Middlefield Banc - 10-Q quarterly report FY

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YESþ NO o

MIDDLEFIELD BANC CORP.

CONSOLIDATED BALANCE SHEET

(Dollar amounts in thousands)

(Unaudited)

See accompanying notes to the unaudited consolidated financial statements.

MIDDLEFIELD BANC CORP.

CONSOLIDATED STATEMENT OF INCOME

(Dollar amounts in thousands, except per share data)

(Unaudited)

See accompanying notes to the unaudited consolidated financial statements.

MIDDLEFIELD BANC CORP.

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

(Dollar amounts in thousands, except dividend per share amount)

(Unaudited)

See accompanying notes to the unaudited consolidated financial statements.

MIDDLEFIELD BANC CORP.

CONSOLIDATED STATEMENT OF CASH FLOWS

(Dollar amounts in thousands)

(Unaudited)

See accompanying notes to the unaudited consolidated financial statements.

MIDDLEFIELD BANC CORP.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 — BASIS OF PRESENTATION

The consolidated financial statements of Middlefield Banc Corp. (“Company”) includes its two bank subsidiaries (The Middlefield Banking Company (“MB”) and Emerald Bank (“EB”)) and a non-bank asset resolution subsidiary EMORECO. All significant inter-company items have been eliminated in consolidation.

The accompanying financial statements have been prepared in accordance with U.S. generally accepted accounting principles and the instructions for Form 10-Q and Article 10 of Regulation S-X. In management’s opinion, the financial statements include all adjustments, consisting of normal recurring adjustments, that the Company considers necessary to fairly state the Company’s financial position and the results of operations and cash flows. The balance sheet at December 31, 2009, has been derived from the audited financial statements at that date but does not include all of the necessary informational disclosures and footnotes as required by U. S. generally accepted accounting principles. The accompanying financial statements should be read in conjunction with the financial statements and notes thereto included with the Company’s Form 10-K. The results of the Company’s operations for any interim period are not necessarily indicative of the results of the Company’s operations for any other interim period or for a full fiscal year.

Recent Accounting Pronouncements:

In December 2009, the FASB issued ASU 2009-16, Accounting for Transfer of Financial Assets. ASU 2009-16 provides guidance to improve the relevance, representational faithfulness, and comparability of the information that an entity provides in its financial statements about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement, if any, in transferred financial assets. ASU 2009-16 is effective for annual periods beginning after November 15, 2009 and for interim periods within those fiscal years. The adoption of this guidance did not have a material impact on the Company’s financial position or results of operation.

In January 2010, the FASB issued ASU 2010-01, Equity (Topic 505): Accounting for Distributions to Shareholders with Components of Stock and Cash — a consensus of the FASB Emerging Issues Task Force. ASU 2010-01 clarifies that the stock portion of a distribution to shareholders that allows them to elect to receive cash or stock with a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate is considered a share issuance that is reflected in EPS prospectively and is not a stock dividend. ASU 2010-01 is effective for interim and annual periods ending on or after December 15, 2009 and should be applied on a retrospective basis. The adoption of this guidance did not have a material impact on the Company’s financial position or results of operation.

In January 2010, the FASB issued ASU 2010-05, Compensation — Stock Compensation (Topic 718): Escrowed Share Arrangements and the Presumption of Compensation. ASU 2010-05 updates existing guidance to address the SEC staff’s views on overcoming the presumption that for certain shareholders escrowed share arrangements represent compensation. ASU 2010-05 is effective January 15, 2010. The adoption of this guidance did not have a material impact on the Company’s financial position or results of operation.

In January 2010, the FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. ASU 2010-06 amends Subtopic 820-10 to clarify existing disclosures, require new disclosures, and includes conforming amendments to guidance on employers’ disclosures about postretirement benefit plan assets. ASU 2010-06 is effective for interim and annual periods beginning after December 15, 2009, except for disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. The adoption of this guidance is not expected to have a significant impact on the Company’s financial statements.

In February 2010, the FASB issued ASU 2010-08, Technical Corrections to Various Topics. ASU 2010-08 clarifies guidance on embedded derivatives and hedging. ASU 2010-08 is effective for interim and annual periods beginning after December 15, 2009. The adoption of this guidance did not have a material impact on the Company’s financial position or results of operation.

In March 2010, the FASB issued ASU 2010-11, Derivatives and Hedging. ASU 2010-11 provides clarification and related additional examples to improve financial reporting by resolving potential ambiguity about the breadth of the embedded credit derivative scope exception in ASC 815-15-15-8. ASU 2010-11 is effective at the beginning of the first fiscal quarter beginning after June 15, 2010. The adoption of this guidance is not expected to have a significant impact on the Company’s financial statements.

In April 2010, the FASB issued ASU 2010-18, Receivables (Topic 310): Effect of a Loan Modification When the Loan is a Part of a Pool That is Accounted for as a Single Asset — a consensus of the FASB Emerging Issues Task Force. ASU 2010-18 clarifies the treatment for a modified loan that was acquired as part of a pool of assets. Refinancing or restructuring the loan does not make it eligible for removal from the pool, the FASB said. The amendment will be effective for loans that are part of an asset pool and are modified during financial reporting periods that end July 15, 2010 or later and is not expected to have a significant impact on the Company’s financial statements.

In July 2010, FASB issued ASU No. 2010-20, Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. ASU 2010-20 is intended to provide additional information to assist financial statement users in assessing an entity’s credit risk exposures and evaluating the adequacy of its allowance for credit losses. The disclosures as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. The disclosures about activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010. The amendments in ASU 2010-20 encourage, but do not require, comparative disclosures for earlier reporting periods that ended before initial adoption. However, an entity should provide comparative disclosures for those reporting periods ending after initial adoption. The Company is currently evaluating the impact the adoption of this guidance will have on the Company’s financial position or results of operations.

In August, 2010, the FASB issued ASU 2010-21, Accounting for Technical Amendments to Various SEC Rules and Schedules. This ASU amends various SEC paragraphs pursuant to the issuance of Release No. 33-9026: Technical Amendments to Rules, Forms, Schedules, and Codification of Financial Reporting Policies and is not expected to have a significant impact on the Company’s financial statements.

In August, 2010, the FASB issued ASU 2010-22, Technical Corrections to SEC Paragraphs — An announcement made by the staff of the U.S. Securities and Exchange Commission. This ASU amends various SEC paragraphs based on external comments received and the issuance of SAB 112, which amends or rescinds portions of certain SAB topics and is not expected to have a significant impact on the Company’s financial statements.

NOTE 2 — STOCK-BASED COMPENSATION

The Company has no unrecognized stock-based compensation costs or unvested stock options outstanding as of September 30, 2010.

Stock option activity during the nine months ended September 30, 2010 and 2009 is as follows:

NOTE 3 — EARNINGS PER SHARE

The Company provides dual presentation of Basic and Diluted earnings per share. Basic earnings per share utilizes net income as reported as the numerator and the actual average shares outstanding as the denominator. Diluted earnings per share includes any dilutive effects of options, warrants, and convertible securities.

There are no convertible securities that would affect the numerator in calculating basic and diluted earnings per share; therefore, net income as presented on the Consolidated Statement of Income (Unaudited) will be used as the numerator. The following tables set forth the composition of the weighted-average common shares (denominator) used in the basic and diluted earnings per share computation.

Options to purchase 99,219 shares of common stock at prices ranging from $17.90 to $40.24 were outstanding during the three months ended September 30, 2010 and options to purchase 89,077 shares of common stock at prices ranging from $22.33 to $40.24 were outstanding during the nine months ended September 30, 2010 but were not included in the computation of diluted earnings per share as they were anti-dilutive due to the strike price being greater than the market price as of September 30, 2010. Options to purchase 92,618 shares of common stock at prices ranging from $22.33 to $40.24 were outstanding during the three and nine months ended September 30, 2009 but were not included in the computation of diluted earnings per share.

NOTE 4 — COMPREHENSIVE INCOME

The components of comprehensive income consist exclusively of unrealized gains and losses on available for sale securities. For the nine months ended September 30, 2010, this activity is shown under the heading Comprehensive Income as presented in the Consolidated Statement of Changes in Stockholders’ Equity (Unaudited).

The following shows the components and activity of comprehensive income during the periods ended September 30, 2010 and 2009 (net of the income tax effect):

NOTE 5 — FAIR VALUE MEASUREMENTS

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for an asset or liability in an orderly transaction between market participants at the measurement date. GAAP established a fair value hierarchy that prioritizes the use of inputs used in valuation methodologies into the following three levels:

The following tables present the assets and liabilities measured on a recurring basis on the consolidated balance sheet at their fair value as of September 30, 2010 and December 31, 2009 by level within the fair value hierarchy. Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

Financial instruments are considered Level III when their values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable. In addition to these unobservable inputs, the valuation models for Level III financial instruments typically also rely on a number of inputs that are readily observable either directly or indirectly. Level III financial instruments also include those for which the determination of fair value requires significant management judgment or estimation. The Company has no securities considered to be Level III as of September 30, 2010.

The following tables present the assets measured on a nonrecurring basis on the consolidated balance sheet at their fair value as of September 30, 2010 and December 31, 2009, by level within the fair value hierarchy. Impaired loans that are collateral dependent are written down to fair value through the establishment of specific reserves. Techniques used to value the collateral that secure the impaired loan include: quoted market prices for identical assets classified as Level I inputs; observable inputs, employed by certified appraisers, for similar assets classified as Level II inputs. In cases where valuation techniques included inputs that are unobservable and are based on estimates and assumptions developed by management based on the best information available under each circumstance, the asset valuation is classified as Level III inputs.

The estimated fair value of the Company’s financial instruments is as follows:

Financial instruments are defined as cash, evidence of ownership interest in an entity, or a contract which creates an obligation or right to receive or deliver cash or another financial instrument from/to a second entity on potentially favorable or unfavorable terms.

Fair value is defined as the amount at which a financial instrument could be exchanged in a current transaction between willing parties other than in a forced liquidation sale. If a quoted market price is available for a financial instrument, the estimated fair value would be calculated based upon the market price per trading unit of the instrument.

If no readily available market exists, the fair value estimates for financial instruments should be based upon management’s judgment regarding current economic conditions, interest rate risk, expected cash flows, future estimated losses, and other factors as determined through various option pricing formulas or simulation modeling. Since many of these assumptions result from judgments made by management based upon estimates which are inherently uncertain, the resulting estimated fair values may not be indicative of the amount realizable in the sale of a particular financial instrument. In addition, changes in assumptions on which the estimated fair values are based may have a significant impact on the resulting estimated fair values.

As certain assets such as deferred tax assets and premises and equipment are not considered financial instruments, the estimated fair value of financial instruments would not represent the full value of the Company.

The Company employed simulation modeling in determining the estimated fair value of financial instruments for which quoted market prices were not available based upon the following assumptions:

The fair value is equal to the current carrying value.

The fair value is equal to the cash surrender value of the life insurance policies.

The fair value of investment securities is equal to the available quoted market price. If no quoted market price is available, fair value is estimated using the quoted market price for similar securities. Fair value for certain private-label collateralized mortgage obligations was determined utilizing discounted cash flow models, due to the absence of a current market to provide reliable market quotes for the instruments.

The fair value is estimated by discounting future cash flows using current market inputs at which loans with similar terms and qualities would be made to borrowers of similar credit quality. Where quoted market prices were available, primarily for certain residential mortgage loans, such market rates were utilized as estimates for fair value.

The fair values of certificates of deposit and other borrowed funds are based on the discounted value of contractual cash flows. The discount rates are estimated using rates currently offered for similar instruments with similar remaining maturities. Demand, savings, and money market deposits are valued at the amount payable on demand as of year-end.

These financial instruments are generally not subject to sale, and estimated fair values are not readily available. The carrying value represented by the net deferred fee arising from the unrecognized commitment or letter of credit, and the fair value, determined by discounting the remaining contractual fee over the term of the commitment using fees currently charged to enter into similar agreements with similar credit risk, are not considered material for disclosure.

NOTE 6 — INVESTMENT SECURITIES AVAILABLE FOR SALE

The amortized cost and fair values of securities available for sale are as follows:

The amortized cost and fair value of debt securities at September 30, 2010, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

Proceeds from sales of investment securities available for sale were $5.8 million and $0 during the nine-months ended September 30, 2010 and September 30, 2009, respectively. Gross gains realized were $45,000 and $0, respectively, during the nine-months ended September 30, 2010 and September 30, 2009.

Proceeds from sales of investment securities available for sale were $715,000 and $0 during the three-months ended September 30, 2010 and September 30, 2009, respectively. Gross gains realized were $18,000 and $0 during the three-months ended September 30, 2010 and September 30, 2009, respectively.

The following table shows the Company’s gross unrealized losses and fair value, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position.

There were 16 and 103 securities that were considered temporarily impaired at September 30, 2010 and December 31, 2009.

On a quarterly basis, the Company performs an assessment to determine whether there have been any events or economic circumstances indicating that a security with an unrealized loss has suffered other-than-temporary impairment (OTTI) pursuant to FASB ASC Topic 320 “Investments — Debt and Equity Securities. A debt security is considered impaired if the fair value is less than its amortized cost basis at the reporting date. The accounting literature requires the Company to assess whether the unrealized loss is other-than-temporary. Prior to the adoption of FSP FAS 115-2 which was subsequently incorporated into FASB ASC Topic 320 “Investments — Debt and Equity Securities, unrealized losses that were determined to be temporary were recorded, net of tax, in other comprehensive income for available for sale securities, whereas unrealized losses related to held-to-maturity securities determined to be temporary were not recognized. Regardless of whether the security was classified as available for sale or held to maturity, unrealized losses that were determined to be other-than-temporary were recorded to earnings. An unrealized loss was considered other-than-temporary if (i) it was probable that the holder would not collect all amounts due according to the contractual terms of the debt security, or (ii) the fair value was below the amortized cost of the debt security for a prolonged period of time and the Company did not have the positive intent and ability to hold the security until recovery or maturity.

The Company adopted this ASC during the second quarter of 2009 which amended the OTTI model for debt securities. Under the new guidance, OTTI losses must be recognized in earnings if an investor has the intent to sell the debt security or it is more likely than not that it will be required to sell the debt security before recovery of its amortized cost basis. However, even if a Company does not expect to sell a debt security, it must evaluate expected cash flows to be received and determine if a credit loss has occurred.

Under this ASC, an unrealized loss is generally deemed to be other-than-temporary and a credit loss is deemed to exist if the present value of the expected future cash flows is less than the amortized cost basis of the debt security. As a result the credit loss component of an OTTI is recorded as a component of investment securities gains (losses) in the accompanying consolidated statement of income, while the remaining portion of the impairment loss is recognized in other comprehensive income, provided the Company does not intend to sell the underlying debt security and it is “more likely than not” that the company will not have to sell the debt security prior to recovery.

Debt securities issued by U.S. government agencies, U.S. government-sponsored enterprises, and state and political subdivisions accounted for more than 90% of the total available-for-sale portfolio as of September 30, 2010 and no credit losses are expected, given the explicit and implicit guarantees provided by the U.S. federal government and the lack of significant unrealized loss positions within the obligations of state and political subdivisions security portfolio. The Company’s assessment was concentrated mainly on private-label collateralized mortgage obligations of approximately $17.8 million for which the Company evaluates credit losses on a quarterly basis. Gross unrealized gain and loss positions related to these private-label collateralized mortgage obligations amounted to $1.3 million and 441,000 respectively. The Company considered the following factors in determining whether a credit loss exists and the period over which the debt security is expected to recover:

For the nine months ended September 30, 2010, there were no available-for-sale debt securities with an unrealized loss that has suffered OTTI.

NOTE 7 — SUBSEQUENT EVENTS

None

The following discussion and analysis provides further detail to the financial condition and results of operations of the Company. The MD&A should be read in conjunction with the notes and financial statements presented in this report.

This release contains forward-looking statements relating to present or future trends or factors affecting the banking industry, and specifically the financial condition and results of operations, including without limitation, statements relating to the earnings outlook of the Company, as well as its operations, markets and products. Actual results could differ materially from those indicated. Among the factors that could cause results to differ materially are changes in interest rates, continued weakening of the economy, which could materially impact credit quality and the opportunity to generate loans, competitive pressures, changes in accounting, tax or regulatory requirements and those risk factors detailed in the Company’s periodic reports and registration statements filed with the Securities and Exchange Commission. The Company undertakes no obligation to release revisions to these forward-looking statements or reflect events or circumstances after the date of this release.

The Company’s critical accounting estimates involving the more significant judgments and assumptions used in the preparation of the consolidated financial statements as of September 30, 2010, have remained unchanged from December 31, 2009.

General. The Company’s total assets increased $78.4 million or 14.0% from December 31, 2009 to September 30, 2010 to a balance of $637.1 million. Loans receivable, cash and cash equivalents and investment securities increased $11.6 million, $10.3 million and $58.4 million, respectively. The increase in total assets reflects a corresponding increase in total liabilities of $73.4 million or 14.1% and an increase in stockholders’ equity of $5.0 million or 13.6%. The increase in total liabilities was the result of deposit growth of $76.4 million. The increase in stockholders’ equity was the result of increases in common stock, retained earnings and accumulated other comprehensive income of $396,000, $598,000 and $4.0 million, respectively.

Cash on hand and due from banks. Cash and due from banks, Federal funds sold and interest-bearing deposits in other institutions represent cash and cash equivalents. Cash and cash equivalents increased $10.3 million or 25.1% to $51.5 million at September 30, 2010 from $41.2 million at December 31, 2009. Deposits from customers into savings and checking accounts, loan and security repayments and proceeds from borrowed funds typically increase these accounts. Decreases result from customer withdrawals, new loan originations, security purchases and repayments of borrowed funds.

Investment securities. Investment securities available for sale ended the September 30, 2010 nine month period at $195.1 million an increase of $58.4 million or 42.7% from $136.7 million at December 31, 2009. During this period the Company recorded purchases of available for sale securities of $89.9 million, consisting of purchases of mortgage-backed securities, U.S. government agencies and municipal securities. Offsetting the purchases of securities were repayments and maturities of securities of $31.9 million and sales of securities totaling $5.8 million during the nine months ended September 30, 2010. In addition, the securities portfolio increased approximately $6.9 million due to an increase in the market value. These fair value adjustments represent temporary fluctuations resulting from changes in market rates in relation to average yields in the available for sale portfolio. If securities are held to their respective maturity dates, no fair value gain or loss will be realized.

Loans receivable. The loans receivable category consists primarily of single family mortgage loans used to purchase or refinance personal residences located within the Company’s market area and commercial real estate loans used to finance properties that are used in the borrowers’ businesses or to finance investor-owned rental properties, and to a lesser extent commercial and consumer loans. Net loans receivable increased $10.5 million or 3.0% to $359.2 million as of September 30, 2010 from $348.7 million at December 31, 2009. Included in this amount was an increase in the commercial real estate loan portfolio of $3.0 million or 3.8% and real estate construction loans of $6.0 million or 77.1% during the nine months ended September 30, 2010. The Company’s lending philosophy is to focus on the commercial loans and to attempt to grow the portfolio. To attract and build the commercial loan portfolio, the Company has taken a proactive approach in contacting new and current clients to ensure that the Company is servicing its client’s needs. These lending relationships generally offer more attractive returns than residential loans and also offer opportunities for attracting larger balance deposit relationships. However, the shift in loan portfolio mix from residential real estate to commercial oriented loans may increase credit risk.

Allowance for Loan Losses and Asset Quality. For the first nine months of 2010, because of continued high unemployment, depressed real estate values for both residential and commercial properties and sustained economic weakness in the Company’s market area, management believes that non-performing assets may increase further and therefore believes it is prudent to continue funding the allowance for loan losses at higher than historical levels.

The Company increased the allowance for loan losses to $6.0 million, or 1.63% of total loans, at September 30, 2010, from $4.9 million, or 1.40%, at December 31, 2009. The increase in the allowance for loan losses was necessitated by loan downgrades and an increase to specific reserves for impaired commercial real estate loans, coupled with the impact of charge-offs remaining at an elevated level. Third quarter 2010 net loan charge-offs totaled $1.1 million, or 0.30% of average loans, compared to $135,000, or 0.04%, and $592,000, or 0.17%, for the second quarter of 2010 and third quarter of 2009, respectively. Year to date net loan charge-offs totaled $1.3 million compared to $895,000 for the same period in 2009. To maintain the adequacy of the allowance for loan losses, the Company recorded a third quarter provision for loan losses of $1.2 million, versus $1.3 million for third quarter of 2009. For the nine month period ended September 30, 2010, the Company recorded a provision for loan losses of $2.4 million compared to $1.8 million for the comparable period in 2009.

Management analyzes the adequacy of the allowance for loan losses regularly through reviews of the performance of the loan portfolio considering economic conditions, changes in interest rates and the effect of such changes on real estate values and changes in the amount and composition of the loan portfolio. The allowance for loan losses is a material estimate that is particularly susceptible to significant changes in the near term. Such evaluation, which includes a review of all loans for which full collectability may not be reasonably assured, considers among other matters, historical loan loss experience, the estimated fair value of the underlying collateral, economic conditions, current interest rates, trends in the borrower’s industry and other factors that management believes warrant recognition in providing for an appropriate allowance for loan losses. Future additions to the allowance for loan losses will be dependent on these factors. Additionally, the Company utilizes an outside party to conduct an independent review of commercial and commercial real estate loans. The Company uses the results of this review to help determine the effectiveness of the existing policies and procedures, and to provide an independent assessment of the allowance for loan losses allocated to these types of loans. Management believes that the allowance for loan losses was appropriately stated at September 30, 2010. Based on the variables involved and the fact that management must make judgments about outcomes that are uncertain, the determination of the allowance for loan losses is considered a critical accounting policy.

Non-performing assets. Non-performing assets includes non-accrual loans, troubled debt restructurings (TDR), loans 90 days or more past due, assets purchased by EMORECO from EB in November 2009, other real estate, and repossessed assets. A loan is classified as non-accrual when, a loan becomes 90 days past due in principal and interest or in the opinion of management, there are serious doubts about the collectability of interest and principal. At that time the accrual of interest is discontinued, future income is recognized only when cash is received and is not applied to the principal. TDRs are those loans which the Company, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to the borrower that the Company would not otherwise consider. The Company had six TDR’s with a combined principal balance of $603,000 as of September 30, 2010. Non-performing loans amounted to $21.0 million or 5.8% and $16.3 million or 4.6% of total loans at September 30, 2010 and December 31, 2009, respectively. The increase in nonperforming loans has occurred primarily in the commercial loan portfolio and in one-to-four family real estate loans. Non-performing loans secured by real estate totaled $16.6 million as of September 30, 2010, up $3.7 million from $12.9 million at December 31, 2009. The depressed state of the economy and continued levels of high unemployment have contributed to this trend, as well as the decline in the housing market across our geographic footprint that reflected declining home prices and increasing inventories of houses for sale. Real estate owned is written down to fair value at its initial recording and continually monitored.

Nonperforming Assets and Allowance for Loan Losses. The following table indicates asset quality data over the past five quarters.

Asset Quality History

A major factor in determining the appropriateness of the allowance for loan losses is the type of collateral which secures the loans. Of the total nonperforming loans at September 30, 2010, 79.3% were secured by real estate. Although this does not insure against all losses, the real estate provides substantial recovery, even in a distressed-sale and declining-value environment. In response to the poor economic conditions which have eroded the performance of the Company’s loan portfolio, additional resources have been allocated to the loan workout process. The Company’s objective is to work with the borrower to minimize the burden of the debt service and to minimize the future loss exposure to the Company.

Deposits. The Company considers various sources when evaluating funding needs, including but not limited to deposits, which are a significant source of funds totaling $563.5 million or 95.0% of the Company’s total funding sources at September 30, 2010. Total deposits increased $76.4 million or 15.7% to $563.5 million at September 30, 2010 from $487.1 million at December 31, 2009. The increase in deposits is primarily related to the growth of savings deposits, money market and noninterest-bearing accounts of $34.3 million or 32.0%, $14.6 million or 25.9% and $11.1 million or 24.9%, respectively.

Borrowed funds. The Company utilizes short and long-term borrowings as another source of funding for asset growth and liquidity needs. These borrowings primarily include FHLB advances, junior subordinated debt, short-term borrowings from other banks and repurchase agreements. Short-term borrowings increased $1.0 million or 14.2% to $7.8 million at September 30, 2010 from $6.8 million at December 31, 2009. For the nine months ended September 30, 2010, other borrowings declined $3.8 million which represents advances from the Federal Home Loan Bank of Cincinnati. The decline in FHLB advances was the result of scheduled principal payments.

Stockholders’ equity. Stockholders’ equity increased $5.0 million or 13.6% to $41.7 million at September 30, 2010 from $36.7 million at December 31, 2009. This increase was the result of increases in common stock, retained earnings and accumulated other comprehensive income of $396,000, $598,000 and $4.0 million, respectively. The increase of accumulated other comprehensive income was the result of an increase in the fair value of the Company’s securities available for sale portfolio. The increase in common stock was the result of issuing 19,699 shares through the Company’s dividend reinvestment and purchase plan at an average price of $20.05 since December 31, 2009.

General. Net income for the third quarter of 2010 of $463,000 represented a $250,000, or 117.4% increase from the $213,000 earned during the third quarter of 2009. Net income for the nine months ended September 30, 2009, totaled $1.8 million a $546,000, or 42.8% increase from the $1.3 million earned during the same period in 2009. Diluted earnings per share for the third quarter of 2010 were $0.29 compared to $0.14 for the same period in 2009. Year-to-date diluted earnings per share were $1.16 in 2010 compared to $0.83 in 2009.

The company’s annualized return on average assets (ROA) and return on average equity (ROE) for the third quarter of 2010 were 0.29% and 4.54%, respectively, compared with 0.17% and 2.34% for the third quarter of 2009. For the first nine months of 2010, the company’s annualized ROA was 0.41% compared to 0.35% in 2009, while the ROE was 6.31% compared to 4.72% for the same period of 2009.

The Company’s earnings for the quarter and the year were positively impacted by an increase in loan and investment interest income combined with a decrease in interest expense. This was partially offset by increases in the provision for loan losses and non-interest expense.

Net interest income. Net interest income, the primary source of revenue for the Company, is determined by the Company’s interest rate spread, which is defined as the difference between income on earning assets and the cost of funds supporting those assets, and the relative amounts of interest-earning assets and interest-bearing liabilities. Management periodically adjusts the mix of assets and liabilities, as well as the rates earned or paid on those assets and liabilities in order to manage and improve net interest income. The level of interest rates and changes in the amount and composition of interest-earning assets and liabilities affect the Company’s net interest income. Historically from an interest rate risk perspective, it has been management’s goal to maintain steady net interest income growth while managing the risks associated with interest rate fluctuations by pricing and growth strategies.

Net interest income totaled $4.6 million for the third quarter of 2010, an increase of 21.9% from the $3.8 million reported for the comparable period of 2009. The net interest margin of 3.39% for the third quarter of 2010 declined slightly from the 3.46% reported for the same quarter of 2009. The decrease in the net interest margin is primarily attributable to the lack of quality lending opportunities which forces excess funds into lower yielding short-term investments.

Net interest income increased $2.9 million, or 27.8%, to $13.3 million for the nine months ended September 30, 2010 compared to the same period in the prior year. The year to date net interest margin was positively impacted by increases in investment securities interest of $1.6 million and loan interest of $641,000 coupled with the reduced cost of interest-bearing liabilities by $540,000 when compared to the same period in 2009. The net interest margin of 3.39% for the first three quarters of 2010 was up from the 3.31% reported for the same period of 2009. The increasing margin for the first nine months of the year is primarily attributable to deposit growth in products which generally carry lower interest costs than other deposit alternatives allowing for increased loan underwriting and the purchase of investment securities that maximize the Company’s interest income.

Interest income. Interest income increased $720,000, or 10.8%, for the three months ended September 30, 2010, compared to the same period in the prior year. This increase was partly offset by a 66 basis point decline on the yield of average interest-earning assets. Interest income increased $2.3 million, or 12.2%, for the nine months ended September 30, 2010, compared to the same period in the prior year. The year-to-date increase can be attributed to the growth of average interest-earning assets of $114.6 million. A decrease of 59 basis points offset some of the gains from the increased levels of interest-earning assets.

Interest earned on loans receivable increased $149,000, or 2.9%, for the three months ended September 30, 2010, compared to the same period in the prior year. This increase was attributable to a $24.2 million or a 7.1% increase in the average balance of loans receivable from September 30, 2009. This increase was partially offset by a decline in the yield on the total loan portfolio of 24 basis points to 5.80% for the three months ended September 30, 2010 from 6.04% for the same period in the prior year.

For the nine months ended September 30, 2010, interest earned on loans receivable increased $641,000, or 4.3%, compared to the same period in the prior year. This increase was attributable to an increase in the average balance of loans outstanding of $29.9 million, or 9.1%, to $360.8 million for the nine months ended September 30, 2010 compared to $330.8 million for the same period in the prior year. This increase was partially offset by a decline in the yield on the total loan portfolio of 26 basis points to 5.83% for the nine months ended September 30, 2010 from 6.09% for the same period in the prior year.

Interest earned on securities increased $541,000, or 37.3%, for the three months ended September 30, 2010, compared to the same period in the prior year. This increase was primarily the result of an increase in the average balance of the securities portfolio of $76.6 million, or 71.9%, to $183.2 million at September 30, 2010 from $106.6 million for the same period in the prior year. The increase of interest earned on investment securities was partially offset by a decrease in the yield on the average investments to 5.10% for the three months ended September 30, 2010 from 6.31% for the same period in the prior year.

Interest earned on securities increased $1.6 million, or 39.8%, for the nine months ended September 30, 2010, compared to the same period in the prior year. This increase was primarily the result of an increase in the average balance of the securities portfolio of $64.4 million, or 61.3%, to $169.5 million at September 30, 2010 from $105.1 million for the same period in the prior year. The increase of interest earned on investment securities was partially offset by a decrease of 81 basis points to 5.34% for the nine months ended September 30, 2010 from 6.15% for the same period in the prior year.

Interest expense. Interest expense decreased $110,000, or 3.8%, for the three months ended September 30, 2010, compared to the same period in the prior year. The decline in interest expense can be attributed to decreases in interest incurred on deposits of $110,000. This reduction in interest cost was mainly due to the rate paid on interest-bearing liabilities which declined by 66 basis points when comparing the two quarters.

Interest expense decreased $540,000, or 6.1%, for the nine months ended September 30, 2010, compared to the same period in the prior year. The year-to-date decline is the result of lower rates paid on interest-bearing liabilities. Interest incurred on deposit decreased $527,000 and borrowings declined $13,000 when compared to the first three quarters of 2009. These decreases were partially offset by increased deposits.

Interest incurred on deposits, the largest component of the Company’s interest-bearing liabilities, decreased $110,000, or 4.4%, for the three months ended September 30, 2010, compared to the same period in the prior year. Interest expense was positively affected by a reduction in the cost of interest-bearing deposits to 1.91% from 2.57% for the quarters ended September 30, 2010 and 2009, respectively. The reduced cost was partially offset by the average balance of interest-bearing deposits which increased by $108.5 million, or 28.0%, to $495.5 million for the three months ended September 30, 2010, compared to $387.0 million for the same period in the prior year. The Company diligently monitors the interest rates on its products as well as the rates being offered by its competition and utilizing rate surveys to keep its total interest expense costs down.

For the nine months ended September 30, 2010 interest incurred on deposits declined $527,000, or 6.8%, compared to the same period in the prior year. This was primarily attributable to a decrease in interest expense which was positively affected by a reduction in the cost of interest-bearing deposits to 2.02% from 2.82% for the nine months September 30, 2010 and 2009, respectively. The reduction in interest costs was partially offset by an increase in the average balance of interest-bearing deposits of $110.7 million, or 30.0%, to $479.1 million for the nine months ended September 30, 2010, compared to $368.4 million for the same period in the prior year.

Interest incurred on borrowed funds totaled $361,000 for the three months ended September 30, 2010, unchanged when compared to the same period in the prior year. The interest rate paid on borrowings declined to 4.65 % from 4.67% for the quarters ended September 30, 2010 and 2009, respectively. Offsetting the reduction in the cost of these funds was an increase in the average balance of borrowed funds of $156,000, or 0.5%, to $30.8 million for the three months ended September 30, 2010, compared to $30.6 million for the same period in the prior year.

For the nine months ended September 30, 2010, interest incurred on borrowed funds decreased by $13,000, or 1.1%, compared to the same period in the prior year. This decline was due to a decrease in the average balance of borrowing. The average balance of borrowed funds declined by $499,000, or 1.6%, to $31.8 million for the nine months ended September 30, 2010, compared to $32.3 million for the nine months ended September 30, 2009.

Provision for loan losses. The provision for loan losses represents the charge to income necessary to adjust the allowance for loan losses to an amount that represents management’s assessment of the estimated probable incurred credit losses inherent in the loan portfolio. Each quarter management performs a review of estimated probable credit losses in the loan portfolio. Based on this review, a provision for loan losses of $1.2 million was recorded for the quarter ended September 30, 2010 compared to $1.3 million for the quarter ended September 30, 2009. The year-to-date provision for loan losses increased $595,000 or 33.8% compared to the first three quarters of 2009. The provision for loan losses was higher year-to-date due to increases in net charge-offs, increases in nonperforming and delinquent loans and the continued distressed state of the economy. Nonperforming loans were $21.0 million, or 5.8% of total loans at September 30, 2010 compared with $14.4 million, or 4.2% at September 30, 2009. Net charge-offs were $1.1 million for the quarter ended September 30, 2010 and $1.3 million year-to-date compared with $592,000 and $895,000 for the same periods ended September 30, 2009. Total loans were $365.2 million at September 30, 2010 compared with $345.9 million at September 30, 2009.

Non-interest income. Non-interest income increased $5,000, or 0.7%, and $39,000, or 2.0%, for the three and nine months ended September 30, 2010, respectively, compared to the same periods of 2009. This increase is primarily a result of rental income on other real estate owned of $14,000 and $42,000 for the three and nine month periods ended September 30, 2010, respectively. Additionally the Company recognized a net gain on the sale of investment securities of $18,000 for the quarter and $45,000 year-to-date.

Non-interest expense. Non-interest expense of $3.7 million for the third quarter of 2010 was 23.1%, or $703,000, higher than the third quarter of 2009. The increase in salaries and employee benefits of $147,000 is primarily attributable to the growth of the Company and a 10% increase in employee health insurance premiums. Losses on the sale of other real estate owned totaled $536,000, an increase of 318.8% when compared to the third quarter of 2009. The entire amount was recognized by the Company’s non-bank asset resolution subsidiary EMORECO. Other expenses grew $126,000 over the 2009 quarter to $682,000. Expenses related to delinquent loans, foreclosures and other real estate owned totaled $213,000 or 169.1% of the increase. EMORECO had $34,000 in loan and other real estate owned expenses as of the quarter ended September 30, 2010.

The year-to-date non-interest expense total of $11.1 million was 19.2%, or $1.8 million, higher than the same period of 2009. The increase in salaries and employee benefits of $463,000 is attributable to the growth of the Company and a 10% increase in employee health insurance premiums. The Company upgraded its computer network in conjunction with changing data processors in April 2010. These improvements have resulted in an increase of $133,000 in equipment expense when compared to September 30, 2009. The FDIC fees increased $60,000 for the nine months ended September 30, 2010 when compared to the same period in the prior year. Losses on the sale of other real estate owned totaled $750,000, an increase of $567,000 or 309.8% over the comparable period in 2009. This increase reflects the Company’s active pursuit of sales opportunities of other real estate owned properties and conservative approach in valuing these properties. Included in this total is the Company’s non-bank asset resolution subsidiary EMORECO which had $693,000 in losses on the sale of other real estate owned for the nine months ended September 30, 2010. Based on the number of non-performing loans management believes that the higher than historic losses on other real estate owned will continue in the fourth quarter of 2010 and into 2011. Other expenses grew $578,000 or 34.0%, over the first three quarters of 2009. Included in this amount are expenses related to delinquent loans, foreclosures and other real estate owned which totaled $443,000 or 76.6% of the increase. EMORECO had $319,000 in loan and other real estate owned expenses for the nine months ended September 30, 2010.

Provision for income taxes. The Company recognized $60,000 in income tax benefit, which reflected an effective tax rate of (3.4%) for the nine months, ended September 30, 2010, as compared to an income tax benefit of $55,000 with an effective tax rate of (4.5%) for the respective 2009 period. The increase in income tax benefit for the nine month period was due to an increase in the percentage of tax-exempt income to total income before taxes. For the nine months ending September 30, 2010 non-taxable income from obligations of states and political subdivisions totaled $1.9 million or a 41.2% increase over the comparable prior year period. This benefit was offset by a 44.3% increase in pre-tax income.

Average Balance Sheet and Yield/Rate Analysis. The following tables sets forth, for the periods indicated, information concerning the total dollar amounts of interest income from interest-earning assets and the resultant average yields, the total dollar amounts of interest expense on interest-bearing liabilities and the resultant average costs, net interest income, interest rate spread and the net interest margin earned on average interest-earning assets. For purposes of this table, average balances are calculated using monthly averages and the average loan balances include non-accrual loans and exclude the allowance for loan losses, and interest income includes accretion of net deferred loan fees. Interest and yields on tax-exempt securities (tax-exempt for federal income tax purposes) are shown on a fully tax equivalent basis utilizing a federal tax rate of 34%. Yields and rates have been calculated on an annualized basis utilizing monthly interest amounts.