Ames National Corp. - 10-Q quarterly report FY

[Mark One]

For the quarterly period ended June 30, 2010

                       For the transition period from ____________ to ____________

Commission File Number 0-32637

(Exact Name of Registrant as Specified in Its Charter)

405 FIFTH STREET

AMES, IOWA 50010

(Address of Principal Executive Offices)

Registrant's Telephone Number, Including Area Code: (515) 232-6251

NOT APPLICABLE

(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes 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 (Section 232.405 of this Chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes o     No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or a smaller reporting company.  See definition of “accelerated filer”, “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:

Large accelerated filer o   Accelerated filer x   Non-accelerated filer o   Smaller 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

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

Net loan charge-offs for the quarter totaled $2,000, compared to net charge-offs of $571,000 in the second quarter of 2009.  The provision for loan losses for the second quarter of 2010 totaled $170,000 compared to the provision for loan losses of $327,000 for the same period in 2009.  This decrease in the provision for loan losses was due primarily to a decrease in outstanding loans, lower net charge offs and improving asset quality.

The Company had net income of $6,396,000, or $0.68 per share, for the six months ended June 30, 2010, compared to net income of $4,850,000, or $0.51 per share, for the six months ended June 30, 2009.

The Company’s earnings for the six months ended June 30, 2010 increased $1,546,000 from the $4,850,000 earned a year ago.  The higher year-to-date earnings can be primarily attributed to increased securities gains, lower other real estate owned expenses, lower FDIC insurance assessments and higher net interest income.  For the six months ended June 30, 2010, securities gains were $672,000 as compared to securities losses of $96,000 for the six month ended June 30, 2009.  The decrease in other real estate costs of $1,035,000 is due primarily to write downs in 2009, with no significant write downs in 2010.  The decrease in the FDIC insurance assessments of $446,000 is due primarily to lower quarterly deposit assessments.

Net loan charge-offs for the six months ended June 30, 2010 totaled $296,000, compared to net charge-offs of $647,000 for the six months ended June 30, 2009.  The provision for loan losses for the six months ended June 30, 2010 totaled $494,000 compared to the provision for loan losses of $556,000 for the same period in 2009.  This decrease in the provision for loan losses was due primarily to a decrease in outstanding loans, lower net charge offs and improving asset quality.

The following management discussion and analysis will provide a review of important items relating to:

Challenges

Management has identified certain challenges that may negatively impact the Company’s revenues in the future and is attempting to position the Company to best respond to those challenges.

·           In March of 2009, the OCC imposed individual minimum capital ratios requiring First National to maintain, on an ongoing basis, Tier One Leverage Capital of 9% of Adjusted Total Assets and Total Risk Based Capital of 11% of Risk Weighted Assets.  As of June 30, 2010, First National exceeded these capital ratios.  Failure to maintain the individual minimum capital ratios could result in additional regulatory action against First National.

·           Interest rates are likely to increase as the economy continues its gradual recovery and an increasing interest rate environment may present a challenge to the Company.  Increases in interest rates may negatively impact the Company’s net interest margin if interest expense increases more quickly than interest income.  The Company’s earning assets (primarily its loan and investment portfolio) have longer maturities than its interest bearing liabilities (primarily deposits and other borrowings); therefore, in a rising interest rate environment, interest expense may increase more quickly than interest income as the interest bearing liabilities reprice more quickly than earni ng assets.  In response to this challenge, the Banks model quarterly the changes in income that would result from various changes in interest rates.  Management believes Bank earning assets have the appropriate maturity and repricing characteristics to optimize earnings and the Banks’ interest rate risk positions.

·           The Company’s market in central Iowa has numerous banks, credit unions, and investment and insurance companies competing for similar business opportunities.  This competitive environment will continue to put downward pressure on the Banks’ net interest margins and thus affect profitability.  Strategic planning efforts at the Company and Banks continue to focus on capitalizing on the Banks’ strengths in local markets while working to identify opportunities for improvement to gain competitive advantages.

·           The Company’s equity securities portfolio (held at the holding company level and excluding equity holdings by the Banks) is $3.5 million as of June 30, 2010.  The Company invests a portion of its’ capital that may be utilized for future expansion in a portfolio of primarily financial and utility stocks.  The Company has focused on stocks that have historically paid dividends in an effort to lessen the negative effects of a bear market.  The strategy, however, did not prove successful in 2010 and 2009 as problems due to the national recession caused a significant decline in the market value and dividend rates of the Company’s equity securities.   Unrealized losses in the Company’s equity portfolio totaled $1,355,000 and $1,312,000 (at the holding company level on an unconsolidated basis) as of June 30, 2010 and December 31, 2009, respectively.  The Company had realized gains of $3,000 in its equity portfolio during the six months ended June 30, 2010, compared to realized losses of $55,000 during the six months ended June 30, 2009 (at the holding company level on an unconsolidated basis).  Additionally, the Company recognized no impairment losses in the equity portfolio during the six months ended June 30, 2010 and 2009.  It is possible that the Company may incur impairment losses in the remainder of 2010 which would have a negative impact on the Company’s earnings for the year.

·           Loans amounted to $410.4 million and $415.4 million as of June 30, 2010 and December 31, 2009, respectively.  The loan portfolio decreased 1.2% during the six months ended June 30, 2010.  The decline in the loan portfolio is primarily due to the decrease in loan volume due to a weakening of loan demand as payments and prepayments exceeded originations.  The declines in the loan portfolio occurred primarily in the commercial real estate and commercial operating loan portfolios, offset in part by increases in one-to-four family real estate, agricultural operating and agricultural real estate loan portfolios.

·           The economic conditions for commercial real estate developers in the Des Moines metropolitan area deteriorated in recent years and significantly contributed to the Company’s increased level of non-performing loans, other real estate owned and related costs since 2007.  The Company has $8,880,000 in other real estate owned in the Des Moines market.  The Company has $3.4 million in impaired loans with two Des Moines development companies with specific reserves totaling $338,000.  The Company has additional customer relationships with real estate developers in the Des Moines area that may become impaired in the future if economic conditions do not improve or become wors e.  The Company has a limited number of such credits and is actively engaged with the customers to minimize credit risk.

·           Other real estate owned amounted to $10.6 million and $10.5 million as of June 30, 2010 and December 31, 2009, respectively.  Other real estate owned costs amounted to $119,000 and $1,155,000 for the six months ended June 30, 2010 and 2009, respectively.  Management obtains independent appraisals or performs evaluations to determine that these properties are carried at the lower of the new cost basis or fair value less cost to sell.  It is at least reasonably possible that change in fair values will occur in the near term and that such changes could have a negative impact on the Company’s earnings.

·           The FDIC imposes an assessment against all depository institutions for deposit insurance.  Notably, the FDIC has the authority to increase insurance assessments.  FDIC insurance assessments amounted to $591,000 and $1,037,000 for the six months ended June 30, 2010 and 2009, respectively.  For the six months ended June 30, 2010, 89 banks failed as compared 140 bank failures for the year ended December 31, 2009.  In 2011, the FDIC has a scheduled assessment increase for all FDIC insured institutions.  An increase in FDIC deposit assessments will have a negative impact on the Company’s earnings.

·           The Company operates in a highly regulated environment and is subject to extensive regulation, supervision and examination.  Applicable laws and regulations may change, and there is no assurance that such changes will not adversely affect the Company’s business.  In this respect potentially landscape-changing legislative proposals have been introduced in Congress and by regulatory agencies with respect to their respective regulatory powers.  Such regulation and supervision govern the activities in which an institution may engage and are intended primarily for the protection of the Bank, its depositors and the FDIC.   ;Regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including but not limited to the imposition of restrictions on the operation of an institution, the classification of assets by the institution and the adequacy of an institution’s allowance for loan losses.  Any change in such regulation and oversight, whether in the form of restrictions on activities, regulatory policy, regulations, or legislation, including but not limited to changes in the regulations governing banks, could have a material impact on the Company’s operations.  In particular, the Dodd-Frank Wall Street Reform and Consumer Protection Act was recently signed into law by the President.  The effect of this new law on the banking industry and on the Company is uncertain at the present time given that many of the changes will be implemented through regulatory rules that have yet to be proposed or adopted.

Key Performance Indicators and Industry Results

Certain key performance indicators for the Company and the industry are presented in the following chart.  The industry figures are compiled by the Federal Deposit Insurance Corporation (FDIC) and are derived from 7,932 commercial banks and savings institutions insured by the FDIC.  Management reviews these indicators on a quarterly basis for purposes of comparing the Company’s performance from quarter to quarter against the industry as a whole.

Selected Indicators for the Company and the Industry

*Latest available data

Key performances indicators include:

This ratio is calculated by dividing net income by average assets.  It is used to measure how effectively the assets of the Company are being utilized in generating income.  The Company's annualized return on average assets was 1.35% and 1.08%, respectively, for the three month periods ending June 30, 2010 and 2009.  The increase in this ratio in 2010 from the previous period is primarily the result of higher net income, offset in part by an increase in average assets.

This ratio is calculated by dividing net income by average equity.  It is used to measure the net income or return the Company generated for the shareholders’ equity investment in the Company. The Company's return on average equity was 10.73% and 9.09%, respectively for the three month periods ending June 30, 2010 and 2009.  The increase in this ratio in 2010 from the previous period is primarily the result of higher net income, offset in part by an increase in average equity.

The net interest margin for the three months ended June 30, 2010 and 2009 was 3.73%.  The ratio is calculated by dividing net interest income by average earning assets.  Earning assets are primarily made up of loans and investments that earn interest.  This ratio is used to measure how well the Company is able to maintain interest rates on earning assets above those of interest-bearing liabilities, which is the interest expense paid on deposits and other borrowings.  Although no change in the net interest margin occurred, higher interest earning assets and lower cost of funds on interest bearing deposits were offset by higher interest bearing liabilities and higher yields on interest earning assets.  The lower yields and cost of funds were due primarily to lower market interest rates as interest earning assets and interest-bearing liabilities are repricing.

This ratio is calculated by dividing noninterest expense by net interest income and noninterest income.  The ratio is a measure of the Company’s ability to manage noninterest expenses.  The Company’s efficiency ratio was 51.51% and 62.25% for the three months ended June 30, 2010 and 2009, respectively.  The improvement in the efficiency ratio in 2010 from the previous period is primarily the result of decreased expenses related to other real estate owned and FDIC insurance assessments.

The average capital ratio is calculated by dividing average total equity capital by average total assets.  It measures the level of average assets that are funded by shareholders’ equity.  Given an equal level of risk in the financial condition of two companies, the higher the capital ratio, generally the more financially sound the company.  The Company’s capital ratio is significantly higher than the industry average.

Industry Results

The FDIC Quarterly Banking Profile reported the following results for the first quarter of 2010:

Earnings Post Significant Increase

First quarter results for insured commercial banks and savings institutions contained positive signs of recovery for the industry. While new accounting rules had a major effect on several components of the industry’s balance sheet and income statement, there was clear improvement in certain performance indicators. Lower provisions for loan losses and reduced expenses for goodwill impairment lifted the earnings of FDIC-insured commercial banks and savings institutions to $18.0 billion. While still low by historical standards, first quarter earnings represented a significant improvement from the $5.6 billion the industry earned in first quarter 2009 and are the highest quarterly total since first quarter 2008. The largest year-over-year increases occurred at the biggest banks, but a majority of institutions (52.2%) reported net inc ome growth. This is the highest percentage of institutions reporting increased quarterly earnings in more than three years (since third quarter 2006).

Reduced Loan-Loss Provisions Help Drive Earnings Improvement

Insured institutions set aside $51.3 billion in provisions for loan and lease losses in the first quarter, a $10.2 billion (16.6%) decline from a year earlier. However, only about one-third of insured institutions reported year-over-year declines in loss provisions, with much of the overall reduction concentrated among a few of the largest banks. Another positive factor in the earnings improvement at larger institutions was a $2.2 billion (2.3%) decline in noninterest expenses that was caused by lower goodwill impairment losses. Total noninterest income was $6.6 billion (9.7%) lower than a year earlier because of the declines in securitization and servicing income and a $1.5 billion (15.1%) reduction in trading revenue. The average return on assets (ROA) rose to 0.54%, compared to 0.16% in first quarter 2009. This is the highest quarte rly ROA for the industry since first quarter 2008. Almost half of all institutions—48.1%—reported improved ROAs.

Rise in Average Margin Reflects Impact of New Rules

The sharp increase in net interest income caused by adoption of the new accounting rules significantly boosted the industry’s net interest margin (NIM). The average margin increased to a seven-year high of 3.83%, from 3.53% in fourth quarter 2009 and 3.41% in first quarter 2009. Most of the improvement occurred at a few large credit card lenders; only 40.7% of institutions reported higher NIMs compared to the fourth quarter, although 57.8% reported year-over-year improvement.

C&I Charge-Offs Decline for First Time in Four Years

Loan losses posted a year-over-year increase for a 13th consecutive quarter. Net charge-offs totaled $52.4 billion, an increase of $14.5 billion (38.4%) from a year earlier. Credit cards accounted for almost three quarters ($10.4 billion) of the growth in charge-offs, reflecting the securitized receivables brought back onto balance sheets by the new accounting rules. Charge-offs were up from a year ago in most major loan categories, although the increases were smaller than in recent quarters. Most non-consumer loan categories were not affected by the new accounting rules. A notable exception to the rising trend was loans to commercial and industrial (C&I) borrowers, where charge-offs fell for the first time since first quarter 2006, declining by $675 million (10.2%). Net charge-offs of real estate loans secured by nonfarm nonreside ntial real estate properties increased by $1.6 billion (155.5%). Charge-offs of residential mortgage loans were $1.6 billion (22.9%) higher than a year earlier, while charged-off home equity loans rose by $1.2 billion (29.9%).

Increase in Noncurrent Loans Is Smallest in Three Years

The amount of loans and leases that were noncurrent (90 days or more past due or in nonaccrual status) increased for a 16th consecutive quarter, rising by $17.4 billion (4.4%) from the level at the end of 2009.  This is the smallest quarterly increase in noncurrent loans since third quarter 2007, and all of the increase consisted of loans and leases 90 days or more past due. Loans and leases in nonaccrual status fell for the first time in four years, declining by $65 million. Noncurrent credit card loans increased during the quarter by $7.6 billion (51.9%), reflecting the inclusion of securitized credit card receivables. Noncurrent residential mortgage loans rose by $12.9 billion (7.2%), and noncurrent nonfarm nonresidential real estate loans increased by $3.7 billion (8.8%). In contrast, noncurrent C&I loans declined by $5.1 billion (12.2%), and noncurrent real estate construction and development loans fell by $1.8 billion (2.5%). It was the second consecutive quarterly decline in noncurrent levels for both loan categories.

Internal Capital Generation Turns Positive for First Time in Two Years

Total equity capital increased by $15.1 billion (1.0%) in the first quarter. The increase would have been larger, but institutions reported almost $22 billion in reductions in equity capital stemming from the application of FAS 167. More than three-quarters of all institutions (76.6%) increased their equity capital by a combined total of $30 billion during the quarter, but these increases were partially offset by the accounting related equity declines noted above. Retained earnings were positive for the first time since first quarter 2008, as net income exceeded dividends by $13.6 billion. Insured institutions paid $4.4 billion in dividends in the first quarter, down $2.9 billion (39.4%) from a year earlier.

Securitized Consumer Loans Return to Balance Sheets

The increase in loan balances was mirrored by declines in loans securitized and sold. Securitized credit card receivables declined by $347.4 billion (95.6%) during the quarter, while securitized other consumer loans fell by $25.7 billion (80.5%), and securitized home equity lines of credit dropped by $5.8 billion (97.2%). In all, securitized assets posted a $403.1 billion (22.2%) decline in the first quarter.

Secured Borrowings Register Sharp Increase

A substantial amount of short-term secured borrowings accompanied securitized loans onto bank balance sheets in the first quarter. Total deposits fell for the first time in a year, declining by $28.6 billion (0.3%).  Nondeposit liabilities increased by $262.9 billion (10.9%). Federal Home Loan Bank advances fell for a sixth consecutive quarter, declining by $52.9 billion (9.9%), while other nondeposit borrowings increased by $294.3 billion (52.8%).

“Problem List” Continues to Grow

The number of institutions reporting quarterly financial results declined by 80 in the first quarter of 2010, from 8,012 to 7,932. Forty-one FDIC-insured institutions failed during the quarter, while 37 institutions were merged into other charters. Only three new charters were added during the quarter, and all three were charters formed to acquire failed banks. The number of insured commercial banks and savings institutions on the FDIC’s “Problem List” increased from 702 to 775 during the quarter, and total assets of “problem” institutions increased from $403 billion to $431 billion.

The discussion contained in this Item 2 and other disclosures included within this report are based, in part, on the Company’s audited consolidated financial statements.  These statements have been prepared in accordance with accounting principles generally accepted in the United States of America.  The financial information contained in these statements is, for the most part, based on the financial effects of transactions and events that have already occurred. However, the preparation of these statements requires management to make certain estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses.

The Company’s significant accounting policies are described in the “Notes to Consolidated Financial Statements” contained in the Company’s Annual Report.  Based on its consideration of accounting policies that involve the most complex and subjective estimates and judgments, management has identified its most critical accounting policies to be those related to the allowance for loan losses, valuation of other real estate owned and the assessment of other-than-temporary impairment of certain financial instruments.

Allowance for Loan Losses

The allowance for loan losses is established through a provision for loan losses that is treated as an expense and charged against earnings.  Loans are charged against the allowance for loan losses when management believes that collectability of the principal is unlikely. The Company has policies and procedures for evaluating the overall credit quality of its loan portfolio, including timely identification of potential problem loans.  On a quarterly basis, management reviews the appropriate level for the allowance for loan losses, incorporating a variety of risk considerations, both quantitative and qualitative.  Quantitative factors include the Company’s historical loss experience, delinquency and charge-off trends, collateral values, known information about individual loans and other factors.& #160; Qualitative factors include the general economic environment in the Company’s market area.  To the extent actual results differ from forecasts and management’s judgment, the allowance for loan losses may be greater or lesser than future charge-offs.  Due to potential changes in conditions, it is at least reasonably possible that change in estimates will occur in the near term and that such changes could be material to the amounts reported in the Company’s financial statements.

Other Real Estate Owned

Real estate properties acquired through or in lieu of foreclosure are initially recorded at the fair value less estimated selling cost at the date of foreclosure.  Any write-downs based on the asset’s fair value at the date of acquisition are charged to the allowance for loan losses.  After foreclosure, valuations are periodically performed by management and property held for sale is carried at the lower of the new cost basis or fair value less cost to sell.  Impairment losses are measured as the amount by which the carrying amount of a property exceeds its fair value.  Costs of significant property improvements are capitalized, whereas costs relating to holding property are expensed.  The portion of interest costs relating to development of real estate is capitalized.   Independent appraisals or evaluations are periodically performed by management, and any subsequent write-downs are recorded as a charge to operations, if necessary, to reduce the carrying value of a property to the lower of its cost basis or fair value less cost to sell. These appraisals or evaluations are inherently subjective and require estimates that are susceptible to significant revisions as more information becomes available.  Due to potential changes in conditions, it is at least reasonably possible that changes in fair values will occur in the near term and that such changes could materially affect the amounts reported in the Company’s financial statements.

Other-Than-Temporary Impairment of Investment Securities

Declines in the fair value of available-for-sale securities below their cost that are deemed to be other-than-temporary are generally reflected in earnings as realized losses.  In estimating other-than-temporary impairment losses, management considers (1) the intent to sell the investment securities and the more likely than not requirement that the Company will be required to sell the investment securities prior to recovery (2) the length of time and the extent to which the fair value has been less than cost and (3) the financial condition and near-term prospects of the issuer.  Due to potential changes in conditions, it is at least reasonably possible that change in management’s assessment of other-than-temporary impairment will occur in the near term and that such changes could be material to the amounts rep orted in the Company’s financial statements.

Income Statement Review for the Three Months ended June 30, 2010

The following highlights a comparative discussion of the major components of net income and their impact for the three month periods ended June 30, 2010 and 2009:

AVERAGE BALANCES AND INTEREST RATES

The following two tables are used to calculate the Company’s net interest margin.  The first table includes the Company’s average assets and the related income to determine the average yield on earning assets.  The second table includes the average liabilities and related expense to determine the average rate paid on interest bearing liabilities.  The net interest margin is equal to the interest income less the interest expense divided by average earning assets.