
Forfeited
Outstanding at September 30, 2015
Exercisable at September 30, 2015
Outstanding at December 31, 2013
Outstanding at September 30, 2014
Exercisable at September 30, 2014
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 nine months ended September 30, 2015 and 2014. As of September 30, 2015, 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:
Three months
ended September 30,
Nine months
Numerator for basic and diluted earnings per share - net income
Denominator for basic earnings per share - weighted average shares outstanding
Effect of dilutive securities - employee stock options
Denominator for diluted earnings per share - adjusted weighted average shares outstanding
There were 21,000 stock options that were anti-dilutive for both the three and nine-month periods ended September 30, 2015. There were 31,450 stock options that were anti-dilutive for both the three and nine-month periods ended September 30, 2014. These stock options were not included in the above calculation.
6. OTHER COMPREHENSIVE INCOME
The following shows the components of accumulated other comprehensive income at September 30, 2015 and December 31, 2014:
Unrealized net holding gains on available-for-sale securities
Unrealized losses on available-for-sale securities for which a portion of an other-than-temporary impairment loss has been recognized in earnings
Accumulated other comprehensive income
Tax effect
The following tables present amounts reclassified out of accumulated other comprehensive income for the three and nine months ended September 30, 2015 and 2014:
Amount reclassified from
accumulated other
comprehensive income
Details about accumulated other comprehensive income
Affected line item in statement of income
Total reclass out of accumulated other comprehensive income, net of tax
Net of tax
6. OTHER COMPREHENSIVE INCOME (continued)
Details about accumulated other comprehensive
income
7. INVESTMENT SECURITIES
QNB engages in trading activities for its own account. Municipal securities that are held principally for resale in the near term are recorded in the trading account at fair value with changes in fair value recorded in non-interest income. There were net realized and unrealized gains of $36,000 and $40,000 recorded for the three months ended September 30, 2015 and 2014, respectively. There were net realized and unrealized gains of $17,000 and $155,000 recorded for the nine months ended September 30, 2015 and 2014, respectively. Unrealized gains on trading activity related to trading securities still held at September 30, 2015 and December 31, 2014 totaled $29,000 and $24,000, respectively. Interest and dividends are included in interest income.
Trading securities, at fair value, at September 30, 2015 and December 31, 2014 were as follows:
State and municipal securities
The amortized cost and estimated fair values of investment securities available-for-sale at September 30, 2015 and December 31, 2014 were as follows:
Gross
unrealized
Fair
holding
Amortized
September 30, 2015
value
gains
losses
cost
U.S. Government agency
State and municipal
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed
Collateralized mortgage obligations (CMOs)
Pooled trust preferred
Corporate debt
Equity
Total investment securities available-for-sale
7. INVESTMENT SECURITIES (continued)
December 31, 2014
The amortized cost and estimated fair value of securities available-for-sale by contractual maturity at September 30, 2015 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.
Fair value
Due in one year or less
Due after one year through five years
Due after five years through ten years
Due after ten years
Equity securities
For the three months ended September 30, 2015 and 2014, proceeds from sales of investment securities available-for-sale were approximately $685,000 and $534,000. Proceeds from sales of investment securities available-for-sale were approximately $27,480,000 and $19,504,000 for the nine months ended September 30, 2015 and 2014, respectively.
At September 30, 2015 and December 31, 2014, investment securities available-for-sale totaling approximately $238,281,000 and $206,774,000, 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 (“OTTI”) 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:
Three months ended September 30, 2015
Three months ended September 30, 2014
Other-than-
temporary
realized
impairment
Net gains
Debt securities
Nine months ended September 30, 2015
Nine months ended September 30, 2014
The tax expense applicable to the net realized gains for the nine-month periods ended September 30, 2015 and 2014 amounted to approximately $273,000 and $370,000, 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 roll forward 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 on debt securities in the first nine months of 2015 or 2014.
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:
Balance, beginning of period
Additions:
Initial credit impairments
Subsequent credit impairments
Balance, end of period
The amortized cost and estimated fair values of investment securities held-to-maturity at September 30, 2015 and December 31, 2014 were as follows:
The amortized cost and estimated fair value of securities held-to-maturity by contractual maturity at September 30, 2015 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.
Total investment securities held-to-maturity
There were no sales of investment securities classified as held-to-maturity during the three and nine months ended September 30, 2015 or 2014.
The following table indicates the length of time individual securities have been in a continuous unrealized loss position at September 30, 2015 and December 31, 2014:
Less than 12 months
12 months or longer
No. of
Unrealized
securities
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 September 30, 2015 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.
The Company’s investment in marketable equity securities primarily consists of investments in large cap stock companies. These equity securities are analyzed for impairment on an ongoing basis. Management believes these equity securities will recover in the foreseeable future. QNB evaluated the near-term prospects of the issuers in relation to the severity and duration of the impairment. Based on that evaluation and the Company’s ability and intent to hold those securities for a reasonable period of time sufficient for a forecasted recovery of fair value, the Company does not consider these equity securities to be other-than-temporarily impaired.
QNB holds six pooled trust preferred securities as of September 30, 2015. These securities have a total amortized cost of approximately $3,409,000 and a fair value of $2,600,000. Five of the six 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 September 30, 2015:
Deal
Book
Unreal-ized gains (losses)
Realized
OTTI
credit
loss
(YTD 2015)
recognized
Moody's
/Fitch
ratings
Current
number of
performing
banks
insurance
companies
Actual deferrals and defaults as a % of total collateral
Total performing collateral as a % of outstanding bonds
PreTSL IV
Mezzanine*
B1/BB
PreTSL XVII
Mezzanine
C/CC
PreTSL XIX
Caa3/CC
PreTSL XXV
C/C
PreTSL XXVI
Caa3/C
Mezzanine* - only class of bonds still outstanding (represents the senior-most obligation of the trust)
On January 14, 2014, Federal bank regulatory agencies released a final rule authorizing retention of pooled trust preferred securities backed primarily by bank-issued trust preferred securities which included the PreTSLs held by QNB. Due to the uncertainty invoked between the original release of the Volcker Rule and the final rule, there was a noticeable increase in trading activity. However, we believe most of these trades occurred under distress and do not represent trades made in an orderly market. Despite the trades that took place as discussed previously, the market for these securities at September 30, 2015 was not active and markets for similar securities also are not active. The new issue market is also inactive and the market values for these securities are depressed relative to historical levels. 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 previous table, 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, except for PreTSL IV which represents the senior-most obligation of the trust.
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 impairment 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 and nine months ended September 30, 2015 and 2014, 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:
Estimate of Future Cash Flows – Cash flows are constructed in an INTEXcalc valuation model. INTEX is a proprietary cash flow model recognized as the industry standard for analyzing all types of structured debt products. It includes each deal’s structural features updated with trustee information, including asset-by-asset detail, as it becomes available. The modeled cash flows are then used to determine if all the scheduled principal and interest payments of the investments will be returned. For purposes of the cash flow analysis, relatively modest rates of prepayment of 1% were forecasted. In addition to the base prepayment assumption, due to the enactment of the Dodd-Frank Act additional prepayment analysis was performed. First, 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. 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. We then assumed any holding company that could refinance for a cost savings of more than 2% will refinance and will do so as soon as possible. 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.
Credit Analysis – A quarterly credit evaluation is performed for the companies comprising the collateral across the various pooled trust preferred securities. This credit evaluation considers any available evidence and focuses on capitalization, asset quality, profitability, liquidity, stock price performance, whether the institution has received TARP funding and whether the institution has shown the ability to generate additional capital either internally or externally.
Probability of Default – A near-term probability of default is determined for each issuer based on its financial condition and is used to calculate the expected impact of future deferrals and defaults on the expected cash flows. Each issuer in the collateral pool is assigned a near-term probability of default based on individual performance and financial characteristics. Various studies suggest that the rate of bank failures between 1934 and 2008 were approximately 0.36%. Thus, in addition to the specific bank default assumptions used for the near term, future defaults on the individual banks in the analysis for 2016 and beyond the rate used is calculated based on using the above mentioned thirty-six basis points and factoring that number based on a comparison of key financial ratios of active individual issuers without a short-term probability of default compared to all FDIC insured banks.
Severity of Loss – In addition to the probability of default discussed above, a severity of loss (projected recovery) is determined in all cases. In the current analysis, the severity of loss ranges from 0% to 100% depending on the estimated credit worthiness of the individual issuer. Based on information from various published studies, a 95% severity of loss was utilized for defaults projected in 2016 and thereafter.
Based upon the analysis performed by management as of September 30, 2015, it is probable that we will collect all contractual principal and interest payments on one of our six 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 write-downs 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:
1.
Lending policies and procedures, including underwriting standards and collection, charge-off and recovery practices.
2.
Effect of external factors, such as legal and regulatory requirements.
8. LOANS & ALLOWANCE FOR LOAN LOSSES (continued)
3.
National, regional, and local economic and business conditions as well as the condition of various market segments, including the value of underlying collateral for collateral dependent loans.
4.
Nature and volume of the portfolio including growth.
5.
Experience, ability, and depth of lending management and staff.
6.
Volume and severity of past due, classified and nonaccrual loans.
7.
Quality of the Company’s loan review system, and the degree of oversight by the Company’s Board of Directors.
8.
Existence and effect of any concentrations of credit and changes in the level of such concentrations.
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:
Commercial:
Commercial and industrial
Construction
Secured by commercial real estate
Secured by residential real estate
State and political subdivisions
Indirect lease financing
Retail:
1-4 family residential mortgages
Home equity loans and lines
Consumer
Total loans
Net unearned costs (fees)
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 September 30, 2015 and December 31, 2014, overdrafts were approximately $214,000 and $142,000, 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 September 30, 2015, 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.
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 September 30, 2015 and December 31, 2014:
Pass
Special mention
Substandard
Doubtful
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 September 30, 2015 and December 31, 2014:
Performing
Non-performing
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 September 30, 2015 and December 31, 2014:
30-59 days past due
60-89 days past due
90 days or more past due
Total past due loans
Total loans receivable
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 September 30, 2015 and December 31, 2014:
90 days or more past due (still accruing)
Non-accrual
Activity in the allowance for loan losses for the three months ended September 30, 2015 and 2014 are as follows:
Provision for (credit to) loan losses
Charge-offs
Recoveries
Unallocated
Provision (credit) for loan losses
Loans to depository institutions
Activity in the allowance for loan losses for the nine months ended September 30, 2015 and 2014 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.
Performing TDRs (not reported as non-accrual or past due 90 days or more and still accruing) totaled $626,000 and $1,897,000 as of September 30, 2015 and December 31, 2014, respectively. Non-performing TDRs totaled $1,239,000 and $3,690,000 as of September 30, 2015 and December 31, 2014, respectively. All TDRs are included in impaired loans.
The following table illustrates the specific reserve for loan losses allocated to loans modified as TDRs. These specific reserves are included in the allowance for loan losses for loans individually evaluated for impairment.
December 31, 2014 2013
Unpaid principal balance
Related allowance
TDRs with no specific allowance recorded
TDRs with an allowance recorded
There was one newly identified TDR during the nine months ended September 30, 2015. QNB granted a concession to an existing retail borrower who was experiencing financial difficulties. As of September 30, 2015 and December 31, 2014, QNB had commitments of $1,939,000 and $1,729,000, respectively, to lend additional funds to customers with loans whose terms have been modified in troubled debt restructurings. There were charge-offs of $5,000 and $522,000 during the nine months ended September 30, 2015 and 2014, respectively, resulting from loans previously modified as TDRs.
The following tables present loans, by loan class, modified as TDRs during the three and nine months ended September 30, 2015 and 2014. The pre-modification and post-modification outstanding recorded investments disclosed in the tables below, represent carrying amounts immediately prior to the modification and as of the period end indicated.
Number of contracts
Pre-modification outstanding recorded
investment
Post-modification outstanding recorded
There were no loans modified as TDRs within 12 months prior to September 30, 2015 for which there was a payment default (60 days or more past due) during the three and nine months ended September 30, 2015. There were no loans modified as TDRs within 12 months prior to September 30, 2014 for which there was a payment default during the three months ended September 30, 2014. There were 12 loans modified as TDRs within 12 months prior to September 20, 2014 with a recorded balance of $658,000 for which there was a payment default during the nine months ended September 30, 2014. All of these loans were either charged off or repaid during the thrid quarter 2014, resulting in $0 recorded balance at September 30, 2014.
The company has one consumer mortgage loan secured by residential real estate for which foreclosure proceedings are in process at September 30, 2015. The recorded investment is $45,000.
The following tables present the balance in the allowance for loan losses at September 30, 2015 and December 31, 2014 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:
Allowance for Loan Losses
Loans Receivable
Balance
Balance related to loans individually evaluated for impairment
Balance related to loans collectively evaluated for impairment
Balance individually evaluated for impairment
Balance collectively evaluated for impairment
The following tables summarize additional information in regards to impaired loans by loan portfolio class as of September 30, 2015 and December 31, 2014:
Recorded investment (after charge-offs)
With no specific allowance recorded:
With an allowance recorded:
Total:
Nine Months Ended
Year Ended
Average recorded investment
Interest income recognized
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:
Level 1:
Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.
Level 2:
Quoted prices in markets that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability.
Level 3:
Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported with little or no market activity).
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.
9. FAIR VALUE MEASUREMENTS AND DISCLOSURES (continued)
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.
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 September 30, 2015:
Quoted prices in active markets for identical assets (Level 1)
Significant other observable input (Level 2)
Significant unobservable inputs (Level 3)
Balance at end of period
Recurring fair value measurements
Trading Securities
Securities available-for-sale
U.S. Government agency securities
Mortgage-backed securities
Pooled trust preferred securities
Corporate debt securities
Total securities available-for-sale
Total recurring fair value measurements
Nonrecurring fair value measurements
Impaired loans
Mortgage servicing rights
Total nonrecurring fair value measurements
There were no transfers in and out of Level 1 and Level 2 fair value measurements during the nine months ended September 30, 2015. 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 nine-month period ended September 30, 2015.
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, 2014:
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:
Quantitative information about Level 3 fair value measurements
Valuation techniques
Unobservable input
Value or range of values
September 30, 2015 - Impaired loans
Appraisal of collateral (1)
Appraisal adjustments (2)
Liquidation expenses (3)
Discounted cash flow (4)
Discount rate
September 30, 2015 - Mortgage servicing rights
Discounted cash flow
Remaining term
December 31, 2014 - Impaired loans
Agreement of sale (5)
December 31, 2014 - Mortgage servicing rights
(1)
Fair value is primarily determined through appraisals of the underlying collateral by independent parties, which generally includes various level 3 inputs which are not always identifiable.
(2)
Appraisals may be adjusted by management for qualitative factors such as economic conditions and the age of the appraisal. The range is presented as a percent of the initial appraised value.
(3)
Appraisals and pending agreements of sale are adjusted by management for estimated liquidation expenses. The range is presented as a percent of the initial appraised value.
(4)
Fair value is determined using the cash flow of the borrower and the effective interest rate of the original note.
(5)
Fair value is determined by the net amount due.
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 nine months ended September 30, 2015:
Fair value measurements using
significant unobservable inputs
(Level 3)
Balance, January 1, 2015
Payments received
Total gains or losses (realized/unrealized)
Included in earnings
Included in other comprehensive income
Transfers in and/or out of Level 3
The Level 3 securities consist of six collateralized debt obligation securities, PreTSL securities, which are backed by trust preferred securities issued by banks, thrifts, and insurance companies. As discussed in Note 7, despite the fact that there were some trades during 2015, the market for these securities at September 30, 2015 was 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 few observable transactions and market quotations that are available are not reliable for purposes of determining fair value at September 30, 2015;
An income valuation approach technique (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs will be equally or more representative of fair value than the market approach valuation technique used at prior measurement dates; and
PreTSLs will be classified within Level 3 of the fair value hierarchy because significant adjustments are required to determine fair value at the measurement date.
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 INTEXcalc valuation model. Default rates are 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. The base loss severity assumption and long-term loss severity assumptions are modeled at 95%. The severity factor for near-term default 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 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. 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 3.36% to 7.80%. The determination of appropriate market discount rates involved the consideration of the following:
the time value of money
the price for bearing uncertainty in cash flows
other factors that would be considered by market participants
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. For a further discussion of PreTSL valuation, see Note 7, Investment Securities.
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 September 30, 2015 and December 31, 2014:
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 - trading (carried at fair value), 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 Community 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 2 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.
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 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:
Fair value measurements
Carrying
Significant other observable inputs
(Level 2)
Significant unobservable inputs
Financial assets
Cash and cash equivalents
Investment securities:
Available-for-sale
Held-to-maturity
Financial liabilities
Deposits with no stated maturities
Deposits with stated maturities
Off-balance sheet instruments
Commitments to extend credit
Standby letters of credit
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:
Commitments to extend credit and unused lines of credit
Total financial instrument commitments
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 September 30, 2015 and December 31, 2014 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 both State and Federal 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 bank regulatory agencies. Failure to meet minimum capital requirements can initiate actions by regulators that could have an effect on the financial statements and the amount of dividens that can be paid to shareholders. 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 September 30, 2015, that the Company and the Bank met capital adequacy requirements to which they were subject.
The Bank is presently considered it to be “well capitalized” under the regulatory framework. 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)
Capital levels
Actual
Minimum required
Well capitalized
As of September 30, 2015
Amount
Ratio
Total risk-based capital (to risk-weighted assets):
Consolidated
Bank
Tier I capital (to risk-weighted assets):
Common equity tier 1 capital (to risk-weighted assets):
Tier I capital (to average assets):
Adequately capitalized
As of December 31, 2014
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
QNB Corp. is a bank holding company headquartered in Quakertown, Pennsylvania. QNB Corp., through its wholly-owned subsidiary, the Bank, has been serving the residents and businesses of upper Bucks, northern Montgomery and southern Lehigh counties in Pennsylvania since 1877. Due to its limited geographic area, growth is pursued through expansion of existing customer relationships and building new relationships by stressing a consistent high level of service at all points of contact. 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 2014 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:
•
Volatility in interest rates and shape of the yield curve;
Credit risk;
Liquidity risk;
Operating, legal and regulatory risks;
Economic, political and competitive forces affecting QNB’s business; and
The risk that the analysis of these risks and forces could be incorrect, and/or that the strategies developed to address them could be unsuccessful.
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 nine months of 2015 or 2014.
The determination of the allowance for loan losses involves a higher degree of judgment and complexity than the Company’s 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 or present value of future estimated cash flows. 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.
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 collection. 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 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 third quarter of 2015 of $2,220,000, or $0.66 per share on a diluted basis, compared to net income of $2,044,000, or $0.62 per share on a diluted basis, for the same period in 2014. For the nine month period ended September 30, 2015, QNB reported net income of $6,290,000, or $1.88 per share on a diluted basis. This compares to net income of $6,512,000, or $1.98 per share on a diluted basis, reported for the nine month period ended September 30, 2014.
Net income expressed as an annualized rate of return on average assets and average shareholders’ equity was 0.88% and 9.86%, respectively, for the quarter ended September 30, 2015 compared with 0.85% and 9.73%, respectively, for the quarter ended September 30, 2014. For the comparative nine month periods, the annualized rate of return on average assets and average shareholders’ equity was 0.86% and 9.56%, respectively, for 2015 compared with 0.93% and 10.64%, respectively, for 2014.
Total assets as of September 30, 2015 were $1,039,317,000, compared with $977,135,000 at December 31, 2014. Loans receivable at September 30, 2015 were $582,255,000, compared with $555,282,000 at December 31, 2014, an increase of $26,973,000, or 4.9%, with commercial lending as the largest contributor to the growth. Total deposits of $908,674,000 at September 30, 2015 increased $57,082,000, or 6.7%, compared with total deposits of $851,592,000 at December 31, 2014, due primarily to the seasonal inflow in public funds balances.
Results for the three and nine months ended September 30, 2015 include the following significant components:
Net interest income increased $430,000, or 6.5%, to $7,015,000 and $869,000, or 4.5%, to $20,344,000 for the three and nine months ended September 30, 2015, respectively.
Net interest margin on a tax-equivalent basis increased four basis points for the quarter and decreased four basis points year-to-date, to 3.08% and 3.07%, respectively.
QNB recorded no provision for loan losses for the third quarter and $60,000 for the first nine months of 2015 compared with no provision recorded for first nine months of 2014.
Non-interest income decreased $24,000, or 1.6%, to $1,493,000 for the third quarter and declined $185,000, or 3.7%, to $4,769,000 for year-to-date 2015, respectively, compared to the same periods in 2014.
Non-interest expense increased $95,000, or 1.7%, to $5,573,000 for the third quarter and increased $760,000, or 4.7%, to $16,764,000 year-to-date 2015, respectively, compared to the same periods in 2014.
Total non-performing loans were $8,760,000, or 1.50% of loans receivable at September 30, 2015, compared to $12,667,000, or 2.28% of loans receivable at December 31, 2014. Loans on non-accrual status were $8,082,000 at September 30, 2015 compared with $10,770,000 at December 31, 2014. Net charge-offs for the first nine months of 2015 were $392,000, or 0.09% annualized of average total loans, as compared with $559,000, or 0.14% annualized of average total loans for the first nine months of 2014.
These items, as well as others, will be explained more thoroughly in the next sections.
NET INTEREST INCOME
QNB Corp. earns its net income primarily through its subsidiary, the Bank. Net interest income, or the spread between the interest, dividends and fees earned on loans and investment securities and the expense incurred on deposits and other interest-bearing liabilities, is the primary source of operating income for QNB. 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. QNB seeks to achieve sustainable and consistent earnings growth while maintaining adequate levels of capital and liquidity and limiting its exposure to credit and interest rate risk levels approved by the Board of Directors.
The following table presents the adjustment to convert net interest income to net interest income on a fully taxable-equivalent basis for the three and nine month periods ended September 30, 2015 and 2014.
Tax-equivalent adjustment
Net interest income (fully taxable-equivalent)
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.
Average Balances, Rate, and Interest Income and Expense Summary (Tax-Equivalent Basis)
Three Months Ended
September 30, 2014
Average
Rate
Interest
Trading securities
Investment securities (AFS & HTM):
U.S. Government agencies
Mortgage-backed and CMOs
Equities
Total investment securities
Loans:
Commercial real estate
Residential real estate
Home equity loans
Consumer loans
Tax-exempt loans
Total loans, net of unearned income*
Other earning assets
Total earning assets
Liabilities and Shareholders' Equity
Interest-bearing deposits:
Municipals
Time of $100,000 or more
Total interest-bearing deposits
Long-term debt
Total interest-bearing liabilities
Non-interest-bearing deposits
Shareholders' equity
Net interest rate spread
Margin/net interest income
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.
September 30, 2015 compared
to September 30, 2014
Due to change in:
Change
Volume
Interest income:
Total Investment securities (AFS & HTM)
Total Loans
Interest expense:
Net Interest Income and Net Interest Margin – quarter to quarter comparison
Net interest income for the quarter ended September 30, 2015 totaled $7,015,000, an increase of $430,000, or 6.5%, over the same period in 2014. When compared to the second quarter of 2015, net interest income increased $373,000 from the $6,642,000 reported.
Net interest income and net interest margin continue to be negatively impacted by declining yields on earning assets resulting from the prolonged low interest rate environment under which banks have been operating since 2008, the beginning of the financial crisis. Average earning assets for the third quarter of 2015 were $960,883,000, an increase of $39,376,000 from the third quarter of 2014, with average loans increasing $51,043,000, or 9.7%, and average investment securities decreasing $14,725,000, or 4.1%, over the same period. Growth in the loan portfolio mitigates the impact of the low rate environment on net interest income and the net interest margin as loans generally earn a higher yield than investment securities. Average loans as a percent of average earning assets grew from 57.0% for the third quarter 2014 to 59.9% for the third quarter 2015. On the funding side, average deposits increased $26,583,000, or 3.1%, to $870,751,000 for the third quarter of 2015 with growth in all categories with the exception of municipal deposits and time deposits. Customers continue to reinvest funds into non-time deposits, as the yield in time deposits remains low and customers prefer to keep their funds liquid to capitalize on rising rates. During this same time period, average borrowed funds increased $3,106,000 to $31,134,000, which in 2015 consisted solely of commercial repurchase agreements, as long-term debt matured and was repaid in April 2014.
The low interest rate environment and loan rate competition continues 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. The net interest margin for the third quarter of 2015 was 3.08% compared to 3.04% for the third quarter of 2014 and 3.06% reported for the second quarter of 2015.
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 increased $375,000, or 4.6%, to $8,587,000 for the third quarter of 2015, while total interest expense declined to $1,123,000. Growth in earning assets contributed an additional $544,000 of interest income but was offset by a decline in interest income of $169,000 resulting from lower yields. Interest expense on deposits declined $36,000. The decline in higher-costing funding time deposits and municipal deposits was the primary contributor while rate declines resulted in a small improvement in interest expense. Consumer and businesses continue to shift deposits into lower rate accounts.
The yield on earning assets on a tax-equivalent basis increased one basis point from 3.54% for the third quarter of 2014, to 3.55% for the third quarter of 2015 and increased one basis point from the 3.54% reported for the second quarter of 2015. The rate paid on interest-bearing liabilities decreased two basis points to 0.56% for the third quarter of 2015 compared to the same period in 2014 and declined one basis point compared to the funding rate reported for the quarter ended June 30, 2015.
Interest income on investment securities (trading, available-for-sale and held-to-maturity) decreased $114,000 when comparing the two quarters primarily as a result of the decrease in average balances for the three months ended September 30, 2015, compared to the same period in 2014. A three basis point decline in average yield also contributed to the decrease in interest income. The average yield on the investment portfolio was 2.45% for the third quarter of 2015 compared with 2.48% for the third quarter of 2014. The yield on the investment portfolio declined along with decreases in Treasury rates since the end of 2014. The current market has provided little opportunity to invest the cash flow from calls and prepayments in the portfolio in bonds with better yields than the securities being called and repaid. During the first nine months of 2015, cash flows from calls and principal and interest payments on mortgage backed securities funded loan growth, as well as seasonal deposit withdrawals by municipalities.
Income on U.S. Government agency securities decreased $34,000, as the $7,988,000, or 14.6%, decline in average balances reduced interest income by $31,000. A two basis point decrease in the yield from 1.59% for the third quarter of 2014 to 1.57% for the same period in 2015 contributed an additional $3,000 decrease in interest income.
Interest income on tax-exempt municipal securities decreased $38,000 with the decline in average yield from 4.34% in the third quarter 2014 to 4.15% for the third quarter 2015 contributing $36,000 of the decline in interest income. QNB had purchased many municipal securities when rates were significantly higher. Many of these bonds have either reached maturity or their call dates and are being replaced with municipal bonds with lower yields. Historically, QNB purchased municipal bonds with 10-15 year maturities; however, given the current rate environment has shortened the maturity range to between 7-10 years with call dates between 2-5 years. The yield on this portfolio is expected to continue to decline as additional higher yielding municipal bonds are expected to be called or mature during 2015. The current yield on replacement bonds is well below the yield of the bonds being called or maturing.
Interest income on mortgage-backed securities and CMOs decreased $58,000. Average balances declined $7,576,000, or 3.6%, from $207,817,000 for third quarter 2014 to $200,241,000 for the same period in 2015, which contributed $38,000 to the overall decline in interest income. The yield on the mortgage-backed and CMO portfolio decreased four basis points from 2.03% to 1.99% for the third quarters in 2014 and 2015, respectively, which resulted in a decrease of $20,000 in interest income. This portfolio 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 increased $503,000 to $6,447,000 when comparing the third quarters of 2015 and 2014, with growth in average balances offsetting the decline in the portfolio yield. During the third quarter 2015, a non-accrual loan payoff contributed an additional $150,000 to interest income. The yield on the loan portfolio decreased five basis points to 4.44% when comparing the same periods, resulting in a reduction in interest income of $103,000. When comparing the two quarters, the 9.7% increase in average balances resulted in an increase of $606,000 in interest income. As a result of the prolonged low interest rate environment and competitive pressures, new loans are being originated at lower rates, variable rate loans are repricing lower and many customers with fixed rates are requesting modifications for lower rates.
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 increased $398,000 and was impacted positively by both the increase in average balances and by the increase in yield. Average balances increased $31,905,000, or 12.1%, to $295,979,000 for the three months ended September 30, 2015 compared with the same quarter in 2014. The yield on commercial real estate loans was 4.62% for the third quarter of 2015, an increase of three basis points from the 4.59% reported for the third quarter of 2014.
Income on commercial and industrial loans, the second largest category, increased $36,000 as average commercial and industrial loan balances increased $10,093,000, or 8.9%, to $123,416,000 for the third quarter of 2015 resulting in an additional $115,000 in income. The average yield on these loans decreased 25 basis points to 4.29% resulting in a decrease in income of $79,000. Many of the loans in this category are indexed to the prime interest rate and have floors.
Tax-exempt loan income was $424,000 for the third quarter of 2015, a decrease of $33,000 from the same period in 2014. With the decline in market interest rates many municipalities have refinanced existing debt or taken on new debt. Although QNB has been successful in winning some of these bids, average balances have decreased $1,135,000, or 2.6%, to $42,191,000 for the third quarter of 2015, resulting in a $12,000 decrease in income. Rate renegotiation or bidding on these loans has resulted in a $21,000 decline in interest income as the average yield on the tax-exempt loan portfolio declined from 4.19% for the third quarter of 2014 to 3.99% for the third quarter of 2015.
QNB desires to become the “local consumer lender of choice” and to accomplish this QNB focused its retail lending efforts, adding new product offerings and increasing marketing and promotion. QNB achieved year-over-year growth in balances in all three categories of retail lending: residential mortgage, home equity and consumer loans. Average residential mortgage loans secured by first lien 1-4 family residential mortgages increased by $5,210,000, or 14.6%, to $40,789,000 for the third quarter of 2015 compared to the same period in 2014. Over this same timeframe, the average yield on the portfolio increased seven basis points to 4.23% for the third quarter of 2015. The result of the increase in balances and yield was an increase in interest income of $60,000. Average home equity loans increased $2,706,000, or 4.7%, to $60,066,000 while the average yield declined 12 basis points to 3.55%. The result is an increase in interest income of $6,000. Average consumer loans increased slightly to $3,927,000 while the yield on the portfolio decreased 26 basis points to 5.37% for the third quarter of 2015 resulting in a $3,000 decrease in interest income.
For the most part, earning assets are funded by deposits, which increased 3.1% when comparing the third quarters of 2015 and 2014. Interest expense on total deposits decreased $36,000 when comparing the two quarters while interest expense on borrowed funds increased $3,000, due to growth in these balances and a slight increase in rate paid on these balances. While the rate paid on interest-bearing deposits declined three basis points comparing the third quarters of 2015 and 2014, we do not anticipate deposit yields to decline much further as deposit rates are close to reaching an inherent floor and may actually begin to increase as short-term interest rates begin to increase and competition for deposits increases.
The growth in average deposits continues to be centered in accounts with greater liquidity, such as non-interest and interest-bearing demand, money market, and savings deposits. Average non-interest-bearing demand accounts increased $16,811,000, or 19.9%, to $101,429,000 for the third quarter of 2015. QNB has been successful in increasing business checking accounts as average balances in these accounts have increased by $13,608,000, or 20.1%, when comparing the quarters. Average interest-bearing demand accounts increased $17,420,000, or 14.8%, to $135,455,000 for the third quarter of 2015. Interest expense on interest-bearing demand accounts increased $1,000 to $71,000 for the same period, as the average rate paid declined by two basis points from 0.23% for the third quarter of 2014 to 0.21% for the third quarter of 2015. Included in this category is QNB-Rewards checking, a higher-rate checking account product that pays 1.00% on balances up to $25,000 and 0.25% for balances over $25,000. 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 third quarter of 2015, the average balance in this product was $40,395,000 and the related interest expense was $57,000 for an average yield of 0.56%. In comparison, the average balance of the QNB-Rewards accounts for the third quarter of 2014 was $35,976,000 with a related interest expense of $57,000 and an average rate paid of 0.63%. 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 $82,059,000 for the third quarter of 2014 to $95,060,000 for the third quarter of 2015. The average rate paid on these balances was 0.06% for both periods.
The average balance of municipal interest-bearing demand accounts decreased $12,233,000 to $116,572,000, with the average interest rate paid on these accounts at 0.34% for the third quarter of 2015 and 0.33% for the same period in 2014. The decrease in balances in 2015 may be attributable to school districts’ need for funds, as state funding has been delayed due to the state budget impasse. Interest expense on municipal interest-bearing demand accounts decreased $9,000 to $99,000 for the third quarter of 2015. Many of these accounts are indexed to the Federal funds rate with rate floors between 0.25% and 0.50%. Many of these deposits are seasonal in nature and are received during the third quarter as tax receipts are collected and are withdrawn over the course of the next year. It is anticipated that these balances will decrease during the fourth quarter of 2015 as school districts and municipalities invest tax receipts.
Average money market accounts increased $8,403,000, or 14.4%, to $66,854,000 for the third quarter of 2015 compared with the same period in 2014. Interest expense on money market accounts increased $5,000 to $40,000 and the average interest rate paid on money market accounts was 0.24% for both the third quarter of 2014 and 2015. The majority of balances in this category are in a product that pays a tiered rate based on account balances.
Interest expense on savings accounts increased $12,000 when comparing the third quarter of 2015 to the third quarter of 2014, with the average rate at 0.37% for both periods. When comparing these same periods average savings accounts increased $11,471,000, or 5.5%, to $218,753,000 for the third quarter of 2015 with both the statement savings and e-Savings products accounting for the growth in savings balances. QNB’s online e-Savings product is the largest category of savings deposits, with average balances for the third quarter of 2015 of $161,002,000, increasing $6,030,000, or 3.9% from the same period in 2014. This product has grown successfully since its introduction in the third quarter of 2009. The average yield paid on these accounts was 0.46% for both the third quarter of 2014 and 2015. Traditional statement savings accounts, passbook savings and club accounts are also included in the savings category and average balances in these types of savings accounts increased $5,441,000, or 10.4%, when comparing the third quarter 2015 average to the same 2014 quarter. The average yield paid was 0.12% for third quarter 2015, up two basis points from 0.10% paid for third quarter 2014.
Total interest expense on time deposits decreased $45,000 to $681,000 for the third quarter of 2015. Average total time deposits decreased by $15,289,000 to $231,688,000 for the third quarter of 2015. 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. The average rate paid on time deposits remained unchanged at 1.17% when comparing the third quarter of 2014 to the same period in 2015.
Approximately $104,059,000, or 45.4%, of time deposits at September 30, 2015 will reprice or mature over the next 12 months. The average rate paid on these time deposits is approximately 0.99%. The yield on the time deposit portfolio may change slightly in the next quarter as short-term time deposits reprice. However, given the short-term nature of these deposits, interest expense could increase if short-term time deposit rates were to increase suddenly or if customers select higher paying longer-term time deposits.
Short-term borrowings are comprised of sweep accounts structured as repurchase agreements with our commercial customers. Interest expense on short-term borrowings increased $3,000 for the third quarter of 2015 to $28,000. When comparing these same periods average balances increased from $28,028,000 to $31,134,000 while the average rate paid increased one basis point to 0.37% when comparing the periods.
Nine Month Comparison
For the nine month period ended September 30, 2015 net interest income was $20,344,000, an increase of $869,000, or 4.5%, higher than the $19,475,000 reported for the first nine months of 2014. For the nine month period ending September 30, 2015 average earning assets increased $43,008,000, or 4.8%, to $942,665,000, with average loans increasing 10.0% and average investment securities decreasing 3.8%. Average total deposits increased $36,690,000, or 4.5%, to $852,704,000 for the nine-month period ended September 30, 2015 compared to the same period in 2014. The net interest margin on a tax-equivalent basis was 3.07% for the nine-month period ended September 30, 2015, a decrease of four basis points from the same period in 2014.
Total interest income on a tax-equivalent basis increased $718,000, or 3.0%, from $24,301,000 to $25,019,000, when comparing the nine-month periods ended September 30, 2014 and September 30, 2015 as the additional interest income generated from the growth in earning assets was partially offset by the impact of declining yields on those assets. Interest income increased $1,495,000 as a result of volume increases but declined $777,000 as a result of lower yields. The analysis of the nine-month comparison periods is similar to what was described in the quarterly analysis: Loan demand was funded by growth in average deposits combined with a reduction of the investment securities portfolio.
The yield on earning assets decreased from 3.61% to 3.55% for the nine-month periods with the yield on loans decreasing from 4.50% to 4.37% comparing the same periods. As discussed previously, the decline in yields reflects the impact of historically low levels of interest rates over the past several years and competitive pressures on loan pricing. The yield on investments, including trading securities, decreased eight basis points from 2.49% to 2.41% when comparing the nine-month periods.
Total interest expense decreased $34,000 for the nine-month period ended September 30, 2015 compared with the same period in 2014, attributable in part to the absence of long-term debt in 2015, which was repaid in 2014. The average rate paid on interest bearing deposits decreased one basis point from 0.58% for the nine months ended September 30, 2014 to 0.57% for the same period in 2015.
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.
Based on this analysis, QNB recorded no provision for loan losses in the third quarter and $60,000 year-to-date 2015, while no provision was recorded in the same periods in 2014. QNB's allowance for loan losses of $7,669,000 represents 1.32% of loans receivable at September 30, 2015 compared to an allowance for loan losses of $8,001,000, or 1.44% of loans receivable, at December 31, 2014, and $8,366,000, or 1.56% of loans receivable at September 30, 2014. The allowance for loan losses at September 30, 2015 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.
Net recoveries were $14,000 for the third quarter of 2015, comprising net overdraft charge-offs totaling $6,000, offset by net recoveries on individual accounts. This compares with net loan charge-offs of $534,000 for the third quarter of 2014. For the nine month periods ended September 30, 2015 and 2014 net loan charge-offs were $392,000 and $559,000, respectively.
Non-performing assets of $11,360,000 at September 30, 2015 compares favorably with $18,152,000 as of December 31, 2014 and $17,962,000 as of September 30, 2014. Included in this classification are non-performing loans, other real estate owned (OREO) and repossessed assets, and non-accrual pooled trust preferred securities. Total non-performing loans, which represent loans on non-accrual status, loans past due 90 days or more and still accruing interest and restructured loans were $8,760,000, or 1.50% of loans receivable at September 30, 2015, compared with $12,667,000, or 2.28% of loans receivable at December 31, 2014, and $12,454,000, or 2.32% of loans receivable at September 30, 2014. 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. At September 30, 2015, $6,037,000, or approximately 75% of the loans classified as non-accrual are current or past due less than 30 days. In addition to the decline in total non-performing loans when comparing the third quarter of 2015 with the same quarter of the prior year, loans classified as substandard or doubtful, which include non-performing loans, also improved. At September 30, 2015 commercial loans rated substandard or doubtful totaled $23,462,000, a reduction of $9,907,000, or 29.7%, from the $33,369,000 reported as of September 30, 2014, and a decrease of $10,892,000, or 31.7%, from the $34,354,000 reported at December 31, 2014.
QNB had $52,000 of loans past due 90 days or more and still accruing interest at September 30, 2015 consisting of indirect lease financing balances. At December 31, 2014 and September 30, 2014, there were no loans past due 90 days or more and still accruing. Total loans 30 days or more past due, which includes non-accrual loans by actual number of days delinquent, represented 0.42% of loans receivable at September 30, 2015 compared with 1.21% at December 31, 2014 and 0.64% at September 30, 2014.
Troubled debt restructured loans, not classified as non-accrual loans or loans past due 90 days or more and accruing, were $626,000 at September 30, 2015, compared with $1,897,000 at December 31, 2014, and $1,895,000 at September 30, 2014. There was additional credit extended to two troubled debt restructures since September 2014; one residential borrower and one borrower rated substandard whose credit facility was renewed in 2015. QNB had no other real estate owned or repossessed assets as of September 30, 2015 compared with $3,046,000 at December 31, 2014 and September 30, 2014, respectively. Included in the December 31, and September 30, 2014 amount was one property with a fair value of $2,325,000, which was sold in January 2015. All OREO properties held at December 31, 2014 or aquired in 2015 have been sold at a cumulative net gain of $2,000 recognized in the quarter and a total net loss of $9,000 recognized on the sale of six properties for the nine months ended September 30, 2015. Non-accrual pooled trust preferred securities are carried at fair value of $2,600,000, $2,439,000, and $2,462,000 at September 30, 2015, December 31, 2014 and September 30, 2014, respectively. The change in the carrying value of these securities reflects an improvement in their fair value.
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 September 30, 2015 and December 31, 2014, the recorded investment in loans for which impairment has been identified totaled $12,054,000 and $21,077,000 of which $10,284,000 and $19,019,000, respectively, required no specific allowance for loan loss. The recorded investment in impaired loans requiring an allowance for loan losses was $1,770,000 and $2,058,000 at September 30, 2015 and December 31, 2014, respectively. At September 30, 2015 and December 31, 2014, the related allowance for loan losses associated with these loans was $867,000 and $1,194,000, 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:
Non-accrual loans
Loans past due 90 days or more and still accruing interest
Troubled debt restructured loans (not already included above)
Total non-performing loans
Other real estate owned and repossessed assets
Non-accrual investment securities
Total non-performing assets
Total loans (excluding loans held-for-sale):
Average total loans (YTD)
Allowance for loan losses to:
Non-performing loans
Total loans (excluding held-for-sale)
Average total loans
Non-performing loans / total loans (excluding held-for-sale)
Non-performing assets / total assets
An analysis of loan charge-offs for the three and nine months ended September 30, 2015 compared to 2014 is as follows:
Net charge-offs (recoveries)
Net annualized charge-offs (recoveries) to:
Average total loans excluding held-for-sale
NON-INTEREST INCOME
Non-Interest Income Comparison
Change from
prior year
Percent
Net gain on investment securities
Net gain on trading activity
Merchant income
Quarter to Quarter Comparison
Total non-interest income for the third quarter of 2015 was $1,493,000, a decrease of $24,000, compared to $1,517,000 for the third quarter of 2014. Excluding net gains on investment securities, trading activities and sale of loans for both periods, total non-interest income was $1,254,000 and $1,187,000, an increase of $67,000, or 5.6%.
Decreases in net gains on investment securities and trading activity, which declined from $180,000 and $40,000, respectively, in the third quarter of 2014, to $83,000 and $36,000, respectively, in the same period in 2015, contributed $101,000 of the decrease in non-interest income. Gain on investments are primarily derived from sale of equities. Market conditions in the equities market for the quarter ended September 30, 2015 versus the same period in 2014 resulted in fewer opportunities for sales in 2015 compared to 2014. Trading revenue represents realized and unrealized gains and losses, net of expenses, on the municipal trading account portfolio, first established during the first quarter of 2014. This portfolio is marked to market with any change in fair value recorded as non-interest income. Interest earned on these securities during the holding period is included in net interest income. The decrease in trading investment portfolio is attributable to significantly decreased activity in the municipal bond markets for the third quarter of 2015 compared to the same period in 2014. The net gains on investment securities in both 2015 and 2014 were primarily gains on sale of equity securities. There were no OTTI charges in the third quarter of 2015 or 2014.
QNB originates residential mortgage loans for sale in the secondary market. Net gains on sale of loans increased from $110,000 during the third quarter of 2014 to $120,000 during the third quarter of 2015 due to increased residential mortgage activity and low interest rates. 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. Proceeds from the sale of residential mortgages were $3,108,000 and $2,650,000 for the third quarters of 2015 and 2014, respectively.
Fees for services for customers, combined with ATM and debit card fees increased $21,000 for the third quarter of 2015, compared to the same period in 2014 due to increased debit card transactions. Retail brokerage and advisory income was $180,000 for the third quarter of 2015 compared to $138,000 for the third quarter of 2014. This represents an increase of $42,000, or 30.4%. QNB provides securities and advisory services under the name of QNB Financial Services through Investment Professionals, Inc., a registered Broker/Dealer and Registered Investment Advisor. Assets under management at September 30, 2015 were $63,326,000, increasing $18,366,000 from assets under management of $44,960,000 at September 30, 2014.
Nine-Month Comparison
Total non-interest income for the nine month periods ended September 30, 2015 and 2014 was $4,769,000 and $4,954,000, respectively, a decrease of $185,000, or 3.7%. Excluding net gains on investment securities, trading activities and loans for both periods total non-interest income was $3,650,000 and $3,541,000, an increase of $109,000, or 3.1%.
Net investment securities gains decreased $287,000, or 26.4%, to $800,000 for the nine months ended September 30, 2015 compared to $1,087,000 for the comparable nine months in 2014. The gains in both periods were primarily on the sale of equity securities. There were no OTTI charges in the 2015 or 2014 periods.
Fees for services to customers decreased $1,000 in the first nine months of 2015 compared to 2014. Overdraft income net of waived charges, representing approximately 74% of total fees for services to customers during the nine months ended September 30, 2015, increased by $39,000. The increase in overdraft income reflects an increase in the volume of overdrafts as there has been no change to the fee charged to customers. This increase was offset by a $23,000 decline in internet banking fees, as the fees related to this transaction channel were reduced beginning in 2015. Service charges on business checking accounts declined $11,000 during the period, as increased balances covered transaction costs and reduced fee income. ATM and debit card income increased $40,000, or 3.6%, to $1,153,000 due to increased purchases by cardholders during the period.
Retail brokerage and advisory income was $557,000 for nine months of 2015 compared to $453,000 for nine months of 2014, an increase of $104,000, or 23.0%.
Net gains on the sale of loans increased $131,000, or 76.6%, when comparing the nine months ended September 30, 2015 to the same period in 2014. As noted for the quarter, the low interest rate environment and recovery of the local housing market over the past year significantly impacted residential mortgage loan activity. Proceeds from the sale of residential mortgages were $9,595,000 and $4,192,000 for the nine-month periods ended September 30, 2015 and 2014, respectively.
Other non-interest income decreased $27,000, or 9.4%, when comparing the nine-month periods ended September 30, 2015 and 2014, due to net losses on the sale of OREO and repossessed assets and a non-recurring sales tax refund received in 2014.
NON-INTEREST EXPENSE
Non-Interest Expense Comparison
Third-party services
Total non-interest expense was $5,573,000 for the third quarter of 2015, an increase of $95,000, or 1.7%, compared to the third quarter of 2014.
Salaries and benefits comprise 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 third quarter of 2015 were $2,911,000, a decrease of $52,000, or 1.8%, from the $2,963,000 reported in the third quarter of 2014. When comparing the two periods, the net decrease is attributed to a decrease in net benefits expense due primarily to insurance reimbursements for medical claims paid in prior periods. Partially offsetting this was increased salary expenses of $124,000.
Net occupancy costs increased $6,000, or 1.4%, primarily branch rent. Furniture and equipment expense declined by $20,000, or 4.5%, with declines in depreciation expense being somewhat offset by increases in software and equipment maintenance. Marketing expense decreased $27,000, or 13.4%, to $174,000 for the three month period ended September 30, 2015. The decrease was largely due to expenses in prior year related to public relations for the Company’s domain name change and rebranding that took place in the fourth quarter of 2014.
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 decreased $65,000, or 14.3%, to $389,000 for the three months ended September 30, 2015 when compared to the same period in 2014, attributable primarily to reduced third party IT services, consultant services, and other third party expenses, which decreased $19,000, $23,000 and $28,000, respectively.
FDIC insurance premium expense decreased $8,000, or 4.7%, to $162,000, when comparing the three months ended September 30, 2015 to the same period in 2014. The lower expense reflects a decrease in the rate charged.
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 $173,000 for the third quarter of 2015, an increase of $21,000 compared to the same period in 2014. The increase related to the change in the Bank’s equity capital.
Other non-interest expense increased $245,000, or 50.4%, to $731,000 for the third quarter of 2015. Contributing to the higher expenses was a $208,000 third party contract termination fee related to debit card platform upgrades anticipated to occur during 2016.
Total non-interest expense was $16,764,000 for the nine-month period ended September 30, 2015, an increase of $760,000, or 4.7%, compared to the same period in 2014.
Salaries and benefits expense increased $366,000, or 4.3%, to $8,960,000 for the nine months ended September 30, 2015 compared to the same period in 2014. Salary expense and related taxes increased $587,000 during the period to $7,732,000. Included in this increase was an incentive compensation accrual for the period which increased by approximately $69,000 compared with the first nine months of 2014. The remainder of the increase is attributable to two additional full-time equivalent employees, higher commissions on retail brokerage income and normal merit increases. Benefits expense decreased $221,000, to $1,228,000, related to medical claims insurance reimbursements received in the third quarter 2015 compared with increased medical claims for third quarter 2014.
Net occupancy costs increased $45,000, or 3.5%, primarily branch rent. Marketing expense declined $45,000, or 7.0%, to $596,000 for the nine months ended September 30, 2015 for the same reason noted for the quarter.
Third party services expense decreased $31,000, or 2.4%, to $1,235,000 for the nine months ended September 30, 2015 when compared to the same period in 2014. This included a decrease in expenses for consultant services, which, in 2014 were engaged to evaluate the executive management team.
State tax expense was $520,000 for the nine months ended September 30, 2015, an increase of $64,000 compared to the same period in 2014 due to the increase in the Bank’s equity capital for the period.
Other non-interest expense increased $387,000, or 27.3%, to $1,802,000 for the nine months ended September 30, 2015. Contributing to the higher expenses were a $208,000 third party contract termination fee noted previously for the quarter, $74,000 for additional collections expenses and tax payments for delinquent loans, $54,000 of third party processing costs for a product designed to enhance cash flow for business loan customers, $24,000 related to additional expenses for check card charge-offs, and $14,000 for a higher regulatory fee assessment.
INCOME TAXES
QNB utilizes an asset and liability approach for financial accounting and reporting of income taxes. As of September 30, 2015, QNB’s net deferred tax asset was $2,677,000. The primary components of deferred taxes are deferred tax assets of $2,607,000 relating to the allowance for loan losses, $477,000 related to non-accrual interest income, $123,000 related to deferred fees and rent, $66,000 generated by OTTI charges on equity securities and $392,000 related to OTTI charges on trust preferred securities. These amounts are offset by a deferred tax liability of approximately $1,000,000 resulting from furniture and equipment depreciation, prepaid items, mortgage servicing rights and unrealized gains on available for sale securities. As of December 31, 2014, QNB’s net deferred tax asset was $2,925,000. The primary difference in the balance of net deferred tax assets when comparing September 30, 2015 to December 31, 2014 is the decrease in deferred tax asset related to the reduction in allowance for loan losses and deferred tax liability due to decreased 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.
Applicable income tax expense was $715,000 for the three-month period ended September 30, 2015 compared to $580,000 for the three-month period ended September 30, 2014. The effective tax rate for third quarter of 2015 was 24.4% compared with 22.1% for the third quarter of 2014. For the nine-month periods ended September 30, 2015 and 2014 applicable income taxes and the effective tax rates were $1,999,000, or 24.1%, and $1,913,000, or 22.7%, respectively. The higher effective tax rates in 2015 are due to the decreased proportion of tax-free income to total income, primarily municipal securities interest income, and state income tax.
FINANCIAL CONDITION ANALYSIS
Financial service organizations are challenged to demonstrate they can generate sustainable and consistent earnings growth in a dynamic operating environment. While the economy continues to improve and strong loan demand continued from the latter half of 2014 into the first three quarters of 2015, the low level of interest rates and the increasing competition for quality loans is anticipated to continue through 2015. It is also anticipated that the rate competition for attracting and retaining deposits may increase in 2016 as short-term interest rates may to begin to increase which could result in a lower net interest margin and a decline in net interest income.
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. QNB is committed to make credit available to its customers.
Total assets at September 30, 2015 were $1,039,317,000 compared with $977,135,000 at December 31, 2014. Cash and cash equivalents increased $51,459,000 to $69,704,000 at September 30, 2015. Proceeds from the decline in total investment securities of $13,232,000 were used in part to fund the growth in loans receivable, which totaled $26,973,000 when compared to December 31, 2014. Loans receivable were $582,255,000 at September 30, 2015. Demand for loans by both businesses and consumers was strong during the first nine months of 2015.
Average total commercial loans increased $42,940,000 when comparing the first nine months of 2015 to the first nine months of 2014. Commercial and industrial loans increased $11,520,000, or 10.2%, to $124,211,000. 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 increased $28,963,000, or 11.1%, when comparing the average balances for the nine month periods while average tax-exempt loans to state and municipal organizations increased $1,573,000, or 3.6%, over the same time period.
Average residential real estate loans and home equity loans increased $8,239,000, or 9.3%, when comparing the first nine months of 2015 to the same period in 2014. The Bank had several successful loan promotions over the past year and has received a strong response to the product offerings.
Total investment securities, including trading securities, available-for-sale securities and held-to-maturity securities were $366,340,000 at September 30, 2015 and $379,572,000 at December 31, 2014. Despite the overall decline in investment security balances since year end, the composition of the portfolio is little changed since December 31, 2014. 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.
QNB owns 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. In most cases QNB owns the mezzanine tranches of these securities, with the exception of one that now represents the senior-most obligation of the trust. 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 six of these securities with an amortized cost of $3,409,000 and a fair value of $2,600,000 at September 30, 2015. The company received principal and interest payments totaling $110,000 on three of these securities during the third quarter, which was recorded as a reduction to the amortized cost. There was no credit-related other-than-temporary impairment charge in the nine months ended September 30, 2015 or 2014. 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.
Total deposits increased $57,082,000, or 6.7%, to $908,674,000 at September 30, 2015 compared to the December 31, 2014 balances. Interest bearing demand balances increased $37,586,000 to $289,572,000 at September 30, 2015. This increase is primarily attributable to municipal deposits which increased $32,946,000. Municipal deposits can be volatile depending on the timing of deposits and withdrawals, and the cash flow needs of the school districts or municipalities. Non-interest bearing demand deposits increased $11,172,000, or 12.9%, when comparing September 30, 2015 to year-end 2014. The majority of this increase is from business deposits. Money market and savings balances increased $13,484,000 and $8,993,000, respectively, to $71,683,000 and $220,233,000, respectively. Time deposits decreased $14,153,000, declining from $243,247,000 at December 31, 2014 to $229,094,000 at September 30, 2015, as customers continue to look for liquidity in anticipation of rising interest rates. It is anticipated that total deposits will decline during the fourth quarter as tax money is received by the local school districts are expected to flow out over the next year as the schools use the funds for operations. These deposits provide incremental income as they are invested in short-term investment securities but will further reduce the net interest margin as the spread earned is significantly less than the current net interest margin.
Short-term borrowings decreased $2,601,000 from $35,189,000 at December 31, 2014 to $32,588,000 at September 30, 2015. 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 September 30, 2015, the Bank had a maximum borrowing capacity with the FHLB of approximately $250,554,000. The maximum borrowing capacity changes as a function of qualifying collateral assets. QNB has no outstanding borrowings with the FHLB at September 30, 2015. In addition, the Bank maintains unsecured Federal funds lines with three correspondent banks totaling $46,000,000. At September 30, 2015, there were no outstanding borrowings under these lines. During the first five months of 2015, QNB borrowed from the FHLB to fund short-term liquidity needs to fund loan growth. Future availability under these lines is subject to the policies of the granting banks and may be withdrawn.
Liquid sources of funds have increased $38,166,000, or 9.6%, since December 31, 2014. Total cash and cash equivalents, trading and available-for-sale investment securities and loans held-for-sale totaled $436,217,000 and $398,051,000 at September 30, 2015 and December 31, 2014, respectively, primarily due to the seasonal inflow of public funds deposits and other deposit growth, net of principal and interest payments of mortgage-backed securities available for sale. These liquid sources should be adequate to meet normal fluctuations in loan demand or deposit withdrawals. It is anticipated that the investment portfolio will continue to provide sufficient liquidity, even in a rising rate environment, as municipal bonds and agency securities are called and as cash flow on mortgage-backed and CMO securities continues to be steady. In the event interest rates rise, the cash flow available from the investment portfolio could decrease.
Approximately $238,281,000 and $206,774,000 of available-for-sale securities at September 30, 2015 and December 31, 2014, respectively, were pledged as collateral for repurchase agreements and deposits of public funds. The increase in the amount of pledged securities corresponds with the increase in municipal deposits from December 31, 2014 to September 30, 2015.
As an additional source of liquidity, QNB is a member of the Certificate of Deposit Account Registry Services (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. QNB also has available Insured Cash Sweep (ICS), another program through Promontory Interfinancial Network, LLC, which is 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 September 30, 2015 was $90,996,000, or 8.76% of total assets, compared to shareholders' equity of $86,354,000, or 8.84% of total assets, at December 31, 2014. Shareholders’ equity at September 30, 2015 and December 31, 2014 included a positive adjustment of $1,260,000 and $907,000, 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 8.64% and 8.75% at September 30, 2015 and December 31, 2014, respectively.
Average shareholders' equity and average total assets were $87,941,000 and $975,955,000 for the first nine months of 2015, an increase of 6.4% and 3.0%, respectively, from the averages for the year ended December 31, 2014. The ratio of average total equity to average total assets was 9.01% for the nine months of 2015 compared to 8.72% for all of 2014.
Retained earnings at September 30, 2015 were impacted by nine months of net income of $6,290,000 partially offset by cash dividends declared and paid of $2,901,000 for the same period. QNB offers 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 $667,000 and $552,000 to capital during the first nine months of 2015 and 2014, respectively.
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 September 30, 2015, 57,883 shares were repurchased under this authorization at an average price of $16.97 and a total cost of $982,000. There have been no additional shares repurchased under the plan since the first quarter of 2009.
QNB is subject to various regulatory capital requirements as issued by Federal regulatory authorities. The final rules implementing the Basel Committee on Banking Supervision’s capital guidelines for U.S. banks (“Basel III”) became effective for QNB on January 1, 2015, with full compliance with all the of final rule’s requirements phased in over a multi-year schedule, to be fully phased-in by January 1, 2019.
Under the final rules, minimum requirements will increase for both the quantity and quality of capital held by banks. The rules include a new common equity Tier 1 capital to risk-weighted assets minimum ratio of 4.5%, raise the minimum ratio of Tier 1 capital to risk-weighted assets from 4.0% to 6.0%, require a minimum ratio of Total Capital to risk-weighted assets of 8.0%, and require a minimum Tier 1 leverage ratio of 4.0%. A new capital conservation buffer, comprised of common equity Tier 1 capital, is also established above the regulatory minimum capital requirements. This capital conservation buffer will be phased in beginning January 1, 2016, at 0.625% of risk-weighted assets and increase each subsequent year by an additional 0.625% until reaching its final level of 2.5% on January 1, 2019. Strict eligibility criteria for regulatory capital instruments were also implemented. The final rules also revise the definition and calculation of Tier 1 capital, Total Capital, and risk-weighted assets. QNB continues to analyze these new rules and their effects on the business, operations and capital levels of the Company and the Bank.
As of September 30, 2015, the capital levels for QNB and the Bank remained characterized as “well-capitalized” under the new rules.
The following table sets forth consolidated information for QNB Corp.
Capital Analysis
Regulatory Capital
Net unrealized securities gains, net of tax
Disallowed intangible assets
Common equity tier I capital
N/A
Tier I capital
Allowable portion: Allowance for loan losses and reserve for unfunded commitments
Unrealized gains on equity securities, net of tax
Total regulatory capital
Risk-weighted assets
Quarterly average assets for leverage capital purposes
Capital Ratios
Common equity tier I capital / risk-weighted assets
Tier I capital / risk-weighted assets
Total regulatory capital / risk-weighted assets
Tier I capital / average assets (leverage ratio)
Under the requirements, at September 30, 2015 and December 31, 2014, QNB has a tier 1 capital ratio of 11.97% and 12.79%, a total regulatory capital ratio of 13.01% and 14.06%, and a leverage ratio of 8.99% and 8.65%, respectively. The leverage ratio improved from December 31, 2014 due to the proportion increase of tier I capital compared to the increase in quarterly average assets when compared to the fourth quarter of 2014. The decline in the tier 1 and total regulatory capital to risk-weighted asset ratios is a result of the adoption of the asset risk-weighting requirements of Basel III. Despite the implementation of this new standard and the decline in these ratios from December 31, 2014, the Company remains well-capitalized by all applicable regulatory requirements as of September 30, 2015.
MARKET RISK MANAGEMENT
Market risk reflects the risk of economic loss resulting from changes in interest rates and market prices. QNB’s primary market risk exposure is interest rate risk and liquidity risk. QNB’s liquidity position was discussed in a prior section.
QNB’s largest source of revenue is net interest income, which is subject to changes in market interest rates. Interest rate risk management seeks to minimize the effect of interest rate changes on net interest margins and interest rate spreads and to provide growth in net interest income through periods of changing interest rates. QNB’s Asset/Liability and Investment Management Committee (ALCO) is responsible for managing interest rate risk and for evaluating the impact of changing interest rate conditions on net interest income.
QNB uses computer simulation analysis to measure the sensitivity of projected earnings to changes in interest rates. Simulation takes into account current balance sheet volumes and the scheduled repricing dates, instrument level optionality, and maturities of assets and liabilities. It incorporates assumptions for growth, changes in the mix of assets and liabilities, prepayments, and average rates earned and paid. Based on this information, management uses the model to project net interest income under multiple interest rate scenarios.
A balance sheet is considered liability sensitive when its liabilities (deposits and borrowings) reprice faster or to a greater extent than its earning assets (loans and securities). A liability sensitive balance sheet will produce relatively less net interest income when interest rates rise and more net interest income when they decline. Based on our simulation analysis, management believes QNB’s interest sensitivity position at September 30, 2015 is liability sensitive. Management expects that market interest rates may gradually increase in the next 12 months, based on the economic environment and policy of the Board of Governors of the Federal Reserve System.
The following table shows the estimated impact of changes in interest rates on net interest income as of September 30, 2015 assuming instantaneous rate shocks, and consistent levels of assets and liabilities. Net interest income for the subsequent twelve months is projected to decrease when interest rates are higher than current rates.
Estimated Change in Net Interest Income
Changes in Interest rates
(in basis points)
+300
+200
+100
* Certain short-term interest are below 1%
Computations of future effects of hypothetical interest rate changes are based on numerous assumptions and should not be relied upon as indicative of actual results. Assets and liabilities may react differently than projected to changes in market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while rates on other types of assets and liabilities may lag changes in market interest rates. Interest rate shifts may not be parallel.
Changes in interest rates can cause substantial changes in the amount of prepayments of loans and mortgage-backed securities, which may in turn affect QNB’s interest rate sensitivity position. Additionally, credit risk may rise if an interest rate increase adversely affects the ability of borrowers to service their debt.
QNB is not subject to foreign currency exchange or commodity price risk. At September 30, 2015 QNB did not have any hedging transactions in place such as interest rate swaps, caps or floors.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.
The information required in response to this item is set forth in Item 2, above.
ITEM 4. CONTROLS AND PROCEDURES
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
SEPTEMBER 30, 2015
Item 1.
Legal Proceedings
No material proceedings.
Item 1A.
Risk Factors
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, 2014.
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
Period
Total Number of
Purchased
Average Price
Paid per Share
Purchased as
Part of Publicly
Announced
Plan
Maximum
Shares that
may yet be
Under the Plan
July 1, 2015 through July 31, 2015
-
42,117
August 1, 2015 through August 31, 2015
September 1, 2015 through September 30, 2015
Transactions are reported as of settlement dates.
QNB’s current stock repurchase plan was approved by its Board of Directors and announced on January 24, 2008 and subsequently increased on February 9, 2009.
The total number of shares approved for repurchase under QNB’s current stock repurchase plan is 100,000.
QNB’s current stock repurchase plan has no expiration date.
QNB has no stock repurchase plan that it has determined to terminate or under which it does not intend to make further purchases.
Item 3.
Default Upon Senior Securities
None.
Item 4.
Mine Safety Disclosures
Item 5.
Other Information
Item 6.
Exhibits
Exhibit 3.1
Articles of Incorporation of Registrant, as amended. (Incorporated by reference to Exhibit 3(i) of Registrant’s Annual Report on Form 10-K, SEC File No. 0-17706, filed with the Commission on March 13, 2015).
Exhibit 3.2
Bylaws of Registrant, as amended. (Incorporated by reference to Exhibit 3(ii) of Registrant’s Annual Report on Form 10-K, SEC File No. 0-17706, filed with the Commission on March 13, 2015).
Exhibit 11
Statement Re: Computation of Earnings Per Share. (Included in Part I, Item I, hereof.)
Exhibit 31.2
Section 302 Certification of Chief Financial Officer
Exhibit 32.1
Section 906 Certification of Chief Executive Officer
Exhibit 32.2
Section 906 Certification of Chief Financial Officer
The following Exhibits are being furnished* as part of this report:
No.
Description
101.INS
XBRL Instance Document.*
101.SCH
XBRL Taxonomy Extension Schema Document.*
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document.*
101.LAB
XBRL Taxonomy Extension Label Linkbase Document.*
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document.*
101.DEF
XBRL Taxonomy Extension Definitions Linkbase Document.*
*
These interactive data files are being furnished as part of this Quarterly Report, and, in accordance with Rule 402 of Regulation S-T, shall not be deemed filed for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to liability under those sections.
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.
Date: November 6, 2015
By:
/s/ David W. Freeman
David W. Freeman
Chief Executive Officer
Chief Financial Officer