SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended September 30, 2011
OR
For the transition period from to
Commission File Number 0-14492
FARMERS & MERCHANTS BANCORP, INC.
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S Employer
Identification No.)
307-11 North Defiance Street, Archbold, Ohio
(Address of principal executive offices)
(419) 446-2501
Registrant’s telephone number, including area code
(Former name, former address and former fiscal year, if changed since last report.)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). x Yes ¨ No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ¨ Yes x No
Indicate the number of shares of each of the issuers classes of common stock, as of the latest practicable date:
Common Stock, No Par Value
4,691,622
FORM 10Q
INDEX
Form 10-Q Items
PART I.
FINANCIAL INFORMATION
Item 1.
Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets- September 30, 2011 and December 31, 2010
Condensed Consolidated Statements of Net Income- Three Months and Nine Months Ended September 30, 2011 and September 30, 2010
Condensed Consolidated Statements of Cash Flows- Nine Months Ended September 30, 2011 and September 30, 2010
Notes to Condensed Financial Statements
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
Qualitative and Quantitative Disclosures About Market Risk
Item 4.
Controls and Procedures
PART II.
OTHER INFORMATION
Legal Proceedings
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Removed and Reserved
Item 5.
Other Information
Item 6.
Exhibits
Signatures
Exhibit 31.
Certifications Under Section 302
Exhibit 32.
Certifications Under Section 906
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
(in thousands of dollars)
ASSETS:
Cash and due from banks
Interest bearing deposits with banks
Federal funds sold
Total cash and cash equivalents
Securities - available for sale (Note 2)
Other Securities, at cost
Loans, net (Note 4)
Bank premises and equipment
Goodwill
Mortgage Servicing Rights
Other Real Estate Owned
Accrued interest and other assets
TOTAL ASSETS
LIABILITIES AND SHAREHOLDERS’ EQUITY
LIABILITIES:
Deposits:
Noninterest bearing
Interest bearing
NOW accounts
Savings
Time
Total deposits
Federal funds purchased and securities sold under agreement to repurchase
FHLB Advances
Dividend Payable
Accrued expenses and other liabilities
Total Liabilities
SHAREHOLDERS’ EQUITY:
Common stock, no par value - authorized 6,500,000 shares; issued 5,200,000 shares
Treasury Stock - 478,663 shares 2011, 465,326 shares 2010
Unearned Stock Awards 29,715 shares 2011, 27,675 shares 2010
Retained Earnings
Accumulated other comprehensive income
Total Shareholders’ Equity
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
See Notes to Condensed Consolidated Unaudited Financial Statements.
Note: The December 31, 2010 Balance Sheet has been derived from the audited financial statements of that date.
1
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(in thousands of dollars, except per share data)
INTEREST INCOME:
Loans, including fees
Debt Securities:
U.S. Treasury securities
Securities of U.S. Government agencies
Obligations of states and political subdivisions
Dividends
Other
Total Interest Income
INTEREST EXPENSE:
Deposits
Federal Funds purchased and securities sold under agreements to repurchase
Borrowed funds
Total Interest Expense
NET INTEREST INCOME BEFORE PROVISION FOR LOAN LOSSES
PROVISION FOR LOAN LOSSES (Note 4)
NET INTEREST INCOME AFTER
PROVISION FOR LOAN LOSSES
NONINTEREST INCOME
Customer service fees
Other service charges and fees
Net gain (loss) on sale of other assets owned
Net gain on sale of loans
Net gain on sale of securities
Total Noninterest Income
NONINTEREST EXPENSE
Salaries and wages
Pension and other employee benefits
Occupancy expense (net)
Furniture and Equipment
Data processing
Franchise Taxes
FDIC Assessment
Mortgage servicing rights amortization
Other general and administrative
Total Noninterest Expense
INCOME BEFORE FEDERAL INCOME TAX
FEDERAL INCOME TAXES
NET INCOME
OTHER COMPREHENSIVE INCOME (NET OF TAX):
Unrealized gains on securities
COMPREHENSIVE INCOME
NET INCOME PER SHARE
Weighted Average Shares Outstanding
DIVIDENDS DECLARED
No disclosure of diluted earnings per share is required as shares are antidilutive as of quarter end.
2
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income
Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities:
Depreciation
Accretion and amortization of securities
Amortization of servicing rights
Amortization of core deposit intangible
Provision for loan losses
Gain on sale of loans held for sale
Originations of loans held for sale
Proceeds from sale of loans held for sale
Loss on sale of other assets
Gain on sale of investment securities
Change in Operating Assets and Liabilities, net
Net Cash Provided by Operating Activities
CASH FLOWS FROM INVESTING ACTIVITIES
Activity in securities:
Maturities, prepayments and calls
Sales
Purchases
Proceeds from sale of assets
Additions to premises and equipment
Loan originations and principal collections, net
Net Cash (Used) in Investing Activities
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase (decrease) in deposits
Net change in short-term debt
Proceeds from issuance of long-term debt
Repayments of long-term debt
Purchase of Treasury stock
Cash dividends paid on common stock
Net Cash Provided by Financing Activities
Net Increase (Decrease) in cash and cash equivalents
Cash and cash equivalents - Beginning of year
Cash and cash equivalents - End of period
RECONCILIATION OF CASH AND CASH EQUIVALENTS:
Cash and cash due from banks
Supplemental Information
Cash paid during the period for:
Interest
Income Taxes
3
NOTE 1 BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions for Form 10Q and Rule 10-01 of Regulation S-X; accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included. Operating results for the nine months ended September 30, 2011 are not necessarily indicative of the results that are expected for the year ended December 31, 2011. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2010.
NOTE 2 FAIR VALUE OF INSTRUMENTS
FAIR VALUE OF FINANCIAL INSTRUMENTS
Fair values of financial instruments are management’s estimate of the values at which the instruments could be exchanged in a transaction between willing parties. These estimates are subjective and may vary significantly from amounts that would be realized in actual transactions. In addition, other significant assets are not considered financial assets including deferred tax assets, premises, equipment and intangibles. Further, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on the fair value estimates and have not been considered in any of the elements.
The following assumptions and methods were used in estimating the fair value for financial instruments.
Cash and Cash Equivalents
The carrying amounts reported in the balance sheet for cash, cash equivalents and federal funds sold approximate their fair values. Also included in this line item are the carrying amounts of interest-bearing deposits maturing within ninety days which approximate their fair values. Fair values of other interest-bearing deposits are estimated using discounted cash flow analyses based on current rates for similar types of deposits.
Securities and Other Securities
Fair values for securities, excluding Federal Home Loan Bank stock, are based on quoted market price, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. The carrying value of Federal Home Loan Bank stock approximates fair value based on the redemption provisions of the Federal Home Loan Bank.
Loans
Most commercial, agricultural and real estate mortgage loans are made on a variable rate basis. For those variable rate loans that re-price frequently, and with no significant change in credit risk, fair values are based on carrying values.The fair values of the fixed rate and all other loans are estimated using discounted cash flow analysis. This is accomplished by using interest rates currently being offered for loans with similar terms to borrowers with similar credit quality.
The fair values disclosed for deposits with no defined maturities are equal to their carrying amounts, which represent the amount payable on demand. The carrying amounts for variable-rate, fixed term money market accounts and certificates of deposit approximate their fair value at the reporting date. Fair value for fixed-rate certificates of deposit are estimated using a discounted cash flow analysis that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.
Borrowings
Short-term borrowings are carried at cost that approximates fair value. Other long-term debt was generally valued using a discounted cash flow analysis with a discounted rate based on current incremental borrowing rates for similar types of arrangements, or if not available, based on an approach similar to that used for loans and deposits.
4
FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)
Accrued Interest Receivable and Payable
The carrying amounts of accrued interest approximate their fair values.
Dividends Payable
The carrying amounts of dividends payable approximate their fair values and are generally paid within forty days of declaration.
Off Balance Sheet Financial Instruments
Fair values for off-balance sheet, credit related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counter parties’ credit standing.
The estimated fair values, and related carrying or notional amounts, for balance sheet financial instruments as of September 30, 2011 and December 31, 2010 are reflected below.
Financial Assets:
Securities - available for sale
Other Securities
Loans, net
Accrued interest receivable
Financial Liabilities:
Short-term debt
Repurchase agreement sold
Federal Home Loan Bank advances
Accrued interest payable
Dividends payable
Fair Value Measurements
The following tables present information about the Company’s assets and liabilities measured at fair value on a recurring basis at September 30, 2011, and the valuation techniques used by the Company to determine those fair values.
In general, fair values determined by Level 1 inputs use quoted prices in active markets for identical assets or liabilities that the Company has the ability to access.
Fair values determined by Level 2 inputs use other inputs that are observable, either directly or indirectly. These Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals.
Level 3 inputs are unobservable inputs, including inputs that are available in situations where there is little, if any, market activity for the related asset or liability.
In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest level input that is significant to the valuation. The Company’s assessment of the significance of particular inputs to these fair value measurements requires judgment and considers factors specific to each asset or liability.
5
Fair Value Measurements (Continued)
Disclosures concerning assets and liabilities measured at fair value are as follows:
Assets and Liabilities Measured at Fair Value on a Recurring Basis (In Thousands)
Assets-Securities Available for Sale
U.S. Treasury
U.S. Government agency
Mortgage-backed securities
State and local governments
Total Securities Available for Sale
Liabilities
The Company did have assets measured at fair value that were categorized as Level 3 during the period. The Company’s available for sale securities includes bonds issued by local municipalities. Those municipal bonds that did not have CUSIP or credit rating numbers were treated as Level 3. Those bonds, including municipalities, that did have CUSIP numbers or have similar characteristics of those in like markets, were considered comparable and marketable and reported as Level 2.
The Company also has assets that, under certain conditions, are subject to measurement at fair value on a non-recurring basis. At September 30, 2011, such assets consist primarily of impaired loans and other real estate. The Company has established the fair values of these assets using Level 3 inputs, each individually described below.
Impaired loans categorized as Level 3 assets consist of non-homogeneous loans that are considered impaired. The Company estimates the fair value of the loans based on the present value of expected future cash flows using management’s best estimate of key assumptions. These assumptions include future payment ability, timing of payment streams, and estimated realizable values of available collateral (typically based on outside appraisals.)
Other real estate is reported at either the fair value of the real estate minus the estimated costs to sell the asset or the cost of the asset. The determination of fair value of the real estate relies primarily on appraisals from third parties. If the fair value of the real estate, minus the estimated costs to sell the asset, is less than the asset’s cost, the deficiency is recognized as a valuation allowance against the asset through a charge to expense.
Impaired loans
Other real estate owned - residential mortgages
Other real estate owned - commercial
6
Other real estate owned commercial
NOTE 3 ASSET PURCHASE
On July 9, 2010, the Bank completed its purchase of a branch office in Hicksville, Ohio from First Place Bank. Deposits of close to $28 million and loans of $14 million were included in the purchase. The new office is located within the Bank’s current market area, shortening the distance between offices in the Ohio and Indiana market area. The following table summarizes the estimated values of the assets acquired and the liabilities assumed:
Cash
Loans, Net of Discount
Accrued Interest on Loans
Premises and Equipment
Core Deposit Intangible
Other Assets
Total Assets Acquired
Accrued Interest on Deposits
Other Liabilities
Total Liabilities Assumed
Net Liabilities Assumed
In connection with the purchase, the Bank recognized an addition to core deposit intangible by $1.09 million, which is being amortized on a straight line basis over the estimated remaining economic life of the deposits of 7 years.
On December 31, 2007 the Bank acquired 100% of the outstanding shares of Knisely Bank. $1.1 million was recognized as a core deposit intangible, which is being amortized on a straight line basis over the estimated remaining economic life of the deposits of 7 years.
The estimated amortization expense for the years ended December 31, 2010, 2009 and 2008 was $235, $157 and $157 thousand respectively. Amortization of these core deposit intangibles is scheduled to be as follows:
2011
2012
2013
2014
2015
Thereafter
Total Core Deposit Intangible
7
LOANS
NOTE 4 LOANS
Loan balances as of September 30, 2011 and December 31, 2010:
Loans:
Commercial real estate
Agricultural real estate
Consumer real estate
Commercial and industrial
Agricultural
Consumer
Industrial Development Bonds
Less: Net deferred loan fees and costs
Less: Allowance for loan losses
Loans - Net
The following is a maturity schedule by major category of loans as of September 30, 2011:
Commercial Real Estate
Agricultural Real Estate
Consumer Real Estate
Commercial/Industrial
The distribution of fixed rate loans and variable rate loans by major loan category is as follows as of September 30, 2011. Variable rate loans whose current rates are equal to their floor or ceiling are classified as fixed in this table.
As of September 30, 2011 and 2010 one to four family residential mortgage loans amounting to $72.0 million and $76.5 million, respectively, have been pledged as security for loans the Bank has received from the Federal Home Loan Bank.
The percentage of delinquent loans has trended downward since the beginning of 2010 from a high of 2.85% of total loans in January to a low of .76% as of the end of March 2011. At the end of the third quarter 2011, the percentage increased to 1.73% due mainly to the addition of one large agricultural related credit during the second quarter. A credit for which the Bank is fully collateralized and should be collected yet in 2011. Consumer delinquency continued to decrease and remained low. These percentages do not include nonaccrual loans which are not past due. This level of delinquency is due in part to an adherence to sound underwriting practices over the course of time, an improvement in the financial status of companies to which the Bank extends credit, continued financial stability in the agricultural loan portfolio, and the writing down of uncollectable credits in a timely manner.
Industrial Development Bonds are included in the commercial and industrial category for the remainder of the tables in this Note 4.
8
NOTE 4 LOANS (Continued)
The following table represents the contractual aging of the recorded investment in past due loans by class or loans as of September 30, 2011 and December 31, 2010 (in thousands):
Commercial and Industrial
Total
The following table presents the recorded investment in nonaccrual loans by class or loans as of September 30, 2011 and December 31, 2010:
The Bank uses a nine tier risk rating system to grade its loans. The grade of a loan may change during the life of the loan. The risk ratings are described as follows.
9
Loans may be graded 3 when there is no recent information on which to base a current risk evaluation and the following conditions apply:
At inception, the loan was properly underwritten and did not possess an unwarranted level of credit risk:
10
The following table represents the risk category of loans by class based on the most recent analysis performed as of September 30, 2011 and December 31, 2010 (in thousands):
September 30, 2011
1-2
December 31, 2010
For consumer residential real estate, and other, the Company also evaluates credit quality based on the aging status of the loan, which was previously stated, and by payment activity. The following tables present the recorded investment in those classes based on payment activity and assigned grading as of September 30, 2011 and December 31, 2010.
Grade
Pass
Special Mention (5)
Substandard (6)
Doubtful (7)
Performing
Nonperforming
11
The Bank did classify approximately $3.5 million of its impaired loans as troubled debt restructured (TDR) during 2010 and this balance decreased to $3.2 million as of September 30, 2011 for those TDRs still current and accruing. The following table indicates the number of contracts and their corresponding balances which the Bank has classified as TDR.
Troubled Debt Restructurings
Ag Real Estate
That Subsequently Defaulted
For the majority of the Bank’s impaired loans, the Bank will apply the observable market price methodology. However, the Bank may also utilize a measurement incorporating the present value of expected future cash flows discounted at the loan’s effective rate of interest. To determine observable market price, collateral asset values securing an impaired loan are periodically evaluated. Maximum time for re-evaluation is every 12 months for chattels and titled vehicles and every two years for real estate. In this process, third party evaluations are obtained and heavily relied upon. Until such time that updated appraisals are received, the
Bank may discount the collateral value used.
The Bank uses the following guidelines as stated in policy to determine when to realize a charge-off, whether a partial or full loan balance. A charge-off in whole or in part is realized when unsecured consumer loans, credit card credits and overdraft lines of credit reach 90 days delinquency. At 120 days delinquent, secured consumer loans are charged down to the value of the collateral, if repossession of the collateral is assured and/or in the process of repossession. Consumer mortgage loan deficiencies are charged down upon the sale of the collateral or sooner upon the recognition of collateral deficiency. Commercial and agricultural credits are charged down at 120 days delinquency, unless an established and approved work-out plan is in place or litigation of the credit will likely result in recovery of the loan balance. Upon notification of bankruptcy, unsecured debt is charged off. Additional charge-off may be realized as further unsecured positions are recognized.
The following table presents loans individually evaluated for impairment by class of loans as of September 30, 2011 and December 31, 2010 (in thousands):
With no related allowance recorded:
Agriculture real estate
Agriculture
With a specific allowance recorded:
Totals:
12
The ALLL has a direct impact on the provision expense. An increase in the ALLL is funded through recoveries and provision expense. The following tables summarize the activities in the allowance for credit losses.
Allowance for Loan Losses
Balance at beginning of year
Provision for loan loss
Loans charged off
Recoveries
Allowance for Loan & Leases Losses
Allowance for Unfunded Loan Commitments & Letters of Credit
Total Allowance for Credit Losses
The Company segregates its Allowance for Loan and Lease Losses (ALLL) into two reserves: The ALLL and the Allowance for Unfunded Loan Commitments and Letters of Credit (AULC). When combined, these reserves constitute the total Allowance for Credit Losses (ACL).
The AULC is reported within other liabilities on the balance sheet while the ALLL is netted within the loans, net asset line. The ACL presented above represents the full amount of reserves available to absorb possible credit losses. The next table breaks down the activity within ALLL for each loan portfolio segment and shows the contribution provided by both the recoveries and the provision along with the reduction of the allowance caused by charge-offs.
13
Additional analysis related to the allowance for credit losses as of September 30, 2011 and December 31, 2010 is as follows (in thousands):
ALLOWANCE FOR CREDIT LOSSES:
Beginning balance
Charge Offs
Provision
Other Non-interest expense related to unfunded
Ending Balance
Ending balance: individually evaluated for impairment
Ending balance: collectively evaluated for impairment
Ending balance: loans acquired with deteriorated credit quality
FINANCING RECEIVABLES:
Ending balance
14
INTRODUCTION
Farmers & Merchants Bancorp, Inc. (the “Company”) was incorporated on February 25, 1985, under the laws of the State of Ohio. Farmers & Merchants Bancorp, Inc., and its subsidiary The Farmers & Merchants State Bank (the “Bank”) are engaged in commercial banking. The executive offices of the Company are located at 307 North Defiance Street, Archbold 43502.
The Farmers & Merchants State Bank engages in general commercial banking and savings business. Their activities include commercial, agricultural and residential mortgage, consumer and credit card lending activities. Because the Bank’s offices are located in Northwest Ohio and Northeast Indiana, a substantial amount of the loan portfolio is comprised of loans made to customers in the farming industry for such things as farm land, farm equipment, livestock and general operation loans for seed, fertilizer, and feed. Other types of lending activities include loans for home improvements, and loans for such items as autos, trucks, recreational vehicles, motorcycles, etc.
The Bank’s underwriting policies exercised through established procedures facilitates operating in a safe and sound manner in accordance with supervisory and regulatory guidance. Within this sphere of safety and soundness, the Bank’s practice has been not to promote innovative, unproven credit products which will not be in the best interest of the Bank or its customers. The Bank does offer a hybrid mortgage loan. Hybrid loans are loans that start out as a fixed rate mortgage but after a set number of years they automatically adjust to an adjustable rate mortgage. The Bank offers a three year fixed rate mortgage after which the interest rate will adjust annually. The majority of the Bank’s adjustable rate mortgages are of this type. In order to offer longer term fixed rate mortgages, the Bank does participate in the Freddie Mac, Farmer Mac and Small Business Lending programs. The Bank does also retain the servicing on these partially or 100% sold loans. In order for the customer to participate in these programs they must meet the requirements established by these agencies.
The Bank does not fund sub-prime loans. Sub-prime loans are characterized as a lending program or strategy that target borrowers who pose a significantly higher risk of default than traditional retail banking customers.
Following are the characteristics and underwriting criteria for each major type of loan the Bank offers:
Commercial Real Estate –Construction, purchase, and refinance of business purpose real estate. Risks include loan amount in relation to construction delays and overruns, vacancies, collateral value subject to market value fluctuations, interest rate, market demands, borrower’s ability to repay in orderly fashion, and others. The Bank does employ stress testing on higher balance loans to mitigate risk by ensuring the customer’s ability to repay in a changing rate environment before granting loan approval.
Agricultural Real Estate – Purchase of farm real estate or for permanent improvements to the farm real estate. Cash flow from the farm operation is the repayment source and is therefore subject to the financial success of the farm operation.
Consumer Real Estate – Purchase, refinance, or equity financing of one to four family owner occupied dwelling. Success in repayment is subject to borrower’s income, debt level, character in fulfilling payment obligations, employment, and others.
Commercial/Industrial – Loans to proprietorships, partnerships, or corporations to provide temporary working capital and seasonal loans as well as long term loans for capital asset acquisition. Risks include adequacy of cash flow, reasonableness of profit projections, financial leverage, economic trends, management ability, and others. The Bank does employ stress testing on higher balance loans to mitigate risk by ensuring the customer’s ability to repay in a changing rate environment before granting loan approval.
Agricultural – Loans for the production and housing of crops, fruits, vegetables, and livestock or to fund the purchase or re-finance of capital assets such as machinery and equipment, and livestock. The production of crops and livestock is especially vulnerable to commodity prices and weather. The vulnerability to commodity prices is offset by the farmers ability to hedge their position by using the future contracts. The risk related to weather is often mitigated by requiring federal crop insurance.
Consumer – Funding for individual and family purposes. Success in repayment is subject to borrower’s income, debt level, character in fulfilling payment obligations, employment, and others.
Industrial Development Bonds – Funds for public improvements in the Bank’s service area. Repayment ability is based on the continuance of the taxation revenue as the source of repayment.
All loan requests are reviewed as to credit worthiness and are subject to the Bank’s underwriting guidelines as to secured versus unsecured credit. Secured loans are in turn subject to loan to value (LTV) requirements based on collateral types as set forth in the Bank’s Loan Policy. In addition, credit scores of principal borrowers are reviewed and an approved exception from an additional officer is required should a credit score not meet the Bank’s Loan Policy guidelines.
15
INTRODUCTION (Continued)
Consumer Loans:
Maximum loan to value (LTV) for cars, trucks and light trucks vary from 90% to 110% depending on whether direct or indirect.
Loans above 100% are generally due to additional charges for extended warranties and/or insurance coverage periods of lost wages or death.
Boats, campers, motorcycles, RV’s and Motor Coaches range from 80%-90% based on age of vehicle.
1st or 2nd mortgages on 1-4 family homes range from 75%-90% with “in-house” first real estate mortgages requiring private mortgage insurance on those exceeding 80% LTV.
Raw land LTV maximum ranges from 65%-75% depending on whether or not the property has been improved.
Risks are mitigated through an adherence to Loan Policy with exceptions being recorded and approved by Senior Management or committees comprised of Senior Management. Loan Policy defines parameters to essential underwriting guidelines such as loan-to-value ratio, cash flow and debt-to-income ratio, loan requirements and covenants, financial information tracking, collection practice and others. Limitation to any one borrower is defined by the Bank’s legal lending limits and is stated in policy. On a broader basis, the Bank restricts total aggregate funding in comparison to Bank capital to any one business and agricultural sector by an approved sector percentage to capital limitation.
The Bank also provides checking account services, as well as savings and time deposit services such as certificates of deposits. In addition ATM’s (automated teller machines) are provided at most branch locations along with other independent locations such as major employers and hospitals in the market area. The Bank has custodial services for IRA’s (Individual Retirement Accounts) and HSA’s (Health Savings Accounts).
F&M Investment Services, the brokerage department of the Bank, opened for business in April, 1999. Securities are offered through Raymond James Financial Services Inc.
The Bank’s primary market includes communities located in the Ohio counties of Defiance, Fulton, Henry, Williams and Wood and in the Indiana counties of DeKalb and Steuben. The commercial banking business in this market are highly competitive with approximately 17 other depository institutions doing business in the Bank’s primary market. The Bank competes directly with other commercial banks, credit unions and farm credit services and savings and loan institutions in each of their operating localities. In a number of locations, the Bank competes against institutions which are much larger.
The Company’s common stock is not listed on any exchange or the NASDAQ Stock Market. The stock is currently quoted in over-the-counter markets.
16
2011 IN REVIEW
The impact of new legislation, such as Health Care and Dodd-Frank Financial Reform (collectively, “Financial Reform legislation”), weighs heavily on the minds of bankers along with their customers during its implementation. Legislation has impacted the collection of fees as related to discretionary overdraft protection during the first half of 2011. A carve out of limited regulation for banks under $10 billion in assets as it relates to debit interchange fees may help to maintain the debit card program through the remainder of 2011. However, the primary concerns at this point are the impact on future revenues and expenses and how quickly it will be felt should the carve out provide only short term relief.
Short-term rates remain low and are expected to remain low throughout 2011. This has enabled the Company to continue to sell investment securities and recognize a gain without compromising the yield while modestly increasing the duration of the investment portfolio. As of September 30, 2010, the favorable gain produced from the sale of securities was $956 thousand. Most of the securities sold were agencies maturing in a shorter time period than the securities that were purchased to replace them. As of September 30, 2011, the favorable gain was at $504 thousand and the securities sold were out of state municipals and agencies. The Bank was able to continue to capitalize on the steepness of the yield curve throughout 2011.
During the first quarter of 2011, the Bank received a payoff on a large nonaccrual loan. The collection of which included over $600 thousand of interest and a reimbursement of over $300 thousand in legal fees. The collection process took almost three years to complete. This boost to income is evident throughout from net interest margin, improved asset quality to lower non-interest expense for the quarter. It also offsets tightening margins due to soft loan demand and high liquidity caused from higher deposit growth. As was expected, the second and third quarter numbers, as they relate to interest earnings, were lower in yield than first quarter without an additional large influx of nonaccrual interest collection. However, the Bank was able to realize improvement in a lower loan provision requirement. In comparing to a year ago, provision expense was $3.35 million lower for nine months and $1.1 million lower in comparing third quarter 2011 performance to third quarter 2010. This contributed to ROA and ROE remaining higher than a year ago. Unfortunately, another large large agricultural credit was placed in collection and on non-accrual during the second quarter. While the Bank expects to collect all principal, fees and interest owed on this credit, this has again impacted the short term performance. Unlike the previous mentioned credit collection, the collection of this credit should occur within the current year and not extend over a three year process.
A large amount of write-downs and losses on the sale of other real estate owned (ORE) hampered 2011 as compared to the same time period 2010. The balance at $3.9 million is almost $1.3 million higher as of September 30, 2011 compared to September 30, 2010. While September 30, 2010 recognized $31.7 thousand in losses from sales of ORE, as of September 30, 2011, the Bank has recognized $1.0 million in a compilation of write -downs and losses on ORE. This impact is evident in the lower non-interest income for both the third quarter and year-to-date financials of 2011.
The Bank’s local service area has experienced a very slight improvement in employment rates from mid year 2010 through current 2011. The improvement is not considered significant at this time as unemployment remains close to, if not in, double digits in most of the Company’s market areas. The majority of the Bank’s commercial borrowers have experienced slight improvement, although a few still lag. As the economic recovery remains fragile and consumer confidence remains at lower levels, consumer sensitive industries and the retail sector may continue to experience pressures as well.
On July 9, 2010, the Bank completed its purchase of a branch office in Hicksville, Ohio from First Place Bank, a savings association with its main office in Warren, OH. Deposits of close to $28 million and loans of $14 million were included in the purchase. The new office is located within the Bank’s current market area, shortening the distance between offices in the Ohio and Indiana market area. The transaction has been accretive to earnings during its first year of operation.
The Company remains strong, stable and well capitalized and has the capacity to continue to cover the increased costs of doing business in a tough economy and is seeking good loans to improve profitability.
CRITICAL ACCOUNTING POLICY AND ESTIMATES
The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, and the Company follows general practices within the industries in which it operates. At times the application of these principles requires Management to make assumptions, estimates and judgments that affect the amounts reported in the financial statements. These assumptions, estimates and judgments are based on information available as of the date of the financial statements. As this information changes, the financial statements could reflect different assumptions, estimates and judgments. Certain policies inherently have a greater reliance on assumptions, estimates and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Examples of critical assumptions, estimates and judgments are when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not required to be recorded at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability must be recorded contingent upon a future event.
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CRITICAL ACCOUNTING POLICY AND ESTIMATES (Continued)
Based on the valuation techniques used and the sensitivity of financial statement amounts to assumptions, estimates, and judgments underlying those amounts, management has identified the determination of the Allowance for Loan and Lease Losses (ALLL) and the valuation of its Mortgage Servicing Rights and Other Real Estate Owned (OREO) as the accounting areas that requires the most subjective or complex judgments, and as such have the highest possibility of being subject to revision as new information becomes available.
The ALLL represents management’s estimate of credit losses inherent in the Bank’s loan portfolio at the report date. The estimate is a composite of a variety of factors including past experience, collateral value and the general economy. ALLL includes a specific portion, a formula driven portion, and a general nonspecific portion.
The Bank’s ALLL methodology captures trends in leading, current, and lagging indicators which will have a direct affect on the Bank’s allocation amount. Trends in such leading indicators as delinquency, unemployment, changes in the Bank’s service area, experience and ability of staff, regulatory trends, and credit concentrations are referenced. A current indicator such as the total Watch List loan amount to Capital, and a lagging indicator such as the charge off amount are referenced as well. A matrix is formed by loan type from these indicators that is responsive in making ALLL adjustments.
Servicing assets are recognized as separate assets when rights are acquired through purchase or through sale of financial assets. Capitalized servicing rights are reported in other assets and are amortized into noninterest expense in proportion to, and over the period of, the estimated future servicing income of the underlying financial assets. Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to the amortized cost. Impairment is deter- mined using prices for similar assets with similar characteristics, when available, or based upon discounted cash flows using market based assumptions. Impairment is recognized through a valuation allowance for an individual stratum, to the extent that fair value is less than the capitalized amount for the stratum. Fees received for servicing loans owned by investors are based on a percentage of the outstanding monthly principal balance of such loans and are included in operating income as loan payments are received. Costs of servicing loans are charged to expense as incurred. The Bank utilizes a third party vendor to estimate the fair value of their mortgage servicing rights which utilizes national prepayment speeds in its calculations.
MATERIAL CHANGES IN FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
In comparing the balance sheet of September 30, 2011 to that of December 31, 2010, the liquidity of the Bank has increased by approximately $24 million and remains strong with additional funds being moved from short-term Bank deposits and Federal Funds sold to a higher yielding security portfolio. The Bank has taken advantage of the Federal Reserve paying interest on its checking account and also placed funds in term deposits at a correspondent bank. The Bank also expects to receive additional payoffs from a few larger loans that along with security sales may be used to fund new loan growth.
Overall, cash and cash equivalents decreased almost $5 million and securities increased $29 million over yearend 2010. The Company’s increased liquidity came from a decrease of almost $21.5 million in the Bank’s loan portfolio due to regular payments, paydowns on line usage, payoffs and charge offs. An additional correspondent bank relationship was formed giving the Bank access to another $18 million of unsecured borrowing capacity bringing the total access to $45 million of unsecured borrowings through correspondent banks and over $116.6 million of unpledged securities which may be sold or used as collateral. During the third quarter, $41 thousand of Federal Home Loan Bank stock was redeemed. This stock was acquired in the Knisely acquisition and was already scheduled for redemption. The strength of the security portfolio is shown in the tables to follow. With the exception of stock, all of the Bank’s security portfolio is categorized as available for sale and as such is recorded at market value. The charts which follow do not include stock.
Investment securities will at times depreciate to an unrealized loss position. The Bank utilizes the following criteria to assess whether or not an impaired security is other than temporary. No one item by itself will necessarily signal that a security should be recognized as other than temporary impairment.
If the impairment is judged to be other than temporary, the cost basis of the individual security shall be written down to fair value, thereby establishing a new cost basis. The amount of the write down shall be included in earnings as a realized loss. The new cost basis shall not be changed for subsequent recoveries in fair value. The recovery in fair value shall be recognized in earnings when the security is sold. The first table is presented by category of security and length of time in a
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MATERIAL CHANGES IN FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES (Continued)
continuous loss position. Municipalities may be more likely to be in a loss position greater than 12 months due to their length to maturity and are not indicative of an issue with safety and soundness of the municipality. The Bank currently does not hold any securities with other than temporary impairment.
The following chart shows the breakdown of the unrealized gain or loss associated within each category of the investment portfolio as of September 30, 2011.
Available-for-Sale:
The following table shows the maturity schedule of the security portfolio with the largest portion due within less than 5 years. Management feels confident that loan growth can easily be funded from an orderly runoff of the investment portfolio.
One year or less
After one year through five years
After five years through ten years
After ten years
Subtotal
Mortgage Backed Securities
As previously stated, net loans show a decrease of $21.5 million for the nine months ended September 30, 2011. $2.4 million was charged-off during the nine month period indicating the decrease was not all due to having been charged-off. The balance of the decrease in loans was due to the payoff or refinancing of troubled loans. The loan watch list increased slightly, which included $5 million in new loans added to the list and a reduction of existing watch list loans of nearly the same amount. The $5 million added to the watch list was represented by mainly one relationship of which full payment is expected to be received in fourth quarter 2011.
The chart below shows the breakdown of the loan portfolio by category less deferred loan fees and costs as of September 30 for the last three years.
Consumer, Overdrafts and other loans
Total Loans
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All categories of loans experienced a decrease in balances over the time periods shown.
Overall, total assets of the Company increased $1.4 million from December 31, 2010 to September 30, 2011.
Deposits decreased $4.9 million in total from December 31, 2010. The mix of the portfolio continued to transition to a higher level of core deposits as a result primarily of the Bank’s offering of a high interest bearing transaction account along with an increase in health savings accounts. The success of this product is also the reason for the continued movement of deposits out of Certificates of Deposit to interest bearing transaction accounts. In 2010, the Bank strengthened its line of deposit products by adding additional products which added additional options to its already highly successful Reward Checking, which was renamed KASASA Cash. The additional options include KASASA Saver, KASASA Giver and KASASA ITunes. KASASA Saver, whose product utilizes a higher yielding rate than the Bank’s regular saving account, is the reason behind the retention of dollars in savings. These continue to be the deposit of choice and attract not only new money from existing customers but new customers to the Bank.
The Certificate of Deposit (COD) portfolio has decreased $21.3 million during the first nine months of 2011 which is helping to decrease the cost of funds, as demonstrated below in the section of this MD&A captioned “MATERIAL CHANGES IN RESULTS OF OPERATION - Interest Expense”.
The Bank paid off $8.2 million in FHLB advances which had matured during 2011 and securities sold under agreement to repurchase increased almost $2.0 million during the first nine months of 2011 as compared to yearend.
Capital increased approximately $9.3 million from year-end during the nine months of 2011. Positive earnings and a large increase in accumulated other comprehensive income are the factors behind the increase. Comprehensive income increased $6.4 million even with the shift of $504 thousand from unrealized gain to realized gain with the sale of securities. Dividends paid increased 4.7% during the period as compared to first nine months of 2010.
The Company continues to be well-capitalized in accordance with Federal regulatory capital requirements as the capital ratios below show:
Primary Ratio
Tier I Leverage Ratio
Risk Based Capital Tier I
Total Risk Based Capital
Stockholders’ Equity/Total Assets
MATERIAL CHANGES IN RESULTS OF OPERATIONS
Interest Income
Annualized interest income and yield on earning assets is down in 2011 as compared to September 30, 2010. While total assets were only slightly higher than yearend, the decrease in interest income resulted primarily from the transition of the Company’s earning assets from high yield to lower yield assets. As the table that follows confirms, the shift of funds within the interest earning portfolios of loans to investments caused a lower yield thereby causing lower interest income. The increased volume in the security portfolio, however, did not offset the loss in interest income due to rate changes. Nor was the spread between cash and investments as large as the spread between loans and investments. The portfolio was also impacted by calls due to the low rate environment.
The Bank worked to minimize the impact of the low rate environment on its loan portfolio with the use of floors on renewed and new loans. 2011 loan yield was positively impacted by the collection of nonaccrual interest and adjustments to the Farmer Mac portfolio, which is a loan participation program that generated additional interest income in first quarter 2010. To protect the yield, the Bank is working to add spread to the margin on the variable rate loans so that when prime does adjust up, the Bank’s rate also adjusts up over the floor. Overall, interest income from loans was down $2.6 million in comparing the nine months ended September 30, 2011 to same period for 2010 and due to the decrease in balances and lower interest rates.
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MATERIAL CHANGES IN RESULTS OF OPERATIONS (Continued)
Interest income and yield on the securities portfolio were down as agency notes continued to be called due to the low interest rate environment. Period ending balances are deceiving as compared to the interest earnings due to the shift of holdings from the sales, calls and maturity and the replacement securities. The average balances in the table are more useful to see the impact of those activities.
Total interest income was down almost $2.9 million, of which $2.6 million was from loans, in comparing the first nine months of 2011 to the first nine months of 2010. Loans were the largest asset that decreased in volume which emphasizes the importance of growing loans as it is the highest yielding earning asset. The overall asset yield also decreased 62 basis points between the two periods which was consistent with last quarter’s comparison.
Interest Earning Assets:
Taxable Investment Securities
Tax-exempt Investment Securities
Fed Funds Sold & Interest Bearing Deposits
Total Interest Earning Assets
Change in September 30, 2011 Interest Income Compared to September 30, 2010 (In Thousands)
The yields on tax-exempt securities and the portion of tax-exempt IDB loans included in loans have been tax adjusted based on a 34% tax rate in the charts above.
Interest Expense
Interest expense continued to be lower than the comparable nine months from 2010. Interest expense related to deposits was down $1.7 million while the average interest-bearing deposit balance increased by $32.8 million in comparing the balances of each first nine months. Approximately $28 million of the growth came through the purchase of the Hicksville office. Time deposits continue to reprice down and the Bank continues to try and lengthen the duration of the portfolio with specials offered in terms longer than 12 months. However, depositors continue to place more funds in shorter term deposits or move elsewhere. KASASA Cash and Saver helped to increase the savings deposit balances as seen in the increase due to volume.
Interest on borrowed funds was $432 thousand lower for the nine month periods ended September 30, 2011 and 2010. Additional borrowings from Federal Home Loan Bank in the amount of $9 million were taken in the first quarter of 2010, and $13 million of higher priced advances matured the remaining quarters of 2010. In third quarter 2011, $5 million of borrowings were paid off. Thus the largest decrease in cost of funds for other borrowed money was due to the decreased volume which also impacted the rate of the remaining borrowings portfolio. Fed Funds Purchased and Securities Sold under Agreement to Repurchase was higher in 2011 than 2010 mainly through an increase in balances.
The decrease in interest expense did not outpace the decrease in interest income as it did last year and remains a focus for improvement in 2011. Asset yield decreased 62 basis points while cost of funds decreased 44 basis points. The main focus is to increase asset yield by using excess cash and investments to fund loan growth.
Interest Bearing Liabilities:
Savings Deposits
Other Time Deposits
Other Borrowed Money
Fed Funds Purchased & Securities Sold under Agreement to Repurch.
Total Interest Bearing Liabilities
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Interest Expense (Continued)
Change in September 30, 2011 Interest Expense Compared to September 30, 2010 (In Thousands)
Fed Funds Purchased & Securities
Sold under Agreement to Repurch.
Net Interest Income
Net interest income is lower in three and nine month comparisons, reversing the positive position of the first quarter’s comparison. This comes as no surprise as the first quarter 2011 was boosted by the collection of $600 thousand of nonaccrual interest income and the second quarter 2011 had an increase in the nonaccrual loan balances of almost $5 million without collection of a significant amount of interest. (Accrued interest is reversed when a loan is placed into nonaccrual status.)
Net interest income, in comparison to 2010, should increase by yearend as the Bank continues to work to increase interest income by reducing the amount of nonaccrual loans, fully expecting to collect on the additional $5 million that was placed into nonaccrual during the second quarter and attempting to add spread on renewing loans. Interest expense on time deposits should also continue to show a decrease until depositors begin to transition back into longer-term deposits. If and when rates begin to rise, the challenge will be to delay the pricing up of deposits.
Provision Expense
Provision for loan loss was almost $3.4 million lower for the nine months ended September 30, 2011 as compared to the same 2010 period. The decrease in the average balance in nonaccrual loans, along with improving asset quality and low loan growth warranted the lower provision to the loan loss reserve. The balance in nonaccrual loans decreased $5.3 million as of September 30, 2011 as compared to the balances as of September 30, 2010. The overall loan portfolio was also $41.4 million lower as of September 2011 compared to September 30, 2010. The Bank continues to focus on the commercial and commercial real estate portfolios for both asset quality and growth. As charts below will show for 2011, a large portion of the current provision was also to replace the reserve balance depleted from net charge-offs during the period. The longer the economy struggles, the more likely additional credits may encounter cash flow problems and the Bank remains diligent in providing funds to offset future losses.
The Bank uses the following guidelines as stated in policy to determine when to realize a charge-off, whether a partial or full loan balance. A charge down in whole or in part is realized when unsecured consumer loans, credit card credits and overdraft lines of credit reach 90 days delinquency. At 120 days delinquent, secured consumer loans are charged down to the value of the collateral, if repossession of the collateral is assured and/or in the process of repossession. Consumer mortgage loan deficiencies are charged down upon the sale of the collateral or sooner upon the recognition of collateral deficiency. Commercial and agricultural credits are charged down at 120 days delinquency, unless an established and approved work-out plan is in place or litigation of the credit will likely result in recovery of the loan balance. Upon notification of bankruptcy, unsecured debt is charged off. Additional charge-off may be realized as further unsecured positions are recognized.
Looking at the balance in impaired loans, it shows the Bank has recognized an increase in the overall balance of impaired loans when looking at December 2010 compared to September 2011. However, two positive factors can also been seen: A decrease in the current average balance during 2011 and a decrease in the impaired loans with a valuation allowance balance. These are due mainly to the collection of principal from the sale of collateral from one borrower and the remainder from charge-off activity within this classification of loans.
An increase in the impaired loans without a valuation allowance relates to one relationship of approximately $5 million which the Bank expects to be fully collectible based on collateral valuation.
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Provision Expense (Continued)
The following table tracks the change in impaired loans and their valuation allowance along with nonaccrual balances as of September 30, 2011 and December 31, 2010 upon which the previous comments were made.
Impaired loans without a valuation allowance
Impaired loans with a valuation allowance
Total impaired loans
Valuation allowance related to impaired loans
Total non-accrual loans
Total loans past-due ninety days or more and still accruing
Average investment in impaired loans
The Bank did classify almost $3.2 million of its current and accruing loans as troubled debt restructured during the third quarter of 2011, down from $3.5 million at December 31, 2010.
In determining the allocation for impaired loans the Bank applies the observable market price of the collateral securing the asset, reduced by applying a discount for estimated costs of collateral liquidation. In some instances where the discounted market value is less than the loan amount, a specific impairment allocation is assigned, which may be reduced or eliminated by the write down of the credit’s active principal outstanding balance.
For the majority of the Bank’s impaired loans, the Bank will apply the observable market price methodology. However, the Bank may also utilize a measurement incorporating the present value of expected future cash flows discounted at the loan’s effective rate of interest. To determine observable market price, collateral asset values securing an impaired loan are periodically evaluated. Maximum time of re-evaluation is every 12 months for chattels and titled vehicles and every two years for real estate. In this process, third party evaluations are obtained and heavily relied upon. Until such time that updated appraisals are received, the Bank may discount the collateral value used.
The ALLL has a direct impact on the provision expense. The increase in the ALLL is funded through recoveries and provision expense. The following tables both deal with the allowance for credit losses. The first table breaks down the activity within ALLL for each loan portfolio segment and shows the contribution provided by both the recoveries and the provision along with the reduction of the allowance caused by charge-offs. The second table discloses how much of ALLL is attributed to each segment of the loan portfolio, as well as the percent that each particular segment of the loan portfolio represents to the entire loan portfolio in the aggregate. As was mentioned in previous discussion, the commercial and commercial real estate portfolios are having a major impact on the ALLL and the provision expense.
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Daily average of outstanding loans
Allowance for Loan Losses - Jan 1
Loans Charged off:
Consumer & other loans
Loan Recoveries
Net Charge Offs
Acquisition provision for loan loss
Allowance for Loan & Lease Losses - September 30
Allowance for Unfunded Loan Commitments & Letters of Credit September 30
Total Allowance for Credit Losses - September 30
Ratio of net charge-offs to average Loans outstanding
Ratio of Allowance for Loan Loss to Nonperforming Loans
Balance at End of Period Applicable To:
Unallocated
Allowance for Loan & Lease Losses
Off Balance Sheet Commitments
The percentage of delinquent loans has trended downward since the beginning of 2010 from a high of 2.85% of total loans in January to 1.73% as of the end of September 2011. These percentages do not include nonaccrual loans which are not past due. This level of delinquency is due in part to an adherence to sound underwriting practices over the course of time, an improvement in the financial status of companies to which the Bank extends credit, continued financial stability in the agricultural loan portfolio, and the writing down of uncollectable credits in a timely manner.
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Non-interest Income
Non-interest income was lower for the nine months ended September 30, 2011 as compared to same period in September 30, 2010. 2011 has been hurt from the loss on other assets owned of $1.0 million. This has come from not only sales but from write-downs to the Bank’s ORE as new appraisals have been obtained. While both years show this line item in a loss position, 2011 is higher by $968 thousand. The total $1.0 million in the line item is made up of loss on sale of ORE and loss on sale or disposal of fixed assets. Somewhat offsetting this loss is the gain on sale of securities, $504 thousand so far in 2011 and $956 thousand for the nine month period ended September 30, 2010.
Improvement in non-interest income was reached in other service charges and fees. The increase in the checking and savings portfolios in terms of number of accounts in 2011 as compared to 2010 has been the main factor behind the additional collection of fees. With implementation of Regulation E on 8/15/2010, the increase in the number of accounts was not enough to offset the regulation changes and year-to-date overdraft fee income is $48 thousand lower than during the same period last year. Increases came from debit card usage which is currently under regulatory scrutiny and has been impacted by a heavier volume of fraudulent activity on these cards in the second and third quarter of 2011. This revenue stream is very important to the Bank and its ability to offer ‘free’ checking accounts to our customers. Overall, non- interest income decreased and ended $1.5 million lower for the first nine months of operations in 2011 as compared to 2010.
The impact of mortgage servicing rights, both to income and expense, is shown in the following table which reconciles the value of mortgage servicing rights which is reported as an “other asset” on the balance sheet. The capitalization runs through non-interest income while the amortization thereof is included in non-interest expense. A slight impairment in the valuation of the seven and ten year segment occurred in third quarter 2011.
Beginning Balance, January 1
Capitalized Additions
Amortizations
Valuation Allowance
Ending Balance, September 30
Of concern for the remainder of the year is the impact of recently amended Federal Reserve Regulation E on overdraft revenue and the cost of compliance. Regulation E continues to be modified and costs are being incurred that reduce revenue. At this point in time, the Bank is also concerned with changes to interchange fees and the potential loss of revenue.
As long as the opportunity exists for gains to be recognized from the sale of securities without impacting yield and extending the maturity duration too long, the Bank will continue to take advantage of it. This provides an opportunity for the Bank to offset the loss of noninterest income. The gain booked in 2010 was based on security sales of $28.3 million while 2011’s gain was based on security sales of $30.4 million. There were not any securities sold at a loss in either period.
The movement of income from comprehensive income to realized gain on sale of securities is disclosed in the table to follow. Since the Bank classifies its entire investment portfolio, with the exception of stock, as available for sale, the majority of any gain/loss on the sale is a direct shift of funds from unrealized gain to realized gain. Since the purchase of additional or replacement securities occurs at the same time, those new securities immediately impact the other comprehensive income. Also impacting the comprehensive income is the movement of the market rates in general and its impact on the overall portfolio.
Net Unrealized gain on available-for-sale securities
Reclassification adjustment for gain on sale of available-for-sale securities
Net unrealized gains
Tax Effect
Other comprehensive income
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Non-Interest Expense
Non-interest expense for the quarter ended September 30, 2011 was only $25 thousand higher than for the same period of 2010. Salaries and wages were higher by $193 thousand during the quarter which was expected with the addition of the Hicksville office and the improved performance of the Company as a whole over 2010 and the likelihood of paying an incentive. Base pay was lower in 2011 than 2010.
Other general and administrative was lower during the quarter bringing the year-to-date comparison also lower. Driving this line item was a reduction in loan collection expenses from legal fees to past due real estate fees as properties were moved and/or held in ORE. With respect to FDIC assessments, the expense is still large in 2011, though changes to the assessment calculation decreased starting with second quarter 2011 making the second quarter lower by $150 thousand and third quarter lower by $95 thousand. FDIC expense was approximately $179 thousand lower year-to-date than 2010. Continuing on the positive side, a smaller decrease of $36 thousand in comparing September 30, 2011 to September 30, 2010 was derived from a change in service bureaus for the Bank’s core operating system in first quarter 2010. The improvement continued even with the addition of the new branch office in July 2010 and an increasing customer base.
Occupancy expense was higher by $412 thousand in the nine months comparison of 2011 to 2010. The increase is partly attributed to the increase in the number of offices. Overall, non-interest expense was $25 thousand higher in the third quarter comparison but $45 thousand lower in the year-to-date comparison of 2011 to 2010. First quarter 2011 did include a reimbursement of $300 thousand in loan collection fees.
Net Income
Overall, net income was up $833 thousand for the nine months ended September 30, 2011, compared to the same period of 2010. The improvement in asset quality that has occurred over the last half of 2010 and the first nine months of 2011 along with lower loan balances enabled the Company to have $3.4 million less in provision expense in 2011 as compared to 2010. This coupled with the collection of nonaccrual interest income and reimbursement of collection costs offset the increased cost of ORE write-downs and losses. The gain on sale of investments obviously plays a role in the improvement and the Company is fortunate that the opportunity existed to capture income that has been used to offset the provision expense of the last two years. The decrease in net interest income for the quarter is proof of the importance of the effect of balance sheet mix as the decreased loan balances impacts overall asset yield. The movement of the one large credit to nonaccrual has impacted the second and third quarter but should be fully collected during the fourth.
The Company remains positioned for continued improvement in the net interest margin while rates remain low, if loan demand would increase. It will be a challenge to maintain the margin once short term rates begin to rise. However, the Bank remains focused on improving the asset yield through improved asset quality and added spread to prime on variable loans. As an industry, the Company is also limited from achieving higher profitability by the cost of increased regulatory requirements such as Regulation E, Dodd-Frank Wall Street Reform and Consumer Protection Act and any other additional regulations that may be enacted during 2011 and their corresponding cost of compliance. The Company will continue to seek to enhance existing products and services to increase revenue, improve efficiency and increase customer satisfaction.
FORWARD LOOKING STATEMENTS
Statements contained in this portion of the Company’s report may be forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements may be identified by the use of words such as “intend,” “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” and “potential.” Such forward-looking statements are based on current expectations, but may differ materially from those currently anticipated due to a number of factors, which include, but are not limited to, factors discussed in documents filed by the Company with the Securities and Exchange Commission from time to time. Other factors which could have a material adverse effect on the operations of the company and its subsidiaries which include, but are not limited to, changes in interest rates, general economic conditions, legislative and regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality and composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Bank’s market area, changes in relevant accounting principles and guidelines and other factors over which management has no control. The forward-looking statements are made as of the date of this report, and the Company assumes no obligation to update the forward-looking statements or to update the reasons why actual results differ from those projected in the forward-looking statements.
Market risk is the exposure to loss resulting from changes in interest rates and equity prices. The primary market risk to which the Company is subject to is interest rate risk. The majority of the Company’s interest rate risk arises from the instruments, positions and transactions entered into for purposes, other than trading, such as lending, investing and securing sources of funds. Interest rate risk occurs when interest bearing assets and liabilities reprice at different times as market interest rates change. For example, if fixed rate assets are funded with variable rate debt, the spread between asset and liability rates will decline or turn negative if rates increase.
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Interest rate risk is managed within an overall asset/liability framework for the Company. The principal objectives of asset/liability management are to manage sensitivity of net interest spreads and net income to potential changes in interest rates. Funding positions are kept within predetermined limits designed to ensure that risk-taking is not excessive and that liquidity is properly managed.
The Company employs a sensitivity analysis in the form of a net interest rate shock as shown in the following table.
Net Interest
Margin (Ratio)
2.86%
2.92%
2.99%
3.06%
3.02%
2.89%
2.71%
The net interest margin represents the forecasted twelve month margin. It also shows what effect rate changes will have on both the margin and the net interest income. The goal of the Company is to lengthen some of the liabilities or sources of funds to decrease the exposure to a rising rate environment. The Bank has offered higher rates on certificates of deposits for longer periods during 2010 and so far in 2011. Of course, customer desires also drive the ability to capture longer term deposits. Currently, the customer looks for terms twelve months and under while the Bank would prefer 24 months and longer. It is often a meeting in the middle that satisfies both.
The Bank continues to remain focused on gaining more relationships per customer as a way to help control the cost of funds also. In the flat and rising rate environment scenario, the model cannot take into account the addition of floors and increased spread on the loan accounts. These are added as the note is renewed and cannot be captured until then. To the extent the Bank is successful in this endeavor, the flat and rising rate scenario will be less costly than forecasted here.
Overall, what the chart shows is that the Company cannot remain stagnant in its choices. Changes in portfolio and/or balance sheet composition are needed for the margin to improve regardless of any rate shock.
As of September 30, 2011, an evaluation was performed under the supervision and with the participation of the Company’s management including the CEO and CFO, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on that evaluation, the Company’s management, including the CEO and CFO, concluded that the Company’s disclosure controls and procedures were effective as of September 30, 2011. There have been no significant changes in the Company’s internal control over financial reporting that occurred during the quarter ended September 30, 2011.
PART II
None
There have been no material changes in the risk factors disclosed by Registrant in its Report on Form 10-K for the fiscal year ended December 31, 2010.
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PART II OTHER INFORMATION (Continued)
Period
7/1/2011 to 7/31/2011
8/1/2011 to 8/31/2011
9/1/2011 to 9/30/2011
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.
Date: October 27, 2011
/s/ Paul S. Siebenmorgen
Paul S. Siebenmorgen
President and CEO
/s/ Barbara J. Britenriker
Barbara J. Britenriker
Exec. Vice-President and CFO
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