UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the Quarterly Period Ended September 30, 2015
OR
Commission File Number: 0-20293
UNION BANKSHARES CORPORATION
(Exact name of registrant as specified in its charter)
1051 East Cary Street
Suite 1200
Richmond, Virginia 23219
(Address of principal executive offices) (Zip Code)
(804) 633-5031
(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 xNo ¨
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 xNo ¨
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.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨No x
The number of shares of common stock outstanding as of November 2, 2015 was 44,923,602.
INDEX
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Glossary of Acronyms
PART I – FINANCIAL INFORMATION
ITEM 1 – FINANCIAL STATEMENTS
UNION BANKSHARES CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (UNAUDITED)
(Dollars in thousands, except share data)
See accompanying notes to consolidated financial statements.
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CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)
(Dollars in thousands)
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CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (UNAUDITED)
NINE MONTHS ENDED SEPTEMBER 30, 2015 AND 2014
(Dollars in thousands, except share amounts)
(1) Retained earnings as of December 31, 2013 and 2014 includes the cumulative impact of $429,000 and $856,000, respectively, resulting from the adoption of ASU 2014-01 “Accounting For Investments in Qualified Affordable Housing Projects.” See “Note 1 - Accounting Policies” for additional information.
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CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
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Notes to Consolidated Financial Statements (Unaudited)
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Significant inter-company accounts and transactions have been eliminated in consolidation.
The unaudited consolidated financial statements have been prepared in accordance with U.S. GAAP for interim financial information and follow general practice within the banking industry. Accordingly, the unaudited consolidated financial statements do not include all the information and footnotes required by U.S. GAAP for complete financial statements. However, in the opinion of management, all adjustments (consisting only of normal recurring accruals) necessary for a fair presentation of the results of the interim periods presented have been made. The results of operations for the interim periods are not necessarily indicative of the results that may be expected for the full year.
These financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s 2014 Annual Report on Form 10-K. Certain prior period amounts have been reclassified to conform to current period presentation.
Adoption of New Accounting Standards
The Company adopted ASU 2014-01, “Accounting for Investments in Qualified Affordable Housing Projects” as of January 1, 2015. As permitted by the guidance, the Company adopted the proportional amortization method of accounting for qualified affordable housing projects. The proportional amortization method amortizes the cost of the investment over the period in which the Company will receive tax credits and other tax benefits, and the resulting amortization is recognized as a component of income taxes attributable to continuing operations. Historically, these investments were accounted for under the equity method of accounting and the passive losses related to the investments were recognized within noninterest expense. The Company adopted this guidance in the first quarter of 2015 with retrospective application as required by the ASU. Prior period results and related metrics have been recast to conform to this presentation. The recast of prior period information did not have a material impact on the Company’s financial condition or results of operations.
For the three and nine months ended September 30, 2015, the Company recognized amortization of $118,000 and $397,000, respectively, and tax credits of $213,000 and $641,000, respectively, associated with these investments within “Income tax expense” on the Company’s Consolidated Statements of Income. The carrying value of the Company’s investments in these qualified affordable housing projects was $10.1 million and $10.4 million as of September 30, 2015 and December 31, 2014, respectively. The Company recorded a liability of $5.1 million for the related unfunded commitments as of September 30, 2015, which are expected to be paid from 2015 to 2019.
Recent Accounting Pronouncements
In January 2015, the FASB issued ASU No. 2015-01, “Income Statement—Extraordinary and Unusual Items (Subtopic 225-20): Simplifying Income Statement Presentation by Eliminating the Concept of Extraordinary Items.” The amendments in this ASU eliminate from U.S. GAAP the concept of extraordinary items. Subtopic 225-20, Income Statement - Extraordinary and Unusual Items, required that an entity separately classify, present, and disclose extraordinary events and transactions. Presently, an event or transaction is presumed to be an ordinary and usual activity of the reporting entity unless evidence clearly supports its classification as an extraordinary item. If an event or transaction meets the criteria for extraordinary classification, an entity is required to segregate the extraordinary item from the results of ordinary operations and show the item separately in the income statement, net of tax, after income from continuing operations. The entity also is required to disclose applicable income taxes and either present or disclose earnings-per-share data applicable to the extraordinary item. The amendments in this ASU are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted provided that the guidance is applied from the beginning of the fiscal year of adoption. The Company does not expect the adoption of ASU 2015-01 to have a material impact on its consolidated financial statements.
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In February 2015, the FASB issued ASU No. 2015-02, “Amendments to the Consolidation Analysis.” The amendments in this ASU amend the consolidation requirements in ASC 810, Consolidation, and significantly change the consolidation analysis required under U.S. GAAP. Under this guidance, limited partnerships will be considered variable interest entities (“VIEs”) unless the limited partners have either substantive kick-out or participating rights; this amendment will result in more partnerships being considered VIEs, but it will be less likely that a general partner will consolidate a limited partnership. The amendments also change the effect that fees paid to a decision maker or service provider have on the consolidation analysis; it is less likely that the fees themselves will be considered a variable interest, that an entity will be a VIE, or that consolidation will result. The changes modify how a reporting entity considers how its variable interests affect its consolidation process; the related party tiebreaker test and mandatory consolidation by one of the related parties will have to be performed less frequently than under current U.S. GAAP. For entities other than limited partnerships, the amendments clarify how to determine whether the equity holders have power over the entity and could affect whether the entity is a VIE. The amendments are expected to result in the deconsolidation of many entities. The amendments in this ASU are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted provided that the guidance is applied from the beginning of the fiscal year of adoption. The Company is currently assessing the impact that ASU 2015-02 will have on its consolidated financial statements.
In April 2015, the FASB issued ASU No. 2015-03, “Interest – Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs.” The ASU does not change the existing recognition and measurement guidance for debt issuance costs but requires that debt issuance costs related to a debt liability recorded on the balance sheet be present in the balance sheet as a direct deduction from the carrying amount of that debt liability. The amendments should be disclosed consistent with the disclosure requirement of a change in accounting principle and applied on a retrospective basis. This ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted. The Company does not expect the adoption of ASU 2015-03 to have a material impact on its consolidated financial statements.
In April 2015, the FASB issued ASU No. 2015-05, “Intangibles – Goodwill and Other – Internal-Use Software (Subtopic 350-40: Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement.” This ASU clarifies the circumstances under which a cloud computing customer would account for the arrangement as a license of internal-use software. If a cloud computing arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses; otherwise, the customer should account for the arrangement as a service contract. The amendments in this ASU are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted. The Company is currently assessing the impact of ASU 2015-05 will have on its consolidated financial statements.
In August 2015, the FASB issued ASU No. 2015-15, “Interest—Imputation of Interest (Subtopic 835-30): Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements.”This ASU clarifies the guidance issued within ASU 2015-03 described above. Given the absence of authoritative guidance within Update 2015-03 for debt issuance costs related to line-of-credit arrangements, the SEC staff would not object to an entity presenting the cost of securing a revolving line of credit as an asset, regardless of whether a balance is outstanding. The costs should be amortized over the term of the arrangement. This ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted. The Company does not expect the adoption of ASU 2015-15 to have a material impact on its consolidated financial statements.
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The Company’s merger and acquisition strategy focuses on high-growth areas with strong market demographics and targets organizations that have a comparable corporate culture, strong performance, and good asset quality, among other factors. On January 1, 2014, the Company completed the acquisition of StellarOne, a bank holding company based in Charlottesville, Virginia, in an all-stock transaction. StellarOne’s common shareholders received 0.9739 shares of the Company’s common stock in exchange for each share of StellarOne’s common stock, resulting in the Company issuing 22,147,874 shares of common stock at a fair value of $549.5 million. The fair value of assets acquired totaled $2.96 billion and liabilities assumed totaled $2.64 billion. As a result of the transaction, StellarOne’s former bank subsidiary, StellarOne Bank, became a wholly owned bank subsidiary of the Company. On May 9, 2014, StellarOne Bank was merged with and into the Bank. Information regarding this acquisition is included in the Company’s 2014 Annual Report on Form 10-K. The Company has not completed any acquisitions of businesses in 2015.
The net effect of the amortization and accretion of premiums and discounts associated with the Company’s acquisition accounting adjustments had the following impact on the Consolidated Statements of Income during the three and nine months ended September 30, 2015 and 2014 (dollars in thousands):
(1) Loan discount accretion is included in "Interest and fees on loans" in the "Interest and dividend income" section of the Company's Consolidated Statements of Income.
(2) Core deposit intangible premium amortization is included in "Amortization of intangible assets" in the "Noninterest expense" section of the Company's Consolidated Statements of Income.
(3) Borrowings discount accretion is included in "Interest on long-term borrowings" in the "Interest Expense" section of the Company's Consolidated Statements of Income.
(4) Certificate of deposit discount accretion is included in "Interest on deposits" in the "Interest expense" section of the Company's Consolidated Statements of Income.
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Available for Sale
The amortized cost, gross unrealized gains and losses, and estimated fair values of securities available for sale as of September 30, 2015 and December 31, 2014 are summarized as follows (dollars in thousands):
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The following table shows the gross unrealized losses and fair value (in thousands) of the Company’s available for sale investments with unrealized losses that are not deemed to be other-than-temporarily impaired. These are aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position.
As of September 30, 2015, there were $52.5 million, or 22 issues, of individual available for sale securities that had been in a continuous loss position for more than 12 months. Additionally, these securities had an unrealized loss of $1.1 million and consisted of municipal obligations, mortgage-backed securities, and corporate bonds. As of December 31, 2014, there were $96.4 million, or 60 issues, of individual securities that had been in a continuous loss position for more than 12 months. Additionally, these securities had an unrealized loss of $1.1 million and consisted of municipal obligations, mortgage-backed securities, corporate bonds, and other securities. The Company has determined that these securities are temporarily impaired as of September 30, 2015 and December 31, 2014 for the reasons set out below:
U.S. Government agencies and corporations. The unrealized losses in this category of investments were caused by interest rate fluctuations. The contractual terms of the investments do not permit the issuer to settle the securities at a price less than the cost basis of each investment. Because the Company does not intend to sell any of the investments and the accounting standard of “more likely than not” has not been met for the Company to be required to sell any of these investments before recovery of its amortized cost basis, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired.
Mortgage-backed securities. This category’s unrealized losses are primarily the result of interest rate fluctuations. Since the decline in market value is attributable to changes in interest rates and not credit quality, the Company does not intend to sell the investments, and it is not likely that the Company will be required to sell the investments before recovery of their amortized cost basis, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired. Also, the majority of the Company’s mortgage-backed securities are agency-backed securities, which have a government guarantee.
State and political subdivisions. This category’s unrealized losses are primarily the result of interest rate fluctuations and also a certain few ratings downgrades brought about by the impact of the economic downturn on states and political subdivisions. The contractual terms of the investments do not permit the issuer to settle the securities at a price less than the cost basis of each investment. Because the Company does not intend to sell any of the investments and the accounting standard of “more likely than not” has not been met for the Company to be required to sell any of the investments before recovery of its amortized cost basis, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired. As discussed below, one security was identified as containing credit-related OTTI.
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Corporate debt securities. The Company’s unrealized losses in corporate debt securities are related to both interest rate fluctuations and ratings downgrades for a limited number of securities. The majority of the securities remain investment grade and the Company’s analysis did not indicate the existence of a credit loss. The contractual terms of the investments do not permit the issuer to settle the securities at a price less than the cost basis of each investment. Because the Company does not intend to sell any of the investments before recovery of its amortized cost basis, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired.
The following table presents the amortized cost and estimated fair value of available for sale securities as of September 30, 2015 and December 31, 2014, by contractual maturity (dollars in thousands). Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The following table presents available for sale securities which were pledged to secure public deposits, repurchase agreements, and for other purposes as permitted or required by law as of September 30, 2015 and December 31, 2014 (dollars in thousands):
(1) The "Other purposes" category consists of borrowings, derivatives, and accounts held at the Bank.
Held to Maturity
During the second quarter of 2015, the Company transferred securities, which it intends and has the ability to hold until maturity, with a fair value of $201.8 million on the date of transfer, from securities available for sale to securities held to maturity. The Company transferred these securities to held to maturity to reduce the impact of price volatility on capital and in consideration of changes to the regulatory environment. The securities included net pre-tax unrealized gains of $8.1 million at the date of transfer with a remaining balance of $7.3 million as of September 30, 2015.
The Company reports securities held to maturity on the Consolidated Balance Sheets at carrying value. Carrying value is amortized cost which includes any unamortized unrealized gains and losses recognized in accumulated other comprehensive income prior to reclassifying the securities from securities available for sale to securities held to maturity. Investment securities transferred into the held to maturity category from the available for sale category are recorded at fair value at the date of transfer. The unrealized holding gain or loss at the date of transfer is retained in accumulated other comprehensive income and in the carrying value of the securities held to maturity. Such unrealized gains/(losses) are accreted over the remaining life of the security with no impact on future net income.
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The carrying value, gross unrealized gains and losses, and estimated fair values of securities held to maturity as of September 30, 2015 are summarized as follows (dollars in thousands):
(1) The carrying value includes $7.3 million of unrealized gains and losses present at the time of transfer from available for securities, net of any accretion.
The following table shows the gross unrealized losses and fair value (in thousands) of the Company’s held to maturity securities with unrealized losses that are not deemed to be other-than-temporarily impaired. These are aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position.
The following table presents the amortized cost and estimated fair value of held to maturity securities as of September 30, 2015, by contractual maturity (dollars in thousands). Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The following table presents held to maturity securities which were pledged to secure public deposits as permitted or required by law as of September 30, 2015 (dollars in thousands):
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Restricted Stock, at cost
Due to restrictions placed upon the Bank’s common stock investment in the Federal Reserve Bank and FHLB, these securities have been classified as restricted equity securities and carried at cost. These restricted securities are not subject to the investment security classifications and are included as a separate line item on the Company’s Consolidated Balance Sheets. At September 30, 2015, the FHLB required the Bank to maintain stock in an amount equal to 4.25% of outstanding borrowings and a specific percentage of the Bank’s total assets. At December 31, 2014, the FHLB required the Bank to maintain stock in an amount equal to 4.5% of outstanding borrowings and a specific percentage of the Bank’s total assets. The Federal Reserve Bank required the Bank to maintain stock with a par value equal to 6% of its outstanding capital at both September 30, 2015 and December 31, 2014. Restricted equity securities consist of Federal Reserve Bank stock in the amount of $23.8 million for both September 30, 2015 and December 31, 2014 and FHLB stock in the amount of $28.9 million and $31.0 million as of September 30, 2015 and December 31, 2014, respectively.
Other-Than-Temporary-Impairment
During each quarter, the Company conducts an assessment of the securities portfolio for OTTI consideration. The assessment considers factors such as external credit ratings, delinquency coverage ratios, market price, management’s judgment, expectations of future performance, and relevant industry research and analysis. An impairment is other-than-temporary if any of the following conditions exist: the entity intends to sell the security; it is more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis; or the entity does not expect to recover the security’s entire amortized cost basis (even if the entity does not intend to sell). If a credit loss exists, but an entity does not intend to sell the impaired debt security and is not more likely than not to be required to sell before recovery, the impairment is other-than-temporary and should be separated into a credit portion to be recognized in earnings and the remaining amount relating to all other factors recognized as other comprehensive loss. Based on the assessment for the quarter ended September 30, 2015 and in accordance with the guidance, the Company determined that a municipal security in the available for sale portfolio incurred credit-related OTTI of $300,000, which was recognized in earnings for the quarter ended September 30, 2015.
Realized Gains and Losses
The following table presents the gross realized gains and losses on the sale of securities available for sale and the proceeds from the sale of securities during the three and nine months ended September 30, 2015 (dollars in thousands). The Company did not sell any investment securities that are held to maturity.
The following table presents the gross realized gains and losses on the sale of securities available for sale and the proceeds from the sale of securities during the three and nine months ended September 30, 2014 (dollars in thousands).
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Loans are stated at their face amount, net of deferred fees and costs, and consist of the following at September 30, 2015 and December 31, 2014 (dollars in thousands):
The following table shows the aging of the Company’s loan portfolio, by class, at September 30, 2015 (dollars in thousands):
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The following table shows the aging of the Company’s loan portfolio, by class, at December 31, 2014 (dollars in thousands):
The following table shows the PCI commercial and consumer loan portfolios, by class and their delinquency status, at
September 30, 2015 (dollars in thousands):
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The following table shows the PCI commercial and consumer loan portfolios, by class and their delinquency status, at December 31, 2014 (dollars in thousands):
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The Company measures the amount of impairment by evaluating loans either in their collective homogeneous pools or individually. The following table shows the Company’s impaired loans, excluding PCI loans related to the StellarOne acquisition, by class at September 30, 2015 (dollars in thousands):
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The following table shows the Company’s impaired loans, by class, at December 31, 2014 (dollars in thousands):
The Company considers TDRs to be impaired loans. A modification of a loan’s terms constitutes a TDR if the creditor grants a concession that it would not otherwise consider to the borrower for economic or legal reasons related to the borrower’s financial difficulties. TDRs totaled $11.6 million and $26.8 million as of September 30, 2015 and December 31, 2014, respectively. All loans that are considered to be TDRs are evaluated for impairment in accordance with the Company’s allowance for loan loss methodology and are included in the preceding impaired loan tables. For the quarter ended September 30, 2015, the recorded investment in restructured loans prior to modifications was not materially impacted by the modification.
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The following table provides a summary, by class, of modified loans that continue to accrue interest under the terms of the restructuring agreement, which are considered to be performing, and modified loans that have been placed on nonaccrual status, which are considered to be nonperforming, as of September 30, 2015 and December 31, 2014 (dollars in thousands):
The Company considers a default of a restructured loan to occur when the borrower is 90 days past due following the restructure or a foreclosure and repossession of the applicable collateral occurs. During the three and nine months ended September 30, 2015, the Company did not identify any restructured loans that went into default that had been restructured in the twelve-month period prior to default. During the three months ended September 30, 2014, the Company did not identify any restructured loans that went into default that had been restructured in the twelve-month period prior to default. During the nine months ended September 30, 2014, the Company identified one loan, totaling approximately $24,000, that went into default that had been restructured in the twelve-month period prior to the time of default. This loan was a mortgage loan which had a term modification at a market rate.
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The following table shows, by class and modification type, TDRs that occurred during the three and nine months ended September 30, 2015 (dollars in thousands):
The following table shows, by class and modification type, TDRs that occurred during the three and nine months ended September 30, 2014 (dollars in thousands):
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The following table shows the allowance for loan loss activity, balances for allowance for loan losses, and loan balances based on impairment methodology by portfolio segment for the nine months ended and as of September 30, 2015. The table below includes the provision for loan losses. In addition, a $300,000 provision was recognized during the nine months ended September 30, 2015 for unfunded loan commitments for which the reserves are recorded as a component of “Other Liabilities” on the Company’s Consolidated Balance Sheets. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories (dollars in thousands):
The following table shows the allowance for loan loss activity, balances for allowance for loan losses, and loan balances based on impairment methodology by portfolio segment for the nine months ended and as of September 30, 2014. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories (dollars in thousands):
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The Company uses the past due status and delinquency trends as the primary credit quality indicator for the consumer loan portfolio segment while a risk rating system is utilized for commercial loans. Commercial loans are graded on a scale of 0 through 9. A general description of the characteristics of the risk grades follows:
The following table shows the recorded investment in all loans, excluding PCI loans, in the commercial portfolios by class with their related risk rating current as of September 30, 2015 (dollars in thousands):
The following table shows the recorded investment in all loans, excluding PCI loans, in the commercial portfolios by class with their related risk rating current as of December 31, 2014 (dollars in thousands):
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The following table shows the recorded investment in only PCI loans in the commercial portfolios by class with their related risk rating and credit quality indicator information current as of September 30, 2015 (dollars in thousands):
The following table shows the recorded investment in only PCI loans in the commercial portfolios by class with their related risk rating and credit quality indicator information current as of December 31, 2014 (dollars in thousands):
Loans acquired are originally recorded at fair value, with certain loans being identified as impaired at the date of purchase. The fair values were determined based on the credit quality of the portfolio, expected future cash flows, and timing of those expected future cash flows.
The following shows changes in the accretable yield for loans accounted for under ASC 310-30, Receivables – Loans and Debt Securities Acquired with Deteriorated Credit Quality,for the periods presented (dollars in thousands):
(1) This line item represents changes in the cash flows expected to be collected due to the impact of non-credit changes such as prepayment assumptions, changes in interest rates on variable rate PCI loans, and discounted payoffs that occurred in the quarter.
The carrying value of the Company’s PCI loan portfolio, accounted for under ASC 310-30, totaled $78.6 million at September 30, 2015 and $105.8 million at December 31, 2014. The outstanding balance of the Company’s PCI loan portfolio totaled $95.7 million at September 30, 2015 and $126.3 million at December 31, 2014. The carrying value of the Company’s acquired performing loan portfolio, accounted for under ASC 310-20, Receivables – Nonrefundable Fees and Other Costs, totaled $1.5 billion at September 30, 2015 and $1.8 billion at December 31, 2014; the remaining discount on these loans totaled $21.9 million at September 30, 2015 and $24.3 million at December 31, 2014, respectively.
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The Company’s intangible assets consist of core deposits and goodwill arising from previous acquisitions. The Company has determined that core deposit intangibles have a finite life and amortizes them over their estimated useful life. Core deposit intangible assets are being amortized over the period of expected benefit, which ranges from 4 to 14 years, using an accelerated method. On January 1, 2014, the Company completed the acquisition of StellarOne and acquired intangible assets of $29.6 million and recorded $234.1 million of goodwill.
In accordance with ASC 350, Intangibles-Goodwill and Other, the Company reviews the carrying value of indefinite lived intangible assets at least annually or more frequently if certain impairment indicators exist. The Company performed its annual impairment testing in the second quarter of 2015 and determined that there was no impairment to its goodwill or intangible assets.
Information concerning intangible assets with a finite life is presented in the following table (dollars in thousands):
Amortization expense of core deposit intangibles for the three and nine months ended September 30, 2015 totaled $2.1 million and $6.4 million, respectively; for the three and nine months ended September 30, 2014 totaled $2.4 million and $7.5 million, respectively; and for the year ended December 31, 2014 was $9.8 million. As of September 30, 2015, the estimated remaining amortization expense of core deposit intangibles is as follows (dollars in thousands):
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Short-term Borrowings
The Company classifies all borrowings that will mature within a year from the date on which the Company enters into them as short-term borrowings. Total short-term borrowings consist primarily of advances from the FHLB, federal funds purchased (which are secured overnight borrowings from other financial institutions), and other lines of credit. Also included in total short-term borrowings are securities sold under agreements to repurchase, which are secured transactions with customers and generally mature the day following the date sold. Total short-term borrowings consist of the following as of September 30, 2015 and December 31, 2014 (dollars in thousands):
The Bank maintains federal funds lines with several correspondent banks; the remaining available balance was $170.0 million and $150.0 million at September 30, 2015 and December 31, 2014, respectively. The Company has certain restrictive covenants related to certain asset quality, capital, and profitability metrics associated with these lines and is considered to be in compliance with these covenants. Additionally, the Company had a collateral dependent line of credit with the FHLB of up to $1.5billion and $1.4 billion at September 30, 2015 and December 31, 2014, respectively.
Long-term Borrowings
In connection with two bank acquisitions prior to 2006, the Company issued trust preferred capital notes to fund the cash portion of those acquisitions, collectively totaling $58.5 million. In connection with the acquisition of StellarOne, the Company acquired trust preferred capital notes totaling $32.0 million with a remaining fair value discount of $7.0 million at September 30, 2015. The trust preferred capital notes currently qualify for Tier 1 capital of the Company for regulatory purposes.
(1) reported as "Other Assets" within the Consolidated Balance Sheets.
As part of a prior acquisition, the Company assumed subordinated debt with terms of LIBOR plus 1.45% and a maturity date of April 2016. At September 30, 2015, the carrying value of the subordinated debt was $17.5 million, with a remaining fair value discount of $285,000.
On August 23, 2012, the Company modified its fixed rate FHLB advances to floating rate advances, which resulted in reducing the Company’s FHLB borrowing costs. In connection with this modification, the Company incurred a prepayment penalty of $19.6 million on the original advances, which is included as a component of long-term borrowings in the Company’s Consolidated Balance Sheets. In accordance with ASC 470-50, Modifications and Extinguishments, the Company will amortize this prepayment penalty over the term of the modified advances using the effective rate method. The amortization expense is included as a component of interest expense on long-term borrowings in the Company’s Consolidated Statements of Income. Amortization expense for the three and nine months ended September 30, 2015 and 2014 was $463,000 and $1.4 million and $452,000 and $1.3 million, respectively.
In connection with the StellarOne acquisition, the Company assumed $70.0 million in long-term borrowings with the FHLB of which there is $60.0 million remaining at September 30, 2015 that had a remaining fair value premium of $1.4 million.
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As of September 30, 2015, the Company had advances from the FHLB consisting of the following (dollars in thousands):
As of December 31, 2014, the Company had advances from the FHLB consisting of the following (dollars in thousands):
The carrying value of the loans and securities pledged as collateral for FHLB advances totaled $1.8 billion and $1.2 billion as of September 30, 2015 and December 31, 2014, respectively.
As of September 30, 2015, the contractual maturities of long-term debt are as follows for the years ending (dollars in thousands):
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Litigation Matters
In the ordinary course of its operations, the Company and its subsidiaries are parties to various legal proceedings. Based on the information presently available, and after consultation with legal counsel, management believes that the ultimate outcome in such proceedings, in the aggregate, will not have a material adverse effect on the business, financial condition, or results of operations of the Company.
Financial Instruments with Off-Balance Sheet Risk
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve elements of credit and interest rate risk in excess of the amount recognized in the Company’s Consolidated Balance Sheets. The contractual amounts of these instruments reflect the extent of the Company’s involvement in particular classes of financial instruments.
The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and letters of credit written is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Unless noted otherwise, the Company does not require collateral or other security to support off-balance sheet financial instruments with credit risk. The Company considers credit losses related to off-balance sheet commitments by undergoing a similar process in evaluating losses for loans that are carried on balance sheet. The Company considers historical loss rates, current economic conditions, risk ratings, and past due status among other factors in the consideration of whether credit losses are inherent in the Company’s off-balance sheet commitments to extend credit. The Company does not expect credit losses arising from off-balance sheet commitments to have a material adverse impact on the Company’s consolidated financial statements.
Commitments to extend credit are agreements to lend to customers as long as there are no violations of any conditions established in the contracts. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Because many of the commitments may expire without being completely drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
Letters of credit are conditional commitments issued by the Company to guarantee the performance of customers to third parties. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers.
UMG, a wholly owned subsidiary of the Bank, uses rate lock commitments and best efforts contracts during the origination process and for loans held for sale. These best efforts contracts are designed to mitigate UMG’s exposure to fluctuations in interest rates in connection with rate lock commitments and loans held for sale. The Company held approximately $2.1 million and $2.6 million in loans held for sale in which the related rate lock commitment had expired as of September 30, 2015 and December 31, 2014, respectively. At September 30, 2015 and December 31, 2014, the reserves associated with these loans held for sale were $102,000 and $104,000, respectively, and are reflected on the balance sheet of the mortgage segment.
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The following table presents the balances of commitments and contingencies (dollars in thousands):
(1) Includes unfunded overdraft protection.
The Company must maintain a reserve against its deposits in accordance with Regulation D of the Federal Reserve Act. For the final weekly reporting period in the periods ended September 30, 2015 and December 31, 2014, the aggregate amount of daily average required reserves was approximately $41.4 million and $48.7 million, respectively.
The Company has approximately $24.6 million in deposits in other financial institutions, of which $10.0 million and $3.8 million serve as collateral for the cash flow hedges and loan swaps, respectively, as discussed in Note 8 “Derivatives”. The Company had approximately $9.7 million in deposits in other financial institutions that were uninsured at September 30, 2015. On an annual basis, the Company’s management evaluates the loss risk of its uninsured deposits in financial counterparties.
For asset/liability management purposes, the Company uses interest rate swap agreements to hedge various exposures or to modify the interest rate characteristics of various balance sheet accounts. See Note 8 “Derivatives” for additional information.
In the ordinary course of business, the Company records an indemnification reserve relating to mortgage loans previously sold based on historical statistics and loss rates; as of September 30, 2015 and December 31, 2014, the Company’s indemnification reserve for such mortgage loans was $384,000 and $662,000, respectively.
The Company is exposed to economic risks arising from its business operations and uses derivatives primarily to manage risk associated with changing interest rates, and to assist customers with their risk management objectives. The Company designates its derivatives either as hedging instruments in a qualifying hedge accounting relationship (cash flow or fair value hedge) or as a free standing derivative such as interest rate lock commitments that do not qualify for hedge accounting. The Company uses interest rate derivatives to manage its exposure to interest rate movements and add stability to interest income and expense. The Company also enters into back-to-back loan swaps to assist customers in managing the risks due to changing interest rates.
Cash Flow Hedges
As part of its cash flow hedging strategy, the Company uses interest rate swap agreements to limit the variability of expected future cash flows (primarily associated with the Company’s variable rate borrowings) by exchanging a notional amount, equal to the principal amount of the borrowings, for fixed-rate interest based on benchmarked interest rates. As of September 30, 2015, the Company had 11 interest rate swaps designated as cash flow hedges with an aggregate notional amount of $263.0 million.
The Company has entered into three interest rate swap agreements (the “trust swaps”) to mitigate the variable interest rate risk related to the trust preferred capital notes further described in Note 6 “Borrowings.” The Company receives interest of LIBOR from a counterparty and pays a weighted average fixed rate of 2.77% to the same counterparty calculated on a notional amount of $68.0 million. The original terms of the trust swaps range from three to six years.
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The Company has entered into four interest rate swap agreements (the “prime loan swaps”) to mitigate the variable interest rate risks of certain prime commercial loans. The Company receives a fixed interest rate ranging from 4.71% to 5.20% from the counterparty and pays interest based on the Wall Street Journal prime index, with a spread of up to 0.49%, to the same counterparty calculated on a notional amount of $55.0 million. One of the four prime loan swaps contains a floor rate of 4.00%. The original terms of the four prime loan swaps is six years with a fixed rate that started September 17, 2013.
The Company has entered into four interest rate swap agreements (“FHLB advance swaps”) to mitigate variable interest rate risk on certain designated variable rate FHLB borrowings. The Company receives an interest rate based on the three month LIBOR from the counterparty and pays an interest rate ranging from 3.16% to 3.46% to the same counterparty calculated on a notional amount of $140.0 million. The FHLB advance swaps are deferred starting swaps with terms of six years and five years and effective dates of February 23, 2017 and February 23, 2018, respectively.
All swaps were entered into with counterparties that met the Company’s credit standards and the agreements contain collateral provisions protecting the at-risk party. The Company believes that the credit risk inherent in the contract is not significant. As of September 30, 2015, the Company had $10.0 million of cash pledged as collateral for the cash flow hedges and securities with a market value of $4.3 million pledged as collateral for the prime loan swaps and FHLB advance swaps.
Amounts receivable or payable are recognized as accrued under the terms of the agreements. In accordance with ASC 815, Derivatives and Hedging, the Company has designated the trust swaps, prime loan swaps, and FHLB advance swaps as cash flow hedges, with the effective portions of the derivatives’ unrealized gains or losses recorded as a component of other comprehensive income. The ineffective portions of the unrealized gains or losses, if any, would be recorded in interest income and interest expense in the Company’s Consolidated Statements of Income. The Company has assessed the effectiveness of each hedging relationship by comparing the changes in cash flows of the hedging instrument. Based on the Company’s assessment, its cash flow hedges are highly effective. At September 30, 2015, the fair value of the Company’s cash flow hedges was a net unrealized loss of $10.4 million, the amount the Company would have expected to pay if the contracts were terminated.
Shown below is a summary of the derivatives designated as cash flow hedges at September 30, 2015 and December 31, 2014 (dollars in thousands):
(1) Due to their deferred nature, the rates and the life exclude the four FHLB advance swaps.
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Fair Value Hedge
During the normal course of business, the Company enters into interest rate swaps to convert certain long-term fixed-rate loans to floating rates to hedge the Company’s exposure to interest rate risk. The Company applies hedge accounting in accordance with ASC 815, and the fair value hedge and the underlying hedged item, attributable to the risk being hedged, are recorded at fair value with unrealized gains and losses being recorded in the Company’s Consolidated Statements of Income. The ineffective portions of the unrealized gains or losses, if any, would be recorded in interest income and interest expense in the Company’s Consolidated Statements of Income. The Company uses statistical regression analysis to assess hedge effectiveness, both at inception of the hedging relationship and on an ongoing basis. The regression analysis involves regressing the periodic change in fair value of the hedging instrument against the periodic changes in fair value of the asset being hedged due to changes in the hedged risk.
As of September 30, 2015, the Company had three swaps constituting fair value hedges, whereby the Company pays a fixed interest rate ranging from 3.23% to 3.53% to the counterparty and receives interest of one month LIBOR plus a spread of up to 2.13% from the same counterparty calculated on an aggregate notional amount of $53.6 million with terms ranging from 15 to 17 years. At December 31, 2014, the Company had one fair value hedge with an aggregate notional amount of $38.3 million. At September 30, 2015, the fair value of the Company’s fair value hedges was an unrealized loss of $1.4 million, the amount the Company would have expected to pay if the contract was terminated; the liability is reported in “Other Liabilities” in the Company’s Consolidated Balance Sheets. At September 30, 2015, the aggregate notional amount of the hedged items was $53.6 million with a fair value of $1.4 million. At December 31, 2014, the Company had one hedged item with an aggregate notional amount and fair value of $38.3 million. The Company’s fair value hedges continue to be highly effective and had no material impact on the Company’s Consolidated Statements of Income.
Loan Swaps
During the normal course of business, the Company enters into interest rate swap loan relationships (“loan swaps”) with borrowers to meet their financing needs. Upon entering into the loan swaps, the Company enters into offsetting positions with counterparties in order to minimize interest rate risk. These back-to-back loan swaps qualify as financial derivatives with fair values as reported in “Other Assets” and “Other Liabilities” in the Company’s Consolidated Balance Sheets. As of September 30, 2015, the Company had cash and securities with a market value of $6.6 million pledged as collateral for the loan swaps.
Shown below is a summary regarding loan swap derivative activities at September 30, 2015 and December 31, 2014 (dollars in thousands):
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Interest Rate Lock Commitments
During the normal course of business, the Company enters into commitments to originate mortgage loans whereby the interest rate on the loan is determined prior to funding (“rate lock commitments”). Rate lock commitments on mortgage loans that are intended to be sold are considered to be derivatives. The period of time between issuance of a loan commitment, closing, and sale of the loan generally ranges from 30 to 120 days. The Company protects itself from changes in interest rates through the use of best efforts forward delivery commitments, whereby the Company commits to sell a loan at the time the borrower commits to an interest rate with the intent that the buyer has assumed interest rate risk on the loan. The correlation between the rate lock commitments and the best efforts contracts is high due to their similarity.
The market values of rate lock commitments and best efforts forward delivery commitments is not readily ascertainable with precision because rate lock commitments and best efforts contracts are not actively traded in stand-alone markets. The Company determines the fair value of rate lock commitments and best efforts contracts by measuring the change in the value of the underlying asset while taking into consideration the probability that the rate lock commitments will close. The fair value of the rate lock commitments as of September 30, 2015 was $1.3 million and is reported as a component of “Other Assets” in the Company’s Consolidated Balance Sheets; the fair value of the Company’s best efforts forward delivery commitments was $544,000 and is recorded as a component of “Other Liabilities” in the Company’s Consolidated Balance Sheets. Any impact to income is recorded in current period earnings as a component of “Gain on sale of mortgage loans, net of commissions” in the Company’s Consolidated Statements of Income. The aggregate notional amount of these derivatives was $61.0 million and $49.6 million at September 30, 2015 and December 31, 2014, respectively.
The change in accumulated other comprehensive income (loss) for the three and nine months ended September 30, 2015 is summarized as follows, net of tax (dollars in thousands):
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The change in accumulated other comprehensive income (loss) for the three and nine months ended September 30, 2014 is summarized as follows, net of tax (dollars in thousands):
Reclassifications of unrealized gains (losses) on available for sale securities are reported in the Company’s Consolidated Statements of Income as “Gains on securities transactions, net” with the corresponding income tax effect being reflected as a component of income tax expense. The Company reported gains of $75,000 and $672,000 for the three and nine months ended September 30, 2015, respectively, related to the sale of securities. Excluding OTTI recovery of $400,000 in the second quarter of 2014, the Company reported net gains of $995,000 and $1.0 million for the three and nine months ended September 30, 2014, respectively, related to the sale of securities. The Company recorded $300,000 in other-than-temporary impairment in the current quarter on a municipal security in the available for sale portfolio. The tax effect of these transactions during the three and nine months ended September 30, 2015 and 2014 were $79,000 and $130,000 and $348,000 and $367,000, respectively, which amounts were included as a component of income tax expense.
Reclassifications of the change in fair value of cash flow hedges are reported in interest income and interest expense in the Company’s Consolidated Statements of Income with the corresponding income tax effect being reflected as a component of income tax expense. The Company reported net interest expense of $241,000 and $723,000 and $253,000 and $659,000 for the three and nine months ended September 30, 2015 and 2014, respectively. The tax effect of these transactions during the three and nine months ended September 30, 2015 and 2014 were $84,000 and $253,000 and $89,000 and $231,000, respectively, which amounts were included as a component of income tax expense.
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The Company follows ASC 820, Fair Value Measurements and Disclosures, to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. This codification clarifies that fair value of certain assets and liabilities is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between willing market participants.
ASC 820 specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. The three levels of the fair value hierarchy under ASC 820 based on these two types of inputs are as follows:
The following describes the valuation techniques used by the Company to measure certain financial assets and liabilities recorded at fair value on a recurring basis in the financial statements.
Derivative instruments
As discussed in Note 8 “Derivatives”, the Company records derivative instruments at fair value on a recurring basis. The Company utilizes derivative instruments as part of the management of interest rate risk to modify the re-pricing characteristics of certain portions of the Company’s interest-bearing assets and liabilities. The Company has contracted with a third party vendor to provide valuations for derivatives using standard valuation techniques and therefore classifies such valuations as Level 2. Third party valuations are validated by the Company using Bloomberg Valuation Service’s derivative pricing functions. The Company has considered counterparty credit risk in the valuation of its derivative assets and has considered its own credit risk in the valuation of its derivative liabilities.
During the ordinary course of business, the Company enters into interest rate lock commitments related to the origination of mortgage loans held for sale as well as best effort forward delivery commitments to mitigate interest rate risk; these instruments are recorded at estimated fair value based on the value of the underlying loan, which in turn is based on quoted prices for similar loans in the secondary market. However, this value is adjusted by a pull-through rate which considers the likelihood that the loan in a lock position will ultimately close. The pull-through rate is derived from the Company’s internal data and is adjusted using significant management judgment. The pull-through rate is largely dependent on the loan processing stage that a loan is currently in and the change in prevailing interest rates from the time of the rate lock. As such, interest rate lock commitments are classified as Level 3. An increase in the pull-through rate utilized in the fair value measurement of the interest rate lock commitment derivative will result in positive fair value adjustments while a decrease in the pull-through rate will result in a negative fair value adjustment. The Company’s weighted average pull-through rate was approximately 80% as of September 30, 2015 and approximately 90% as of December 31, 2014. As of September 30, 2015, the interest rate lock commitments are recorded as a component of “Other Assets” and the best effort forward delivery commitments are recorded as a component of “Other Liabilities” on the Company’s Consolidated Balance Sheets.
Securities available for sale
Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data (Level 2). If the inputs used to provide the evaluation for certain securities are unobservable and/or there is little, if any, market activity, then the security would fall to the lowest level of the hierarchy (Level 3).
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The Company’s investment portfolio is primarily valued using fair value measurements that are considered to be Level 2. The Company has contracted with a third party portfolio accounting service vendor for valuation of its securities portfolio. The vendor’s primary source for security valuation is Interactive Data Corporation (“IDC”), which evaluates securities based on market data. IDC utilizes evaluated pricing models that vary by asset class and include available trade, bid, and other market information. Generally, the methodology includes broker quotes, proprietary models, vast descriptive terms and conditions databases, as well as extensive quality control programs.
The vendor utilizes proprietary valuation matrices for valuing all municipals securities. The initial curves for determining the price, movement, and yield relationships within the municipal matrices are derived from industry benchmark curves or sourced from a municipal trading desk. The securities are further broken down according to issuer, credit support, state of issuance, and rating to incorporate additional spreads to the industry benchmark curves.
The Company uses Bloomberg Valuation Service, an independent information source that draws on quantitative models and market data contributed from over 4,000 market participants, to validate third party valuations. Any material differences between valuation sources are researched by further analyzing the various inputs that are utilized by each pricing source. No material differences were identified during the validation as of September 30, 2015 and December 31, 2014.
The carrying value of restricted Federal Reserve Bank and FHLB stock approximates fair value based on the redemption provisions of each entity and is therefore excluded from the following table.
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The following table presents the balances of financial assets and liabilities measured at fair value on a recurring basis at September 30, 2015 and December 31, 2014 (dollars in thousands):
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Certain assets are measured at fair value on a nonrecurring basis in accordance with U.S. GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.
The following describes the valuation techniques used by the Company to measure certain assets recorded at fair value on a nonrecurring basis in the financial statements.
Loans held for sale
Loans held for sale are carried at the lower of cost or market value. These loans currently consist of residential loans originated for sale in the secondary market and the credit card portfolio that was transferred from loans held for investment during the quarter. See Note 13 “Subsequent Events” for additional information. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data which is not materially different than cost due to the short duration between origination and sale (Level 2). As such, the Company records any fair value adjustments on a nonrecurring basis. Gains and losses on the sale of loans are recorded within the mortgage segment and are reported on a separate line item in the Company’s Consolidated Statements of Income.
Impaired loans
Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreements will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Collateral dependent loans are reported at the fair value of the underlying collateral if repayment is solely from the underlying value of the collateral. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the Company’s collateral is real estate. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser using observable market data. When evaluating the fair value, management may discount the appraisal further if, based on their understanding of the market conditions, it is determined the collateral is further impaired below the appraised value (Level 3). The value of business equipment is based upon an outside appraisal, of one year or less, if deemed significant, or the net book value on the applicable business’s financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Collateral dependent impaired loans allocated to the allowance for loan losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Company’s Consolidated Statements of Income.
Other real estate owned
OREO is evaluated for impairment at least quarterly by the Bank’s Special Asset Loan Committee and any necessary write downs to fair values are recorded as impairment and included as a component of noninterest expense. Fair values of OREO are carried at fair value less selling costs. Fair value is based upon independent market prices, appraised values of the collateral, or management’s estimation of the value of the collateral. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the foreclosed asset as Level 3 valuation.
Total valuation expenses related to OREO properties for the three and nine months ended September 30, 2015 totaled $473,000 and $1.8 million, respectively, and for the three and nine months ended September 30, 2014 totaled $6.2 million and $7.3 million, respectively.
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The following tables summarize the Company’s financial assets that were measured at fair value on a nonrecurring basis at September 30, 2015 and December 31, 2014 (dollars in thousands):
The following table displays quantitative information about Level 3 Fair Value Measurements at September 30, 2015 (dollars in thousands):
(1) A discount percentage (in addition to expected selling costs) is applied based on the age of independent appraisals, current market conditions, and experience within the local market.
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The following table displays quantitative information about Level 3 Fair Value Measurements at December 31, 2014 (dollars in thousands):
ASC 825, Financial Instruments, requires disclosure about fair value of financial instruments for interim periods and excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.
Cash and cash equivalents
For those short-term instruments, the carrying amount is a reasonable estimate of fair value.
Held to Maturity Securities
The Company’s investment portfolio is primarily valued using fair value measurements that are considered to be Level 2. The Company has contracted with a third party portfolio accounting service vendor for valuation of its securities portfolio. The vendor’s primary source for security valuation is IDC, which evaluates securities based on market data. IDC utilizes evaluated pricing models that vary by asset class and include available trade, bid, and other market information. Generally, the methodology includes broker quotes, proprietary models, vast descriptive terms and conditions databases, as well as extensive quality control programs.
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Loans
The fair value of performing loans is estimated by discounting expected future cash flows using a yield curve that is constructed by adding a loan spread to a market yield curve. Loan spreads are based on spreads currently observed in the market for loans of similar type and structure. Fair value for impaired loans and their respective level within the fair value hierarchy, are described in the previous disclosure related to fair value measurements of assets that are measured on a nonrecurring basis.
Bank owned life insurance
The carrying value of bank owned life insurance approximates fair value. The Company records these policies at their cash surrender value, which is estimated using information provided by insurance carriers.
Deposits
The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair value of certificates of deposit is estimated by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities.
Borrowings
The carrying value of the Company’s repurchase agreements is a reasonable estimate of fair value. Other borrowings are discounted using the current yield curve for the same type of borrowing. For borrowings with embedded optionality, a third party source is used to value the instrument. The Company validates all third party valuations for borrowings with optionality using Bloomberg’s derivative pricing functions.
Accrued interest
The carrying amounts of accrued interest approximate fair value.
Commitments to extend credit and standby letters of credit
The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date. At September 30, 2015 and December 31, 2014, the fair value of loan commitments and standby letters of credit was immaterial.
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The carrying values and estimated fair values of the Company’s financial instruments at September 30, 2015 and December 31, 2014 are as follows (dollars in thousands):
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The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of the Company’s financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company’s overall interest rate risk.
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Basic EPS is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted EPS is computed using the weighted average number of common shares outstanding during the period, including the effect of dilutive potential common shares outstanding attributable to stock awards.
There were approximately 51,179 and 155,433 shares underlying anti-dilutive awards for the three months ended September 30, 2015 and 2014, respectively, and there were approximately 54,475 and 130,499 shares underlying anti-dilutive awards for the nine months ended September 30, 2015 and 2014, respectively. Anti-dilutive awards were excluded from the calculation of diluted EPS.
The following is a reconciliation of the denominators of the basic and diluted EPS computations for the three and nine months ended September 30, 2015 and 2014 (in thousands except per share data):
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The Company has two reportable segments: a traditional full service community bank segment and a mortgage loan origination business segment. The community bank segment includes one subsidiary bank, the Bank, which provides loan, deposit, investment, and trust services to retail and commercial customers throughout its 124 retail locations in Virginia. The mortgage segment includes UMG, which provides a variety of mortgage loan products principally in Virginia, North Carolina, Maryland, and the Washington D.C. metro area. These loans are originated and sold primarily in the secondary market through purchase commitments from investors, which serves to mitigate the Company’s exposure to interest rate risk.
Profit and loss is measured by net income after taxes including realized gains and losses on the Company’s investment portfolio. The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies. Inter-segment transactions are recorded at cost and eliminated as part of the consolidation process.
Both of the Company’s reportable segments are service-based. The mortgage business is a primarily fee-based business while the bank is driven principally by net interest income. The bank segment provides a distribution and referral network through its customers for the mortgage loan origination business. The mortgage segment offers a more limited referral network for the bank segment.
The community bank segment provides the mortgage segment with the short-term funds needed to originate mortgage loans through a warehouse line of credit and charges the mortgage banking segment interest. The interest rate on the warehouse line of credit for the three and nine months ended September 30, 2015 was the three month LIBOR rate plus 0.15% with no floor. During 2014, the interest rate on the warehouse line of credit was the three month LIBOR rate plus 1.5% with a floor of 2.0% through May 31, 2014; beginning on June 1, 2014, the interest rate was one month LIBOR rate plus 1.5% with no floor. These transactions are eliminated in the consolidation process. A management fee for operations and administrative support services is charged to all subsidiaries and eliminated in the consolidated totals.
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Information about reportable segments and reconciliation of such information to the consolidated financial statements for the three and nine months ended September 30, 2015 and 2014 is as follows (dollars in thousands):
SEGMENT FINANCIAL INFORMATION
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Sale of Credit Card Portfolio
During the third quarter of 2015, the Company concluded that it met the pertinent criteria for transferring the credit card portfolio from loans held for investment to loans held for sale.
On October 16, 2015, the Company entered into an agreement to sell the credit card portfolio, approximately $26.4 million in outstanding balances, and enter into an outsourced partnership solution with Elan Financial Services. The company sold these loans at a premium which is not expected to have a material impact on the Company’s Consolidated Statements of Income. As part of the agreement, the Company will continue to share in interchange fee income and finance charges.
Share Repurchase Authorization
On October 29, 2015, the Company’s Board of Directors authorized a share repurchase program to purchase up to $25.0 million worth of the Company’s common stock on the open market or in privately negotiated transactions. The repurchase program is authorized through December 31, 2016.
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Review Report of Independent Registered Public Accounting Firm
The Shareholders and Board of Directors of Union Bankshares Corporation
We have reviewed the consolidated balance sheet of Union Bankshares Corporation (the “Company”) as of September 30, 2015, and the related consolidated statements of income and comprehensive income for the three- and nine-month periods ended September 30, 2015 and the related consolidated statements of changes in stockholders’ equity and cash flows for the nine-month period ended September 30, 2015. These financial statements are the responsibility of the Company's management. The consolidated financial statements of the Company as of September 30, 2014, and for the three- and nine-month periods then ended, were reviewed by other auditors whose report dated November 5, 2014 stated that based on their review they were not aware of any material modifications that should be made to those statements for them to be in conformity with U.S. generally accepted accounting principles. The consolidated balance sheet of the Company as of December 31, 2014, and the related consolidated statements of income, comprehensive income, shareholders' equity and cash flows for the year then ended (not presented herein) were audited by other auditors whose report dated February 27, 2015 expressed an unqualified opinion on those statements.
We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the 2015 consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.
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ITEM 2 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Management’s discussion and analysis is presented to aid the reader in understanding and evaluating the financial condition and results of operations of Union Bankshares Corporation and its subsidiaries (collectively, the “Company”). This discussion and analysis should be read with the consolidated financial statements, the notes to the financial statements, and the other financial data included in this report, as well as the Company’s Annual Report on Form 10-K and management’s discussion and analysis for the year ended December 31, 2014. Highlighted in the discussion are material changes from prior reporting periods and any identifiable trends affecting the Company. Results of operations for the three and nine months ended September 30, 2015 and 2014 are not necessarily indicative of results that may be attained for any other period. Amounts are rounded for presentation purposes while some of the percentages presented are computed based on unrounded amounts.
FORWARD-LOOKING STATEMENTS
Certain statements in this report may constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements that include projections, predictions, expectations, or beliefs about future events or results or otherwise are not statements of historical fact. Such statements are often characterized by the use of qualified words (and their derivatives) such as “expect,” “believe,” “estimate,” “plan,” “project,” “anticipate,” “intend,” “will,” or words of similar meaning or other statements concerning opinions or judgment of the Company and its management about future events. Although the Company believes that its expectations with respect to forward-looking statements are based upon reasonable assumptions within the bounds of its existing knowledge of its business and operations, there can be no assurance that actual results, performance, or achievements of the Company will not differ materially from any projected future results, performance, or achievements expressed or implied by such forward-looking statements. Actual future results and trends may differ materially from historical results or those anticipated depending on a variety of factors, including, but not limited to, the effects of and changes in: general economic and bank industry conditions, the interest rate environment, legislative and regulatory requirements, competitive pressures, new products and delivery systems, inflation, stock and bond markets, accounting standards or interpretations of existing standards, mergers and acquisitions, technology, and consumer spending and savings habits. More information is available on the Company’s website,http://investors.bankatunion.com and on the Securities and Exchange Commission’s website, www.sec.gov. The information on the Company’s website is not a part of this Form 10-Q. The Company does not intend or assume any obligation to update or revise any forward-looking statements that may be made from time to time by or on behalf of the Company.
CRITICAL ACCOUNTING POLICIES
General
The accounting and reporting policies of the Company are in accordance with U.S. GAAP and conform to general practices within the banking industry. The Company’s financial position and results of operations are affected by management’s application of accounting policies, including estimates, assumptions, and judgments made to arrive at the carrying value of assets and liabilities and amounts reported for revenues, expenses, and related disclosures. Different assumptions in the application of these policies could result in material changes in the Company’s consolidated financial position and/or results of operations.
The more critical accounting and reporting policies include the Company’s accounting for the allowance for loan losses, mergers and acquisitions, and goodwill and intangible assets. The Company’s accounting policies are fundamental to understanding the Company’s consolidated financial position and consolidated results of operations. Accordingly, the Company’s significant accounting policies are discussed in detail in Note 1 “Summary of Significant Accounting Policies” in the “Notes to the Consolidated Financial Statements” contained in Item 8 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2014.
The following is a summary of the Company’s critical accounting policies that are highly dependent on estimates, assumptions, and judgments.
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Allowance for Loan Losses
The provision for loan losses charged to operations is an amount sufficient to bring the allowance for loan losses to an estimated balance that management considers adequate to absorb incurred losses in the portfolio. Loans are charged against the allowance when management believes the collectability of the principal is unlikely. Recoveries of amounts previously charged-off are credited to the allowance. Management’s determination of the adequacy of the allowance is based on an evaluation of the composition of the loan portfolio, the value and adequacy of collateral, current economic conditions, historical loan loss experience, and other risk factors. Management believes that the allowance for loan losses is adequate. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions, particularly those affecting real estate values. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to make adjustments to the allowance based on their judgments about information available to them at the time of their examination.
The Company performs regular credit reviews of the loan portfolio to review the credit quality and adherence to its underwriting standards. The credit reviews consist of reviews by its Loan Review group and reviews performed by an independent third party. Upon origination, each commercial loan is assigned a risk rating ranging from one to nine, with loans closer to one having less risk. This risk rating scale is the Company’s primary credit quality indicator. Consumer loans are generally not risk rated; the primary credit quality indicator for this portfolio segment is delinquency status. The Company has various committees that review and ensure that the allowance for loan losses methodology is in accordance with U.S. GAAP and loss factors used appropriately reflect the risk characteristics of the loan portfolio.
The Company’s ALL consists of specific and general components.
Specific Reserve Component– The specific reserve component relates to impaired loans. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Upon being identified as impaired, for loans not considered to be collateral dependent, an allowance is established when the discounted cash flows of the impaired loan are lower than the carrying value of that loan. Nonaccrual loans under $100,000 and other impaired loans under $500,000 are aggregated based on similar risk characteristics. The level of credit impairment within the pool(s) is determined based on historical loss factors for loans with similar risk characteristics, taking into consideration environmental factors specifically related to the underlying pool. The impairment of collateral dependent loans is measured based on the fair value of the underlying collateral (based on independent appraisals), less selling costs, compared to the carrying value of the loan. If the Company determines that the value of an impaired collateral dependent loan is less than the recorded investment in the loan, it either recognizes an impairment reserve as a specific component to be provided for in the allowance for loan losses or charges off the deficiency if it is determined that such amount represents a confirmed loss. Typically, a loss is confirmed when the Company is moving towards foreclosure (or final disposition) of the underlying collateral, the collateral deficiency has not improved for two consecutive quarters, or when there is a payment default of 180 days, whichever occurs first.
The Company obtains independent appraisals from a pre-approved list of independent, third party appraisal firms located in the market in which the collateral is located. The Company’s approved appraiser list is continuously maintained to ensure the list only includes such appraisers that have the experience, reputation, character, and knowledge of the respective real estate market. At a minimum, it is ascertained that the appraiser is currently licensed in the state in which the property is located, experienced in the appraisal of properties similar to the property being appraised, has knowledge of current real estate market conditions and financing trends, and is reputable. The Company’s internal Real Estate Valuation Group, which reports to the Risk and Compliance Group, performs either a technical or administrative review of all appraisals obtained. A technical review will ensure the overall quality of the appraisal, while an administrative review ensures that all of the required components of an appraisal are present. Generally, independent appraisals are updated every 12 to 24 months or more frequently as necessary. The Company’s impairment analysis documents the date of the appraisal used in the analysis, whether the officer preparing the report deems it current, and, if not, allows for internal valuation adjustments with justification. Adjustments to appraisals generally include discounts for continued market deterioration subsequent to the appraisal date. Any adjustments from the appraised value to carrying value are documented in the impairment analysis, which is reviewed and approved by senior credit administration officers and the Special Assets Loan Committee. External appraisals are the primary source to value collateral dependent loans; however, the Company may also utilize values obtained through broker price opinions or other valuations sources. These alternative sources of value are used only if deemed to be more representative of value based on updated information regarding collateral resolution. Impairment analyses are updated, reviewed, and approved on a quarterly basis at or near the end of each reporting period.
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General Reserve Component – The general reserve component covers non-impaired loans and is derived from an estimate of credit losses adjusted for various environmental factors applicable to both commercial and consumer loan segments. The estimate of credit losses is a function of the product of net charge-off historical loss experience to the loan balance of the loan portfolio averaged during the preceding twelve quarters, as management has determined this to adequately reflect the losses inherent in the loan portfolio. The environmental factors consist of national, local, and portfolio characteristics and are applied to both the commercial and consumer segments. The following table shows the types of environmental factors management considers:
Impaired Loans
A loan is considered impaired when, based on current information and events, it is probable that the Company 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. A loan that is classified substandard or worse is considered impaired. Management determines 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. Impairment is measured on a loan-by-loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. The impaired loan policy is the same for each of the seven classes within the commercial portfolio segment.
For the consumer loan portfolio segment, large groups of smaller balance homogeneous loans are collectively evaluated for impairment. This evaluation subjects each of the Company’s homogenous pools to a historical loss factor derived from net charge-offs experienced over the preceding twelve quarters. The Company applies payments received on impaired loans to principal and interest based on the contractual terms until they are placed on nonaccrual status. All payments received are then applied to reduce the principal balance and recognition of interest income is terminated.
Business Combinations and Acquired Loans
The Company’s merger and acquisition strategy focuses on high-growth areas with strong market demographics and targets organizations that have a comparable corporate culture, strong performance, and good asset quality, among other factors.
Business combinations are accounted for under ASC 805, Business Combinations, using the acquisition method of accounting. The acquisition method of accounting requires an acquirer to recognize the assets acquired and the liabilities assumed at the acquisition date measured at their fair values as of that date. To determine the fair values, the Company will continue to rely on third party valuations, such as appraisals, or internal valuations based on discounted cash flow analyses or other valuation techniques. Under the acquisition method of accounting, the Company will identify the acquirer and the closing date and apply applicable recognition principles and conditions. If they are necessary to implement its plan to exit an activity of an acquiree, costs that the Company expects, but is not obligated, to incur in the future are not liabilities at the acquisition date, nor are costs to terminate the employment of or relocate an acquiree’s employees. The Company does not recognize these costs as part of applying the acquisition method. Instead, the Company recognizes these costs as expenses in its post-combination financial statements in accordance with other applicable U.S. GAAP.
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Acquisition-related costs are incremental costs the Company incurs to effect a business combination. Those costs include advisory, legal, accounting, valuation, and other professional or consulting fees. Some other examples of acquisition-related costs to the Company include systems conversions, integration planning consultants, and advertising costs. The Company will account for acquisition-related costs as expenses in the periods in which the costs are incurred and the services are received, with one exception. The costs to issue debt or equity securities will be recognized in accordance with other applicable U.S. GAAP. These acquisition-related costs are included within the Consolidated Statements of Income classified within the noninterest expense caption.
Loans acquired in a business combination are recorded at fair value on the date of the acquisition. Loans acquired with deteriorated credit quality are accounted for in accordance with ASC 310-30, Receivables – Loans and Debt Securities Acquired with Deteriorated Credit Quality, and are initially measured at fair value, which includes estimated future credit losses expected to be incurred over the life of the loans. Loans acquired in business combinations with evidence of credit deterioration are not considered to be impaired unless they deteriorate further subsequent to the acquisition. Certain acquired loans, including performing loans and revolving lines of credit (consumer and commercial), are accounted for in accordance with ASC 310-20, Receivables – Nonrefundable Fees and Other Costs, where the discount is accreted through earnings based on estimated cash flows over the estimated life of the loan.
Goodwill and Intangible Assets
The Company follows ASC 350, Intangibles– Goodwill and Other, which prescribes the accounting for goodwill and intangible assets subsequent to initial recognition. Goodwill resulting from business combinations prior to January 1, 2009 represents the excess of the purchase price over the fair value of the net assets of businesses acquired. Goodwill resulting from business combinations after January 1, 2009, is generally determined as the excess of the fair value of the consideration transferred, plus the fair value of any noncontrolling interests in the acquiree, over the fair value of the net assets acquired and liabilities assumed as of the acquisition date. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually or more frequently if events and circumstances exists that indicate that a goodwill impairment test should be performed. The Company has selected April 30th as the date to perform the annual impairment test. Intangible assets with definite useful lives are amortized over their estimated useful lives, which range from 4 to 14 years, to their estimated residual values. Goodwill is the only intangible asset with an indefinite life on the Company’s Consolidated Balance Sheets.
The Company performed its annual impairment testing in the second quarter of 2015 and determined that there was no impairment to its goodwill or intangible assets.
Long-lived assets, including purchased intangible assets subject to amortization, such as the core deposit intangible asset, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. Management concluded that no circumstances indicating an impairment of these assets existed as of the balance sheet date.
ABOUT UNION BANKSHARES CORPORATION
Headquartered in Richmond, Union Bankshares Corporation is the largest community banking organization headquartered in Virginia and operates in all major banking markets of the Commonwealth. Union Bankshares Corporation is the holding company for Union Bank & Trust, which provides banking, trust, and wealth management services and has a statewide presence of 124 bank branches and 202 ATMs. Non-bank affiliates of the holding company include: Union Investment Services, Inc., which provides full brokerage services; Union Mortgage Group, Inc., which provides a full line of mortgage products; and Union Insurance Group, LLC, which offers various lines of insurance products.
The Company announced that, effective February 16, 2015, it had changed its subsidiary bank’s name from “Union First Market Bank” to “Union Bank & Trust”.
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Shares of the Company’s common stock are traded on the NASDAQ Global Select Market under the symbol UBSH. Additional information is available on the Company’s website at http://investors.bankatunion.com. The information contained on the Company’s website is not a part of or incorporated into this report.
RESULTS OF OPERATIONS
Executive Overview
For the quarter ended September 30, 2015, the Company reported net income of $18.2 million and earnings per share of $0.40. These results represent an increase of $3.4 million, or 22.9%, from $14.8 million in earnings from the third quarter of 2014. Excluding after-tax acquisition-related expenses of $1.1 million incurred during the third quarter of 2014, operating earnings(1) increased $2.3 million, or 14.4%, primarily a result of lower operating expenses. Operating earnings per share(1) were $0.40 and $0.35 for the quarters ended September 30, 2015 and 2014, respectively.
For the nine months ended September 30, 2015, the Company reported net income of $49.3 million and earnings per share of $1.09. These results represent an increase of $12.1 million, or 32.4%, from $37.2 million for the first nine months of 2014. Excluding after-tax acquisition-related expenses of $13.2 million incurred during the first nine months of 2014, operating earnings(1) declined $1.1 million, primarily a result of an increase in provision for loan losses, and lower net interest income partially offset by lower noninterest expenses. Operating earnings per share(1) were $1.09 for the nine months ended September 30, 2015 and 2014, respectively.
(1) These supplementary measures are provided because the Company believes they may be valuable to investors. For a reconciliation of the non-GAAP measures operating earnings, EPS, ROA, ROTCE, and efficiency ratio, see “NON-GAAP MEASURES” included in this Item 2.
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Net Interest Income
(1) Core metrics exclude the impact of acquisition accounting accretion and amortization adjustments in net interest income.
For the third quarter of 2015, tax-equivalent net interest income was $65.7 million, a decrease of $806,000 from the third quarter of 2014, primarily driven by the impact of declines in net interest margin and lower net accretion related to acquisition accounting, partially offset by lower interest expense as growth in low cost deposits outpaced the net run-off in higher cost certificates of deposit. Net accretion related to acquisition accounting decreased $1.5 million from the third quarter of 2014 to $1.6 million in the third quarter of 2015. The third quarter 2015 tax-equivalent net interest margin decreased by 25 basis points to 3.86% compared to 4.11% in the comparable quarter in the prior year. Core tax-equivalent net interest margin (which excludes the 9 basis point impact of acquisition accounting accretion in the third quarter of 2015 and 19 basis points in the third quarter of 2014) decreased by 15 basis points to 3.77% in the third quarter of 2015 from 3.92% in the third quarter of 2014. The decrease in core tax-equivalent net interest margin was driven by the 20 basis point decline in interest-earning asset yields outpacing the 5 basis point reduction in cost of funds. The decline in interest-earning asset yields was primarily driven by lower loan yields, as new and renewed loans were originated and re-priced at lower rates.
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For the nine months ended September 30, 2015, tax-equivalent net interest income was $196.0 million, a decrease of $2.1 million from the same period of 2014, primarily driven by the impact of declines in net interest margin and lower net accretion related to acquisition accounting. Net accretion related to acquisition accounting decreased $2.6 million from the first nine months of 2014 to $5.3 million in the first nine months of 2015. The year-to-date tax-equivalent net interest margin decreased by 18 basis points to 3.93% compared to 4.11% in the prior year. Core tax-equivalent net interest margin (which excludes the 11 basis point impact of acquisition accounting in 2015 and 16 basis points in 2014) decreased by 13 basis points from 3.95% for the nine months ended September 30, 2014 to 3.82% for the nine months ended September 30, 2015. The decrease in core tax-equivalent net interest margin was driven by the 18 basis point decline in interest-earning asset yields outpacing the 5 basis point reduction in the cost of funds. The decline in interest-earning asset yields was primarily driven by lower loan yields, as new and renewed loans were originated and re-priced at lower rates.
The Company continues to believe that net interest margin will decline modestly over the next several quarters as decreases in interest-earning asset yields are projected to outpace any further declines in interest-bearing liabilities rates.
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The following tables show interest income on earning assets and related average yields as well as interest expense on interest-bearing liabilities and related average rates paid for the periods indicated (dollars in thousands):
AVERAGE BALANCES, INCOME AND EXPENSES, YIELDS AND RATES (TAXABLE EQUIVALENT BASIS)
(1) Rates and yields are annualized and calculated from actual, not rounded, amounts in thousands, which appear above.
(2) Nonaccrual loans are included in average loans outstanding.
(3) Interest income on loans includes $1.4 million and $846,000 for the three months ended September 30, 2015 and 2014, respectively, in accretion of the fair market value adjustments related to acquisitions.
(4) Interest expense on certificates of deposits includes $154,000 and $2.0 million for the three months ended September 30, 2015 and 2014, respectively, in accretion of the fair market value adjustments related to acquisitions.
(5) Interest expense on borrowings includes $87,000 and $262,000 for the three months ended September 30, 2015 and 2014, respectively, in accretion of the fair market value adjustments related to acquisitions.
(6) Income and yields are reported on a taxable equivalent basis using the statutory federal corporate tax rate of 35%.
(7) Core net interest margin excludes purchase accounting adjustments and was 3.77% and 3.92% for the three months ended September 30, 2015 and 2014, respectively.
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(3) Interest income on loans includes $3.1 million and $81,000 for the nine months ended September 30, 2015 and 2014, respectively, in accretion of the fair market value adjustments related to acquisitions.
(4) Interest expense on certificates of deposits includes $1.8 million and $7.4 million for the nine months ended September 30, 2015 and 2014, respectively, in accretion of the fair market value adjustments related to acquisitions.
(5) Interest expense on borrowings includes $362,000 and $412,000 for the nine months ended September 30, 2015 and 2014, respectively, in accretion of the fair market value adjustments related to acquisitions.
(7) Core net interest margin excludes purchase accounting adjustments and was 3.82% and 3.95% for the nine months ended September 30, 2015 and 2014, respectively.
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The Volume Rate Analysis table below presents changes in interest income and interest expense and distinguishes between the changes related to increases or decreases in average outstanding balances of interest-earning assets and interest-bearing liabilities (volume), and the changes related to increases or decreases in average interest rates on such assets and liabilities (rate). Changes attributable to both volume and rate have been allocated proportionally. Results, on a taxable equivalent basis, are as follows (dollars in thousands):
(1) The rate-related change in interest income on loans includes the impact of higher accretion of the acquisition-related fair market value adjustments of $518,000 and $3.0 million for the three- and nine-month change, respectively.
(2) The rate-related change in interest expense on time deposits includes the impact of lower accretion of the acquisition-related fair market value adjustments of $1.8 million and $5.5 million for the three- and nine-month change, respectively.
(3) The rate-related change in interest expense on other borrowings includes the impact of lower accretion of the acquisition-related fair market value adjustments of $175,000 and $50,000 for the three- and nine-month change, respectively.
The Company’s fully taxable equivalent net interest margin includes the impact of acquisition accounting fair value adjustments. The 2015 and remaining estimated net accretion impact are reflected in the following table (dollars in thousands):
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Noninterest Income
NM - Not Meaningful
For the quarter ended September 30, 2015, noninterest income increased $407,000, or 2.5%, to $16.7 million from $16.3 million in the third quarter of 2014. Customer-related noninterest income (service charge and fiduciary and asset management fees) increased $901,000 primarily due to higher overdraft fees, interchange fees, and brokerage income. Gains of sales of mortgage loans, net of commissions, and bank owned life insurance income remained constant with the prior period. Other noninterest income decreased $494,000, as lower gains on sales of securities of $920,000 and a $300,000 OTTI charge on a municipal security in the available-for-sale portfolio in the current quarter was partially offset by increases in other operating income related to the resolution of a problem credit resulting in a note sale.
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For the nine months ended September 30, 2015, noninterest income increased $1.6 million, or 3.5%, to $48.0 million from $46.4 million in the first nine months of 2014. Customer-related fee income increased $856,000 primarily related to higher overdraft and interchange fees. Other operating income increased $2.1 million primarily driven by higher loan swap fees in 2015, gains from the dissolution of a limited partnership in the first quarter of 2015, and gains on the resolution of a problem credit in the third quarter of 2015. These increases were partially offset by declines in gains on sales of mortgage loans, net of commissions, of $343,000, primarily driven by lower mortgage loan originations. Mortgage loan origination volume decreased $95.1 million from $522.2 million in the first nine months of 2014 to $427.1 million in the first nine months of 2015. Additionally, gains on sales of securities were $777,000 lower compared to the prior year and there was a $300,000 OTTI charge on a municipal security in the available-for-sale portfolio in the current year.
Noninterest expense
(1) OREO related costs include foreclosure related expenses, gains/losses on the sale of OREO, valuation reserves, and asset resolution related legal expenses.
For the quarter ended September 30, 2015, noninterest expense decreased $6.1 million to $53.3 million from $59.4 million when compared to the third quarter of 2014, partially driven by acquisition expenses incurred in the third quarter of 2014. Excluding acquisition-related costs of $1.7 million in 2014, noninterest expense decreased $4.4 million, or 7.6%. The decrease in noninterest expense is primarily due to a decrease in OREO and credit-related expenses of $5.3 million related to lower valuation adjustments of $5.6 million. In the third quarter of 2014, $6.2 million in valuation adjustments were recorded in connection with a shift in strategy to more aggressively market OREO in inactive rural markets. These decreases were partially offset by increased professional fees of $591,000 relating to consulting fees and higher technology and data processing fees of $269,000 related to software maintenance.
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For the nine months ended September 30, 2015, noninterest expense decreased $23.3 million to $162.4 million from $185.7 million when compared to the first nine months of 2014, largely driven by acquisition expenses incurred in 2014. Excluding acquisition-related costs of $19.5 million, noninterest expense decreased $3.8 million, or 2.2%. The decrease in noninterest expense is primarily due to a decrease in OREO and credit-related expenses of $5.8 million related to lower valuation adjustments of $5.5 million. In the third quarter of 2014, $6.2 million in valuation adjustments were recorded in connection with a shift in strategy to more aggressively market OREO in inactive rural markets. Salaries and benefits expenses declined $3.6 million due to lower salaries and profit sharing expenses, partially offset by increased incentive compensation. Amortization of core deposit intangible decreased $1.0 million when compared to the same period in the prior year. The decreases were partially offset by $1.1 million in higher professional fees related to consulting and legal fees, $1.0 million in higher marketing expenses related to advertising campaigns in the current year, $919,000 in increased fraud-related losses, $875,000 in higher technology expenses related to online banking and data processing fees, and $630,000 in increased expenses related to employee training.
SEGMENT INFORMATION
Community Bank Segment
For the three months ended September 30, 2015, the community bank segment reported net income of $18.2 million, which was $2.7 million higher than net income in third quarter of 2014. Excluding after-tax acquisition-related costs of $1.1 million in the third quarter of 2014, net income increased $1.6 million, or 9.7%. Net interest income decreased $1.1 million from $64.2 million in the third quarter of 2014 to $63.1 million, primarily driven by the impact of declines in net interest margin and lower net accretion related to acquisition accounting. The provision for loan losses for the quarter ended September 30, 2015 was $1.9 million, an increase of $100,000 compared to the same quarter a year ago. The increase in the provision for loan losses in the current periods compared to the same periods in the prior year was primarily driven by higher loan balances in 2015.
Noninterest income increased $403,000, or 2.9%, from $13.9 million in the third quarter of 2014 to $14.3 million in the third quarter of 2015. Customer-related noninterest income (service charge and fiduciary and asset management fees) increased $901,000 primarily due to higher overdraft fees, interchange fees, and brokerage income. Other noninterest income decreased $495,000, as lower gains on sales of securities of $920,000 and a $300,000 OTTI charge on a municipal security in the available-for-sale portfolio in the current quarter was partially offset by increases in other operating income related to the resolution of a problem credit resulting in a note sale.
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Noninterest expense decreased $5.0 million from $55.7 million in the third quarter of 2014 to $50.7 million in the current quarter. Excluding prior year third quarter acquisition-related costs of $1.7 million, noninterest expense decreased $3.3 million, or 6.1%, compared to the third quarter of 2014. The decrease in noninterest expense is primarily due to a decrease in OREO and credit-related expenses of $5.3 million related to lower valuation adjustments of $5.6 million. In the third quarter of 2014, $6.2 million in valuation adjustments were recorded in connection with a shift in strategy to more aggressively market OREO in inactive rural markets. These decreases were offset by increased salaries and benefits expenses of $836,000 due to higher salaries, incentive compensation, and group insurance costs; higher professional and consulting fees of $720,000; increased employee training costs of $458,000; and higher technology and data processing fees of $326,000 related to software maintenance. The community banking segment’s operating efficiency ratio was 63.7% compared to 67.4% for the third quarter of 2014.
For the nine months ended September 30, 2015, the community bank segment reported net income of $49.4 million, an increase of $9.6 million from $39.8 million for the first nine months of 2014. Excluding after-tax acquisition-related costs of $13.2 million in the first nine months of 2014, net income decreased $3.6 million, or 6.8%. Net interest income decreased $2.9 million from the same period last year, largely a result of lower core net interest margin and lower net accretion related to acquisition accounting. The provision for credit losses increased $4.2 million compared to the first nine months of 2014, primarily driven by higher loan balances in 2015 and an increase in net charge-offs in 2015, primarily due to a net recovery in the first quarter of 2014.
Noninterest income increased $1.7 million, or 4.3%, from $39.0 million in the first nine months of 2014 to $40.7 million in the first nine months of 2015. Customer-related fee income increased $937,000 primarily related to higher overdraft and interchange fees. Other operating income increased $774,000 primarily driven by higher loan swap fees in 2015, gains from the dissolution of a limited partnership in the first quarter of 2015, and gains on the resolution of a problem credit in the third quarter of 2015. These increases were partially offset by declines in gains on sales of securities compared to the prior year, OTTI charge on a municipal security in the available-for-sale portfolio in the current year, and declines in interest recognized on previously charged off loans.
Noninterest expense decreased $19.3 million from $173.3 million in the first nine months of 2014 to $154.0 million in 2015, largely driven by acquisition expenses incurred in 2014. Excluding the prior year acquisition-related costs of $19.5 million, noninterest expense increased $267,000, or 0.2%, compared to the first nine months of 2014. Salaries and benefits declined $936,000, or 1.3%, primarily due to cost savings from the StellarOne acquisition being realized in the current year and lower profit-sharing expense in the current year. OREO and credit-related expenses declined $5.8 million related to lower valuation adjustments of $5.5 million. In the third quarter of 2014, $6.2 million in valuation adjustments were recorded in connection with a shift in strategy to more aggressively market OREO in inactive rural markets. The decreases in noninterest expense were offset by $1.3 million in higher professional fees related to consulting and legal fees, $1.1 million in higher marketing expenses related to advertising campaigns in the current year, $1.1 million in higher technology expenses related to online banking and data processing fees, $916,000 in branch closure costs in the current year, $786,000 in increased fraud-related losses, and $630,000 in increased expenses related to employee training. The community banking segment’s operating efficiency ratio was 65.4% compared to 65.1% for the first nine months of 2014.
Mortgage Segment
The mortgage segment reported net income of $59,000 for the third quarter of 2015, an improvement of $687,000 from a loss of $628,000 in the third quarter of 2014. The improvement was due to a reduction in noninterest expense of $1.1 million, largely a result of cost control initiatives in personnel costs, occupancy expenses, loan production costs, and other operating expenses. Gains on sales of mortgage loans, net of commissions, remained consistent with the third quarter of 2014 at $2.6 million.
The mortgage segment reported a net loss of $113,000 for the first nine months of 2015, an improvement of $2.5 million from a loss of $2.6 million in the first nine months of 2014. The improvement was due to a reduction in noninterest expense of $4.0 million, largely a result of cost control initiatives in personnel costs, occupancy expenses, loan production costs, and other operating expenses. Gains on sales of mortgage loans, net of commissions, declined $343,000, or 4.3 %, primarily driven by lower mortgage loan originations. Mortgage loan origination volume decreased $95.1 million from $522.2 million in the first nine months of 2014 to $427.1 million in the first nine months of 2015.
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Income Taxes
The provision for income taxes is based upon the results of operations, adjusted for the effect of certain tax-exempt income and non-deductible expenses. In addition, certain items of income and expense are reported in different periods for financial reporting and tax return purposes. The tax effects of these temporary differences are recognized currently in the deferred income tax provision or benefit. Deferred tax assets or liabilities are computed based on the difference between the financial statement and income tax bases of assets and liabilities using the applicable enacted marginal tax rate.
In assessing the ability to realize deferred tax assets, management considers the scheduled reversal of temporary differences, projected future taxable income, and tax planning strategies. Management continues to believe that it is not likely that the Company will realize its deferred tax asset related to net operating losses generated at the state level and accordingly has established a valuation allowance. The Company’s bank subsidiary is not subject to a state income tax in its primary place of business (Virginia). The Company’s other subsidiaries are subject to state income taxes and have generated losses for state income tax purposes which the Company is currently unable to utilize. State net operating loss carryovers will begin to expire after 2026.
The effective tax rate for the three months ended September 30, 2015 and 2014 was 26.5% and 24.3%, respectively; the effective tax rate for the nine months ended September 30, 2015 and 2014 was 26.7% and 24.7%, respectively. The increase in the effective tax rate is primarily related to tax-exempt interest income on the investment portfolio and tax-exempt bank-owned life insurance income being a larger percentage of pre-tax income during 2014 due to elevated merger-related costs included in pre-tax income.
BALANCE SHEET
Assets
At September 30, 2015, total assets were $7.6 billion, an increase of $235.7 million from December 31, 2014. The following is a general discussion of changes in certain of the more significant asset line items of the Company’s Consolidated Balance Sheets.
Liabilities and Stockholders’ Equity
At September 30, 2015, total liabilities were $6.6 billion, an increase of $217.8 million from December 31, 2014. The following is a general discussion of changes in certain of the more significant line items in the liability and stockholders’ equity sections of the Company’s Consolidated Balance Sheets.
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At September 30, 2015, stockholders’ equity was $995.0 million, an increase of $17.8 million from $977.2 million reported at December 31, 2014. The Company’s capital ratios continue to exceed the minimum capital requirements for regulatory purposes. The total capital ratios at September 30, 2015 and December 31, 2014 were 12.69% and 13.38%, respectively. The Tier 1 capital ratios were 12.16% and 12.76% at September 30, 2015 and December 31, 2014, respectively. The Company’s common equity to total asset ratios at September 30, 2015 and December 31, 2014 were 13.10% and 13.28%, respectively, while its tangible common equity to tangible assets ratios were 9.29% and 9.27%, respectively, at the same dates.
On January 30, 2014, the Company’s Board of Directors authorized a share repurchase program to purchase up to $65.0 million worth of the Company’s common stock on the open market or in privately negotiated transactions. The repurchase program is authorized through December 31, 2015. During the nine months ended September 30, 2015, approximately 347,000 common shares were repurchased and approximately $4.5 million remained available under the program. Additionally, on October 29, 2015, the Company’s Board of Directors authorized a new share repurchase program to purchase to to $25.0 million worth of the Company’s common stock. This repurchase program is authorized through December 31, 2016.
Also, the Company paid a cash dividend of $0.17 per share during the third quarter of 2015, the same dividend level as the prior quarter, and a $0.02 per share, or 13%, increase over the prior year quarterly dividend rate. The dividends paid year-to-date of $0.49 per share represent a $0.06 per share, or 14%, increase over the first nine months of 2014.
Securities
At September 30, 2015, the Company had total investments in the amount of $1.1 billion, or 15.0% of total assets, as compared to $1.2 billion, or 15.7% of total assets, at December 31, 2014. The Company seeks to diversify its portfolio to minimize risk. It focuses on purchasing mortgage-backed securities for cash flow and reinvestment opportunities and securities issued by states and political subdivisions due to the tax benefits and the higher yield offered from these securities. The majority of the Company’s mortgage-backed securities are investment grade. The investment portfolio has a high percentage of municipals and mortgage-backed securities; therefore a higher taxable equivalent yield exists on the portfolio compared to its peers. The Company does not engage in structured derivative or hedging activities within the investment portfolio.
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The table below sets forth a summary of the securities available for sale, securities held to maturity, and restricted stock, at fair value for the following periods (dollars in thousands):
During each quarter and at year end, the Company conducts an assessment of the securities portfolio for OTTI consideration. Based on the assessment for the quarter ended September 30, 2015 and in accordance with the guidance, the Company determined that a municipal security in the available for sale portfolio incurred credit-related OTTI of $300,000, which was recognized in earnings for the quarter ended September 30, 2015. No OTTI was recognized in 2014 or for the first six months of 2015. The Company monitors the portfolio, which is subject to liquidity needs, market rate changes, and credit risk changes, to determine whether adjustments are needed. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
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The following table summarizes the contractual maturity of securities available for sale at fair value and their weighted average yields as of September 30, 2015 (dollars in thousands):
(1) Yields on tax-exempt securities have been computed on a tax-equivalent basis.
The following table summarizes the contractual maturity of securities held to maturity at carrying value and their weighted average yields as of September 30, 2015 (dollars in thousands):
As of September 30, 2015, the Company maintained a diversified municipal bond portfolio with approximately 74% of its holdings in general obligation issues and the remainder backed by revenue bonds. Issuances within the State of Texas represented 13%, the State of Washington represented 12%, and the Commonwealth of Virginia represented 12% of the municipal portfolio; no other state had a concentration above 10%. Substantially all municipal holdings are considered investment grade by Moody’s or Standard & Poor’s. The non-investment grade securities are principally insured Texas municipalities with no underlying rating. When purchasing municipal securities, the Company focuses on strong underlying ratings for general obligation issuers or bonds backed by essential service revenues.
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Liquidity
Liquidity represents an institution’s ability to meet present and future financial obligations through either the sale or maturity of existing assets or the acquisition of additional funds through liability management. Liquid assets include cash, interest-bearing deposits with banks, money market investments, federal funds sold, securities available for sale, loans held for sale, and loans maturing or re-pricing within one year. Additional sources of liquidity available to the Company include its capacity to borrow additional funds when necessary through federal funds lines with several correspondent banks, a line of credit with the FHLB, the purchase of brokered certificates of deposit, and a corporate line of credit with a large correspondent bank. Management considers the Company’s overall liquidity to be sufficient to satisfy its depositors’ requirements and to meet its customers’ credit needs.
As of September 30, 2015, the cash, interest-bearing deposits in other banks, money market investments, federal funds sold, loans held for sale, and loans that mature within one year totaled $1.9 billion, or 27.3 %, of total earning assets. As of September 30, 2015, approximately $1.6 billion, or 29.2%, of total loans are scheduled to mature within one year based on contractual maturity, adjusted for expected prepayments.
Loan Portfolio
Loans, net of deferred fees and costs, were $5.5 billion at September 30, 2015, $5.3 billion at December 31, 2014, and $5.2 billion at September 30, 2014. Loans secured by real estate continue to represent the Company’s largest category, comprising 83.7% of the total loan portfolio at September 30, 2015.
The following table presents the Company’s composition of loans, net of deferred fees and costs, in dollar amounts and as a percentage of total gross loans as of the quarter ended (dollars in thousands):
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The following table presents the remaining maturities, based on contractual maturity, by loan type and by rate type (variable or fixed), as of September 30, 2015 (dollars in thousands):
While the current economic environment is challenging, the Company remains committed to originating soundly underwritten loans to qualifying borrowers within its markets. The Company is focused on providing community-based financial services and discourages the origination of portfolio loans outside of its principal trade areas. As reflected in the loan table, at September 30, 2015, the largest component of the Company’s loan portfolio consisted of real estate loans, concentrated in commercial, construction, and residential 1-4 family. The risks attributable to these concentrations are mitigated by the Company’s credit underwriting and monitoring processes, including oversight by a centralized credit administration function and credit policy and risk management committee, as well as seasoned bankers focusing their lending to borrowers with proven track records in markets with which the Company is familiar. UMG serves as a mortgage brokerage operation, selling the majority of its loan production in the secondary market or selling loans to meet the Bank’s current asset/liability management needs.
Asset Quality
Overview
During the first nine months of 2015, the Company experienced declines in total past due and nonaccrual loan and OREO balances from December 31, 2014. The decline in OREO balances was mostly attributable to sales of closed bank premises and foreclosed residential real estate property and land during the period. The loan loss provision increased from the same period in the prior year driven by higher loan balances in 2015 and an increase in net charge-offs in 2015, primarily due to a net recovery in the first quarter of 2014. The allowance for loan losses to total loans ratios (both unadjusted and adjusted for acquisition accounting) decreased from both December 31, 2014 and September 30, 2014. All nonaccrual and past due loan metrics discussed below exclude PCI loans totaling $78.6 million (net of fair value mark).
Troubled Debt Restructurings
The total recorded investment in TDRs as of September 30, 2015 was $11.6 million, a decrease of $15.2 million, or 56.8%, from $26.8 million at December 31, 2014 and a decline of $17.4 million, or 60.1%, from $29.0 million at September 30, 2014. Of the $11.6 million of TDRs at September 30, 2015, $9.5 million, or 81.9%, were considered performing while the remaining $2.1 million were considered nonperforming. The decrease in the TDR balance from December 31, 2014 is primarily attributable to $12.0 million being removed from TDR status, $50,000 transferred to OREO, $4.7 million in net payments, and $522,000 in charge-offs, partially offset by $2.1 million in additions. Loans removed from TDR status represent restructured loans with a market rate of interest at the time of the restructuring. These loans have performed in accordance with their modified terms for twelve consecutive months and were no longer considered impaired. Loans removed from TDR status are collectively evaluated for impairment; due to the significant improvement in the expected future cash flows, these loans are grouped based on their primary risk characteristics, typically using the Company’s internal risk rating system as its primary credit quality indicator. Impairment is measured based on historical loss experience taking into consideration environmental factors. The significant majority of these loans have been subject to new credit decisions due to the improvement in the expected future cash flows, the financial condition of the borrower, and other factors considered during re-underwriting. The TDR activity during the quarter did not have a material impact on the Company’s allowance for loan losses, financial condition, or results of operations.
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Nonperforming Assets
At September 30, 2015, nonperforming assets totaled $35.1 million, a decrease of $12.3 million, or 26.0%, from December 31, 2014 and a decrease of $23.0 million, or 39.6%, from a year ago. In addition, NPAs as a percentage of total outstanding loans decreased 26 basis points to 0.63% in the current quarter from 0.89% as of December 31, 2014 and declined 49 basis points from 1.12% a year earlier.
The following table shows a summary of assets quality balances and related ratios as of and for the quarters ended (dollars in thousands):
Nonperforming assets at September 30, 2015 included $13.0 million in nonaccrual loans (excluding PCI loans), a net decrease of $6.3 million, or 32.7%, from December 31, 2014 and a decline of $7.3 million, or 36.1%, from September 30, 2014. The following table shows the activity in nonaccrual loans for the quarter ended (dollars in thousands):
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The majority of the additions to nonaccrual loans in the first quarter of 2015 were attributable to three credit relationships. During the second quarter of 2015, the decline in nonaccrual loans was largely due to payments received in settlements, sales of collateral, and liquidation of customer assets. The majority of additions to nonaccrual loans in the third quarter of 2015 were comprised of smaller credit relationships.
The following table presents the composition of nonaccrual loans (excluding PCI loans) and the coverage ratio, which is the allowance for loan losses expressed as a percentage of nonaccrual loans, at the quarters ended (dollars in thousands):
Nonperforming assets at September 30, 2015 also included $22.1 million in OREO, a decrease of $6.0 million, or 21.4%, from December 31, 2014 and a decrease of $15.7 million, or 41.5%, from the prior year. The following table shows the activity in OREO for the quarters ended (dollars in thousands):
During the first nine months of 2015, the majority of sales of OREO were related to closed bank premises and foreclosed residential real estate and land.
The following table presents the composition of the OREO portfolio at the quarter ended (dollars in thousands):
(1) Includes closed branch property and land previously held for branch sites.
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Past Due Loans
At September 30, 2015, total accruing past due loans, excluding PCI loans, were $27.5 million, or 0.50% of total loans, compared to $48.1 million, or 0.90%, at December 31, 2014 and $58.4 million, or 1.13%, a year ago. At September 30, 2015, loans past due 90 days or more and accruing interest, excluding PCI loans, totaled $5.2 million, or 0.09% of total loans, compared to $10.0 million, or 0.19%, at December 31, 2014 and $16.1 million, or 0.31%, a year ago.
Charge-offs and delinquencies
For the quarter ended September 30, 2015, net charge-offs were $1.0 million, or 0.07% on an annualized basis, compared to $1.1 million, or 0.08%, for the same quarter last year. For the nine months ended September 30, 2015, net charge-offs were $6.4 million, or 0.15% on an annualized basis, compared to $1.3 million, or 0.03% annualized, for the nine months ended September 30, 2014. Of the $6.4 million in loans charged off in the first nine months of 2015, $4.7 million, or 73.4%, related to loans specifically reserved for in the prior period.
Provision
The provision for loan losses for the quarter ended September 30, 2015 was $2.0 million, an increase of $162,000 compared to the same quarter a year ago. During the nine months ended September 30, 2015, the provision for loan losses was $7.3 million, an increase of $4.0 million compared to the first nine months of 2014. The increase in the provision for loan losses in the current periods compared to the same periods in the prior year was primarily driven by higher loan balances in 2015 and an increase in net charge-offs in 2015, primarily due to a net recovery in the first quarter of 2014. Additionally, a $300,000 provision was recognized during the current year for unfunded loan commitments.
The allowance for loan losses of $33.3 million at September 30, 2015, is an increase of $885,000 compared to the allowance for loan losses at December 31, 2014. The ALL as a percentage of the total loan portfolio, adjusted for acquisition accounting (non-GAAP), was 1.01% at September 30, 2015, a decrease from 1.08% at December 31, 2014 and 1.12% at September 30, 2014. The allowance for loan losses as a percentage of the total loan portfolio was 0.60% at September 30, 2015, 0.61% at December 31, 2014, and 0.62% at September 30, 2014. In acquisition accounting, there is no carryover of previously established allowance for loan losses, as acquired loans are recorded at fair value.
Due to the decline in nonaccrual loans during 2015, the nonaccrual loan coverage ratio significantly increased to 256.6% at September 30, 2015, compared to 168.2% at December 31, 2014, and 158.3% at September 30, 2014. The current level of the allowance for loan losses reflects specific reserves related to nonperforming loans, current risk ratings on loans, net charge-off activity, loan growth, delinquency trends, and other credit risk factors that the Company considers important in assessing the adequacy of the allowance for loan losses.
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The following table summarizes activity in the allowance for loan losses during the quarters ended (dollars in thousands):
The following table shows both an allocation of the allowance for loan losses among loan categories based upon the loan portfolio’s composition and the ratio of the related outstanding loan balances to total loans as of the quarters ended (dollars in thousands):
As of September 30, 2015, total deposits were $5.8 billion, an increase of $180.1 million, or 3.2%, from December 31, 2014. Total interest-bearing deposits consist of NOW, money market, savings, and time deposit account balances. Total time deposit balances of $1.2 billion accounted for 27.0% of total interest-bearing deposits at September 30, 2015. The Company continues to experience a shift from time deposits into lower cost transaction accounts (NOW, money market, savings and noninterest bearing demand accounts), driven by the Company’s focus on acquiring low cost funding sources and customer preference for liquidity in response to current market conditions.
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The following table presents the deposit balances by major categories as of the quarters ended (dollars in thousands):
The Company may also borrow additional funds by purchasing certificates of deposit through a nationally recognized network of financial institutions. The Company utilizes this funding source when rates are more favorable than other funding sources. As of September 30, 2015 and December 31, 2014, none were purchased and included in certificates of deposit on the Company’s Consolidated Balance Sheets. Maturities of time deposits as of September 30, 2015 are as follows (dollars in thousands):
Capital Resources
Capital resources represent funds, earned or obtained, over which financial institutions can exercise greater or longer control in comparison with deposits and borrowed funds. The adequacy of the Company’s capital is reviewed by management on an ongoing basis with reference to size, composition, and quality of the Company’s resources and consistency with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and to absorb potential losses, yet allow management to effectively leverage its capital to maximize return to shareholders.
In July 2013, the Federal Reserve issued a final rule that makes technical changes to its market risk capital rule to align it with the Basel III regulatory capital framework and meet certain requirements of the Dodd-Frank Act. Effective January 1, 2015, the final rule requires the Company to comply with the following minimum capital ratios: (i) a new common equity Tier 1 capital ratio of 4.5% of risk-weighted assets; (ii) a Tier 1 capital ratio of 6.0% of risk-weighted assets (increased from the prior requirement of 4.0%); (iii) a total capital ratio of 8.0% of risk-weighted assets (unchanged from prior requirement); and (iv) a leverage ratio of 4.0% of total assets (unchanged from the prior requirement). These are the initial capital requirements applicable to the Company. All such capital requirements will be phased in over a four-year period; the next phase does not take effect until January 1, 2016. The capital requirements contained in the final rule also include changes in the risk weights of assets to better reflect credit risk and other risk exposures.
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Beginning January 1, 2015, the Company calculates its regulatory capital under the U.S. Basel III Standardized Approach. The Company calculated regulatory capital measures for periods prior to 2015 under previous regulatory requirements. The table summarizes the Company’s regulatory capital and related ratios for the periods presented (dollars in thousands):
NON-GAAP MEASURES
In reporting the Company’s results as of and for the periods ended September 30, 2015 and 2014, the Company has provided supplemental performance measures on an operating or tangible basis. Operating measures exclude acquisition costs unrelated to the Company’s normal operations. The Company believes these measures are useful to investors as they exclude non-operating adjustments resulting from acquisition activity and allow investors to see the combined economic results of the organization. Tangible common equity is used in the calculation of certain capital and per share ratios. The Company believes tangible common equity and the related ratios are meaningful measures of capital adequacy because they provide a meaningful base for period-to-period and company-to-company comparisons, which the Company believes will assist investors in assessing the capital of the Company and its ability to absorb potential losses.
These measures are a supplement to U.S. GAAP used to prepare the Company’s financial statements and should not be viewed as a substitute for U.S. GAAP measures. In addition, the Company’s non-GAAP measures may not be comparable to non-GAAP measures of other companies.
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The following table reconciles these non-GAAP measures from their respective U.S. GAAP basis measures for each of the periods presented (dollars in thousands, except per share amounts):
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The allowance for loan losses ratio, adjusted for acquisition accounting (non-GAAP), includes an adjustment for the fair value mark on acquired performing loans. The acquired performing loans are reported net of the related fair value mark in loans, net of deferred fees and costs, on the Company’s Consolidated Balance Sheets; therefore, the fair value mark is added back to the balance to represent the total loan portfolio. The adjusted allowance for loan losses, including the fair value mark, represents the total reserve on the Company’s loan portfolio. The PCI loans, net of the respective fair value mark, are removed from the loans, net of deferred fees and costs, as these PCI loans are not covered by the allowance established by the Company unless changes in expected cash flows indicate that one of the PCI loan pools is impaired, at which time an allowance for PCI loans will be established. U.S. GAAP requires the acquired allowance for loan losses not be carried over in an acquisition or merger. The Company believes the presentation of the allowance for loan losses ratio, adjusted for acquisition accounting, is useful to investors because the acquired loans were purchased at a market discount with no allowance for loan losses carried over to the Company, and the fair value mark on the purchased performing loans represents the allowance associated with those purchased loans. The Company believes that this measure is a better reflection of the reserves on the Company’s loan portfolio. The following table shows the allowance for loan losses as a percentage of the total loan portfolio, adjusted for acquisition accounting, as of the quarters ended (dollars in thousands):
ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates, exchange rates, and equity prices. The Company’s market risk is composed primarily of interest rate risk. The ALCO of the Company is responsible for reviewing the interest rate sensitivity position of the Company and establishing policies to monitor and limit exposure to this risk. The Company’s Board of Directors reviews and approves the guidelines established by ALCO.
Interest rate risk is monitored through the use of three complementary modeling tools: static gap analysis, earnings simulation modeling, and economic value simulation (net present value estimation). Each of these models measures changes in a variety of interest rate scenarios. While each of the interest rate risk models has limitations, taken together they represent a reasonably comprehensive view of the magnitude of interest rate risk in the Company, the distribution of risk along the yield curve, the level of risk through time, and the amount of exposure to changes in certain interest rate relationships. Static gap, which measures aggregate re-pricing values, is less utilized because it does not effectively measure the options risk impact on the Company and is not addressed here. Earnings simulation and economic value models, which more effectively measure the cash flow and optionality impacts, are utilized by management on a regular basis and are explained below.
The Company determines the overall magnitude of interest sensitivity risk and then formulates policies and practices governing asset generation and pricing, funding sources and pricing, and off-balance sheet commitments. These decisions are based on management’s expectations regarding future interest rate movements, the states of the national, regional, and local economies, and other financial and business risk factors. The Company uses simulation modeling to measure and monitor the effect of various interest rate scenarios and business strategies on net interest income. This modeling reflects interest rate changes and the related impact on net interest income and net income over specified time horizons.
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EARNINGS SIMULATION ANALYSIS
Management uses simulation analysis to measure the sensitivity of net interest income to changes in interest rates. The model calculates an earnings estimate based on current and projected balances and rates. This method is subject to the accuracy of the assumptions that underlie the process, but it provides a better analysis of the sensitivity of earnings to changes in interest rates than other analyses, such as the static gap analysis discussed above.
Assumptions used in the model are derived from historical trends and management’s outlook and include loan and deposit growth rates and projected yields and rates. Such assumptions are monitored by management and periodically adjusted as appropriate. All maturities, calls, and prepayments in the securities portfolio are assumed to be reinvested in like instruments. Mortgage loans and mortgage-backed securities prepayment assumptions are based on industry estimates of prepayment speeds for portfolios with similar coupon ranges and seasoning. Different interest rate scenarios and yield curves are used to measure the sensitivity of earnings to changing interest rates. Interest rates on different asset and liability accounts move differently when the prime rate changes and are reflected in the different rate scenarios.
The Company uses its simulation model to estimate earnings in rate environments where rates are instantaneously shocked up or down around a “most likely” rate scenario, based on implied forward rates. The analysis assesses the impact on net interest income over a 12 month time horizon after an immediate increase or “shock” in rates, of 100 basis points up to 300 basis points. The shock down 200 or 300 basis points analysis is not as meaningful as interest rates across most of the yield curve are at historic lows and cannot decrease another 200 or 300 basis points. The model, under all scenarios, does not drop the index below zero.
The following table represents the interest rate sensitivity on net interest income for the Company across the rate paths modeled for balances as of September 30, 2015 and 2014 (dollars in thousands):
Asset sensitivity indicates that in a rising interest rate environment the Company’s net interest income would increase and in a decreasing interest rate environment the Company’s net interest income would decrease. Liability sensitivity indicates that in a rising interest rate environment the Company’s net interest income would decrease and in a decreasing interest rate environment the Company’s net interest income would increase.
As of September 30, 2015, the Company asset sensitivity is relatively unchanged in a rising interest rate environment when compared to September 30, 2014 due to the composition of the balance sheet. The Company expects net interest income to increase as market rates increase. In the decreasing interest rate environments, the Company shows a decline in net interest income as interest-earning assets re-price at lower rates and interest-bearing deposits remain at or near their floors. It should be noted that although net interest income simulation results are presented through the down 300 basis points interest rate environments, the Company does not believe the down 200 and 300 basis point scenarios are plausible given the current level of interest rates.
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ECONOMIC VALUE SIMULATION
Economic value simulation is used to calculate the estimated fair value of assets and liabilities over different interest rate environments. Economic values are calculated based on discounted cash flow analysis. The net economic value of equity is the economic value of all assets minus the economic value of all liabilities. The change in net economic value over different rate environments is an indication of the longer-term earnings capability of the balance sheet. The same assumptions are used in the economic value simulation as in the earnings simulation. The economic value simulation uses instantaneous rate shocks to the balance sheet.
The following chart reflects the estimated change in net economic value over different rate environments using economic value simulation for the balances at the quarterly periods ended September 30, 2015 and 2014 (dollars in thousands):
The shock down 200 or 300 basis points analysis is not as meaningful since interest rates across most of the yield curve are at historic lows and cannot decrease another 200 or 300 basis points. While management considers this scenario highly unlikely, the natural floor increases the Company’s sensitivity in rates down scenarios.
Compared to September 30, 2014, the Company’s economic value of equity model as of September 30, 2015 projects that a instantaneous change in market interest rates would result in a greater overall variation in the Company’s estimated economic value of equity in the shock up 100 or 200 basis point and shock down 100 basis point interest rate scenarios, while the Company is less sensitive to market interest rates in a shock up 300 basis point scenario. The Company believes the down 200 and 300 basis point scenarios are not plausible given the current low level of interest rates.
ITEM 4 – CONTROLS AND PROCEDURES
The Company maintains “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Exchange Act, that are designed to ensure that information required to be disclosed in reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating its disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, management was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.
Based on their evaluation as of the end of the period covered by this quarterly report on Form 10-Q, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the disclosure controls and procedures were effective at the reasonable assurance level. There was no change in the internal control over financial reporting that occurred during the quarter ended September 30, 2015 that has materially affected, or is reasonably likely to materially affect, the internal control over financial reporting.
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PART II – OTHER INFORMATION
ITEM 1 – LEGAL PROCEEDINGS
In the ordinary course of its operations, the Company and its subsidiaries are parties to various legal proceedings. Based on the information presently available, and after consultation with legal counsel, management believes that the ultimate outcome in such proceedings, in the aggregate, will not have a material adverse effect on the business or the financial condition or results of operations of the Company.
ITEM 1A – RISK FACTORS
There have been no material changes with respect to the risk factors disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2014.
ITEM 2 – UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Stock Repurchase Program
The following information describes the Company’s common stock repurchases during 2014 and the nine months ended September 30, 2015:
(1)On January 30, 2014, the Company’s Board of Directors authorized a share repurchase program to purchase up to $65.0 million worth of the Company’s common stock on the open market or in privately negotiated transactions. The repurchase program is authorized through December 31, 2015.
(2)For purposes of the Company’s consolidated financial statements included in this Form 10-Q, the impact of these repurchases is recorded according to settlement dates.
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ITEM 6 – EXHIBITS
The following exhibits are filed as part of this Form 10-Q and this list includes the Exhibit Index:
Form of Performance Share Unit Agreement under Union Bankshares Corporation Stock and Incentive Plan (incorporated by reference to Exhibit 10.24 to Current Report on Form 8-K filed on April 27, 2015).
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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.
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