Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
x Quarterly Report pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934
for the Quarterly Period Ended June 30, 2012.
o Transition report pursuant to Section 13 or 15 (d) of the Exchange Act
for theTransition Period from to .
No. 0-17077
(Commission File Number)
PENNS WOODS BANCORP, INC.
(Exact name of Registrant as specified in its charter)
PENNSYLVANIA
23-2226454
(State or other jurisdiction of
(I.R.S. Employer
incorporation or organization)
Identification No.)
300 Market Street, P.O. Box 967 Williamsport, Pennsylvania
17703-0967
(Address of principal executive offices)
(Zip Code)
(570) 322-1111
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 (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES x NO o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o
Accelerated filer x
Non-accelerated filer o
Small reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES o NO x
On August 2, 2011 there were 3,837,908 shares of the Registrant’s common stock outstanding.
INDEX TO QUARTERLY REPORT ON FORM 10-Q
Page
Number
Part I
Financial Information
Item 1.
Financial Statements
Consolidated Balance Sheet (Unaudited) as of June 30, 2012 and December 31, 2011
3
Consolidated Statement of Income (Unaudited) for the Three and Six Months Ended June 30, 2012 and 2011
4
Consolidated Statement of Comprehensive Income (Unaudited) for the Three and Six Months Ended June 30, 2012 and 2011
5
Consolidated Statement of Changes in Shareholders’ Equity (Unaudited) for the Six Months Ended June 30, 2012 and 2011
Consolidated Statement of Cash Flows (Unaudited) for the Six Months Ended June 30, 2012 and 2011
6
Notes to Consolidated Financial Statements (Unaudited)
7
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
22
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
33
Item 4.
Controls and Procedures
Part II
Other Information
Legal Proceedings
34
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Mine Safety Disclosures
Item 5.
Item 6.
Exhibits
Signatures
35
Exhibit Index and Exhibits
36
2
Part I. FINANCIAL INFORMATION
Item 1. Financial Statements
CONSOLIDATED BALANCE SHEET
(UNAUDITED)
June 30,
December 31,
(In Thousands, Except Share Data)
2012
2011
ASSETS:
Noninterest-bearing balances
$
16,052
13,829
Interest-bearing deposits in other financial institutions
21
56
Total cash and cash equivalents
16,073
13,885
Investment securities, available for sale, at fair value
295,121
270,097
Investment securities, held to maturity, (fair value of $0 and $55)
—
54
Loans held for sale
3,496
3,787
Loans
465,342
435,959
Allowance for loan losses
(7,438
)
(7,154
Loans, net
457,904
428,805
Premises and equipment, net
8,229
7,707
Accrued interest receivable
4,071
3,905
Bank-owned life insurance
16,101
16,065
Investment in limited partnerships
3,213
3,544
Goodwill
3,032
Deferred tax asset
5,960
7,991
Other assets
5,233
5,081
TOTAL ASSETS
818,433
763,953
LIABILITIES:
Interest-bearing deposits
523,405
470,310
Noninterest-bearing deposits
117,762
111,354
Total deposits
641,167
581,664
Short-term borrowings
17,855
29,598
Long-term borrowings, Federal Home Loan Bank (FHLB)
61,278
Accrued interest payable
490
536
Other liabilities
9,532
10,417
TOTAL LIABILITIES
730,322
683,493
SHAREHOLDERS’ EQUITY:
Preferred stock, no par value, 3,000,000 shares authorized; no shares issued
Common stock, par value $8.33, 15,000,000 shares authorized; 4,018,386 and 4,017,677 shares issued
33,486
33,480
Additional paid-in capital
18,136
18,115
Retained earnings
39,874
36,394
Accumulated other comprehensive gain (loss):
Net unrealized gain on available for sale securities
7,058
2,914
Defined benefit plan
(4,133
Treasury stock at cost, 180,596 shares
(6,310
TOTAL SHAREHOLDERS’ EQUITY
88,111
80,460
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
See accompanying notes to the unaudited consolidated financial statements.
CONSOLIDATED STATEMENT OF INCOME
Three Months Ended
Six Months Ended
(In Thousands, Except Per Share Data)
INTEREST AND DIVIDEND INCOME:
Loans, including fees
6,294
6,144
12,608
12,432
Investment securities:
Taxable
1,517
1,411
2,991
2,786
Tax-exempt
1,383
1,272
2,788
2,539
Dividend and other interest income
86
57
178
109
TOTAL INTEREST AND DIVIDEND INCOME
9,280
8,884
18,565
17,866
INTEREST EXPENSE:
Deposits
934
1,182
1,895
2,376
28
42
62
99
Long-term borrowings, FHLB
620
742
1,240
1,476
TOTAL INTEREST EXPENSE
1,582
1,966
3,197
3,951
NET INTEREST INCOME
7,698
6,918
15,368
13,915
PROVISION FOR LOAN LOSSES
600
1,200
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES
7,098
6,318
14,168
12,715
NON-INTEREST INCOME:
Service charges
458
527
905
1,030
Securities gains, net
170
9
759
134
Earnings on bank-owned life insurance
133
139
401
313
Gain on sale of loans
343
242
526
491
Insurance commissions
316
180
758
389
Brokerage commissions
247
281
459
556
Other
614
495
1,236
TOTAL NON-INTEREST INCOME
2,281
1,873
5,044
3,818
NON-INTEREST EXPENSE:
Salaries and employee benefits
2,850
2,475
5,867
5,107
Occupancy, net
318
301
646
649
Furniture and equipment
357
349
703
657
Pennsylvania shares tax
167
172
336
344
Amortization of investment in limited partnerships
166
165
331
Federal Deposit Insurance Corporation deposit insurance
115
186
238
373
1,370
1,208
2,686
2,383
TOTAL NON-INTEREST EXPENSE
5,343
4,856
10,807
9,844
INCOME BEFORE INCOME TAX PROVISION
4,036
3,335
8,405
6,689
INCOME TAX PROVISION
638
371
1,318
872
NET INCOME
3,398
2,964
7,087
5,817
EARNINGS PER SHARE - BASIC
0.89
0.78
1.85
1.52
EARNINGS PER SHARE - DILUTED
WEIGHTED AVERAGE SHARES OUTSTANDING - BASIC
3,837,579
3,835,785
3,837,391
3,835,542
WEIGHTED AVERAGE SHARES OUTSTANDING - DILUTED
DIVIDENDS PER SHARE
0.47
0.46
0.94
0.92
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
Three Months Ended June 30,
Six Months Ended June 30,
(In Thousands)
Net Income
Other comprehensive income:
Change in unrealized gain on available for sale securities
2,028
5,604
7,038
7,655
Tax effect
(690
(1,905
(2,393
(2,603
Net realized gain included in net income
(170
(9
(759
(134
58
258
46
Total other comprehensive income
1,226
3,693
4,144
4,964
Comprehensive income
4,624
6,657
11,231
10,781
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY
ACCUMULATED
COMMON
ADDITIONAL
OTHER
TOTAL
STOCK
PAID-IN
RETAINED
COMPREHENSIVE
TREASURY
SHAREHOLDERS’
SHARES
AMOUNT
CAPITAL
EARNINGS
INCOME (LOSS)
EQUITY
Balance, December 31, 2010
4,015,753
33,464
18,064
31,091
(9,689
66,620
Comprehensive income:
Net income
Other comprehensive income
Dividends declared, ($0.92 per share)
(3,529
Common shares issued for employee stock purchase plan
933
8
26
Balance, June 30, 2011
4,016,686
33,472
18,090
33,379
(4,725
73,906
Balance, December 31, 2011
4,017,677
(1,219
Dividends declared, ($0.94 per share)
(3,607
709
27
Balance, June 30, 2012
4,018,386
2,925
CONSOLIDATED STATEMENT OF CASH FLOWS
OPERATING ACTIVITIES:
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
380
353
Provision for loan losses
Accretion and amortization of investment security discounts and premiums
(605
(908
Originations of loans held for sale
(15,872
(20,432
Proceeds of loans held for sale
16,689
21,188
(526
(491
(401
(313
Decrease in prepaid federal deposit insurance
216
337
Other, net
(1,937
(803
Net cash provided by operating activities
5,472
5,814
INVESTING ACTIVITIES:
Investment securities available for sale:
Proceeds from sales
18,014
2,877
Proceeds from calls and maturities
13,725
4,339
Purchases
(49,670
(25,573
Investment securities held to maturity:
55
25
Net increase in loans
(30,287
(5,663
Acquisition of bank premises and equipment
(902
(215
Proceeds from the sale of foreclosed assets
698
388
Purchase of bank-owned life insurance
(29
(32
Proceeds from bank-owned life insurance death benefit
383
Proceeds from redemption of regulatory stock
549
674
Net cash used for investing activities
(47,464
(23,176
FINANCING ACTIVITIES:
Net increase in interest-bearing deposits
53,095
41,568
Net increase in noninterest-bearing deposits
6,408
10,757
Net decrease in short-term borrowings
(11,743
(10,292
Dividends paid
Issuance of common stock
Net cash provided by financing activities
44,180
38,538
NET INCREASE IN CASH AND CASH EQUIVALENTS
2,188
21,176
CASH AND CASH EQUIVALENTS, BEGINNING
9,493
CASH AND CASH EQUIVALENTS, ENDING
30,669
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Interest paid
3,243
4,025
Income taxes paid
1,950
1,790
Transfer of loans to foreclosed real estate
588
PENNS WOODS BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1. Basis of Presentation
The consolidated financial statements include the accounts of Penns Woods Bancorp, Inc. (the “Company”) and its wholly-owned subsidiaries: Woods Investment Company, Inc., Woods Real Estate Development Company, Inc., and Jersey Shore State Bank (the “Bank”) and its wholly-owned subsidiary, The M Group, Inc. D/B/A The Comprehensive Financial Group (“The M Group”). All significant inter-company balances and transactions have been eliminated in the consolidation.
The interim financial statements are unaudited but, in the opinion of management, reflect all adjustments necessary for the fair presentation of results for such periods. The results of operations for any interim period are not necessarily indicative of results for the full year. These financial statements should be read in conjunction with the financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.
The accounting policies followed in the presentation of interim financial results are the same as those followed on an annual basis. These policies are presented on pages 37 through 43 of the Annual Report on Form 10-K for the year ended December 31, 2011.
In reference to the attached financial statements, all adjustments are of a normal recurring nature pursuant to Rule 10-01(b) (8) of Regulation S-X.
Note 2. Recent Accounting Pronouncements
In May 2011, the FASB issued ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. The amendments in this update result in common fair value measurement and disclosure requirements in U.S. GAAP and IFRSs. Consequently, the amendments change the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. The amendments in this update are to be applied prospectively. For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011. For nonpublic entities, the amendments are effective for annual periods beginning after December 15, 2011. Early application by public entities is not permitted. The Company has provided the necessary disclosures in Note 10 — Fair Value Measurements.
In June 2011, the FASB issued ASU 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. The amendments in this update improve the comparability, clarity, consistency, and transparency of financial reporting and increase the prominence of items reported in other comprehensive income. To increase the prominence of items reported in other comprehensive income and to facilitate convergence of U.S. GAAP and IFRS, the option to present components of other comprehensive income as part of the statement of changes in stockholders’ equity was eliminated. The amendments require that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In the two-statement approach, the first statement should present total net income and its components followed consecutively by a second statement that should present total other comprehensive income, the components of other comprehensive income, and the total of comprehensive income. All entities that report items of comprehensive income, in any period presented, will be affected by the changes in this update. For public entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. For nonpublic entities, the amendments are effective for fiscal years ending after December 15, 2012, and interim and annual periods thereafter. The amendments in this update should be applied retrospectively, and early adoption is permitted. The Company has provided the necessary disclosure in the Consolidated Statement of Comprehensive Income.
In September 2011, the FASB issued ASU 2011-08, Intangibles — Goodwill and Other Topics (Topic 350), Testing Goodwill for Impairment. The objective of this update is to simplify how entities, both public and nonpublic, test goodwill for impairment. The amendments in the update permit an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in Topic 350. The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent. Under the amendments in this update, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount. The amendments in this update apply to all entities, both public and nonpublic, that have goodwill reported in their financial statements and are effective for interim and annual goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted, including for annual and interim goodwill impairment tests performed as of a date before September 15, 2011, if an entity’s financial statements for the most recent annual or interim period have not yet been issued or, for nonpublic entities, have not yet been made available for issuance. This ASU did not have a significant impact on the Company’s financial statements.
In December 2011, the FASB issued ASU 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities. The amendments in this update affect all entities that have financial instruments and derivative instruments that are either (1) offset in accordance with either Section 210-20-45 or Section 815-10-45 or (2) subject to an enforceable master netting arrangement or similar
agreement. The requirements amend the disclosure requirements on offsetting in Section 210-20-50. This information will enable users of an entity’s financial statements to evaluate the effect or potential effect of netting arrangements on an entity’s financial position, including the effect or potential effect of rights of setoff associated with certain financial instruments and derivative instruments in the scope of this Update. An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented. This ASU is not expected to have a significant impact on the Company’s financial statements.
In December 2011, the FASB issued ASU 2011-12, Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05. In order to defer only those changes in update 2011-05 that relate to the presentation of reclassification adjustments, the paragraphs in this update supersede certain pending paragraphs in update 2011-05. Entities should continue to report reclassifications out of accumulated other comprehensive income consistent with the presentation requirements in effect before update 2011-05. All other requirements in update 2011-05 are not affected by this update, including the requirement to report comprehensive income either in a single continuous financial statement or in two separate but consecutive financial statements. Public entities should apply these requirements for fiscal years, and interim periods within those years, beginning after December 15, 2011. Nonpublic entities should begin applying these requirements for fiscal years ending after December 15, 2012, and interim and annual periods thereafter. The Company has provided the necessary disclosure in the Statement of Comprehensive Income.
Note 3. Per Share Data
There are no convertible securities which would affect the denominator in calculating basic and dilutive earnings per share. Net income as presented on the consolidated statement of income will be used as the numerator. The following table sets forth the composition of the weighted average common shares (denominator) used in the basic and dilutive earnings per share computation.
Weighted average common shares issued
4,018,175
4,016,381
4,017,987
4,016,138
Average treasury stock shares
(180,596
Weighted average common shares and common stock equivalents used to calculate basic and diluted earnings per share
Note 4. Investment Securities
The amortized cost and fair values of investment securities at June 30, 2012 and December 31, 2011 are as follows:
June 30, 2012
Gross
Amortized
Unrealized
Fair
Cost
Gains
Losses
Value
Available for sale (AFS)
U.S. Government and agency securities
23,454
1,536
(1
24,989
State and political securities
175,406
10,846
(2,337
183,915
Other debt securities
70,535
438
(855
70,118
Total debt securities
269,395
12,820
(3,193
279,022
Financial institution equity securities
8,913
1,138
(43
10,008
Other equity securities
6,119
220
(248
6,091
Total equity securities
15,032
1,358
(291
16,099
Total investment securities AFS
284,427
14,178
(3,484
Held to maturity (HTM)
Total investment securities HTM
December 30, 2011
26,755
1,916
28,671
174,790
8,398
(4,887
178,301
51,447
(2,066
49,514
252,992
10,447
(6,953
256,486
9,939
1,095
(232
10,802
2,751
(75
2,809
12,690
1,228
(307
13,611
265,682
11,675
(7,260
1
The following tables show 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, at June 30, 2012 and December 31, 2011.
Less than Twelve Months
Twelve Months or Greater
Total
1,953
8,299
(228
13,095
(2,109
21,394
35,417
(668
9,191
(187
44,608
45,669
(897
22,286
(2,296
67,955
568
(19
195
(24
763
2,433
(167
144
(81
2,577
3,001
(186
339
(105
3,340
48,670
(1,083
22,625
(2,401
71,295
December 31, 2011
1,142
(6
28,260
(4,881
29,402
35,858
(2,048
82
(18
35,940
37,000
(2,054
28,342
(4,899
65,342
1,140
(116
273
1,413
263
(65
130
(10
393
1,403
(181
403
(126
1,806
38,403
(2,235
28,745
(5,025
67,148
At June 30, 2012 there were a total of 57 and 48 individual securities that were in a continuous unrealized loss position for less than twelve months and twelve months or greater, respectively.
The Company reviews its position quarterly and has determined that, at June 30, 2012, the declines outlined in the above table represent temporary declines and the Company does not intend to sell and does not believe it will be required to sell these securities before recovery of their cost basis, which may be at maturity. There were 105 positions that were temporarily impaired at June 30,
2012. The Company has concluded that the unrealized losses disclosed above are not other than temporary but are the result of interest rate changes, sector credit ratings changes, or company-specific ratings changes that are not expected to result in the non-collection of principal and interest during the period.
The amortized cost and fair value of debt securities at June 30, 2012, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities since borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Amortized Cost
Fair Value
Due in one year or less
3,129
3,122
Due after one year to five years
44,760
44,517
Due after five years to ten years
34,166
34,552
Due after ten years
187,340
196,831
Total gross proceeds from sales of securities available for sale were $18,014,000 and $2,877,000, for the six months ended June 30, 2012 and 2011, respectively. The following table represents gross realized gains and losses on those transactions:
Gross realized gains:
138
51
77
461
126
131
Total gross realized gains
853
148
Gross realized losses:
14
67
Total gross realized losses
94
There were no impairment charges included in gross realized losses for the six months ended June 30, 2012 and 2011, respectively.
Note 5. Federal Home Loan Bank Stock
The Bank is a member of the Federal Home Loan Bank (“FHLB”) of Pittsburgh and as such, is required to maintain a minimum investment in stock of the FHLB that varies with the level of advances outstanding with the FHLB. The stock is bought from and sold to the FHLB based upon its $100 par value. The stock does not have a readily determinable fair value and as such is classified as restricted stock, carried at cost and evaluated for impairment as necessary. The stock’s value is determined by the ultimate recoverability of the par value rather than by recognizing temporary declines. The determination of whether the par value will ultimately be recovered is influenced by criteria such as the following: (a) the significance of the decline in net assets of the FHLB as compared to the capital stock amount and the length of time this situation has persisted (b) commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance (c) the impact of legislative and regulatory changes on the customer base of the FHLB and (d) the liquidity position of the FHLB.
The FHLB had incurred losses in 2009 and for parts of 2010 due primarily to other-than-temporary impairment credit losses on its private-label mortgage-backed securities portfolio. These securities were the most effected by the extreme economic conditions in place during the previous several years. As a result, the FHLB had suspended the payment of dividends and limited the amount of excess capital stock repurchases. The FHLB has reported net income for the year ended December 31, 2011 and has declared a 0.10 percent annualized dividend to its shareholders that was paid during the first and second quarters of 2012. While the FHLB has not committed to regular dividend payments or future limited repurchases of excess capital stock, it will continue to monitor the overall financial performance of the FHLB in order to determine the status of limited repurchases of excess capital stock or dividends in the future. Management evaluated the stock and concluded that the stock was not impaired for the periods presented herein. More consideration was given to the long-term prospects for the FHLB as opposed to the recent stress caused by the extreme economic conditions the world is facing. Management also considered that the FHLB maintains regulatory capital ratios in excess of all
10
regulatory capital requirements, liquidity appears adequate, new shares of FHLB stock continue to change hands at the $100 par value, and the resumption of dividends.
Note 6. Credit Quality and Related Allowance for Loan Losses
Management segments the Bank’s loan portfolio to a level that enables risk and performance monitoring according to similar risk characteristics. Loans are segmented based on the underlying collateral characteristics. Categories include commercial and agricultural, real estate, and installment loans to individuals. Real estate loans are further segmented into three categories: residential, commercial and construction.
The following table presents the related aging categories of loans, by segment, as of June 30, 2012 and December 31, 2011:
Past Due
Past Due 90
30 To 89
Days Or More
Non-
Current
Days
& Still Accruing
Accrual
Commercial and agricultural
51,488
49
51,537
Real estate mortgage:
Residential
209,371
1,384
410
211,165
Commercial
162,632
711
1,166
164,509
Construction
21,515
79
7,149
28,743
Installment loans to individuals
10,723
72
10,795
455,729
2,295
8,725
466,749
Less: Net deferred loan fees and discounts
1,407
7,438
446,884
53,124
53,129
176,875
1,438
378
692
179,383
162,977
135
1,176
164,288
19,605
95
9,757
29,457
11,180
111
11,297
423,761
1,784
384
11,625
437,554
1,595
7,154
415,012
The following table presents the interest income if interest had been recorded based on the original loan agreement terms and rate of interest for non-accrual loans and interest income recognized on a cash basis for non-accrual loans as of June 30, 2012 and December 31, 2011:
Interest income if interest had been recorded based on the original loan agreement terms and rate of interest for non-accrual loans
276
325
Interest income recognized on a cash basis for non-accrual loans
37
15
11
Impaired Loans
Impaired loans are loans for which it is probable the Bank will not be able to collect all amounts due according to the contractual terms of the loan agreement. The Bank evaluates such loans for impairment individually and does not aggregate loans by major risk classifications. The definition of “impaired loans” is not the same as the definition of “non-accrual loans,” although the two categories overlap. The Bank may choose to place a loan on non-accrual status due to payment delinquency or uncertain collectability, while not classifying the loan as impaired. Factors considered by management in determining impairment include payment status and collateral value. The amount of impairment for these types of loans is determined by the difference between the present value of the expected cash flows related to the loan, using the original interest rate, and its recorded value, or as a practical expedient in the case of collateralized loans, the difference between the fair value of the collateral and the recorded amount of the loan. When foreclosure is probable, impairment is measured based on the fair value of the collateral.
Management evaluates individual loans in all of the commercial segments for possible impairment if the loan is greater than $100,000 and if the loan is either on non-accrual status or has a risk rating of substandard. Management may also elect to measure an individual loan for impairment if less than $100,000 on a case by case basis.
Mortgage loans on one-to-four family properties and all consumer loans are large groups of smaller-balance homogeneous loans and are measured for impairment collectively. Loans that experience insignificant payment delays, which are defined as 90 days or less, generally are not classified as impaired. Management determines the significance of payment delays on a case-by-case basis taking into consideration all circumstances surrounding the loan and the borrower including the length of the delay, the borrower’s prior payment record, and the amount of shortfall in relation to the principal and interest owed. Interest income for impaired loans is recorded consistent with the Bank’s policy on nonaccrual loans.
The following table presents the recorded investment, unpaid principal balance, and related allowance of impaired loans by segment as of June 30, 2012 and December 31, 2011:
Recorded
Unpaid Principal
Related
Investment
Balance
Allowance
With no related allowance recorded:
Real estate mortgages - residential
407
416
Real estate mortgages - commercial
335
Real estate mortgages - construction
768
1,092
1,510
1,843
With an allowance recorded:
728
753
6,159
6,178
1,514
6,394
8,744
1,260
13,281
15,675
2,868
Total:
1,135
1,169
6,494
6,513
7,162
9,836
14,791
17,518
12
751
382
815
1,113
1,939
2,246
861
888
101
6,150
1,481
8,929
10,429
2,155
15,940
17,467
3,737
1,603
1,639
6,532
9,744
11,542
17,879
19,713
The following table presents the average recorded investment in impaired loans and related interest income recognized for the three and six months ended for June 30, 2012 and 2011:
Average investment in impaired loans
16,184
18,179
16,749
14,767
Interest income recognized on an accrual basis on impaired loans
105
75
154
Interest income recognized on a cash basis on impaired loans
93
18
There is approximately $285,000 committed to be advanced in connection with impaired loans.
Modifications
The loan portfolio also includes certain loans that have been modified in a Troubled Debt Restructuring (TDR), where economic concessions have been granted to borrowers who have experienced or are expected to experience financial difficulties. These concessions typically result from loss mitigation activities and could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions. Certain TDRs are classified as nonperforming at the time of restructure and may only be returned to performing status after considering the borrower’s sustained repayment performance for a reasonable period, generally six months.
Loan modifications that are considered TDRs completed during the three and six months ended June 30, 2012 and 2011 were as follows:
(In Thousands, Except Number of Contracts)
Number of Contracts
Pre-Modification Outstanding Recorded Investment
Post-Modification Outstanding Recorded Investment
Troubled debt restructurings
3,812
4,259
8,071
13
123
4,693
4,869
217
16
9,687
Loan modifications considered troubled debt restructurings made during the twelve months previous to June 30, 2012, that have defaulted during the six month period ending June 30, 2012 were as follows:
Six Months Ended June 30, 2012
Recorded Investment
48
211
259
Troubled debt restructurings amounted to $14,544,000 and $17,478,000 as of June 30, 2012 and December 31, 2011.
Internal Risk Ratings
Management uses a ten point internal risk rating system to monitor the credit quality of the overall loan portfolio. The first six categories are considered not criticized, and are aggregated as “Pass” rated. The criticized rating categories utilized by management generally follow bank regulatory definitions. The special mention category includes assets that are currently protected but are potentially weak, resulting in an undue and unwarranted credit risk, but not to the point of justifying a substandard classification. Loans in the substandard category have well-defined weaknesses that jeopardize the liquidation of the debt, and have a distinct possibility that some loss will be sustained if the weaknesses are not corrected. All loans greater than 90 days past due are considered Substandard. Loans in the doubtful category exhibit the same weaknesses found in the substandard loans, however, the weaknesses are more pronounced. Such loans are static and collection in full is improbable. However, these loans are not yet rated as loss because certain events may occur which would salvage the debt. Loans classified loss are considered uncollectible and charge-off is imminent.
To help ensure that risk ratings are accurate and reflect the present and future capacity of borrowers to repay a loan as agreed, the Bank has a structured loan rating process with several layers of internal and external oversight. Generally, consumer and residential mortgage loans are included in the pass category unless a specific action, such as bankruptcy, repossession, or death occurs to raise awareness of a possible credit event. An external annual loan review of all commercial relationships $800,000 or greater is performed, as well as a sample of smaller transactions. Confirmation of the appropriate risk category is included in the review. Detailed reviews, including plans for resolution, are performed on loans classified as Substandard, Doubtful, or Loss on a quarterly basis.
The following table presents the credit quality categories identified above as of June 30, 2012 and December 31, 2011:
Commercial and
Real Estate Mortgages
Installment Loans
Agricultural
to Individuals
Totals
Pass
50,320
210,341
149,782
21,547
442,785
Special Mention
1,071
5,329
6,400
Substandard
146
824
9,398
7,196
17,564
Doubtful
51,663
177,916
152,994
19,652
11,291
413,516
1,198
89
5,804
7,091
268
1,378
5,490
9,805
16,947
Allowance for Loan Losses
An allowance for loan losses (“ALL”) is maintained to absorb losses from the loan portfolio. The ALL is based on management’s continuing evaluation of the risk characteristics and credit quality of the loan portfolio, assessment of current economic conditions, diversification and size of the portfolio, adequacy of collateral, past and anticipated future loss experience, and the amount of non-performing loans.
The Bank’s methodology for determining the ALL is based on the requirements of ASC Section 310-10-35 for loans individually evaluated for impairment (previously discussed) and ASC Subtopic 450-20 for loans collectively evaluated for impairment, as well as the Interagency Policy Statements on the Allowance for Loan and Lease Losses and other bank regulatory guidance. The total of the two components represents the Bank’s ALL.
Loans that are collectively evaluated for impairment are analyzed with general allowances being made as appropriate. Allowances are segmented based on collateral characteristics previously disclosed, and consistent with credit quality monitoring. Loans that are collectively evaluated for impairment are grouped into two classes for evaluation. A general allowance is determined for “Pass” rated credits, while a separate pool allowance is provided for “Criticized” rated credits that are not individually evaluated for impairment.
For the general allowances, historical loss trends are used in the estimation of losses in the current portfolio. These historical loss amounts are modified by other qualitative factors. A historical charge-off factor is calculated utilizing a twelve quarter moving average. Management has identified a number of additional qualitative factors which it uses to supplement the historical charge-off factor because these factors are likely to cause estimated credit losses associated with the existing loan pools to differ from historical loss experience. The additional factors that are evaluated quarterly and updated using information obtained from internal, regulatory, and governmental sources are: national and local economic trends and conditions; levels of and trends in delinquency rates and non-accrual loans; trends in volumes and terms of loans; effects of changes in lending policies; experience, ability, and depth of lending staff; value of underlying collateral; and concentrations of credit from a loan type, industry and/or geographic standpoint.
Loans in the criticized pools, which possess certain qualities or characteristics that may lead to collection and loss issues, are closely monitored by management and subject to additional qualitative factors. Management also monitors industry loss factors by loan segment for applicable adjustments to actual loss experience.
Management reviews the loan portfolio on a quarterly basis in order to make appropriate and timely adjustments to the ALL. When information confirms all or part of specific loans to be uncollectible, these amounts are promptly charged off against the ALL.
Activity in the allowance is presented for the six months ended June 30, 2012 and 2011:
Beginning Balance
430
964
2,719
2,846
Charge-offs
(11
(877
(51
(957
Recoveries
41
Provision
(47
96
764
Ending Balance
1,052
3,467
2,344
June 30, 2011
466
980
1,508
2,893
188
6,035
(34
(1,500
(35
(1,569
20
31
98
(70
(154
177
1,270
(23
404
826
1,705
2,668
161
5,764
The Company grants commercial, industrial, residential, and installment loans to customers throughout north-central Pennsylvania. Although the Company has a diversified loan portfolio at June 30, 2012, a substantial portion of its debtors’ ability to honor their contracts is dependent on the economic conditions within this region.
The Company has a concentration of loans at June 30, 2012 and 2011 as follows:
Owners of residential rental properties
13.52
%
14.31
Owners of commercial rental properties
15.25
16.69
The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of June 30, 2012 and December 31, 2011:
Allowance for Loan Losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment
Collectively evaluated for impairment
958
1,084
4,570
Total ending allowance balance
Loans:
210,030
158,015
21,581
451,958
Total ending loans balance
863
1,238
691
3,417
177,780
157,756
419,675
Note 7. Net Periodic Benefit Cost-Defined Benefit Plans
For a detailed disclosure on the Company’s pension and employee benefits plans, please refer to Note 12 of the Company’s Consolidated Financial Statements included in the Annual Report on Form 10-K for the year ended December 31, 2011.
The following sets forth the components of the net periodic benefit cost of the domestic non-contributory defined benefit plan for the three and six months ended June 30, 2012 and 2011, respectively:
Service cost
156
106
212
Interest cost
372
356
Expected return on plan assets
(195
(391
(370
Amortization of transition obligation
(2
Amortization of prior service cost
Amortization of net loss
218
Net periodic cost
262
145
524
291
Employer Contributions
The Company previously disclosed in its consolidated financial statements, included in the Annual Report on Form 10-K for the year ended December 31, 2011, that it expected to contribute a minimum of $750,000 to its defined benefit plan in 2012. As of June 30, 2012, there were contributions of $1,225,000 made to the plan with additional contributions of at least $400,000 anticipated during the second half of 2012. The increased level of contributions are the result of management’s plan to reduce the unfunded portion of the Company’s defined benefit pension plan.
Note 8. Employee Stock Purchase Plan
The Company maintains the Penns Woods Bancorp, Inc. 2006 Employee Stock Purchase Plan (“Plan”). The Plan is intended to encourage employee participation in the ownership and economic progress of the Company. The Plan allows for up to 1,000,000 shares to be purchased by employees. The purchase price of the shares is 95% of market value with an employee eligible to purchase up to the lesser of 15% of base compensation or $12,000 in market value annually. During the six months ended June 30, 2012 and 2011, there were 709 and 933 shares issued under the plan, respectively.
Note 9. Off Balance Sheet Risk
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments are primarily comprised of commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit, interest rate, or liquidity risk in excess of the amount recognized in the consolidated balance sheet. The contract amounts of these instruments express the extent of involvement the Company has in particular classes of financial instruments.
The Company’s exposure to credit loss from nonperformance by the other party to the financial instruments for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. The Company may require collateral or other security to support financial instruments with off-balance sheet credit risk.
Financial instruments whose contract amounts represent credit risk are as follows at June 30, 2012 and December 31, 2011:
Commitments to extend credit
99,451
80,320
Standby letters of credit
1,181
1,180
Commitments to extend credit are legally binding agreements to lend to customers. Commitments generally have fixed expiration dates or other termination clauses and may require payment of fees. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future liquidity requirements. The Company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company, on an extension of credit is based on management’s credit assessment of the counterparty.
Standby letters of credit represent conditional commitments issued by the Company to guarantee the performance of a customer to a third party. These instruments are issued primarily to support bid or performance related contracts. The coverage period for these instruments is typically a one year period with an annual renewal option subject to prior approval by management. Fees earned from the issuance of these letters are recognized upon expiration of the coverage period. For secured letters of credit, the collateral is typically Bank deposit instruments or customer business assets.
Note 10. Fair Value Measurements
The following disclosures show the hierarchal disclosure framework associated with the level of pricing observations utilized in measuring assets and liabilities at fair value.
Level I:
Quoted prices are available in active markets for identical assets or liabilities as of the reported date.
Level II:
Pricing inputs are other than quoted prices in active markets, which are either directly or indirectly observable as of the reported date. The nature of these assets and liabilities include items for which quoted prices are available but traded less frequently, and items that are fair valued using other financial instruments, the parameters of which can be directly observed.
Level III:
Assets and liabilities that have little to no pricing observability as of the reported date. These items do not have two-way markets and are measured using management’s best estimate of fair value, where the inputs into the determination of fair value require significant management judgment or estimation.
17
This hierarchy requires the use of observable market data when available.
The following table presents the assets reported on the balance sheet at their fair value on a recurring basis as of June 30, 2012 and December 31, 2011, 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.
Level I
Level II
Level III
Assets measured on a recurring basis:
Investment securities, available for sale:
Financial institution securities
Total assets measured on a recurring basis
The following table presents the assets reported on the consolidated balance sheet at their fair value on a non-recurring basis as of June 30, 2012 and December 31, 2011, 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.
Assets measured on a non-recurring basis:
Impaired loans
11,923
Other real estate owned
1,504
Total assets measured on a non-recurring basis
13,427
14,142
2,144
16,286
The following table provides a listing of significant unobservable inputs used in the fair value measurement process for items valued utilizing level III techniques as of June 30, 2012.
Quantitative Information About Level III Fair Value Measurements
Valuation Technique(s)
Unobservable Inputs
Range
Discounted cash flow
Temporary change in payment amount
0 to -30%
Probability of default
0%
Appraisal of collateral
Appraisal adjustments (1)
0 to -20%
(1) Appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated liquidation expenses. The range of appraisal adjustments are presented as a percent of the appraisal.
The significant unobservable inputs used in the fair value measurement of the Company’s impaired loans using the discounted cash flow valuation technique include temporary changes in payment amounts and the probability of default. Significant increases (decreases) in payment amounts would result in significantly higher (lower) fair value measurements. The probability of default is 0% for impaired loans using the discounted cash flow valuation technique because all defaulted impaired loans are valued using the appraisal of collateral valuation technique.
The significant unobservable input used in the fair value measurement of the Company’s impaired loans using the appraisal of collateral valuation technique include appraisal adjustments, which are adjustments to appraisals by management for qualitative factors such as economic conditions and estimated liquidation expenses. The significant unobservable input used in the fair value measurement of the Company’s other real estate owned are the same inputs used to value impaired loans using the appraisal of collateral valuation technique.
Note 11. Fair Value of Financial Instruments
The Company is required to disclose fair values for its financial instruments. Fair values are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Also, it is the Company’s general practice and intention to hold most of its financial instruments to maturity and not to engage in trading or sales activities. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These fair values are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions can significantly affect the fair values.
Fair values have been determined by the Company using historical data and an estimation methodology suitable for each category of financial instruments. The Company’s fair values, methods, and assumptions are set forth below for the Company’s other financial instruments.
As certain assets and liabilities, such as deferred tax assets, premises and equipment, and many other operational elements of the Company, are not considered financial instruments but have value, this fair value of financial instruments would not represent the full market value of the Company.
The fair values of the Company’s financial instruments are as follows at June 30, 2012 and December 31, 2011:
19
Fair Value Measurements at June 30, 2012
Quoted Prices in
Active Markets for
Significant Other
Significant
Carrying
Identical Assets
Observable Inputs
(Level I)
(Level II)
(Level III)
Financial assets:
Cash and cash equivalents
Available for sale
Held to maturity
454,205
Financial liabilities:
525,271
66,395
424,586
471,212
65,848
Cash and Cash Equivalents, Loans Held for Sale, Accrued Interest Receivable, Short-term Borrowings, and Accrued Interest Payable:
The fair value is equal to the carrying value.
Investment Securities:
The fair value of investment securities available for sale and held to maturity 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. Regulatory stocks’ fair value is equal to the carrying value.
Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial and agricultural, commercial real estate, residential real estate, construction real estate, and installment loans to individuals. Each loan category is further segmented into fixed and adjustable rate interest terms and by performing and nonperforming categories.
The fair value of performing loans is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The estimate of maturity is based on the Company’s historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions.
Fair value for significant nonperforming loans is based on recent external appraisals. If appraisals are not available, estimated cash flows are discounted using a rate commensurate with the risk associated with the estimated cash flows. Assumptions regarding credit risk, cash flows, and discounted rates are judgmentally determined using available market information and specific borrower information.
Bank-Owned Life Insurance:
The fair value is equal to the cash surrender value of the life insurance policies.
Deposits:
The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits, savings, NOW, and money market accounts, is equal to the amount payable on demand. The fair value of certificates of deposit is based on the discounted value of contractual cash flows.
The fair value estimates above do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market, commonly referred to as the core deposit intangible.
Long Term Borrowings:
The fair value of long term borrowings is based on the discounted value of contractual cash flows.
Commitments to Extend Credit, Standby Letters of Credit, and Financial Guarantees Written:
There is no material difference between the notional amount and the estimated fair value of off-balance sheet items. The contractual amounts of unfunded commitments and letters of credit are presented in Note 9 (Off Balance Sheet Risk).
Note 12. Reclassification of Comparative Amounts
Certain comparative amounts for the prior period have been reclassified to conform to current period presentations. Such reclassifications had no effect on net income or shareholders’ equity.
CAUTIONARY STATEMENT FOR PURPOSES OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
This Report contains certain “forward-looking statements” including statements concerning plans, objectives, future events or performance and assumptions and other statements which are other than statements of historical fact. The Company cautions readers that the following important factors, among others, may have affected and could in the future affect the Company’s actual results and could cause the Company’s actual results for subsequent periods to differ materially from those expressed in any forward-looking statement made by or on behalf of the Company herein: (i) the effect of changes in laws and regulations, including federal and state banking laws and regulations, with which the Company must comply, and the associated costs of compliance with such laws and regulations either currently or in the future as applicable; (ii) the effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies as well as by the Financial Accounting Standards Board, or of changes in the Company’s organization, compensation and benefit plans; (iii) the effect on the Company’s competitive position within its market area of the increasing consolidation within the banking and financial services industries, including the increased competition from larger regional and out-of-state banking organizations as well as non-bank providers of various financial services; (iv) the effect of changes in interest rates; and (v) the effect of changes in the business cycle and downturns in the local, regional or national economies.
You should not put undue reliance on any forward-looking statements. These statements speak only as of the date of this Quarterly Report on Form 10-Q, even if subsequently made available by the Company on its website or otherwise. The Company undertakes no obligation to update or revise these statements to reflect events or circumstances occurring after the date of this Quarterly Report on Form 10-Q.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operation
EARNINGS SUMMARY
Comparison of the Three and Six Months Ended June 30, 2012 and 2011
Summary Results
Net income for the three months ended June 30, 2012 was $3,398,000 compared to $2,964,000 for the same period of 2011 as after-tax securities gains increased $106,000 (from a gain of $6,000 to a gain of $112,000). Basic and diluted earnings per share for the three months ended June 30, 2012 were $0.89 compared to $0.78 for the three months ended June 30, 2011. Return on average assets and return on average equity were 1.67% and 15.48% for the three months ended June 30, 2012 compared to 1.64% and 16.29% for the corresponding period of 2011. Net income from core operations (“operating earnings”) increased to $3,286,000 for the three months ended June 30, 2012 compared to $2,958,000 for the same period of 2011. Operating earnings per share for the three months ended June 30, 2012 were $0.86 basic and dilutive compared to $0.77 basic and dilutive for the three months ended June 30, 2011.
The six months ended June 30, 2012 generated net income of $7,087,000 compared to $5,817,000 for the same period of 2011. Comparable results were impacted by an increase in after-tax securities gains of $413,000 (from a gain of $88,000 to a gain of $501,000). Earnings per share, basic and dilutive, for the six months ended June 30, 2012 were $1.85 compared to $1.52 for the comparable period of 2011. Return on average assets and return on average equity were 1.78% and 16.42% for the six months ended June 30, 2012 compared to 1.64% and 16.45% for the corresponding period of 2011. Operating earnings increased 13.1% to $6,477,000 for the six months ended June 30, 2012 compared to $5,729,000 for the comparable period of 2011, resulting in basic and dilutive operating earnings per share increasing 13.4% to $1.69 from $1.49 for the six month periods ended June 30, 2012 and 2011, respectively.
Management uses the non-GAAP measure of net income from core operations, or operating earnings, in its analysis of the Company’s performance. This measure, as used by the Company, adjusts net income by excluding significant gains or losses that are unusual in nature. Because certain of these items and their impact on the Company’s performance are difficult to predict, management believes the presentation of financial measures excluding the impact of such items provides useful supplemental information in evaluating the operating results of the Company’s core businesses. For purposes of this Quarterly Report on Form 10-Q, net income from core operations, or operating earnings, means net income adjusted to exclude after-tax net securities gains or losses. These disclosures should not be viewed as a substitute for net income determined in accordance with GAAP, nor are they necessarily comparable to non-GAAP performance measures that may be presented by other companies.
Reconciliation of GAAP and Non-GAAP Income
(Dollars in Thousands, Except Per Share Data)
GAAP net income
Less: net securities and bank-owned life insurance gains, net of tax
112
610
88
Non-GAAP operating earnings
3,286
2,958
6,477
5,729
Return on average assets (ROA)
1.67
1.64
1.78
0.06
0.01
0.15
0.02
Non-GAAP operating ROA
1.61
1.63
1.62
Return on average equity (ROE)
15.48
16.29
16.42
16.45
0.51
0.04
1.42
0.25
Non-GAAP operating ROE
14.97
16.25
15.00
16.20
Basic earnings per share (EPS)
0.03
0.16
Non-GAAP basic operating EPS
0.86
0.77
1.69
1.49
Dilutive EPS
Non-GAAP dilutive operating EPS
Interest and Dividend Income
Interest and dividend income for the three months ended June 30, 2012 increased to $9,280,000 compared to $8,884,000 for the same period of 2011. The increase was due in part to loan portfolio income increasing as the impact of portfolio growth offset a reduction in yield of 34 basis points (“bp”) due to the competitive landscape and the continued low rate environment that is impacting new loan rates as well as the variable rate segment of the loan portfolio. Investment portfolio interest increased due to growth in the average investment portfolio of $59,999,000 primarily from the addition of short-term corporate and municipal bonds to the portfolio, which offset a decline in the average taxable equivalent yield of 77 bp.
During the six months ended June 30, 2012, interest and dividend income was $18,565,000, an increase of $699,000 over the same period in 2011. Interest income on the loan portfolio increased as the growth in the portfolio was countered by a 35 bp decline in average yield. The investment portfolio interest income increased as the increase in portfolio size more than offset the decline in yield.
Interest and dividend income composition for the three and six months ended June 30, 2012 and 2011 was as follows:
For The Three Months Ended
Change
Amount
% Total
Loans including fees
67.82
69.16
150
2.44
16.35
15.88
7.51
14.90
14.32
8.73
0.93
0.64
29
50.88
Total interest and dividend income
100.00
396
4.46
For The Six Months Ended
67.91
69.59
176
16.11
15.59
205
7.36
15.02
14.21
249
9.81
0.96
0.61
69
63.30
699
3.91
Interest Expense
Interest expense for the three months ended June 30, 2012 decreased $384,000 to $1,582,000 compared to $1,966,000 for the same period of 2011. The substantial decrease associated with deposits is primarily the result of a reduction of 35 bp in the rate paid on time deposits and a shift from higher cost time deposits to core deposits, with emphasis on money market and NOW accounts. Factors that led to the rate decreases include, but are not limited to, Federal Open Market Committee (“FOMC”) actions to maintain low interest rates and campaigns conducted by the Company to focus on core deposit (non-time deposit) growth as the building block to solid customer relationships. In addition, during the past two years the time deposit portfolio has been shortened in order to increase repricing frequency. The time deposit portfolio is now slowly being lengthened to build protection when interest rates begin to increase with a focus on maturities of 36 months and greater. In addition, the Marcellus Shale natural gas exploration in north central
23
Pennsylvania is creating opportunities to gather new and build upon existing deposit relationships. Borrowing interest expense decreased as the significant growth in deposits has allowed for a reduction in the average balance of borrowings.
Interest expense for the six months ended June 30, 2012 decreased 19.08% from the same period of 2011. The reasons noted for the decline in interest expense for the three month period comparison also apply to the six month period.
Interest expense composition for the three and six months ended June 30, 2012 and 2011 was as follows:
59.04
60.12
(20.98
)%
1.77
2.14
(14
(33.33
39.19
37.74
(122
(16.44
Total interest expense
(384
(19.53
59.27
60.13
(481
(20.24
1.94
2.51
(37
(37.37
38.79
37.36
(236
(15.99
(754
(19.08
Net Interest Margin
The net interest margin (“NIM”) for the three months ended June 30, 2012 was 4.47% compared to 4.58% for the corresponding period of 2011. The NIM declined as a 39 bp decline in the rate paid on interest bearing liabilities was countered by a 45 bp decline in the yield on interest earning assets. The decrease in earning asset yield is due to the impact of the current low rate environment on the loan and investment portfolios. In addition, the duration of the investment portfolio has been shortened by utilizing shorter term corporate and agency bonds to offset the relatively longer duration of the municipal bonds within the portfolio. This shortening of the investment portfolio limits current earnings due to the low rates on the short end of the interest rate curve, but it also limits interest rate risk and will provide cash flow over the next few years as we anticipate a period of increasing rates. The decrease in the cost of interest bearing liabilities from 1.44% to 1.05% was driven by a reduction in the rate paid on time deposits of 35 bp. The reduction in the rate paid on time deposits was the result of shortening the time deposit portfolio, which has resulted in an increasing repricing frequency during this period of low rates. In addition, a focus on increasing core deposits has resulted in significant growth in lower cost core deposits. The duration of the time deposit portfolio has slowly started to be lengthened due to the apparent bottoming or near bottoming of deposit rates. The average rate on long-term borrowings declined due to the maturity of FHLB borrowings.
The NIM for the six months ended June 30, 2012 was 4.59% compared to 4.73% for the same period of 2011. The impact of the items mentioned in the three month discussion also applies to the six month period. A 36 bp decline in the rate paid on time deposits served as the foundation for a 33 bp decline in the rate paid on deposits, while the FOMC and general market actions affected the yield on earning assets and cost of borrowings.
The following is a schedule of average balances and associated yields for the three and six months ended June 30, 2012 and 2011:
24
AVERAGE BALANCES AND INTEREST RATES
Average Balance
Interest
Average Rate
Assets:
Tax-exempt loans
21,621
298
5.54
20,369
306
6.03
All other loans
435,918
6,097
5.63
400,072
5,942
5.96
Total loans
457,539
6,395
5.62
420,441
6,248
Taxable securities
163,294
1,601
3.92
126,139
1,467
4.65
Tax-exempt securities
130,313
2,095
6.43
107,469
1,927
7.17
Total securities
293,607
3,696
5.04
233,608
3,394
5.81
13,285
17,860
Total interest-earning assets
764,431
10,093
5.30
671,909
9,643
5.75
50,251
53,037
Total assets
814,682
724,946
Liabilities and shareholders’ equity:
Savings
79,465
0.08
70,698
0.19
Super Now deposits
120,066
153
82,483
107
0.52
Money market deposits
152,858
202
0.53
123,116
0.95
Time deposits
172,431
563
1.31
181,250
750
1.66
Total interest-bearing deposits
524,820
0.72
457,547
1.04
17,222
0.65
14,623
1.15
4.00
71,778
4.09
Total borrowings
78,500
648
3.27
86,401
784
3.59
Total interest-bearing liabilities
603,320
1.05
543,948
1.44
Demand deposits
112,683
98,371
10,889
9,832
Shareholders’ equity
87,790
72,795
Total liabilities and shareholders’ equity
Interest rate spread
4.25
4.31
Net interest income/margin
8,511
4.47
7,677
4.58
(1) Information on this table has been calculated using average daily balance sheets to obtain average balances.
(2) Nonaccrual loans have been included with loans for the purpose of analyzing net interest earnings.
(3) Income and rates on a fully taxable equivalent basis include an adjustment for the difference between annual income from tax-exempt obligations and the taxable equivalent of such income at the standard 34% tax rate.
21,574
607
5.66
20,370
6.08
429,040
12,207
5.72
399,839
12,027
6.07
450,614
12,814
420,209
12,641
155,247
3,167
4.08
120,471
4.80
130,452
4,224
6.48
105,301
3,847
7.31
285,699
7,391
5.17
225,772
6,740
5.97
7,660
0.05
9,975
743,973
20,207
5.45
655,956
19,383
5.94
50,517
53,464
794,490
709,420
76,546
0.07
68,616
70
0.21
114,218
295
75,867
190
140,122
0.58
116,194
555
174,754
1.34
184,885
1,561
1.70
505,640
0.75
445,562
1.08
19,640
0.63
16,902
1.18
80,918
1,302
3.18
88,680
1,575
3.54
586,558
1.09
534,242
1.48
110,382
94,941
11,216
9,502
86,334
70,735
4.36
17,010
4.59
15,432
4.73
The following table presents the adjustment to convert net interest income to net interest income on a fully taxable equivalent basis for the three and six months ended June 30, 2012 and 2011.
For the Three Months Ended
For the Six Months Ended
Total interest income
Net interest income
Tax equivalent adjustment
813
1,642
Net interest income (fully taxable equivalent)
The following table sets forth the respective impact that both volume and rate changes have had on net interest income on a fully taxable equivalent basis for the three and six month periods ended June 30, 2012 and 2011:
2012 vs. 2011
Increase (Decrease) Due to
Volume
Rate
Net
Interest income:
Loans, tax-exempt
(26
(8
(7
501
(346
155
876
(696
Taxable investment securities
(254
748
(474
274
Tax-exempt investment securities
381
(213
168
842
(465
377
Interest bearing deposits
1,288
(838
450
2,502
(1,678
Interest expense:
Savings deposits
(22
(50
100
(198
(89
200
(348
(148
(152
(80
(315
(395
(20
(48
(106
(16
(208
(28
(410
30
(784
Change in net interest income
1,262
(428
834
2,472
(894
1,578
Provision for Loan Losses
The provision for loan losses is based upon management’s quarterly review of the loan portfolio. The purpose of the review is to assess loan quality, identify impaired loans, analyze delinquencies, ascertain loan growth, evaluate potential charge-offs and recoveries, and assess general economic conditions in the markets served. An external independent loan review is also performed annually for the Bank. Management remains committed to an aggressive program of problem loan identification and resolution.
The allowance for loan losses is determined by applying loss factors to outstanding loans by type, excluding loans for which a specific allowance has been determined. Loss factors are based on management’s consideration of the nature of the portfolio segments, changes in mix and volume of the loan portfolio, and historical loan loss experience. In addition, management considers industry standards and trends with respect to non-performing loans and its knowledge and experience with specific lending segments.
Although management believes it uses the best information available to make such determinations and that the allowance for loan losses is adequate at June 30, 2012, future adjustments could be necessary if circumstances or economic conditions differ substantially from the assumptions used in making the initial determinations. A downturn in the local economy, increased unemployment, and delays in receiving financial information from borrowers could result in increased levels of nonperforming assets, charge-offs, loan loss provisions, and reductions in income. Additionally, as an integral part of the examination process, bank regulatory agencies periodically review the Bank’s loan loss allowance. The banking agencies could require the recognition of additions to the loan loss allowance based on their judgment of information available to them at the time of their examination.
When determining the appropriate allowance level, management has attributed the allowance for loan losses to various portfolio segments; however, the allowance is available for the entire portfolio as needed.
The allowance for loan losses increased from $7,154,000 at December 31, 2011 to $7,438,000 at June 30, 2012. The increase in the allowance for loan losses was limited by net charge-offs of $916,000 for the six month period ended June 30, 2012. The primary driver of the charge-offs for the period was a partial charge-off of a construction real-estate loan that partially offset the provision for
loan losses during the six months ended June 30, 2012. At June 30, 2012 and December 31, 2011, the allowance for loan losses to total loans was 1.60% and 1.64%, respectively.
The provision for loan losses totaled $600,000 and $1,200,000 for the three and six months ended June 30, 2012, compared to $600,000 and $1,200,000 for the same periods in 2011. The amount of the provision for loan losses was the result of several factors, including but not limited to, a ratio of nonperforming loans to total loans of 1.87% at June 30, 2012 and a ratio of the allowance for loan losses to nonperforming loans of 85.25% at June 30, 2012. Nonperforming loans decreased to $8,725,000 at June 30, 2012 from $10,911,000 at June 30, 2011 due to charge-offs and the receipt of collateral in lieu of payment with the collateral now carried as other real estate owned. Internal loan review and analysis and the continued uncertainty surrounding the economy, coupled with the ratios noted previously, dictated that the provision for loan losses was at a level of $1,200,000 for the six month period ended June 30, 2012. The level of provision for loan losses did not equate to the change in nonperforming loans due to the economic situation and the collateral status of the nonperforming loans and overall loan portfolio in general, which limits the loan specific allocation of the allowance for loan losses.
The following is a table showing total nonperforming loans as of:
Total Nonperforming Loans
90 Days
Nonaccrual
March 31, 2012
11,307
11,308
12,009
September 30, 2011
11,885
2,459
14,344
10,911
Non-interest Income
Total non-interest income for the three months ended June 30, 2012 compared to the same period in 2011 increased $408,000 to $2,281,000. Excluding net securities gains, non-interest income for the three months ended June 30, 2012 would have increased $247,000 compared to the 2011 period. Deposit service charges decreased as overdraft fees have declined as an overdrawn dollar threshold must now be reached before the customer is charged a fee. Gain on sale of loans increased as the level of real estate transactions processed has increased over the past year. The increase in number of transactions processed is a direct result of our strategy to increase the number of mortgage originators within our market area, while also hiring additional mortgage originators to expand our market area. Other income increased as debit and credit card related income continues to build as debit cards continue to gain in popularity, while an increasing number of merchants utilize our merchant card services.
Insurance and brokerage commissions for the three months ended June 30, 2012 increased due to continued efforts to add sales representatives. Management of The M Group continues to pursue new and build upon current relationships. The sales call program continues to expand outside of central Pennsylvania, which results in additional revenue for The M Group if an additional sales outlet is added. However, the addition of a sales outlet for The M Group can take up to a year or more to be completed.
Total non-interest income for the six months ended June 30, 2012 compared to the same period in 2011 increased $1,226,000. Excluding net securities gains, non-interest income would have increased $601,000 compared to the 2011 period. The increase in non-interest income for the six month period is the result of the same items noted in the three month discussion.
Non-interest income composition for the three and six months ended June 30, 2012 and 2011 was as follows:
Deposit service charges
20.08
28.14
(69
(13.09
7.45
0.48
1,788.89
Bank owned life insurance
5.83
7.42
(4.32
15.04
12.92
41.74
13.85
9.61
136
75.56
10.83
(12.10
26.92
26.43
119
24.04
Total non-interest income
408
21.78
17.94
26.98
(125
(12.14
15.05
3.51
625
466.42
7.95
8.20
28.12
10.43
12.86
7.13
15.03
10.19
369
94.86
9.10
14.56
(97
(17.45
24.50
23.70
36.57
32.11
Non-interest Expense
Total non-interest expense increased $487,000 for the three months ended June 30, 2012 compared to the same period of 2011. The increase in salaries and employee benefits was attributable to increases in health insurance, salaries, and bonus accrual. FDIC deposit insurance decreased due to a change in the assessment base from a deposit to asset based calculation. Other expenses increased primarily due to expenses, such as advertising, associated with the opening of a branch during 2012 and increased fees related to providing debit card services.
Total non-interest expense increased $963,000 for the six months ended June 30, 2012 compared to the same period of 2011. The increase in non-interest expense for the six month period is primarily the result of the same items noted in the three month discussion.
Non-interest expense composition for the three and six months ended June 30, 2012 and 2011 was as follows:
53.34
50.97
375
15.15
5.95
6.20
5.65
6.68
7.19
2.29
3.13
(5
(2.91
3.11
3.40
FDIC deposit insurance
2.15
3.83
(71
(38.17
25.64
24.87
162
13.41
Total non-interest expense
487
10.03
54.29
51.88
760
14.88
5.98
6.59
(3
(0.46
6.51
6.67
7.00
3.49
(2.33
3.06
3.36
2.20
3.79
(135
(36.19
24.85
24.22
303
12.72
963
9.78
Provision for Income Taxes
Income taxes increased $267,000 and $446,000 for the three and six months ended June 30, 2012 compared to the same periods of 2011. The primary cause of the increase in tax expense for the three and six month periods ended June 30, 2012 compared to 2011 is the impact of increased net income. Excluding the impact of the net securities gains, the effective tax rate for the three and six months ended June 30, 2012 was 15.00% and 13.86% compared to 11.06% and 12.60% for the same period of 2011. The Company currently is in a deferred tax asset position due to the low income housing tax credits earned both currently and previously. Management has reviewed the deferred tax asset and has determined that the asset will be utilized within the appropriate carry forward period and therefore does not require a valuation allowance.
ASSET/LIABILITY MANAGEMENT
Cash and Cash Equivalents
Cash and cash equivalents increased $2,188,000 from $13,885,000 at December 31, 2011 to $16,073,000 at June 30, 2012 primarily as a result of the following activities during the six months ended June 30, 2012:
Loans Held for Sale
Activity regarding loans held for sale resulted in loan originations trailing sale proceeds, less $526,000 in realized gains, by $291,000 for the six months ended June 30, 2012.
Gross loans increased $29,383,000 since December 31, 2011 due primarily to an increase of residential real estate loans with an emphasis on home equity products.
The allocation of the loan portfolio, by category, as of June 30, 2012 and December 31, 2011 is presented below:
11.07
12.19
(1,592
(3.00
45.38
41.15
31,782
17.72
35.35
37.68
221
0.13
6.18
6.76
(714
(2.42
2.32
2.59
(502
(4.44
(0.30
(0.37
(188
(11.79
Gross loans
29,383
6.74
Investments
The fair value of the investment securities portfolio at June 30, 2012 increased $24,969,000 since December 31, 2011. The change is primarily due to purchases of short-term state and political and other debt securities coupled with a net unrealized gain of $10,694,000 at June 30, 2012 compared to an unrealized gain of $4,415,000 at December 31, 2011. The unrealized losses within the debt securities portfolio are the result of market activity, not credit issues/ratings, as approximately 93% of the debt securities portfolio on an amortized cost basis is currently rated A or higher by either S&P or Moody’s.
The Company considers various factors, which include examples from applicable accounting guidance, when analyzing the available for sale portfolio for possible other than temporary impairment. The Company primarily considers the following factors in its analysis: length of time and severity of the market value being less than carrying value; reduction of dividend paid (equities); continued payment of dividend/interest, credit rating, and financial condition of an issuer; intent and ability to hold until anticipated recovery (which may be maturity); and general outlook for the economy, specific industry, and entity in question.
The bond portion of the portfolio review is conducted with emphases on several factors. Continued payment of principal and interest is given primary importance with credit rating and financial condition of the issuer following as the next most important. Credit ratings were reviewed with the ratings of the bonds being satisfactory. Bonds that were not currently rated were discussed with a third party and/or underwent an internal financial review. The Company also monitors whether each of the investments incurred a decline in market value from carrying value of at least 20% for twelve consecutive months or a similar decline of at least 50% for three consecutive months. Each bond is reviewed to determine whether it is a general obligation bond, which is backed by the credit and taxing power of the issuing jurisdiction, or revenue bond, which is only payable from specified revenues. Based on the review undertaken by the Company, the Company determined that the decline in value of the various bond holdings were temporary and were the result of the general market downturns and interest rate/yield curve changes, not credit issues. The fact that almost all of such bonds are general obligation bonds further solidified the Company’s determination that the decline in the value of these bond holdings is temporary.
The fair value of the equity portfolio continues to fluctuate as the economic turbulence continues to impact financial sector stock pricing. The amortized cost of the equity securities portfolio has increased $2,342,000 to $15,032,000 at June 30, 2012 from $12,690,000 at December 31, 2011 as the Company has been slowly building the portfolio balance, while continuing to diversify geographic and sector risk as seen in the growth of non-financial institution holdings.
The equity portion of the portfolio is reviewed for possible other than temporary impairment in a similar manner to the bond portfolio with greater emphasis placed on the length of time the market value has been less than the carrying value and financial sector outlook. The Company also reviews dividend payment activities and, in the case of financial institutions, whether or not such issuer was participating in the TARP Capital Purchase Program. The starting point for the equity analysis is the length and severity of a market price decline. The Company monitors two primary measures: 20% decline in market value from carrying value for twelve consecutive months and 50% decline for three consecutive months.
The distribution of credit ratings by amortized cost and fair values for the debt security portfolio at June 30, 2012 follows:
A- to AAA
B- to BBB+
C to CCC+
Not Rated
21,062
22,569
2,392
2,420
160,572
169,860
7,039
6,503
7,795
7,552
68,978
68,674
539
541
1,018
903
Total debt securities AFS
250,612
261,103
7,578
7,044
11,205
10,875
Financing Activities
Total deposits increased $59,503,000 from December 31, 2011 to June 30, 2012. The growth was led by an increase in money market accounts from December 31, 2011 to June 30, 2012 of 22.34%. The increase in core deposits (deposits less time deposits) has provided relationship driven funding for the loan and investment portfolios, while also reducing the utilization of FHLB borrowings. The increase in deposits is the result of our focus on building relationships with money market accounts being the key building block. Over the past year and through the first six months of 2012, time deposits have decreased as we have taken a position of using these accounts as complementary accounts to core deposits. To facilitate this strategy we are actively working single product time deposit relationships to create a solid relationship through the addition of other products to the customer’s portfolio. In addition, approximately $20,000,000 of the total deposit growth has been generated from the opening of the Danville branch in January 2012.
Deposit balances and their changes for the periods being discussed follow:
18.37
19.14
NOW accounts
115,972
18.09
101,808
17.50
14,164
13.91
152,114
23.72
124,335
21.38
27,779
22.34
81,479
12.71
71,646
12.32
9,833
13.72
173,840
27.11
172,521
29.66
1,319
0.76
59,503
10.23
Borrowed Funds
Total borrowed funds decreased 12.92% or $11,743,000 to $79,133,000 at June 30, 2012 compared to $90,876,000 at December 31, 2011. The decrease in borrowed funds is primarily the result of growth in deposits as the deposit growth provided loan portfolio funding and funds to reduce the level of total borrowings. FHLB repurchase agreements were utilized as their structure allowed for a reduction in interest expense, while providing the ability to reduce the borrowings at our discretion as deposit levels increased.
Short-term borrowings:
FHLB repurchase agreements
300
0.38
16,445
18.10
(16,145
(98.18
Securities sold under agreement to repurchase
17,555
22.18
13,153
14.47
4,402
33.47
Total short-term borrowings
22.56
32.57
(39.67
77.44
67.43
Total borrowed funds
79,133
90,876
(12.92
Capital
The adequacy of the Company’s capital is reviewed on an ongoing basis with reference to the size, composition, and quality of the Company’s resources and regulatory guidelines. Management seeks to maintain a level of capital sufficient to support existing assets and anticipated asset growth, maintain favorable access to capital markets, and preserve high quality credit ratings.
Bank holding companies are required to comply with the Federal Reserve Board’s risk-based capital guidelines. The risk-based capital rules are designed to make regulatory capital requirements more sensitive to differences in risk profiles among banks and bank holding companies and to minimize disincentives for holding liquid assets. Specifically, each is required to maintain certain minimum dollar amounts and ratios of total risk-based, tier I risk-based, and tier I leverage capital. In addition to the capital requirements, the Federal Deposit Insurance Corporation Improvements Act (FDICIA) established five capital categories ranging from “well capitalized” to “critically undercapitalized.” To be classified as “well capitalized”, total risk-based, tier I risked-based, and tier I leverage capital ratios must be at least 10%, 6%, and 5%, respectively.
Capital ratios as of June 30, 2012 and December 31, 2011 were as follows:
Ratio
Total Capital (to Risk-weighted Assets)
Actual
81,518
14.91
77,863
15.27
For Capital Adequacy Purposes
43,741
8.00
40,796
To Be Well Capitalized
54,676
10.00
50,995
Tier I Capital (to Risk-weighted Assets)
74,197
13.57
71,064
13.94
21,870
20,398
32,806
6.00
30,597
Tier I Capital (to Average Assets)
9.35
9.57
31,749
29,688
39,686
5.00
37,110
Liquidity; Interest Rate Sensitivity and Market Risk
The asset/liability committee addresses the liquidity needs of the Company to ensure that sufficient funds are available to meet credit demands and deposit withdrawals as well as to the placement of available funds in the investment portfolio. In assessing liquidity requirements, equal consideration is given to the current position as well as the future outlook.
The following liquidity measures are monitored for compliance and were within the limits cited at June 30, 2012:
1. Net Loans to Total Assets, 85% maximum
2. Net Loans to Total Deposits, 100% maximum
3. Cumulative 90 day Maturity GAP %, +/- 20% maximum
4. Cumulative 1 Year Maturity GAP %, +/- 25% maximum
Fundamental objectives of the Company’s asset/liability management process are to maintain adequate liquidity while minimizing interest rate risk. The maintenance of adequate liquidity provides the Company with the ability to meet its financial obligations to depositors, loan customers, and shareholders. Additionally, it provides funds for normal operating expenditures and business opportunities as they arise. The objective of interest rate sensitivity management is to increase net interest income by managing interest sensitive assets and liabilities in such a way that they can be repriced in response to changes in market interest rates.
The Bank, like other financial institutions, must have sufficient funds available to meet its liquidity needs for deposit withdrawals, loan commitments and originations, and expenses. In order to control cash flow, the Bank estimates future cash flows from deposits, loan payments, and investment security payments. The primary sources of funds are deposits, principal and interest payments on loans and investment securities, FHLB borrowings, and brokered deposits. Management believes the Bank has adequate resources to meet its normal funding requirements.
Management monitors the Company’s liquidity on both a long and short-term basis, thereby providing management necessary information to react to current balance sheet trends. Cash flow needs are assessed and sources of funds are determined. Funding strategies consider both customer needs and economical cost. Both short and long-term funding needs are addressed by maturities and sales of available for sale investment securities, loan repayments and maturities, and liquidating money market investments such as federal funds sold. The use of these resources, in conjunction with access to credit provides core funding to satisfy depositor, borrower, and creditor needs.
Management monitors and determines the desirable level of liquidity. Consideration is given to loan demand, investment opportunities, deposit pricing and growth potential, as well as the current cost of borrowing funds. The Company has a current maximum borrowing capacity at the FHLB of $231,337,000. In addition to this credit arrangement, the Company has additional lines of credit with correspondent banks of $27,081,000. Management believes it has sufficient liquidity to satisfy estimated short-term and long-term funding needs. FHLB borrowings totaled $61,578,000 as of June 30, 2012.
Interest rate sensitivity, which is closely related to liquidity management, is a function of the repricing characteristics of the Company’s portfolio of assets and liabilities. Asset/liability management strives to match maturities and rates between loan and investment security assets with the deposit liabilities and borrowings that fund them. Successful asset/liability management results in a balance sheet structure which can cope effectively with market rate fluctuations. The matching process is affected by segmenting both assets and liabilities into future time periods (usually 12 months, or less) based upon when repricing can be effected. Repriceable assets are subtracted from repriceable liabilities, for a specific time period to determine the “gap”, or difference. Once known, the gap is managed based on predictions about future market interest rates. Intentional mismatching, or gapping, can enhance net interest income if market rates move as predicted. However, if market rates behave in a manner contrary to predictions, net interest income
32
will suffer. Gaps, therefore, contain an element of risk and must be prudently managed. In addition to gap management, the Company has an asset/liability management policy which incorporates a market value at risk calculation which is used to determine the effects of interest rate movements on shareholders’ equity and a simulation analysis to monitor the effects of interest rate changes on the Company’s balance sheet.
The Company currently maintains a GAP position of being liability sensitive. The Company has strategically taken this position as it has decreased the duration of the time deposit portfolio, while continuing to maintain a primarily fixed rate earning asset portfolio with a duration greater than the liabilities utilized to fund earning assets. Lengthening of the liability portfolio coupled with the addition of limited short-term assets is being undertaken. These actions are expected to reduce, but not eliminate, the liability sensitive structure of the balance sheet.
A market value at risk calculation is utilized to monitor the effects of interest rate changes on the Company’s balance sheet and more specifically shareholders’ equity. The Company does not manage the balance sheet structure in order to maintain compliance with this calculation. The calculation serves as a guideline with greater emphases placed on interest rate sensitivity. Changes to calculation results from period to period are reviewed as changes in results could be a signal of future events. As of the most recent analysis, the results of the market value at risk calculation were within established guidelines due to the strategic direction being taken.
Interest Rate Sensitivity
In this analysis the Company examines the result of a 100, 200, 300, and 400 basis point change in market interest rates and the effect on net interest income. It is assumed that the change is instantaneous and that all rates move in a parallel manner. Assumptions are also made concerning prepayment speeds on mortgage loans and mortgage securities.
The following is a rate shock forecast for the twelve month period ending June 30, 2013 assuming a static balance sheet as of June 30, 2012.
Parallel Rate Shock in Basis Points
-200
-100
Static
+100
+200
+300
+400
28,402
29,155
29,568
29,663
29,769
29,798
29,596
Change from static
(1,166
(413
201
230
Percent change from static
-3.94
-1.40
0.32
0.68
0.09
The model utilized to create the report presented above makes various estimates at each level of interest rate change regarding cash flow from principal repayment on loans and mortgage-backed securities and/or call activity on investment securities. Actual results could differ significantly from these estimates which would result in significant differences in the calculated projected change. In addition, the limits stated above do not necessarily represent the level of change under which management would undertake specific measures to realign its portfolio in order to reduce the projected level of change. Generally, management believes the Company is well positioned to respond expeditiously when the market interest rate outlook changes.
Inflation
The asset and liability structure of a financial institution is primarily monetary in nature. Therefore, interest rates rather than inflation have a more significant impact on the Company’s performance. Interest rates are not always affected in the same direction or magnitude as prices of other goods and services, but are reflective of fiscal policy initiatives or economic factors which are not measured by a price index.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Market risk for the Company is comprised primarily of interest rate risk exposure and liquidity risk. Interest rate risk and liquidity risk management is performed at the Bank level as well as the Company level. The Company’s interest rate sensitivity is monitored by management through selected interest rate risk measures produced by an independent third party. There have been no substantial changes in the Company’s gap analyses or simulation analyses compared to the information provided in the Annual Report on Form 10-K for the period ended December 31, 2011. Additional information and details are provided in the “Liquidity and Interest Rate Sensitivity” section of “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Generally, management believes the Company is well positioned to respond in a timely manner when the market interest rate outlook changes.
Item 4. Controls and Procedures
An analysis was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2012. There were no changes in the Company’s internal control over financial reporting that occurred during the quarter ended June 30, 2012, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Part II. OTHER INFORMATION
Item 1. Legal Proceedings
None.
Item 1A. Risk Factors
There are no material changes to the risk factors set forth in Part I, Item 1A, “Risk Factors,” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2011. Please refer to that section for disclosures regarding the risks and uncertainties related to the Company’s business.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Average
Total Number of
Maximum Number (or
Number of
Price Paid
Shares (or Units)
Approximate Dollar Value)
Shares (or
per Share
Purchased as Part of
of Shares (or Units) that
Units)
(or Units)
Publicly Announced
May Yet Be Purchased
Period
Purchased
Plans or Programs
Under the Plans or Programs
Month #1 (April 1 - April 30, 2012)
76,776
Month #2 (May 1 - May 31, 2012)
Month #3 (June 1 - June 30, 2012)
On April 26, 2012, the Board of Directors extended the previously approved authorization to repurchase up to 197,000 shares, or approximately 5%, of the outstanding shares of the Company for an additional year to April 30, 2013. To date, there have been 120,224 shares repurchased under this plan.
Item 3. Defaults Upon Senior Securities
Item 4. Mine Safety Disclosures
Not applicable.
Item 5. Other Information
Item 6. Exhibits
3(i)
Articles of Incorporation of the Registrant as presently in effect (incorporated by reference to Exhibit 3(i) of the Registrant’s Annual Report on Form 10-Q for the period ended March 31, 2012 filed May 9, 2012).
3(ii)
Bylaws of the Registrant as presently in effect (incorporated by reference to Exhibit 3(ii) of the Registrant’s Current Report on Form 8-K filed June 17, 2005).
31(i)
Rule 13a-14(a)/Rule 15d-14(a) Certification of Chief Executive Officer.
31(ii)
Rule 13a-14(a)/Rule 15d-14(a) Certification of Chief Financial Officer.
32(i)
Section 1350 Certification of Chief Executive Officer.
32(ii)
Section 1350 Certification of Chief Financial Officer.
Interactive data file containing the following financial statements formatted in XBRL (Extensible Business Reporting Language): (i) the Consolidated Balance Sheet at June 30, 2012 and December 31, 2011; (ii) the Consolidated Statement of Income for the three and six months ended June 30, 2012 and 2011; (iii) the Consolidated Statements of Shareholders’ Equity for the six months ended June 30, 2012 and 2011; (iv) Consolidated Statement of Comprehensive Income for the three and six months ended June 30, 2012 and 2011; (v) the Consolidated Statement of Cash Flows for the six months ended June 30, 2012 and 2011; and (vi) the Notes to Consolidated Financial Statements. As provided in Rule 406T of Regulation S-T, this interactive data file shall not be deemed to be “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, and shall not be deemed “filed” or part of any registration statement or prospectus for purposes of Section 11 or 12 under the Securities Act of 1933, or otherwise subject to liability under those sections.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
(Registrant)
Date:
August 9, 2012
/s/ Richard A. Grafmyre
Richard A. Grafmyre, President and Chief Executive Officer
(Principal Executive Officer)
/s/ Brian L. Knepp
Brian L. Knepp, Chief Financial Officer
(Principal Financial Officer and Principal Accounting Officer)
EXHIBIT INDEX
Exhibit 31(i)
Rule 13a-14(a)/Rule 15d-14(a) Certification of Chief Executive Officer
Exhibit 31(ii)
Rule 13a-14(a)/Rule 15d-14(a) Certification of Chief Financial Officer
Exhibit 32(i)
Section 1350 Certification of Chief Executive Officer
Exhibit 32(ii)
Section 1350 Certification of Chief Financial Officer
Exhibit 101