UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
______________________
FORM 10-Q
For the quarterly period ended September 30, 2014
OR
For the transition period from _____ to _____.
Commission file number 001-16767
Westfield Financial, Inc.
(Exact name of registrant as specified in its charter)
141 Elm Street, Westfield, Massachusetts 01086
(Address of principal executive offices)
(Zip Code)
(413) 568-1911
(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 SNo £
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 SNo £
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 definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes £No S
At October 31, 2014, the registrant had 18,793,583 shares of common stock, $.01 par value, issued and outstanding.
TABLE OF CONTENTS
FORWARD–LOOKING STATEMENTS
We may, from time to time, make written or oral “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, including statements contained in our filings with the Securities and Exchange Commission (the “SEC”), our reports to shareholders and in other communications by us. This Quarterly Report on Form 10-Q contains “forward-looking statements,” which may be identified by the use of such words as “believe,” “expect,” “anticipate,” “should,” “would,” “plan,” “estimate,” “potential” and other similar expressions. Examples of forward-looking statements include, but are not limited to, estimates with respect to our financial condition, results of operation and business that are subject to various factors which could cause actual results to differ materially from these estimates. These factors include, but are not limited to:
Although we believe that the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially from the results discussed in these forward-looking statements. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. We do not undertake any obligation to republish revised forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.
PART I – FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
WESTFIELD FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS - UNAUDITED
(Dollars in thousands, except per share data)
See accompanying notes to unaudited consolidated financial statements.
CONSOLIDATED STATEMENTS OF NET INCOME – UNAUDITED
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) – UNAUDITED
(Dollars in thousands)
(1) Amortization of net unrealized loss on held-to-maturity securities is recognized as a component of interest income on debt securities, taxable.
(2) Loss realized in interest expense on derivative instruments is recognized as a component of interest expense on long-term debt.
(3) Amounts represent the reclassification of defined benefit plans amortization and have been recognized as a component of salaries and benefit expense.
See accompanying notes to unaudited consolidated financial statements
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
SEPTEMBER 30, 2014
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations – Westfield Financial, Inc. (“Westfield Financial,” “we” or “us”) is a Massachusetts-chartered stock holding company and the parent company of Westfield Bank (the “Bank”), a federally chartered stock savings bank (the “Bank”).
The Bank’s deposits are insured to the limits specified by the Federal Deposit Insurance Corporation (“FDIC”). The Bank operates 11 branches in western Massachusetts and 1 branch in Granby, Connecticut. The Bank’s primary source of revenue is income from securities and earnings on loans to small and middle-market businesses and to residential property homeowners.
Elm Street Securities Corporation and WFD Securities Corporation, Massachusetts-chartered security corporations, were formed by Westfield Financial for the primary purpose of holding qualified securities. WB Real Estate Holdings, LLC, a Massachusetts-chartered limited liability company was formed for the primary purpose of holding real property acquired as security for debts previously contracted by the Bank.
Principles of Consolidation – The unaudited consolidated financial statements include the accounts of Westfield Financial, the Bank, Elm Street Securities Corporation, WB Real Estate Holdings, LLC and WFD Securities Corporation. All material intercompany balances and transactions have been eliminated in consolidation.
Estimates – The preparation of unaudited consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities and the reported amounts of income and expenses for both at the date of the unaudited consolidated financial statements. Actual results could differ from those estimates. Estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for loan losses, other-than-temporary impairment of securities, and the valuation of deferred tax assets.
Basis of Presentation – In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of our financial condition as of September 30, 2014, and the results of operations, changes in shareholders’ equity and cash flows for the interim periods presented. The results of operations for the three and nine months ended September 30, 2014 are not necessarily indicative of the results of operations for the year ending December 31, 2014. Certain information and disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been omitted pursuant to the rules and regulations of the Securities and Exchange Commission.
These unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements as of and for the year ended December 31, 2013, included in our Annual Report on Form 10-K for the year ended December 31, 2013 (the “2013 Annual Report”).
Reclassifications - Amounts in the prior period financial statements are reclassified when necessary to conform to the current year presentation.
2. EARNINGS PER SHARE
Basic earnings per share represent income available to shareholders divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential shares had been issued, as well as any adjustment to income that would result from the assumed issuance. No dilutive potential shares were outstanding during the periods presented. Share-based compensation awards that qualify as participating securities (entitled to receive non-forfeitable dividends) are included in basic earnings per share.
Earnings per common share for the three and nine months ended September 30, 2014 and 2013 have been computed based on the following:
__________
3. COMPREHENSIVE INCOME/LOSS
Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income.
The components of accumulated other comprehensive loss included in shareholders’ equity are as follows:
(1) The net unrealized loss at the date of transfer before tax was $1.5 million for all securities transferred in 2013. The gains or losses on individual securities are amortized through comprehensive income over the remaining life of the security.
The following table presents changes in accumulated other comprehensive income (loss) for the periods ended September 30, 2014 and 2013 by component:
4.SECURITIES
Securities available for sale and held to maturity are summarized as follows:
U.S. government-sponsored and guaranteed mortgage-backed securities are collateralized by both residential and multifamily loans.
Our repurchase agreements and advances from the Federal Home Loan Bank of Boston (“FHLBB”) are collateralized by government-sponsored enterprise obligations and certain mortgage-backed securities (see Note 7).
The amortized cost and fair value of securities available for sale and held to maturity at September 30, 2014, by maturity, are shown below. Actual maturities may differ from contractual maturities because certain issuers have the right to call or repay obligations.
Gross realized gains and losses on sales of securities available for sale for the three and nine months ended September 30, 2014 and 2013 are as follows:
Proceeds from the sale of securities available for sale amounted to $63.6 million and $169.0 million for the nine months ended September 30, 2014 and 2013, respectively.
The tax provision applicable to net realized gains was $77,000 and $94,000 for the three and nine months ended September 30, 2014, respectively. The tax provision applicable to net realized gains was $185,000 and $956,000 for the three and nine months ended September 30, 2013, respectively.
Information pertaining to securities with gross unrealized losses at September 30, 2014, and December 31, 2013, aggregated by investment category and length of time that individual securities have been in a continuous loss position is as follows:
These unrealized losses are the result of changes in interest rates and not credit quality. Because we do not intend to sell the securities and it is more likely than not that we will not be required to sell the investments before recovery of their amortized cost bases, no declines are deemed to be other-than-temporary.
5. LOANS AND ALLOWANCE FOR LOAN LOSSES
During the nine months ended September 30, 2014 and 2013, we purchased residential real estate loans aggregating $38.4 million and $34.6 million, respectively. None were deemed credit impaired at the time of acquisition.
We have transferred a portion of our originated commercial real estate loans to participating lenders. The amounts transferred have been accounted for as sales and are therefore not included in our accompanying unaudited consolidated balance sheets. We share ratably with our participating lenders in any gains or losses that may result from a borrower’s lack of compliance with contractual terms of the loan. We continue to service the loans on behalf of the participating lenders and, as such, collect cash payments from the borrowers, remit payments (net of servicing fees) to participating lenders and disburse required escrow funds to relevant parties. At September 30, 2014 and December 31, 2013, we serviced loans for participants aggregating $26.0 million and $14.3 million, respectively.
Loans are recorded at the principal amount outstanding, adjusted for charge-offs, unearned premiums and deferred loan fees and costs. Interest on loans is calculated using the effective yield method on daily balances of the principal amount outstanding and is credited to income on the accrual basis to the extent it is deemed collectable. Our general policy is to discontinue the accrual of interest when principal or interest payments are delinquent 90 days or more based on the contractual terms of the loan, or earlier if the loan is considered impaired. Any unpaid amounts previously accrued on these loans are reversed from income. Subsequent cash receipts are applied to the outstanding principal balance or to interest income if, in the judgment of management, collection of the principal balance is not in question. Loans are returned to accrual status when they become current as to both principal and interest and perform in accordance with contractual terms for a period of at least six months, reducing the concern as to the collectability of principal and interest. Loan fees and certain direct loan origination costs are deferred, and the net fee or cost is recognized as an adjustment to interest income over the estimated average lives of the related loans.
The allowance for loan losses is established through provisions for loan losses charged to expense. Loans are charged-off against the allowance when management believes that the collectability of the principal is unlikely. Subsequent recoveries, if any, are credited to the allowance.
The allowance for loan losses is evaluated on a regular basis by management. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. The allowance consists of general, allocated, and unallocated components, as further described below.
General component
The general component of the allowance for loan losses is based on historical loss experience adjusted for qualitative factors stratified by the following loan segments: residential real estate (includes one-to-four family and home equity), commercial real estate, commercial and industrial, and consumer. Management uses a rolling average of historical losses based on a time frame appropriate to capture relevant loss data for each loan segment. This historical loss factor is adjusted for the following qualitative factors: trends in delinquencies and nonperforming loans; trends in volume and terms of loans; effects of changes in risk selection and underwriting standards and other changes in lending policies, procedures and practices; and national and local economic trends and industry conditions. There were no changes in our policies or methodology pertaining to the general component of the allowance for loan losses during the periods presented for disclosure.
The qualitative factors are determined based on the various risk characteristics of each loan segment. Risk characteristics relevant to each portfolio segment are as follows:
Residential real estate – We require private mortgage insurance for all loans originated with a loan-to-value ratio greater than 80% and we do not grant subprime loans. All loans in this segment are collateralized by owner-occupied residential real estate and repayment is dependent on the credit quality of the individual borrower. The overall health of the economy, including unemployment rates and housing prices, will have an effect on the credit quality in this segment. Home equity loans are secured by first or second mortgages on one-to-four family owner occupied properties.
Commercial real estate – Loans in this segment are primarily income-producing investment properties and owner occupied commercial properties throughout New England. The underlying cash flows generated by the properties or operations can be adversely impacted by a downturn in the economy due to increased vacancy rates or diminished cash flows, which in turn, would have an effect on the credit quality in this segment. Management obtains financial information annually and continually monitors the cash flows of these loans.
Commercial and industrial loans – Loans in this segment are made to businesses and are generally secured by assets of the business. Repayment is expected from the cash flows of the business. A weakened economy, and resultant decreased consumer spending, will have an effect on the credit quality in this segment.
Consumer loans – Loans in this segment are secured or unsecured and repayment is dependent on the credit quality of the individual borrower.
Allocated component
The allocated component relates to loans that are classified as impaired. Impaired loans are identified by analysis of loan performance, internal credit ratings and watch list loans that management believes are subject to a higher risk of loss. Impairment is measured on a loan by loan basis for commercial real estate and commercial and industrial loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral if the loan is collateral dependent. An allowance is established when the discounted cash flows (or collateral value) of the impaired loan is lower than the carrying value of that loan. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, we do not separately identify individual consumer and residential real estate loans for impairment disclosures, unless such loans are subject to a troubled debt restructuring agreement.
A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. We determine the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.
Unallocated component
An unallocated component may be maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance, if any, reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating allocated and general reserves in the portfolio.
An analysis of changes in the allowance for loan losses by segment for the periods ended September 30, 2014 and 2013 is as follows:
Further information pertaining to the allowance for loan losses by segment at September 30, 2014 and December 31, 2013 follows:
The following is a summary of past due and non-accrual loans by class at September 30, 2014 and December 31, 2013:
The following is a summary of impaired loans by class at September 30, 2014 and December 31, 2013:
All interest income recognized for impaired loans was recognized on the accrual basis during the three and nine months ended September 30, 2014 and 2013.
We may periodically agree to modify the contractual terms of loans. When a loan is modified and a concession is made to a borrower experiencing financial difficulty, the modification is considered a troubled debt restructuring (“TDR”). These concessions could include a reduction in the interest rate on the loan, payment extensions, postponement or forgiveness of principal, forbearance or other actions intended to maximize collection. All TDRs are initially classified as impaired.
When we modify loans in a TDR, we evaluate any possible impairment similar to other impaired loans based on the present value of expected future cash flows, discounted at the contractual interest rate of the original loan agreement, or use the current fair value of the collateral, less selling costs for collateral dependent loans. If we determine that the value of the modified loan is less than the recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs and unamortized premium or discount), impairment is recognized through an allowance estimate or a charge-off to the allowance. In periods subsequent to modification, we evaluate all TDRs, including those that have payment defaults, for possible impairment and recognize impairment through the allowance.
Nonperforming TDRs are shown as nonperforming assets and are included in the table below. Prior to modifications, the four loans listed below had been paying interest only. Upon stabilization of the credits, the related loans were modified and placed on an amortization schedule with higher interest rates. During the three months ended September 30, 2014, one loan relationship with a balance of $14.3 million previously restructured in March 2012 was removed from TDR status upon maturity of the existing loans. The new loans were granted under market conditions and are performing according to the terms of the loan agreements.
A default occurs when a loan is 30 days or more past due and is within 12 months of restructuring. No TDRs defaulted during the three and nine months ended September 30, 2014 and 2013.
As of September 30, 2014, we have not committed to lend any additional funds for loans that are classified as TDRs. There were no charge-offs on TDRs during the three and nine months ended September 30, 2014. There were $38,000 and $74,000 in charge-offs on TDRs during the three and nine months ended September 30, 2013.
Credit Quality Information
We utilize an eight-grade internal loan rating system for commercial real estate and commercial and industrial loans. Performing residential real estate, home equity and consumer loans are grouped with “Pass” rated loans. Nonperforming residential real estate, home equity and consumer loans are monitored individually for impairment and risk rated as “Substandard.”
Loans rated 1 – 3 are considered “Pass” rated loans with low to average risk.
Loans rated 4 are considered “Pass Watch,” which represent loans to borrowers with declining earnings, losses, or strained cash flow.
Loans rated 5 are considered “Special Mention.” These loans exhibit potential credit weaknesses or downward trends and are being closely monitored by us.
Loans rated 6 are considered “Substandard.” Generally, a loan is considered substandard if the borrower exhibits a well-defined weakness that may be inadequately protected by the current net worth and cash flow capacity to pay the current debt.
Loans rated 7 are considered “Doubtful.” Loans classified as doubtful have all the weaknesses inherent in those classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, highly questionable and improbable and that a partial loss of principal is likely.
Loans rated 8 are considered uncollectible and of such little value that their continuance as loans is not warranted.
On an annual basis, or more often if needed, we formally review the ratings on all commercial real estate and commercial and industrial loans. Construction loans are reported within commercial real estate loans and total $27.7 million and $23.4 million at September 30, 2014 and December 31, 2013, respectively. We engage an independent third party to review a significant portion of loans within these segments on a semi-annual basis. We use the results of these reviews as part of our annual review process.
The following table presents our loans by risk rating at September 30, 2014 and December 31, 2013:
6. SHARE-BASED COMPENSATION
Under our 2007 Recognition and Retention Plan and our 2007 Stock Option Plan, we may grant up to 624,041 stock awards and 1,560,101 stock options, respectively, to our directors, officers, and employees.
During the third quarter of 2013, we completed a tender offer to purchase for cancellation 1,665,415 outstanding options to purchase common stock. The recipients of each eligible option tendered received a cash payment equal to the current fair valuation of the option as measured under the binomial model. The total cash paid to purchase the options was $2.1 million, which resulted in a decrease to cash and shareholders’ equity. A deferred tax asset of $566,000 was charged to shareholders’ equity as a result of the tender offer. As of December 31, 2013, 57,232 stock options that had been available for future grants were returned to the 2007 Stock Option Plan reserve and the 2002 and 2007 Stock Option Plans were frozen.
Stock awards are recorded as unearned compensation based on the market price at the date of grant. Unearned compensation is amortized over the vesting period. No stock awards were granted during the three and nine months ended September 30, 2014. At September 30, 2014, no stock awards were available for future grants.
No stock options were granted during the three and nine months ended September 30, 2014.
Our stock award and stock option plans activity for the nine months ended September 30, 2014 and 2013 is summarized below:
We recorded compensation cost related to the stock options of $101,000 with a related tax benefit of $27,000 for the three months ended September 30, 2013. We recorded compensation cost related to the stock options of $128,000 with a related tax benefit of $34,000 for the nine months ended September 30, 2013.
We recorded compensation cost related to the stock awards of $25,000 and $41,000 for the three months ended September 30, 2014 and 2013, respectively. We recorded compensation cost related to the stock awards of $74,000 and $96,000 with related tax benefits of $1,000 and 3,000 for the nine months ended September 30, 2014 and 2013, respectively.
In May 2014, our shareholders approved a new stock based compensation plan under which up to 516,000 shares of our common stock have been reserved for future grants of stock awards, including stock options and restricted stock, which may be granted to any officer, key employee or non-employee director of Westfield Financial. At September 30, 2014, no awards had been granted under this plan.
7. SHORT-TERM BORROWINGS AND LONG-TERM DEBT
We utilize short-term borrowings and long-term debt as an additional source of funds to finance our lending and investing activities and to provide liquidity for daily operations.
Short-term borrowings are made up of FHLBB advances with an original maturity of less than one year as well as customer repurchase agreements, which have an original maturity of one day. Short-term borrowings issued by the FHLBB were $43.0 million at September 30, 2014 and $20.0 million at December 31, 2013. We had a line of credit with the FHLBB of $312,000 at September 30, 2014 while there were no outstanding lines at December 31, 2013. Customer repurchase agreements were $35.4 million at September 30, 2014 and $28.2 million at December 31, 2013. A customer repurchase agreement is an agreement by us to sell to and repurchase from the customer an interest in specific securities issued by or guaranteed by the U.S. government. This transaction settles immediately on a same day basis in immediately available funds. Interest paid is commensurate with other products of equal interest and credit risk. All of our customer repurchase agreements at September 30, 2014 and December 31, 2013, were held by commercial customers. In addition, we have lines of credit of $4.0 million and $50.0 million with Bankers Bank Northeast (“BBN”) and PNC Bank, respectively. The interest rates on these lines are determined and reset on a daily basis by each respective bank. There were no advances outstanding under these lines of credit at September 30, 2014 or December 31, 2013. As part of our contract with BBN, we are required to maintain a reserve balance of $300,000 with BBN for our use of this line of credit.
Long-term debt consists of FHLBB advances, securities sold under repurchase agreements and customer repurchase agreements with an original maturity of one year or more. At September 30, 2014, we had $231.1 million in long-term debt with the FHLBB and $10.0 million in securities sold under repurchase agreements with an approved broker-dealer. This compares to $232.7 million in long-term debt with FHLBB advances and $10.0 million in securities sold under repurchase agreements with an approved broker-dealer at December 31, 2013. The securities sold under agreement to repurchase are callable quarterly at the issuer’s option. Customer repurchase agreements were $5.7 million and $5.6 million at September 30, 2014 and December 31, 2013, respectively. All FHLBB advances are collateralized by a blanket lien on our owner occupied residential real estate loans and certain mortgage-backed securities.
For the nine months ended September 30, 2014, we did not prepay any repurchase agreements. Likewise, there were no prepayments of repurchase agreements as of December 31, 2013.
8. PENSION BENEFITS
The following table provides information regarding net pension benefit costs for the periods shown:
We maintain a pension plan for our eligible employees. We plan to contribute to the pension plan the amount required to meet the minimum funding standards under Section 412 of the Internal Revenue Code of 1986, as amended. Additional contributions will be made as deemed appropriate by management in conjunction with the pension plan’s actuaries. We have not yet determined how much we expect to contribute to our pension plan in 2014. No contributions have been made to the plan for the nine months ended September 30, 2014. The pension plan assets are invested in group annuity contracts with the Principal Financial Group, who also acts as our 401(k) plan provider.
9. DERIVATIVES AND HEDGING ACTIVITIES
Risk Management Objective of Using Derivatives
We are exposed to certain risks arising from both our business operations and economic conditions. We principally manage our exposures to a wide variety of business and operational risks through management of our core business activities. We manage economic risks, including interest rate, liquidity, and credit risk, primarily by managing the amount, sources, and duration of our assets and liabilities and the use of derivative financial instruments. Specifically, we entered into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. Our derivative financial instruments are used to manage differences in the amount, timing, and duration of our known or expected cash receipts and our known or expected cash payments principally related to certain variable rate loan assets and variable rate borrowings.
Fair Values of Derivative Instruments on the Balance Sheet
The table below presents the fair value of our derivative financial instruments designated as hedging instruments as well as our classification on the balance sheet as of September 30, 2014 and December 31, 2013.
Cash Flow Hedges of Interest Rate Risk
Our objectives in using interest rate derivatives are to add stability to interest income and expense and to manage our exposure to interest rate movements. To accomplish this objective, we entered into interest rate swaps in September 2013 as part of our interest rate risk management strategy. These interest rate swaps are designated as cash flow hedges and involve the receipt of variable rate amounts from a counterparty in exchange for our making fixed payments.
The following table presents information about our cash flow hedges at September 30, 2014 and December 31, 2013:
The five forward-starting interest rate swaps will become effective in 2014, 2015, and 2016 with notional amounts of $20.0 million, $47.5 million and $67.5 million, respectively.
For derivatives designated as cash flow hedges, the effective portion of changes in the fair value of the derivative is initially reported in other comprehensive income (outside of earnings), net of tax, and subsequently reclassified to earnings when the hedged transaction affects earnings, and the ineffective portion of changes in the fair value of the derivative is recognized directly in earnings. We assess the effectiveness of each hedging relationship by comparing the changes in cash flows of the derivative hedging instrument with the changes in cash flows of the designated hedged transactions. We have not recognized any hedge ineffectiveness in earnings on any of the interest rate swaps since inception.
We are hedging our exposure to the variability in future cash flows for forecasted transactions over a maximum period of six years (excluding forecasted transactions related to the payment of variable interest on existing financial instruments).
Amounts reported in accumulated other comprehensive loss related to these derivatives will be reclassified to interest expense as interest payments are made on our rate sensitive assets/liabilities. The amount reclassified from accumulated other comprehensive loss into interest expense for the effective portion of interest rate swaps was $48,000 and $142,000 during the three and nine months ended September 30, 2014, respectively. We had no gain or loss reclassified from accumulated other comprehensive loss into income during the three and nine months ended September 30, 2014. During the next 12 months, we estimate that $728,000 will be reclassified as an increase in interest expense.
The table below presents the pre-tax net gains (losses) of our cash flow hedges for the periods indicated.
Credit-risk-related Contingent Features
By using derivative financial instruments, we expose ourselves to credit risk. Credit risk is the risk of failure by the counterparty to perform under the terms of the derivative contract. When the fair value of a derivative contract is positive, the counterparty owes us, which creates credit risk for us. When the fair value of a derivative is negative, we owe the counterparty and, therefore, it does not possess credit risk. The credit risk in derivative instruments is mitigated by entering into transactions with highly-rated counterparties that we believe to be creditworthy and by limiting the amount of exposure to each counterparty.
We have agreements with our derivative counterparties that contain a provision where if we default on any of our indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender, then we could also be declared in default on our derivative obligations. We also have agreements with certain of our derivative counterparties that contain a provision where if we fail to maintain our status as well capitalized, then the counterparty could terminate the derivative positions and we would be required to settle our obligations under the agreements. Certain of our agreements with our derivative counterparties contain provisions where if a formal administrative action by a federal or state regulatory agency occurs that materially changes our creditworthiness in an adverse manner, we may be required to fully collateralize our obligations under the derivative instrument.
As of September 30, 2014, the termination value of derivatives in a net liability position related to these agreements, which includes accrued interest but excludes any adjustment for nonperformance risk, was $2.9 million. As of September 30, 2014, we have minimum collateral posting thresholds with certain of our derivative counterparties and have no collateral posted against our obligations under these agreements. If we had breached any of these provisions at September 30, 2014, we could have been required to settle our obligations under the agreements at the termination value.
10. FAIR VALUE OF ASSETS AND LIABILITIES
Determination of Fair Value
We use fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. The fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for our various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.
Fair Value Hierarchy - We group our assets and liabilities that are measured at fair value in three levels, based on the markets in which the assets are traded and the reliability of the assumptions used to determine fair value.
Level 1 – Valuation is based on quoted prices in active markets for identical assets. Level 1 assets generally include debt and equity securities that are traded in an active exchange market. Valuations are obtained from readily available pricing sources for market transactions involving identical assets.
Level 2 – Valuation is based on observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3 – Valuation is based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets. Level 3 assets include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.
Methods and assumptions for valuing our financial instruments are set forth below. Estimated fair values are calculated based on the value without regard to any premium or discount that may result from concentrations of ownership of a financial instrument, possible tax ramifications or estimated transaction cost.
Cash and cash equivalents – The carrying amounts of cash and short-term instruments approximate fair values based on the short-term nature of the assets.
Securities – Fair value of securities are primarily measured using unadjusted information from an independent pricing service. The securities measured at fair value in Level 1 are based on quoted market prices in an active exchange market. These securities include marketable equity securities. All other securities are measured at fair value in Level 2 and are based on pricing models that consider standard input factors such as observable market data, benchmark yields, interest rate volatilities, broker/dealer quotes, credit spreads and new issue data.
Federal Home Loan Bank and other restricted stock- These investments are carried at cost which is their estimated redemption value.
Loans receivable – For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. Fair values for other loans (e.g., commercial real estate and investment property mortgage loans, commercial and industrial loans and residential real estate loans) are estimated using discounted cash flow analyses, using market interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Fair values for nonperforming loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable.
Accrued interest – The carrying amounts of accrued interest approximate fair value.
Deposit liabilities – The fair values disclosed for demand deposits (e.g., interest and non-interest checking, passbook savings, and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). The carrying amounts of variable-rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies market interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.
Short-term borrowings and long-term debt – The fair values of our debt instruments are estimated using discounted cash flow analyses based on the current incremental borrowing rates in the market for similar types of borrowing arrangements.
Interest rate swaps - The valuation of our interest rate swaps is obtained from a third-party pricing service and is determined using a discounted cash flow analysis on the expected cash flows of each derivative. The pricing analysis is based on observable inputs for the contractual terms of the derivatives, including the period to maturity and interest rate curves. We have determined that the majority of the inputs used to value our interest rate derivatives fall within Level 2 of the fair value hierarchy.
Commitments to extend credit - Fair values for off-balance sheet lending commitments are based on fees currently charged to enter into similar agreements, taking into account the term and credit risk. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. Such differences are not considered significant.
Assets and liabilities measured at fair value on a recurring basis are summarized below:
Also, we may be required, from time to time, to measure certain other assets at fair value on a non-recurring basis in accordance with U.S. GAAP. These adjustments to fair value usually result from application of lower-of-cost-or-market accounting or write-downs of individual assets. The following table summarizes the fair value hierarchy used to determine each adjustment and the carrying value of the related assets at September 30, 2014 and 2013. Total gains (losses) represent the change in carrying value as a result of fair value adjustments related to assets still held at September 30, 2014 and 2013.
The amount of impaired loans represents the carrying value and related write-down and valuation allowance of impaired loans for which adjustments are based on the estimated fair value of the underlying collateral. The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on real estate appraisals performed by independent licensed or certified appraisers. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Management will discount appraisals as deemed necessary based on the date of the appraisal and new information deemed relevant to the valuation. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value. The resulting losses were recognized in earnings through the provision for loan losses. Impaired loans with adjustments resulting from discounted cash flows or without a specific reserve are not included in this disclosure.
There were no transfers to or from Level 1 and 2 during the three and nine months ended September 30, 2014 and 2013. We did not measure any liabilities, other than those arising from interest rate swaps, at fair value on a recurring or non-recurring basis on the consolidated balance sheets.
Fair value estimates 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 our entire holdings of a particular financial instrument. Where quoted market prices are not available, 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 estimates are subjective in nature and involve uncertainties and matters of significant judgment. Changes in assumptions could significantly affect the estimates. The estimated fair values of our financial instruments are as follows:
11. RECENT ACCOUNTING PRONOUNCEMENTS
In January 2014, FASB issued ASU 2014-04- Receivables - Troubled Debt Restructurings by Creditors (Subtopic 310-40): “Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans Upon Foreclosure.” This ASU clarifies that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (i) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (ii) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar agreement. In addition, the amendments require disclosure of both the amount of foreclosed residential real estate property held by the creditor and the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure in accordance with local requirements of the applicable jurisdiction. An entity can elect to adopt the amendments using either a modified retrospective method or a prospective transition method. The amendments are effective for annual and interim periods beginning after December 15, 2014. We do not expect the application of this guidance to have a material impact on our consolidated financial statements.
ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Overview
We strive to remain a leader in meeting the financial service needs of our local community, and to provide quality service to the individuals and businesses in the market areas that we have served since 1853. Historically, we have been a community-oriented provider of traditional banking products and services to business organizations and individuals, including products such as residential and commercial loans, consumer loans and a variety of deposit products. We meet the needs of our local community through a community-based and service-oriented approach to banking.
We have adopted a growth-oriented strategy that has focused on increasing commercial lending. Our strategy also calls for increasing deposit relationships and broadening our product lines and services. We believe that this business strategy is best for our long-term success and viability, and complements our existing commitment to high-quality customer service. In connection with our overall growth strategy, we seek to:
You should read the following financial results for the three and nine months ended September 30, 2014 in the context of this strategy.
CRITICAL ACCOUNTING POLICIES
Our consolidated financial statements are prepared in accordance with U.S. GAAP and practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Actual results could differ from those estimates.
Critical accounting estimates are necessary in the application of certain accounting policies and procedures, and are particularly susceptible to significant change. Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and could potentially result in materially different results under different assumptions and conditions. There have been no material changes to our critical accounting policies during the three and nine months ended September 30, 2014. For additional information on our critical accounting policies, please refer to the information contained in Note 1 of the accompanying unaudited consolidated financial statements and Note 1 of the consolidated financial statements included in our 2013 Annual Report.
COMPARISON OF FINANCIAL CONDITION AT SEPTEMBER 30, 2014 AND DECEMBER 31, 2013
Total assets were stable at $1.3 billion at September 30, 2014 and December 31, 2013. Securities decreased $42.9 million to $510.9 million at September 30, 2014 from $553.8 million at December 31, 2013 primarily due to sales of securities.
Total loans increased by $82.2 million to $719.6 million at September 30, 2014 from $637.4 million at December 31, 2013. Residential loans increased $30.3 million to $264.4 million at September 30, 2014 from $234.1 million at December 31, 2013. We purchased $24.3 million in residential loans from a New England-based bank as a means of supplementing our loan growth. In addition, through our long standing relationship with a third-party mortgage company, we purchased a total of $15.0 million in residential loans within and contiguous to our market area. While in prior quarters management has used residential loan growth to supplement the loan portfolio, the long-term strategy remains focused on commercial lending.
Commercial and industrial loans increased $29.8 million to $165.4 million at September 30, 2014 from $135.6 million at December 31, 2013. Commercial real estate loans increased $22.7 million to $287.2 million at September 30, 2014 from $264.5 at December 31, 2013. Non-owner occupied commercial real estate loans increased $24.8 million to $176.7 million at September 30, 2014 from $151.9 million at December 31, 2013, while owner occupied commercial real estate loans decreased $2.1 million to $110.4 million at September 30, 2014 from $112.5 million at December 31, 2013. The increase in loans was primarily due to organic growth within and contiguous to our market area.
All loans where the interest payment is 90 days or more in arrears as of the closing date of each month are placed on nonaccrual status. Nonperforming loans were $8.9 million at September 30, 2014 and $2.6 million at December 31, 2013. The increase in nonaccrual loans for the nine months ended September 30, 2014 was primarily due to a $6.8 million manufacturing loan relationship that went into nonaccrual and impaired status during the third quarter of 2014. If all nonaccrual loans had been performing in accordance with their terms, we would have earned additional interest income of $125,000 for both the nine months ended September 30, 2014 and 2013. At September 30, 2014 and December 31, 2013, there was no real estate in foreclosure. At September 30, 2014 and December 31, 2013, our nonperforming loans to total loans were 1.23% and 0.41%, respectively, while our nonperforming assets to total assets were 0.68% and 0.20%, respectively. A summary of our nonaccrual and past due loans by class are listed in Note 5 of the accompanying unaudited consolidated financial statements.
Total deposits increased $11.7 million to $828.8 million at September 30, 2014 from $817.1 million at December 31, 2013. The increase in deposits was due to a $25.9 million increase in money market accounts, which were $230.4 million and $204.5 million at September 30, 2014 and December 31, 2013, respectively. Time deposit accounts increased $3.9 million to $345.3 million at September 30, 2014 from $341.4 million at December 31, 2013. Checking accounts decreased $13.7 million to $176.3 million at September 30, 2014 from $190.0 million at December 31, 2013. Regular savings accounts decreased $4.5 million to $76.7 million at September 30, 2014. We modified the interest rate structure on consumer checking accounts, which resulted in some funds from consumer checking shifting to the relationship-based money market account.
Borrowings increased $29.0 million to $325.5 million at September 30, 2014 from $296.5 million at December 31, 2013. Short-term borrowings increased $30.5 million to $78.7 million at September 30, 2014 from $48.2 million at December 31, 2013. Long-term debt decreased $1.5 million to $246.8 million at September 30, 2014 from $248.3 million at December 31, 2013. The change in our short-term debt and long-term borrowings was to take advantage of short-term, low cost FHLBB funding. Our short-term borrowings and long-term debt are discussed in Note 7 of the accompanying unaudited consolidated financial statements.
We have entered into several forward-starting interest rate swap contracts with a combined notional value of $155.0 million. The swap contracts have start dates ranging from the fourth quarter of 2013 to the third quarter of 2016 and have durations ranging from four to six years. This hedge strategy converts the LIBOR based rate of interest on certain FHLB advances to fixed interest rates, thereby protecting us from floating interest rate variability. On a stand-alone basis, the interest rate swaps introduce potential future volatility in tangible book value and accumulated other comprehensive income (“AOCI”); however, the valuation of the swaps is expected to change in the opposite direction of the valuations on the available-for-sale securities portfolio. This is consistent with our objective to reduce total volatility in tangible book value and AOCI.
Shareholders’ equity was $144.3 million and $154.1 million, which represented 11.0% and 12.1% of total assets at September 30, 2014 and December 31, 2013, respectively. The decrease in shareholders’ equity during the nine months ended September 30, 2014 reflects the repurchase of 1,317,945 shares of our common stock at a cost of $9.6 million pursuant to our stock repurchase program, the payment of regular dividends amounting to $3.3 million and a decrease in other comprehensive income of $2.1 million due to changes in the market value of our securities and swaps. This was partially offset by net income of $4.5 million for the nine months ended September 30, 2014.
COMPARISON OF OPERATING RESULTS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2014 AND SEPTEMBER 30, 2013
General
Net income was $1.5 million, or $0.08 per diluted share, for the quarter ended September 30, 2014, compared to $1.6 million, or $0.08 per diluted share, for the same period in 2013. Net interest income was $7.8 million for the three months ended September 30, 2014 and 2013, respectively.
Net Interest and Dividend Income
The following tables set forth the information relating to our average balance and net interest income for the three months ended September 30, 2014 and 2013, and reflect the average yield on interest-earning assets and average cost of interest-bearing liabilities for the periods indicated. Yields and costs are derived by dividing interest income by the average balance of interest-earning assets and interest expense by the average balance of interest-bearing liabilities for the periods shown. The interest rate spread is the difference between the total average yield on interest-earning assets and the cost of interest-bearing liabilities. Net interest margin represents tax-equivalent net interest and dividend income as a percentage of average interest-earning assets. Average balances are derived from actual daily balances over the periods indicated. Interest income includes fees earned from making changes in loan rates and terms and fees earned when the real estate loans are prepaid or refinanced. For analytical purposes, the interest earned on tax-exempt assets is adjusted to a tax-equivalent basis to recognize the income tax savings which facilitates comparison between taxable and tax-exempt assets.
Average
The following table shows how changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected our interest income and interest expense during the periods indicated. Information is provided in each category with respect to:
The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate.
Net interest income was $7.8 million for the three months ended September 30, 2014 and 2013, respectively. The net interest margin, on a tax-equivalent basis, was 2.58% for the three months ended September 30, 2014, compared to 2.62% for the same period in 2013.
The stable net interest income was primarily driven by a favorable shift in average interest-earnings assets out of securities and into loans; however, this was partially offset by a decrease in the average yield on loans. In addition, the cost of interest-bearing liabilities was flat due to an increase in the cost of short-term borrowings and long-term debt that offset a decrease in the cost of interest-bearing deposits. The average balance of securities decreased $81.1 million to $492.9 million from $574.0 million, while the average balance of loans increased $93.8 million to $703.7 million from $609.9 million for the three months ended September 30, 2014 from the same period in 2013. The average yield on loans decreased 12 basis points to 4.08% for the three months ended September 30, 2014, compared to 4.20% for the same period in 2013. The primary reason for the decrease in loan yield from the comparable 2013 period is that a portion of the new loan volume is adjustable and priced around prime rate, which is lower than current fixed rates, but will generate additional revenue and yield once rates begin to rise.
Interest expense was $2.5 million for the three months ended September 30, 2014 and 2013, respectively. The average cost of interest-bearing deposits decreased 16 basis points to 1.20% for the three months ended September 30, 2014 from 1.36% for the same period in 2013. The cost of short-term borrowings and long-term debt increased 14 basis points to 1.52% for the three months ended September 30, 2014 from 1.38% for the three months ended September 30, 2013, primarily due to certain FHLBB flipper advances that converted into a fixed-rate instrument once their adjustable terms reached expiration.
Provision for Loan Losses
The amount that we provided for loan losses during the three months ended September 30, 2014 was based upon the changes that occurred in the loan portfolio during that same period. The changes in the loan portfolio for the three months ended September 30, 2014, described in detail below, include an increase in nonaccrual loans and charge-offs related to a single commercial loan relationship with a balance of $6.8 million, an increase in commercial and industrial loans, commercial real estate loans and residential real estate loans and a decrease in impaired loan balances. After evaluating these factors, we recorded a provision of $750,000 for loan losses for the three months ended September 30, 2014, compared to a credit of $71,000 for the same period in 2013. The allowance was $7.7 million and $8.0 million and 1.07% and 1.17% of total loans at September 30, 2014 and June 30, 2014, respectively.
Nonaccrual loans were $8.9 million at September 30, 2014 and $3.2 million at June 30, 2014. During the third quarter of 2014, one manufacturing loan relationship with a balance of $6.8 million, which is comprised of commercial and industrial loans of $4.1 million and a commercial real estate loan of $2.7 million, was placed into nonaccrual status and deemed impaired. We have maintained a relationship with this borrower for over 15 years. The relationship has been classified as a substandard credit since 2011 and has experienced declining sales that impacted their business operations. Based upon the fair value of the underlying business collateral, we recorded a charge-off of $950,000 for the three months ended September 30, 2014 related to this single relationship.
Net charge-offs were $1.1 million for the three months ended September 30, 2014. This comprised charge-offs of $1.1 million for the three months ended September 30, 2014, offset by recoveries of $4,000. Net charge-offs were $91,000 for the three months ended September 30, 2013. This comprised charge-offs of $116,000 for the three months ended September 30, 2013, partially offset by recoveries of $25,000.
Commercial and industrial loans increased $17.8 million to $165.4 million at September 30, 2014 from $147.6 million at June 30, 2014. Commercial real estate loans increased $1.2 million to $287.2 million at September 30, 2014 from $286.0 at June 30, 2014. Non-owner occupied commercial real estate loans increased $1.8 million to $176.7 million at September 30, 2014 from $174.9 million at June 30, 2014, while owner occupied commercial real estate loans decreased $700,000 to $110.4 million at September 30, 2014 from $111.1 million at June 30, 2014. Residential loans increased $14.5 million to $264.4 million at September 30, 2014 from $249.9 million at June 30, 2014. We consider residential real estate loans to contain less credit risk and market risk than both commercial and industrial and commercial real estate loans.
Impaired loans decreased $8.3 million to $8.4 million at September 30, 2014 from $16.7 million at June 30, 2014. The decrease in impaired loan balances was due to the financial improvement of a single commercial real estate loan relationship with a balance of $14.3 million, which returned to the general allowance pool for reserve measurement during the three months ended September 30, 2014. This decrease was partially offset by an increase in impaired loan balances of $6.8 million related to the manufacturing loan relationship described above as of September 30, 2014.
During the 2013 period, the credit for loan losses was the result of continued improvement in the overall risk profile of the commercial loan portfolio. Impaired loans that previously carried higher allowances showed improvement resulting in allowances on impaired loans decreasing $70,000 to $238,000 at September 30, 2013. A summary of our provision for loan losses by loan segment is listed in Note 5 of the accompanying unaudited consolidated financial statements.
Although we believe that we have established and maintained the allowance for loan losses at adequate levels, future adjustments may be necessary if economic, real estate and other conditions differ substantially from the current operating environment.
Noninterest Income
Noninterest income increased $256,000 to $1.3 million for the three months ended September 30, 2014, compared to $1.0 million for the same period in 2013, primarily due to net gains on the sales of securities of $226,000 during the three months ended September 30, 2014. The three months ended September 30, 2013 included a loss on the prepayment of borrowings of $540,000, offset by securities gains of $546,000.
Noninterest Expense
Noninterest expense decreased $503,000 to $6.3 million for the three months ended September 30, 2014 from $6.9 million for the same period in 2013. Salaries and benefits decreased $436,000 to $3.6 million for the three months ended September 30, 2014 from $4.1 million for the same period in 2013, primarily due to a $286,000 decrease in share-based compensation expense and other employee benefits costs. Other noninterest expense decreased $68,000 to $721,000 for the three months ended September 30, 2014, primarily due to an $89,000 decrease in advertising expenses for the period.
Income Taxes
For the three months ended September 30, 2014, we had a tax provision of $491,000, as compared to $476,000 for the same period in 2013. The effective tax rate was 24.5% for the three months ended September 30, 2014 and 23.1% for the same period in 2013. The change in effective tax rate reflects slightly lower levels of tax-advantaged income such as BOLI and tax-exempt municipal obligations for the three months ended September 30, 2014.
COMPARISON OF OPERATING RESULTS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2014 AND SEPTEMBER 30, 2013
Net income was $4.5 million, or $0.25 per diluted share, for the nine months ended September 30, 2014, compared to $4.9 million, or $0.24 per diluted share, for the same period in 2013. Net interest income was $23.2 million and $23.1 million for the nine months ended September 30, 2014 and 2013, respectively.
The following tables set forth the information relating to our average balance and net interest income for the nine months ended September 30, 2014 and 2013, and reflect the average yield on interest-earning assets and average cost of interest-bearing liabilities for the periods indicated. Yields and costs are derived by dividing interest income by the average balance of interest-earning assets and interest expense by the average balance of interest-bearing liabilities for the periods shown. The interest rate spread is the difference between the total average yield on interest-earning assets and the cost of interest-bearing liabilities. Net interest margin represents tax-equivalent net interest and dividend income as a percentage of average interest-earning assets. Average balances are derived from actual daily balances over the periods indicated. Interest income includes fees earned from making changes in loan rates and terms and fees earned when the real estate loans are prepaid or refinanced. For analytical purposes, the interest earned on tax-exempt assets is adjusted to a tax-equivalent basis to recognize the income tax savings which facilitates comparison between taxable and tax-exempt assets.
Net interest income was $23.2 million and $23.1 million for the nine months ended September 30, 2014 and 2013, respectively. The net interest margin, on a tax-equivalent basis, was 2.61% and 2.59% for the nine months ended September 30, 2014 and 2013, respectively.
The stable net interest income was primarily driven by a favorable shift in average interest-earnings assets out of securities and into loans and a reduction in the cost of interest-bearing liabilities; however, this was partially offset by a decrease in the average yield on loans and interest-earning assets. The average balance of securities decreased $90.5 million to $507.9 million from $598.4 million, while the average balance of loans increased $70.3 million to $670.1 million from $599.8 million for the nine months ended September 30, 2014 from the same period in 2013. The average yield on loans decreased 14 basis points to 4.10% for the nine months ended September 30, 2014, compared to 4.24% for the same period in 2013. The primary reason for the decrease in loan yield from the comparable 2013 period is that a portion of the new loan volume is adjustable and priced around prime rate, which is lower than current fixed rates, but will generate additional revenue and yield once rates begin to rise.
Interest on earning-assets, on a tax-equivalent basis, decreased $524,000 to $30.9 million for the nine months ended September 30, 2014 from $31.5 million for the same period in 2013. The average yield on interest-earning assets decreased 2 basis point to 3.41% for the nine months ended September 30, 2014 from 3.43% for the same period in 2013. In addition, average interest-earning assets decreased $12.5 million to $1.2 billion for the nine months ended September 30, 2014. Despite a decrease in the average yield on loans, the asset shift from securities into loans helped to stabilize the average yield on interest-earning assets due to the higher average yield on loans compared to securities.
Interest expense decreased $479,000 to $7.3 million for the nine months ended September 30, 2014 from $7.8 million for the same period in 2013. The average cost of interest-bearing liabilities decreased 6 basis points to 0.99% for the nine months ended September 30, 2014 from 1.05% for the same period in 2013. The decrease in the cost of interest-bearing liabilities was primarily due to a decrease in rates on time deposits. In addition, for the nine months ended September 30, 2013, we prepaid repurchase agreements in the amount of $43.3 million and incurred a prepayment expense of $3.4 million. The repurchase agreements had a weighted average cost of 2.99%.
The amount that we provided for loan losses during the nine months ended September 30, 2014 was based upon the changes that occurred in the loan portfolio during that same period. The changes in the loan portfolio for the nine months ended September 30, 2014, described in detail below, include increases in commercial and industrial loans, commercial real estate loans, residential real estate loans, an increase in charge-offs driven primarily by the impairment of one single manufacturing loan relationship and a decrease in impaired loan balances. After evaluating these factors, we recorded a provision of $1.3 million for loan losses for the nine months ended September 30, 2014, compared to a credit of $376,000 for the same period in 2013. The allowance was $7.7 million at September 30, 2014 and $7.5 million at December 31, 2013. The allowance for loan losses was 1.07% of total loans at September 30, 2014 and 1.17% at December 31, 2013, respectively.
Commercial and industrial loans increased $29.8 million to $165.4 million at September 30, 2014 from $135.6 million at December 31, 2013. Commercial real estate loans increased $22.7 million to $287.2 million at September 30, 2014 from $264.5 million at December 31, 2013. Residential real estate loans increased $30.3 million to $264.4 million at September 30, 2014, compared to $234.1 million at December 31, 2013. We consider residential real estate loans to contain less credit risk and market risk than both commercial and industrial and commercial real estate loans.
Nonaccrual loans were $8.9 million at September 30, 2014 and $2.6 million at December 31, 2013. During the third quarter of 2014, one manufacturing loan relationship with a balance of $6.8 million, which is comprised of commercial and industrial loans of $4.1 million and a commercial real estate loan of $2.7 million, was placed into nonaccrual status and deemed impaired. We have maintained a relationship with this borrower for over 15 years. The relationship has been classified as a substandard credit since 2011 and has experienced declining sales that impacted their business operations. Based upon the fair value of the business collateral, we recorded a charge-off of $950,000 for the three months ended September 30, 2014 related to this single relationship. Net charge-offs were $1.1 million for the nine months ended September 30, 2014. This comprised charge-offs of $1.2 million for the nine months ended September 30, 2014, offset by recoveries of $124,000. Net charge-offs were $107,000 for the nine months ended September 30, 2013. This comprised charge-offs of $336,000 for the nine months ended September 30, 2013, partially offset by recoveries of $229,000.
Impaired loans decreased $8.1 million to $8.4 million at September 30, 2014 from $16.5 million at December 31, 2014. The decrease in impaired loan balances was due to the financial improvement of a single commercial real estate loan relationship with a balance of $14.3 million, which returned to the general allowance pool for reserve measurement during the three months ended September 30, 2014. This decrease was partially offset by an increase in impaired loan balances of $6.8 million related to the manufacturing loan relationship described above as of September 30, 2014.
During the 2013 period, the credit for loan losses was the result of continued improvement in the overall risk profile of the commercial loan portfolio. Impaired loans that previously carried higher allowances showed considerable improvement resulting in allowances on impaired loans decreasing $300,000 to $238,000 at September 30, 2013. A summary of our provision for loan losses by loan segment is listed in Note 5 of the accompanying unaudited consolidated financial statements.
Noninterest income increased $455,000 to $3.4 million for the nine months ended September 30, 2014, compared to $2.9 million for the same period in 2013. Service charges and fees increased $179,000 to $2.0 million at September 30, 2014 from $1.8 million at September 30, 2013. This was primarily due to the collection of $97,000 in prepayment fees on a commercial loan relationship that paid off early during the first quarter of 2014. Fees collected from card-based transactions increased $62,000 for the nine months ended September 30, 2014, which reflects an increase in customer debit card and automated teller machine transactions. In addition, fee income from wealth management was $46,000 for the nine months ended September 30, 2014. We began offering wealth management services during the first quarter of 2014.
Net gains on the sales of securities were $276,000 during the nine months ended September 30, 2014. During the nine months ended September 30, 2013, we recorded income on the proceeds of BOLI death benefits of $563,000 and $2.8 million in gains on sales of securities. For the nine months ended September 30, 2013, the income on BOLI death benefits and sales of securities was offset by $3.4 million in expense on the prepayment of borrowings.
Noninterest expense decreased $741,000 to $19.4 million for the nine months ended September 30, 2014 from $20.2 million for the same period in 2013. Salaries and benefits decreased $618,000 to $11.1 million for the nine months ended September 30, 2014 from $11.7 million for the same period in 2013, mainly resulting from a reduction in share-based compensation expense and other employee benefits costs. Other expenses decreased $150,000 to $2.4 million for the nine months ended September 30, 2014, primarily due to a decrease of $63,000 in advertising expenses for the period and a decrease of $41,000 in net ATM/debit card expense resulting from changes in interchange fees. Occupancy expense increased $88,000 for the nine months ended September 30, 2014.
For the nine months ended September 30, 2014, we had a tax provision of $1.4 million, as compared to $1.3 million for the same period in 2013. The effective tax rate was 23.2% for the nine months ended September 30, 2014 and 21.3% for the same period in 2013. The change in effective tax rate is primarily due to the net income on BOLI death benefits recognized during the nine months ended September 30, 2013.
LIQUIDITY AND CAPITAL RESOURCES
The term “liquidity” refers to our ability to generate adequate amounts of cash to fund loan originations, loan purchases, withdrawals of deposits and operating expenses. Our primary sources of liquidity are deposits, scheduled amortization and prepayments of loan principal and mortgage-backed securities, maturities and calls of securities and funds provided by operations. We also can borrow funds from the FHLBB based on eligible collateral of loans and securities. Our maximum additional borrowing capacity from the FHLBB at September 30, 2014, was $67.7 million. In addition, we have lines of credit of $4.0 million and $50.0 million with Bankers Bank Northeast (“BBN”) and PNC Bank, respectively. The interest rates on these lines are determined and reset on a daily basis by each respective bank. As of September 30, 2014, our additional borrowing capacity from BBN and PNC Bank was $4.0 million and $50.0 million, respectively.
Liquidity management is both a daily and long-term function of business management. The measure of a company’s liquidity is its ability to meet its cash commitments at all times with available cash or by conversion of other assets to cash at a reasonable price. Loan repayments and maturing securities are a relatively predictable source of funds. However, deposit flow, calls of securities and repayments of loans and mortgage-backed securities are strongly influenced by interest rates, general and local economic conditions and competition in the marketplace. These factors reduce the predictability of the timing of these sources of funds. Management believes that we have sufficient liquidity to meet its current operating needs.
At September 30, 2014, we exceeded each of the applicable regulatory capital requirements. As of September 30, 2014, the most recent notification from the Office of Comptroller of the Currency categorized us as “well-capitalized” under the regulatory framework for prompt corrective action. To be categorized as “well-capitalized” we must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the following table. There is also a requirement to maintain a ratio of 1.5% tangible capital to tangible assets. There are no conditions or events since that notification that management believes would change our category. Our actual capital ratios of September 30, 2014, and December 31, 2013, are also presented in the following table.
We also have outstanding, at any time, a significant number of commitments to extend credit and provide financial guarantees to third parties. These arrangements are subject to strict credit control assessments. Guarantees specify limits to our obligations. Because many commitments and almost all guarantees expire without being funded in whole or in part, the contract amounts are not estimates of future cash flows. We are obligated under leases for certain of our branches and equipment. The following table summarizes the contractual obligations and credit commitments at September 30, 2014:
OFF-BALANCE SHEET ARRANGEMENTS
We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
There have been no material changes in our assessment of our sensitivity to market risk since its presentation in our 2013 Annual Report. Please refer to Item 7A of the 2013 Annual Report for additional information.
ITEM 4. CONTROLS AND PROCEDURES.
Disclosure Controls and Procedures.
Management, including our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)), as of the end of the period covered by this report. Based upon the evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures were effective, to ensure that information required to be disclosed in the reports we file and submit under the Securities Exchange Act of 1934, as amended, is (i) recorded, processed, summarized and reported as and when required and (ii) accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely discussion regarding required disclosure.
Changes in Internal Control Over Financial Reporting.
There have been no changes in our internal control over financial reporting identified in connection with the evaluation that occurred during our last fiscal quarter that have materially affected, or that are reasonably likely to materially affect, our internal control over financial reporting.
PART II – OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
We are subject to claims and legal actions in the ordinary course of business. We believe that all such claims and actions currently pending against us, if any, are either adequately covered by insurance or would not have a material adverse effect on us if decided in a manner unfavorable to us.
ITEM 1A. RISK FACTORS.
For a summary of risk factors relevant to our operations, see Part 1, Item 1A, “Risk Factors” in our 2013 Annual Report. There are no material changes in the risk factors relevant to our operations.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.
The following table sets forth information with respect to purchases made by us of our common stock during the three months ended September 30, 2014.
There were no sales by us of unregistered securities during the three months ended September 30, 2014.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES.
None.
ITEM 4. MINE SAFETY DISCLOSURE.
Not applicable.
ITEM 5. OTHER INFORMATION.
ITEM 6. EXHIBITS.
The exhibits required to be filed as part of this Quarterly Report on Form 10-Q are listed in the Exhibit Index attached hereto and are incorporated herein by reference.
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 on November 6, 2014.
EXHIBIT INDEX
ExhibitNumber
Description
* Filed herewith.