10-Q 1 v325668_10q.htm QUARTERLY REPORT

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-Q

 

(Mark One)

 

x QUARTERLY 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 EXHANGE ACT OF 1934

 

For the transition period from _______________ to _______________________ 

 

Commission File Number:   000-27905

 

MutualFirst Financial, Inc.
(Exact name of registrant specified in its charter)

 

Maryland   35-2085640
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification No.)
     
                110 East Charles Street, Muncie, Indiana                                                                                     47305
                (Address of principal executive offices)                                                                                  (Zip Code)

 

(765) 747-2800
(Registrant’s telephone number, including area code)

 

None
(Former name, former address and former fiscal year, if changed since last report)

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  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 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 ¨
(Do not check if a smaller reporting company)
Smaller reporting company x

 

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

 

As of November 9, 2012, there were 6,994,637 shares of the registrant’s common stock outstanding.

 

 
 

 

FORM 10-Q

MutualFirst Financial, Inc.

 

INDEX

  Page
  Number
PART I – FINANCIAL INFORMATION  
     
Item 1. Financial Statements  
  Consolidated Condensed Balance Sheets 1
  Consolidated Condensed Statements of Income 2
  Consolidated Condensed Statements of Comprehensive Income 3
  Consolidated Condensed Statement of Stockholders’ Equity 4
  Consolidated Condensed Statements of Cash Flows 5
  Notes to Unaudited Consolidated Condensed Financial Statements 6
     
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 33
     
Item 3. Quantitative and Qualitative Disclosures about Market Risk 47
     
Item 4. Controls and Procedures 48
     
PART II – OTHER INFORMATION  
     
Item 1. Legal Proceedings 49
     
Item 1A. Risk Factors 49
     
Item 2. Unregistered Sales of Equity Changes in Securities and Use of Proceeds 49
     
Item 3. Defaults Upon Senior Securities 49
     
Item 4. Submission of Matters to a Vote of Security Holders 49
     
Item 5. Other Information 49
     
Item 6. Exhibits 50
     
Signature   Page   53
     
Exhibits   54

 

 
 

 

PART IFINANCIAL INFORMATION

Item 1.Financial Statements

 

MUTUALFIRST FINANCIAL, INC. AND SUBSIDIARY

Consolidated Condensed Balance Sheets

(Table Dollar Amounts in Thousands, Except Share and Per Share Data)

 

   September 30, 2012   December 31, 2011 
   (Unaudited)     
Assets          
Cash  $7,111   $7,710 
Interest-bearing demand deposits   37,208    47,513 
Cash and cash equivalents   44,319    55,223 
Interest-bearing deposits   -    1,415 
Investment securities available for sale   342,863    330,878 
Loans held for sale   4,072    1,441 
Loans   962,911    917,275 
Allowance for loan losses   (15,536)   (16,815)
Net loans   947,375    900,460 
Premises and equipment   32,344    32,025 
Federal Home Loan Bank of Indianapolis stock, at cost   14,391    14,391 
Investment in limited partnerships   2,730    3,113 
Deferred income tax benefit   14,896    17,386 
Income tax receivable   278    1,344 
Cash surrender value of life insurance   48,076    47,023 
Prepaid FDIC premium   1,947    2,821 
Core deposit and other intangibles   2,634    3,373 
Foreclosed real estate   6,184    6,525 
Other assets   10,287    9,775 
Total assets  $1,472,396   $1,427,193 
           
Liabilities          
Deposits          
Non-interest-bearing  $133,244   $122,215 
Interest-bearing   1,059,787    1,044,422 
Total deposits   1,193,031    1,166,637 
Federal Home Loan Bank advances   113,194    101,451 
Other borrowings   11,812    12,410 
Other liabilities   15,084    14,068 
Total liabilities   1,333,121    1,294,566 
           
Commitments and contingencies          
           
Stockholders' Equity          
Preferred stock, $.01 par value          
Authorized - 5,000,000 shares
Issued and outstanding - 28,923 shares; liquidation preference $1,000 per share
   1    1 
Common stock, $.01 par value          
Authorized - 20,000,000 shares
Issued and outstanding - 6,993,971 and 6,987,586 shares
   70    70 
Additional paid-in capital - preferred stock   28,923    28,923 
Additional paid-in capital - common stock   71,944    71,796 
Retained earnings   34,171    31,270 
Accumulated other comprehensive income   4,563    1,203 
Unearned employee stock ownership plan (ESOP) shares   (397)   (636)
Total stockholders' equity   139,275    132,627 
Total liabilities and stockholders' equity  $1,472,396   $1,427,193 

See notes to consolidated condensed financial statements. 

 

1
 

 

MUTUALFIRST FINANCIAL, INC. AND SUBSIDIARY

Consolidated Condensed Statements of Income

(Unaudited)

(Table Dollar Amounts in Thousands, Except Share and Per Share Data)

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
   2012   2011   2012   2011 
Interest Income                    
Loans receivable, including fees  $11,532   $12,992   $34,760   $40,091 
Investment securities:                    
Mortgage-backed securities   2,054    1,964    6,161    5,805 
Federal Home Loan Bank stock   107    107    323    315 
Other investments   201    170    634    460 
Deposits with financial institutions   14    17    29    68 
Total interest income   13,908    15,250    41,907    46,739 
                     
Interest Expense                    
Passbook savings   13    27    39    98 
Certificates of deposit   2,523    3,459    8,032    11,007 
Daily Money Market accounts   102    127    302    370 
Demand and NOW accounts   226    292    674    886 
Federal Home Loan Bank advances   533    741    1,733    2,486 
Other interest expense   196    208    593    628 
Total interest expense   3,593    4,854    11,373    15,475 
                     
Net Interest Income   10,315    10,396    30,534    31,264 
Provision for losses on loans   1,475    3,200    4,675    9,100 
Net Interest Income After Provision for Loan Losses   8,840    7,196    25,859    22,164 
                     
Other Income                    
Service fee income   1,644    1,862    5,049    5,193 
Net realized gain on sale of securities   1,095    1,764    1,575    1,839 
Equity in losses of limited partnerships   (124)   (107)   (372)   (256)
Commissions   859    879    2,914    2,835 
Net gains on sales of loans   541    245    1,388    685 
Net servicing fees (expenses)   (16)   (337)   (126)   (293)
Increase in cash surrender value of life insurance   340    346    1,017    1,071 
Gain (loss) on sale of other real estate and repossessed assets   30    (22)   (523)   (358)
Other-than-temporary losses on securities                    
Total other-than-temporary losses   -    -    -    (723)
Portion of loss recognized in other comprehensive income (before taxes)   -    -    -    530 
Net impairment losses recognized in earnings   -    -    -    (193)
Other income   12    34    93    100 
Total other income   4,381    4,664    11,015    10,623 
                     
Other Expenses                    
Salaries and employee benefits   5,273    5,240    15,910    16,103 
Net occupancy expenses   641    583    1,744    1,917 
Equipment expenses   454    505    1,346    1,487 
Data processing fees   361    373    1,178    1,153 
Automated teller machine   258    241    743    776 
Deposit insurance   312    330    939    1,170 
Professional fees   420    433    1,188    1,169 
Advertising and promotion   488    453    1,214    1,053 
Software subscriptions and maintenance   384    338    1,145    969 
Intangible amortization   229    280    745    894 
Other real estate and repossessed assets   247    279    691    746 
Other expenses   1,066    982    2,816    2,801 
Total other expenses   10,133    10,037    29,659    30,238 
                     
Income Before Income Tax   3,088    1,823    7,215    2,549 
Income tax expense   915    375    1,971    114 
                     
Net Income   2,173    1,448    5,244    2,435 
Preferred stock dividends and amortization   362    852    1,085    1,753 
Net Income Available to Common Shareholders  $1,811   $596   $4,159   $682 
                     
Basic earnings per common share  $0.26   $0.09   $0.60   $0.10 
                     
Diluted earnings per common share  $0.26   $0.09   $0.59   $0.10 
                     
Dividends per common share  $0.06   $0.06   $0.18   $0.18 

 

See notes to consolidated condensed financial statements.

  

2
 

 

MUTUALFIRST FINANCIAL, INC. AND SUBSIDIARY

Consolidated Condensed Statements of Comprehensive Income

(Unaudited)

(Table Dollar Amounts in Thousands, Except Share and Per Share Data)

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
   2012   2011   2012   2011 
                 
Net income  $2,173   $1,448   $5,244   $2,435 
Other comprehensive income:                    
Net unrealized holding gain on securities available-for-sale   2,643    3,802    6,724    11,724 
Net unrealized gain (loss) on securities available-for-sale for which a portion of an other-than-temporary impairment has been recognized in income   132    (418)   (20)   (136)
Less: Reclassification adjustment for realized gains included in net income   (1,095)   (1,764)   (1,575)   (1,646)
Net unrealized gain (loss) on derivative used for cash flow hedges   2    (119)   16    (162)
Income taxes related to other comprehensive income   (578)   (528)   (1,785)   (3,448)
                     
Other comprehensive income   1,104    973    3,360    6,332 
                     
Comprehensive income  $3,277   $2,421   $8,604   $8,767 

 

See notes to consolidated condensed financial statements.

 

3
 

 

MUTUALFIRST FINANCIAL, INC. AND SUBSIDIARY

Consolidated Condensed Statement of Stockholders' Equity

For the Period Ended September 30, 2012

(Unaudited)

(Table Dollar Amounts in Thousands, Except Share and Per Share Data) 

 

   Common Stock   Preferred Stock       Accumulated         
           Additional           Additional       Other   Unearned     
   Shares       paid-in   Shares       paid-in   Retained   Comprehensive   ESOP     
   Outstanding   Amount   capital   Outstanding   Amount   capital   Earnings   Income   shares   Total 
                                         
Balances,  January 1, 2012   6,987,586   $70   $71,796    28,923   $1   $28,923   $31,270   $1,203   $(636)  $132,627 
                                                   
Net income for the period                                 5,244              5,244 
                                                   
Other comprehensive income, net of tax                                      3,360         3,360 
                                                   
ESOP shares earned             (1)                            239    238 
                                                   
Stock options vested             102                                  102 
                                                   
Stock options exercised   6,385    -    47                                  47 
                                                   
Cash dividends ($.18 per common share)                                 (1,258)             (1,258)
                                                   
Cash dividends - preferred stock                                 (1,085)             (1,085)
                                                   
Balances,  September 30, 2012   6,993,971   $70   $71,944    28,923   $1   $28,923   $34,171   $4,563   $(397)  $139,275 

 

See notes to consolidated condensed financial statements.

 

4
 

 

MutualFirst Financial, Inc.

Consolidated Condensed Statements of Cash Flows

(Unaudited)

(Table Dollar Amounts in Thousands, Except Share and Per Share Data) 

 

   Nine Months Ended 
   September 30, 
   2012   2011 
Operating Activities          
Net income  $5,244   $2,435 
Items not requiring (providing) cash          
Provision for loan losses   4,675    9,100 
Depreciation and amortization   4,337    4,648 
Deferred income tax   705    (336)
Loans originated for sale   (30,184)   (16,976)
Proceeds from sales of loans held for sale   32,203    26,355 
Gains on sales of loans held for sale   (1,388)   (685)
Gain on sale of securities-available-for sale   (1,575)   (1,839)
Loss on sale of premise and equipment   -    44 
Loss on other real estate and repossessed assets   523    2,630 
Loss on other-than-temporary impairment, securities   -    193 
Other equity adjustments   340    255 
Change in          
Prepaid FDIC premium   874    1,088 
Interest receivable and other assets   588    (21,987)
Interest payable and other liabilities   (46)   721 
Cash value of life insurance   (1,017)   (1,071)
Other adjustments   468    (56)
Net cash provided by operating activities   15,747    4,519 
           
Investing Activities          
Net change in interest earning assets   1,415    - 
Purchases of securities available-for-sale   (104,448)   (119,349)
Proceeds from maturities and paydowns of securities available-for-sale   50,641    29,714 
Proceeds from sale of securities-available for sale   47,141    56,436 
Redemption of Federal Home Loan Bank Stock   -    2,292 
Net change in loans   (63,700)   18,458 
Proceeds from sales of loans transferred to held for sale   3,669    - 
Purchases of premises and equipment   (1,702)   (452)
Proceeds from real estate owned sales   4,132    3,396 
Other investing activities   (22)   (37)
Net cash used in investing activities   (62,874)   (9,542)
           
Financing Activities          
Net change in          
Noninterest-bearing, interest-bearing demand and savings deposits   81,587    60,709 
Certificates of deposit   (55,193)   (4,157)
Proceeds from FHLB advances   382,250    47,600 
Repayment of FHLB advances   (370,450)   (81,375)
Repayment of other borrowings   (630)   (595)
Preferred stock issued   -    28,923 
Stock/warrants repurchased   -    (33,282)
Cash dividends paid   (2,343)   (2,517)
Other financing activities   1,002    742 
Net cash provided by financing activities   36,223    16,048 
           
Net Change in Cash and Cash Equivalents   (10,904)   11,025 
           
Cash and Cash Equivalents, Beginning of Period   55,223    26,821 
           
Cash and Cash Equivalents, End of Period  $44,319   $37,846 
           
Additional Cash Flows Information          
Interest paid  $11,480   $15,132 
Income tax paid   200    200 
Transfers from loans to foreclosed real estate   4,102    7,344 
Mortgage servicing rights capitalized   231    397 

 

See Notes to Consolidated Condensed Financial Statements

 

5
 

 

MutualFirst Financial, Inc. and Subsidiaries

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(Unaudited)

(Table Dollar Amounts in Thousands, Except Share and Per Share Data)

  

Note 1:  Basis of Presentation

 

The consolidated condensed financial statements include the accounts of MutualFirst Financial, Inc. (MutualFirst or the “Company”), its wholly owned subsidiary MutualBank, an Indiana commercial bank (“Mutual” or the “Bank”), Mutual’s wholly owned subsidiaries, First MFSB Corporation, Mishawaka Financial Services, and Mutual Federal Investment Company (“MFIC”), and MFIC majority owned subsidiary, Mutual Federal REIT, Inc. All significant inter-company accounts and transactions have been eliminated in consolidation.

 

Certain information and note disclosures normally included in the Company’s annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. These consolidated condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s annual report on Form 10-K for year ended December 31, 2011, filed with the Securities and Exchange Commission on March 16, 2012.

 

The interim consolidated financial statements at September 30, 2012, have not been audited by independent accountants, but in the opinion of management, reflect all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position, results of operations and cash flows for such periods. The results of operations for the periods are not necessarily indicative of the results to be expected for the full year.

 

The Consolidated Condensed Balance Sheet of the Company as of December 31, 2011 has been derived from the Audited Consolidated Balance Sheet of the Company as of that date.

 

Note 2: Earnings per share

 

Earnings per share were computed as follows:

 

   Three Months Ended September 30, 
   2012   2011 
       Weighted-           Weighted-     
   Net   Average   Per-Share   Net   Average   Per-Share 
   Income   Shares   Amount   Income   Shares   Amount 
                         
Basic Earnings Per Share                              
Net income  $2,173    6,992,831        $1,448    6,911,597      
Dividends and accretion on preferred stock   (362)             (852)          
Income available to common stockholders   1,811    6,992,831   $0.26    596    6,911,597   $0.09 
Effect of Dilutive securities                              
Stock options and RRP grants        82,065              15,836      
Diluted Earnings Per Share                              
                               
Income available to common stockholders and assumed conversions  $1,811    7,074,896   $0.26   $596    6,927,433   $0.09 

 

6
 

 

   Nine Months Ended September 30, 
   2012   2011 
       Weighted-           Weighted-     
   Net   Average   Per-Share   Net   Average   Per-Share 
   Income   Shares   Amount   Income   Shares   Amount 
                         
Basic Earnings Per Share                              
Net income  $5,244    6,937,229        $2,435    6,902,676      
Dividends and accretion on preferred stock   (1,085)             (1,753)          
Income available to common stockholders   4,159    6,937,229   $0.60    682    6,902,676   $0.10 
Effect of Dilutive securities                              
Stock options and RRP grants        94,803              89,753      
Diluted Earnings Per Share                              
                               
Income available to common stockholders and assumed conversions  $4,159    7,032,032   $0.59   $682    6,992,429   $0.10 

 

Options to purchase 250,681 and 499,637 shares of common stock were outstanding at September 30, 2012 and 2011 for the three and nine months ended, respectively, but were not included in the computation of diluted EPS above, because the average exercise price of the options was greater than the average market price of the common shares.

 

Note 3:  Impact of Accounting Pronouncements

 

The FASB has issued Accounting Standards Update (ASU) No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This ASU represents the converged guidance of the FASB and the IASB (the Boards) on fair value measurement. The collective efforts of the Boards and their staffs, reflected in ASU 2011-04, have resulted in common requirements for measuring fair value and for disclosing information about fair value measurements, including a consistent meaning of the term “fair value.” The Boards have concluded the common requirements will result in greater comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with U.S. GAAP and IFRSs.

 

The amendments to the FASB Accounting Standards Codification (Codification) in this ASU are to be applied prospectively. For public entities, the amendments were effective during interim and annual periods beginning after December 15, 2011, and did not have a material impact on the Company’s financial statements.

 

The FASB has issued Accounting Standards Update (ASU) No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. This ASU amendment allows an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders' equity. The amendments to the Codification in the ASU do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. ASU 2011-05 is to be applied retrospectively. For public entities, the amendments were effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The adoption of ASU No. 2011-05 did not have a material impact on the Company’s financial statements.

 

7
 

 

The FASB issued ASU No. 2011-12, Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.  This ASU defers the effective date of the requirement to present separate line items on the income statement for reclassification adjustments of items out of accumulated other comprehensive income into net income for all periods presented. The ASU does not change the other requirements of FASB ASU No. 2011-05, Presentation of Comprehensive Income. Entities are still required to present reclassification adjustments within other comprehensive income either on the face of the statement that reports other comprehensive income or in the notes to the financial statements. The requirement to present comprehensive income in either a single continuous statement or two consecutive condensed statements remains for both annual and interim reporting. The deferral of the requirement for the presentation of reclassification adjustments is intended to be temporary until the FASB reconsiders the operational concerns and needs of financial statement users.

 

The Company adopted the amendments in this Update at the same time as ASU 2011-05, which became effective beginning in the interim period ended March 31, 2012. As the Company had no reclassifications adjustments within other comprehensive income, ASU No. 2011-12 had no impact on its financial statements.

 

The FASB issued ASU No. 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities. This ASU amends Topic 210 to require an entity to disclose both gross and net information about financial instruments, such as sales and repurchase agreements and reverse sale and repurchase agreements and securities borrowing/lending arrangements, and derivate instruments that are eligible for offset in the statement of financial position and/or subject to a master netting arrangement or similar agreement. ASU 2011-11 is effective for annual and interim period beginning on January 1, 2013, and is not expected to have a significant impact on the Corporation’s financial statements.

 

Note 4: Investments

 

The amortized cost and approximate fair values of securities as of September 30, 2012 and December 31, 2011 are as follows.

 

   September 30, 2012 
       Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
   Cost   Gains   Losses   Value 
Available for Sale Securities                    
Mortgage-backed securities                    
Government sponsored agencies  $179,467   $7,972   $-   $187,439 
Collateralized mortgage obligations                    
Government sponsored agencies   125,153    3,845    (34)   128,964 
Federal agencies   3,000    18    0    3,018 
Municipals   3,129    158    (15)   3,272 
Small Business Administration   9    -    -    9 
Corporate obligations   24,099    397    (4,335)   20,161 
Total  $334,857   $12,390   $(4,384)  $342,863 

 

   December 31, 2011 
       Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
   Cost   Gains   Losses   Value 
Available for Sale Securities                    
Mortgage-backed securities                    
Government sponsored agencies  $198,039   $4,813   $(6)  $202,846 
Collateralized mortgage obligations                    
Government sponsored agencies   97,098    2,963    -    100,061 
Federal agencies   2,000    2    -    2,002 
Municipals   3,364    208    (14)   3,558 
Small Business Administration   12    -    -    12 
Corporate obligations   27,488    -    (5,089)   22,399 
Total  $328,001   $7,986   $(5,109)  $330,878 

 

8
 

 

The amortized cost and fair value of available-for-sale securities at September 30, 2012, by contractual maturity, are shown below.  Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

   Available for Sale 
   Amortized   Fair 
Description Securities  Cost   Value 
Security obligations due          
One to five years  $17,356   $17,752 
Five to ten years   4,946    4,972 
After ten years   7,926    3,727 
    30,228    26,451 
Mortgage-backed securities   179,467    187,439 
Collateralized mortgage obligations   125,153    128,964 
Small Business Administration   9    9 
Totals  $334,857   $342,863 

 

The carrying value of securities pledged as collateral, to secure public deposits and for other purposes, was $2.6 million at September 30, 2012.

 

Gross gains of $1.6 million and $1.9 million resulting from sales of securities were realized for the nine months ended September 30, 2012 and 2011, respectively. Losses recognized on the sale of securities for the nine months ended September 30, 2012 and 2011 were $0 and $22,000, respectively.  Other-than-temporary impairment losses were recognized on securities for the nine months ended September 30, 2012 and 2011 of $0 and $193,000, respectively.

 

Certain investments in debt and marketable equity securities are reported in the financial statements at an amount less than their historical cost.  Total fair value of these investments at September 30, 2012, was $11.3 million, a decrease from $28.5 million at December 31, 2011, which is approximately 3% and 9%, respectively, of the Bank's portfolio.  The Bank has continued to see an improvement since year-end due to increased market values.

 

Based on evaluation of available evidence, including recent changes in market interest rates, management believes the declines in fair value for these securities, other than those discussed below, are temporary. Should the impairment of any of these securities become other-than-temporary, the cost basis of the investment will be reduced and the resulting loss recognized in net income in the period the other-than-temporary impairment is identified.

 

The following tables show our investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at September 30, 2012 and December 31, 2011:

 

   September 30, 2012 
   Less than 12 months   12 months or more   Total 
   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
   Value   Losses   Value   Losses   Value   Losses 
Available for Sale                              
Collateralized mortgage obligations                              
Government sponsored agencies  $8,010   $(34)  $-   $-   $8,010   $(34)
Municipals   876    (15)   -    -    876    (15)
Corporate obligations   -    -    2,408    (4,335)   2,408    (4,335)
Total temporarily impaired securities  $8,886   $(49)  $2,408   $(4,335)  $11,294   $(4,384)

 

9
 

 

   December 31, 2011 
   Less than 12 months   12 months or more   Total 
   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
   Value   Losses   Value   Losses   Value   Losses 
Available for Sale                              
Mortgage-backed securities                              
Government sponsored agencies  $5,076   $(6)  $-   $-   $5,076   $(6)
Municipals   971    (14)   -    -    971    (14)
Corporate obligations   19,957    (790)   2,454    (4,299)   22,411    (5,089)
Total temporarily impaired securities  $26,004   $(810)  $2,454   $(4,299)  $28,458   $(5,109)

 

Mortgage-Backed Securities (MBS) and Collateralized Mortgage Obligations (CMO)

 

The unrealized losses on the Company’s investment in MBSs and CMOs were caused by interest rate changes.  The Company expects to recover the amortized cost basis over the term of the securities.  Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company does not intend to sell the investments and it is more likely than not the Company will not be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired at September 30, 2012.

 

Corporate Obligations

 

The Company’s unrealized loss on investments in corporate obligations primarily relates to investments in pooled trust preferred securities. The unrealized losses were primarily caused by (a) a decrease in performance and regulatory capital at the underlying banks resulting from exposure to subprime mortgages and (b) a sector downgrade by several industry analysts. The Company currently expects some of the securities to settle at a price less than the amortized cost basis of the investment (that is, the Company expects to recover less than the entire amortized cost basis of the security). The Company has recognized a loss equal to the credit loss for these securities, establishing a new, and lower amortized cost basis. The credit loss was calculated by comparing expected discounted cash flows based on performance indicators of the underlying assets in the security to the carrying value of the investment. Because the Company does not intend to sell the investments and it is likely the Company will not be required to sell the investments before recovery of its new, lower amortized cost basis, which may be maturity, it does not consider the remainder of the investments to be other-than-temporarily impaired at September 30, 2012.

 

Mutual evaluates securities for other-than-temporary impairment (“OTTI”) on a quarterly basis. During the quarter ended September 30, 2012, the Bank’s evaluation indicated that there was no other-than-temporary impairment of securities. Impairment on securities is determined after analyzing the estimated cash flows to be received, underlying collateral and determining the amount of additional losses needed in the individual pools to create a shortfall in interest or principal payments. All trust preferred securities were valued using a discounted cash flow analysis as of September 30, 2012.

 

Other-than-temporary Impairment

 

Upon acquisition of a security, the Company decides whether it is within the scope of the accounting guidance for beneficial interests in securitized financial assets or will be evaluated for impairment under the accounting guidance for investments in debt and equity securities.

 

The accounting guidance for beneficial interests in securitized financial assets provides incremental impairment guidance for a subset of the debt securities within the scope of the guidance for investments in debt and equity securities. For securities where the security is a beneficial interest in securitized financial assets, the Company uses the beneficial interests in securitized financial asset impairment model. Where the security is not a beneficial interest in securitized financial assets, the Company uses the debt and equity securities impairment model.

 

The Company routinely conducts reviews to identify and evaluate each investment security to determine whether an other-than-temporary impairment has occurred.  Economic models are used to determine whether an other-than-temporary impairment has occurred on these securities.  While all securities are considered, the securities primarily impacted by other-than-temporary impairment testing are pooled trust preferred securities.  For each pooled trust preferred security in the investment portfolio (including but not limited to those whose fair value is less than their amortized cost basis), an extensive, regular review is conducted to determine if an other-than-temporary impairment has occurred.  Various inputs to the economic models are used to determine if an unrealized loss is other-than-temporary.

 

10
 

 

The Bank’s trust preferred securities valuation was prepared by an independent third party.  The approach to determining fair value involved several steps including:

 

  · Detailed credit and structural evaluation of each piece of collateral in the trust preferred securities;

 

  · Collateral performance projections for each piece of collateral in the trust preferred security;

 

  · Terms of the trust preferred structure, as laid out in the indenture; and

 

  · Discounted cash flow modeling.

 

MutualFirst uses market-based yield indicators as a baseline for determining appropriate discount rates, and then adjusts the resulting discount rates on the basis of its credit and structural analysis of specific trust preferred securities.  The primary focus is on the returns a fixed income investor would require in order to allocate capital on a risk adjusted basis.  There is currently no active market for pooled trust preferred securities; however, the Company looks principally to market yields for stand-alone trust preferred securities issued by banks, thrifts and insurance companies for which there is an active and liquid market.  The next step is to make a series of adjustments to reflect the differences that exist between these products (both credit and structural) and, most importantly, to reflect idiosyncratic credit performance differences (both actual and projected) between these products and the underlying collateral in the specific trust preferred security.  Importantly, as part of the analysis described above, MutualFirst considers the fact that structured instruments frequently exhibit leverage not present in stand-alone instruments, and make adjustments as necessary to reflect this additional risk.

 

 The default and recovery probabilities for each piece of collateral were formed based on the evaluation of the collateral credit and a review of historical industry default data and current/near-term operating conditions.  For collateral that has already defaulted, the Company assumed no recovery.  For collateral that was in deferral, the Company assumed a recovery of 10% of par for banks, thrifts or other depository institutions, and 15% of par for insurance companies.  Although the Company conservatively assumed that the majority of the deferring collateral continues to defer and eventually defaults, we also recognize there is a possibility that some deferring collateral may become current at some point in the future.

 

11
 

 

Pooled Trust Preferred Securities

 

At September 30, 2012, MutualFirst had an amortized cost in pooled trust preferred securities of $6.7 million, which had an original par value of $8.0 million.  These securities had a fair value of $2.4 million at September 30, 2012.  The following table provides additional information related to the Bank’s investment in trust preferred securities as of September 30, 2012:

 

Deal  Class   Original
Par
   Book
Value
   Fair
Value
   Unrealized
Loss
   Recognized
Losses 2012
   Lowest
Rating
  Number of
Banks/Insurance
Companies Currently
Performing
   Actual
Deferrals/Defaults (as %
of original collateral)
  

Total Projected

Defaults (as a %

of performing

collateral)a

  

Excess Subordination

(after taking into

account best estimate of

future

deferrals/defaults)b

 
                                            
Alesco Preferred Funding IX   A2A   $1,000   $902   $375   $527   $-   B2   44    16.64%   15.38%   44.11%
Preferred Term Securities XIII   B1    1,000    823    254    569    -   Ca   40    34.94%   27.67%   0.84%
Preferred Term Securities XVIII   C    1,000    917    210    707    -   Ca   48    29.43%   16.14%   1.73%
Preferred Term Securities XXVII   C1    1,000    710    200    510    -   C   34    26.61%   22.84%   6.09%
U.S. Capital Funding I   B1    3,000    2,891    1,148    1,743    -   Caa1   30    15.90%   14.84%   1.55%
U.S. Capital Funding III   B1    1,000    500    221    279    -   Ca   28    27.94%   16.86%   0.00%
                                                      
Total       $8,000   $6,743   $2,408   $4,335   $-                        

 

 

(a) A 10% recovery is applied to all projected defaults.  A 15% recovery is applied to all projected insurance defaults.  No recovery is applied to current defaults.
   
(b) Excess subordination represents the additional defaults in excess of both current and projected defaults that the CDO can absorb before the bond experiences any credit impairment. Excess subordinated percentage is calculated by (a) determining what percentage of defaults a deal can experience before the bond has credit impairment, and (b) subtracting from this default breakage percentage both total current and expected future default percentages.

 

Credit Losses Recognized on Investments

 

Certain debt securities have experienced fair value deterioration due to credit losses, as well as due to other market factors, but are not otherwise other-than-temporarily impaired.

 

The following table provides information about debt securities for which only a credit loss was recognized in income and other losses are recorded in other comprehensive income.

 

   Accumulated Credit Losses
Three Months Ended
September 30,
 
   2012   2011 
Credit losses on debt securities held          
Beginning of period  $(1,205)  $(1,205)
Additions related to increases in previously recognized other-than-temporary losses for the three months ended   -    - 
           
As of September 30,  $(1,205)  $(1,205)

 

12
 

 

   Accumulated Credit Losses
Nine Months Ended
September 30,
 
   2012   2011 
Credit losses on debt securities held          
Beginning of year  $(1,205)  $(1,179)
Additions related to increases in previously recognized other-than-temporary losses for the nine months ended   -    (26)
           
As of September 30,  $(1,205)  $(1,205)

 

Note 5: Accumulated Other Comprehensive Income

 

The following table represents the components of accumulated other comprehensive income:

 

   September
30,
   December 31, 
   2012   2011 
Net unrealized gain on securities available-for-sale  $11,815   $6,666 
Net unrealized loss on securities available-for-sale for which a portion of other-than-temporary impairment has been recognized in income   (3,808)   (3,788)
Net unrealized loss on derivative used for cash flow hedges   (456)   (472)
Net unrealized loss relating to defined benefit plan liability   (448)   (448)
    7,103    1,958 
Tax expense   2,540    755 
           
Net-of-tax amount  $4,563   $1,203 

 

Note 6: Disclosures About Fair Value of Assets and Liabilities

 

FASB Codification Topic 820 (ASC 820), Fair Value Measurements and Disclosures, defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  ASC 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  

 

The standard describes three levels of inputs that may be used to measure fair value:

 

Level 1  Quoted prices in active markets for identical assets or liabilities  
Level 2 Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities
Level 3 Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities

 

Items Measured at Fair Value on a Recurring Basis

 

Following is a description of the valuation methodologies and inputs used for instruments measured at fair value on a recurring basis and recognized in the accompanying balance sheets, as well as the general classification of such instruments pursuant to the valuation hierarchy.

 

13
 

 

Available-for-Sale Securities

 

Where quoted market prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy.  The Company uses a third-party provider to provide market prices on its securities.  Level 1 securities include the marketable equity securities.  If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics or discounted cash flows.  Level 2 securities include mortgage-backed, collateralized mortgage obligations, small business administration, marketable equity, municipal, federal agency and certain corporate obligation securities.  In certain cases where Level 1 or Level 2 inputs are not available, securities are classified within Level 3 of the hierarchy and include certain corporate obligation securities.

 

Third party vendors compile prices from various sources and may apply such techniques as matrix pricing to determine the value of identical or similar investment securities (Level 2). Matrix pricing is a mathematical technique widely used in the banking industry to value investment securities without relying exclusively on quoted prices for specific investment securities but rather relying on investment securities relationship to other benchmark quoted investment securities. Any investment security not valued based upon the methods above are considered Level 3.

 

Fair value determinations for Level 3 measurements of securities are the responsibility of the Treasury function of the Company.  The Company contracts with a pricing specialist to generate fair value estimates on a monthly basis.  The Treasury function of the Company challenges the reasonableness of the assumptions used and reviews the methodology to ensure the estimated fair value complies with accounting standards generally accepted in the United States, analyzes the changes in fair value and compares these changes to internally developed expectations and monitors these changes for appropriateness.

 

The following table presents the fair value measurement of assets measured at fair value on a recurring basis and the level within the ASC 820 fair value hierarchy used for such fair value measurements:

 

       Fair Value Measurements Using 
   Fair Value   Level 1   Level 2   Level 3 
September 30, 2012                    
Mortgage-backed securities                    
Government sponsored agencies  $187,439   $-   $187,439   $- 
Collateralized mortgage obligations                    
Government sponsored agencies   128,964    -    128,964    - 
Federal agencies   3,018    -    3,018    - 
Municipals   3,272    -    3,272    - 
Small Business Administration   9    -    9    - 
Corporate obligations   20,161    -    17,753    2,408 
Available-for-sale securities  $342,863   $-   $340,455   $2,408 
                     
December 31, 2011                    
Mortgage-backed securities                    
Government sponsored agencies  $202,846   $-   $202,846   $- 
Collateralized mortgage obligations                    
Government sponsored agencies   100,061    -    100,061    - 
Federal agencies   2,002    -    2,002    - 
Municipals   3,558    -    3,558    - 
Small Business Administration   12    -    12    - 
Corporate obligations   22,399    -    19,945    2,454 
Available-for-sale securities  $330,878   $-   $328,424   $2,454 

 

14
 

 

The following is a reconciliation of the beginning and ending balances for the three months ended September 30, 2012 and 2011 of recurring fair value measurements recognized in the accompanying balance sheet using significant unobservable (Level 3) inputs:

 

   2012   2011 
         
Beginning balance  $2,264   $2,958 
           
Total realized and unrealized gains and losses          
Included in net income   -    - 
Included in other comprehensive loss   144    (418)
Purchases, issuances and settlements   -    13 
           
Ending balance  $2,408   $2,553 
           
Total gains or losses for the period included in net income attributable to the change in unrealized gains or losses related to assets still held at the reporting date  $-   $- 

 

The following is a reconciliation of the beginning and ending balances for the nine months ended September 30, 2012 and 2011 of recurring fair value measurements recognized in the accompanying balance sheet using significant unobservable (Level 3) inputs:

 

   2012   2011 
         
Beginning balance  $2,454   $2,645 
           
Total realized and unrealized gains and losses          
Included in net income   -    (193)
Included in other comprehensive loss   (36)   57 
Purchases, issuances and settlements   (10)   44 
           
Ending balance  $2,408   $2,553 
           
Total gains or losses for the period included in net income attributable to the change in unrealized gains or losses related to assets still held at the reporting date  $-   $(193)

 

Items Measured at Fair Value on a Non-Recurring Basis

 

From time to time, certain assets may be recorded at fair value on a non-recurring basis.  These non-recurring fair value adjustments typically are a result of the application of lower of cost or fair value accounting or a write-down occurring during the period.  The following is a description of the valuation methodologies used for certain assets that are recorded at fair value.

 

Impaired Loans (Collateral Dependent)

 

Loans for which it is probable that Mutual will not collect all principal and interest due according to contractual terms are measured for impairment.  Allowable methods for determining the amount of impairment include estimating fair value include using the fair value of the collateral for collateral dependent loans.

 

If the impaired loan is identified as collateral dependent, then the fair value method of measuring the amount of impairment is utilized.  This method requires obtaining a current independent appraisal of the collateral and applying a discount factor to the value.

 

Impaired loans that are collateral dependent are classified within Level 3 of the fair value hierarchy when impairment is determined using the fair value method. 

 

15
 

 

Other Real Estate Owned

 

The fair value of real estate is generally determined based on appraisals by qualified licensed appraisers. The appraisers typically determine the value of the real estate by utilizing an income or market valuation approach. If an appraisal is not available, the fair value may be determined by using a cash flow analysis.

 

The estimated fair value of other real estate owned is based on current appraisal, less discount to reflect realizable value and estimated cost to sell.  Other real estate owned is classified within Level 3 of the fair value hierarchy.  Appraisals of other real estate owned are obtained when the real estate is acquired and subsequently as deemed necessary by the asset classification committee.  The Risk Management division reviews the appraisals for accuracy and consistency.  Appraisals are selected from the list of approved appraisers maintained by the Board.  The reductions in fair value of other real estate owned were $456,000 and $276,000 for the nine months ended September 30, 2012 and 2011, respectively. The changes were recorded as adjustments to current earnings through other real estate owned related expenses.

 

Mortgage Servicing Rights

 

We initially measure our mortgage servicing rights at fair value, and amortize them over the period of estimated net servicing income. They are periodically assessed for impairment based on fair value at the reporting date. Mortgage-servicing rights do not trade in an active market with readily observable prices. Accordingly, the fair value is estimated based on a valuation model which calculates the present value of estimated future net servicing income. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, market discount rates, cost to service, float earnings rates and other ancillary income, including late fees. The fair value measurements are classified as Level 3.

 

The following table presents the fair value measurement of assets measured at fair value on a nonrecurring basis and the level within the ASC 820 fair value hierarchy in which the fair value measurements fall:

 

       Fair Value Measurements Using 
   Fair Value   Level 1   Level 2   Level 3 
September 30, 2012                    
Impaired loans (collateral dependent)  $7,235   $-   $-   $7,235 
Foreclosed real estate   2,136    -    -    2,136 
Mortgage servicing rights   2,109              2,109 
                     
December 31, 2011                    
Impaired loans (collateral dependent)  $16,511   $-   $-   $16,511 
Foreclosed real estate   202    -    -    202 
Mortgage-servicing rights   2,626    -    -    2,626 

 

16
 

 

The following table presents quantitative information about unobservable inputs used in recurring and nonrecurring Level 3 fair value measurements.

 

   Fair Value at
September 30,
2012
   Valuation Technique  Unobservable Inputs  Range 
Trust Preferred Securities  $2,408   Discounted cash flow  Discount rate
Constant prepayment rate
Cumulative projected prepayments
Probability of default
Projected cures given deferral
Loss severity
   

9.0% - 16.0%

2.0%

 30.0%

1.5%-2.4%

0%-15.0%

56.7% – 81.4%

 
                 
Impaired loans (collateral dependent)  $7,235   Third party valuations  Discount to reflect realizable value
   0%-40% 
                 
Foreclosed real estate
  $2,136   Third party valuations  Discount to reflect realizable value less estimated selling costs
   0%-25% 
                 
Mortgage servicing rights  $2,109   Third party valuations  Prepayment speeds
Discount rates
Servicing fee
   

220%-700%

9.0%

0.25%

 

 

The estimated fair values of the Company’s financial instruments not carried at fair value in the consolidated condensed balance sheets as of dates noted below are as follows:

 

   Carrying       Fair Value Measurements Using 
September 30,  2012  Amount   Fair Value   Level 1   Level 2   Level 3 
                     
Assets                         
Cash and cash equivalents  $44,319   $44,319   $44,319   $-   $- 
Loans held for sale   4,072    4,216    -    4,216    - 
Loans   947,375    977,803    -    -    977,803 
FHLB stock   14,391    14,391    -    14,391    - 
Interest receivable   3,930    3,930    -    3,930    - 
                          
Liabilities                         
Deposits   1,193,031    1,210,969    596,913    -    614,056 
FHLB advances   113,194    115,174    -    115,174    - 
Other borrowings   11,812    13,006    -    13,006    - 
Interest payable   447    447    -    447    - 
Advances by borrowers for taxes and insurance   2,675    2,675    -    2,675    - 

 

17
 

 

   December 31, 2011 
   Carrying
Amount
   Fair
Value
 
Assets          
Cash and cash equivalents  $55,223   $55,223 
Interest-bearing deposits   1,415    1,415 
Loans held for sale   1,441    1,459 
Loans   900,460    921,212 
FHLB stock   14,391    14,391 
Interest receivable   4,248    4,248 
           
Liabilities          
Deposits  $1,166,637   $1,132,031 
FHLB advances   101,451    103,980 
Other borrowings   12,410    13,083 
Interest payable   340    340 
Advances by borrowers for taxes and insurance   1,720    1,720 

 

The following methods and assumptions were used to estimate the fair value of each class of financial instruments listed above:

 

Cash and Cash Equivalents - The fair value of cash and cash equivalents approximates carrying value.

 

Interest-Bearing Deposits - The fair value of interest-bearing deposits approximates carrying value.

 

Loans Held For Sale - Fair values are based on current investor purchase commitments.

 

Loans - The fair value for loans is estimated using discounted cash flow analyses using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.

 

FHLB Stock - Fair value of FHLB stock is based on the price at which it may be resold to the FHLB.

 

Interest Receivable/Payable - The fair values of interest receivable/payable approximate carrying values.

 

Deposits - The fair values of noninterest-bearing, interest-bearing demand and savings accounts are equal to the amount payable on demand at the balance sheet date.  Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on such time deposits.

 

Federal Home Loan Bank Advances - The fair value of these borrowings are estimated using a discounted cash flow calculation, based on current rates for similar debt for periods comparable to the remaining terms to maturity of these advances.

 

Other Borrowings - The fair value of other borrowings are estimated using a discount calculation based on current rates.

 

Advances by Borrowers for Taxes and Insurance - The fair value approximates carrying value.

 

Off-Balance Sheet Commitments - Commitments include commitments to purchase and originate mortgage loans, commitments to sell mortgage loans, and standby letters of credit and are generally of a short-term nature.  The fair values of such commitments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.  The fair value of commitments is immaterial.

 

18
 

 

Note 7: Loans

 

Categories of loans at September 30, 2012 and December 31, 2011 include:

 

   September 30,   December 31, 
   2012   2011 
Commercial          
Real estate  $195,465   $197,390 
Construction and development   16,718    20,831 
Other   61,876    64,628 
    274,059    282,849 
           
Residential Mortgage          
One- to four- family   491,012    434,976 
           
Consumer loans          
Real estate   98,572    96,864 
Auto   15,337    15,203 
Boat/RVs   79,175    83,557 
Other   6,692    6,760 
    199,776    202,384 
Total loans   964,847    920,209 
           
Undisbursed loans in process   (4,372)   (5,352)
Unamortized deferred loan costs, net   2,436    2,418 
Allowance for loan losses   (15,536)   (16,815)
Net loans  $947,375   $900,460 

 

The risk characteristics of each loan portfolio segment are as follows:

 

Commercial

 

Commercial real estate

 

These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing the Company’s commercial real estate portfolio are diverse in terms of type and geographic location. Management monitors and evaluates commercial real estate loans based on collateral, geography and risk grade criteria. As a general rule, the Company avoids financing single purpose projects unless other underwriting factors are present to help mitigate risk. In addition, management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied loans.

 

Construction and Development

 

Construction loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analyses of absorption and lease rates and financial analyses of the developers and property owners. Construction loans are generally based on estimates of costs and value associated with the complete project. These estimates may be inaccurate. Construction loans often involve the disbursement of substantial funds with repayment substantially dependent on the success of the ultimate project. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions and the availability of long-term financing.

 

19
 

 

Commercial other

 

Commercial loans are primarily based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may incorporate a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.

 

Mortgage and Consumer

 

With respect to residential loans that are secured by 1-4 family residences and are primarily owner occupied, the Company generally establishes a maximum loan-to-value ratio and requires PMI if that ratio is exceeded. Home equity loans are typically secured by a subordinate interest in 1-4 family residences, and consumer loans are secured by consumer assets such as automobiles or recreational vehicles. Some consumer loans are unsecured such as small installment loans and certain lines of credit. Repayment of these loans is primarily dependent on the personal income of the borrowers, which can be impacted by economic conditions in their market areas such as unemployment levels. Repayment can also be impacted by changes in property values on residential properties. Risk is mitigated by the fact that the loans are of smaller individual amounts and spread over a large number of borrowers.

 

Nonaccrual Loan and Past Due Loans

 

Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due.  The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 90 days past due unless the credit is well-secured and in process of collection.  Past due status is based on contractual terms of the loan.  In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful.

 

All interest accrued but not collected for loans that are placed on nonaccrual or charged off is reversed against interest income.  The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual.  Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

 

Non-accrual loans, segregated by class of loans, as of September 30, 2012 and December 31, 2011 are as follows:

 

   September 30,   December 31, 
   2012   2011 
Commercial          
Real Estate  $2,688   $7,592 
Construction and development   6,301    9,314 
Other   1,412    1,160 
Residential Mortgage   9,862    10,080 
Consumer          
Real estate   1,942    2,081 
Auto   39    24 
Boat/RV   784    371 
Other   104    89 
           
   $23,112   $30,711 

 

20
 

 

An age analysis of Company’s past due loans, segregated by class of loans, as of September 30, 2012 and December 31, 2011 is as follows:

 

   September 30, 2012 
   30-59 Days
Past Due
   60-89 Days
Past Due
   Greater
Than 90
Days
   Total Past
Due
   Current   Total Loans
Receivable
   Total Loans
> 90 Days
and
Accruing
 
Commercial                                   
Real Estate  $816   $161   $2,508   $3,485   $191,980   $195,465   $- 
Construction and development   563    -    5,805    6,368    10,350    16,718    - 
Other   1,167    158    780    2,105    59,771    61,876    - 
Residential Mortgage   10,566    3,006    9,345    22,917    468,095    491,012    756 
Consumer                                   
Real estate   587    353    1,442    2,382    96,190    98,572    - 
Auto   63    4    33    100    15,237    15,337    - 
Boat/RV   1,409    735    378    2,522    76,653    79,175    - 
Other   155    6    68    229    6,463    6,692    1 
                                    
   $15,326   $4,423   $20,359   $40,108   $924,739   $964,847   $757 

 

   December 31, 2011 
   30-59 Days
Past Due
   60-89 Days
Past Due
   Greater
Than 90
Days
   Total Past
Due
   Current   Total
Loans
Receivable
   Total Loans
> 90 Days
and
Accruing
 
Commercial                                   
Real Estate  $1,173   $1,439   $6,569   $9,181   $188,209   $197,390   $- 
Construction  and development   845    3,595    4,850    9,290    11,541    20,831    - 
Other   791    99    955    1,845    62,783    64,628    - 
Residential Mortgage   13,309    3,427    11,207    27,943    407,033    434,976    1,127 
Consumer                                   
Real estate   1,395    1,167    2,081    4,643    92,221    96,864    - 
Auto   143    28    24    195    15,008    15,203    - 
Boat/RV   2,084    825    371    3,280    80,277    83,557    - 
Other   227    5    89    321    6,439    6,760    - 
                                    
   $19,967   $10,585   $26,146   $56,698   $863,511   $920,209   $1,127 

 

Impaired Loans.  

 

Loans are considered impaired in accordance with the impairment accounting guidance (ASC 310-10-35-16), when based on current information and events, it is probable the Company will be unable to collect all amounts due from the borrower in accordance with the contractual terms of the loan.  Impaired loans include nonperforming commercial loans but also include loans modified in troubled debt restructurings where concessions have been granted to borrowers experiencing financial difficulties.  These concessions could include a reduction in the interest rate on the loan, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collection.

 

21
 

 

Loans are individually evaluated for impairment based on internal limits outlined in our lending policies. The current threshold for these evaluations is set at $250,000. Although all troubled debt restructurings are considered impaired loans they are not necessarily individually evaluated for impairment based on the guidelines noted previously.

 

Interest on impaired loans is recorded based on the performance of the loan.  All interest received on impaired loans that are on nonaccrual is accounted for on the cash-basis method until qualifying for return to accrual.  Interest is accrued per contract for impaired loans that are performing.

 

22
 

 

The following tables present impaired loans for the three and nine month periods ended September 30, 2012 and 2011 and the year ended December 31, 2011.

 

   September 30, 2012 
   Recorded
Balance
   Unpaid
Principal
Balance
   Specific
Allowance
   Average
Investment in
Impaired
Loans -
Quarter
   Average
Investment in
Impaired
Loans - YTD
   Interest Income
Recognized -
Quarter
   Interest Income
Recognized -
YTD
 
Loans without a specific valuation allowance                                   
Commercial                                   
Real estate  $3,570   $4,122   $-   $4,546   $5,646   $37   $147 
Construction and development   7,111    9,101    -    7,669    9,092    11    35 
Other   1,076    1,076    -    2,098    3,028    5    28 
Residential Mortgage   3,960    5,048    -    3,613    4,124    19    58 
                                    
Loans with a specific valuation allowance                                   
Commercial                                   
Construction and development   1,364    4,337    375    1,364    1,482    18    55 
Other   1,178    1,178    357    1,191    1,206    9    35 
Residential Mortgage   529    529    37    530    532    18    35 
                                    
Total                                   
Commercial                                   
Real estate  $3,570   $4,122   $-   $4,546   $5,646   $37   $147 
Construction and development  $8,475   $13,438   $375   $9,033   $10,574   $29   $90 
Other  $2,254   $2,254   $357   $3,289   $4,234   $14   $63 
Residential Mortgage  $4,489   $5,577   $37   $4,143   $4,656   $37   $93 

  

23
 

 

   December 31, 2011 
               Average     
       Unpaid       Investment in   Interest 
   Recorded   Principal   Specific   Impaired   Income 
   Balance   Balance   Allowance   Loans   Recognized 
Loans without a specific valuation allowance                         
Commercial                         
Real estate  $4,883   $5,275   $-   $4,221   $137 
Construction and development   5,872    11,801    -    9,451    348 
Other   4,030    4,167    -    1,480    211 
Residential Mortgage   5,378    6,870    -    5,532    142 
                          
Loans with a specific valuation allowance                         
Commercial                         
Real estate   2,083    2,489    209    1,086    74 
Construction and development   7,071    7,281    1,437    3,775    233 
Other   1,470    1,524    543    246    60 
Residential Mortgage   537    537    36    67    36 
                          
Total                         
Commercial                         
Real estate  $6,966   $7,764   $209   $5,307   $211 
Construction and development  $12,943   $19,082   $1,437   $13,226   $581 
Other  $5,500   $5,691   $543   $1,726   $271 
Residential Mortgage  $5,915   $7,407   $36   $5,599   $178 

 

24
 

 

   September 30, 2011 
   Average
Investment in
Impaired Loans
- Quarter
   Average
Investment in
Impaired
Loans - YTD
   Interest Income
Recognized -
Quarter
   Interest Income
Recognized -
YTD
 
Loans without a specific valuation allowance                    
Commercial                    
Real estate  $3,349   $4,890   $4   $81 
Construction and development   9,158    11,776    31    227 
Other   1,358    1,972    1    28 
Residential Mortgage   4,765    5,866    47    119 
                     
Loans with a specific valuation allowance                    
Commercial                    
Real estate   1,640    1,648    8    52 
Construction and development   3,985    4,122    24    60 
Other   125    250    3    7 
Residential Mortgage   -    -    -    - 
                     
Total                    
Commercial                    
Real estate  $4,989   $6,538   $12   $133 
Construction and development  $13,143   $15,898   $55   $287 
Other  $1,483   $2,222   $4   $35 
Residential Mortgage  $4,765   $5,866   $47   $119 

 

Commercial Loan Grades

 

Definition of Loan Grades.  Loan grades are numbered 1 through 8.  Grades 1-4 are "pass" credits, grade 5 [Special Mention] loans are "criticized" assets, and grades 6 [Substandard], 7 [Doubtful] and 8 [Loss] are "classified" assets.  The use and application of these grades by the Bank are uniform and conform to the Bank's policy and regulatory definitions.

 

Pass.  Pass credits are loans in grades prime through fair.  These are at least considered to be credits with acceptable risks and would be granted in the normal course of lending operations.

 

Special Mention.  Special mention credits have potential weaknesses that deserve management’s close attention.  If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the credits or in the Bank’s credit position at some future date.  If weaknesses cannot be identified, classifying as special mention is not appropriate.  Special mention credits are not adversely classified and do not expose the Bank to sufficient risk to warrant an adverse classification.  No apparent loss of principal or interest is expected.

 

Substandard.  Credits which are inadequately protected by the current sound worth and paying capacity of the obligor or by the collateral pledged.  Financial statements normally reveal some or all of the following:  poor trends, lack of earnings and cash flow, excessive debt, lack of liquidity, and the absence of creditor protection.  Credits so classified must have a well-defined weakness, or weaknesses that jeopardize the liquidation of the debt.  They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.

 

25
 

 

Doubtful.  An  extension of credit “doubtful” has all the weaknesses inherent in one classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.  The possibility of loss is extremely high, but because of certain important and reasonably specific pending factors that may work to the advantage and strengthening of the asset, its classification as an estimated loss is deferred until its more exact status may be determined.  Pending factors include proposed merger, acquisition, or liquidation procedures, capital injection, perfecting liens on additional collateral, and refinancing plans.  A Doubtful classification for an entire credit should be avoided when collection of a specific portion appears highly probable with the adequately secured portion graded Substandard.  

 

Retail Loan Grades

 

Pass.  Pass credits are loans that are currently performing as agreed and are not troubled debt restructurings.

 

Special Mention.  Special mention credits have potential weaknesses that deserve management’s close attention.  If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the credits or in the Bank’s credit position at some future date.  If weaknesses cannot be identified, classifying as special mention is not appropriate.  Special mention credits are not adversely classified and do not expose the Bank to sufficient risk to warrant an adverse classification.  No apparent loss of principal or interest is expected.

 

Substandard.  Substandard credits are loans that have reason to be considered to have a well defined weakness and placed on non-accrual.  This would include all retail loans over 90 days and troubled debt restructurings which were delinquent at the time of modification.

  

The following information presents the credit risk profile of the Company’s loan portfolio based on rating category and payment activity as of September 30, 2012 and December 31, 2011.

 

September 30, 2012  
Commercial Credit Exposure Credit Risk Profile  
Internal Rating  Real estate   Construction and
Development
   Other 
             
Pass  $169,089   $8,686   $57,472 
Special Mention   15,392    172    300 
Substandard   10,984    7,860    3,234 
Doubtful   -    -    870 
                
Total  $195,465   $16,718   $61,876 

 

Retail Credit Exposure Credit Risk Profile  
   Mortgage   Consumer 
   Residential   Real Estate   Auto   Boat/RV   Other     
                     
Pass  $474,440   $95,994   $15,287   $78,012   $6,595 
Special Mention   2,031    -    -    -    - 
Substandard   14,541    2,578    50    1,163    97 
                          
Total  $491,012   $98,572   $15,337   $79,175   $6,692 

  

December 31, 2011  
Commercial Credit Exposure Credit Risk Profile  
       Construction     
       and     
Internal Rating  Real estate   Development   Other 
                
Pass  $167,991   $8,093   $56,691 
Special Mention   11,940    538    880 
Substandard   16,488    12,105    6,260 
Doubtful   971    95    797 
                
Total  $197,390   $20,831   $64,628 

 

26
 

 

Retail Credit Exposure Credit Risk Profile    
    Mortgage     Consumer  
    Residential     Real Estate     Auto     Boat/RV     Other    
                                 
Pass   $ 417,772     $ 94,066     $ 15,135     $ 82,639     $ 6,680    
Special Mention     2,473       -       -       -       -    
Substandard     14,731       2,798       68       918       80    
                                           
Total   $ 434,976     $ 96,864     $ 15,203     $ 83,557     $ 6,760    

 

Allowance for Loan Losses.

 

We maintain an allowance for loan losses to absorb losses inherent in the loan portfolio. The allowance is based on ongoing, quarterly assessments of the estimated losses inherent in the loan portfolio.  Our methodology for assessing the appropriateness of the allowance consists of several key elements, including the general allowance and specific allowances for identified problem loans and portfolio segments.  In addition, the allowance incorporates the results of measuring impaired loans as provided in FASB ASC 310, Receivables.  These accounting standards prescribe the measurement methods, income recognition and disclosures related to impaired loans. The general allowance is calculated by applying loss factors to outstanding loans based on the internal risk evaluation of such loans or pools of loans. Changes in risk evaluations of both performing and nonperforming loans affect the amount of the general allowance. Loss factors are based on our historical loss experience as well as on significant factors that, in management’s judgment, affect the collectability of the portfolio as of the evaluation date.

 

The appropriateness of the allowance is reviewed by management based upon its evaluation of then-existing economic and business conditions affecting our key lending areas and other conditions, such as credit quality trends (including trends in non-performing loans expected to result from existing conditions), collateral values, loan volumes and concentrations, specific industry conditions within portfolio segments and recent loss experience in particular segments of the portfolio that existed as of the balance sheet date and the impact that such conditions were believed to have had on the collectability of the loan.  Senior management reviews these conditions quarterly in discussions with our senior credit officers.  To the extent that any of these conditions is evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management’s estimate of the effect of such condition may be reflected as a specific allowance applicable to such credit or portfolio segment.  Where any of these conditions is not evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management’s evaluation of the loss related to this condition is reflected in the general allowance for loan losses.  The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty because they are not identified with specific problem credits or portfolio segments.

 

The allowance for loan losses is based on estimates of losses inherent in the loan portfolio.  Actual losses can vary significantly from the estimated amounts.  Our methodology as described permits adjustments to any loss factor used in the computation of the general allowance in the event that, in management’s judgment, significant factors which affect the collectability of the portfolio as of the evaluation date are not reflected in the loss factors.  By assessing the probable incurred losses inherent in the loan portfolio on a quarterly basis, we are able to adjust specific and inherent loss estimates based upon any more recent information that has become available.  Due to the loss of numerous manufacturing jobs in the communities we serve during recent years and the increase in higher risk loans, like consumer and commercial loans, as a percentage of total loans, management has concluded that our allowance for loan losses should be greater than historical loss experience and specifically identified losses would otherwise indicate.

 

The following table details activity in the allowance for loan losses by portfolio segment for the three and nine months ended September 30, 2012 and 2011 and year ended December 31, 2011.  Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other segments.

 

27
 

 

   Three Months Ended September 30, 2012 
   Commercial   Mortgage   Consumer   Total 
Allowance for loan losses:                    
Balance, beginning of period  $10,004   $3,392   $2,607   $16,003 
Provision charged to expense   985    480    10    1,475 
Losses charged off   1,484    505    268    2,257 
Recoveries   16    196    103    315 
                     
Balance, end of period  $9,521   $3,563   $2,452   $15,536 

 

   Nine Months Ended September 30, 2012 
   Commercial   Mortgage   Consumer   Total 
Allowance for loan losses:                    
Balance, beginning of year  $10,602   $3,444   $2,769   $16,815 
Provision charged to expense   2,410    1,571    694    4,675 
Losses charged off   4,034    1,652    1,354    7,040 
Recoveries   543    200    343    1,086 
                     
Balance, end of period  $9,521   $3,563   $2,452   $15,536 
                     
Ending balance:                    
Individually evaluated for impairment  $732   $37   $-   $769 
Collectively evaluated for impairment  $8,789   $3,526   $2,452   $14,767 
                     
Loans:                    
Ending balance                    
Individually evaluated for impairment  $14,299   $4,489   $-   $18,788 
Collectively evaluated for impairment  $259,760   $486,523   $199,776   $946,059 

 

28
 

 

   Year Ended December 31, 2011 
   Commercial   Mortgage   Consumer   Total 
Allowance for loan losses:                    
Balance, beginning of year  $10,124   $2,212   $4,036   $16,372 
Provision charged to expense   8,592    4,390    118    13,100 
Losses charged off   8,260    3,432    2,126    13,818 
Recoveries   146    274    741    1,161 
                     
Balance, end of period  $10,602   $3,444   $2,769   $16,815 
                     
Ending balance:                    
Individually evaluated for impairment  $2,189   $36   $-   $2,225 
Collectively evaluated for impairment  $8,413   $3,408   $2,769   $14,590 
                     
Loans:                    
Ending balance                    
Individually evaluated for impairment  $25,409   $5,915   $-   $31,324 
Collectively evaluated for impairment  $257,440   $429,061   $202,384   $888,885 

 

   Three Months Ended September 30, 2011 
   Commercial   Mortgage   Consumer   Total 
Allowance for loan losses:                    
Balance, beginning of year  $9,790   $2,135   $4,032   $15,957 
Provision charged to expense   2,915    100    185    3,200 
Losses charged off   2,017    464    556    3,037 
Recoveries   64    63    234    361 
                     
Balance, end of period  $10,752   $1,834   $3,895   $16,481 

 

   Nine Months Ended September 30, 2011 
   Commercial   Mortgage   Consumer   Total 
Allowance for loan losses:                    
Balance, beginning of year  $10,124   $2,212   $4,036   $16,372 
Provision charged to expense   6,145    2,100    855    9,100 
Losses charged off   5,582    2,644    1,647    9,873 
Recoveries   65    166    651    882 
                     
Balance, end of period  $10,752   $1,834   $3,895   $16,481 

 

Management’s general practice is to proactively charge down loans individually evaluated for impairment to the fair value of the underlying collateral.

 

For all loan portfolio segments except 1-4 family residential properties and consumer, the Company promptly charges-off loans, or portions thereof, when available information confirms that specific loans are uncollectible based on information that includes, but is not limited to, (1) the deteriorating financial condition of the borrower, (2) declining collateral values, and/or (3) legal action, including bankruptcy, that impairs the borrower’s ability to adequately meet its obligations. For impaired loans that are considered to be solely collateral dependent, a partial charge-off is recorded when a loss has been confirmed by an updated appraisal or other appropriate valuation of the collateral.

 

29
 

 

The Company charges-off 1-4 family residential and consumer loans, or portions thereof, when the Company reasonably determines the amount of the loss. The Company adheres to timeframes established by applicable regulatory guidance which provides for the charge-down of 1-4 family first and junior lien mortgages to the net realizable value less costs to sell when the loan is 180 days past due, charge-off of unsecured open-end loans when the loan is 180 days past due, and charge-down to the net realizable value when other secured loans are 120 days past due. Loans at these respective delinquency thresholds for which the Company can clearly document that the loan is both well-secured and in the process of collection, such that collection will occur regardless of delinquency status, need not be charged-off.

 

Information on non-performing assets, excluding performing restructured loans, is provided below:

 

   September 30, 
   2012   2011 
Non-performing assets          
Non-accrual loans  $23,112   $25,937 
Accruing loans 90 days + past due   757    1,103 
Total non-performing loans   23,869    27,040 
Foreclosed real estate   6,184    5,686 
Other repossessed assets   573    1,142 
Total non-performing assets  $30,626   $33,868 

 

Troubled Debt Restructurings

 

Included in certain loan categories of impaired loans are certain loans that have been modified in a troubled debt restructuring, where economic concessions have been granted to borrowers who have experienced financial difficulties.  These concessions typically result from our loss mitigation activities and could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions.  Modifications of terms for our loans and their inclusion as troubled debt restructurings are based on individual facts and circumstances.

 

When we modify loans in a troubled debt restructuring, we evaluate any possible impairment similar to other impaired loans based on the present value of expected future cash flows, discounted at the contractual interest rate of the original loan agreement, or use the current fair value of the collateral, less selling costs for collateral dependent loans. If we determined that the value of the modified loan is less than the recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs and unamortized premium or discount), impairment is recognized through a specific reserve or a charge-off to the allowance.

 

Loans retain their accrual status at the time of their modification.  As a result, if a loan is on nonaccrual at the time it is modified, it stays as nonaccrual until a period of satisfactory performance, generally six months, is obtained.  If a loan is on accrual at the time of the modification, the loan is evaluated to determine the collection of principal and interest is reasonably assured and generally stays on accrual.

 

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The following tables provide detail regarding troubled debts restructured in the three and nine month periods ended September 30, 2012 and 2011.

 

Three Months Ended September 30, 2012  
       Pre-
Modification
   Post-
Modification
 
       Outstanding   Outstanding 
   No. of
Loans
   Recorded
Balance
   Recorded
Balance
 
Commercial               
Real Estate   1   $439   $439 
Construction and development   1    172    172 
Other   2    46    46 
Residential Mortgage   10    719    734 
Consumer               
Real estate   14    439    438 
Auto   2    9    8 
Boat/RV   4    96    95 
Other   2    36    36 

 

Three Months Ended September 30, 2011  
       Pre-
Modification
   Post-
Modification
 
       Outstanding   Outstanding 
   No. of
Loans
   Recorded
Balance
   Recorded
Balance
 
Commercial               
Real Estate   1   $113   $70 
Residential Mortgage   6    463    492 
Consumer               
Real estate   10    231    231 
Auto   1    10    10 
Boat/RV   4    134    133 

 

Nine Months Ended September 30, 2012  
       Pre-
Modification
   Post-
Modification
 
       Outstanding   Outstanding 
   No. of
Loans
   Recorded
Balance
   Recorded
Balance
 
Commercial               
Real Estate   4   $1,359   $1,520 
Construction and development   1    172    172 
Other   5    262    324 
Residential Mortgage   28    2,455    2,596 
Consumer               
Real estate   24    830    830 
Auto   3    16    15 
Boat/RV   7    154    153 
Other   4    53    52 

 

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Nine Months Ended September 30, 2011  
       Pre-
Modification
   Post-
Modification
 
       Outstanding   Outstanding 
   No. of
Loans
   Recorded
Balance
   Recorded
Balance
 
Commercial               
Real Estate   1   $113   $70 
Construction and development   2    3,728    3,728 
Other   1    103    103 
Residential Mortgage   22    2,529    2,598 
Consumer               
Real estate   22    555    551 
Auto   1    10    10 
Boat/RV   12    364    357 
Other   1    14    1 

 

The impact to the allowance for loan losses due to these modifications was insignificant.

 

Newly restructured loans by types are as follows:

 

Three Months Ended September 30, 2012  
   Interest Only   Term   Combination   Total
Modification
 
Commercial                    
Real Estate  $-   $-   $439   $439 
Construction and development   -    -    172    172 
Other   -    46    -    46 
Residential Mortgage   -    36    698    734 
Consumer                    
Real estate   -    22    416    438 
Auto   -    4    4    8 
Boat/RV   -    95    -    95 
Other   -    -    36    36 

 

Nine Months Ended September 30, 2012  
   Interest Only   Term   Combination   Total
Modification
 
Commercial                    
Real Estate  $-   $403   $1,117   $1,520 
Construction and development   -    -    172    172 
Other   -    143    181    324 
Residential Mortgage   320    169    2,107    2,596 
Consumer                    
Real estate   -    55    775    830 
Auto   -    11    4    15 
Boat/RV   -    153    -    153 
Other   -    8    44    52 

 

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The following tables provide detail regarding troubled debts restructured in the last twelve months that have defaulted in the quarter ended September 30, 2012.

 

Three and Nine Months Ended September 30, 2012  
       Post-
Modification
 
       Outstanding 
   No. of
Loans
   Recorded
Balance
 
Commercial          
Real Estate   1   $109 
Other   1    518 
Residential Mortgage   1    31 
Consumer          
Other   1    14 

 

We had no defaults of any loans modified as troubled debt restructurings made for the three and nine months ended September 30, 2011. Default is defined as any loan that becomes more than 90 days past due.

 

Item 2:  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Overview and Significant Events in the Three and Nine Months Ended September 30, 2012

 

The following should be read in conjunction with the Management’s Discussion and Analysis in Item 7 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, which was filed with the SEC on March 16, 2012.

 

The Company is a Maryland corporation and a bank holding company headquartered in Muncie, Indiana, with operations in Delaware, Elkhart, Grant, Kosciusko, Randolph, St. Joseph and Wabash counties in Indiana. It owns MutualBank, an Indiana commercial bank with 32 bank branches in Indiana, trust offices in Carmel and Crawfordsville, Indiana and a loan origination office in New Buffalo, Michigan. The Company is subject to regulation, supervision and examination by the Board of Governors of the Federal Reserve System (“FRB”), and the Bank is subject to regulation, supervision and examination by the Indiana Department of Financial Institutions (“IDFI”)and the Federal Deposit Insurance Corporation (“FDIC”).

 

Our principal business consists of attracting retail deposits from the general public, including some brokered deposits, and investing those funds primarily in loans secured by first mortgages on owner-occupied, one- to four-family residences, a variety of consumer loans, loans secured by commercial and multi-family real estate and commercial business loans. Funds not invested in loans generally are invested in investment securities, including mortgage-backed and mortgage-related securities. We also obtain funds from FHLB advances and other borrowings.

 

Our results of operations depend primarily on the level of our net interest income, which is the difference between interest income on interest-earning assets, such as loans, mortgage-backed securities and investment securities, and interest expense on interest-bearing liabilities, primarily deposits and borrowings. The structure of our interest-earning assets versus the structure of interest-bearing liabilities, along with the shape of the yield curve, has a direct impact on our net interest income. Historically, our interest-earning assets have been longer term in nature (i.e., fixed-rate mortgage loans) and interest-bearing liabilities have been shorter term (i.e., certificates of deposit, regular savings accounts, etc.). This structure would impact net interest income favorably in a decreasing rate environment, assuming a normally shaped yield curve, as the rates on interest-bearing liabilities would decrease more rapidly than rates on interest-earning assets. Conversely, in an increasing rate environment, assuming a normally shaped yield curve, net interest income would be impacted unfavorably as rates on interest-earning assets would increase at a slower rate than rates on interest-bearing liabilities.

 

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Third Quarter Highlights. At September 30, 2012, we had $1.5 billion in assets, $962.9 million in loans, $1.2 billion in deposits and $139.3 million in stockholders’ equity. The Bank’s total risk-based capital ratio at September 30, 2012 was 15.01%, exceeding the 10.00% requirement for a well-capitalized institution. The ratio of tangible common equity was 7.33% as of September 30, 2012, an increase from 7.05% at December 31, 2011. For the quarter ended September 30, 2012, income available to common shareholders totaled $1.8 million, or $.26 per basic and diluted share, compared with net income of $596,000 available to common shareholders, or $.09 per basic and diluted share for the quarter ended September 30, 2011.

 

Key aspects of our operations in the third quarter of 2012, include the following:

 

·Gross loans increased $8.5 million.
·Deposits increased $21.5 million.
·Tangible common equity increased to 7.33% in the third quarter of 2012 and tangible book value increased to $15.40.
·Non-performing assets declined $2.2 million, or 6.7% in the third quarter of 2012 and declined $8.6 million, or 21.9% compared to December 31, 2011. Classified assets declined $5.8 million, or 9.5% in the third quarter of 2012 to $54.9 million compared to $60.6 million at December 31, 2011.
·Net charge offs on an annualized basis were .81% in the third quarter of 2012 compared to 1.11% in the same period of 2011. Net charge offs on a linked quarter basis decreased from 1.04%.
·Net interest margin was 3.05% for the third quarter of 2012 compared to 3.19% in the same period of 2011. On a linked quarter basis, net interest margin declined from 3.10%.
·Non-interest income for the quarter ended September 30, 2012 decreased $283,000 compared to the same period in 2011. On a linked quarter basis, non-interest income increased $676,000.
·Non-interest expense for the third quarter of 2012 increased $97,000 over the same period in 2011. Non-interest expense increased $200,000 over the linked quarter.

 

The Management’s Discussion and Analysis in Item 7 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, contains a summary of our management strategy. The financial highlights of our strategy during the quarter include: increasing core deposits by 0.4% during the quarter to 49.6% of total deposits; decreasing non-performing assets to total assets from 2.23% at June 30, 2012 to 2.08% at the end of the quarter; and maintaining increased capital ratios from year-end levels.

 

Critical Accounting Policies

 

Note 1 to the Notes to the Consolidated Financial Statements in Item 8 of the Form 10-K for the year ended December 31, 2011 contains a summary of MutualFirst ’s significant accounting policies. Certain of these policies are important to the portrayal of the Company’s financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain.  Management believes that its critical accounting policies include determining the allowance for loan losses, the valuation of foreclosed assets, mortgage servicing rights and intangible assets.

 

Allowance for Loan Losses. The allowance for loan losses is a significant estimate that can and does change based on management’s assumptions about specific borrowers and current general economic and business conditions, among other factors.  Management reviews the adequacy of the allowance for loan losses on at least a quarterly basis.  The evaluation by management includes consideration of past loss experience, changes in the composition of the loan portfolio, the current condition and amount of loans outstanding, identified problem loans and the probability of collecting all amounts due.

 

The determination of the adequacy of the allowance for loan losses is based on estimates that are particularly susceptible to significant changes in the economic environment and market conditions.  A worsening or protracted economic decline would increase the likelihood of additional losses due to credit and market risk and could create the need for additional loss reserves.

 

Foreclosed Assets. Foreclosed assets are carried at the lower of cost or fair value less estimated selling costs.  Management estimates the fair value of the properties based on current appraisal information.  Fair value estimates are particularly susceptible to significant changes in the economic environment, market conditions, and real estate market.  A worsening or protracted economic decline would increase the likelihood of a decline in property values and could create the need to write down the properties through current operations.

 

34
 

 

Management recently reviewed the Bank’s processes for foreclosed properties and deemed they are in compliance with regulations and state laws.

 

Mortgage Servicing Rights. Mortgage servicing rights (“MSRs”) associated with loans originated and sold, where servicing is retained, are capitalized and included in other assets in the consolidated balance sheet.  The value of the capitalized servicing rights represents the fair value of the right to service loans in the portfolio.  Critical accounting policies for MSRs relate to the initial valuation and subsequent impairment tests.  The methodology used to determine the valuation of MSRs requires the development and use of a number of estimates, including anticipated principal amortization and prepayments of that principal balance.  Events that may significantly affect the estimates used are changes in interest rates, mortgage loan prepayment speeds and the payment performance of the underlying loans.  The carrying value of the MSRs is periodically reviewed for impairment based on a determination of fair value.  For purposes of measuring impairment, the servicing rights are compared to a valuation prepared based on a discounted cash flow methodology, utilizing current prepayment speeds and discount rates.  Impairment, if any, is recognized through a valuation allowance and is recorded as a reduction in loan servicing fee income.

 

Intangible Assets. The Company periodically assesses the potential impairment of its core deposit intangible.  If actual external conditions and future operating results differ from the Company’s judgments, impairment and/or increased amortization charges may be necessary to reduce the carrying value of these assets to the appropriate value.    

 

Securities. Under FASB Codification Topic 320 (ASC 320), Investments-Debt and Equity Securities, investment securities must be classified as held-to-maturity, available-for-sale or trading.  Management determines the appropriate classification at the time of purchase. The classification of securities is significant since it directly impacts the accounting for unrealized gains and losses on securities. Debt securities are classified as held-to-maturity and carried at amortized cost when management has the positive intent and the Company has the ability to hold the securities to maturity. Securities not classified as held-to-maturity are classified as available-for-sale and are carried at fair value, with the unrealized holding gains and losses, net of tax, reported in other comprehensive income.

 

The fair values of the Company’s securities are generally determined by reference to quoted prices from reliable independent sources utilizing observable inputs. Certain of the Company’s fair values of securities are determined using models whose significant value drivers or assumptions are unobservable and are significant to the fair value of the securities. These models are utilized when quoted prices are not available for certain securities or in markets where trading activity has slowed or ceased. When quoted prices are not available and are not provided by third party pricing services, management judgment is necessary to determine fair value. As such, fair value is determined using discounted cash flow analysis models, incorporating default rates, estimation of prepayment characteristics and implied volatilities.

 

The Company evaluates securities on a quarterly basis, and more frequently when economic conditions warrant additional evaluations, to determine if an other-than-temporary impairment (OTTI) exists pursuant to guidelines established in ASC 320.  In evaluating the possible impairment of securities, consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial conditions and near-term prospects of the issuer, and the ability and intent of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.  In analyzing an issuer’s financial condition, the Company may consider whether the securities are issued by the federal government or its agencies or government sponsored agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition.

 

If management determines that an investment experienced an OTTI, management must then determine the amount of the OTTI to be recognized in earnings.  For investments in debt securities, if management does not intend to sell the security and it is more likely than not that the Company will not be required to sell the security before recovery of its amortized cost basis less any current period loss, the OTTI will be separated into the amount representing the credit loss and the amount related to all other factors.  The amount of OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings.  The amount of the OTTI related to other factors will be recognized in other comprehensive income, net of applicable taxes.  The previous amortized cost basis less the OTTI recognized in earnings will become the new amortized cost basis of the investment.  If management intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current period credit loss, the OTTI will be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date.  Any recoveries related to the value of these securities are recorded as an unrealized gain (as other comprehensive income (loss) in stockholders’ equity) and not recognized in income until the security is ultimately sold.

 

35
 

 

The Company from time to time may dispose of an impaired security in response to asset/liability management decisions, future market movements, business plan changes, or if the net proceeds can be reinvested at a rate of return that is expected to recover the loss within a reasonable period of time.

 

Income Tax Accounting

 

We file a consolidated federal income tax return.  The provision for income taxes is based upon income in our consolidated financial statements, rather than amounts reported on our income tax return.  Deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.  Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.  The effect of a change in tax rates on our deferred tax assets and liabilities is recognized as income or expense in the period that includes the enactment date.

 

Forward-Looking Statements

 

This Form 10-Q contains and our future filings with the SEC, Company press releases, other public pronouncements, stockholder communications and oral statements made by or with the approval of an authorized executive officer will contain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. You can identify these forward-looking statements through our use of words such as “may,” “will,” “anticipate,” “assume,” “should,” “indicate,” “would,” “believe,” “contemplate,” “expect,” “estimate,” “continue,” “plan,” “project,” “could,” “intend,” “target” and other similar words and expressions of the future. These forward-looking statements include, but are not limited to: (i) statements of our goals, intentions and expectations; (ii) statements regarding our business plans, prospects, growth and operating strategies; (iii) statements regarding the asset quality of our loan and investment portfolios; and (iv) estimates of our risks and future costs and benefits. These forward-looking statements are based on current beliefs and expectations of our management and are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change. The Company does not undertake and specifically declines any obligation to publicly release the result of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of unanticipated events.

 

36
 

 

The following factors, among others, could cause actual results to differ materially from the anticipated results or other expectations expressed in the forward-looking statements: (i) the credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs and changes in our allowance for loan losses and provision for loan losses that may be impacted by deterioration in the housing and commercial real estate markets; (ii) changes in general economic conditions, either nationally or in our market areas; (iii) changes in the levels of general interest rates and the relative differences between short- and long-term interest rates, deposit interest rates, our net interest margin and funding sources; (v) fluctuations in the demand for loans, the number of unsold homes, land and other properties and fluctuations in real estate values in our market areas; (vi) decreases in the secondary market for the sale of loans that we originate; (vii) results of examinations of us by the IDFI, FDIC, FRB or other regulatory authorities, including the possibility that any such regulatory authority may, among other things, require us to increase our reserve for loan losses, write-down assets, change our regulatory capital position or affect our ability to borrow funds or maintain or increase deposits, which could adversely affect our liquidity and earnings; (viii) legislative or regulatory changes that adversely affect our business including the effect of Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act”), changes in regulatory policies and principles, or the interpretation of regulatory capital or other rules, including changes that increase our capital requirements; (ix) the uncertainties arising from our participation in the SBLF or any future redemption of the SBLF shares issued to Treasury; (x) our ability to attract and retain deposits; (xi) increases in premiums for deposit insurance; (xii) management’s assumptions in determining the adequacy of the allowance for loan losses; (xiii) our ability to control operating costs and expenses; (xiv) the use of estimates in determining fair value of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation; (xv) difficulties in reducing risks associated with the loans on our balance sheet; (xvi) staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our workforce and potential associated charges; (xvii) a failure or security breach in the computer systems on which we depend; (xviii) our ability to retain key members of our senior management team; (xix) costs and effects of litigation, including settlements and judgments; (xx) our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we may in the future acquire into our operations and our ability to realize related revenue synergies and cost savings within expected time frames and any goodwill charges related thereto; (xxi) increased competitive pressures among financial services companies; (xxii) changes in consumer spending, borrowing and savings habits; (xxiii) the availability of resources to address changes in laws, rules, or regulations or to respond to regulatory actions; (xxiv) adverse changes in the securities markets; (xv) inability of key third-party providers to perform their obligations to us; (xvi) changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies, the Public Company Accounting Oversight Board or the Financial Accounting Standards Board; and (xvii) other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services and the other risks described elsewhere in this report.

 

The Company wishes to advise readers that these factors could affect the Company's financial performance and could cause the Company's actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods in any current statements. 

 

Financial Condition

 

General. Total assets at September 30, 2012 were $1.5 billion and increased $45.2 million since December 31, 2011, primarily as a result of a 4.9% increase in gross loans, excluding loans held for sale, and a 3.6% increase in investment securities, which were offset in part by a decrease in cash and cash equivalents. Average interest-earning assets increased $29.3 million or 2.2% to $1.34 billion at September 30, 2012 from $1.31 billion at December 31, 2011, reflecting an increase in average investments. Average interest-bearing liabilities increased by $13.0 million or 1.1% to $1.17 billion at September 30, 2012, from $1.16 billion at December 31, 2011, reflecting an increase in average borrowings. Stockholders’ equity increased by $6.6 million or 5.0% during the nine months ended September 30, 2012.

 

Loans. Our gross loan portfolio, excluding loans held for sale, increased $44.6 million or 4.9% to $964.8 million at September 30, 2012 from $920.2 million at December 31, 2011.

 

37
 

 

The following table reflects the changes in the gross amount of loans, excluding loans held for sale, by type during the period:

 

   At       
   September
30, 2012
   December 31,
2011
   Amount
Change
   Percent
Change
 
     
Commercial Loans:                    
Real Estate  $195,465   $197,390   $(1,925)   (0.98)%
Construction and Development   16,718    20,831    (4,113)   (19.74)
Other   61,876    64,628    (2,752)   (4.26)
Total Commercial   274,059    282,849    (8,790)   (3.11)
                     
Residential Mortgages   491,012    434,976    56,036    12.88 
                     
Consumer Loans:                    
Real estate   98,572    96,864    1,708    1.76 
Auto   15,337    15,203    134    0.88 
Boat/RV   79,175    83,557    (4,382)   (5.24)
Other   6,692    6,760    (68)   (1.01)
Total Consumer   199,776    202,384    (2,608)   (1.29)
Total Loans  $964,847   $920,209   $44,638    4.85%

 

Although the Bank has an overall strategy to increase commercial and consumer loans, the strategy has been hindered by depressed economic conditions in Indiana as a result of the recent recession. Due to increased unemployment and decreased real estate values, loan demand, especially for business loans, has remained sluggish. We are seeking opportunities to refinance sound commercial borrowers from other financial institutions. The decrease in the commercial and consumer portfolios was offset by an increase in residential mortgage lending of $56.0 million during the period. The lower rates have allowed consumers to refinance their mortgage loans and the Bank continues to see this business as strong with less credit risk. Currently the bank is also selling 30-year fixed-rate mortgage loans which helps reduce risk.

 

Delinquencies and Non-performing Assets. As of September 30, 2012, our total loans delinquent 30-to-89 days were $19.7 million or 2.0% of total loans compared to $30.5 million or 2.9% at December 31, 2011.

 

At September 30, 2012, our non-performing assets totaled $30.6 million or 2.08% of total assets, compared to $39.2 million or 2.75% of total assets at December 31, 2011. This $8.6 million, or 21.9% decrease was primarily the result of a decrease of non-performing commercial real estate loans. The table below sets forth the amounts and categories of non-performing assets in our loan portfolio at the dates indicated.

 

   At       
   September 30, 
2012
   December 31,
2011
   Amount
Change
   Percent
Change
 
     
Non-accruing loans  $23,112   $30,711   $(7,599)   (24.74)%
Accruing loans delinquent 90 days or more   757    1,127    (370)   (32.83)
Foreclosed assets   6,757    7,392    (635)   (8.59)
Total  $30,626   $39,230   $(8,604)   (21.93)%

 

Our non-performing assets have decreased dramatically due to continued improvement in the economic environment and being able to work through problem credits. As of September 30, 2012, we have seen our third consecutive quarter of decreases as non-performing assets were down $2.2 million and $8.6 million at the three and nine months ended September 30, 2012, respectively. The Bank is diligently monitoring and writing down loans that appear to have irreversible weakness. In addition to the decrease in non-performing assets, the Company has seen significant improvement during the year in total classified assets. Total classified assets decreased 20.9% from $69.4 million at December 31, 2011 to $54.9 million at September 30, 2012. The Bank works to ensure possible problem loans have been identified and steps have been taken to reduce loss by restructuring loans to improve cash flow or by increasing collateral, when necessary.

  

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At September 30, 2012, foreclosed commercial real estate totaled $1.9 million and consisted of 13 commercial buildings in our existing lending footprint. In addition, 44 residential properties with a book value of $4.3 million remained as foreclosed assets at September 30, 2012. Of the total foreclosed assets, one property held in real estate owned totaled $2.4 million. At September 30, 2012, the Bank had $573,000 in other repossessed assets. Non-accruing commercial real estate loans, including construction and development loans, decreased $1.9 million in the quarter from $10.9 million at June 30, 2011, to $9.0 million at September 30, 2012. During the quarter, non-accruing one- to four-family loans remained fairly consistent, only increasing by $130,000. Management continues to monitor these loans aggressively and it is management’s opinion that the non-accruing loans are sufficiently reserved as of September 30, 2012.  

 

Allowance For Loan Loss. Allowance for loan losses decreased $945,000 to $15.5 million at September 30, 2012 when compared to September 30, 2011 as reflected below.

 

   At and For the Nine Months Ended
September 30,
 
   2012   2011 
     
Balance at beginning of period  $16,815   $16,372 
Charge-offs   7,040    9,873 
Recoveries   1,086    882 
Net charge-offs   5,954    8,991 
Provisions charged to operations   4,675    9,100 
Balance at end of period  $15,536   $16,481 
           
Ratio of net charge-offs during the period to average loans outstanding during the period   0.81%   1.24%
           
Allowance as a percentage of non-performing loans   65.09%   60.95%
Allowance as a percentage of total loans (end of period)   1.61%   1.72%

 

Specific loan loss allocations related to loans that have been individually evaluated for impairment decreased and general loan loss reserves have remained approximately the same. Charge-offs were taken against loans that had previous specific loan loss reserves. Net charge offs for the first nine months of 2012 were $6.0 million, or 0.84% of average loans on an annualized basis, compared to $9.0 million, or 1.24% of average loans for the first nine months of 2011. The decrease was due to what management believes is a stabilization of the loan portfolio. As of September 30, 2012, the allowance for loan losses as a percentage of loans receivable and non-performing loans was 1.61% and 65.09%, respectively, compared to 1.83% and 52.81% respectively, at December 31, 2011. Allowance for loan losses as a percentage of loans receivable decreased due to an increase in the net loan portfolio of $44.6 million since year-end. Allowance for loan losses as a percentage of non-performing loans increased due to the decrease in non-performing loans in the first nine months of 2012.

 

Over 24.8% of our non-accrual loans are comprised of four commercial loans totaling $5.7 million. All of these loans are commercial real estate loans, including construction and development loans.

 

Deposits. Total deposits increased $26.4 million to $1.19 billion at September 30, 2012, primarily due to increased activity in new and existing core deposit relationships as reflected in the table below with corresponding weighted average rates partially offset by a decrease in certificates of deposit. The increase in non-interest bearing deposits reflects an increase in business checking. These changes are consistent with the Bank’s strategy to grow and strengthen core deposit relationships.

 

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   At 
   September 30, 2012   December 31, 2011 
   Amount   Weighted
Average
Rate
   Amount   Weighted
Average
Rate
 
     
Type of Account                    
Non-interest Checking  $133,244    0.00%  $122,215    0.00%
Interest-bearing NOW   252,791    0.35    218,916    0.49 
Savings   106,859    0.05    98,122    0.05 
Money Market   98,308    0.44    85,069    0.65 
Certificates of Deposit   601,829    1.70    642,315    1.91 
Total  $1,193,031    0.97%  $1,166,637    1.22%

 

Borrowings. Total borrowings increased $11.1 million, or 9.8%, to $125.0 million at September 30, 2012 primarily due to an $11.7 million increase in FHLB advances to $113.2 million at the end of the period. The increase in advances was necessary to fund current loan demand. Other borrowings, consisting of a bank loan and a subordinated debenture, decreased $598,000 to $11.8 million at September 30, 2012 due to regular loan payments.

 

In 2009, the Company borrowed $10.0 million from First Tennessee Bank, N.A. to refinance existing long-term debt. The loan bears a 5.9% interest rate, has a term expiring in December 2014 and is secured by Bank stock. The balance of that loan was $8.0 million at September 30, 2012.

 

The Company acquired $5.0 million of issuer trust preferred securities in a 2008 acquisition of another financial institution. The net balance of the note as of September 30, 2012 was $4.0 million due to the purchase accounting adjustment from the acquisition. The securities were issued on July 29, 2005. The securities bore a fixed rate of interest of 6.22% through July 2010, and, thereafter, the rate was to reset quarterly at the prevailing three-month LIBOR rate plus 170 basis points. In December 2009, the Company entered into a cash flow hedge with FTN Financial to fix the floating portion of the issued trust preferred security at 5.15% for the next five years starting on September 15, 2010. The Company has had the right to redeem the trust preferred securities, in whole or in part, without penalty, since establishing the cash flow hedge. These securities mature on September 15, 2035.

 

Stockholders’ Equity. Stockholders’ equity was $139.3 million at September 30, 2012, an increase of $6.6 million from December 31, 2011. The increase was due primarily to net income of $5.2 million and unrealized gains on securities of $3.3 million. The increase was offset by dividend payments of $2.3 million to common and preferred shareholders. The Company’s tangible book value per share as of September 30, 2012 increased to $15.40 compared to $14.38 as of December 31, 2011 and the tangible common equity ratio was 7.33% as of September 30, 2012 compared to 7.05% as of December 31, 2011.  

 

Comparison of Results of Operations for the Three Months Ended September 30, 2012 and 2011

 

General. Net income available to common shareholders for the three months ended September 30, 2012 was $1.8 million or $0.26 basic and diluted earnings per common share compared to net income of $596,000, or $0.09 basic and diluted earnings per common share for the three months ended September 30, 2011. The primary reason for this increase was a reduction in the provision for loan loss of $1.7 million compared to the same period last year. Annualized return on assets was .59% and return on average tangible common equity was 6.83% for the third quarter of 2012 compared to .41% and 2.37% respectively, for the same period last year.

 

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Interest Income. Total interest income decreased $1.3 million, or 8.8%, to $13.9 million during the three months ended September 30, 2012 from $15.2 million during the three months ended September 30, 2011. The decrease was a result of a decline in net interest yield on interest-earning assets of 56 basis points, partially offset by an increase in average earning assets of $46.8 million comparing the third quarter of 2012 with the same period in 2011. The decline in yield was primarily due to the decline in national and local prevailing interest rates and the mix of interest-earning assets. Interest income on loans in the third quarter of 2012 was $11.5 million compared to $13.0 million for same period in 2011, reflecting a slight decrease in the average balance of the loan portfolio at September 30, 2012 and a 60 basis point decrease in the weighted average yield on loans for the three months ended September 30, 2012 to 4.79%. Interest income on investment securities for the third quarter 2012 was $2.4 million compared to $2.2 million for the same period in 2011, reflecting a $51.3 million increase in our average investment securities portfolio to $368.9 million as of September 30, 2012.

 

Interest Expense. Interest expense decreased $1.3 million, or 26.0%, to $3.6 million during the three months ended September 30, 2012 compared to $4.9 million during the three months ended September 30, 2011. The primary reason for this decrease was a decline of 47 basis points in the average cost of interest-bearing liabilities from 1.69% in the 2011 period to 1.22% in the 2012 period, which was primarily due to continued re-pricing of deposit accounts and reduction of higher rate FHLB advances. Interest expense on deposits decreased $1.0 million, due to a 40 basis point decline in average rates. Interest expense on borrowings decreased $220,000 as a result of a 139 basis point decline in average rates, partially offset by a $31.4 million increase in average borrowings in the third quarter 2012.

 

Net Interest Income. Net interest income before the provision for loan losses decreased $80,000 for the quarter ended September 30, 2012 compared to the same period in 2011. The decrease was a result of a decline in net interest margin by 14 basis points, partially offset by an increase in average earning assets of $46.8 million comparing the third quarter of 2012 with the same period in 2011. For more information on our asset/liability management, especially as it relates to interest rate risk, see Item 7A - Quantitative and Qualitative Disclosures About Market Risk” on Form 10-K for the period ended December 31, 2011.

 

Provision for Loan Losses. The provision for loan losses for the third quarter of 2012 decreased to $1.5 million compared to $3.2 million during last year’s comparable period. The decrease was due to management’s ongoing evaluation of the adequacy of the allowance for loan losses, which was partially attributable to net charge offs decreasing to $1.9 million, or .81% of loans on an annualized basis in the third quarter of 2012 compared to net charge offs of $2.7 million, or 1.11% of loans on an annualized basis in the third quarter of 2011. Net charge offs exceeded the provision primarily due to charge offs related to previously identified loans which had established specific allocations. Non-performing loans to total loans at September 30, 2012 were 2.48% compared to 2.82% at September 30, 2011. Non-performing assets to total assets were 2.08% at September 30, 2012 compared to 2.43% at September 30, 2011.  

 

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Other Income. Other (non-interest) income decreased by $283,000 to $4.4 million in the third quarter of 2012 compared to $4.7 million in the same period in 2011.

 

   Three Months Ended   Amount   Percent 
Non-Interest Income  9/30/2012   9/30/2011   Change   Change 
                 
Service fee income  $1,644   $1,862   $(218)   -11.7%
Net realized gain on sale of securities   1,095    1,764    (669)   -37.9%
Equity in losses of limited partnerships   (124)   (107)   (17)   -15.9%
Commissions   859    879    (20)   -2.3%
Net gains on sales of loans   541    245    296    120.8%
Net servicing fees (costs)   (16)   (337)   321    95.3%
Increase in cash surrender value of life insurance   340    346    (6)   -1.7%
Loss on sale of other real estate and repossessed assets   30    (22)   52    236.4%
Other income   12    34    (22)   -64.7%
                     
Total Non-Interest Income  $4,381   $4,664   $(283)   -6.1%

 

The decrease in non-interest income is primarily due to the decrease in gain on sale of securities. Service fee income on deposit accounts also decreased as fees collected on overdrafts have declined as overdraft transactions have decreased. This was partially offset by the increase in gain on sale of loans and servicing of loans due to the increased activity in the mortgage banking market. On a linked quarter basis, non-interest income increased $676,000 primarily due to gain on sale of investments.

 

Other Expense. Other (non-interest) expense increased by $96,000 to $10.1 million in the third quarter of 2012 compared to $10.0 million in the same period in 2011.

 

   Three Months Ended   Amount   Percent 
Non-Interest Expense  9/30/2012   9/30/2011   Change   Change 
                 
Salaries and employee benefits  $5,273   $5,240   $33    0.6%
Net occupancy expenses   641    583    58    10.0%
Equipment expenses   454    505    (51)   -10.1%
Data processing fees   361    373    (12)   -3.2%
Automated teller machine   258    241    17    7.1%
Deposit insurance   312    330    (18)   -5.5%
Professional fees   420    433    (13)   -3.0%
Advertising and promotion   488    453    35    7.7%
Software subscriptions and publications   384    338    46    13.6%
Intangible amortization   229    280    (51)   -18.2%
Other real estate and repossessed assets   247    279    (32)   -11.5%
Other expenses   1,066    982    84    8.5%
                     
Total Non-Interest Expense  $10,133   $10,037   $96    1.0%

  

The increase in non-interest expense was primarily due to an approximately $200,000 expense related to property taxes to maintain secure collateral on a large problem loan, which was partially offset by the decrease in intangible amortization and equipment expenses. On a linked quarter, non-interest expense increased $200,000 for the above stated reason.

 

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Income Tax Expense. Income tax expense for the quarter ended September 30, 2012 increased $540,000 compared to the same period in 2011 because of increased earnings. The Company’s effective tax rate increased to 29.6% in the 2012 period from 20.6% in the 2011 period because of increased net income and decreased low income housing credits as a percentage of net income.

 

Comparison of Results of Operations for the Nine Months Ended September 30, 2012 and 2011

 

General. Net income available to common stockholders for the nine months ended September 30, 2012 was $4.2 million or $0.60 basic and $0.59 diluted earnings per common share compared to net income of $682,000, or $0.10 basic and diluted earnings per common share for the nine months ended September 30, 2011. The primary reason for this increase was a decrease in provision for loan loss due to stabilization of the loan portfolio. Annualized return on assets was .48% and return on average tangible common equity was 5.31% for the nine months ended in 2012 compared to .23% and .93% respectively, for the same period last year.

 

Interest Income. Total interest income decreased $4.8 million, or 10.3%, to $41.9 million during the nine months ended September 30, 2012 from $46.7 million during the same period ended September 30, 2011, reflecting the decrease in our average yield on interest-earning assets by 57 basis points to 4.18% for the period ended September 30, 2012 compared to 4.75% for the period ended September 30, 2011 as national and local prevailing interest rates continued to decline and the mix of interest-earning assets shifted towards lower yielding investment securities. Interest income on loans in the first nine months of 2012 was $34.8 million compared to $40.1 million for same period in 2011, reflecting a $19.5 million increase in the average loan portfolio to $950.0 million at September 30, 2012 and a 63 basis point decrease in the weighted average yield on loans for the nine months ended September 30, 2012 to 4.88%. Interest income on investment securities for the first nine months of 2012 was $7.1 million compared to $6.6 million for the same period in 2011, reflecting a $60.0 million increase in our average investment securities portfolio to $365.0 million for the period ended September 30, 2012.

 

Interest Expense. Interest expense decreased $4.1 million, or 26.5%, to $11.4 million during the nine months ended September 30, 2012 compared to $15.5 million during the nine months ended September 30, 2011. The primary reason for this decrease was a decline of 48 basis points on interest-bearing liabilities from 1.77% in 2011 to 1.29% in 2012, which was primarily due to continued re-pricing of deposit accounts and reduction of higher rate FHLB advances. Interest expense on deposits decreased $3.3 million, due to a 42 basis point decline in average rates partially offset by an $819,000 increase in average interest-bearing deposits. Interest expense on borrowings decreased $788,000 as a result of a 107 basis point decline in average rates which was partially offset by an $8.7 million increase in average borrowings in the first nine months of 2012.

 

Net Interest Income. Net interest income before the provision for loan losses decreased $730,000 for the nine months ended of 2012 compared to the same period in 2011. The decrease was a result of the decline in the net interest margin from 3.18% in the first nine months of 2011 to 3.05% in the first nine months of 2012, which was partially offset by an increase in average earning assets of $23.8 million. For more information on our asset/liability management, especially as it relates to interest rate risk, see Item 7A - Quantitative and Qualitative Disclosures About Market Risk” on Form 10-K for the period ended December 31, 2011

 

Provision for Loan Losses. The provision for loan losses for the first nine months of 2012 decreased to $4.7 million compared to $9.1 million during last year’s comparable period. The decrease was due to management’s ongoing evaluation of the adequacy of the allowance for loans losses, which was partially attributable to a reduction in net charge offs to $6.0 million in the first nine months of 2012 compared to net charge offs of $9.0 million in the same period in 2011. Non-performing loans to total loans at September 30, 2012 were 2.48% compared to 3.47% at December 31, 2011. Non-performing loans decreased $8.0 million, or 25% as of September 30, 2012 compared to December 31, 2011.

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Other Income. Other (non-interest) income increased by $392,000 to $11.0 million during nine months of 2012 compared to $10.6 million in the same period in 2011.

 

   Nine Months Ended   Amount   Percent 
Non-Interest Income  9/30/2012   9/30/2011   Change   Change 
                 
Service fee income  $5,049   $5,193   $(144)   -2.8%
Net realized gain on sale of securities   1,575    1,839    (264)   -14.4%
Equity in losses of limited partnerships   (372)   (256)   (116)   -45.3%
Commissions   2,914    2,835    79    2.8%
Net gains on sales of loans   1,388    685    703    102.6%
Net servicing fees (costs)   (126)   (293)   126    -43.0%
Increase in cash surrender value of life insurance   1,017    1,071    (54)   -5.0%
Loss on sale of other real estate and repossessed assets   (523)   (358)   (165)   -46.1%
Net other-than-temporary losses on securities   -    (193)   193    100.0%
Other income   93    100    (7)   -7.0%
                     
Total Non-Interest Income  $11,015   $10,623   $392    3.7%

 

The increase in non-interest income was primarily due to additional gains on sales of loans and decreased servicing costs of loans as the increased production in the mortgage banking area in combination with the lower market rates allowed for mortgage loans to be sold at gains. Partially offsetting these increases was a decrease in gain on sale of securities due to decreased investment sales in 2012 as well as the decrease in service fee income on deposits due to the reduction in overdraft fee income.

 

Other Expense. Other (non-interest) expense decreased by $579,000 to $29.7 million in the first nine months of 2012 compared to $30.2 million in the same period in 2011.

 

   Nine Months Ended   Amount   Percent 
Non-Interest Expense  9/30/2012   9/30/2011   Change   Change 
                 
Salaries and employee benefits  $15,910   $16,103   $(193)   -1.2%
Net occupancy expenses   1,744    1,917    (173)   -9.0%
Equipment expenses   1,346    1,487    (141)   -9.5%
Data processing fees   1,178    1,153    25    2.2%
Automated teller machine   743    776    (33)   -4.3%
Deposit insurance   939    1,170    (231)   -19.7%
Professional fees   1,188    1,169    19    1.6%
Advertising and promotion   1,214    1,053    161    15.3%
Software subscriptions and publications   1,145    969    176    18.2%
Intangible amortization   745    894    (149)   -16.7%
Other real estate and repossessed assets   691    746    (55)   -7.4%
Other expenses   2,816    2,801    15    0.5%
                     
Total Non-Interest Expense  $29,659   $30,238   $(579)   -1.9%

  

Non-interest expense decreased primarily as a result of decreased occupancy and equipment expense due to operating one less branch that was closed in March of 2011 and a much milder winter than normal; decreased salaries and benefits primarily due to changes in employee benefits; and decreased FDIC expense due to the decreased assessment base established in 2011 by the FDIC. These decreases were partially offset by increases in software subscriptions and maintenance and an increase in marketing expense.

 

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Income Tax Expense. Income tax expense for the nine months ended September 30, 2012 increased $1.9 million compared to the same period in 2011 because of increased net income. The Company’s effective tax rate increased to 27.3% in the 2012 period from 4.5% in the 2011 period because of increased net income and the decreased low income housing credits as a percentage of net income.

 

Off-Balance Sheet Activities

 

In the normal course of operations, the Bank engages in a variety of financial transactions that are not recorded in our financial statements. These transactions involve varying degrees of off-balance sheet credit, interest rate and liquidity risks. These transactions are used primarily to manage customers’ requests for funding and take the form of loan commitments and lines of credit. We also have off-balance sheet obligations to repay borrowings and deposits. During the quarter ended September 30, 2012, we engaged in no off-balance sheet transactions likely to have a material effect on our financial condition, results of operations or cash flows. At September 30, 2012, the Bank had $57.4 million in commitments to make loans, $5.7 million in undisbursed portions of closed loans, $84.1 million in unused lines of credit and $2.3 million in standby letters of credit.

 

Liquidity

 

Information about the Company’s liquidity needs and management is included in Item 7 of the Form 10-K for the year ended December 31, 2011, filed with the SEC on March 16, 2012, under the heading “Liquidity.”

 

During the third quarter of 2012, our liquidity levels stayed fairly consistent with that of the prior quarter. The Board of Directors requires the Bank to maintain a minimum liquidity ratio of 10% of deposits. At September 30, 2012, our ratio was 29.9%.

 

At September 30, 2012, the Company on a consolidated basis, had $387.1 million in cash and investment securities available for sale and $4.1 million in loans held for sale generally available for its cash needs. At September 30, 2012, the Bank had the ability to borrow an additional $183.3 million in FHLB advances and other available funding sources, if needed.

 

The Company is a separate legal entity from the Bank and must provide for its own liquidity. In addition to its own operating expenses (many of which are paid to the Bank), the Company is responsible for paying SBLF dividends to the Treasury, amounts owed on its trust preferred securities, any dividends declared to its common shareholders, and interest and principal on outstanding debt. The Company’s primary source of funds is Bank dividends, which are subject to regulatory limits. At September 30, 2012, the Company, on an unconsolidated basis, had $1.7 million in cash, interest-bearing deposits and liquid investments generally available for its cash needs.

 

At September 30, 2012, the approved outstanding loan commitments, including unused lines of credit, amounted to $149.8 million. Certificates of deposit scheduled to mature in one year or less at September 30, 2012, totaled $239.8 million; however, due to our competitive rates, we believe that a majority of maturing deposits will remain with the Bank.

 

Except as set forth above, management is not aware of any trends, events, or uncertainties that will have, or that are reasonably likely to have a material impact on liquidity, capital resources or operations. Further, management is not aware of any current recommendations by regulatory agencies, which, if they were to be implemented, would have this effect.

 

Capital Resources

 

Effective with the conversion to an Indiana bank charter on January 1, 2012, the Bank became subject to minimum capital requirements imposed by the FDIC, which are substantially the same as the requirements the Bank was previously subject to as a federal savings bank. At September 30, 2012, the Bank’s regulatory capital exceeded these regulatory requirements, and the Bank was well-capitalized under regulatory prompt corrective action standards, consistent with our goals to operate a sound and profitable organization. The FDIC may require the Bank to have additional capital above specific regulatory levels if it believes the Bank is subject to increased risk due to asset problems, high interest rate risk and other risks. The FDIC has not required such additional capital.

 

45
 

 

When the Company became a bank holding company on January 1, 2012, it became subject to minimum capital requirements imposed by the FRB, which are substantially similar to those imposed on the Bank, including guidelines for bank holding companies to be considered well-capitalized. At September 30, 2012, the Company’s capital levels exceeded the bank holding company capital requirements and it was considered well-capitalized under FRB guidelines, consistent with our goals to operate a sound and profitable organization. 

 

The Company’s and Bank’s relevant capital ratios at September 30, 2012, are reflected below:

 

   Actual
Capital Levels
   Minimum
Regulatory
Capital Levels
   Minimum
Required
To be Considered
Well-Capitalized
 
   Amount   Ratio   Amount   Ratio   Amount   Ratio 
                         
Leverage Capital Level(1):                              
MutualFirst (Consolidated)  $123,181    8.47%  $57,693    4.0%  $72,117    N/A 
MutualBank   129,997    8.94    58,140    4.0    72,674    5.0 
Tier 1 Risk-Based Capital Level (2) :                              
MutualFirst (Consolidated)  $123,181    13.02%  $37,837    4.0%  $56,756    6.0%
MutualBank   129,997    13.76    37,796    4.0    56,694    6.0 
Total Risk-Based Capital Level (3) :                              
MutualFirst (Consolidated)  $135,038    14.28%  $75,674    8.0%  $94,593    10.0%
MutualBank   141,854    15.01    75,592    8.0    94,490    10.0 

 

 

1. Tier 1 Capital to Average Total Assets of $1.5 billion for the Bank and Company, respectively.

2. Tier 1 Capital to Risk-Weighted Assets of $944.9 million and $945.9 for the Bank and Company, respectively.

3. Total Capital to Risk-Weighted Assets of $944.9 million and $945.9 for the Bank and Company, respectively.

 

Impact of Inflation

 

The effects of price changes and inflation can vary substantially for most financial institutions.  While management believes that inflation affects the economic value of total assets, it believes that it is difficult to assess the overall impact.  Management believes this to be the case due to the fact that generally neither the timing nor the magnitude of changes in the consumer price index coincides with changes in interest rates or asset values.  For example, the price of one or more of the components of the consumer price index may fluctuate considerably, influencing composite consumer price index, without having a corresponding affect on interest rates, asset values, or the cost of those goods and services normally purchased by us.  In years of high inflation and high interest rates, intermediate and long-term interest rates tend to increase, adversely impacting the market values of investment securities, mortgage loans and other long-term fixed rate loans.  In addition, higher short-term interest rates tend to increase the cost of funds.  In other years, the opposite may occur.

 

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Item 3 - Quantitative and Qualitative Disclosures about Market Risk

 

Information about the Company’s asset and liability management and market and interest-rate risks is included in Item 7A of the Form 10-K for the year ended December 31, 2011, filed with the SEC on March 16, 2012.

 

Asset and Liability Management and Market Risk

 

Our Risk When Interest Rates Change. The rates of interest we earn on assets and pay on liabilities generally is established contractually for a period of time. Market interest rates change over time. Accordingly, our results of operations, like those of other financial institutions, are impacted by changes in interest rates and the interest rate sensitivity of our assets and liabilities. The risk associated with changes in interest rates and our ability to adapt to these changes is known as interest rate risk and is one of our most significant market risks.

 

How We Measure Our Risk of Interest Rate Changes. As part of our attempt to manage our exposure to changes in interest rates and comply with applicable regulations, we monitor our interest rate risk. In monitoring interest rate risk, we continually analyze and manage assets and liabilities based on their payment streams and interest rates, the timing of their maturities, and their sensitivity to actual or potential changes in market interest rates. In order to minimize the potential for adverse effects of material and prolonged changes in interest rates on our results of operations, we adopted asset and liability management policies to better match the maturities and repricing terms of our interest-earning assets and interest-bearing liabilities.

 

The Bank’s Board of Directors sets and recommends these asset and liability policies, which are implemented by the Asset and Liability Management Committee. The Asset and Liability Management Committee is chaired by the Chief Financial Officer and is comprised of members of our senior management team. The purpose of the Asset and Liability Management Committee is to communicate, coordinate and control asset/liability management issues consistent with our business plan and board-approved policies. This committee establishes and monitors the volume and mix of assets and funding sources taking into account relative costs and spreads, interest rate sensitivity and liquidity needs. The objectives are to manage assets and funding sources consistent with liquidity, capital adequacy, growth, risk and profitability goals. The Asset and Liability Management Committee generally meets monthly to review, among other things, economic conditions and interest rate outlook, current and projected liquidity needs and capital position, anticipated changes in the volume and mix of assets and liabilities and interest rate risk exposure limits versus current projections pursuant to a net present value of portfolio equity analysis and income simulations. At each meeting, the Asset and Liability Management Committee recommends appropriate strategy changes based on this review. The chief financial officer is responsible for reviewing and reporting on the effects of the policy implementations and strategies to the Board of Directors, at least quarterly.

 

In order to manage our assets and liabilities and achieve the desired liquidity, credit quality, interest rate risk, profitability and capital targets, we have sought to:

 

  · Originate and purchase adjustable rate mortgage loans and commercial business loans,

 

  · Originate shorter-duration consumer loans,

 

  · Manage our deposits to establish stable deposit relationships,

 

  · Acquire longer-term borrowings at fixed rates, when appropriate, to offset the negative impact of longer-term fixed rate loans in our loan portfolio, and

 

  · Limit the percentage of long-term fixed-rate loans in our portfolio.

 

Depending on the level of general interest rates, the relationship between long and short-term interest rates, market conditions and competitive factors, the Asset and Liability Management Committee may increase our interest rate risk position somewhat in order to maintain our net interest margin. We will continue to increase our emphasis on the origination of relatively short-term and/or adjustable rate loans. In addition, in an effort to avoid an increase in the percentage of long-term fixed-rate loans in our portfolio, during the quarter ended September 30, 2012, we sold in the secondary market $19.5 million of fixed rate, one- to four-family mortgage loans with a term to maturity of over 15 years.

 

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In connection with our conversion to a commercial bank charter in the first quarter of 2012; we formulated a new interest rate risk measurement process that measures both earnings and capital risk in accordance with the FDIC guidance on interest rate risk. The following chart indicates the Bank’s percentage change in net income and capital assuming the most severe movement in interest rates as an immediate parallel rate shock in a range from down 100 basis points to up 400 basis points as of September 30, 2012.

 

Rate Shock  Net Interest
Income 
(% Change)
   Capital 
(% Change)
 
         
Up 400 bp   (29.1)%   (30.4)%
Up 300 bp   (20.8)   (18.5)
Up 200 bp   (13.0)   (7.7)
Up 100 bp   (6.0)   (0.4)
Down 100 bp   (5.9)   (20.8)

 

The Company also does interest rate shocks that are not immediate parallel shocks in various rate scenarios. Management currently believes that interest rate risk is managed appropriately in more practical rate shock scenarios than those in the chart above.

 

Item - 4 Controls and Procedures.

 

An evaluation of the Company’s disclosure controls and procedures (as defined in Rule 13a -15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), as of September 30, 2012, was carried out under the supervision of and with the participation of the Company’s Chief Executive Officer, Chief Financial Officer and several other members of the Company’s senior management since that date. The Company’s Chief Executive Officer and Chief Financial Officer concluded that, as of September 30, 2012, the Company’s disclosure controls and procedures were effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is (i) accumulated and communicated to the Company’s management (including the Chief Executive Officer and the Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

 

There have been no changes in our internal control over financial reporting (as defined in Rule 13a - 15(f) under the Exchange Act) that occurred during the quarter ended September 30, 2012 that have materially affected, or are likely to materially affect our internal control over financial reporting.

 

The Company does not expect that its disclosure controls and procedures and internal control over financial reporting will prevent all errors and fraud.  A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control procedure is met.  Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.  These inherent limitations include the realities that judgments in decision making can be faulty, and that breakdowns can occur because of simple error or mistake.  Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control.  The design of any control procedure also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.  Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected.

 

The Company intends to continually review and to evaluate the design and effectiveness of its disclosure controls and procedures and to improve its controls and procedures over time and to correct any deficiencies that it may discover in the future.  The goal is to ensure that senior management has timely access to all material financial and non-financial information concerning the Company’s business.  While the Company believes the present design of its disclosure controls and procedures is effective to achieve its goal, future events affecting its business may cause the Company to modify its disclosure controls and procedures.

 

 

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PART II.  OTHER INFORMATION