UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended June 30, 2017
or
For the transition period from _______________ to _______________.
Commission file number: 000-16084
CITIZENS & NORTHERN CORPORATION
(Exact name of Registrant as specified in its charter)
90-92 MAIN STREET, WELLSBORO, PA 16901
(Address of principal executive offices) (Zip code)
570-724-3411
(Registrant’s telephone number including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
(Check one):
Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨ Smaller reporting company ¨
Emerging growth company ¨
If an emerging growth company, indicate by check mark whether if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) 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
Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.
Index
ITEM 1. FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS
(In Thousands, Except Share and Per Share Data) (Unaudited)
The accompanying notes are an integral part of these unaudited consolidated financial statements.
Consolidated Statements of Income
(In Thousands Except Per Share Data) (Unaudited)
Consolidated Statements of Comprehensive Income
(In Thousands) (Unaudited)
CONSOLIDATED STATEMENTS OF CASH FLOWS
Consolidated Statements of Changes in Stockholders’ Equity
(In Thousands Except Share and Per Share Data)
(Unaudited)
Notes to Unaudited Consolidated Financial Statements
1. BASIS OF INTERIM PRESENTATION
The consolidated financial information included herein, with the exception of the consolidated balance sheet dated December 31, 2016, is unaudited. Such information reflects all adjustments (consisting solely of normal recurring adjustments) that are, in the opinion of management, necessary for a fair presentation of the financial position, results of operations, comprehensive income, cash flows and changes in stockholders’ equity for the interim periods; however, the information does not include all disclosures required by accounting principles generally accepted in the United States of America (“U.S. GAAP”) for a complete set of financial statements. Certain 2016 information has been reclassified for consistency with the 2017 presentation.
Operating results reported for the three-month and six-month periods ended June 30, 2017 might not be indicative of the results for the year ending December 31, 2017. The Corporation evaluates subsequent events through the date of filing with the Securities and Exchange Commission.
2. PER SHARE DATA
Basic earnings per common share are calculated using the two-class method to determine income attributable to common shareholders. Unvested restricted stock awards that contain nonforfeitable rights to dividends are considered participating securities under the two-class method. Distributed dividends and an allocation of undistributed net income to participating securities reduce the amount of income attributable to common shareholders. Income attributable to common shareholders is then divided by weighted-average common shares outstanding for the period to determine basic earnings per common share.
Diluted earnings per common share are calculated under the more dilutive of either the treasury method or the two-class method. Diluted earnings per common share is computed using weighted-average common shares outstanding, plus weighted-average common shares available from the exercise of all dilutive stock options, less the number of shares that could be repurchased with the proceeds of stock option exercises based on the average share price of the Corporation’s common stock during the period.
(a) Basic and diluted earnings per share under the two-class method are determined on net income reported on the income statement less earnings allocated to nonvested restricted shares with nonforfeitable dividends (participating securities).
The weighted-average number of nonvested restricted shares outstanding was 62,080 shares in the three-month period ended June 30, 2017 and 65,876 shares in the three-month period ended June 30, 2016. The weighted-average number of nonvested restricted shares outstanding was 63,633 shares in the six-month period ended June 30, 2017 and 66,847 shares in the six-month period ended June 30, 2016.
Stock options that were anti-dilutive were excluded from net income per share calculations. There were no anti-dilutive instruments in the three-month or six-month periods ended June 30, 2017. Weighted-average common shares available from anti-dilutive instruments totaled 47,139 shares in the second quarter 2016 and 47,224 shares in the six-month period ended June 30, 2016.
3. COMPREHENSIVE INCOME
Comprehensive income is the total of (1) net income, and (2) all other changes in equity from non-stockholder sources, which are referred to as other comprehensive income. The components of other comprehensive income, and the related tax effects, are as follows:
Changes in the components of accumulated other comprehensive income are as follows and are presented net of tax:
Items reclassified out of each component of other comprehensive income are as follows:
For the Six Months Ended June 30, 2017
(In Thousands)
For the Six Months Ended June 30, 2016
For the Three Months Ended June 30, 2017
For the Three Months Ended June 30, 2016
4. CASH AND DUE FROM BANKS
Cash and due from banks at June 30, 2017 and December 31, 2016 include the following:
Certificates of deposit are issues by U.S. banks with original maturities greater than three months. Each certificate of deposit is fully FDIC-insured. The Corporation maintains cash and cash equivalents with certain financial institutions in excess of the FDIC insurance limit.
The Corporation is required to maintain reserves against deposit liabilities in the form of cash and balances with the Federal Reserve Bank of Philadelphia. The reserves are based on deposit levels, account activity, and other services provided by the Federal Reserve Bank. Required reserves were $12,812,000 at June 30, 2017 and $16,654,000 at December 31, 2016.
5. FAIR VALUE MEASUREMENTS AND FAIR VALUES OF FINANCIAL INSTRUMENTS
The Corporation measures certain assets at fair value. Fair value is defined as the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. FASB Accounting Standards Codification (ASC) topic 820, “Fair Value Measurements and Disclosures” establishes a framework for measuring fair value that includes a hierarchy used to classify the inputs used in measuring fair value. The hierarchy prioritizes the inputs used in determining valuations into three levels. The level in the fair value hierarchy within which the fair value measurement falls is determined based on the lowest level input that is significant to the fair value measurement. The levels of the fair value hierarchy are as follows:
Level 1 – Fair value is based on unadjusted quoted prices in active markets that are accessible to the Corporation for identical assets. These generally provide the most reliable evidence and are used to measure fair value whenever available.
Level 2 – Fair value is based on significant inputs, other than Level 1 inputs, that are observable either directly or indirectly for substantially the full term of the asset through corroboration with observable market data. Level 2 inputs include quoted market prices in active markets for similar assets, quoted market prices in markets that are not active for identical or similar assets and other observable inputs.
Level 3 – Fair value is based on significant unobservable inputs. Examples of valuation methodologies that would result in Level 3 classification include option pricing models, discounted cash flows and other similar techniques.
The Corporation monitors and evaluates available data relating to fair value measurements on an ongoing basis and recognizes transfers among the levels of the fair value hierarchy as of the date of an event or change in circumstances that affects the valuation method chosen. Examples of such changes may include the market for a particular asset becoming active or inactive, changes in the availability of quoted prices, or changes in the availability of other market data.
At June 30, 2017 and December 31, 2016, assets measured at fair value and the valuation methods used are as follows:
Management’s evaluation and selection of valuation techniques and the unobservable inputs used in determining the fair values of assets valued using Level 3 methodologies include sensitive assumptions. Other market participants might use substantially different assumptions, which could result in calculations of fair values that would be substantially different than the amount calculated by management.
At June 30, 2017 and December 31, 2016, quantitative information regarding significant techniques and inputs used for assets measured on a recurring basis using unobservable inputs (Level 3 methodologies) are as follows:
The fair value of servicing rights is affected by expected future interest rates. Increases (decreases) in future expected interest rates tend to increase (decrease) the fair value of the Corporation’s servicing rights because of changes in expected prepayment behavior by the borrowers on the underlying loans. Unrealized gains (losses) in fair value of servicing rights are included in Loan servicing fees, net, in the unaudited consolidated statements of income.
Following is a reconciliation of activity for Level 3 assets measured at fair value on a recurring basis:
Loans are classified as impaired when, based on current information and events, it is probable that the Corporation will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Foreclosed assets held for sale consist of real estate acquired by foreclosure. For impaired commercial loans secured by real estate and foreclosed assets held for sale, estimated fair values are determined primarily using values from third-party appraisals. Appraised values are discounted to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value. The discounts also include estimated costs to sell the property.
At June 30, 2017 and December 31, 2016, quantitative information regarding significant techniques and inputs used for nonrecurring fair value measurements using unobservable inputs (Level 3 methodologies) are as follows:
Certain of the Corporation’s financial instruments are not measured at fair value in the consolidated financial statements. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. Certain financial instruments and all nonfinancial instruments are excluded from disclosure requirements. Therefore, the aggregate fair value amounts presented may not represent the underlying fair value of the Corporation.
The Corporation used the following methods and assumptions in estimating fair value disclosures for financial instruments:
CASH AND CASH EQUIVALENTS - The carrying amounts of cash and short-term instruments approximate fair values.
CERTIFICATES OF DEPOSIT - Fair values for certificates of deposit, included in cash and due from banks in the consolidated balance sheet, are based on quoted market prices for certificates of similar remaining maturities.
SECURITIES - Fair values for securities, excluding restricted equity securities, are based on quoted market prices or other methods as described above. The carrying value of restricted equity securities approximates fair value based on applicable redemption provisions.
LOANS HELD FOR SALE - Fair values of loans held for sale are determined based on applicable sale prices available under the Federal Home Loan Banks’ MPF Xtra and MPF Original programs.
LOANS - Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, commercial real estate, residential mortgage and other consumer. Each loan category is further segmented into fixed and adjustable rate interest terms and by performing and nonperforming categories. The fair value of performing loans is calculated by discounting contractual cash flows, adjusted for estimated prepayments based on historical experience, using estimated market discount rates that reflect the credit and interest rate risk inherent in the loans. Fair value of nonperforming loans is based on recent appraisals or estimates prepared by the Corporation’s lending officers.
SERVICING RIGHTS - The fair value of servicing rights, included in other assets in the consolidated balance sheet, is determined through a discounted cash flow valuation. Significant inputs include expected net servicing income, the discount rate and the expected prepayment speeds of the underlying loans.
DEPOSITS - The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits, savings, money market and interest checking accounts, is (by definition) equal to the amount payable on demand at June 30, 2017 and December 31, 2016. The fair value of time deposits, such as certificates of deposit and Individual Retirement Accounts, is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities. The fair value estimates of deposits do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market, commonly referred to as the core deposit intangible.
BORROWED FUNDS - The fair value of borrowings is estimated using discounted cash flow analyses based on rates currently available to the Corporation for similar types of borrowing arrangements.
ACCRUED INTEREST - The carrying amounts of accrued interest receivable and payable approximate fair values.
OFF-BALANCE SHEET COMMITMENTS - The Corporation has commitments to extend credit and has issued standby letters of credit. Standby letters of credit are conditional guarantees of performance by a customer to a third party. Estimates of the fair value of these off-balance sheet items were not made because of the short-term nature of these arrangements and the credit standing of the counterparties.
The estimated fair values, and related carrying amounts, of the Corporation’s financial instruments are as follows:
6. SECURITIES
Amortized cost and fair value of available-for-sale securities at June 30, 2017 and December 31, 2016 are summarized as follows:
The following table presents gross unrealized losses and fair value of available-for-sale securities with unrealized loss positions that are not deemed to be other-than-temporarily impaired, aggregated by length of time that individual securities have been in a continuous unrealized loss position at June 30, 2017 and December 31, 2016:
Gross realized gains and losses from available-for-sale securities were as follows:
The amortized cost and fair value of available-for-sale debt securities by contractual maturity are shown in the following table as of June 30, 2017. Actual maturities may differ from contractual maturities because counterparties may have the right to call or prepay obligations with or without call or prepayment penalties.
The Corporation’s mortgage-backed securities have stated maturities that may differ from actual maturities due to borrowers’ ability to prepay obligations. Cash flows from such investments are dependent upon the performance of the underlying mortgage loans and are generally influenced by the level of interest rates. In the table above, mortgage-backed securities and collateralized mortgage obligations are shown in one period.
Investment securities carried at $223,562,000 at June 30, 2017 and $230,803,000 at December 31, 2016 were pledged as collateral for public deposits, trusts and certain other deposits as provided by law. See Note 8 for information concerning securities pledged to secure borrowing arrangements.
Management evaluates securities for other-than-temporary impairment (OTTI) at least on a quarterly basis, and more frequently when economic or market conditions warrant such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) whether the Corporation intends to sell the security or more likely than not will be required to sell the security before its anticipated recovery.
A summary of information management considered in evaluating debt and equity securities for other-than-temporary impairment (“OTTI”) at June 30, 2017 is provided below.
Debt Securities
At June 30, 2017, management performed an assessment for possible OTTI of the Corporation’s debt securities on an issue-by-issue basis, relying on information obtained from various sources, including publicly available financial data, ratings by external agencies, brokers and other sources. The extent of individual analysis applied to each security depended on the size of the Corporation’s investment, as well as management’s perception of the credit risk associated with each security. Based on the results of the assessment, management believes impairment of debt securities at June 30, 2017 to be temporary.
Equity Securities
The Corporation’s marketable equity securities at June 30, 2017 and December 31, 2016 consisted exclusively of one mutual fund. At June 30, 2017, there was an unrealized loss on the mutual fund of $23,000, and at December 31, 2016 there was an unrealized loss of $29,000. Management determined an OTTI charge was not required on this security at June 30, 2017 and December 31, 2016.
The Corporation had no realized gains or losses from the sale of equity securities in the first six months of 2017. The Corporation realized gains from sales of bank stocks totaling $28,000 in the three-month period ended June 30, 2016 and $277,000 during the first six months of 2016.
C&N Bank is a member of the Federal Home Loan Bank of Pittsburgh (FHLB-Pittsburgh), which is one of 11 regional Federal Home Loan Banks. As a member, C&N Bank is required to purchase and maintain stock in FHLB-Pittsburgh. There is no active market for FHLB-Pittsburgh stock, and it must ordinarily be redeemed by FHLB-Pittsburgh in order to be liquidated. C&N Bank’s investment in FHLB-Pittsburgh stock, included in Other Assets in the consolidated balance sheet, was $3,448,000 at June 30, 2017 and $4,296,000 at December 31, 2016. The Corporation evaluated its holding of FHLB-Pittsburgh stock for impairment and deemed the stock to not be impaired at June 30, 2017 and December 31, 2016. In making this determination, management concluded that recovery of total outstanding par value, which equals the carrying value, is expected. The decision was based on review of financial information that FHLB-Pittsburgh has made publicly available.
7. LOANS
The loans receivable portfolio is segmented into residential mortgage, commercial and consumer loans. Loans outstanding at June 30, 2017 and December 31, 2016 are summarized by segment, and by classes within each segment, as follows:
The Corporation grants loans to individuals as well as commercial and tax-exempt entities. Commercial, residential and personal loans are made to customers geographically concentrated in the Pennsylvania and New York counties that comprise the market serviced by Citizens & Northern Bank. Although the Corporation has a diversified loan portfolio, a significant portion of its debtors’ ability to honor their contracts is dependent on the local economic conditions within the region. There is no concentration of loans to borrowers engaged in similar businesses or activities that exceed 10% of total loans at either June 30, 2017 or December 31, 2016.
The Corporation maintains an allowance for loan losses that represents management’s estimate of the losses inherent in the loan portfolio as of the balance sheet date and recorded as a reduction of the investment in loans. The allowance for loan losses is maintained at a level considered adequate to provide for losses that can be reasonably anticipated. Management performs a quarterly evaluation of the adequacy of the allowance. The allowance is based on the Corporation’s past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant revision as more information becomes available. In the process of evaluating the loan portfolio, management also considers the Corporation’s exposure to losses from unfunded loan commitments. As of June 30, 2017 and December 31, 2016, management determined that no allowance for credit losses related to unfunded loan commitments was required.
Transactions within the allowance for loan losses, summarized by segment and class, for the three-month and six-month periods ended June 30, 2017 and 2016 were as follows:
In the evaluation of the loan portfolio, management determines two major components for the allowance for loan losses – (1) a specific component based on an assessment of certain larger relationships, mainly commercial purpose loans, on a loan-by-loan basis; and (2) a general component for the remainder of the portfolio based on a collective evaluation of pools of loans with similar risk characteristics. The general component is assigned to each pool of loans based on both historical net charge-off experience, and an evaluation of certain qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the above methodologies for estimating specific and general losses in the portfolio.
In determining the larger loan relationships for detailed assessment under the specific allowance component, the Corporation uses an internal risk rating system. Under the risk rating system, the Corporation classifies problem or potential problem loans as “Special Mention,” “Substandard,” or “Doubtful” on the basis of currently existing facts, conditions and values. Substandard loans include those characterized by the distinct possibility that the Corporation will sustain some loss if the deficiencies are not corrected. Loans classified as Doubtful have all the weaknesses inherent in those classified as Substandard with the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. Loans that do not currently expose the Corporation to sufficient risk to warrant classification as Substandard or Doubtful, but possess weaknesses that deserve management’s close attention, are deemed to be Special Mention. Risk ratings are updated any time that conditions or the situation warrants. Loans not classified are included in the “Pass” column in the table below.
The following tables summarize the aggregate credit quality classification of outstanding loans by risk rating as of June 30, 2017 and December 31, 2016:
The general component of the allowance for loan losses covers pools of loans including commercial loans not considered individually impaired, as well as smaller balance homogeneous classes of loans, such as residential real estate, home equity lines of credit and other consumer loans. Accordingly, the Corporation generally does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are subject to a restructuring agreement. The pools of loans are evaluated for loss exposure based upon average historical net charge-off rates for each loan class, adjusted for qualitative factors (described in the following paragraphs). The time period used in determining the average historical net charge-off rate for each loan class is based on management’s evaluation of an appropriate time period that captures an historical loss experience relevant to the current portfolio. Throughout 2016 and at March 31, 2017, a three-year average net charge-off rate was used for all loan classes. At June 30, 2017, a five-year average net charge-off rate was used for commercial loans secured by real estate and for multi-family residential loans, while a three-year average net charge-off rate was used for all other loan classes.
Qualitative risk factors are evaluated for the impact on each of the three segments (residential mortgage, commercial and consumer) within the loan portfolio. Each qualitative factor is assigned a value to reflect improving, stable or declining conditions based on management’s judgment using relevant information available at the time of the evaluation. The adjustment for qualitative factors is applied as an increase or decrease to the average net charge-off rate for each loan class within each segment.
The qualitative factors used in the general component calculations are designed to address credit risk characteristics associated with each segment. The Corporation’s credit risk associated with all of the segments is significantly impacted by these factors, which include economic conditions within its market area, the Corporation’s lending policies, changes or trends in the portfolio, risk profile, competition, regulatory requirements and other factors. Further, the residential mortgage segment is significantly affected by the values of residential real estate that provide collateral for the loans. The majority of the Corporation’s commercial segment loans (approximately 55% at June 30, 2017) is secured by real estate, and accordingly, the Corporation’s risk for the commercial segment is significantly affected by commercial real estate values. The consumer segment includes a wide mix of loans for different purposes, primarily secured loans, including loans secured by motor vehicles, manufactured housing and other types of collateral.
Loans are classified as impaired, when, based on current information and events, it is probable that the Corporation 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. 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 shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial loans, by the fair value of the collateral (if the loan is collateral dependent), by future cash flows discounted at the loan’s effective rate or by the loan’s observable market price.
The scope of loans reviewed individually each quarter to determine if they are impaired include all loan relationships greater than $200,000 for which there is at least one extension of credit graded Special Mention, Substandard or Doubtful. Loans that are individually reviewed, but which are determined to not be impaired, are combined with all remaining loans that are not reviewed on a specific basis, and such loans are included within larger pools of loans based on similar risk and loss characteristics for purposes of determining the general component of the allowance. The loans that have been individually reviewed, but which have been determined to not be impaired, are included in the “Collectively Evaluated” column in the table summarizing the allowance and associated loan balances as of June 30, 2017 and December 31, 2016. All loans classified as troubled debt restructurings (discussed in more detail below) and all loan relationships less than $200,000 in the aggregate, but with an estimated loss of $100,000 or more, are individually evaluated for impairment.
The following tables present a summary of loan balances and the related allowance for loan losses summarized by portfolio segment and class for each impairment method used as of June 30, 2017 and December 31, 2016:
Summary information related to impaired loans at June 30, 2017 and December 31, 2016 is as follows:
The average balance of impaired loans and interest income recognized on impaired loans is as follows:
Loans are placed on nonaccrual status for all classes of loans when, in the opinion of management, collection of interest is doubtful. Any unpaid interest previously accrued on those loans is reversed from income. Interest income is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest payments received on loans for which the risk of further loss is greater than remote are applied as a reduction of the loan principal balance. Interest income on other nonaccrual loans, including impaired loans, is recognized only to the extent of interest payments received. Generally, loans are restored to accrual status when the obligation is brought current, has performed in accordance with the contractual terms for a reasonable period of time (generally six months) and the ultimate collectability of the total contractual principal and interest is no longer in doubt. The past due status of all classes of loans receivable is determined based on contractual due dates for loan payments. Also, the amortization of deferred loan fees is discontinued when a loan is placed on nonaccrual status.
The breakdown by portfolio segment and class of nonaccrual loans and loans past due ninety days or more and still accruing is as follows:
The amounts shown in the table immediately above include loans classified as troubled debt restructurings (described in more detail below), if such loans are past due ninety days or more or nonaccrual.
The table below presents a summary of the contractual aging of loans as of June 30, 2017 and December 31, 2016:
Nonaccrual loans are included in the contractual aging in the immediately preceding table. A summary of the contractual aging of nonaccrual loans at June 30, 2017 and December 31, 2016 is as follows:
Loans whose terms are modified are classified as Troubled Debt Restructurings (TDRs) if the Corporation grants such borrowers concessions, and it is deemed that those borrowers are experiencing financial difficulty. Loans classified as TDRs are designated as impaired. The outstanding balance of loans subject to TDRs, as well as contractual aging information at June 30, 2017 and December 31, 2016 is as follows:
At June 30, 2017 and December 31, 2016, there were no commitments to loan additional funds to borrowers whose loans have been classified as TDRs.
TDRs that occurred during the three-month and six-month periods ended June 30, 2017 and 2016 are as follows:
In the three-month and six-month periods ended June 30 2017 and 2016, defaults on loans for which modifications considered to be TDRs were entered into within the previous 12 months are summarized as follows:
The carrying amount of foreclosed residential real estate properties held as a result of obtaining physical possession (included in Foreclosed assets held for sale in the unaudited Consolidated Balance Sheet) is as follows:
The recorded investment of consumer mortgage loans secured by residential real properties for which formal foreclosure proceedings were in process is as follows:
8. BORROWED FUNDS
Short-term borrowings include the following:
The FHLB-Pittsburgh loan facilities are collateralized by qualifying loans secured by real estate with a book value totaling $490,474,000 at June 30, 2017 and $471,454,000 at December 31, 2016. Also, the FHLB-Pittsburgh loan facilities require the Corporation to invest in established amounts of FHLB-Pittsburgh stock. The carrying values of the Corporation’s holdings of FHLB-Pittsburgh stock (included in Other Assets) were $3,448,000 at June 30, 2017 and $4,296,000 at December 31, 2016.
At June 30, 2017, the short-term borrowing from FHLB-Pittsburgh of $4,000,000 was an overnight borrowing with an interest rate of 1.24%. At December 31, 2016, the short-term borrowing from FHLB-Pittsburgh of $21,000,000 was an overnight borrowing with an interest rate of 0.74%.
The Corporation engages in repurchase agreements with certain commercial customers. These agreements provide that the Corporation sells specified investment securities to the customers on an overnight basis and repurchases them on the following business day. The weighted average interest rate paid by the Corporation on customer repurchase agreements was 0.10% at June 30, 2017 and December 31, 2016.
Long-term borrowings are as follows:
Long-term borrowings from FHLB-Pittsburgh are as follows:
The repurchase agreement included in long-term borrowings has an interest rate of 3.595% and an effective maturity date in December 2017.
The “Repurchase Date,” as defined in the Master Repurchase Agreement between the Corporation and the broker-dealer, occurs quarterly on or about the 20th of each March, June, September and December until the “Final Repurchase Date” (as defined) on December 20, 2017. The Corporation pays interest, and the borrowing is putable by the issuer, on each Repurchase Date. The Final Repurchase Date is the effective maturity date of the borrowing.
Securities sold under repurchase agreements were delivered to the broker-dealer who is the counter-party to the transactions. The broker-dealer may have sold, loaned or otherwise disposed of such securities to other parties in the normal course of their operations, and has agreed to resell to the Corporation substantially identical securities at the maturities of the agreements. The Master Repurchase Agreement provides that the Agreement constitutes a “netting contract,” as defined; however, the Corporation and the broker-dealer have no other obligations to one another and accordingly, no netting has occurred.
The carrying value of the underlying securities was $32,858,000 at June 30, 2017 and $31,494,000 at December 31, 2016, detailed in the following table:
Two of the more significant risks associated with the repurchase agreement with the broker-dealer are as follows:
The Corporation manages these risks by maintaining sufficient available assets of acceptable credit quality, as well as maintaining other borrowing facilities, to meet ongoing collateral maintenance requirements or pay off the borrowing if required. In particular, the Corporation had unused borrowing capacity available from the FHLB-Pittsburgh of $338,020,000 at June 30, 2017.
9. DEFINED BENEFIT PLANS
The Corporation sponsors a defined benefit health care plan that provides postretirement medical benefits and life insurance to employees who meet certain age and length of service requirements. Full-time employees no longer accrue service time toward the Corporation-subsidized portion of the medical benefits. The plan contains a cost-sharing feature which causes participants to pay for all future increases in costs related to benefit coverage. Accordingly, actuarial assumptions related to health care cost trend rates do not significantly affect the liability balance at June 30, 2017 and December 31, 2016, and are not expected to significantly affect the Corporation’s future expenses. The Corporation uses a December 31 measurement date for the postretirement plan.
In an acquisition in 2007, the Corporation assumed the Citizens Trust Company Retirement Plan, a defined benefit pension plan. This plan covers certain employees who were employed by Citizens Trust Company on December 31, 2002, when the plan was amended to discontinue admittance of any future participant and to freeze benefit accruals. Information related to the Citizens Trust Company Retirement Plan has been included in the tables that follow. The Corporation uses a December 31 measurement date for this plan.
The components of net periodic benefit costs from these defined benefit plans are as follows:
In the first six months of 2017, the Corporation funded postretirement contributions totaling $24,000, with estimated annual postretirement contributions of $62,000 expected in 2017 for the full year. Based upon preliminary actuarial information, no defined benefit pension contributions are required in 2017, though the Corporation may make discretionary contributions.
10. STOCK-BASED COMPENSATION PLANS
The Corporation has a Stock Incentive Plan for a selected group of officers and an Independent Directors Stock Incentive Plan. In the first quarter 2017, the Corporation awarded 22,312 shares of restricted stock under the Stock Incentive Plan and 8,470 shares of restricted stock under the Independent Directors Stock Incentive Plan. The 2017 restricted stock awards under the Stock Incentive Plan vest ratably over three years, and vesting for one-half of the 14,897 restricted shares awarded to Executive Officers depends on the Corporation meeting a return on average equity (“ROAE”) target each year. The 2017 restricted stock issued under the Independent Directors Stock Incentive Plan vests over one year.
Compensation cost related to restricted stock is recognized based on the market price of the stock at the grant date over the vesting period. Management has estimated restricted stock expense in the first six months of 2017 based on an assumption that the ROAE target for awards to Executive Officers in 2016 and 2017 will not be met, resulting in forfeiture of the restricted stock.
Total annual stock-based compensation for the year ending December 31, 2017 is estimated to total $652,000. If the ROAE targets for awards to Executive Officers in 2016 and 2017 are met or exceeded, total annual stock-based compensation would increase by approximately $123,000. Total stock-based compensation expense attributable to restricted stock awards amounted to $154,000 in the second quarter 2017 and $322,000 in the six-month period ended June 30, 2017. Total stock-based compensation expense attributable to restricted stock awards amounted to $163,000 in the second quarter 2016 and $325,000 in the six-month period ended June 30, 2016.
11. INCOME TAXES
The net deferred tax asset at June 30, 2017 and December 31, 2016 represents the following temporary difference components:
The provision for income tax for the three-month and six month periods ended June 30, 2017 and 2016 is based on the Corporation’s estimate of the effective tax rate expected to be applicable for the full year. The effective tax rates for the Corporation are as follows:
The effective tax rate for each period presented differs from the statutory rate of 35% principally because of the effects of tax-exempt interest income.
The Corporation has investments in three limited partnerships that manage affordable housing projects that have qualified for the federal low-income housing tax credit. The Corporation’s expected return from these investments is based on the receipt of tax credits and tax benefits from deductions of operating losses. The Corporation uses the effective yield method to account for these investments, with the benefits recognized as a reduction of the provision for income taxes. For two of the three limited partnership investments, the tax credits have been received in full in prior years, and the Corporation has fully realized the benefits of the credits and amortized its initial investments in the partnerships. The most recent affordable housing project was completed in 2013, and the Corporation received tax credits in 2013 through 2016 and expects to continue to receive tax credits annually through 2022. The carrying amount of the Corporation’s investment is $660,000 at June 30, 2017 and $713,000 at December 31, 2016 (included in Other Assets in the consolidated balance sheets). For the year ending December 31, 2017, the estimated amount of tax credits and other tax benefits to be received is $157,000 and the estimated amount to be recognized as a reduction of the provision for income taxes is $73,000. The total reduction in the provision for income taxes resulting from this investment is $19,000 in the second quarter 2017 and $37,000 for the six months ended June 30, 2017, and $19,000 in the second quarter 2016 and $38,000 for the six months ended June 30, 2016.
The Corporation has no unrecognized tax benefits, nor pending examination issues related to tax positions taken in preparation of its income tax returns. With limited exceptions, the Corporation is no longer subject to examination by the Internal Revenue Service for years prior to 2013.
12. CONTINGENCIES
In the normal course of business, the Corporation may be subject to pending and threatened lawsuits in which claims for monetary damages could be asserted. In management’s opinion, the Corporation’s financial position and results of operations would not be materially affected by the outcome of such pending legal proceedings.
13. RECENT ACCOUNTING PRONOUNCEMENTS
The FASB issues Accounting Standards Updates (ASUs) to the FASB ASC. This section provides a summary description of recent ASUs that have significant implications (elected or required) within the consolidated financial statements, or that management expects may have a significant impact on financial statements issued in the near future.
In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers, which provides a principles-based framework for revenue recognition that supersedes virtually all previously issued revenue recognition guidance under U.S. GAAP. Additionally, the ASU requires improved disclosures to help users of financial statements better understand the nature, amount, timing, and uncertainty of revenue that is recognized. The core principle of the five-step revenue recognition framework is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Additional ASUs related to revenue recognition include the following:
The amendments should be applied either retrospectively to each prior reporting period presented or retrospectively with the cumulative effect of initially applying the amendments recognized at the date of initial application. Initial adoption of this ASU is not expected to have a significant impact on the Corporation, as recognition of interest income and the larger sources of noninterest income in the Corporation’s current business model would not be impacted by the ASU.
In January 2016, the FASB issued ASU 2016-01, Recognition and Measurement of Financial Assets and Liabilities. This makes significant changes in U.S. GAAP related to certain aspects of recognition, measurement, presentation and disclosure of financial instruments. The changes provided for in this Update that are applicable to the Corporation are as follows: (1) require equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income; however, an entity may choose to measure equity investments that do not have readily determinable fair values at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer; (2) for equity investments without readily determinable fair values, require a qualitative assessment to identify impairment, and if a qualitative assessment indicates that impairment exists, requiring an entity to measure the investment at fair value; (3) eliminate the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet; (4) require public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; (5) require an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments (at June 30, 2017 and December 31, 2016, the Corporation has no liabilities for which the fair value measurement option has been elected); (6) require separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (that is, securities or loans and receivables) on the balance sheet or the accompanying notes to the financial statements; and (7) clarify that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets. The amendments in this Update will become effective for the Corporation for annual and interim periods beginning in the first quarter 2018. With limited exceptions, early adoption of the amendments in this Update is not permitted. Amendments are to be applied by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. The amendments related to equity securities without readily determinable fair values should be applied prospectively. Initial adoption of this ASU is not expected to have a significant impact on the Corporation’s financial position; however, the method for determining the fair value of loans and other financial instruments for disclosure purposes will be affected.
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The core principle of Topic 842 is that a lessee should recognize the assets and liabilities that arise from leases. Specifically, a lessee should recognize on the balance sheet a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term. For leases with a term of 12 months or less, a lessee would be permitted to make an accounting policy election by class of underlying asset not to recognize lease assets and liabilities. Topic 842 would not significantly change the recognition, measurement and presentation of expenses and cash flows arising from a lease by a lessee from current U.S. GAAP; however, the principal change from current GAAP is that lease assets and liabilities arising from operating leases would be recognized on the balance sheet. Topic 842 provides several other changes or clarifications to existing GAAP, and will require qualitative disclosures, along with quantitative disclosures, so that financial statement users can understand more about the nature of an entity’s leasing activities. In transition, Topic 842 provides that lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach, including optional practical expedients. An entity that elects to apply the practical expedients will, in effect, continue to account for leases that commence before the effective date in accordance with previous GAAP unless the lease is modified, except that lessees will be required to recognize a right-of-use asset and a lease liability for all operating leases at each reporting date based on the present value of the remaining minimum rental payments that were tracked and disclosed under previous GAAP. Topic 842 will become effective for the Corporation for annual and interim periods beginning in the first quarter 2019. The Corporation is in the early stages of evaluating the potential impact of adopting this amendment.
In March 2016, the FASB issued ASU No. 2016-07, Investments – Equity Method and Joint Ventures. This ASU eliminates the requirement that when an investment qualifies for the equity method as a result of an increase in the level of ownership interest or influence, an investor must adjust the investment, results of operations and retained earnings retroactively as if the equity method had been in effect during all previous periods the investment had been held. The ASU requires the equity method investor to add the cost of acquiring an additional interest in the investee to the basis of the investor’s previously held interest and adopt the equity method of accounting as of the date the investment becomes qualified for the equity method. The ASU further requires that an entity that has an available-for-sale equity security that becomes qualified for the equity method recognize through earnings the unrealized gain or loss in accumulated other comprehensive income at the date the investment becomes qualified for use of the equity method. The amendments in this Update were effective for the Corporation for annual and interim periods beginning in the first quarter 2017. Initial adoption of this ASU in 2017 did not have a significant impact on the Corporation.
In March 2016, the FASB issued ASU No. 2016-09, Compensation – Stock Compensation. This ASU changes several aspects of accounting for share-based payment transactions, and includes some changes that apply only to nonpublic companies. This Update includes amendments that currently apply, or may apply in the future, to the Corporation related to the following: (1) accounting for the difference between the deduction for tax purposes and the amount of compensation cost recognized for financial reporting purposes; (2) classification of excess tax benefits on the statement of cash flows; (3) accounting for forfeitures; (4) accounting for awards partially settled in cash in excess of the employer’s minimum statutory tax withholding requirements; and (5) classification of employee taxes paid on the statement of cash flows when an employer withholds shares for tax-withholding purposes. The amendments in this Update were effective for the Corporation for annual and interim periods beginning in the first quarter 2017. The ASU provides separate transition provisions for each of the amendments. Initial adoption of this ASU in 2017 did not have a significant impact on the Corporation.
In June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326). This ASU will result in significant changes in the Corporation’s accounting for credit losses related to loans receivable and investment securities. A summary of significant provisions of this ASU is as follows:
The Corporation is in the early stages of evaluating the potential impact of adopting this amendment.
In June 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230) – Classification of Certain Cash Receipts and Cash Payments. This Update provides clarification regarding eight specific cash flow issues with the objective of reducing diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows. For the Corporation, the amendments in this Update are effective beginning in the first quarter 2018. The amendments in this Update should be applied using a retroactive transition method to each period presented. The Corporation anticipates there will be no adjustments to the Consolidated Statements of Cash Flows, as previously reported, as a result of the clarifications provided in the Update.
In January 2017, the FASB issued ASU 2017-04, Intangibles – Goodwill and Other (Topic 350) to simplify the accounting for goodwill impairment. This guidance, among other things, removes step 2 of the goodwill impairment test thus eliminating the need to determine the fair value of individual assets and liabilities of the reporting unit. Upon adoption of this ASU, goodwill impairment will be the amount by which a reporting unit’s carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. This may result in more or less impairment being recognized than under current guidance. This Update will become effective for the Corporation’s annual and interim goodwill impairment tests beginning in the first quarter of 2020.
In March 2017, the FASB issued ASU 2017-08, Receivables – Nonrefundable Fees and Other Costs (Subtopic 310-20). This Update will shorten the amortization period for certain callable debt securities held at a premium. Under current U.S. GAAP, entities generally amortize the premium over the contractual life of the instrument. Discounts will continue to be amortized to maturity. The amendments in this Update are effective for the Corporation for annual and interim periods beginning in the first quarter 2019. An entity should apply the amendments in this Update through a cumulative-effect adjustment directly to retained earnings as of the beginning of the year of adoption. Early adoption is permitted, including adoption in an interim period. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. The Corporation does not expect adoption of the amendments to have a significant impact on its financial position and does not expect to early adopt the amendments.
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Certain statements in this section and elsewhere in this quarterly report on Form 10-Q are forward-looking statements. Citizens & Northern Corporation and its wholly-owned subsidiaries (collectively, the Corporation) intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Reform Act of 1995. Forward-looking statements, which are not historical facts, are based on certain assumptions and describe future plans, business objectives and expectations, and are generally identifiable by the use of words such as, “should”, “likely”, “expect”, “plan”, “anticipate”, “target”, “forecast”, and “goal”. These forward-looking statements are subject to risks and uncertainties that are difficult to predict, may be beyond management’s control and could cause results to differ materially from those expressed or implied by such forward-looking statements. Factors which could have a material, adverse impact on the operations and future prospects of the Corporation include, but are not limited to, the following:
These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.
EARNINGS OVERVIEW
Second quarter 2017 net income was $0.34 per basic and diluted share, as compared to $0.28 in the first quarter 2017 and $0.32 in the second quarter 2016. For the six months ended June 30, 2017, net income per basic and diluted share was $0.62 as compared to $0.61 for the first six months of 2016. The return on average assets for the first six months of 2017 was 1.22%, and the return on average equity was 8.07%. Highlights related to the Corporation’s earnings results for the comparative periods are presented below.
Net income was $4,121,000 in the second quarter 2017, an increase of $250,000 (6.5%) over the second quarter 2016 amount. Some of the more significant fluctuations in revenues and expenses between the three-month period ended June 30, 2017 and the corresponding period in 2016 were as follows:
Net income for the first six months of 2017 was $7,555,000, an increase of 1.5% over net income for the first six months of 2016 of $7,444,000. Some of the more significant fluctuations in revenues and expenses between the six-month period ended June 30, 2017 and the corresponding period in 2016 were as follows:
More detailed information concerning fluctuations in the Corporation’s earnings results and other financial information are provided in other sections of Management’s Discussion and Analysis.
CRITICAL ACCOUNTING POLICIES
The presentation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect many of the reported amounts and disclosures. Actual results could differ from these estimates.
A material estimate that is particularly susceptible to significant change is the determination of the allowance for loan losses. Management believes the allowance for loan losses is adequate and reasonable. Analytical information related to the Corporation’s aggregate loans and the related allowance for loan losses is summarized by loan segment and classes of loans in Note 7 to the unaudited consolidated financial statements. Additional discussion of the Corporation’s allowance for loan losses is provided in a separate section later in Management’s Discussion and Analysis. Given the very subjective nature of identifying and valuing loan losses, it is likely that well-informed individuals could make materially different assumptions, and could, therefore calculate a materially different allowance value. While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation’s allowance for loan losses. Such agencies may require the Corporation to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination.
Another material estimate is the calculation of fair values of the Corporation’s debt securities. For most of the Corporation’s debt securities, the Corporation receives estimated fair values of debt securities from an independent valuation service, or from brokers. In developing fair values, the valuation service and the brokers use estimates of cash flows, based on historical performance of similar instruments in similar interest rate environments. Based on experience, management is aware that estimated fair values of debt securities tend to vary among brokers and other valuation services.
As described in Note 6 to the unaudited consolidated financial statements, management evaluates securities for other-than-temporary impairment (OTTI). In making that evaluation, consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) whether the Corporation intends to sell the security or more likely than not will be required to sell the security before its anticipated recovery. Management’s assessments of the likelihood and potential for recovery in value of securities are subjective and based on sensitive assumptions.
NET INTEREST INCOME
The Corporation’s primary source of operating income is net interest income, which is equal to the difference between the amounts of interest income and interest expense. Tables II, III and IV include information regarding the Corporation’s net interest income for the three-month and six-month periods ended June 30, 2017 and June 30, 2016. In each of these tables, the amounts of interest income earned on tax-exempt securities and loans have been adjusted to a fully taxable-equivalent basis. Accordingly, the net interest income amounts reflected in these tables exceed the amounts presented in the consolidated financial statements. The discussion that follows is based on amounts in the related Tables.
Six-Month Periods Ended June 30, 2017 and 2016
For the six-month periods, fully taxable equivalent net interest income was $21,903,000 in 2017, $475,000 (2.2%) higher than in 2016. Interest income was $577,000 higher in 2017 as compared to 2016; interest expense was also higher by $102,000 in comparing the same periods. As presented in Table III, the Net Interest Margin was 3.81% in 2017 as compared to 3.79% in 2016, and the “Interest Rate Spread” (excess of average rate of return on earning assets over average cost of funds on interest-bearing liabilities) was 3.66% in each of the six-month periods ended June 30, 2017 and 2016.
INTEREST INCOME AND EARNING ASSETS
Interest income totaled $23,834,000 in 2017, an increase of 2.5% from 2016. Interest and fees on loans receivable increased $1,000,000, or 5.7%. The average balance of gross loans receivable increased $58,649,000, or 8.3%, to $765,408,000 in 2017 from $706,759,000 in 2016. The Corporation experienced growth in both commercial and mortgage loans outstanding. The Corporation’s average yield on loans receivable declined to 4.86% in 2017 from 4.96% in 2016 as average interest rates on new loans have been lower than the average rates on loans that have been fully or partially paid off. More recently, interest rates on floating-rate loans such as commercial and home equity lines of credit have increased, which has caused the overall yield on loans receivable to increase slightly, to 4.87% in the second quarter 2017 as compared to 4.84% in the first quarter 2017.
As indicated in Table III, average available-for-sale securities (at amortized cost) totaled $379,789,000 in 2017, a decrease of $28,984,000 (7.1%) from 2016. The net decrease in the Corporation’s available-for-sale securities portfolio consisted of decreases in all categories of securities with the exception of commercial mortgage-backed securities. The Corporation’s yield on securities was 2.83% in 2017, which was comparable to 2.82% in 2016.
INTEREST EXPENSE AND INTEREST-BEARING LIABILITIES
Interest expense increased $102,000, or 5.6%, to $1,931,000 in 2017 from $1,829,000 in 2016. Table III shows that the overall cost of funds on interest-bearing liabilities increased to 0.48% in 2017 from 0.45% in 2016.
Total average deposits (interest-bearing and noninterest-bearing) increased 1.8%, to $973,640,000 in 2017 from $956,602,000 in 2016. Increases in the average balances of demand deposits, savings and interest checking accounts were partially offset by decreases in Individual Retirement Accounts, money market accounts and certificates of deposit.
Total average borrowed funds increased $1,485,000 to $69,626,000 in 2017 from $68,141,000 in 2016. The average rate on borrowed funds was 2.42% in 2017 compared to 2.44% in 2016.
Three-Month Periods Ended June 30, 2017 and 2016
For the three-month periods, fully taxable equivalent net interest income was $11,062,000 in 2017, which was $378,000 (3.5%) higher than in 2016. Interest income was $431,000 higher in 2017 as compared to 2016, while interest expense was higher by $53,000 in comparing the same periods. As presented in Table III, the Net Interest Margin was 3.83% in 2017 as compared to 3.76% in 2016, and the “Interest Rate Spread” (excess of average rate of return on earning assets over average cost of funds on interest-bearing liabilities) was 3.69% in 2017 as compared to 3.63% in 2016.
Interest income totaled $12,040,000 in 2017, an increase of $431,000 (3.7%) from 2016. Interest and fees from loans receivable increased $597,000, or 6.8%, in 2017 as compared to 2016, while income from available-for-sale securities decreased $169,000 (6.1%). As indicated in Table III, for the three-month periods, the average balance of gross loans receivable increased 8.4% to $771,372,000 in 2017 from $711,882,000 in 2016. The average rate of return on loans was 4.87% in 2017, down from 4.96% in 2016. Total average available-for-sale securities (at amortized cost) in 2017 decreased to $370,799,000 from $406,260,000 in 2016. The average rate of return on available-for-sale securities was 2.83% for 2017, up from 2.76% in 2016.
For the three-month periods, interest expense increased $53,000, or 5.7%, to $978,000 in 2017 from $925,000 in 2016. All of this increase was in interest paid on deposits as the average rate paid on deposits increased 0.02%, including increases of 0.07% on certificates of deposit and 0.06% on interest checking. As presented in Table III, the overall cost of funds on interest-bearing liabilities increased to 0.48% in 2017 from 0.46% in 2016. Total average deposits (interest-bearing and noninterest-bearing) amounted to $979,986,000 in the second quarter 2017, an increase of $11,381,000 (1.2%) from the second quarter 2016 total.
Interest expense on total borrowed funds was unchanged from 2016 to 2017. Interest expense on short-term borrowings increased $4,000 while interest expense on long-term borrowings decreased by the same amount from 2016 to 2017. The average balance of total borrowed funds decreased to $59,558,000 in the second quarter 2017 from $61,874,000 in the second quarter 2016, while the average rate on borrowed funds increased to 2.71% in the second quarter 2017 from 2.62% in the second quarter 2016.
The average balance of short-term borrowings decreased to $21,205,000 in the second quarter 2017 from $23,225,000 in 2016, and the average rate on short-term borrowings increased to 0.85% in 2017 from 0.71% in 2016. The increase in average rate on short-term borrowings reflects increases in overnight borrowing rates, consistent with increases in the Fed Funds rate totaling 0.75% rate over the past several months, including separate 0.25% Fed Funds increases in December 2016, March 2017 and June 2017.
The average balance of long-term borrowings was $38,353,000 in the second quarter 2017, at an average rate of 3.74%, down slightly from an average balance of $38,649,000 at an average rate of 3.77% in the second quarter 2016. Borrowings are classified as long-term within the Tables based on their term at origination; however, within this category, borrowings with a total balance of $37,000,000 at June 30, 2017 mature within the year ending December 31, 2017. The two largest borrowings within the long-term category that mature in 2017 include a $10 million advance from FHLB-Pittsburgh with a 3.81% interest rate that matures in September and a $27 million repurchase agreement with a rate of 3.595% and an effective maturity in December 2017.
TABLE II - ANALYSIS OF INTEREST INCOME AND EXPENSE
Note: Interest income from tax-exempt securities and loans has been adjusted to a fully tax-equivalent basis, using the Corporation’s marginal federal income tax rate of 35%.
TABLE III - ANALYSIS OF AVERAGE DAILY BALANCES AND RATES
(Dollars in Thousands)
(1) Annualized rates of return on tax-exempt securities and loans are presented on a fully taxable-equivalent basis, using the Corporation’s marginal federal income tax rate of 35%.
(2) Nonaccrual loans have been included with loans for the purpose of analyzing net interest earnings.
(3) Rates of return on earning assets and costs of funds are presented on an annualized basis.
TABLE IV - ANALYSIS OF VOLUME AND RATE CHANGES
(1) Changes in income on tax-exempt securities and loans are presented on a fully tax-equivalent basis, using the Corporation’s marginal federal income tax rate of 35%.
(2) The change in interest due to both volume and rates has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amount of the change in each.
Table V excludes realized gains on available-for-sale securities, which are discussed in the “Earnings Overview” section of Management’s Discussion and Analysis. Total noninterest income shown in Table V increased $374,000 (4.9%) in the first six months of 2017 over the first six months of 2016 amount. The most significant variances include the following:
TABLE VI - COMPARISON OF NONINTEREST INCOME
(Dollars In Thousands)
Table VI excludes realized gains on available-for-sale securities, which are discussed in the “Earnings Overview” section of Management’s Discussion and Analysis. Total noninterest income shown in Table VI increased $200,000 (5.1%) in the first six months of 2017 over the first six months of 2016 amount. The most significant variances include the following:
TABLE VII - COMPARISON OF NONINTEREST EXPENSE
As shown in Table VII, total noninterest expense increased $767,000 (4.4%) in the first six months of 2017 as compared to the first six months of 2016. The most significant variances include the following:
TABLE VIII - COMPARISON OF NONINTEREST EXPENSE
As shown in Table VIII, total noninterest expense increased $541,000 (6.3%) in the second quarter 2017 as compared to the second quarter 2016. The most significant variances include the following:
FINANCIAL CONDITION
This section includes information regarding the Corporation’s lending activities or other significant changes or exposures that are not otherwise addressed in Management’s Discussion and Analysis. Significant changes in the average balances of the Corporation’s earning assets and interest-bearing liabilities are described in the “Net Interest Income” section of Management’s Discussion and Analysis. Other significant balance sheet items, including the allowance for loan losses and stockholders’ equity, are discussed in separate sections of Management’s Discussion and Analysis. There are no significant concerns that have arisen related to the Corporation’s off-balance sheet loan commitments or outstanding standby letters of credit at June 30, 2017, and management does not expect capital expenditures to have a material, detrimental effect on the Corporation’s financial condition in 2017.
Gross loans outstanding (excluding mortgage loans held for sale) were $779,692,000 at June 30, 2017, up 3.7% from $751,835,000 at December 31, 2016 and up 7.1 % from $727,842 at June 30, 2016. Total outstanding mortgages and other consumer real estate loans were $9,206,000 (2.2%) higher at June 30, 2017 as compared to December 31, 2016; and increased $31,334,000 (7.9%) compared to June 30, 2016. Total outstanding commercial loans were higher by $17,750,000 (5.6%) at June 30, 2017 as compared to December 31, 2016 and $18,027,000 (5.7%) as compared to June 30, 2016. Average loans outstanding in the first six months of 2017 of $765,408,000 were $58,649,000 (8.3%) higher than the corresponding total in the first six months of 2016. The increase in loans outstanding over the last two quarters of 2016 and first two quarters 2017 have included significant increases in mortgages and other consumer real estate loans as well as commercial loans.
While the Corporation’s lending activities are primarily concentrated in its market area, a portion of the Corporation’s commercial loan segment consists of participation loans. Participation loans represent portions of larger commercial transactions for which other institutions are the “lead banks”. Although not the lead bank, the Corporation conducts detailed underwriting and monitoring of participation loan opportunities. Participation loans are included in the “Commercial and industrial,” “Commercial loans secured by real estate” and “Political subdivisions” classes in the loan tables presented in this Form 10-Q. Total participation loans outstanding amounted to $42,876,000 at June 30, 2017, down from $47,508,000 at December 31, 2016 and down from $47,055,000 at June 30, 2016. At June 30, 2017, the balance of participation loans outstanding includes a total of $31,682,000 to businesses located outside of the Corporation’s market area, including $10,515,000 from participations in loans originated through the Corporation’s membership in a network that originates loans throughout the U.S. The Corporation’s participation loans originated through the network consist of loans to businesses that are larger than the Corporation’s typical commercial customer base. The loans originated through the network are considered “leveraged loans,” meaning the businesses typically have minimal tangible book equity and the extent of collateral available is limited, though at the time of origination the businesses have demonstrated strong cash flow performance in their recent histories. Total leveraged participation loans, including loans originated through the network and two loans originated through another lead institution, totaled $12,359,000 at June 30, 2017, $15,207,000 at December 31, 2016 and $12,199,000 at June 30, 2016.
Since 2009, the Corporation has originated and sold residential mortgage loans to the secondary market through the MPF Xtra program administered by the Federal Home Loan Banks of Pittsburgh and Chicago. Residential mortgages originated and sold through the MPF Xtra program consist primarily of conforming, prime loans sold to the Federal National Mortgage Association (Fannie Mae), a quasi-government entity. In 2014, the Corporation began to originate and sell residential mortgage loans to the secondary market through the MPF Original program, which is also administered by the Federal Home Loan Banks of Pittsburgh and Chicago. Residential mortgages originated and sold through the MPF Original program consist primarily of conforming, prime loans sold to the Federal Home Loan Bank of Pittsburgh.
For loan sales originated under the MPF Xtra and Original programs, the Corporation provides customary representations and warranties to investors that specify, among other things, that the loans have been underwritten to the standards established by the investor. The Corporation may be required to repurchase a loan and reimburse a portion of fees received, or reimburse the investor for a credit loss incurred on a loan, if it is determined that the representations and warranties have not been met. Such repurchases or reimbursements generally result from an underwriting or documentation deficiency. At June 30, 2017, the total outstanding balance of loans the Corporation has repurchased as a result of identified instances of noncompliance amounted to $1,828,000, and the corresponding total outstanding balance repurchased at December 31, 2016 was $1,852,000.
At June 30, 2017, outstanding balances of loans sold and serviced through the two programs totaled $165,789,000, including loans sold through the MPF Xtra program of $112,184,000 and loans sold through the Original program of $53,605,000. At December 31, 2016, outstanding balances of loans sold and serviced through the two programs totaled $163,296,000, including loans sold through the MPF Xtra program of $116,978,000 and loans sold through the Original program of $46,318,000. Based on the fairly limited volume of required repurchases to date, no allowance has been established for representation and warranty exposures as of June 30, 2017 and December 31, 2016.
For loans sold under the Original program, the Corporation provides a credit enhancement whereby the Corporation would assume credit losses in excess of a defined First Loss Account (“FLA”) balance, up to specified amounts. The FLA is funded by the Federal Home Loan Bank of Pittsburgh based on a percentage of the outstanding balance of loans sold. At June 30, 2017, the Corporation has recorded an allowance in the amount of $227,000 for credit losses on loans sold under the MPF Original Program which is included in “Accrued interest and other liabilities” in the accompanying balance sheet. The corresponding recorded allowance at December 31, 2016 was $196,000. The Corporation does not provide a credit enhancement for loans sold through the Xtra program.
PROVISION AND ALLOWANCE FOR LOAN LOSSES
The Corporation maintains an allowance for loan losses that represents management’s estimate of the losses inherent in the loan portfolio as of the balance sheet date and is recorded as a reduction of the investment in loans. Note 7 to the unaudited consolidated financial statements provides an overview of the process management uses for evaluating and determining the allowance for loan losses.
While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation’s allowance for loan losses. Such agencies may require the Corporation to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination.
The allowance for loan losses was $8,635,000 at June 30, 2017, up from $8,473,000 at December 31, 2016. Table X shows total specific allowances on impaired loans increased $409,000 to $1,083,000 at June 30, 2017 from $674,000 at December 31, 2016. The net increase in specific allowances in the first half of 2017 included an increase of $430,000 in the allowance related to one real estate secured commercial loan. The increase in the specific allowance for this loan was based on an updated appraisal. At June 30, 2017, the outstanding balance of this loan was $2,718,000, and the related allowance was $958,000.
Table X also shows that the collectively determined portion of the allowance related to commercial loans decreased $51,000, to $3,022,000 at June 30, 2017 from $3,373,000 at December 31, 2016. The decrease in the collectively determined allowance on commercial loans resulted from an aggregate improvement (reduction) in the net charge-off experience and qualitative factors used to value the allowance on commercial loans, partially offset by the impact of an increase in outstanding loans. The aggregate net charge-off experience factor used in the allowance calculation on commercial loans was 0.09% lower at June 30, 2017 as compared to December 31, 2016. The Corporation’s aggregate net charge-off rate on commercial loans has been improving over the past several quarters, as the effects on the overall rate of a large ($1,486,000) charge-off in 2014 on a commercial loan secured by real estate has gradually diminished. The qualitative factors used in the allowance calculation for commercial loans were 0.05% lower at June 30, 2017 as compared to December 31, 2016, reflecting a pattern of overall improvement in loan delinquency levels and a reduction in the unemployment rate throughout most of the Corporation’s market area over the previous twelve months.
Throughout 2016 and at March 31, 2017, a rolling three-year average net charge-off rate was used for all loan classes. At June 30, 2017, a five-year average net charge-off rate was used for commercial loans secured by real estate and for multi-family residential loans, while a three-year average net charge-off rate was used for all other loan classes. The change in time period for these two loan classes was based on management’s evaluation of an appropriate time period that captures an historical loss experience relevant to the current portfolio. The impact of this change was to increase the allowance for loan losses at June 30, 2017 and resulting provision for the second quarter and six months ended June 30, 2017 by $189,000.
The provision for loan losses by segment in the three-month and six-month period ended June 30, 2017 and 2016 is as follows:
The overall decreases in the provision for loan losses for the second quarter and first six months of 2017 as compared to the corresponding periods of 2016 reflect, in part, increases in the provision due to changes in specific allowances offset by decreases in the collectively determined allowance for loan losses including a reduction in the qualitative factors used to determine the allowance as well as a reduction in the historical average net charge-offs as a percentage of outstanding loans as described above. More detail related to the largest segments, residential mortgage and commercial, is as follows:
Table XI presents information related to past due and impaired loans, and loans that have been modified under terms that are considered troubled debt restructurings (TDRs). Total nonperforming loans as a percentage of outstanding loans was 1.82% at June 30, 2017, down from 2.07% at December 31, 2016, and nonperforming assets as a percentage of total assets was 1.30% at June 30, 2017, down from 1.43% at December 31, 2016. Table XI presents data at June 30, 2017 and at the end of each of the years ended December 31, 2012 through 2016. For the range of dates presented in Table XI, total nonperforming loans as a percentage of loans has ranged from a low of 1.41% at December 31, 2012 to a high of 2.80% at December 31, 2013, and total nonperforming assets as a percentage of assets have ranged from a low of 0.82% at December 31, 2012 to a high of 1.53% at December 31, 2013.
The balance of loans subject to troubled debt restructurings (TDRs) was $3,788,000 at June 30, 2017, which was $4,889,000 lower than the corresponding total at December 31, 2016, mainly due to removal of one commercial relationship from TDR status. At June 30, 2017, the outstanding contractual balances of loans to this borrower total $6,481,000, and the recorded investments total $4,731,000. In 2014, the Corporation entered into a forbearance agreement with this commercial borrower which was extended for two additional twelve-month periods, most recently in July 2016. The Corporation recorded a charge-off of $1,486,000 in the second quarter 2014, as the payment amounts based on the forbearance agreement were not sufficient to fully amortize the contractual amount of principal outstanding on the loans. In December 2016, the Corporation and the borrower entered into a modification agreement, terminating the forbearance agreement and establishing loan terms with essentially the same interest rate and monthly payment amounts as had been in effect under the forbearance agreement. The interest rates provided for in the modification agreement were equal to or greater than rates the Corporation would be willing to accept for loans with comparable terms to borrowers with a comparable risk profile at the time of the modification. The borrower has made all required payments on the loans in accordance with the terms of the forbearance agreement, as extended, and the modification agreement. Accordingly, the loans were restored to full accrual status at December 31, 2016 and are no longer included in the amounts reported as TDRs at June 30, 2017.
Total impaired loans of $8,711,000 at June 30, 2017 are down $2,149,000 from the corresponding amount at December 31, 2016 of $10,860,000, including a decrease in impaired loans without a valuation allowance of $2,070,000. This net decrease in impaired loans is the result of: (1) removal from impairment status of the loans with the modification agreement noted in the previous paragraph, partially offset by (2) the addition of one commercial loan secured by real estate with an outstanding balance of approximately $2.8 million at June 30, 2017. This commercial loan was reviewed in the second quarter 2017 to determine if a specific allowance for loan losses would be required, and it was determined that no allowance was required at June 30, 2017 based on the estimated net realizable value of the related collateral.
Total nonperforming assets of $16,207,000 at June 30, 2017 are $1,547,000 lower than the corresponding amount at December 31, 2016, summarized as follows:
Over the period 2012-2016 and the first six months of 2017, each period includes a few large commercial relationships that have required significant monitoring and workout efforts. As a result, a limited number of relationships may significantly impact the total amount of allowance required on impaired loans, and may significantly impact the amount of total charge-offs reported in any one period.
Management believes it has been conservative in its decisions concerning identification of impaired loans, estimates of loss, and nonaccrual status; however, the actual losses realized from these relationships could vary materially from the allowances calculated as of June 30, 2017. Management continues to closely monitor its commercial loan relationships for possible credit losses, and will adjust its estimates of loss and decisions concerning nonaccrual status, if appropriate.
Tables IX through XII present historical data related to loans and the allowance for loan losses.
TABLE IX - ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES
TABLE X - COMPONENTS OF THE ALLOWANCE FOR LOAN LOSSES
TABLE XI - PAST DUE AND IMPAIRED LOANS, NONPERFORMING ASSETS
AND TROUBLED DEBT RESTRUCTURINGS (TDRs)
TABLE XII - SUMMARY OF LOANS BY TYPE
Summary of Loans by Type
LIQUIDITY
Liquidity is the ability to quickly raise cash at a reasonable cost. An adequate liquidity position permits the Corporation to pay creditors, compensate for unforeseen deposit fluctuations and fund unexpected loan demand. At June 30, 2017, the Corporation maintained overnight interest-bearing deposits with the Federal Reserve Bank of Philadelphia and other correspondent banks totaling $9,758,000.
The Corporation maintains overnight borrowing facilities with several correspondent banks that provide a source of day-to-day liquidity. Also, the Corporation maintains borrowing facilities with the Federal Home Loan Bank of Pittsburgh, secured by various mortgage loans.
The Corporation has a line of credit with the Federal Reserve Bank of Philadelphia’s Discount Window. Management intends to use this line of credit as a contingency funding source. As collateral for the line, the Corporation has pledged available-for-sale securities with a carrying value of $17,188,000 at June 30, 2017.
The Corporation’s outstanding, available, and total credit facilities at June 30, 2017 and December 31, 2016 are as follows:
At June 30, 2017, the Corporation’s outstanding credit facilities with the Federal Home Loan Bank of Pittsburgh consisted of overnight borrowings of $4,000,000 and long-term borrowings with a total amount of $11,321,000. At December 31, 2016, the Corporation’s outstanding credit facilities with the Federal Home Loan Bank of Pittsburgh consisted of overnight borrowings of $21,000,000 and long-term borrowings with a total amount of $11,454,000. Additional information regarding borrowed funds is included in Note 8 of the unaudited consolidated financial statements.
Additionally, the Corporation uses repurchase agreements placed with brokers to borrow funds secured by investment assets and “RepoSweep” arrangements to borrow funds from commercial banking customers on an overnight basis. If required to raise cash in an emergency situation, the Corporation could sell available-for-sale securities to meet its obligations. At June 30, 2017, the carrying value of available-for-sale securities in excess of amounts required to meet pledging or repurchase agreement obligations was $172,788,000.
Management believes the Corporation is well-positioned to meet its short-term and long-term obligations.
STOCKHOLDERS’ EQUITY AND CAPITAL ADEQUACY
The Corporation and C&N Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Details concerning capital ratios at June 30, 2017 and December 31, 2016 are presented below. Management believes, as of June 30, 2017 and December 31, 2016, that the Corporation and C&N Bank meet all capital adequacy requirements to which they are subject and maintain capital conservation buffers (described in more detail below) that allow the Corporation and C&N Bank to avoid limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers. Further, as reflected in the table below, the Corporation’s and C&N Bank’s capital ratios at June 30, 2017 and December 31, 2016 exceed the Corporation’s policy threshold levels.
Management expects the Corporation and C&N Bank to maintain capital levels that exceed the regulatory standards for well-capitalized institutions and the applicable capital conservation buffers for the next 12 months and for the foreseeable future.
Future dividend payments will depend upon maintenance of a strong financial condition, future earnings and capital and regulatory requirements. As described in more detail below, the Corporation and C&N Bank are subject to restrictions on the amount of dividends that may be paid without approval of banking regulatory authorities.
In July 2013, the federal regulatory authorities issued a new capital rule based, in part, on revisions developed by the Basel Committee on Banking Supervision to the Basel capital framework (Basel III). The Corporation and C&N Bank became subject to the new rule effective January 1, 2015. Generally, the new rule implemented higher minimum capital requirements, revised the definition of regulatory capital components and related calculations, added a new common equity tier 1 capital ratio, implemented a new capital conservation buffer, increased the risk weighting for past due loans and provided a transition period for several aspects of the new rule.
The current (new) capital rule provides that, in order to avoid limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers, a banking organization must hold a capital conservation buffer composed of common equity tier 1 capital above its minimum risk-based capital requirements. The buffer is measured relative to risk-weighted assets. The transition schedule for new ratios, including the capital conservation buffer, is as follows:
As fully phased in, a banking organization with a buffer greater than 2.5% would not be subject to additional limits on dividend payments or discretionary bonus payments; however, a banking organization with a buffer less than 2.5% would be subject to increasingly stringent limitations as the buffer approaches zero. The new rule also prohibits a banking organization from making dividend payments or discretionary bonus payments if its eligible retained income is negative in that quarter and its capital conservation buffer ratio was less than 2.5% as of the beginning of that quarter. Eligible net income is defined as net income for the four calendar quarters preceding the current calendar quarter, net of any distributions and associated tax effects not already reflected in net income. A summary of payout restrictions based on the capital conservation buffer is as follows:
At June 30, 2017, the Corporation’s Capital Conservation Buffer, determined based on the minimum total capital ratio, was 15.57%. C&N Bank’s Capital Conservation Buffer (also determined based on the minimum total capital ratio) was 12.97%.
The Corporation’s total stockholders’ equity is affected by fluctuations in the fair values of available-for-sale securities. The difference between amortized cost and fair value of available-for-sale securities, net of deferred income tax, is included in Accumulated Other Comprehensive Income (Loss) within stockholders’ equity. The balance in Accumulated Other Comprehensive Income (Loss) related to unrealized losses on available-for-sale securities, net of deferred income tax, amounted to $369,000 at June 30, 2017 and ($949,000) at December 31, 2016. Changes in accumulated other comprehensive income (loss) are excluded from earnings and directly increase or decrease stockholders’ equity. If available-for-sale securities are deemed to be other-than-temporarily impaired, unrealized losses are recorded as a charge against earnings, and amortized cost for the affected securities is reduced. Note 6 to the unaudited consolidated financial statements provides additional information concerning management’s evaluation of available-for-sale securities for other-than-temporary impairment at June 30, 2017.
Stockholders’ equity is also affected by the underfunded or overfunded status of defined benefit pension and postretirement plans. The balance in Accumulated Other Comprehensive Income related to defined benefit plans, net of deferred income tax, was $151,000 at June 30, 2017 and $51,000 at December 31, 2016.
COMPREHENSIVE INCOME
Comprehensive Income is the total of (1) net income, and (2) all other changes in equity from non-stockholder sources, which are referred to as Other Comprehensive Income. Changes in the components of Accumulated Other Comprehensive Income (Loss) are included in Other Comprehensive Income, and for the Corporation, consist of changes in unrealized gains or losses on available-for-sale securities and changes in underfunded or overfunded defined benefit plans. Fluctuations in interest rates significantly affect fair values of available-for-sale securities, and accordingly have an effect on Other Comprehensive Income (Loss) in each period.
Comprehensive Income totaled $5,116,000 for the three months ended June 30, 2017 as compared to $5,369,000 in the second quarter 2016. For the three months ended June 30, 2017, Comprehensive Income included: (1) Net Income of $4,121,000, which was $250,000 higher than in the second quarter 2016; (2) Other Comprehensive Income from an increase in net unrealized gains on available-for-sale securities of $999,000 as compared to Other Comprehensive Income of $1,502,000 from an increase in net unrealized gains on available-for-sale securities in the second quarter 2016; and (3) Other Comprehensive Loss from defined benefit plans of ($4,000) for the second quarter 2017 and 2016.
Comprehensive Income totaled $8,973,000 for the six months ended June 30, 2017 as compared to $11,810,000 for the six months ended June 30, 2016. In the six months ended June 30, 2017, Comprehensive Income included: (1) Net Income of $7,555,000, which was $111,000 higher than in the first six months of 2016; (2) Other Comprehensive Income from an increase in net unrealized gains on available-for-sale securities, net of deferred income tax, of $1,318,000 as compared to Other Comprehensive Income of $4,356,000 in the first six months of 2016; and (3) Other Comprehensive Income from defined benefit plans of $100,000 as compared to Other Comprehensive Income of $10,000 in the first six months of 2016.
INCOME TAXES
The income tax provision in interim periods is based on the Corporation’s estimate of the effective tax rate expected to be applicable for the full year. The income tax provision for the first six months of 2017 was $2,358,000, or 23.8% of pre-tax earnings, slightly lower than the provision for the first six months of 2016 of $2,396,000, or 24.4% of pre-tax income. The Corporation’s effective tax rates differ from the statutory rate of 35% principally because of the effects of tax-exempt interest income.
The Corporation recognizes deferred tax assets and liabilities based on differences between the financial statement carrying amounts and the tax basis of assets and liabilities. At June 30, 2017 the net deferred tax asset was $3,942,000, down from $5,117,000 at December 31, 2016. The most significant change in temporary difference components was a net reduction of $710,000 related to unrealized gains and losses on available-for-sale securities. At June 30, 2017, the net deferred tax liability associated with the unrealized gain was $198,000, while at December 31, 2016, the deferred tax asset associated with the unrealized loss was $512,000.
The Corporation uses currently enacted tax rates to value deferred tax assets and liabilities. The Trump Administration and the U.S. Congress are in the process of evaluating possible tax changes which may include a reduction in U.S. corporate income tax rates. If corporate tax rates were reduced, management expects the Corporation would record an initial charge against earnings to lower the carrying amount of the net deferred tax asset, and then would record a lower tax provision going forward on an ongoing basis.
The Corporation regularly reviews deferred tax assets for recoverability based on history of earnings, expectations for future earnings and expected timing of reversals of temporary differences. Realization of deferred tax assets ultimately depends on the existence of sufficient taxable income, including taxable income in prior carryback years, as well as future taxable income. Further, as discussed above, realization of deferred tax assets would be impacted if income tax rates are lowered from currently enacted levels.
Management believes the recorded net deferred tax asset at June 30, 2017 is fully realizable; however, if management determines the Corporation will be unable to realize all or part of the net deferred tax asset, the Corporation would adjust the deferred tax asset, which would negatively impact earnings.
Additional information related to income taxes is presented in Note 11 to the unaudited, consolidated financial statements.
INFLATION
The Corporation is significantly affected by the Federal Reserve Board’s efforts to control inflation through changes in short-term interest rates. Since September 2007, the Federal Reserve has maintained the fed funds target rate at extremely low levels by historical standards. Further, throughout the period of low interest rates, the Federal Reserve has injected massive amounts of liquidity into the nation’s monetary system through a variety of programs. Since late 2015, the Federal Reserve has begun to move its fed funds target rate higher, in an effort to re-establish a more normalized level by historical standards, with 0.25% increases in December 2015 and 2016, March 2017 and June 2017, resulting in the current range of 1% to 1.25%. Inflation has remained subdued, measured for most of 2016 and the first half of 2017 at levels below the Federal Open Market Committee’s 2% longer run objective, though there have been some reports of wage pressure as the U.S. employment picture has gradually improved over the past several years.
Although management cannot predict future changes in the rates of inflation, management monitors the impact of economic trends, including any indicators of inflationary pressures, in managing interest rate and other financial risks.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK
Market risk is the risk of loss arising from adverse changes in market rates and prices of the Corporation’s financial instruments. In addition to the effects of interest rates, the market prices of the Corporation’s debt securities within the available-for-sale securities portfolio are affected by fluctuations in the risk premiums (amounts of spread over risk-free rates) demanded by investors. Management attempts to limit the risk that economic conditions would force the Corporation to sell securities for realized losses by maintaining a strong capital position (discussed in the “Stockholders’ Equity and Capital Adequacy” section of Management’s Discussion and Analysis) and ample sources of liquidity (discussed in the “Liquidity” section of Management’s Discussion and Analysis).
The Corporation’s major category of market risk, interest rate risk, is discussed in the following section.
INTEREST RATE RISK
Business risk arising from changes in interest rates is an inherent factor in operating a bank. A significant portion of the Corporation’s assets are long-term, fixed-rate loans and debt securities. Funding for these assets comes principally from shorter-term deposits and borrowed funds. Accordingly, there is an inherent risk of lower future earnings or decline in fair value of the Corporation’s financial instruments when interest rates change.
The Corporation uses a simulation model to calculate the potential effects of interest rate fluctuations on net interest income and the market value of portfolio equity. For purposes of these calculations, the market value of portfolio equity includes the fair values of financial instruments, such as securities, loans, deposits and borrowed funds, and the book values of nonfinancial assets and liabilities, such as premises and equipment and accrued expenses. The model measures and projects the amount of potential changes in net interest income, and calculates the discounted present value of anticipated cash flows of financial instruments, assuming an immediate increase or decrease in interest rates. Management ordinarily runs a variety of scenarios within a range of plus or minus 100-400 basis points of current rates.
The model makes estimates, at each level of interest rate change, regarding cash flows from principal repayments on loans and mortgage-backed securities and call activity on other investment securities. Actual results could vary significantly from these estimates, which could result in significant differences in the calculations of projected changes in net interest income and market value of portfolio equity. Also, the model does not make estimates related to changes in the composition of the deposit portfolio that could occur due to rate competition, and the table does not necessarily reflect changes that management would make to realign the portfolio as a result of changes in interest rates.
The Corporation’s Board of Directors has established policy guidelines for acceptable levels of interest rate risk, based on an immediate increase or decrease in interest rates. The policy limits acceptable fluctuations in net interest income from the baseline (flat rates) one-year scenario and variances in the market value of portfolio equity from the baseline values based on current rates.
Table XIII, which follows this discussion, is based on the results of calculations performed using the simulation model as of April 30, 2017 and December 31, 2016. The table shows that as of the respective dates, the changes in net interest income and changes in market value were within the policy limits in all scenarios.
TABLE XI - THE EFFECT OF HYPOTHETICAL CHANGES IN INTEREST RATES
ITEM 4. CONTROLS AND PROCEDURES
The Corporation’s management, under the supervision of and with the participation of the Corporation’s Chief Executive Officer and Chief Financial Officer, has carried out an evaluation of the design and effectiveness of the Corporation’s disclosure controls and procedures as defined in Rule 13a-15(e) and Rule 15d-15(e) of the Securities Exchange Act of 1934 as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Corporation’s disclosure controls and procedures are effective to ensure that all material information required to be disclosed in reports the Corporation files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms.
There were no significant changes in the Corporation’s internal control over financial reporting that occurred during the period covered by this report that have materially affected, or that are reasonably likely to affect, our internal control over financial reporting.
PART II – OTHER INFORMATION
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.