United States
Securities and Exchange Commission
Washington, D.C. 20549
FORM 10-Q
(Mark One)
ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2013
¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File No.: 000-51821
LAKE SHORE BANCORP, INC.
(Exact name of registrant as specified in its charter)
20-4729288
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification Number)
31 East Fourth Street, Dunkirk, New York
14048
(Address of principal executive offices)
(Zip code)
(716) 366-4070
(Registrant’s telephone number, including area code)
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, and (2) has been subject to such filing requirements for the past 90 days.
Yes [X]No [ ]
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
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 ¨ (Do not check if a smaller reporting company)
Smaller reporting company x
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes [ ] No [X]
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical date:
There were 5,914,638 shares of the registrant’s common stock, $.01 par value per share, outstanding at November 1, 2013.
TABLE OF CONTENTS
ITEM
PART I
PAGE
1
FINANCIAL STATEMENTS
-
Consolidated Statements of Financial Condition as of September 30, 2013 and December 31, 2012 (Unaudited)
Consolidated Statements of Income for the Three and Nine Months ended September 30, 2013 and 2012 (Unaudited)
2
Consolidated Statements of Comprehensive Income for the Three and Nine Months ended September 30, 2013 and 2012 (Unaudited)
3
Consolidated Statements of Changes in Stockholders’ Equity for the Nine Months ended September 30, 2013 and 2012 (Unaudited)
4
Consolidated Statements of Cash Flows for the Nine Months ended September 30, 2013 and 2012 (Unaudited)
5
Notes to Unaudited Consolidated Financial Statements
6
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
28
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
46
CONTROLS AND PROCEDURES
PART II
1A
RISK FACTORS
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
EXHIBITS
47
SIGNATURES
48
Item 1. Financial Statements
Lake Shore Bancorp, Inc. and Subsidiary
Consolidated Statements of Financial Condition
September 30,
December 31,
2013
2012
(Unaudited)
(Dollars in thousands, except share data)
Assets
Cash and due from banks
$
Interest earning deposits
Federal funds sold
Cash and Cash Equivalents
Securities available for sale
Federal Home Loan Bank stock, at cost
Loans receivable, net of allowance for loan losses 2013 $1,819; 2012 $1,806
Premises and equipment, net
Accrued interest receivable
Bank owned life insurance
Other assets
Total Assets
Liabilities and Stockholders' Equity
Liabilities
Deposits:
Interest bearing
Non-interest bearing
Total Deposits
Short-term borrowings
Long-term debt
Advances from borrowers for taxes and insurance
Other liabilities
Total Liabilities
Commitments and Contingencies
Stockholders' Equity
Common stock, $0.01 par value per share, 25,000,000 shares authorized; 6,613,006 shares issued and 5,914,638 shares outstanding at September 30, 2013 and 6,612,500 shares issued and 5,919,132 shares outstanding at December 31, 2012
Additional paid-in capital
Treasury stock, at cost (698,368 shares at September 30, 2013 and 693,368 shares at December 31, 2012)
Unearned shares held by ESOP
Unearned shares held by RRP
Retained earnings
Accumulated other comprehensive income
Total Stockholders' Equity
Total Liabilities and Stockholders' Equity
See notes to consolidated financial statements.
Consolidated Statements of Income
Three Months Ended
Nine Months Ended
(Dollars in thousands, except per share data)
Interest Income
Loans, including fees
Investment securities, taxable
Investment securities, tax-exempt
Other
Total Interest Income
Interest Expense
Deposits
Total Interest Expense
Net Interest Income
Provision for Loan Losses
Net Interest Income after Provision for Loan Losses
Non-Interest Income
Service charges and fees
Earnings on bank owned life insurance
Gain on sale of securities available for sale
Total other-than-temporary impairment (“OTTI”) losses
Portion of OTTI losses recognized in other comprehensive income (before taxes)
Net OTTI losses recognized in earnings
Total Non-Interest Income
Non-Interest Expenses
Salaries and employee benefits
Occupancy and equipment
Professional services
Data processing
Advertising
Postage and supplies
FDIC Insurance
Total Non-Interest Expenses
Income before Income Taxes
Income Tax Expense
Net Income
Basic and diluted earnings per common share
Dividends declared per share
Consolidated Statements of Comprehensive Income
(Dollars in thousands)
Other Comprehensive (Loss) Income, net of tax benefit (expense)
Unrealized holding (losses) gains on securities available for sale, net of tax benefit (expense) 2013 $141; 2012 $(539)
Reclassification adjustments related to:
Gains on sales of securities included in net income, net of tax expense 2013 $80
Impairment charge for losses included in net income, net of tax benefit 2013 $70
Total Other Comprehensive (Loss) Income
Total Comprehensive Income
Unrealized holding (losses) gains on securities available for sale, net of tax benefit (expense) 2013 $2,461; 2012 $(579)
Impairment charge for losses included in net income, net of tax benefit 2013 $70; 2012 $22
Total Comprehensive (Loss) Income
Consolidated Statements of Changes in Stockholders’ Equity
Nine Months Ended September 30, 2013 and 2012 (unaudited)
Unearned
Accumulated
Additional
Shares
Common
Paid-In
Treasury
Held by
Retained
Comprehensive
Stock
Capital
ESOP
RRP
Earnings
Income (Loss)
Total
(In thousands, except share and per share data)
Balance - January 1, 2012
Net income
Other comprehensive income, net of tax expense of $601
ESOP shares earned (5,951 shares)
Stock based compensation
RRP shares earned (2,978 shares)
Cash dividends declared ($0.21 per share)
Balance - September 30, 2012
Balance - January 1, 2013
Other comprehensive loss, net of tax benefit of $2,471
Stock options exercised (506 shares)
RRP shares earned (3,017 shares)
Purchase of treasury stock, at cost (5,000 shares)
Balance - September 30, 2013
Consolidated Statements of Cash Flows
CASH FLOWS FROM OPERATING ACTIVITIES
Adjustments to reconcile net income to net cash provided by operating activities:
Net amortization of investment securities
Amortization of deferred loan costs
Provision for loan losses
Impairment of investment securities
Gain on sale of investment securities
Originations of loans held for sale
Proceeds from sales of loans held for sale
Depreciation and amortization
Increase in bank owned life insurance, net
ESOP shares committed to be released
Stock based compensation expense
Increase in accrued interest receivable
Decrease in other assets
Increase (decrease) in other liabilities
Net Cash Provided by Operating Activities
CASH FLOWS FROM INVESTING ACTIVITIES
Activity in available for sale securities:
Sales
Maturities, prepayments and calls
Purchases
Purchases of Federal Home Loan Bank Stock
Redemptions of Federal Home Loan Bank Stock
Loan origination and principal collections, net
Additions to premises and equipment
Net Cash (Used in) Provided by Investing Activities
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposits
Net decrease in advances from borrowers for taxes and insurance
Net increase in short term borrowings
Proceeds from issuance of long-term debt
Repayment of long-term debt
Proceeds from stock options exercised
Purchase of Treasury Stock
Cash dividends paid
Net Cash Provided by Financing Activities
Net (Decrease) Increase in Cash and Cash Equivalents
CASH AND CASH EQUIVALENTS - BEGINNING
CASH AND CASH EQUIVALENTS - ENDING
SUPPLEMENTARY CASH FLOWS INFORMATION
Interest paid
Income taxes paid
SUPPLEMENTARY SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES
Foreclosed real estate acquired in settlement of loans
Securities sold and not settled
Notes to Consolidated Financial Statements (Unaudited)
Note 1 – Nature of Operations and Basis of Presentation
Lake Shore Bancorp, Inc. (the “Company”, “us,” “our”, or “we”) was formed on April 3, 2006 to serve as the stock holding company for Lake Shore Savings Bank (“the Bank”) as part of the Bank’s conversion and reorganization from a New York-chartered mutual savings and loan association to the federal mutual holding company form of organization.
The interim consolidated financial statements include the accounts of the Company and the Bank, its wholly owned subsidiary. All intercompany accounts and transactions of the consolidated subsidiary have been eliminated in consolidation.
The interim financial statements included herein as of September 30, 2013 and for the three and nine months ended September 30, 2013 and 2012 have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission, and therefore, do not include all information or footnotes necessary for a complete presentation of the consolidated statements of financial condition, results of operations and cash flows in conformity with accounting principles generally accepted in the United States of America (“GAAP”). The consolidated statement of financial condition at December 31, 2012 has been derived from the audited consolidated financial statements at that date, but does not include all of the information and footnotes required by GAAP for complete consolidated financial statements. The consolidated financial statements reflect all adjustments that are, in the opinion of management, necessary for a fair statement of such information and to make the financial statements not misleading. These interim consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the audited consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012. The consolidated results of operations for the three and nine months ended September 30, 2013 are not necessarily indicative of the results for any subsequent period or the entire year ending December 31, 2013.
To prepare these consolidated financial statements in conformity with GAAP, management of the Company made a number of estimates and assumptions relating to the reporting of assets and liabilities and the reporting of revenue and expenses. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, securities valuation estimates, evaluation of impairment of securities and income taxes.
The Company has evaluated events and transactions occurring subsequent to the statement of financial condition as of September 30, 2013 for items that should potentially be recognized or disclosed in these consolidated financial statements. The evaluation was conducted through the date these consolidated financial statements were issued.
Note 2 – New Accounting Standards
There were no new accounting standards affecting the Company during the period that were not previously disclosed.
Note 3 – Investment Securities
The amortized cost and fair value of securities are as follows:
September 30, 2013
Gross
Amortized
Unrealized
Fair
Cost
Gains
Losses
Value
( Dollars in thousands)
SECURITIES AVAILABLE FOR SALE:
U.S. Treasury bonds
Municipal bonds
Mortgage-backed securities:
Collateralized mortgage obligations-private label
Collateralized mortgage obligations-government sponsored entities
Government National Mortgage Association
Federal National Mortgage Association
Federal Home Loan Mortgage Corporation
Asset-backed securities-private label
Asset-backed securities-government sponsored entities
Equity securities
December 31, 2012
7
All of our mortgage-backed securities and collateralized mortgage obligations are backed by residential mortgages.
At September 30, 2013 and at December 31, 2012, equity securities consisted of 22,368 shares of Federal Home Loan Mortgage Corporation (“FHLMC”) common stock.
At September 30, 2013, thirty-one municipal bonds with a cost of $10.6 million and fair value of $11.2 million were pledged under a collateral agreement with the Federal Reserve Bank of New York for liquidity borrowing. At December 31, 2012, thirty-two municipal bonds with a cost of $10.0 million and fair value of $11.1 million were pledged under a collateral agreement with the Federal Reserve Bank of New York for liquidity borrowing. In addition, at September 30, 2013 and December 31, 2012, five municipal bonds with a cost of $1.1 million and a fair value of $1.1 million and $1.2 million, respectively, were pledged as collateral for customer deposits in excess of the Federal Deposit Insurance Corporation (“FDIC”) insurance limits.
The following table sets forth the Company’s investment in securities available for sale with gross unrealized losses of less than twelve months and gross unrealized losses of twelve months or more and associated fair values as of the dates indicated:
Less than 12 months
12 months or more
Fair Value
(Dollars In thousands)
Mortgage-backed securities
Asset-backed securities -private label
The Company reviews investment securities on an ongoing basis for the presence of other-than-temporary impairment (“OTTI”) with formal reviews performed quarterly.
The Company determines whether the unrealized losses are other-than-temporary in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 320 “Investments - Debt and Equity Securities.” The evaluation is based upon factors such as the creditworthiness of the issuers/guarantors, the underlying collateral and the continuing performance of the securities.
Management also evaluates other facts and circumstances that may be indicative of an OTTI condition. This includes, but is not limited to, an evaluation of the type of security, length of time and extent to which fair value has been less than cost, and near-term prospects of the issuer. The Company uses the cash flow expected to be realized from the security, which includes assumptions about interest rates, timing and severity of defaults, estimates of potential recoveries, the cash flow distribution from the provisions in the applicable bond
8
indenture and other factors, then applies a discounting rate equal to the effective yield of the security. If the present value of the expected cash flows is less than the amortized book value it is considered a credit loss. The fair value of the security is determined using the same expected cash flows; the discount rate is a rate the Company determines from open market and other sources as appropriate for the security. The difference between the fair value and the credit loss is recognized in other comprehensive income, net of taxes.
At September 30, 2013, the Company’s investment portfolio included twenty-eight municipal bonds and twenty-four mortgage-backed securities in the unrealized losses less than twelve months category. The municipal bonds and mortgage-backed securities were not evaluated further for OTTI as the unrealized losses on the individual securities were less than 20% of book value, which management deemed to be immaterial, and the mortgage-backed securities were issued by government sponsored entities. The Company expects these securities to be repaid in full, with no losses realized. Management does not intend to sell these securities and it is more likely than not that it will not be required to sell these securities.
At September 30, 2013, the Company had nine mortgage-backed securities and three private label asset-backed securities in the “unrealized losses twelve months or more” category.
The mortgage-backed securities were not evaluated further for OTTI, as the unrealized losses were less than 20% of book value. The temporary impairment was due to declines in fair value resulting from changes in interest rates and/or increased credit liquidity spreads since the securities were purchased. The Company expects these securities to be repaid in full, with no losses realized. Management does not intend to sell these securities and it is more likely than not that it will not be required to sell these securities.
The private label asset-backed securities in this category were evaluated further for OTTI, as the unrealized loss was greater than 20% of book value for the individual security, the probability of default is high, or the Company’s analysis indicated a possible loss of principal. The following table provides additional information relating to these private label asset-backed securities as of September 30, 2013 (dollars in thousands):
Foreclosure/
Lowest
Delinquent %
OREO/
Security
Book Value
Loss
Rating
Over 60 days
Over 90 days
Bankruptcy %
OREO%
(432)
C
32.10%
30.40%
12.40%
1.00%
(217)
CCC
26.30%
24.80%
9.50%
0.80%
(112)
16.80%
16.10%
7.20%
0.90%
(761)
The three private label asset-backed securities listed above were evaluated for OTTI under the guidance of FASB ASC Topic 320. The Company believes the unrealized losses on these three private label asset-backed securities occurred due to the current challenging economic environment, high unemployment rates, stressed housing values in many areas of the country, and increased delinquency trends. It is possible that principal losses may be incurred on the tranches we hold in these specific securities. Management’s evaluation of the estimated discounted cash flows in comparison to the amortized book value for the securities listed above reflected the need to record an additional OTTI charge against earnings of $180,000 for one of the securities noted above during the nine months ended September 30, 2013, as the calculation of the estimated discounted cash flows showed an additional principal loss. Management’s evaluation of the estimated discounted cash flows in comparison to the amortized book value for the remaining securities listed above did not reflect the need to record OTTI charges against earnings during the nine months ended September 30, 2013. The estimated discounted cash flows for these remaining securities did not show an additional principal loss under various prepayment and default scenarios. Management concluded that it does not intend to sell these securities and that it is not likely it will be required to sell these securities.
Management also completed an OTTI analysis for two private label asset-backed securities, which did not have unrealized losses as of September 30, 2013. Management reviewed key credit metrics for these securities, including delinquency rates, cumulative default rates, prepayment speeds, foreclosure rates, loan-to-value ratios and credit support levels. Management’s calculation of the estimated discounted cash flows did not show
9
additional principal losses for these securities under various prepayment and default rate scenarios. As a result of the stress tests that were performed, management concluded that additional OTTI charges were not required as of September 30, 2013 on these securities. Management also concluded that it does not intend to sell the securities and that it is not likely it will be required to sell these securities.
The unrealized losses shown in the previous table, were recorded as a component of other comprehensive income, net of tax on the Company’s Consolidated Statements of Changes in Stockholders’ Equity.
The following table presents a summary of the credit-related OTTI charges recognized as components of earnings:
For the Nine Months
Ended
September 30, 2012
Beginning balance
Additions:
Credit loss not previously recognized
Reductions:
Losses realized during the period on OTTI previously recognized
Ending balance
Further deterioration in credit quality and/or a continuation of the current imbalances in liquidity that exist in the marketplace might adversely affect the fair values of the Company’s investment portfolio and may increase the potential that certain unrealized losses will be designated as “other-than-temporary” and that the Company may incur additional write-downs in future periods.
Scheduled contractual maturities of available for sale securities are as follows:
September 30, 2013:
After five years through ten years
After ten years
Asset-backed securities
The Company sold available for sale securities during the nine months ended September 30, 2013, for total proceeds of $3.0 million, resulting in gross realized gains of $206,000. During the nine months ended September 30, 2013, the Company received a $1.4 million settlement related to the sale of available for sale securities in the fourth quarter of 2012. During the nine months ended September 30, 2012, the Company did not sell any securities available for sale.
10
Note 4 - Allowance for Loan Losses
Management segregates the loan portfolio into loan types and analyzes the risk level for each loan type when determining its allowance for loan losses. The loan types are as follows:
Real Estate Loans:
·
One- to Four-Family – are loans secured by first lien collateral on residential real estate primarily held in the Western New York region. These loans can be affected by economic conditions and the value of underlying properties. Western New York has not been impacted as severely as other parts of the country by fluctuating real estate prices. Furthermore, the Company has conservative underwriting standards and does not have any sub-prime loans in its loan portfolio.
Home Equity - are loans or lines of credit secured by second lien collateral on owner-occupied residential real estate primarily held in the Western New York area. These loans can also be affected by economic conditions and the values of underlying properties. Home equity loans may have increased risk of loss if the Company does not hold the first mortgage, resulting in the Company being in a secondary position in the event of collateral liquidation.
Commercial Real Estate – are loans used to finance the purchase of real property, which generally consists of developed real estate that is held as first lien collateral for the loan. These loans are secured by real estate properties that are primarily held in the Western New York region. Commercial real estate lending involves additional risks compared with one- to four-family residential lending, because payments on loans secured by commercial real estate properties are often dependent on the successful operation or management of the properties, and/or the collateral value of the commercial real estate securing the loan, and repayment of such loans may be subject to adverse conditions in the real estate market or economic conditions to a greater extent than one- to four-family residential mortgage loans. Also, commercial real estate loans typically involve large loan balances to single borrowers or groups of related borrowers.
Construction – are loans to finance the construction of either one- to four-family owner occupied homes or commercial real estate. At the end of the construction period, the loan automatically converts to either a conventional or commercial mortgage, as applicable. Risk of loss on a construction loan depends largely upon the accuracy of the initial estimate of the value of the property at completion compared to the actual cost of construction.
Other Loans:
Commercial – includes business installment loans, lines of credit, and other commercial loans. Most of our commercial loans have variable interest rates tied to the prime rate, and are for terms generally not in excess of 10 years. Whenever possible, we collateralize these loans with a lien on business assets and equipment and require the personal guarantees from principals of the borrower. Commercial loans generally involve a higher degree of credit risk because the collateral underlying the loans may be in the form of intangible assets and/or inventory subject to market obsolescence. Commercial loans can also involve relatively large loan balances to a single borrower or groups of related borrowers, with the repayment of such loans typically dependent on the successful operation of the commercial businesses and the income stream of the borrower. Such risks can be significantly affected by economic conditions.
Consumer – consist of loans secured by collateral such as an automobile or a deposit account, unsecured loans and lines of credit. Consumer loans tend to have a higher credit risk due to the loans being either unsecured or secured by rapidly depreciable assets. Furthermore, consumer loan payments are dependent on the borrower’s continuing financial stability, and therefore are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy.
The allowance for loan losses is a valuation account that reflects the Company’s evaluation of the losses inherent in its loan portfolio. In order to determine the adequacy of the allowance for loan losses, the Company estimates losses by loan type using historical loss factors, as well as other environmental factors, such as trends in loan volume and loan type, loan concentrations, changes in the experience, ability and depth of the Company’s lending management, and national and local economic conditions. The Company's determination
11
as to the classification of loans and the amount of loss allowances are subject to review by regulatory agencies, which can require the establishment of additional loss allowances.
The Company also reviews all loans on which the collectability of principal may not be reasonably assured, by reviewing payment status, financial conditions and estimated value of loan collateral. These loans are assigned an internal loan grade, and the Company assigns the amount of loss components to these classified loans based on loan grade.
The following tables summarize the activity in the allowance for loan losses for the three and nine months ended September 30, 2013 and 2012 and the distribution of the allowance for loan losses and loan receivable by loan portfolio class and impairment method as of September 30, 2013.
Real Estate Loans
Other Loans
One- to Four-Family
Home Equity
Commercial
Construction
Consumer
Unallocated
Allowance for Loan Losses:
Balance – July 1, 2012
Charge-offs
Recoveries
Provision (Credit)
Balance – September 30, 2012
Balance – January 1, 2012
12
Balance – July 1, 2013
Balance – September 30, 2013
Balance – January 1, 2013
Ending balance: individually evaluated for impairment
Ending balance: collectively evaluated for impairment
Gross Loans Receivable (1):
(1)
Gross Loans Receivable does not include allowance for loan losses of $(1,819) or deferred loan costs of $2,778.
13
The following table summarizes the distribution of the allowance for loan losses and loans receivable by loan portfolio class as of December 31, 2012:
Balance – December 31, 2012
Ending Balance
Gross Loans Receivable does not include allowance for loan losses of $(1,806) or deferred loan costs of $2,681.
Although the allocations noted above are by loan type, the allowance for loan losses is general in nature and is available to offset losses from any loan in the Company’s portfolio.
A loan is considered impaired when, based on current information and events, it is probable that the Company will not be able to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Factors considered in determining impairment include payment status, collateral value and the probability of collecting scheduled payments when due. Impairment is measured on a loan-by-loan basis for commercial real estate loans and commercial loans. Larger groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer, home equity, or one- to four-family loans for impairment disclosure, unless they are subject to a troubled debt restructuring.
The following is a summary of information pertaining to impaired loans at or for the periods indicated:
14
Unpaid
Average
Interest
Recorded
Principal
Related
Income
Investment
Balance
Allowance
Recognized
For the Nine Months Ended
At September 30, 2013
With no related allowance recorded:
Residential, one- to four-family
Home equity
Commercial real estate
Commercial loans
With an allowance recorded:
For the Year Ended
At December 31, 2012
The following table provides an analysis of past due loans and non-accruing loans as of the dates indicated:
90 Days or
30-59 Days
60-89 Days
More
Total Past
Current
Total Loans
Loans on
Past Due
Due
Receivable
Non-Accrual
December 31, 2012:
15
The accrual of interest on loans is discontinued when, in management’s opinion, the borrower may be unable to meet payments as they become due. A loan does not have to be 90 days delinquent in order to be classified as nonaccrual. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received. If ultimate collection of principal is in doubt, all cash receipts on impaired loans are applied to reduce the principal balance. Interest income not recognized on non-accrual loans during the nine month periods ended September 30, 2013 and September 30, 2012 was $91,000 and $104,000 respectively.
The Company’s policies provide for the classification of loans as follows:
Pass/Performing;
Special Mention – does not currently expose the Company to a sufficient degree of risk but does possess credit deficiencies or potential weaknesses deserving the Company’s close attention;
Substandard – has one or more well-defined weaknesses and are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected. A substandard asset would be one inadequately protected by the current net worth and paying capacity of the obligor or pledged collateral, if applicable;
Doubtful – has all the weaknesses inherent in substandard loans with the additional characteristic that the weaknesses present make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss; and
Loss – loan is considered uncollectible and continuance without the establishment of a specific valuation reserve is not warranted.
The Company’s Asset Classification Committee is responsible for monitoring risk ratings and making changes as deemed appropriate. Each commercial loan is individually assigned a loan classification. The Company’s consumer loans, including residential one- to four-family loans and home equity loans, are not classified as described above. Instead, the Company uses the delinquency status as the basis for classifying these loans. Unless the loan is well secured and in the process of collection, all consumer loans that are more than 90 days past due are classified.
The following table summarizes the internal loan grades applied to the Company’s loan portfolio as of September 30, 2013 and December 31, 2012:
Pass/Performing
Special Mention
Substandard
Doubtful
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Troubled debt restructurings (“TDRs”) occur when we grant borrowers concessions that we would not otherwise grant but for economic or legal reasons pertaining to the borrower’s financial difficulties. A concession is made when the terms of the loan modification are more favorable than the terms the borrower would have received in the current market under similar financial difficulties. These concessions may include, but are not limited to, modifications of the terms of the debt, the transfer of assets or the issuance of an equity interest by the borrower to satisfy all or part of the debt, or the addition of borrower(s). The Company identifies loans for potential TDRs primarily through direct communication with the borrower and evaluation of the borrower’s financial statements, revenue projections, tax returns, and credit reports. Even if the borrower is not presently in default, management will consider the likelihood that cash flow shortages, adverse economic conditions, and negative trends may result in a payment default in the near future. Generally, we will not return a TDR to accrual status until the borrower has demonstrated the ability to make principal and interest payments under the restructured terms for at least six consecutive months. The Company’s TDRs are impaired loans, which may result in specific allocations and subsequent charge-offs if appropriate.
The following table summarizes the loans that were classified as TDRs as of the dates indicated:
Non-Accruing
Accruing
TDRs That Have Defaulted on Modified Terms Year to Date
Number of Loans
Recorded Investment
The following table details the activity in loans which were first deemed to be TDRs during the nine months ended September 30, 2013. No loans were first deemed TDRs during the three months ended September 30, 2013 and 2012. No loans were first deemed TDRs during the nine months ended September 30, 2012.
For the nine months ended September 30, 2013
Pre-Modification Outstanding Recorded Investment
Post-Modification Outstanding Recorded Investment
Some loan modifications classified as TDRs may not ultimately result in full collection of principal and interest, as modified, which may result in potential losses. These potential losses have been factored into our overall estimate of the allowance for loan losses. The impact on the allowance was immaterial.
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Note 5 – Earnings per Share
Earnings per share was calculated for the three and nine months ended September 30, 2013 and 2012, respectively. Basic earnings per share is based upon the weighted average number of common shares outstanding, exclusive of unearned shares held by the Employee Stock Ownership Plan of Lake Shore Bancorp, Inc. (the “ESOP”) and unearned shares held by the Recognition and Retention Plan (“RRP”). Diluted earnings per share is based upon the weighted average number of common shares outstanding and common share equivalents that would arise from the exercise of dilutive securities. Stock options are regarded as potential common stock and are considered in the diluted earnings per share calculations to the extent they would be dilutive and computed using the treasury stock method.
The calculated basic and diluted earnings per share are as follows:
Numerator – net income
Denominator:
Basic weighted average shares outstanding
Increase in weighted average shares outstanding due to(1):
Stock options
Diluted weighted average shares outstanding (1)
Earnings per share:
Basic
Diluted
Increase in weighted average shares outstanding due to (1):
(1) Stock options to purchase 206,643 shares under the Stock Option Plan at $11.50 per share were outstanding during the three and nine month periods ended September 30, 2012, but were not included in the calculation of diluted earnings per share because to do so would have been anti-dilutive.
Note 6 – Commitments to Extend Credit
The Company has commitments to extend credit with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of financial condition.
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The Company’s exposure to credit loss is represented by the contractual amount of these commitments. The Company follows the same credit policies in making commitments as it does for on-balance sheet instruments.
The following commitments to extend credit were outstanding as of the dates specified:
Contract Amount
Commitments to grant loans
Unfunded commitments under lines of credit
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. The commitments for lines of credit may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Company, is based on management’s credit evaluation of the customer. At September 30, 2013 and December 31, 2012, the Company’s fixed rate loan commitments totaled $9.6 million and $8.9 million, respectively. The range of interest rates on these fixed rate commitments was 3.25% to 10.00% at September 30, 2013.
Note 7 – Stock-based Compensation
As of September 30, 2013, the Company had three stock-based compensation plans currently allocated, which are described below. The compensation cost that has been recorded under salary and benefits expense in the non-interest expense section of the consolidated statements of income for these plans was $33,000 and $31,000 for the three months ended September 30, 2013 and 2012, respectively. The compensation cost that has been recorded for the nine months ended September 30, 2013 and 2012, respectively, was $98,000 and $90,000.
Stock Option Plan
The Company’s 2006 Stock Option Plan (the “Stock Option Plan”), which was approved by the Company’s stockholders, permits the grant of options to its employees and non-employee directors for up to 297,562 shares of common stock.
Both incentive stock options and non-qualified stock options may be granted under the Stock Option Plan. The exercise price of each stock option equals the market price of the Company’s common stock on the date of grant and an option’s maximum term is ten years. The stock options generally vest over a five year period.
A summary of the status of the Stock Option Plan as of September 30, 2013 and 2012 is presented below:
Options
Exercise Price
Remaining Contractual Life
Outstanding at beginning of year
Granted
Exercised
Forfeited
Outstanding at end of quarter
3 years
4 years
Options exercisable at end of quarter
Fair value of options granted
:
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At September 30, 2013, stock options outstanding had an intrinsic value of $103,000 and 60,753 options remained available for grant under the Stock Option Plan. Compensation expense amounted to $3,000 and $1,000 for the three months ended September 30, 2013 and 2012, respectively. Compensation expense amounted to $7,000 for the nine months ended September 30, 2013 and $6,000 for the nine months ended September 30, 2012. At September 30, 2013, $7,000 of unrecognized compensation cost related to stock options is expected to be recognized over a period of 3 to 15 months.
Recognition and Retention Plan
The Company’s 2006 Recognition and Retention Plan (“RRP”), which was approved by the Company’s stockholders, permits the grant of restricted stock awards (“Awards”) to employees and non-employee directors for up to 119,025 shares of common stock.
Awards vest at a rate of 20% per year. As of September 30, 2013 there were 77,711 shares vested or distributed to eligible participants under the RRP. Compensation expense related to the RRP amounted to $7,000 for the three months ended September 30, 2013 and $9,000 for the three months ended September 30, 2012. Compensation expense related to the RRP amounted to $24,000 for the nine months ended September 30, 2013 and 2012. At September 30, 2013, $31,000 of unrecognized compensation cost related to the RRP is expected to be recognized over a period of 3 to 45 months.
Weighted Average Grant Price
Unvested shares outstanding at beginning of year
Vested
Unvested shares outstanding at end of quarter
2012 Equity Incentive Compensation
The Company’s 2012 Equity Incentive Compensation Plan (the “Equity Incentive Plan”), which was approved by the Company’s stockholders on May 23, 2012, permits the grant of restricted stock awards, incentive stock options or non-qualified stock options to employees and non-employee directors for up to 200,000 shares of common stock upon completion of performance goals. As required by federal regulations, awards may not be made under the Equity Incentive Plan until the Federal Reserve Board gives its approval. A request for Federal Reserve Board approval was made in February 2012; however, the Federal Reserve Board has not yet approved or rejected the request. Consequently, awards may not be made under the Equity Incentive Plan until the Federal Reserve Board makes a final determination.
Employee Stock Ownership Plan (“ESOP”)
The Company established the ESOP for the benefit of eligible employees of the Company and the Bank. All Company and Bank employees meeting certain age and service requirements are eligible to participate in the ESOP. Participants’ benefits become fully vested after five years of service once the employee is eligible to participate in the ESOP. The Company utilized $2.6 million of the proceeds of its 2006 stock offering to extend a loan to the ESOP and the ESOP used such proceeds to purchase 238,050 shares of stock on the open market at an average price of $10.70 per share, plus commission expenses. As a result of the purchase of shares by the ESOP, total stockholders’ equity of the Company was reduced by $2.6 million. As of September 30, 2013, the balance of the loan to the ESOP was $2.0 million and the fair value of unallocated shares was $2.1 million. As of September 30, 2013, there were 46,731 allocated shares and 182,504 unallocated shares
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compared to 41,946 allocated shares and 190,439 unallocated shares at September 30, 2012. The ESOP compensation expense was $23,000 for the quarter ended September 30, 2013, and $21,000 for the quarter ended September 30, 2012 based on 1,983 shares earned in each of those quarters. The ESOP compensation expense was $67,000 for the nine months ended September 30, 2013 and $60,000 for the nine months ended September 30, 2012 based on 5,951 shares earned in each of those periods.
Note 8 - Fair Value of Financial Instruments
Management uses its best judgment in estimating the fair value of the Company’s financial instruments; however, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts the Company could have realized in a sale transaction on the dates indicated. The estimated fair value amounts have been measured as of September 30, 2013 and December 31, 2012 and have not been re-evaluated or updated for purposes of these consolidated financial statements subsequent to those respective dates. The estimated fair values of these financial instruments subsequent to the respective reporting dates may be different than the amounts reported here.
The measurement of fair value under FASB ASC Topic 820, “Fair Value Measurements and Disclosures” (“ASC Topic 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 measurements (Level 1) and the lowest priority to unobservable input measurements (Level 3). The three levels of the fair value hierarchy under ASC Topic 820 are as follows:
Level 1: Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity can access at the measurement date.
Level 2: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability either directly or indirectly.
Level 3: Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.
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.
For assets measured at fair value on a recurring and nonrecurring basis, the fair value measurements by level within the fair value hierarchy used at September 30, 2013 and December 31, 2012 were as follows:
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Fair Value Measurements at September 30, 2013
Quoted Prices in Active Markets for Identical Assets
Significant Other Observable Inputs
Significant Other Unobservable Inputs
(Level 1)
(Level 2)
(Level 3)
Measured at fair value on a recurring basis:
Securities available for sale:
Asset-backed securities:
Private label
Government sponsored entities
Measured at fair value on a non-recurring basis:
Impaired loans
Foreclosed real estate
Any transfers between levels would be recognized as of the actual date of event or change in circumstances that caused the transfer. There were no reclassifications between the Level 1 and Level 2 categories for the nine months ended September 30, 2013.
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Fair Value Measurements at December 31, 2012
Level 2 inputs for assets or liabilities measured at fair value on a recurring basis might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by correlation or other means.
The following table presents a reconciliation of the securities available for sale measured at fair value on a recurring basis using significant unobservable inputs (Level 3), specifically, asset-backed securities - private label, for the nine months ended September 30, 2013 and 2012:
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Beginning Balance
Total gains - realized/unrealized:
Included in earnings
Included in other comprehensive income
Total losses - realized/unrealized:
Purchases, issuances and settlements
Principal paydowns
Transfers to (out of) Level 3
Both observable and unobservable inputs may be used to determine the fair value of assets and liabilities measured on a recurring basis that the Company has classified within the Level 3 category. As a result, any unrealized gains and losses for assets within the Level 3 category may include changes in fair value attributable to both observable (e.g., changes in market interest rates) and unobservable (e.g., changes in unobservable long-dated volatilities) inputs.
The following table presents additional quantitative information about the Level 3 inputs for the asset-backed securities - private label category. The fair values for this category were developed using the discounted cash flow technique with the following unobservable input ranges as of September 30, 2013 (dollars in thousands):
Unobservable Inputs
Security Category
Fair Value Estimate
Loan Type/Collateral
Credit Ratings
Constant Prepayment Speed (CPR)
Probability of Default (Annual Default Rate)
Loss Severity
Asset-backed securities - private label
Prime First and Second Lien - Residential Real Estate
CCC thru D
4 - 8
5.0% - 8.0%
70.0% - 100.0%
Level 3 inputs are determined by internal management with inputs from its third party financial advisor on a quarterly basis. The significant unobservable inputs used in the fair value measurement of the reporting entity’s asset-backed, private label securities are prepayment rates, probability of default and loss severity in the event of default. Significant increases or decreases in any of those inputs in isolation would result in a significantly lower or higher fair value measurement. Generally, a change in the assumption used for the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity and a directionally opposite change in the assumption used for prepayment rates.
In addition to disclosure of the fair value of assets on a recurring basis, ASC Topic 820 requires disclosures for assets and liabilities measured at fair value on a non-recurring basis, such as impaired assets and foreclosed real estate. Loans are generally not recorded at fair value on a recurring basis. Periodically, the Company records non-recurring adjustments to the carrying value of loans based on fair value measurements for partial charge-offs of the uncollectible portions of these loans. Non-recurring adjustments also include certain impairment amounts for collateral-dependent loans calculated as required by ASC Topic 310, “Receivables – Loan Impairment,” when establishing the allowance for loan losses. An impaired loan is carried at fair value based on either recent appraisals less estimated selling costs of related collateral or discounted cash flows
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based on current market conditions. As of September 30, 2013, one impaired loan with a specific allowance had a carrying amount of $130,000 with a valuation allowance of $30,000. The allocated allowance is based on a fair value of $65,000 less estimated liquidation expenses of 10% of the collateral value and the anticipated receipt of Small Business Administration (“SBA”) guaranteed funds, resulting in no additional provision for loan losses during the nine month period ended September 30, 2013. As of September 30, 2013, one impaired loan with no specific allowance had a carrying amount of $49,000 and a fair value of $53,000. As of December 31, 2012, impaired loans with a specific allowance had a carrying amount of $201,000 with a valuation allowance of $50,000. The allocated allowance is based on a fair value of $125,000 less estimated liquidation expenses of 10% of the collateral value and the anticipated receipt of SBA guaranteed funds on one of the loans. The use of independent appraisals, discounted cash flow models and management’s best judgment are significant inputs in arriving at the fair value of the underlying collateral of impaired loans and are therefore classified within Level 3 of the fair value hierarchy.
Foreclosed real estate consists of property acquired in settlement of loans which is carried at its fair value based on recent appraisals less estimated selling costs and which has been subsequently written down during the period. Fair value is based upon independent market prices or appraised value of the property. These assets are included in Level 3 fair value based upon the lowest level of input that is significant to the fair value measurement. The use of independent appraisals and management’s best judgment are significant inputs in arriving at the fair value of the underlying collateral on foreclosed real estate and is therefore classified within Level 3 of the fair value hierarchy. As of September 30, 2013, foreclosed real estate had a carrying amount of $425,000 and was written down to $316,000 based on a fair value of $347,000 less estimated liquidation expenses of 7% to 15% of the collateral value, resulting in no additional write downs during the nine month period ended September 30, 2013. As of December 31, 2012 foreclosed real estate had a carrying amount of $457,000 and was written down to $351,000 based on a fair value of $378,000 less estimated liquidation expenses of 7% to 15% of the collateral value.
The carrying amount and estimated fair value of the Company’s financial instruments, whether carried at cost or fair value, are as follows:
Carrying
Estimated
Amount
Financial assets:
Cash and cash equivalents
Federal Home Loan Bank stock
Loans receivable, net
Financial liabilities:
Accrued interest payable
Off-balance-sheet financial instruments
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The following valuation techniques were used to measure the fair value of financial instruments in the above table:
Cash and cash equivalents (carried at cost)
The carrying amount of cash and cash equivalents approximates fair value.
Securities available for sale (carried at fair value)
The fair value of securities available for sale 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. The 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. Level 2 securities which are fixed income instruments that are not quoted on an exchange, but are traded in active markets, are valued using prices obtained from our custodian, who use third party data service providers. Securities available for sale measured within the Level 3 category consist of private label asset-backed securities. The fair value measurement for these Level 3 securities is explained more fully earlier in this footnote.
Federal Home Loan Bank stock (carried at cost)
The carrying amount of Federal Home Loan Bank stock approximates fair value.
Loans Receivable (carried at cost)
The fair value of fixed-rate and variable rate performing loans is estimated using a discounted cash flow method. The discount rates take into account interest rates currently being offered to customers for loans with similar terms, the credit risk associated with the loan, estimated maturity and market factors including liquidity. The estimate of maturity is based on the Company’s contractual cash flows adjusted for prepayment estimates based on current economic and lending conditions. Fair value for significant nonperforming loans is based on carrying value which does not exceed recent external appraisals of any underlying collateral. Due to the significant judgment involved in evaluating credit quality, loans are classified within Level 3 of the fair value hierarchy.
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Accrued Interest Receivable and Payable (carried at cost)
The carrying amount of accrued interest receivable and payable approximates fair value.
Deposits (carried at cost)
The fair value of deposits with no stated maturity, such as savings, money market and checking is the amount payable on demand at the reporting date and are classified within Level 2 of the fair value hierarchy. The fair value of time deposits is based on the discounted value of contractual cash flows at current rates of interest for similar deposits using market rates currently offered for deposits of similar remaining maturities. Due to the minimal amount of unobservable inputs involved in evaluating assumptions used for discounted cash flows of time deposits, these deposits are classified within Level 2 of the fair value hierarchy.
Borrowings (carried at cost)
The fair value of long-term debt was calculated by discounting scheduled cash flows at current market rates of interest for similar borrowings through maturity of each instrument. Due to the minimal amount of unobservable inputs involved in evaluating assumptions used for discounted cash flows of long-term debt, they are classified within Level 2 of the fair value hierarchy. The carrying amount of short term borrowings approximates fair value of such liability.
Off-Balance Sheet Financial Instruments (disclosed at cost)
Fair values of the Company’s off-balance sheet financial instruments (lending commitments) are based on fees currently charged to enter into similar agreements, taking into account, the remaining terms of the agreements and the counterparties’ credit standing. Other than loan commitments, the Company does not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on its financial condition.
Note 9 – Treasury Stock
During the quarter and nine months ended September 30, 2013, the Company repurchased 5,000 shares of common stock at an average cost of $11.55 per share. These shares were repurchased pursuant to the Company’s publicly announced common stock repurchase program. As of September 30, 2013, there were 66,510 shares remaining to be repurchased under the existing stock repurchase program.
During the quarter and nine months ended September 30, 2012, the Company did not repurchase any shares of common stock. As of September 30, 2012, there were 91,510 shares remaining to be repurchased under the existing stock repurchase program.
Note 10 – Subsequent Events
On October 23, 2013, the Board of Directors declared a quarterly dividend of $0.07 per share on the Company’s common stock, payable on November 19, 2013 to stockholders of record as of November 5, 2013. Lake Shore, MHC, which holds 3,636,875 shares, or approximately 61.5% of the Company’s total outstanding stock, elected to waive its right to receive this cash dividend of approximately $255,000. On March 25, 2013, the MHC received the non-objection of the Federal Reserve Bank of Philadelphia to waive its right to receive dividends paid by the Company during the twelve months ending February 26, 2014, aggregating up to $0.28 per share. The MHC waived $255,000 of dividends during the three months ended September 30, 2013 and $765,000 for the nine month period ended September 30, 2013. Cumulatively, Lake Shore, MHC has waived approximately $5.2 million of cash dividends as of September 30, 2013. The dividends waived by Lake Shore, MHC are considered a restriction on the retained earnings of the Company.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Forward-Looking Statements
This Quarterly Report on Form 10-Q contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements may be identified by words such as “believe,” “will,” “expect,” “project,” “may,” “could,” “anticipate,” “estimate,” “intend,” “plan,” “targets” and similar expressions. These statements are based upon our current beliefs and expectations and are subject to significant risks and uncertainties. Actual results may differ materially from those set forth in the forward-looking statements as a result of numerous factors.
The following factors, including the factors set forth in Part II, Item 1A of this and previous Quarterly Reports on Form 10-Q and in Part I, Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2012, among others, could cause actual results to differ materially from the anticipated results or other expectations expressed in our forward-looking statements:
Ÿ
general and local economic conditions;
changes in interest rates, deposit flows, demand for mortgages and other loans, real estate values and competition;
the ability of our customers to make loan payments;
our ability to continue to control costs and expenses;
changes in accounting principles, policies or guidelines;
our success in managing the risks involved in our business;
inflation, and market and monetary fluctuations;
the transfer of supervisory and enforcement authority over savings banks to the Office of the Comptroller of the Currency and savings and loan holding companies to the Federal Reserve Board;
the effect of new capital standards to be imposed by banking regulators;
changes in legislation or regulation, including the implementation of the Dodd-Frank Act; and
other economic, competitive, governmental, regulatory and technological factors affecting our operations, pricing, products and services.
Any or all of our forward-looking statements in this Quarterly Report on Form 10-Q and in any other public statements we make may differ from actual outcomes. They can be affected by inaccurate assumptions we might make or known or unknown risks and uncertainties. Consequently, no forward-looking statements can be guaranteed. We undertake no obligation to publicly update any forward looking statement, whether as a result of new information, future events or otherwise.
Overview
The following discussion and analysis is presented to assist in the understanding and evaluation of our consolidated financial condition and results of operations. It is intended to complement the unaudited consolidated financial statements and notes thereto appearing elsewhere in this Form 10-Q and should be read in conjunction therewith. The detailed discussion focuses on our consolidated financial condition as of
September 30, 2013 compared to the financial condition as of December 31, 2012 and the consolidated results of operations for the three and nine months ended September 30, 2013 and 2012.
Our results of operations depend primarily on our net interest income, which is the difference between the interest income we earn on loans and investments and the interest expense we pay on deposits and other interest-bearing liabilities. Net interest income is affected by the relative amounts of interest-earning assets and interest-bearing liabilities and the interest rates we earn or pay on these balances.
Our operations are also affected by non-interest income, such as service fees and gains and losses on the sales of securities and loans, our provision for loan losses and non-interest expenses which include salaries and employee benefits, occupancy and equipment costs, professional fees, and other general and administrative expenses.
Financial institutions like us, in general, are significantly affected by economic conditions, competition and the monetary and fiscal policies of the federal government. Lending activities are influenced by the demand for and supply of housing, competition among lenders, interest rate conditions, and funds availability. Our operations and lending are principally concentrated in the Western New York area, and our operations and earnings are influenced by local economic conditions. Deposit balances and cost of funds are influenced by prevailing market rates on competing investments, customer preferences, and levels of personal income and savings in our primary market area.
While the recession is officially over, continued weakness in the economy and high unemployment remain. These weaknesses can have a negative effect on a bank’s earnings and liquidity. The Federal Reserve is still actively working on keeping interest rates at very low levels. The Fed Funds rate has remained at 0.00%-0.25% for more than four years. The Federal Reserve has indicated that the Fed Funds rate will remain low and may not increase until mid-2015, which is longer than previously anticipated, regardless of what happens with the quantitative easing (“QE”) programs. Furthermore, the Federal Reserve has indicated that it may reduce or “taper” its QE program to purchase up to $85 billion in mortgage-backed securities and treasuries on a monthly basis, depending on the economic data it receives. This Fed announcement resulted in significant decreases in bond prices and increases in yields. The rates offered on mortgage products have increased with the long-term impact on volume yet to be determined. We will continue to closely monitor the impact of the national and regional economy on our net interest margin, results of operations and critical risk areas, including interest rate risk and credit risk.
As discussed in the Company’s Annual Report on Form 10-K Part I, Item 1 “Business – Supervision and Regulation” for the year ended December 31, 2012, since October 2008, numerous legislative actions, including the Dodd-Frank Act, have been taken in response to the financial crisis affecting the banking system and financial markets. While we do not know all the possible outcomes from these initiatives, we can anticipate that the Company will need to dedicate more resources to ensure compliance with the new legislation and regulations, which may impact profitability. There can be no assurance as to the actual impact any governmental program will have on the financial markets or our financial condition and results of operations. We remain active in monitoring these developments and supporting the interests of our stockholders.
Management Strategy
Our Reputation. Our primary management strategy has been to retain our perceived image as one of the most respected and recognized community banks in Western New York with over 122 years of service to our community. Our management strives to accomplish this goal by continuing to emphasize our high quality customer service and financial strength.
Branching. We opened our sixth branch office in Erie County, New York during the second quarter of 2013. This branch is located in Snyder, New York and is our eleventh branch overall. This office has generated nearly $5.0 million of deposits as of September 30, 2013. Our offices are located in Dunkirk, Fredonia, Jamestown, Lakewood and Westfield in Chautauqua County, New York and in Depew, East Amherst,
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Hamburg, Kenmore, Orchard Park and Snyder in Erie County, New York. Saturation of the market in Chautauqua County led to our expansion plan in Erie County, which is a critical component of our future profitability and growth.
An important strategic objective is to continue to evaluate the technology supporting our customer service. We are committed to making investments in technology and we believe that it represents an efficient way to deploy a portion of our capital. To this end, the Company has developed a five year plan for the implementation of cost effective and efficient digital services to meet our customer’s technology needs, to focus on attracting new customers, and to improve our operational efficiencies. Although we remain committed to expanding our retail branch footprint whenever it makes strategic sense, we will be concentrating our near term efforts on developing “clicks” instead of “bricks.”
Our People. A large part of our success is related to customer service and customer satisfaction. Having employees who understand and value our clientele and their business is a key component to our success. We believe that our present staff is one of our competitive strengths, and thus the retention of such persons and our ability to continue to attract quality personnel is a high priority.
Residential Mortgage and Other Lending. Historically, our lending portfolio has consisted predominately of residential one- to four-family mortgage loans. At September 30, 2013 and December 31, 2012, we held $166.4 million and $167.8 million of residential one- to four-family mortgage loans, respectively, which constituted 61.0% and 61.7% respectively, of our total loan portfolio. We originate commercial real estate loans to finance the purchase of real property, which generally consists of developed real estate. At September 30, 2013 and December 31, 2012, our commercial real estate loan portfolio consisted of loans totaling $59.7 million and $57.7 million, respectively, or 21.9% and 21.2%, respectively, of total loans. In addition to commercial real estate loans, we also engage in small business commercial lending, including business installment loans, lines of credit, and other commercial loans. At September 30, 2013 and December 31, 2012, our commercial loan portfolio consisted of loans totaling $12.7 million and $13.7 million, respectively, or 4.7% and 5.0%, respectively, of total loans. Other loan products offered to our customers include home equity loans and lines of credit, construction loans and consumer loans, including automobile loans, overdraft lines of credit and share loans. We may sell one-to four-family residential loans in the future as part of our interest rate risk strategy and asset/liability management, if it is deemed appropriate. We typically retain servicing rights when we sell one- to four-family residential mortgage loans. One- to four-family residential mortgage loans will continue to be the dominant type of loan in our lending portfolio.
Investment Strategy. Our investment policy is designed primarily to manage the interest rate sensitivity of our assets and liabilities, to generate a favorable return without incurring undue interest rate and credit risk, to complement our lending activities and to provide and maintain liquidity within established guidelines. We employ a third party financial advisor to assist us in managing our investment portfolio and developing balance sheet strategies.
At September 30, 2013 and December 31, 2012, we had $162.2 million and $159.4 million, respectively, invested in securities available for sale, the majority of which are agency mortgage-backed securities, agency collateralized mortgage obligation securities (“CMOs”) and municipal securities.
Asset-Liability Strategy. As stated above, our business consists primarily of originating one- to four-family residential mortgage loans and commercial real estate loans secured by property in our market area and investing in residential mortgage-backed securities, CMOs and municipal securities. Typically, one- to four-family residential mortgage loans involve a lower degree of risk and carry a lower yield than commercial real estate and commercial business loans. Our loans are primarily funded by time deposits and core deposits (i.e. checking, savings and money market accounts). This has resulted in our being vulnerable to increases in interest rates, as our interest-bearing liabilities will mature or re-price more quickly than our interest-earning assets in a rising rate environment. Although we plan to continue to originate one- to four-family residential mortgage loans going forward, we have been and intend to continue to increase our focus on the origination of commercial real estate loans and commercial business loans, which generally provide higher returns and have shorter durations than one- to four-family residential mortgage loans. Furthermore, our interest rate risk
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strategy involves improving our funding mix by increasing our core deposits in order to help reduce and control our cost of funds. We value core deposits because they represent longer-term customer relationships as well as lower cost of funds. As part of our strategy to expand our commercial loan portfolio, we expect to attract lower cost core deposits as part of these borrower relationships. We offer competitive rates on a variety of deposit products to meet the needs of our customers and we promote long term deposits, where possible, to meet asset-liability goals.
We are actively involved in managing our balance sheet through the direction of our Asset-Liability Committee and the assistance of a third party advisor. Recent economic conditions have underscored the importance of a strong balance sheet. We strive to achieve this through managing our interest rate risk and maintaining strong capital levels, putting aside adequate loan loss reserves and keeping liquid assets on hand. Diversifying our asset mix not only improves net interest margin but also reduces the exposure of our net interest income and earnings to interest rate risk. We will continue to manage our interest rate risk by diversifying the type and maturity of our assets in our loan and investment portfolios and monitoring the maturities in our deposit portfolio and borrowing facilities.
Critical Accounting Policies
It is management’s opinion that accounting estimates covering certain aspects of our business have more significance than others due to the relative importance of those areas to overall performance, or the level of subjectivity required in making such estimates. Management considers the accounting policy relating to the allowance for loan losses to be a critical accounting policy given the uncertainty in evaluating the level of the allowance for loan losses required for probable credit losses and the material effect that such judgments can have on the results of operations. Management’s monthly evaluation of the adequacy of the allowance considers our historical loan loss experience, review of specific loans, current economic conditions, and such other factors considered appropriate to estimate loan losses. Management uses presently available information to estimate probable losses on loans; however, future additions to the allowance may be necessary based on changes in estimates, assumptions, or economic conditions. Significant factors that could give rise to changes in these estimates include, but are not limited to, changes in economic conditions in our local area, concentrations of risk and decline in local property values. The Company's determination as to the amount of its allowance for loan losses is subject to review by its regulatory agencies, which can require that we establish additional loss allowances. Refer to Note 4 of the Notes to Consolidated Financial Statements for more information on the allowance for loan losses.
In management’s opinion, the accounting policy relating to the valuation of investments is a critical accounting policy. The fair values of our investments are determined using public quotations, third party dealer quotes, pricing models, or discounted cash flows. Thus, the determination may require significant judgment or estimation, particularly when liquid markets do not exist for the item being valued. The use of different assumptions for these valuations could produce significantly different results which may have material positive or negative effects on the results of our operations. Refer to Note 8 of the Notes to Consolidated Financial Statements for more information on fair value.
Management also considers the accounting policy relating to the impairment of investments to be a critical accounting policy due to the subjectivity and judgment involved and the material effect an impairment loss could have on the consolidated results of income. The credit portion of a decline in the fair market value of investments below cost deemed to be other-than-temporary may be charged to earnings resulting in the establishment of a new cost basis for an asset. Management continually reviews the current value of its investments for evidence of OTTI. Refer to Note 3 of the Notes to Consolidated Financial Statements for more information on OTTI.
These critical policies and their application are reviewed periodically by our Audit Committee and our Board of Directors. All accounting policies are important, and as such, we encourage the reader to review each of the policies included in the notes to our audited Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2012 to better understand how our financial performance is reported.
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Analysis of Net Interest Income
Net interest income represents the difference between the interest we earn on our interest-earning assets, such as mortgage loans and investment securities, and the expense we pay on interest-bearing liabilities, such as deposits and borrowings. Net interest income depends on both the volume of our interest-earning assets and interest-bearing liabilities and the interest rates we earn or pay on them.
Average Balances, Interest and Average Yields. The following tables set forth certain information relating to our average balance sheets and reflects the average yield on interest-earning assets and average cost of interest-bearing liabilities, interest earned and interest paid for the periods indicated. Such yields and costs are derived by dividing interest income or expense by the average balance of interest-earning assets or interest-bearing liabilities, respectively, for the periods indicated. Average balances are derived from daily balances over the periods indicated. The average balances for loans are net of allowance for loan losses, but include non-accrual loans. Interest income on securities does not include a tax equivalent adjustment for bank qualified municipals.
For the Three Months Ended
Interest Income/
Yield/
Expense
Rate
Interest-earning assets:
Interest-earning deposits & federal funds sold
Securities
Loans
Total interest-earning assets
Total assets
Interest-bearing liabilities
Demand & NOW accounts
Money market accounts
Savings accounts
Time deposits
Borrowed funds
Other interest-bearing liabilities
Total interest-bearing liabilities
Other non-interest bearing liabilities
Stockholders' equity
Total liabilities & stockholders' equity
Net interest income
Interest rate spread
Net interest margin
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Rate Volume Analysis. The following tables analyze the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. The tables show the amount of the change in interest income or expense caused by either changes in outstanding balances (volume) or changes in interest rates. The effect of a change in volume is measured by applying the average rate during the first period to the volume change between the two periods. The effect of changes in rate is measured by applying the change in rate between the two periods to the average volume during the first period. Changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately to the absolute value of the change due to volume and the change due to rate.
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Three Months Ended September 30, 2013
Compared to
Three Months Ended September 30, 2012
Volume
Net Change
Interest-bearing liabilities:
Total deposits
Other interest-bearing liabilities:
Borrowed funds & other
Total change in net interest income
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Nine Months Ended September 30, 2013
Nine Months Ended September 30, 2012
Our earnings may be adversely impacted by an increase in interest rates because the majority of our interest-earning assets are long-term, fixed rate mortgage-related assets that will not re-price as long-term interest rates increase. As rates rise, we expect loan applications to decrease, prepayment speeds to slowdown and the interest rate on our loan portfolio to remain static. Conversely, a majority of our interest-bearing liabilities have much shorter contractual maturities and are expected to re-price, resulting in increased interest expense. A significant portion of our deposits have no contractual maturities and are likely to re-price quickly as short-term interest rates increase. Therefore, in an increasing rate environment, our cost of funds is expected to increase more rapidly than the yields earned on our loan and securities portfolios. An increasing rate environment is expected to cause a decrease in our net interest rate spread and a decrease in our earnings. In order to mitigate this effect, the Bank’s Asset-Liability Committee is continuing to review its options in relation to core deposit growth, implementation of new products, promotion of adjustable rate commercial loan products and use of derivative products.
In a decreasing interest rate environment, our earnings may increase or decrease. If long-term interest-earning assets do not re-price and interest rates on short-term deposits begin to decrease, earnings may rise. However, low interest rates on loan products may result in an increase in prepayments, as borrowers refinance their loans. If we cannot re-invest the funds received from prepayments at a comparable spread, net interest income could be reduced. Also, in a falling interest rate environment, certain categories of deposits may reach a point where market forces prevent further reduction in interest paid on those products. The net effect of these circumstances is reduced net interest income and possibly net interest rate spread.
In the current environment, rates on the lending and investment portfolios have declined significantly, but rates on deposit products and borrowed funds have also dropped, which has assisted in keeping our interest rate spread at a moderate level.
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For the three months ended September 30, 2013, the average yields on our loan portfolio and investment portfolio were 5.04% and 3.03%, respectively, in comparison to 5.21% and 3.17%, respectively, for the three months ended September 30, 2012. Overall, the average yield on our interest earning assets decreased by 5 basis points to 4.08% for the three months ended September 30, 2013 in comparison to the three months ended September 30, 2012. For the three months ended September 30, 2013, the average rate that we were paying on interest-bearing liabilities decreased by 25 basis points to 0.93% in comparison to the same period in the prior year. This was partially due to a 46 basis point decrease in the average interest rate paid on our borrowings from 1.58% for the three months ended September 30, 2012 to 1.12% for the three month period ended September 30, 2013 and a 28 basis point decrease in the average interest rate paid on time deposits from 1.69% for the three month period ended September 30, 2012 to 1.41% for the three month period ended September 30, 2013. Our interest rate spread for the three months ended September 30, 2013 and 2012 was 3.15% and 2.95%, respectively. Our net interest margin was 3.30% and 3.15% for the three months ended September 30, 2013 and 2012, respectively.
For the nine month period ended September 30, 2013, the average yields on our loan portfolio and investment portfolio were 5.09% and 2.97%, respectively, in comparison to 5.28% and 3.37%, respectively, for the nine months ended September 30, 2012. Overall, the average yield on our interest earning assets decreased by 19 basis points to 4.11% for the nine months ended September 30, 2013 from 4.30% for the nine months ended September 30, 2012. For the nine months ended September 30, 2013, the average rate we were paying on interest-bearing liabilities decreased by 29 basis points to 0.95% in comparison to the same period in the prior year. This was partially due to a 55 basis point decrease in the average interest rate paid on our borrowings from 1.70% for the nine months ended September 30, 2012 to 1.15% for the nine month period ended September 30, 2013 and a 30 basis point decrease in the average interest rate paid on time deposits from 1.73% for the nine month period ended September 30, 2012 to 1.43% for the nine month period ended September 30, 2013. Our interest rate spread for the nine months ended September 30, 2013 was 3.16%, which was a 10 basis point increase in comparison to the nine months ended September 30, 2012. Our net interest margin was 3.31% and 3.26% for the nine months ended September 30, 2013 and 2012, respectively.
Comparison of Financial Condition at September 30, 2013 and December 31, 2012
Total assets at September 30, 2013 were $485.4 million, an increase of $3.0 million, or 0.6%, from $482.4 million at December 31, 2012. The increase in total assets was primarily due to a $2.9 million increase in securities available for sale as a result of a 3.3% increase in deposit balances over the same time period.
Cash and cash equivalents decreased by $294,000, or 1.5%, from $19.8 million at December 31, 2012 to $19.5 million at September 30, 2013. The decrease was primarily attributed to a $3.8 million decrease in interest earning deposits, which were used to purchase securities available for sale. The decrease was partially offset by a $4.0 million increase in federal funds sold as a result of a $12.6 million increase in deposits which have not yet been fully used to fund loan originations or to purchase securities available for sale.
Securities available for sale increased $2.9 million, or 1.8%, to $162.2 million at September 30, 2013 compared to $159.4 million at December 31, 2012. The increase was primarily due to the Company purchasing $34.7 million of available for sale securities, including collateralized mortgage obligations and municipal bonds during the nine months ended September 30, 2013. The purchases were primarily funded by the receipt of $22.1 million in pay-downs on the investment portfolio and the sale of $2.3 million of municipal bonds during the nine months ended September 30, 2013, with the remainder being funded by deposit growth and cash on hand. The increase was partially offset by a $6.4 million decrease in the market value (before taxes) of the securities available for sale portfolio between December 31, 2012 and September 30, 2013.
Net loans receivable increased during the nine month period ended September 30, 2013, as shown in the table below:
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At September 30,
At December 31,
Change
%
Total real estate loans
Total gross loans
Allowance for loan losses
Net deferred loan costs
The increase in net loans receivable was primarily due to an increase in commercial real estate, home equity, and construction loans, partially offset by a decrease in residential one- to four- family mortgage loans and commercial loans. During 2013, we remain strategically focused on our commercial real estate and commercial loan portfolios to diversify our asset mix, to take advantage of the opportunities available to serve small businesses in our market area, and to maintain an effective net interest margin. During the first half of 2013, the Company made a strategic decision to not match lower rates offered by our competitors on residential one- to four-family mortgage loans in an effort to avoid increased interest rate risk. Management continues to look for high quality loans to add to its portfolio and will continue to emphasize loan originations to the extent that it is profitable and prudent.
Other assets decreased by $619,000, or 21.7%, to $2.2 million as of September 30, 2013 in comparison to $2.9 million at December 31, 2012. The decrease was primarily due to the sale of $1.4 million of available for sale securities in the fourth quarter of 2012, which were settled during the first quarter of 2013. The decrease was partially offset by the sale of $520,000 of available for sale securities in the third quarter of 2013, which did not settle until the fourth quarter of 2013.
The table below shows changes in deposit balances by type of deposit between September 30, 2013 and December 31, 2012:
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Demand deposits and NOW accounts:
Money market
Savings
The increase in total deposits was primarily due to an increase in all deposit categories except for time deposits. The growth in money market, savings and checking accounts was the result of the Company’s continued strategic focus on growing core deposits among its retail and commercial customers.
Our borrowings, consisting of advances from the Federal Home Loan Bank of New York (“FHLBNY”), decreased by $4.8 million, or 18.6%, from $25.6 million at December 31, 2012 to $20.9 million at September 30, 2013. Long-term debt decreased $5.3 million, or 36.5%, from $14.4 million at December 31, 2012 to $9.2 million at September 30, 2013. Short-term borrowings increased $500,000, or 4.5%, from $11.2 million at December 31, 2012 to $11.7 million at September 30, 2013. As long-term debt matured, the Company paid off $4.8 million of such debt in order to reduce interest expense, and the remaining proceeds were transferred into short-term borrowings to take advantage of lower interest rates.
Other liabilities decreased by $1.9 million, or 23.8%, to $6.1 million as of September 30, 2013 in comparison to $8.0 million at December 31, 2012. The decrease was primarily due to a $2.3 million decrease in deferred taxes resulting from a decrease in unrealized gains on the securities available for sale portfolio during 2013.
Total stockholders’ equity decreased by $1.6 million, or 2.4%, to $65.4 million as of September 30, 2013 in comparison to $67.0 million as of December 31, 2012. The decrease was primarily due to a $3.9 million decrease in unrealized gains on available for sale securities (after taxes) resulting from the increase in interest rates during 2013 and $441,000 in cash dividends paid during the nine month period ended September 30, 2013, partially offset by net income of $2.7 million for the same time period.
Comparison of Results of Operations for the Three Months Ended September 30, 2013 and 2012
General. Net income was $986,000 for the three month period ended September 30, 2013, or $0.17 per diluted share, an increase of $123,000, or 14.3%, compared to net income of $863,000, or $0.15 per diluted share, for the three month period ended September 30, 2012. The increase in net income was primarily due to a $160,000 decrease in the provision for loan losses, a $68,000 increase in net interest income and a $35,000 increase in non-interest income, partially offset by a $139,000 increase in non-interest expense.
Interest Income. Interest income decreased by $189,000, or 3.9%, to $4.6 million for the three month period ended September 30, 2013 compared to the three month period ended September 30, 2012. Loan interest income decreased by $24,000, or 0.7%, to $3.4 million for the three month period ended September 30, 2013 compared to the three month period ended September 30, 2012, due to a decrease in the average yield on loans from 5.21% for the three month period ended September 30, 2012 to 5.04% for the three month period ended September 30, 2013. The average yield on the loan portfolio decreased as new loans were originated or existing loans were refinanced at lower yields than the rates earned on loans which had paid off, as a result of the current low interest rate environment. The average balance of the loan portfolio increased $7.0 million, or 2.6%, from $264.7 million for the three month period ended September 30, 2012 to $271.7 million for the three month period ended September 30, 2013. The increase in the average balance of loans receivable was
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primarily due to an increase in the average balance of commercial real estate loans, partially offset by a decrease in the average balance of one- to four-family real estate loans. As previously indicated, the decrease in the average balance of one- to four- family real estate loans was a strategic decision by the Company to not match competitor rates in an effort to avoid increased interest rate risk. Investment interest income decreased by $160,000, or 11.8%, to $1.2 million for the three month period ended September 30, 2013 compared to $1.4 million for the three month period ended September 30, 2012 due to a decrease in the average yield on investments from 3.17% for the three month period ended September 30, 2012 to 3.03% for the three month period ended September 30, 2013. The average yield on the investment portfolio decreased as new securities were purchased at lower yields than the rates earned on securities which had paid off, as a result of the current low interest rate environment. The average balance of the investment portfolio decreased from $171.2 million for the three months ended September 30, 2012 to $157.7 million for the three months ended September 30, 2013 primarily due to the receipt of paydowns which were used to fund loan originations.
Interest Expense. Interest expense decreased by $257,000, or 22.5%, to $886,000 for the three month period ended September 30, 2013 compared to $1.1 million for the three month period ended September 30, 2012. The interest paid on deposits decreased by $198,000, or 19.9%, to $797,000 for the three month period ended September 30, 2013 when compared to the three month period ended September 30, 2012 primarily due to the decrease in the average rate paid on deposits. The average balance of deposits for the three month period ended September 30, 2013 was $357.8 million with an average rate of 0.89% compared to the average balance of deposits of $355.5 million and an average rate of 1.12% for the three month period ended September 30, 2012. The decrease in the average rate paid on deposits was due to the continued low interest rate environment in 2013. The increase in the average balance of deposits was primarily due to deposit growth in core deposit accounts, partially offset by a decrease in the average balance of time deposits. The interest expense related to advances from the FHLBNY decreased $59,000, or 48.8%, to $62,000 for the three month period ended September 30, 2013 when compared to the three month period ended September 30, 2012. This decrease was due to an $8.6 million decrease in average FHLBNY advance balances and a 46 basis point decline in the average rate paid on FHLBNY advances when comparing the three month period ended September 30, 2013 with the three month period ended September 30, 2012. The decrease in the average FHLBNY advance balances was a result of the Company’s decision to utilize excess cash obtained from loan prepayments to pay down borrowings. The low interest rate environment caused the average rate paid on borrowings to decrease.
Provision for Loan Losses. A provision of $60,000 was recorded to the allowance for loan losses during the three month period ended September 30, 2013, a decrease of $160,000, compared to a provision of $220,000 during the three month period ended September 30, 2012. Net charge-offs were $64,000 for the three month period ended September 30, 2013 compared to $45,000 for the three month period ended September 30, 2012.
During the three month period ended September 30, 2013, the Company recorded a $119,000 provision for loan losses in commercial real estate loans due to changes in the related environmental factors used to qualitatively assess inherent losses in the loan portfolio, including an increase in average commercial real estate loan balances. The Company recorded a $38,000 provision for loan losses on home equity loans primarily due to an increase in classified loans. These provisions were offset by a $93,000 credit for loan losses on one- to four-family loans and commercial loans during the three month period ended September 30, 2013, due to a decrease in classified loans in these loan categories.
During the three month period ended September 30, 2012, the Company recorded a $200,000 provision for loan losses on commercial real estate loans due to a downgrade in loan classification for two loans, loan growth and changes in environmental factors. An additional $26,000 reserve was set aside for the commercial loan portfolio due to loan growth and an increased risk of loss on one classified loan based on the Company’s quantitative analysis. The provisions related to commercial loans were partially offset by a $6,000 reduction in the allowance for loan losses for one- to four-family real estate loans and home equity loans, due to the adequacy of the reserves already set aside.
Refer to Note 4 of the Notes to the Consolidated Financial Statements for details on the provision for loan losses.
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Non-interest Income. Non-interest income increased $35,000, or 6.9%, from $506,000 for the three months ended September 30, 2012 to $541,000 for the three months ended September 30, 2013. The increase was primarily due to a $206,000 gain on the sale of eight municipal bond securities and one mortgage-backed security during the three months ended September 30, 2013, partially offset by an additional non-cash, pre-tax impairment charge of $180,000 for one asset-backed security during the three months ended September 30, 2013. The impairment charge was attributable to a significant decline in the market value of this bond that is not expected to be recovered over its term.
Non-interest Expenses. Non-interest expenses increased by $139,000, or 4.8%, to $3.0 million for the three month period ended September 30, 2013 compared to the three month period ended September 30, 2012. Occupancy and equipment expense increased $83,000, or 19.0%, for the three month period ended September 30, 2013 compared to the three month period ended September 30, 2012 primarily due to increases in software maintenance costs, property taxes, maintenance and repairs of buildings and equipment and the opening of the Snyder branch office. Advertising expenses increased by $11,000, or 13.4%, for the three month period ended September 30, 2013 compared to the same period in 2012, primarily due to additional marketing costs related to the opening of the Snyder branch office during the second quarter of 2013. Other expenses increased $48,000, or 22.5%, primarily due to an increase in telephone and communication expenses, donation expenses and foreclosure and other real estate owned expenses for the three months ended September 30, 2013 when compared to the same three month period in 2012.
Income Tax Expense. Income tax expense increased by $1,000, or 0.5%, from $221,000 for the three month period ended September 30, 2012 to $222,000 for the three month period ended September 30, 2013.
Comparison of Results of Operations for the Nine Months Ended September 30, 2013 and 2012
General. Net income was $2.7 million for the nine month period ended September 30, 2013, or $0.47 per diluted share, a decrease of $73,000, or 2.6%, compared to net income of $2.8 million, or $0.48 per diluted share, for the nine month period ended September 30, 2012. The decrease in net income was primarily due to a $390,000 increase in non-interest expenses and a $94,000 decrease in net interest income partially offset by a $165,000 decrease in provision for loan losses, an $87,000 increase in non-interest income and a $159,000 decrease in income tax expense.
Interest Income. Interest income decreased by $1.0 million, or 6.7%, to $13.9 million for the nine month period ended September 30, 2013 compared to the nine month period ended September 30, 2012. Loan interest income decreased by $239,000, or 2.3%, to $10.4 million for the nine month period ended September 30, 2013 compared to the nine month period ended September 30, 2012, due to a decrease in the average yield of the loan portfolio from 5.28% for the nine month period ended September 30, 2012 to 5.09% for the nine month period ended September 30, 2013. The average yield on the loan portfolio decreased as new loans were originated or existing loans were refinanced at lower yields than the rates earned on loans which had paid off, as a result of the current low interest rate environment. The average balance of the loan portfolio increased $3.4 million, or 1.3%, from $267.9 million for the nine month period ended September 30, 2012 to $271.3 million for the nine month period ended September 30, 2013. The increase in the average balance of loans receivable was primarily due to an increase in the average balance of commercial real estate loans, commercial loans and home equity loans, partially offset by a decrease in the average balance of one- to four-family real estate loans. As previously indicated, the decrease in the average balance of one- to four-family real estate loans was a strategic decision by the Company to not match competitor rates in an effort to avoid increased interest rate risk. Investment interest income decreased by $751,000, or 17.5%, from $4.3 million for the nine month period ended September 30, 2012 to $3.5 million for the nine month period ended September 30, 2013 due to a decrease in the average yield on investments from 3.37% for the nine month period ended September 30, 2012 to 2.97% for the nine month period ended September 30, 2013. The average yield on the investment portfolio decreased as new securities were purchased at lower yields than the rates earned on securities which had paid off, as a result of the current low interest rate environment. The average balance of the investment portfolio decreased from $169.7 million for the nine months ended September 30, 2012 to $158.7 million for the nine months ended September 30, 2013 primarily due to the receipt of paydowns which were used to fund loan originations.
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Interest Expense. Interest expense decreased by $906,000, or 25.2%, to $2.7 million for the nine month period ended September 30, 2013 compared to $3.6 million for the nine month period ended September 30, 2012. Interest expense on deposits decreased by $699,000, or 22.5%, to $2.4 million for the nine month period ended September 30, 2013 when compared to the nine month period ended September 30, 2012 primarily due to the decrease in the average rate paid and a shift in deposit mix resulting in a larger percentage of the deposit portfolio consisting of lower cost core deposits. The average balance of deposits for the nine month period ended September 30, 2013 was $353.7 million with an average rate of 0.91% compared to the average balance of deposits of $354.4 million and an average rate of 1.17% for the nine month period ended September 30, 2012. The decrease in the average rate paid on deposits was due to the continued low interest rate environment in 2013. The interest expense related to advances from the FHLBNY decreased $205,000, or 50.3%, to $203,000 for the nine month period ended September 30, 2013 when compared to the nine month period ended September 30, 2012. This decrease was due to an $8.5 million decrease in average FHLBNY advance balances and a 55 basis point decline in the average rate paid on FHLBNY advances when comparing the nine month period ended September 30, 2013 with the nine month period ended September 30, 2012. The decrease in the average FHLBNY advance balances was a result of the Company’s decision to utilize excess cash obtained from loan prepayments to pay down borrowings. The low interest rate environment caused the average rate paid on borrowings to decrease.
Provision for Loan Losses. A provision of $105,000 was recorded to the allowance for loan losses during the nine month period ended September 30, 2013, compared to a provision of $270,000 during the nine month period ended September 30, 2012. Net charge-offs were $92,000 for the nine month period ended September 30, 2013 compared to $137,000 for the nine month period ended September 30, 2012. Our credit quality remains strong, in comparison to the Company’s peer group, with non-performing loans increasing to $2.9 million, or 1.05% of total loans, at September 30, 2013 as compared to $2.4 million, or 0.89% of total loans, at December 31, 2012.
During the nine month period ended September 30, 2013, the Company recorded a $78,000 provision for loan losses in commercial real estate loans due to changes in the related environmental factors, including an increase in average commercial real estate loan balances. The Company also recorded a $40,000 provision for loan losses on commercial loans primarily due to changes in the environmental factors as a result of an increase in historical average net charge-offs, as well as increased loan charge-offs during the nine month period ended September 30, 2013. A $16,000 provision for loan losses was recorded on consumer loans primarily due to increased loan charge-offs during the nine month period ended September 30, 2013. The provision for loan losses was reduced by a $32,000 credit for loan losses on one- to four-family loans and home equity loans during the nine month period ended September 30, 2013, due to a decrease in classified loans.
During the nine month period ended September 30, 2012, the Company recorded a $357,000 provision for loan losses on commercial real estate loans due to an increase in the loan balances and number of classified loans in this category. This provision was offset by a $57,000 reduction in the provision for loan losses on commercial loans due to a reduction in the classified loan balances for this loan type. The provision for loan losses was further reduced by a net $30,000 decrease on the residential real estate loans (including one- to four-family loans and home equity loans) and consumer loans due to declining loan balances in these categories.
Non-interest Income. Non-interest income increased $87,000, or 5.9%, from $1.5 million for the nine months ended September 30, 2012 to $1.6 million for the nine months ended September 30, 2013. The increase was primarily due to a $206,000 gain on the sale of eight municipal bond securities and one mortgage-backed security during the nine months ended September 30, 2013. The increase was partially offset by an additional non-cash, pre-tax impairment charge of $180,000 on one asset-backed security during the nine months ended September 30, 2013, which was a $123,000 increase from the non-cash, pre-tax impairment charge of $57,000 to write-down this security during the nine months ended September 30, 2012. The impairment charge was
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attributable to a significant decline in the market value of this bond that is not expected to be recovered over its term.
Non-interest Expenses. Non-interest expenses increased by $390,000, or 4.3%, to $9.4 million for the nine month period ended September 30, 2013 compared to the nine month period ended September 30, 2012. Salaries and employee benefits expense increased $64,000, or 1.4%, for the nine month period ended September 30, 2013 compared to the nine month period ended September 30, 2012. The increase was primarily due to staffing for our newest branch office in Snyder, NY, which opened in April 2013 and annual salary increases. Occupancy and equipment expense increased $182,000, or 13.7%, for the nine month period ended September 30, 2013 compared to the nine month period ended September 30, 2012, primarily due to increases in software maintenance costs, property taxes, maintenance and repairs of buildings and equipment and the opening of the Snyder branch office in the second quarter of 2013. Professional services expense increased $73,000, or 7.3%, for the nine month period ended September 30, 2013 compared to the nine month period ended September 30, 2012, primarily due to higher accounting and consulting expenses to ensure compliance with regulatory and SEC guidance. Advertising expense increased $22,000, or 6.6%, for the nine month period ended September 30, 2013 when compared to the same time period in 2012 primarily due to increased advertising for the opening of our newest branch office. FDIC insurance expense increased $20,000, or 11.5%, for the nine month period ended September 30, 2013 compared to the nine month period ended September 30, 2012, due to an increase in assessed fees in 2013. Data processing expenses increased $14,000, or 3.0%, during the nine month period ended September 30, 2013. Furthermore, postage and supplies increased $8,000, or 4.3%, during the nine month period ended September 30, 2013 compared to the same period in the prior year. Both of these increases were primarily due to the costs associated with the opening of our newest branch office.
Income Tax Expense. Income tax expense decreased by $159,000, or 20.6%, from $771,000 for the nine month period ended September 30, 2012 to $612,000 for the nine month period ended September 30, 2013. The decrease was primarily due to a decrease in income before income taxes during the nine months ended September 30, 2013 as well as a decrease in the effective tax rate from 21.8% for the nine month period ended September 30, 2012 to 18.5% for the nine month period ended September 30, 2013. The decrease in the effective tax rate was primarily due to a decrease in income as well as a disproportionate increase in tax exempt income.
Loans Past Due and Non-performing Assets. We define non-performing loans as loans that are either non-accruing, accruing whose payments are 90 days or more past due or are classified as troubled debt restructurings. Non-performing assets, including non-performing loans and foreclosed real estate, totaled $3.5 million, or 0.71% of total assets, at September 30, 2013 and $3.0 million, or 0.62% of total assets, at December 31, 2012.
The following table presents information regarding our non‑accrual loans, accruing loans delinquent 90 days or more, and foreclosed real estate as of the dates indicated.
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Loans past due 90 days or more but still accruing:
Real estate loans:
Other loans:
Consumer loans
Loans accounted for on a nonaccrual basis:
Residential, one- to four-family (1)
Home equity (2)
Total non-accrual loans
Total nonperforming loans
Performing restructured loans
Total nonperforming assets
Ratios:
Nonperforming loans as a percent of net loans:
Nonperforming assets as a percent of total assets:
As of September 30, 2013, one residential, one- to four-family loan for $49,000 and accounted for on a non-accrual basis was restructured and classified as a troubled debt restructuring, due to the borrower’s financial difficulties.
(2)
As of December 31, 2012, one home equity loan for $31,000 and accounted for on a non-accrual basis was restructured and classified as a troubled debt restructuring, due to the borrower’s financial difficulties.
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The following table sets forth activity in our allowance for loan losses and other ratios at or for the dates indicated.
At or for the Nine Months Ended
Balance at beginning of period:
Charge-offs:
Total charge-offs
Recoveries:
Total recoveries
Net charge-offs
Balance at end of period
Average loans outstanding
Allowance for loan losses as a percent of total net loans
Allowance for loan losses as a percent of non-performing loans
Ratio of net charge-offs to average loans outstanding(1)
(1) Annualized
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Liquidity and Capital Resources
Liquidity describes our ability to meet the financial obligations that arise during the ordinary course of business. Liquidity is primarily needed to meet the lending and deposit withdrawal requirements of our customers and to fund current and planned expenditures. Our primary sources of funds consist of deposits, scheduled amortization and prepayments of loans and mortgage-backed and asset-backed securities, maturities and sales of other investments, interest earning deposits at other financial institutions and funds provided from operations. We have a written agreement with the Federal Home Loan Bank of New York, which allows us to borrow up to $120.2 million as of September 30, 2013, and is collateralized by a pledge of our mortgage loans. At September 30, 2013, we had outstanding advances under this agreement of $20.9 million. We have a written agreement with the Federal Reserve Bank discount window for overnight borrowings which is collateralized by a pledge of our securities, and allows us to borrow up to the value of the securities pledged, which was equal to a book value of $10.6 million and a fair value of $11.2 million as of September 30, 2013. There were no balances outstanding with the Federal Reserve Bank discount window at September 30, 2013. We have also established a line of credit with a correspondent bank for $7.0 million, of which $5.0 million is unsecured and the remaining $2.0 million is required to be secured by a pledge of our securities when a draw is made. There were no borrowings on this line as of September 30, 2013.
Historically, loan repayments and maturing investment securities were a relatively predictable source of funds. However, in light of the current economic environment, there are now more risks related to loan repayments and the valuation and maturity of investment securities. In addition, deposit flows, calls of investment securities, and prepayments of loans and mortgage-backed securities are strongly influenced by interest rates, general and local economic conditions, and competition in the marketplace. These factors and the current economic environment reduce the predictability of the timing of these sources of funds.
Our primary investing activities include the origination of loans and the purchase of investment securities. For the nine months ended September 30, 2013, we originated loans of approximately $39.7 million in comparison to approximately $33.5 million of loans originated during the nine months ended September 30, 2012. Purchases of investment securities totaled $34.7 million in the nine months ended September 30, 2013 and $28.5 million in the nine months ended September 30, 2012.
At September 30, 2013, we had loan commitments to borrowers of approximately $13.0 million and overdraft lines of protection and unused home equity lines of credit of approximately $24.6 million. Total deposits were $391.2 million at September 30, 2013, as compared to $392.6 million at September 30, 2012. Time deposit accounts scheduled to mature within one year were $74.6 million at September 30, 2013. Based on our deposit retention experience, current pricing strategy, and competitive pricing policies, we anticipate that a significant portion of these time deposits will remain with us following their maturity.
In recent years, macro-economic conditions negatively impacted liquidity and credit quality across the financial markets as the U.S. economy experienced an economic downturn. Although recent reports have indicated improvements in the macro-economic conditions, the economic downturn has had far-reaching effects. However, our financial condition, credit quality and liquidity position remain strong.
We are committed to maintaining a strong liquidity position; therefore, we monitor our liquidity position on a daily basis. We anticipate that we will have sufficient funds to meet our current funding commitments. The marginal cost of new funding, however, whether from deposits or borrowings from the Federal Home Loan Bank, will be carefully considered as we monitor our liquidity needs. Therefore, in order to minimize our cost of funds, we may consider additional borrowings from the Federal Home Loan Bank in the future.
We do not anticipate any material capital expenditures during the remainder of 2013. We do not have any balloon or other payments due on any long-term obligations or any off-balance sheet items other than loan commitments as described in Note 6 in the Notes to our Consolidated Financial Statements and the borrowing agreements noted above.
45
Off-Balance Sheet Arrangements
Other than loan commitments, we do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources that is material to investors. Refer to Note 6 in the Notes to our Consolidated Financial Statements for a summary of commitments outstanding as of September 30, 2013.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Not applicable as the Company is a smaller reporting company.
Item 4. Controls and Procedures.
Disclosure Controls and Procedures
The Company’s management, with the participation of its Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13(a)-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based upon such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures were effective.
Changes in Internal Control over Financial Reporting
There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934) during the quarter ended September 30, 2013 that have materially affected, or are reasonably likely to materially affect, internal control over financial reporting.
Item 1A. Risk Factors.
There have been no material changes in the Company’s risk factors from those disclosed in its Annual Report on Form 10-K.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
The following table reports information regarding repurchases by Lake Shore Bancorp of its common stock in each month of the quarter ended September 30, 2013:
COMPANY PURCHASES OF EQUITY SECURITIES
Period
Total Number of Shares Purchased
Average Price Paid per Share
Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs
Maximum Number of Shares that May Yet be Purchased Under the Plans or Programs (1)
July 1 through July 31, 2013
August 1 through August 31, 2013
September 1 through September 30, 2013
______________
(1) On November 17, 2010, our Board of Directors approved a new stock repurchase plan pursuant to which we can repurchase up to 116,510 shares of our outstanding common stock. This amount represented 5% of our outstanding stock not owned by the MHC as of November 23, 2010. The repurchase plan does not have an expiration date and superseded all of the prior stock repurchase programs.
Item 6. Exhibits
31.1
Certification by the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*
31.2
Certification by the Chief Financial Officer Pursuant to Section 302 of the Sarbanes- Oxley Act of 2002*
32.1
Certification by the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*
32.2
Certification by the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*
101.INS
XBRL Instance Document*
101.SCH
XBRL Taxonomy Extension Schema Document*
101.CAL
XBRL Taxonomy Calculation Linkbase Document*
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document*
101.LAB
XBRL Taxonomy Label Linkbase Document*
101.PRE
XBRL Taxonomy Presentation Linkbase Document*
_________________
*Filed herewith.
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.
(Registrant)
November 12, 2013
By:
/s/ Daniel P. Reininga
Daniel P. Reininga
President and Chief Executive Officer
(Principal Executive Officer)
/s/ Rachel A. Foley
Rachel A. Foley
Chief Financial Officer
(Principal Financial and Accounting Officer)