10-Q 1 v326401_10q.htm FORM 10-Q

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2012

 

OR

¨TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ____________ to ____________

 

Commission File Number 000-29829

 

PACIFIC FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 

  Washington
(State or other jurisdiction of
incorporation or organization)

91-1815009
(IRS Employer Identification No.)

 

 
     
  1101 S. Boone Street
Aberdeen, Washington 98520-5244
(360) 533-8870
(Address, including zip code, and telephone number,
including area code, of Registrant's principal executive offices)
 

 

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 website, if any, every Interactive Data File required to be submitted and posted 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, 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).

 

¨ Large Accelerated Filer ¨ Accelerated Filer ¨ Non-accelerated Filer x Smaller Reporting Company

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

 

The number of shares of the issuer's common stock, par value $1.00 per share, outstanding as of October 31, 2012, was 10,121,853 shares.

 

 
 

 

TABLE OF CONTENTS

 

PART I FINANCIAL INFORMATION 3
     
ITEM 1. FINANCIAL STATEMENTS (UNAUDITED) 3
     
  CONDENSED CONSOLIDATED BALANCE SHEETS SEPTEMBER 30, 2012 AND DECEMBER 31, 2011 3
     
  CONDENSED CONSOLIDATED STATEMENTS OF INCOME THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2012 AND 2011 4
     
  CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2012 AND 2011 5
     
  CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS NINE MONTHS ENDED SEPTEMBER 30, 2012 AND 2011 6
     
  CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY NINE MONTHS ENDED SEPTEMBER 30, 2012 AND 2011 7
     
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 8
     
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 29
     
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 42
     
ITEM 4. CONTROLS AND PROCEDURES 43
     
PART II OTHER INFORMATION 43
     
ITEM 1. LEGAL PROCEEDINGS 43
     
ITEM 1A. RISK FACTORS 43
     
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 43
     
ITEM 3. DEFAULTS UPON SENIOR SECURITIES 43
     
ITEM 4. MINE SAFETY DISCLOSURES 43
     
ITEM 5. OTHER INFORMATION 44
     
ITEM 6. EXHIBITS 44
     
  SIGNATURES 44

 

 
 

 

PART I – FINANCIAL INFORMATION

ITEM 1 – FINANCIAL STATEMENTS

 

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Balance Sheets

September 30, 2012 and December 31, 2011

(Dollars in thousands) (Unaudited)

 

   September 30, 2012   December 31, 2011 
Assets          
Cash and due from banks  $14,752   $12,607 
Interest bearing deposits in banks   28,222    28,525 
Investment securities available-for-sale (amortized cost of $50,267 and $47,015)   51,704    47,652 
Investment securities held-to-maturity (fair value of $6,897 and $7,118)   6,848    7,025 
Federal Home Loan Bank stock, at cost   3,154    3,182 
Loans held for sale   21,948    14,541 
           
Loans   465,970    474,893 
Allowance for credit losses   11,157    11,127 
Loans, net   454,813    463,766 
           
Premises and equipment   14,646    14,884 
Other real estate owned   5,803    7,725 
Accrued interest receivable   2,395    2,156 
Cash surrender value of life insurance   17,663    17,275 
Goodwill   11,282    11,282 
Other intangible assets   1,268    1,268 
Other assets   9,565    9,366 
           
Total assets  $644,063   $641,254 
           
Liabilities and Shareholders' Equity          
Deposits:          
Demand, non-interest bearing  $123,289   $108,899 
Savings and interest-bearing demand   285,303    286,642 
Time, interest-bearing   139,590    152,509 
Total deposits   548,182    548,050 
           
Accrued interest payable   235    1,490 
Secured borrowings   219    741 
Short-term borrowings   3,000     
Long-term borrowings   7,500    10,500 
Junior subordinated debentures   13,403    13,403 
Other liabilities   4,510    3,800 
Total liabilities   577,049    577,984 
           
Commitments and Contingencies (Note 6)        
           
Shareholders' Equity          
Common Stock (par value $1); 25,000,000 shares authorized; 10,121,853 shares issued and outstanding at September 30, 2012 and December 31, 2011   10,122    10,122 
Additional paid-in capital   41,360    41,342 
Retained earnings   15,157    12,051 
Accumulated other comprehensive income (loss)   375    (245)
Total shareholders' equity   67,014    63,270 
           
Total liabilities and shareholders' equity  $644,063   $641,254 

 

See notes to condensed consolidated financial statements.

 

3
 

 

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Statements of Income

Three and nine months ended September 30, 2012 and 2011

(Dollars in thousands, except per share data) (Unaudited)

 

   Three Months Ended
September 30,
   Nine Months Ended
September 30,
 
   2012   2011   2012   2011 
Interest and dividend income                    
Loans  $6,292   $6,861   $19,390   $20,459 
Investment securities   440    516    1,378    1,548 
Deposits with banks and federal funds sold   19    29    55    77 
Total interest and dividend income   6,751    7,406    20,823    22,084 
                     
Interest Expense                    
Deposits   686    1,112    2,259    3,731 
Other borrowings   143    224    462    833 
Total interest expense   829    1,336    2,721    4,564 
                     
Net Interest Income   5,922    6,070    18,102    17,520 
                     
Provision for credit losses       1,050    400    1,550 
Net interest income after provision for credit losses   5,922    5,020    17,702    15,970 
                     
Non-interest Income                    
Service charges on deposits   406    470    1,256    1,350 
Net gain (loss) on sales of other real estate owned   (18)   17    293    (126)
Gain on sales of loans   1,501    1,084    3,501    2,183 
Gain on sales of investments available-for-sale, net   65    352    164    536 
Net other-than-temporary impairment losses (net of $20, $29, $50 and $338, respectively, recognized in other comprehensive income before taxes)   (160)       (265)   (243)
Earnings on bank owned life insurance   130    135    388    398 
Other operating income   519    397    1,363    1,061 
Total non-interest income   2,443    2,455    6,700    5,159 
                     
Non-interest Expense                    
Salaries and employee benefits   4,101    3,363    11,823    10,188 
Occupancy and equipment   614    623    1,865    1,908 
Other real estate owned write-downs   364    62    698    599 
Other real estate owned operating costs   101    89    401    293 
Professional services   178    174    514    574 
FDIC and State assessments   135    215    468    711 
Data processing   355    336    1,048    920 
Other   1,222    1,198    3,762    3,600 
Total non-interest expense   7,070    6,060    20,579    18,793 
                     
Income before income taxes   1,295    1,415    3,823    2,336 
Income taxes   280    211    717    97 
                     
Net Income  $1,015   $1,204   $3,106   $2,239 
                     
Earnings per common share:                    
Basic  $0.10   $0.12   $0.31   $0.22 
Diluted   0.10    0.12    0.31    0.22 
Weighted Average shares outstanding:                    
Basic   10,121,853    10,121,853    10,121,853    10,121,853 
Diluted   10,122,224    10,121,919    10,122,145    10,121,875 

 

See notes to condensed consolidated financial statements.

 

4
 

 

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Statements of Comprehensive Income

Three and nine months ended September 30, 2012 and 2011

(Dollars in thousands) (Unaudited)

 

   Three Months Ended
September 30,
   Nine Months Ended
September 30,
 
   2012   2011   2012   2011 
                 
Net Income  $1,015   $1,204   $3,106   $2,239 
                     
Other comprehensive income, net of tax:                    
Net unrealized gains on investment securities (net of tax of $258, $257, $274 and $488, respectively)   500    499    532    948 
Defined benefit plans (net of tax of $10, $8, $30 and $24, respectively)   29    24    88    70 
                     
Other Comprehensive Income   529    523    620    1,018 
                     
Comprehensive Income  $1,544   $1,727   $3,726   $3,257 

 

See notes to condensed consolidated financial statements.

 

5
 

 

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Statements of Cash Flows

Nine months ended September 30, 2012 and 2011

(Dollars in thousands)

(Unaudited)

 

   2012   2011 
OPERATING ACTIVITIES          
Net income  $3,106   $2,239 
Adjustments to reconcile net income to net cash provided by (used in) operating activities:          
Provision for credit losses   400    1,550 
Depreciation and amortization   1,094    1,191 
Origination of loans held for sale   (184,171)   (104,807)
Proceeds of loans held for sale   180,265    104,771 
Gain on sales of loans   (3,501)   (2,183)
Gain on sale of investments available-for-sale   (164)   (536)
Net OTTI losses recognized in earnings   265    243 
Net (gain) loss on sale of other real estate owned   (293)   126 
Net (gain) loss on sale of premises and equipment   (5)   1 
Increase in accrued interest receivable   (239)   (111)
Increase (decrease) in accrued interest payable   (1,255)   83 
Other real estate owned write-downs   698    599 
Other, net   (130)   2,425 
Net cash provided by (used in) operating activities   (3,930)   5,591 
           
INVESTING ACTIVITIES          
Net decrease in interest bearing balances with banks   303    14,981 
Purchase of securities held-to-maturity       (828)
Purchase of securities available-for-sale   (15,806)   (24,425)
Proceeds from maturities of investments held-to-maturity   176    151 
Proceeds from sales of securities available-for-sale   6,334    12,881 
Proceeds from maturities of securities available-for-sale   6,010    4,309 
Proceeds from sales of government loan pools   1,215    5,514 
Net (increase) decrease in loans   5,675    (18,749)
Proceeds from sales of other real estate owned   3,402    1,061 
Purchase of premises and equipment, and additions to other real estate owned   (844)   (636)
Net cash provided by (used in) investing activities   6,465    (5,741)
           
FINANCING ACTIVITIES          
Net increase in deposits   132    15,983 
Net decrease in short-term borrowings       (10,500)
Proceeds from issuance of long-term borrowings   2,500    7,500 
Repayment of long-term borrowings   (2,500)   (7,500)
Net decrease in secured borrowings   (522)   (170)
Net cash provided by (used in) financing activities   (390)   5,313 
           
Net increase in cash and due from banks   2,145    5,163 
           
Cash and due from banks          
Beginning of period   12,607    7,428 
           
End of period  $14,752   $12,591 
           
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION          
Cash payments for:          
Interest  $3,976   $4,481 
Income taxes   1,411    55 
           
SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES          
Change in fair value of securities available-for-sale, net of tax  $532   $948 
Transfer of loans held for sale to loans held for investment       300 
Other real estate owned acquired in settlement of loans   (2,485)   (4,437)
Financed sale of other real estate owned   783    750 
Reclass of long-term borrowings to short-term borrowings   3,000     

 

See notes to condensed consolidated financial statements.

 

6
 

 

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Statements of Shareholders' Equity

Nine months ended September 30, 2012 and 2011

(Dollars in thousands)

(Unaudited)

 

                   Accumulated     
   Shares of
Common
Stock
   Common
Stock
   Additional
Paid-in
Capital
   Retained
Earnings
   Other
Comprehensive
Income (Loss)
   Total 
                         
Balance January 1, 2011  10,121,853   $ 10,122   $ 41,316   $ 9,233   $ (902)   $ 59,769 
                         
Other comprehensive income:                              
Net income                  2,239         2,239 
Unrealized holding gain on securities less reclassification adjustment for net gains included in net income                       948    948 
Amortization of unrecognized prior service costs and net (gains)/losses                       70    70 
Comprehensive income                            3,257 
                               
Stock compensation expense             19              19 
                               
Balance September 30, 2011   10,121,853   $10,122   $41,335   $11,472   $116   $63,045 
                               
Balance January 1, 2012   10,121,853   $10,122   $41,342   $12,051   $(245)  $63,270 
                               
Other comprehensive income:                              
Net income                  3,106         3,106 
Unrealized holding gain on securities less reclassification adjustment for net gains included in net income                       532    532 
Amortization of unrecognized prior service costs and net (gains)/losses                       88    88 
Comprehensive income                            3,726 
                               
Stock compensation expense             18              18 
                               
Balance September 30, 2012   10,121,853   $10,122   $41,360   $15,157   $375   $67,014 

 

See notes to condensed consolidated financial statements.

 

7
 

 

PACIFIC FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

(Dollars in thousands, except per share amounts)

 

Note 1 – Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements have been prepared by Pacific Financial Corporation ("Pacific" or the "Company") in accordance with accounting principles generally accepted in the United States of America ("GAAP") for interim financial information and with instructions to Form 10-Q. Accordingly, these financial statements do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the nine months ended September 30, 2012, are not necessarily indicative of the results anticipated for the year ending December 31, 2012. Certain information and footnote disclosures included in the Company's consolidated financial statements for the year ended December 31, 2011, have been condensed or omitted from this report. Accordingly, these statements should be read in conjunction with the financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2011.

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.

 

Note 2 – Earnings per Share

 

The following table illustrates the computation of basic and diluted earnings per share.

 

   Three Months Ended
September 30,
   Nine Months Ended
September 30,
 
   2012   2011   2012   2011 
Basic:                    
Net income  $1,015   $1,204   $3,106   $2,239 
Weighted average shares outstanding   10,121,853    10,121,853    10,121,853    10,121,853 
Basic earnings per share  $0.10   $0.12   $0.31   $0.22 
                     

Diluted:

                    
Net income  $1,015   $1,204   $3,106   $2,239 
Weighted average shares outstanding   10,121,853    10,121,853    10,121,853    10,121,853 
Effect of dilutive stock options   371    66    292    22 
Weighted average shares outstanding assuming dilution   10,122,224    10,121,919    10,122,145    10,121,875 
Diluted earnings per share  $0.10   $0.12   $0.31   $0.22 

 

As of September 30, 2012 and 2011, there were 532,107 and 585,048 shares, respectively, subject to outstanding options and 699,642 and 699,642 shares, respectively, subject to outstanding warrants with exercise prices in excess of the current market value. All of these shares are not included in the table above, as exercise of these options and warrants would not be dilutive to shareholders.

 

8
 

 

Note 3 – Investment Securities

 

Investment securities consist principally of short and intermediate term debt instruments issued by the U.S. Treasury, other U.S. government agencies, state and local government units, and other corporations, and mortgage backed securities (“MBS”).

  

Securities Held-to-Maturity  Amortized
Cost
   Unrealized
Gains
   Unrealized
Losses
   Fair
Value
 
                 
September 30, 2012                    
State and municipal securities  $6,610   $28   $   $6,638 
Agency MBS   238    21        259 
Total  $6,848   $49   $   $6,897 
                     
December 31, 2011                    
State and municipal securities  $6,732   $68   $   $6,800 
Agency MBS   293    25        318 
Total  $7,025   $93   $   $7,118 

 

Securities Available-for-Sale  Amortized
Cost
   Unrealized
Gains
   Unrealized
Losses
   Fair
Value
 
                 
September 30, 2012                    
U.S. Government securities  $1,196   $14   $   $1,210 
State and municipal securities   23,595    1,546    2    25,139 
Agency MBS   16,241    323    73    16,491 
Non-agency MBS   5,361    34    391    5,004 
Corporate bonds   3,874    39    53    3,860 
Total  $50,267   $1,956   $519   $51,704 
                     
December 31, 2011                    
U.S. Government securities  $73   $11   $   $84 
State and municipal securities   21,398    1,462    1    22,859 
Agency MBS   16,709    255    49    16,915 
Non-agency MBS   6,825    25    968    5,882 
Corporate bonds   2,010        98    1,912 
Total  $47,015   $1,753   $1,116   $47,652 

 

9
 

 

Unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in continuous unrealized loss position, as of September 30, 2012 and December 31, 2011 are summarized as follows:

 

   Less than 12 Months   12 months or More   Total 
Available-for-Sale  Fair
Value
   Gross
Unrealized
Losses
   Fair
Value
   Gross
Unrealized
Losses
   Fair
Value
   Gross
Unrealized
Losses
 
                         
September 30, 2012                              
State and municipal securities  $78   $2   $   $   $78   $2 
Agency MBS   4,858    67    470    6    5,328    73 
Non-agency MBS           3,644    391    3,644    391 
Corporate bonds   1,533    53            1,533    53 
Total  $6,469   $122   $4,114   $397   $10,583   $519 
                               
December 31, 2011                              
State and municipal securities  $77   $1   $   $   $77   $1 
Agency MBS   4,985    49            4,985    49 
Non-agency MBS   590    90    4,223    878    4,813    968 
Corporate bonds   1,912    98            1,912    98 
Total  $7,564   $238   $4,223   $878   $11,787   $1,116 

 

At September 30, 2012, there were 18 investment securities in an unrealized loss position, of which seven were in a continuous loss position for 12 months or more. The unrealized losses on these securities were caused by changes in interest rates, widening pricing spreads and market illiquidity, leading to a decline in the fair value subsequent to their purchase. The Company has evaluated the securities shown above and anticipates full recovery of amortized cost with respect to these securities at maturity or sooner in the event of a more favorable market environment. Based on management’s evaluation, and because the Company does not have the intent to sell these securities and it is not more likely than not that it will have to sell the securities before recovery of cost basis, the Company does not consider these investments to be other-than-temporarily impaired at September 30, 2012, except as described below with respect to one non-agency MBS.

 

For non-agency MBS the Company estimates expected future cash flows of the underlying collateral, together with any credit enhancements. The expected future cash flows of the underlying collateral are determined using the remaining contractual cash flows adjusted for future expected credit losses (which considers current delinquencies, future expected default rates and collateral value by vintage) and prepayments. The expected cash flows of the security are then discounted to arrive at a present value amount. For the nine months ended September 30, 2012, one non-agency MBS was determined to be other-than-temporarily-impaired resulting in the Company recording $50 in impairments not related to credit losses through other comprehensive income and $265 in impairments related to credit losses through earnings.

 

Gross gains realized on sales of securities were $170 and $557 and gross losses realized were $6 and $21 during the nine months ended September 30, 2012 and 2011, respectively.

 

The Company did not engage in originating subprime mortgage loans and it does not believe that it has material exposure to subprime mortgage loans or subprime mortgage backed securities. Additionally, the Company does not have any investment in, or exposure to, collateralized debt obligations, structured investment vehicles or Euro zone sovereign debt.

 

10
 

 

Note 4 – Loans

 

Loans and Leases

 

Loans (including loans held for sale) at September 30, 2012 and December 31, 2011 are as follows:

 

   September 30,
2012
   December 31,
2011
 
         
Commercial  $98,002   $90,731 
Residential real estate:          
Residential 1-4 family   97,987    90,552 
Multi-family   7,914    7,682 
Commercial real estate:          
Construction and land development   38,760    47,156 
Commercial real estate – owner occupied   112,051    118,469 
Commercial real estate – non owner occupied   100,995    103,005 
Farmland   25,371    23,752 
Consumer   7,641    8,928 
Less unearned income   (803)   (841)
           
Total Loans  $487,918   $489,434 

 

Allowance for Credit Losses

 

Changes in the allowance for credit losses for the three and nine months ended September 30, 2012 and 2011, and the year ended December 31, 2011 are as follows:

 

Allowance for Credit Losses  Commercial   Commercial
Real Estate
(“CRE”)
   Residential
Real Estate
   Consumer   Unallocated   Total 
                         
Three months ended September 30, 2012                              
                               
Beginning balance  $1,105   $6,858   $819   $600   $1,682   $11,064 
Charge-offs   (10)       (275)   (161)       (446)
Recoveries       535        4        539 
Provision for (recapture of) credit losses   102    (756)   254    71    329     
                               
Ending balance  $1,197   $6,637   $798   $514   $2,011   $11,157 
                               
Nine months ended September 30, 2012                              
                               
Beginning balance  $1,012   $6,803   $1,046   $642   $1,624   $11,127 
Charge-offs   (67)   (694)   (395)   (294)       (1,450)
Recoveries   23    888    162    7        1,080 
Provision for (recapture of) credit losses   229    (360)   (15)   159    387    400 
                               
Ending balance  $1,197   $6,637   $798   $514   $2,011   $11,157 

 

11
 

 

   Commercial   Commercial
Real Estate
(“CRE”)
   Residential
Real Estate
   Consumer   Unallocated   Total 
                         
Three months ended September 30, 2011                              
                               
Beginning balance  $829   $6,410   $1,598   $403   $1,726   $10,966 
Charge-offs   (36)   (916)   (271)   (30)       (1,253)
Recoveries       126    32    2        160 
Provision for (recapture of) credit losses   334    390    (112)   31    407    1,050 
                               
Ending balance  $1,127   $6,010   $1,247   $406   $2,133   $10,923 
                               
Nine months ended September 30, 2011                              
                               
Beginning balance  $816   $5,385   $1,754   $690   $1,972   $10,617 
Charge-offs   (134)   (1,466)   (361)   (55)       (2,016)
Recoveries   68    640    57    7        722 
Provision for (recapture of) credit losses   377    1,451    (203)   (236)   161    1,550 
                               
Ending balance  $1,127   $6,010   $1,247   $406   $2,133   $10,923 
                               
Twelve months ended December 31, 2011                              
                               
Beginning balance  $816   $5,385   $1,754   $690   $1,972   $10,617 
Charge-offs   (161)   (2,005)   (665)   (93)       (2,924)
Recoveries   69    750    107    8        934 
Provision for (recapture of) credit losses   288    2,673    (150)   37    (348)   2,500 
                               
Ending balance  $1,012   $6,803   $1,046   $642   $1,624   $11,127 

 

12
 

 

Recorded investment in loans as of September 30, 2012 and December 31, 2011 are as follows:

 

September 30, 2012  Commercial   Commercial
Real Estate
(“CRE”)
   Residential
Real Estate
   Consumer   Unallocated   Total 
                         
Allowance for credit losses:                              
Ending balance: individually evaluated for impairment  $   $1,781   $   $   $   $1,781 
                               
Ending balance: collectively evaluated for impairment   1,197    4,856    798    514    2,011    9,376 
                               
Loans:                              
Ending balance: individually evaluated for impairment  $776   $9,472   $768   $   $   $11,016 
                               
Ending balance: collectively evaluated for impairment   97,226    267,705    83,185    7,641        455,757 
                               
Loans held for sale           21,948            21,948 
                               
Ending balance  $98,002   $277,177   $105,901   $7,641   $   $488,721 
                               
Less unearned income                            (803)
                               
Ending balance total loans                           $487,918 
                               
December 31, 2011                              
                               
Allowance for credit losses:                              
Ending balance: individually evaluated for impairment  $   $1,987   $45   $   $   $2,032 
                               
Ending balance: collectively evaluated for impairment   1,012    4,816    1,001    642    1,624    9,095 
                               
Loans:                              
Ending balance: individually evaluated for impairment  $529   $13,076   $827   $   $   $14,432 
                               
Ending balance: collectively evaluated for impairment   90,202    279,306    82,866    8,928        461,302 
                               
Loans held for sale           14,541            14,541 
                               
Ending balance  $90,731   $292,382   $98,234   $8,928   $   $490,275 
                               
Less unearned income                            (841)
                               
Ending balance total loans                           $489,434 

 

13
 

 

Credit Quality Indicators

 

Federal regulations require that the Bank periodically evaluate the risks inherent in its loan portfolios. In addition, the Washington Division of Banks and the Federal Deposit Insurance Corporation (“FDIC”) have authority to identify problem loans and, if appropriate, require them to be reclassified. There are three classifications for problem loans: Substandard, Doubtful, and Loss. These terms are used as follows:

 

·“Substandard” loans have one or more defined weaknesses and are characterized by the distinct possibility some loss will be sustained if the deficiencies are not corrected.

 

·“Doubtful” loans have the weaknesses of loans classified as "Substandard," with additional characteristics that suggest the weaknesses make collection or recovery in full after liquidation of collateral questionable on the basis of currently existing facts, conditions, and values. There is a high possibility of loss in loans classified as "Doubtful."

 

·“Loss” loans are considered uncollectible and of such little value that continued classification of the credit as a loan is not warranted. If a loan or a portion thereof is classified as "Loss," it must be charged-off; meaning the amount of the loss is charged against the allowance for credit losses, thereby reducing that reserve.

 

The Bank also classifies some loans as “Pass” or Other Loans Especially Mentioned (“OLEM”). Within the Pass classification certain loans are “Watch” rated because they have elements of risk that require more monitoring than other performing loans. Pass grade loans include a range of loans from very high credit quality to acceptable credit quality. These borrowers generally have strong to acceptable capital levels and consistent earnings and debt service capacity. Loans with higher grades within the Pass category may include borrowers who are experiencing unusual operating difficulties, but have acceptable payment performance to date. Overall, loans with a Pass grade show no immediate loss exposure. Loans classified as OLEM continue to perform but have shown deterioration in credit quality and require close monitoring.

 

Loans by credit quality risk rating at September 30, 2012 are as follows:

 

   Pass   Other Loans
Especially
Mentioned
   Substandard   Doubtful   Total 
                     
Commercial  $92,647   $1,911   $3,397   $47   $98,002 
                          
Real estate:                         
Construction and development   30,568    622    7,570        38,760 
Residential 1-4 family   92,808    707    4,445    27    97,987 
Multi-family   7,914                7,914 
CRE – owner occupied   105,759    1,862    4,430        112,051 
CRE – non owner occupied   74,533    17,831    8,631        100,995 
Farmland   24,227    110    1,034        25,371 
Total real estate   335,809    21,132    26,110    27    383,078 
                          
Consumer   7,567        74        7,641 
                          
Subtotal  $436,023   $23,043   $29,581   $74   $488,721 
Less unearned income                       (803)
                          
Total loans                      $487,918 

 

14
 

 

Loans by credit quality risk rating at December 31, 2011 are as follows:

 

   Pass   Other Loans
Especially
Mentioned
   Substandard   Doubtful   Total 
                     
Commercial  $83,920   $2,232   $4,579   $   $90,731 
                          
Real estate:                         
Construction and development   37,804    1,394    7,958        47,156 
Residential 1-4 family   86,239    741    3,572        90,552 
Multi-family   7,682                7,682 
CRE – owner occupied   111,028    1,856    5,585        118,469 
CRE – non owner occupied   77,414    13,877    11,714        103,005 
Farmland   22,543    110    1,099        23,752 
Total real estate   342,710    17,978    29,928        390,616 
                          
Consumer   8,804    53    63    8    8,928 
                          
Subtotal  $435,434   $20,263   $34,570   $8   $490,275 
Less unearned income                       (841)
                          
Total loans                      $489,434 

 

Impaired Loans

 

Following is a summary of information pertaining to impaired loans at September 30, 2012:

 

   Recorded
Investment
   Unpaid
Principal
Balance
   Related
Allowance
   3 Month
Average
Recorded
Investment
   9 Month
Average
Recorded
Investment
   3 Months
Interest
Income
Recognized
   9 Months
Interest
Income
Recognized
 
With no related allowance recorded:                                   
Commercial  $776   $786   $   $692   $653   $9   $24 
Consumer               113    56         
Residential real estate   768    983        734    728    4    13 
Commercial real estate:                                   
CRE – owner occupied   2,086    2,086        1,110    791        2 
CRE – non-owner occupied   2,326    2,419        2,365    2,641    32    54 
Construction and development   1,576    3,855        1,640    2,936    18    53 
                                    
With an allowance recorded:                                   
Residential real estate                   121         
Commercial real estate:                                   
CRE – non-owner occupied   3,485    3,997    1,781    3,485    3,556         
Construction and development               92    189        12 
                                    
Total:                                   
Commercial   776    786        692    653    9    24 
Consumer               113    56         
Residential real estate   768    983        734    849    4    13 
Commercial real estate:                                   
CRE – owner occupied   2,086    2,086        1,110    791        2 
CRE – non-owner occupied   5,811    6,416    1,781    5,850    6,197    32    54 
Construction and development   1,576    3,855        1,732    3,125    18    65 

 

15
 

 

Following is a summary of information pertaining to impaired loans at September 30, 2011:

 

   Recorded
Investment
   Unpaid
Principal
Balance
   Related
Allowance
   3 Month
Average
Recorded
Investment
   9 Month
Average
Recorded
Investment
   3 Months
Interest
Income
Recognized
   9 Months
Interest
Income
Recognized
 
With no related allowance recorded:                                   
Commercial  $180   $194   $   $187   $312   $2   $13 
Residential real estate   406    521        551    1,510    4    15 
Commercial real estate:                                   
CRE – owner occupied   430    481        997    1,057    3    5 
CRE – non-owner occupied   5,981    6,351        5,057    3,248        21 
Construction and development   5,250    7,401        5,054    6,001    18    90 
                                    
With an allowance recorded:                                   
Commercial                   253        5 
Residential real estate               36    18         
Construction and development   1,162    1,162    357    1,503    752        52 
                                    
Total:                                   
Commercial   180    194        187    565    2    18 
Residential real estate   406    521        587    1,528    4    15 
Commercial real estate:                                   
CRE – owner occupied   430    481        997    1,057    3    5 
CRE – non-owner occupied   5,981    6,351        5,057    3,248        21 
Construction and development   6,412    8,563    357    6,557    6,753    18    142 

 

Following is a summary of information pertaining to impaired loans as of and for the year ended December 31, 2011:

 

   Recorded
Investment
   Unpaid
Principal
Balance
   Related
Allowance
   Average
Recorded
Investment
   Interest
Income
Recognized
 
With no related allowance recorded:                         
Commercial  $530   $556   $   $355   $15 
Residential real estate   528    620        1,314    16 
Commercial real estate:                         
CRE – owner occupied   629    719        971    7 
CRE – non-owner occupied   2,912    2,912        3,181    21 
Construction and development   5,335    7,501        5,868    188 
                          
With an allowance recorded:                         
Commercial               202    5 
Residential real estate   298    298    45    74     
Commercial real estate:                         
CRE - non-owner occupied   3,627    3,997    1,782    725     
Construction and development   573    573    205    716    3 
                          
Total:                         
Commercial   530    556        557    20 
Residential real estate   826    918    45    1,388    16 
Commercial real estate:                         
CRE – owner occupied   629    719        971    7 
CRE – non-owner occupied   6,539    6,909    1,782    3,906    21 
Construction and development   5,908    8,074    205    6,584    191 

 

16
 

 

Aging Analysis

 

The following table provides an age analysis of past due loans at September 30, 2012.

 

   Current   30-59
Days
Past Due
   60-89
Days
Past Due
   Greater
Than 90
Days Past
Due and
Still
Accruing
   Total
Past
Due
   Non-accrual
Loans
   Total
Loans
 
                             
Commercial  $96,155   $1,070   $   $   $1,070   $777   $98,002 
                                    
Real estate:                                   
Construction & development   37,179    5            5    1,576    38,760 
Residential 1-4 family   96,242    659    318        977    768    97,987 
Multi-family   7,914                        7,914 
CRE owner occupied (1)   108,714    481        770    1,251    2,086    112,051 
CRE non-owner occupied   95,184                    5,811    100,995 
Farmland   25,371                        25,371 
Total real estate   370,604    1,145    318    770    2,233    10,241    383,078 
                                    
Consumer   7,634    7            7        7,641 
                                    
Less unearned income   (803)                       (803)
                                    
Total  $473,590   $2,222   $318   $770   $3,310   $11,018   $487,918 

 

(1)Loans totaling $770,000 past due 90 days or more and still accruing interest are made up entirely of loans guaranteed by the United Stated Department of Agriculture (USDA) or Small Business Administration.

 

The following table provides an age analysis of past due loans at December 31, 2011.

 

   Current   30-59
Days
Past Due
   60-89
Days
Past Due
   Greater
Than 90
Days Past
Due and
Still
Accruing
   Total
Past
Due
   Non-accrual
Loans
   Total
Loans
 
                             
Commercial  $89,981   $220   $   $   $220   $530   $90,731 
                                    
Real estate:                                   
Construction & development   41,570    76            76    5,510    47,156 
Residential 1-4 family   88,661    880    184    299    1,363    528    90,552 
Multi-family   7,682                        7,682 
CRE owner occupied   116,979    508    353        861    629    118,469 
CRE non-owner occupied   96,332    134            134    6,539    103,005 
Farmland   23,752                        23,752 
Total real estate   374,976    1,598    537    299    2,434    13,206    390,616 
                                    
Consumer   8,869    59            59        8,928 
                                    
Less unearned income   (841)                       (841)
                                    
Total  $472,985   $1,877   $537   $299   $2,713   $13,736   $489,434 

 

17
 

 

Modifications

 

A modification of a loan constitutes a troubled debt restructuring (“TDR”) when a borrower is experiencing financial difficulty and the modification constitutes a concession.  There are various types of concessions when modifying a loan, however, forgiveness of principal is rarely granted by the Company.  Commercial and industrial loans modified in a TDR may involve term extensions, below market interest rates and/or interest-only payments wherein the delay in the repayment of principal is determined to be significant when all elements of the loan and circumstances are considered.  Additional collateral, a co-borrower, or a guarantor is often required.  Commercial mortgage and construction loans modified in a TDR often involve reducing the interest rate for the remaining term of the loan, extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, or substituting or adding a new borrower or guarantor.  Construction loans modified in a TDR may also involve extending the interest-only payment period.  Residential mortgage loans modified in a TDR are primarily comprised of loans where monthly payments are lowered to accommodate the borrowers’ financial needs. Land loans are typically structured as interest-only monthly payments with a balloon payment due at maturity.  Land loans modified in a TDR typically involve extending the balloon payment by one to three years, and providing an interest rate concession. Home equity modifications are made infrequently and are uniquely designed to meet the specific needs of each borrower. 

 

Loans modified in a TDR are typically already on non-accrual status and partial charge-offs have in some cases already been taken against the outstanding loan balance.  As a result, loans modified in a TDR for the Company may have the financial effect of increasing the specific allowance associated with the loan.  An allowance for impaired loans that have been modified in a TDR is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the estimated fair value of the collateral, less any selling costs, if the loan is collateral dependent.  The Company’s practice is to re-appraise collateral dependent loans semi-annually. During the nine months ended September 30, 2012, there was no impact on the allowance from TDRs during the period, as the loans classified as TDRs during the period did not have a specific reserve and were already considered impaired loans at the time of modification.

 

The Company closely monitors the performance of modified loans for delinquency, as delinquency is considered an early indicator of possible future default. The allowance may be increased, adjustments may be made in the allocation of the allowance, or partial charge-offs may be taken to further write-down the carrying value of the loan.

The following tables present TDRs for the three and nine months ended September 30, 2012, all of which were modified due to financial stress of the borrower.

 

   Current TDRs   Subsequently Defaulted TDRs 
         
Nine months ended
September 30, 2012
  Number
of
Contracts
   Pre-TDR
Outstanding
Recorded
Investment
   Post-TDR
Outstanding
Recorded
Investment
   Number
of
Contracts
   Pre-TDR
Outstanding
Recorded
Investment
   Post-TDR
Outstanding
Recorded
Investment
 
                         
Commercial   1   $335   $323                
Residential real estate   3    342    300       $   $ 
CRE owner occupied   1    59    58             
CRE non-owner occupied   1    2,180    2,165             
Construction & development   3    2,972    1,552    2    2,561    2,465 
                               
Ending balance (1)   9   $5,888   $4,398    2   $2,561   $2,465 

 

18
 

 

   Current TDRs   Subsequently Defaulted TDRs 
         
Three months ended
September 30, 2012
  Number
of
Contracts
   Pre-TDR
Outstanding
Recorded
Investment
   Post-TDR
Outstanding
Recorded
Investment
   Number
of
Contracts
   Pre-TDR
Outstanding
Recorded
Investment
   Post-TDR
Outstanding
Recorded
Investment
 
                         
Residential real estate      $   $       $   $ 
                               
Ending balance (1)      $   $       $   $ 

 

(1)The period end balances are inclusive of all partial pay downs and charge-offs since the modification date.

 

The construction and development loan TDRs that subsequently defaulted were modified by extending the maturity date. Both loans were on non-accrual status prior to and after the TDR. The subsequent defaults reported above occurred during the last twelve months and the loans were subsequently transferred to other real estate owned during the three months ended March 31, 2012. There were no other loans modified as a TDR within the previous 12 months that subsequently defaulted during the three and nine months ended September 30, 2012.

 

Loans classified as TDRs are considered impaired loans. The Company had no commitments to lend additional funds for loans classified as troubled debt restructured at September 30, 2012.

 

Note 5 – Stock Based Compensation

 

Stock Options

 

The Company’s 2000 Stock Incentive Plan provided for incentive and non-qualified stock options and other types of stock based awards to key personnel. Under the plan, the Company was authorized to issue up to 1,100,000 shares; however the plan expired January 1, 2011. On April 27, 2011, the shareholders of the Company approved the 2011 Equity Incentive Plan, pursuant to which the Company is authorized to issue up to 900,000 shares of common stock in connection with awards under the plan.

 

The fair value of stock options granted is determined using the Black-Scholes option pricing model based on assumptions noted in the following table. Expected volatility is based on historical volatility of the Company’s common stock. The expected term of stock options granted is based on the simplified method, which is the simple average between contractual term and vesting period. The risk-free rate is based on the expected term of stock options and the applicable U.S. Treasury yield in effect at the time of grant.

 

Grant period ended  Expected
Life
  Risk Free
Interest Rate
   Expected
Volatility
   Dividend
Yield
   Average
Fair Value
 
                    
September 30, 2012  6.5 years   1.34%   22.43%   %  $0.77 
September 30, 2011  6.5 years   1.50%   22.51%   %  $1.05 

 

19
 

 

A summary of stock option activity under the stock option plans as of September 30, 2012 and 2011, and changes during the nine months then ended are presented below:

 

   Shares   Weighted
Average
Exercise Price
   Weighted
Average
Remaining
Contractual
Term ( Years)
   Aggregate
Intrinsic
Value
 
September 30, 2012                    
                     
Outstanding beginning of period   586,448   $11.32           
Granted   10,500    5.00           
Exercised                  
Forfeited   (12,550)   10.44           
Expired   (47,291)   10.57           
                     
Outstanding end of period   537,107   $11.28    4.3   $ 
                     
Exercisable end of period   368,727   $13.26    2.9   $ 
                     
September 30, 2011                    
                     
Outstanding beginning of period   818,612   $11.07           
Granted   5,000    3.95           
Exercised                  
Forfeited   (55,125)   11.16           
Expired   (178,439)   10.10           
                     
Outstanding end of period   590,048   $11.30    4.8   $ 
                     
Exercisable end of period   411,768   $12.88    3.4   $ 

 

A summary of the status of the Company’s non-vested options as of September 30, 2012 and 2011 and changes during the nine months then ended are presented below:

 

   2012   2011 
   Shares   Weighted
Average Fair
Value
   Shares   Weighted
Average Fair
Value
 
                 
Non-vested beginning of period   174,740   $0.37    218,885   $0.51 
Granted   10,500    0.77    5,000    1.05 
Vested   (10,950)   1.69    (19,305)   1.71 
Forfeited   (5,910)   0.27    (26,300)   0.50 
                     
Non-vested end of period   168,380   $0.32    178,280   $0.39 

 

20
 

 

The Company accounts for stock based compensation in accordance with GAAP, which requires measurement of compensation cost for all stock-based awards based on grant date fair value and recognition of compensation cost over the service period of each award. Stock-based compensation expense during the nine months ended September 30, 2012 and 2011 was $13 and $19 ($9 and $13 net of tax), respectively. Future compensation expense for unvested awards outstanding as of September 30, 2012 is estimated to be $27 recognized over a weighted average period of 1.7 years. There were no options exercised during the nine months ended September 30, 2012 and 2011.

 

Restricted Stock Units

 

In March 2012, the Company granted restricted stock units (“RSU”) to certain employees receiving awards under the Company’s Annual Incentive Compensation Plan. Recipients of RSUs will be issued a specified number of shares of the Company’s common stock upon the lapse of their applicable restrictions. Restrictions require the employee to continue in employment for a period of three years from the date the RSU is awarded.

 

The following table summarizes RSU activity during 2012. There was no RSU activity prior to 2012.

 

   Shares   Weighted average
grant price
   Weighted average
remaining contractual
terms (in years)
 
             
Outstanding, January 1, 2012      $     
Granted   7,274    4.15    2.5 
Forfeited   (545)          
                
Outstanding, September 30, 2012   6,729   $4.15    2.5 

 

For the nine months ended September 30, 2012, the Company recognized compensation expense related to RSUs of $5 ($3 net of tax). As of September 30, 2012, there was $23 of total unrecognized compensation expense related to non-vested RSUs.

 

Note 6 – Commitments and Contingencies

 

The Bank is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit, and involve, to varying degrees, elements of credit risk in excess of the amount recognized on the consolidated balance sheets.

 

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as they do for on-balance-sheet instruments. A summary of the Bank’s off-balance sheet commitments at September 30, 2012 and December 31, 2011 is as follows:

 

   September 30,   December 31, 
   2012   2011 
         
Commitments to extend credit  $78,336   $91,596 
Standby letters of credit   2,065    1,310 

 

21
 

 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Many of the commitments expire without being drawn upon; therefore total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on management’s credit evaluation of the customer. Collateral held varies, but may include accounts receivable, inventory, property and equipment, residential real estate, and income-producing commercial properties.

 

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

 

In connection with certain loans held for sale, the Bank typically makes representations and warranties that the underlying loans conform to specified guidelines. If the underlying loans do not conform to the specifications, the Bank may have an obligation to repurchase the loans or indemnify the purchaser against loss. The Bank believes that the potential for loss under these arrangements is remote. Accordingly, no contingent liability is recorded in the condensed consolidated financial statements.

 

The Company is currently not party to any material pending litigation. However, because of the nature of its activities, the Company may be subject to or threatened with legal actions in the ordinary course of business. In the opinion of management, liabilities arising from these claims, if any, will not have a material effect on the results of operations or financial condition of the Company.

 

Note 7 – Recent Accounting Pronouncements

 

In May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2011-04, “Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS.”  This ASU is the result of joint efforts by the FASB and International Accounting Standards Board to develop a single, converged fair value framework on how (not when) to measure fair value and what disclosures to provide about fair value measurements.  The ASU is largely consistent with existing fair value measurement principles in U.S. GAAP (Topic 820), with many of the amendments made to eliminate unnecessary wording differences between U.S. GAAP and International Financial Reporting Standards.  The amendments are effective for interim and annual periods beginning after December 15, 2011 with prospective application required.  The Company adopted the provisions of ASU No. 2011-04 effective January 1, 2012. The fair value measurement provisions had no impact on the Company’s consolidated financial statements. See Note 8 for the enhanced disclosures required by ASU No. 2011-04.

 

In June 2011, FASB issued ASU No. 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income”. This ASU will require companies to present the components of net income and other comprehensive income either as one continuous statement or as two consecutive statements. It eliminates the option to present components of other comprehensive income as part of the statement of changes in shareholders’ equity. The standard does not change the items which must be reported in other comprehensive income, how such items are measured or when they must be reclassified to net income. This standard is effective for interim and annual periods beginning after December 15, 2011. The FASB subsequently deferred the effective date of certain provisions of this standard pertaining to the reclassification of items out of accumulated other comprehensive income. A Consolidated Statement of Comprehensive Income has been included as part of the Company’s unaudited financial statements, for the nine months ended September 30, 2012 and 2011. The adoption of ASU No. 2011-05 had no impact on the Company’s financial condition, results of operations or cash flows.

 

22
 

 

Note 8 – Fair Value Measurements

 

Fair Value Hierarchy

 

The Company uses an established hierarchy for measuring fair value that is intended to maximize the use of observable inputs and minimize the use of unobservable inputs. This hierarchy uses three levels of inputs to measure the fair value of assets and liabilities as follows:

 

Level 1 – Valuations based on quoted prices in active exchange markets for identical assets or liabilities; also includes certain corporate debt securities actively traded in over-the-counter markets.

 

Level 2 – Valuations of assets and liabilities traded in less active dealer or broker markets. Valuations include quoted prices for similar assets and liabilities traded in the same market; quoted prices for identical or similar instruments in markets that are not active; and model–derived valuations whose inputs are observable or whose significant value drivers are observable. Valuations may be obtained from, or corroborated by, third-party pricing services. This category generally includes certain U.S. Government, agency and non-agency securities, state and municipal securities, mortgage-backed securities, corporate securities, and residential mortgage loans held for sale.

 

Level 3 – Valuation based on unobservable inputs supported by little or no market activity for financial instruments whose value is determined using pricing models, discounted cash flow methodologies, yield curves and similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities, but in all cases are corroborated by external data, which may include third-party pricing services.

 

Investment Securities available-for-sale

 

The Company uses an independent pricing service to assist management in determining fair values of investment securities available-for-sale. This service provides pricing information by utilizing evaluated pricing models supported with observable market data. Standard inputs include benchmark yields, reported trades, broker/dealer quotes, credit ratings, bids and offers, relative credit information and reference data from market research publications. Investment securities that are deemed to have been trading in illiquid or inactive markets may require the use of significant unobservable inputs.

 

The pricing service provides quoted market prices when available. Quoted prices are not always available due to bond market inactivity. For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows. Discounted cash flows are calculated using spread to swap and LIBOR curves that are updated to incorporate loss severities, volatility, credit spread and optionality. Additionally, the pricing service may obtain a broker quote when sufficient information is not available to produce a valuation. Valuations and broker quotes are non-binding and do not represent quotes on which one may execute the disposition of the assets.

 

The Company generally obtains one value from its primary external third-party pricing service. The Company’s third-party pricing service has established processes for us to submit inquiries regarding quoted prices. The Company’s third-party pricing service will review the inputs to the evaluation in light of any new market data presented by us. The Company’s third-party pricing service may then affirm the original quoted price or may update the evaluation on a going forward basis.

 

23
 

 

On a quarterly basis, management reviews the pricing information received from the third party-pricing service through a combination of procedures that include an evaluation of methodologies used by the pricing service, analytical reviews and performance analysis of the prices against statistics and trends and maintenance of an investment watch list. Based on this review, management determines whether the current placement of the security in the fair value hierarchy is appropriate or whether transfers may be warranted. As necessary, the Company compares prices received from the pricing service to discounted cash flow models or through performing independent valuations of inputs and assumptions similar to those used by the pricing service in order to ensure prices represent a reasonable estimate of fair value. Although the Company does identify differences from time to time as a result of these validation procedures, the Company did not make any significant adjustments as of September 30, 2012 or December 31, 2011.

 

The following table presents the balances of assets measured at fair value on a recurring basis at September 30, 2012 and December 31, 2011.

 

September 30, 2012  Readily Available
Market Inputs
Level 1
   Observable
Market Inputs
Level 2
   Significant
Unobservable
Inputs
Level 3
   Total 
                 
Securities available-for-sale                    
U.S. Government securities  $   $1,210   $   $1,210 
State and municipal securities       24,068    1,071    25,139 
Agency MBS       16,491        16,491 
Non-agency MBS       5,004        5,004 
Corporate bonds   2,272    1,588        3,860 
                     
Total  $2,272   $48,361   $1,071   $51,704 

 

December 31, 2011  Readily Available
Market Inputs
Level 1
   Observable
Market Inputs
Level 2
   Significant
Unobservable
Inputs
Level 3
   Total 
                 
Securities available-for-sale                    
U.S. Government securities  $   $84   $   $84 
State and municipal securities       21,719    1,140    22,859 
Agency MBS       16,915        16,915 
Non-agency MBS       5,882        5,882 
Corporate bonds   918    994        1,912 
                     
Total  $918   $45,594   $1,140   $47,652 

 

As of September 30, 2012 and December 31, 2011, the Company had two investments classified as Level 3 investments which consist of local non-rated municipal bonds for which the Company is the sole owner of the entire bond issue. The valuation of these securities is supported by analysis prepared by an independent third party. Their approach to determining fair value involves using recently executed transactions and market quotations for similar securities. As these securities are not rated by the rating agencies and there is no trading volume, management determined that these securities should be classified as Level 3 within the fair value hierarchy. Additionally, these securities are considered sensitive to changes in credit given the unobserved assumed credit ratings.

 

24
 

 

The following table presents a reconciliation of assets that are measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the nine months ended September 30, 2012 and 2011, respectively. There were no transfers of assets into or out of Level 1, 2 or 3 for the nine months ended September 30, 2012.

 

   Three months ended
September 30,
   Nine months Ended
September 30,
 
   2012   2011   2012   2011 
                 
Balance beginning of period  $1,069   $1,135   $1,140   $1,157 
Included in other comprehensive income (loss)   2    31    (69)   9 
                     
Balance end of period  $1,071   $1,166   $1,071   $1,166 

 

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

 

Certain assets and liabilities are measured at fair value on a nonrecurring basis after initial recognition such as loans measured for impairment and other real estate owned (“OREO”). The following methods were used to estimate the fair value of each such class of financial instrument:

 

Impaired loans – A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due (both interest and principal) according to the contractual terms of the loan agreement. Impaired loans are classified as Level 3 in the fair value hierarchy and are measured based on the present value of expected future cash flows or by the net realizable value of the collateral if the loan is collateral dependent. In determining the net realizable value of the underlying collateral, we primarily rely on third party appraisals by qualified licensed appraisers, less costs to sell. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach.

 

Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available and include consideration for variations in location, size, and income production capacity of the property. The income approach commonly utilizes a discount or cap rate to determine the present value of expected future cash flows. Additionally, the appraisals are periodically further adjusted by the Company in consideration of charges that may be incurred in the event of foreclosure and are based on management’s historical knowledge, changes in business factors and changes in market conditions. Such discounts are typically significant, and may range from 10% to 30%.

 

Impaired loans are reviewed and evaluated quarterly for additional impairment and adjusted accordingly, based on the same factors identified above. Because of the high degree of judgment required in estimating the fair value of collateral underlying impaired loans and because of the relationship between fair value and general economic conditions, we consider the fair value of impaired loans to be highly sensitive to changes in market conditions.

 

Other real estate owned – OREO is initially recorded at the lower of the carrying amount of the loan or fair value of the property less estimated costs to sell. This amount becomes the property’s new basis. Management considers third party appraisals in determining the fair value of particular properties. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach.

 

25
 

 

Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available and include consideration for variations in location, size, and income production capacity of the property. Additionally, the appraisals are periodically further adjusted by the Company based on management’s historical knowledge, changes in business factors and changes in market conditions. Such discounts are typically significant, and may range from 10% to 25% resulting in a Level 3 classification.

 

Any write-downs based on the property fair value less estimated costs to sell at the date of acquisition are charged to the allowance for credit losses. Management periodically reviews OREO to ensure the property is carried at the lower of its new basis or fair value, net of estimated costs to sell. Any additional write-downs based on re-evaluation of the property fair value are charged to non-interest expense. Because of the high degree of judgment required in estimating the fair value of OREO and because of the relationship between fair value and general economic conditions, we consider the fair value of OREO to be highly sensitive to changes in market conditions.

 

The following table presents the Company’s assets that were held at the end of each period that were accounted for at fair value on a nonrecurring basis at September 30, 2012 and December 31, 2011.

 

   Readily Available
Market Inputs
Level 1
   Observable
Market Inputs
Level 2
   Significant
Unobservable
Inputs
Level 3
   Total 
September 30, 2012                    
Impaired loans  $   $   $4,791   $4,791 
OREO  $   $   $2,995   $2,995 
                     
December 31, 2011                    
Impaired loans  $   $   $7,183   $7,183 
OREO  $   $   $6,455   $6,455 

 

Other real estate owned with a pre-foreclosure loan balance of $2,637 was acquired during the nine months ended September 30, 2012. Upon foreclosure, certain of these assets were written down a total of $152 to their fair value, less estimated costs to sell, which was charged to the allowance for credit losses during the period.

 

The following table presents quantitative information about Level 3 inputs for financial instruments measured at fair value on a nonrecurring basis at September 30, 2012:

 

   Fair
Value
   Valuation
Technique
   Significant
Unobservable
Inputs
   Range (Weighted
Average)
 
                     
Impaired loans  $1,306    Appraised value - Sales comparison approach    Adjustment for market conditions    0-15% (1)%
                     
   $3,485    Income approach    Discount rate    10.5%
                     
OREO  $2,995    Appraised value - Sales comparison approach    Adjustment for market conditions    0-10% (5)%

 

26
 

 

Fair Value of Financial Instruments

 

The following methods and assumptions were used by the Company in estimating the fair values of financial instruments disclosed in these consolidated financial statements:

 

Cash and due from banks, and Interest bearing deposits in banks

The carrying amounts of cash and interest bearing deposits at other financial institutions approximate their fair value.

 

Investment Securities Available-for-Sale and Held-to-Maturity

The fair value of all investment securities are based upon the assumptions market participants would use in pricing the security. Such assumptions include observable and unobservable inputs such as quoted market prices, dealer quotes and analysis of discounted cash flows.

 

Federal Home Loan Bank stock

FHLB stock is carried at cost which approximates fair value and equals its par value because the shares can only be redeemed with the FHLB at par.

 

Loans, net and Loans held for sale

The fair value of loans is estimated based on comparable market statistics for loans with similar credit ratings. An additional liquidity discount is also incorporated to more closely align the fair value with observed market prices. Fair values of loans held for sale are based on a discounted cash flow calculation using interest rates currently available on similar loans. The fair value was determined on an aggregate loan basis.

 

Deposits

The fair value of deposits with no stated maturity date is included at the amount payable on demand. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flow calculation based on interest rates currently offered on similar certificates.

 

Short-term borrowings

The fair values of the Company’s short-term borrowings are estimated using discounted cash flow analysis based on the Company’s incremental borrowing rates for similar types of borrowing arrangements.

 

Long-term borrowings

The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analysis based on the Company’s incremental borrowing rates for similar types of borrowing arrangements.

 

Secured borrowings

For variable rate secured borrowings that reprice frequently and have no significant change in credit risk, fair values are based on carrying values.

 

Junior subordinated debentures

The fair value of the junior subordinated debentures and trust preferred securities is estimated using discounted cash flow analysis based on interest rates currently available for junior subordinated debentures.

 

Off-Balance-Sheet Instruments

The fair value of commitments to extend credit and standby letters of credit was estimated using the rates currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the customers. Since the majority of the Company’s off-balance-sheet instruments consist of non-fee producing, variable-rate commitments, the Company has determined they do not have a material fair value.

 

27
 

 

The estimated fair values of the Company’s financial instruments at September 30, 2012 and December 31, 2011 are as follows:

 

September 30, 2012  Carrying
Amount
   Level 1   Level 2   Level 3   Total
Fair Value
 
                     
Financial Assets                         
Cash and cash equivalents  $42,974   $42,974   $   $   $42,974 
Securities available-for sale   51,704    2,272    48,361    1,071    51,704 
Securities held-to-maturity   6,848        6,897        6,897 
Federal Home Loan Bank stock   3,154        3,154        3,154 
Loans held for sale   21,948        22,491        22,491 
Loans, net   454,813            411,250    411,250 
                          
Financial Liabilities                         
Deposits  $548,182   $   $549,561   $   $549,561 
Short-term borrowings   3,000        3,050        3,050 
Long-term borrowings   7,500        7,779        7,779 
Secured borrowings   219        219        219 
Junior subordinated debentures   13,403            7,057    7,057 

 

December 31, 2011  Carrying
Amount
   Level 1   Level 2   Level 3   Total
Fair Value
 
                     
Financial Assets                         
Cash and cash equivalents  $41,132   $41,132   $   $   $41,132 
Securities available-for sale   47,652    918    45,594    1,140    47,652 
Securities held-to-maturity   7,025        7,118        7,118 
Loans held for sale   14,541        14,808        14,808 
Loans, net   463,766            419,059    419,059 
                          
Financial Liabilities                         
Deposits  $548,050   $   $549,472   $   $549,472 
Short-term borrowings                    
Long-term borrowings   10,500        10,867        10,867 
Secured borrowings   741        741        741 
Junior subordinated debentures   13,403            6,691    6,691 

 

Note 9 – Subsequent Event

 

On November 2, 2012, the Company received a final determination in favor of the Bank in its appeal of a USDA decision to revoke a guaranty on a loan to one of the Bank’s borrowers. As a result of the decision, the guaranty is reinstated, and can only be revoked should the USDA appeal and the decision is reversed. Absent an appeal, the reinstatement of the guarantee during the fourth quarter of 2012 would result in the elimination of a $1.7 million specific reserve for the loan that was included in the Company’s allowance for credit losses at September 30, 2012. The Company expects the reversal to have a favorable, but not necessarily equivalent, impact on provision for credit losses during the fourth quarter of this year.

 

 

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ITEM 2 – MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

A Warning About Forward-Looking Information

 

This document contains forward-looking statements that are subject to risks and uncertainties. These statements are based on the present beliefs and assumptions of our management, and on information currently available to them. Forward-looking statements include the information concerning our possible future results of operations set forth under "Management's Discussion and Analysis of Financial Condition and Results of Operations" and statements preceded by, followed by or that include the words "believes," "expects," "anticipates," "intends," "plans," "estimates" or similar expressions.

 

Any forward-looking statements in this document are subject to the risks of our business, including risk factors described in our Annual Report on Form 10-K for the year ended December 31, 2011 (the “2011 10-K”), as well as risks relating to, among other things, the following:

 

1.          changing laws, regulations, standards, and government programs that may limit our revenue sources, significantly increase our costs, including compliance and insurance costs, limit our opportunities to generate noninterest income, and place additional burdens on our limited management resources;

 

2.          economic and business conditions, nationally and in the regions in which we do business, that have resulted in, and may continue to result in, among other things, restrained demand for credit and other banking services and/or reduced credit quality , and additional workout and other real estate owned (“OREO”) expenses;

 

3.          decreases in real estate and other asset prices, whether or not due to economic conditions, that may reduce the value of the assets that serve as collateral for many of our loans;

 

4          competitive pressures among depository and other financial institutions that may impede our ability to attract and retain depositors, borrowers and other customers, maintain and improve our net interest income and margin and non-interest income, such as fee income, and/or retain our key employees; and

 

5.          a lack of liquidity in the market for our common stock that may make it difficult or impossible for you to liquidate your investment in our stock or lead to distortions in the market price of our stock.

 

Our management believes the forward-looking statements in this report are reasonable; however, you should not place undue reliance on them. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Many of the factors that will determine our future results and share value are beyond our ability to control or predict. We undertake no obligation to update forward-looking statements.

 

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Overview

 

The Company is a bank holding company headquartered in Aberdeen, Washington. The Company's wholly-owned subsidiary, The Bank of the Pacific (the “Bank”), is a state chartered bank, also located in Washington. The Company has two wholly-owned subsidiary trusts known as PFC Statutory Trust I and II (the “Trusts”) that were formed December 2005 and May 2006, respectively, in connection with the issuance of trust preferred securities. The Company was incorporated in the state of Washington on February 12, 1997, pursuant to a holding company reorganization of the Bank.

 

The Company conducts its banking business through the Bank, which operates 16 branches located in communities in Grays Harbor, Pacific, Whatcom, Skagit and Wahkiakum counties in the state of Washington and one in Clatsop County, Oregon. During 2012, the Company opened a loan production office in Burlington, Washington. Additionally, the Company is currently in the process of establishing a full service branch in Warrenton, Oregon, with an estimated opening date in 2013.

 

The Bank provides loan and deposit services to customers who are predominantly small and middle-market businesses and middle-income individuals.

 

Critical Accounting Policies

 

Critical accounting policies are discussed in the 2011 10-K under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operation – Critical Accounting Policies.” There have been no material changes in our critical accounting policies from the 2011 10-K.

 

Recent Accounting Pronouncements

 

Please see Note 7 of the Company's Notes to Condensed Consolidated Financial Statements above for a discussion of recent accounting pronouncements and the likely effect on the Company.

 

Financial Summary

 

The following are significant trends reflected in the Company’s results of operations for the three and nine months ended September 30, 2012, and financial condition as of that date:

 

·Net income for the three months ended September 30, 2012 was $1,015,000, a decrease of $189,000, or 15.7%, compared to the same period of the prior year. The decrease in net income for the three month period was primarily related to increases in other real estate owned write-downs (OREO), other than temporary impairment losses and salaries, which were partially offset by a decrease in provision for credit losses. Net income for the nine months ended September 30, 2012 was $3,106,000, an increase of $867,000, or 38.7%, compared to net income of $2,239,000 for the same period in 2011, which was mostly due to increases in net interest income and gains on sales of loans and OREO, coupled with the positive effects of a decrease in provision for credit losses, which were only partially offset by increased salary and benefit expenses.

 

·Return on average assets and return on average equity were 0.65% and 6.35%, respectively, for the nine months ended September 30, 2012, compared to 0.46% and 4.87%, respectively, for the same period in 2011.

 

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·Net interest income of $5,922,000 for the three months ended September 30, 2012 decreased $148,000 compared to the same period of the prior year due to continued downward pressure on interest rates. Net interest income of $18,102,000 for the nine months ended September 30, 2012 increased $582,000 compared to the same period of the prior year. The increase is primarily the result of decreased average funding costs, which dropped from 1.25% for the nine months ended September 30, 2011, to 0.79% in the current period. Net interest margin improved to 4.14% and 4.23% for the three and nine months ended September 30, 2012, compared to 4.11% and 4.02%, respectively, in the same periods one year ago.

 

·The Bank’s tier 1 leverage ratio was 10.78% and total risk-based capital ratio was 16.04% at September 30, 2012, an increase from 10.35% and 15.05%, respectively, at year-end. During the second quarter of 2012, the Bank paid a $1,400,000 dividend to the Company to allow it to pay accrued interest on outstanding junior subordinated debentures. Approximately $835,000 was paid during June 2012, with another $569,000 paid in the current quarter, bringing all interest payments on the junior subordinated debentures current. The Company had previously elected to exercise the right to defer interest payments as allowed in the debenture agreement. Additionally, during the current quarter, the Company announced a stock repurchase plan authorizing the Company to purchase up to 250,000 shares of its common stock.

 

·Total assets were $644,063,000 at September 30, 2012, an increase of $2,809,000, or 0.44%, over year-end 2011. Increases in investments and loans held for sale were the primary contributors to overall asset decline, which were partially offset by a decrease in loans and OREO. Total loans, including loans held for sale, of $487,918,000 at September 30, 2012, decreased $1,516,000, or 0.31%, compared to year-end 2011.

 

·Non-performing assets (“NPAs”) totaled $17,591,000 at September 30, 2012, which represents 2.73% of total assets, and is a decrease from $21,760,000 at December 31, 2011. The decrease is largely due to a decline in non-performing loans from $14,035,000 at year-end 2011 to $11,788,000 as of September 30, 2012. The largest reduction was in the construction and land development non-performing loan category which decreased by $3,934,000, or 71.40%, due to pay-offs.

 

·Provision for credit losses were zero and $400,000 for the three and nine months ended September 30, 2012 compared to $1,050,000 and $1,550,000 for the same periods one year ago. The decrease in the 2012 third quarter over the prior year is due partly to net recoveries of $93,000 for the three months ended September 30, 2012 compared to net charge-offs of $1,093,000 one year ago. Provision expense for the first nine months of 2012 is down from the prior year due to improving credit quality as evidenced by decreases in non-performing loans. The allowance for credit losses was relatively flat at 2.29% of total loans (including loans held for sale) compared to 2.27% at year-end 2011.

 

·Total deposits of $548,182,000 at September 30, 2012 were flat compared to $548,050,000 at December 31, 2011. However, non-interest bearing demand accounts increased by $14,390,000, or 13.21%, during the current nine-month period, which increase was offset by a similar decrease in higher cost certificates of deposit. Funding costs for interest-bearing deposits decreased to 0.69% for the current quarter, compared to 1.09% for the same period a year ago.

 

·The Company’s liquidity ratio of approximately 43% at September 30, 2012 remains strong and translates into over $278 million in available funding to meet loan and deposit needs.

  

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Results of Operations

 

Net income. For the three and nine months ended September 30, 2012, net income was $1,015,000 and $3,106,000, respectively, compared to $1,204,000 and $2,239,000 for the same periods in 2011. The decrease in net income for the three month period was primarily related to increases in commissions paid in loans sold, OREO write-downs and other than temporary impairment losses (OTTI), which were partially offset by a decrease in provision for credit losses. The increase in net income for the nine month periods was primarily related to increases in net interest income and gain on sale of loans and OREO, coupled with a decrease in FDIC assessments, which were partially offset by an increase in salaries and benefits, OREO costs, and data processing expenses.

 

Net interest income. Net interest income for the three months ended September 30, 2012 decreased $148,000, or 2.44%, compared to the same period in 2011. Net interest income for the nine months ended September 30, 2012 increased $582,000, or 3.32%, compared to the same period in 2011. See the table below and the accompanying discussion for further information on interest income and expense. The net interest margin (net interest income divided by average earning assets and adjusted for tax on tax-exempt securities and loans) increased to 4.14% for the three months ended September 30, 2012 from 4.11% for the same period of the prior year. Net interest margin increased to 4.23% for the nine months ended September 30, 2012 from 4.02% for the same period last year. The increase in the current three and nine month periods is due to an improvement in the average cost of funds to 0.79% for the nine months ended September 30, 2012 from 1.25% one year ago, that was only partially offset by a decline in the Company’s average yield earned on assets from 5.20% to 5.01%. While net interest margin increased during the current nine month period, it has contracted since June 30, 2012 when net interest margin was 4.27%. Management believes the net interest margin may continue to decline slightly through the remainder of 2012 as market interest rates remain at historically low levels.

  

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The following tables set forth information with regard to average balances of interest earning assets and interest bearing liabilities and the resultant yields or cost, net interest income, and the net interest margin on a tax equivalent basis. Loans held for sale and non-accrual loans are included in total loans.

 

Three Months Ended September 30,

  

   2012   2011 
       Interest           Interest     
(dollars in thousands)  Average   Income   Avg   Average   Income   Avg 
   Balance   (Expense)   Rate   Balance   (Expense)   Rate 
Interest Earning Assets                              
Loans (1)  $482,172   $6,374*   5.29%  $483,482   $6,932*   5.74%
Taxable securities   29,626    186    2.51    30,473    260    3.41 
Tax-exempt securities   27,897    385*   5.52    25,083    388*   6.19 
Federal Home Loan Bank Stock   3,181            3,183         
Interest earning balances with banks   29,838    19    0.25    48,627    29    0.24 
                               
Total interest earning assets  $572,714   $6,964    4.86%  $590,848   $7,609    5.15%
                               
Cash and due from banks   10,948              10,700           
Bank premises and equipment (net)   14,726              14,977           
Other real estate owned   6,286              7,857           
Other assets   42,680              41,980           
Allowance for credit losses   (11,030)             (11,098)          
                               
Total assets  $636,324             $655,264           
                               
Interest Bearing Liabilities                              
Savings and interest bearing demand  $286,210   $(253)   0.35%  $282,974   $(394)   0.56%
Time deposits   142,661    (433)   1.21    174,513    (718)   1.65 
Total deposits   428,871    (686)   0.64    457,487    (1,112)   0.97 
                               
Short-term borrowings   3,000    (22)   2.93    7,728    (69)   3.57 
Long-term borrowings   7,500    (51)   2.72    10,500    (79)   3.01 
Secured borrowings   220    (1)   1.82    762    (9)   4.72 
Junior subordinated debentures   13,403    (69)   2.06    13,403    (67)   2.00 
Total borrowings   24,123    (143)   2.37    32,393    (224)   2.77 
                               
Total interest-bearing liabilities  $452,994   $(829)   0.73%  $489,880   $(1,336)   1.09%
                               
Demand deposits   112,364              98,471           
Other liabilities   4,512              4,273           
Shareholders’ equity   66,454              62,640           
                               
Total liabilities and shareholders’ equity   $636,324           $655,264           
                               
Net interest income       $6,135*            $6,273*     
Net interest spread             4.28%             4.25%
Net interest margin             4.14%             4.11%
Tax equivalent adjustment    $213*           $230    

 

* Tax equivalent basis – 34% tax rate used

(1) Interest income on loans includes loan fees of $113 and $138 in 2012 and 2011, respectively.

  

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Nine Months Ended September 30,

 

   2012   2011 
       Interest           Interest     
(dollars in thousands)  Average   Income   Avg   Average   Income   Avg 
   Balance   (Expense)   Rate   Balance   (Expense)   Rate 
Interest Earning Assets                              
Loans (1)  $480,367   $19,625*   5.45%  $481,470   $20,681*   5.73%
Taxable securities   30,336    633    2.78    29,990    810    3.60 
Tax-exempt securities   26,895    1,129*   5.60    23,950    1,118*   6.22 
Federal Home Loan Bank Stock   3,182            3,183         
Interest earning balances with banks   30,270    55    0.24    42,716    77    0.24 
                               
Total interest earning assets  $571,050   $21,442    5.01%  $581,309   $22,686    5.20%
                               
Cash and due from banks   10,264              10,126           
Bank premises and equipment (net)   14,798              15,090           
Other real estate owned   7,340              7,287           
Other assets   41,284              41,842           
Allowance for credit losses   (11,011)             (11,022)          
                               
Total assets  $634,725             $644,632           
                               
Interest Bearing Liabilities                              
Savings and interest bearing demand  $289,776   $(856)   0.39%  $271,496   $(1,261)   0.62%
Time deposits   146,931    (1,403)   1.27    183,117    (2,470)   1.80 
Total deposits   436,707    (2,259)   0.69    454,613    (3,731)   1.09 
                               
Short-term borrowings   2,595    (57)   2.93    9,205    (265)   3.84 
Long-term borrowings   7,905    (166)   2.80    10,500    (256)   3.25 
Secured borrowings   551    (18)   4.36    802    (32)   5.32 
Junior subordinated debentures   13,403    (221)   2.20    13,403    (280)   2.79 
Total borrowings   24,454    (462)   2.52    33,910    (833)   3.28 
                               
Total interest-bearing liabilities  $461,161   $(2,721)   0.79%  $488,523   $(4,564)   1.25%
                               
Demand deposits   103,308              90,163           
Other liabilities   5,014              4,608           
Shareholders’ equity   65,242              61,338           
                               
Total liabilities and shareholders’ equity  $634,725             $644,632           
                               
Net interest income       $18,721*            $18,122*     
Net interest spread             4.37            4.16%
Net interest margin             4.23            4.02%
Tax equivalent adjustment       $619*            $602*     

 

* Tax equivalent basis – 34% tax rate used

(1) Interest income on loans includes loan fees of $416 and $378 in 2012 and 2011, respectively.

  

Interest and dividend income on a tax equivalent basis for the three and nine months ended September 30, 2012 decreased $645,000 and $1,244,000, or 8.48% and 5.48%, respectively, compared to the same periods in 2011. The decrease was primarily due to the decline in income earned on our loan and investment portfolio as a result of the low interest rate environment. Loans averaged $480,367,000 with an average yield of 5.45% for the nine months ended September 30, 2012, compared to average loans of $481,470,000 with an average yield of 5.73% for the same period in 2011. Interest and dividend income on investment securities on a tax equivalent basis for the three and nine months ended September 30, 2012 decreased $77,000 and $166,000, or 11.88% and 8.61%, respectively, compared to the same periods in 2011. The decrease was attributable to the reduction in yield from accelerated prepayments on mortgage-backed securities and the maturity and sale of higher yielding securities that cannot be replaced in the current low rate environment.

  

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Average interest earning balances with banks for the three and nine months ended September 30, 2012 were $29,838,000 and $30,270,000, respectively, compared to $48,627,000 and $42,716,000 for the same periods in 2011. The average yield in all periods was 0.24 – 0.25% and is comparable to the federal funds target rate of 0.25% set by the Federal Open Market Committee.

 

Interest expense for the three and nine months ended September 30, 2012 decreased $507,000 and $1,843,000, or 37.95% and 40.38%, respectively, compared to the same periods in 2011. The decrease is primarily attributable to a decrease in rates paid on deposits, coupled with lower average balances outstanding on time deposits. The Company continued to reduce interest rates on certain deposit products in response to the continued low interest rate environment. The average balance of time deposits declined $36,186,000 compared to the first nine months of 2011, as fewer retail customers have been willing to lock in low interest rates for an extended period of time. In total, average interest-bearing deposit balances for the nine months ended September 30, 2012 and 2011 were $436,707,000 and $454,613,000, respectively, with an average cost of 0.69% and 1.09%, respectively.

 

Average borrowings for the nine months ended September 30, 2012 were $24,454,000 with an average cost of 2.52% compared to $33,910,000 with an average cost of 3.28% for the same period in 2011. The decrease in average borrowing balances outstanding is primarily due to the maturity of $10,500,000 in FHLB advances in the latter part of 2011. The pay down in borrowings was funded by growth in lower cost demand, money market and savings deposits, further improving net interest margin.

 

Provision and allowance for credit losses. The allowance for credit losses reflects management's current estimate of the amount required to absorb probable losses on loans in its loan portfolio based on factors present as of the end of the period.  Loans deemed uncollectible are charged against and reduce the allowance.

 

Periodic provisions for credit losses are charged to current expense to replenish the allowance for credit losses in order to maintain the allowance at a level management considers adequate. The amount of provision is based on an analysis of various factors including historical loss experience based on volumes and types of loans, volumes and trends in delinquencies and non-accrual loans, trends in portfolio volume, results of internal and independent external credit reviews, and anticipated economic conditions. Estimated loss factors used in the allowance for credit loss analysis are established based in part on historic charge-off data by loan category and economic conditions. During the three months ended September 30, 2012, based upon charge-off experience and other factors considered by management, the loss factors used in the allowance for credit losses were updated specifically on pass rated commercial loans from 0.55% to 0.50%, on non-owner occupied commercial real estate loans from 0.65% to 0.50%, on land and land development loans from 5.50% to 5.00% and on speculative residential construction loans from 1.75% to 1.25%, resulting in a decrease in the estimate for the allowance for credit losses. For additional information, please see the discussion under the heading “Critical Accounting Policies” in Item 7 of our 2011 10-K.

 

During the three and nine months ended September 30, 2012, provision for credit losses totaled zero and $400,000 compared to $1,050,000 and $1,550,000 for the same periods in 2011. The decrease in provision for credit losses in the current nine-month period is due to improving credit quality as evidenced by decreases in non-performing loans and loans classified substandard, coupled with a decrease in net charge-offs. Non-performing loans decreased from $14,035,000 at December 31, 2011, to $11,788,000 at September 30, 2012. Loans classified as substandard decreased $4,989,000 from year-end 2011 to $29,581,000 at the close of the third quarter.

  

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For the three and nine months ended September 30, 2012, net charge-offs (recoveries) were ($93,000) and $370,000 compared to $1,093,000 and $1,294,000 for the same periods in 2011. Net charge-offs for the twelve months ended December 31, 2011 were $1,990,000. The ratio of net charge-offs to average loans outstanding for the nine months ended September 30, 2012 and 2011 was 0.08% and 0.27%, respectively.

 

At September 30, 2012, the allowance for credit losses was $11,157,000 compared to $11,127,000 at December 31, 2011, and $10,923,000 at September 30, 2011. The slight increase compared to year-end 2011 is due to net recoveries recognized during the current quarter. The ratio of the allowance for credit losses to total loans outstanding (including loans held for sale) was 2.29%, 2.34% and 2.25%, at September 30, 2012, December 31, 2011 and September 30, 2011, respectively. The allowance for credit losses as a percentage of total loans remains elevated compared to historical standards and is reflective of management’s review since year-end 2011 of qualitative factors including the continued uncertainty in the economy, pervasive high unemployment rates in our geographic markets, and deterioration in real estate values, albeit at a slower pace than in the last three years.

 

The Company’s loan portfolio includes a significant portion of government guaranteed loans which are fully guaranteed by the United States Government. Government guaranteed loans were $50,710,000, $52,928,000, and $56,774,000 at September 30, 2012, December 31, 2011 and September 30, 2011, respectively. The ratio of allowance for credit losses to total loans outstanding excluding the government guaranteed loans was 2.55%, 2.64%, and 2.54%, respectively.

 

There is no precise method of predicting specific credit losses or amounts that ultimately may be charged off. The determination that a loan may become uncollectible, in whole or in part, is a matter of significant management judgment. Similarly, the adequacy of the allowance for credit losses is a matter of judgment that requires consideration of many factors, including (a) economic conditions and the effect on particular industries and specific borrowers; (b) a review of borrowers' financial data, together with industry data, the competitive situation, the borrowers' management capabilities and other factors; (c) a continuing evaluation of the loan portfolio, including monitoring by lending officers and staff credit personnel of all loans which are identified as being of less than acceptable quality; (d) an in-depth review, at a minimum quarterly or more frequently as considered necessary, of all loans judged to present a possibility of loss (if, as a result of such quarterly analysis, the loan is judged to be not fully collectible, the carrying value of the loan is reduced to that portion considered collectible); and (e) an evaluation of the underlying collateral for secured lending, including the use of independent appraisals of real estate properties securing loans. An analysis of the adequacy of the allowance is conducted by management quarterly and is reviewed by the board of directors. Based on this analysis and applicable accounting standards, management considers the allowance for credit losses to be adequate at September 30, 2012.

 

On November 2, 2012, the Company received a final determination in favor of the Bank in its appeal of a USDA decision to revoke a guaranty on a loan to one of the Bank’s borrowers. As a result of the decision, the guaranty is reinstated, and can only be revoked should the USDA appeal and the decision is reversed. Absent an appeal, the reinstatement of the guarantee during the fourth quarter of 2012 would result in the elimination of a $1.7 million specific reserve for the loan that was included in the Company’s allowance for credit losses at September 30, 2012. The Company expects the reversal to have a favorable, but not necessarily equivalent, impact on provision for credit losses during the fourth quarter of this year.

 

Non-performing assets and other real estate owned. Non-performing assets totaled $17,591,000 at September 30, 2012. This represents 2.73% of total assets, compared to $21,760,000, or 3.39%, at December 31, 2011, and $20,589, or 3.15%, at September 30, 2011. Commercial real estate loans are the primary components of non-performing assets, representing $7,897,000, or 44.89%, of non-performing assets.

 

 

 

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The following table presents information related to the Company’s non-performing assets:

 

SUMMARY OF NON-PERFORMING ASSETS
(dollars in thousands)
  September 30,
2012
   December 31,
2011
   September 30,
2011
 
             
Accruing loans past due 90 days or more  $770   $