10-Q 1 v325460_10q.htm 10-Q

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

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

 

For quarterly period ended September 30, 2012

 

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

 

For the transition period from______________to___________________

 

Commission File Number: 001-34214

 

THE BANK OF KENTUCKY FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 

Kentucky   61-1256535
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification Number)

 

111 Lookout Farm Drive, Crestview Hills, Kentucky 41017

(Address of principal executive offices) (Zip Code)

 

Registrant’s telephone number: (859) 371-2340

 

Indicate by checkmark whether the registrant (1) 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 definition of “accelerated filer,” “large accelerated filer,” and “smaller reporting company,” in Rule 12b-2 of the Exchange Act (Check one):

 

Large accelerated filer ¨ Accelerated filer x
Non-accelerated filer ¨ Smaller reporting company ¨
(do not check if a smaller reporting company)  

 

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

 

As of October 19, 2012, 7,470,236 shares of the registrant's Common Stock, no par value, were issued and outstanding.

 

 
 

 

The Bank of Kentucky Financial Corporation

 

INDEX

 

Part I FINANCIAL INFORMATION PAGE
     
  Item 1 – Financial Statements 3
     
  Item 2 – Management’s Discussion and Analysis of   Financial Condition and Results of Operations 33
     
  Item 3 – Quantitative and Qualitative Disclosures About   Market Risk 50
     
  Item 4 – Controls and Procedures 50
     
Part II OTHER INFORMATION  
     
  Item 1 – Legal Proceedings 51
     
  Item 1A – Risk Factors 51
     
  Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds 51
     
  Item 3 – Defaults upon Senior Securities 51
     
  Item 4 – Mine Safety Disclosures 51
     
  Item 5 – Other Information 51
     
  Item 6 – Exhibits 51

 

2
 

 

PART I FINANCIAL INFORMATION

 

Item 1. Financial Statements

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands, except per share data - unaudited)

 

   September 30,
2012
   December 31,
2011
 
Assets          
Cash and cash equivalents  $81,950   $135,964 
Interest-bearing deposits with banks   250    250 
Available-for-sale securities   302,544    322,512 
Held-to-maturity securities   58,314    48,975 
Loans held for sale   19,314    8,920 
Total loans   1,159,074    1,129,954 
Less:  Allowance for loan losses   16,585    18,288 
Net loans   1,142,489    1,111,666 
Premises and equipment, net   22,714    22,827 
FHLB stock, at cost   5,099    5,099 
Goodwill   22,023    22,023 
Acquisition intangibles, net   2,645    3,228 
Cash surrender value of life insurance   33,509    32,850 
Accrued interest receivable and other assets   31,103    30,410 
Total assets  $1,721,954   $1,744,724 
           
Liabilities & Shareholders’ Equity          
Liabilities          
Deposits  $1,471,246   $1,498,821 
Short-term borrowings   22,142    29,300 
Notes payable   48,721    48,739 
Accrued interest payable and other liabilities   12,224    11,294 
Total liabilities   1,554,333    1,588,154 
           
Shareholders’ Equity          
Common stock, no par value, 15,000,000 shares authorized, 7,467,396 (2012) and 7,432,995 (2011) shares issued   3,098    3,098 
Additional paid-in capital   34,971    34,121 
Retained earnings   124,548    116,038 
Accumulated other comprehensive income   5,004    3,313 
Total shareholders’ equity   167,621    156,570 
Total liabilities and shareholders’ equity  $1,721,954   $1,744,724 

 

See accompanying notes.

 

3
 

 

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2012 AND 2011

(Dollars in thousands, except per share data - unaudited)

 

   Three Months
Ended September 30
   Nine Months 
Ended September 30
 
INTEREST INCOME  2012   2011   2012   2011 
     Loans, including related fees  $13,771   $14,488   $41,363   $43,421 
     Securities and other   1,662    1,792    5,419    5,281 
          Total interest income   15,433    16,280    46,782    48,702 
                     
INTEREST EXPENSE                    
    Deposits   1,214    1,954    4,128    6,493 
    Borrowings   257    250    801    758 
         Total interest expense   1,471    2,204    4,929    7,251 
                     
Net interest income   13,962    14,076    41,853    41,451 
Provision for loan losses   2,200    2,550    5,700    8,550 
Net interest income after provision for loan losses   11,762    11,526    36,153    32,901 
                     
NON-INTEREST INCOME                    
    Service charges and fees   2,325    2,470    6,767    7,051 
    Mortgage banking income   917    704    2,092    1,209 
    Net securities gains (losses)   -    -    203    231 
    Company owned life insurance earnings   300    306    910    842 
    Bankcard transaction revenue   940    848    2,794    2,497 
    Trust fee income   710    630    2,093    2,016 
    Other   669    339    1,961    1,348 
         Total non-interest income   5,861    5,297    16,820    15,194 
                     
NON-INTEREST EXPENSE                    
Salaries and benefits   5,909    5,351    17,084    15,150 
    Occupancy and equipment   1,316    1,216    3,908    3,705 
    Data processing   505    500    1,573    1,461 
    Advertising   377    464    1,146    1,186 
    Other   3,692    3,196    10,957    10,209 
         Total non-interest expense   11,799    10,727    34,668    31,711 
                     
INCOME BEFORE INCOME TAXES   5,824    6,096    18,305    16,384 
    Less:  income taxes   1,628    1,822    5,170    4,804 
NET INCOME  $4,196   $4,274   $13,135   $11,580 
    Preferred stock dividend and discount accretion   -    (261)   -    (777)
Net Income available to common shareholders  $4,196   $4,013   $13,135   $10,803 
Comprehensive Income  $5,463   $5,136   $14,826   $14,549 
Net income per common share:                    
    Earnings per share, basic  $.56   $.54   $1.76   $1.45 
    Earnings per share, diluted  $.56   $.54   $1.74   $1.45 

 

See accompanying notes.

 

4
 

 

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

FOR THE NINE MONTHS ENDED SEPTEMBER 30

(Dollars in thousands, except per share data -unaudited)

 

   Nine Months
Ended September 30
 
   2012   2011 
Beginning balance  $156,570   $159,370 
Comprehensive income:          
Net income   13,135    11,580 
Change in net unrealized gain(loss), net of tax   1,691    2,969 
Total comprehensive income   14,826    14,549 
           
Cash dividends declared on common stock   (4,624)   (4,162)
Exercise of stock options (34,401 and 700 shares), including tax benefit   741    14 
Stock-based compensation expense   108    152 
Paid and accrued dividends on preferred stock   -    (637)
Balance as of  September 30  $167,621   $169,286 
           
Dividends per share  $0.62   $0.56 

 

See accompanying notes.

 

5
 

 

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE NINE MONTHS ENDED SEPTEMBER 30

(Dollars in thousands - unaudited)

 

   2012   2011 
         
Cash Flows from Operating Activities          
           
Net income  $13,135   $11,580 
Adjustments to reconcile net income to net cash From operating activities   (1,246)   19,113 
Net cash from operating activities   11,889    30,693 
           
Cash Flows from Investing Activities          
           
Net change in interest-bearing balances   -    (150)
Proceeds from paydowns and maturities of held-to-maturity securities   2,780    4,399 
Proceeds from paydowns and maturities of available-for-sale securities   151,460    172,311 
Purchases of held-to-maturity securities   (12,172)   (10,048)
Purchases of available-for-sale securities   (138,121)   (231,932)
Purchases of company owned life insurance   -    (6,500)
Net change in loans   (39,438)   (24,377)
Proceeds from the sale of other real estate   2,488    3,021 
Proceeds from the sale of securities   6,944    13,367 
Property and equipment expenditures   (1,210)   (722)
Net cash from investing activities   (27,269)   (80,631)
           
Cash Flows from Financing Activities          
           
Net change in deposits   (27,575)   (53,097)
Net change in short-term borrowings   (7,158)   2,829 
Proceeds from exercise of stock options   741    14 
Cash dividends paid   (4,624)   (4,799)
Payments on note payable   (18)   (16)
Net cash from financing activities   (38,634)   (55,069)
           
Net change in cash and cash equivalents   (54,014)   (105,007)
Cash and cash equivalents at beginning of period   135,964    172,664 
Cash and cash equivalents at end of period  $81,950   $67,657 

 

See accompanying notes.

 

6
 

 

THE BANK OF KENTUCKY FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2012

(unaudited)

 

Note 1 - Basis of Presentation:

 

The condensed consolidated financial statements include the accounts of The Bank of Kentucky Financial Corporation (“BKFC” or the “Company”) and its wholly owned subsidiary, The Bank of Kentucky, Inc. (the “Bank”). All significant intercompany accounts and transactions have been eliminated.

 

Note 2 - General:

 

These financial statements were prepared in accordance with the instructions for Form 10-Q and Rule 10-01 of Regulation S-X and, therefore, do not include all of the disclosures necessary for a complete presentation of financial position, results of operations and cash flows in conformity with U.S. generally accepted accounting principles. Except for required accounting changes, these financial statements have been prepared on a basis consistent with the annual financial statements and include, in the opinion of management, all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the results of operations and financial position at the end of and for the periods presented. These financial statements and notes should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto as set forth in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

 

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and future results could differ. The allowance for loan losses and the fair values of financial instruments, in particular, are subject to change.

 

Note 3 - Earnings per Share:

 

Earnings per share are computed based upon the weighted average number of shares of common stock outstanding during the three and nine month periods. Diluted earnings per share show the potential dilutive effect of additional common shares issuable under the Company’s stock compensation plan and warrants. For the three months ended September 30, 2012 and 2011, 187,720 and 416,604 options were not considered, as they were not dilutive, and for the nine months ended September 30, 2012 and 2011, 264,389 and 354,616 options were not considered, as they were not dilutive. The following table presents the numbers of shares used to compute basic and diluted earnings per share for the indicated periods:

 

7
 

 

   Three Months
Ended
September 30
   Nine Months
Ended
September 30
 
   2012   2011   2012   2011 
Weighted average shares outstanding   7,465,926    7,432,995    7,459,988    7,432,762 
Dilutive effects of assumed exercises of stock options, restricted stock units and warrants   88,133    55,748    77,415    41,332 
Shares used to compute diluted earnings per share   7,554,059    7,488,743    7,537,403    7,474,094 

 

Note 4 – Stock-Based Compensation:

 

Stock-based compensation in the form of options to buy stock and restricted stock units (“RSUs”) are granted to directors, officers and employees under the Company’s incentive stock plan (the “Plan”), which provides for the issuance of up to 1,000,000 shares.

 

Stock Options

The specific terms of each option agreement are determined by the Compensation Committee at the date of the grant. For current options outstanding, options granted to directors vest immediately and options granted to employees generally vest evenly over a five-year period.

 

The Company recorded stock option expense of $24,000 (net of taxes) and $76,000 (net of taxes) in the three and nine months ended September 30, 2012, and $51,000 (net of taxes) and $152,000 (net of taxes) in the three and nine months ended September 30, 2011.

 

Restricted Stock Units

 

The specific term of each RSU award are determined by the Compensation Committee at the date of the grant. Compensation expense is recognized over the vesting period of the awards based on the fair value of the stock at issue date. The fair value of the stock was determined using the total number of RSU’s granted multiplied by the grant date fair market value of a share of company stock. RSU’s fully vest on the first anniversary of the grant date.

 

A summary of changes in the Company’s nonvested shares for the year follows:

 

       Weighted-Average 
       Grant-Date 
Nonvested Shares  Shares   Fair Value 
         
Nonvested at January 1, 2012   0   $- 
Granted   4,185    25.80 
Vested   0    - 
Forfeited   0    - 
Nonvested at September 30, 2012   4,185   $25.80 

 

8
 

 

The Company recorded RSU expense of $36,000 for the three and nine months ended September 30, 2012. As of September 30, 2012, there was $84,000 of total unrecognized compensation cost related to nonvested shares granted under the RRP. The cost is expected to be recognized over a period of 7 months.

 

Note 5 – Cash and Cash Equivalents:

 

Cash and cash equivalents include cash on hand, amounts due from banks, federal funds sold and investments in money market mutual funds. The Company reports net cash flows for customer loan and deposit transactions, interest-bearing balances with banks and short-term borrowings with maturities of 90 days or less.

 

Note 6 – Reclassification:

 

Certain prior period amounts have been reclassified to conform to the current period presentation. Such reclassifications have no effect on previously reported net income or shareholders’ equity.

 

Note 7 – New Accounting Pronouncements:

 

In May 2011, the Financial Accounting Standards Board (“FASB”) issued an amendment to achieve common fair value measurement and disclosure requirements between U.S. and International accounting principles. Overall, the guidance is consistent with existing U.S. accounting principles; however, there are some amendments that change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. This update became effective for the Company for interim and annual reporting periods beginning after December 15, 2011 and did not have a material impact on the Company's consolidated financial position or results of operations.

 

In June 2011, the FASB amended existing guidance and eliminated the option to present the components of other comprehensive income as part of the statement of changes in shareholders’ equity. The amendment requires that comprehensive income be presented in either a single continuous statement or in two separate consecutive statements. This update became effective for the Company for interim and annual reporting periods beginning after December 15, 2011 and did not have a material impact on the Company's consolidated financial position or results of operations.

 

Note 8Securities:

 

The fair value of available-for-sale securities and the related gains and losses recognized in accumulated other comprehensive income (loss) was as follows (in thousands):

 

9
 

 

       Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
Available-for-Sale  Cost   Gains   Losses   Value 
September 30, 2012                    
U.S. government, federal agencies and government sponsored enterprises  $112,473   $1,313   $(23)  $113,763 
U.S. government residential mortgage-backed   181,429    6,292    -    187,721 
Corporate   1,060    -    -    1,060 
   $294,962   $7,605   $(23)  $302,544 

 

       Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
   Cost   Gains   Losses   Value 
December 31, 2011                    
U.S. government, federal agencies and government sponsored enterprises  $168,104   $1,368   $(12)  $169,460 
U.S. government residential mortgage-backed   148,329    3,727    (64)   151,992 
Corporate   1,060    -    -    1,060 
   $317,493   $5,095   $(76)  $322,512 

 

The carrying amount, unrecognized gains and losses, and fair value of securities held-to-maturity were as follows (in thousands):

 

       Gross   Gross     
   Amortized   Unrecognized   Unrecognized   Fair 
Held-to-Maturity  Cost   Gains   Losses   Value 
2012                    
Municipal and other obligations  $58,314   $2,169   $(108)  $60,375 
                     
2011                    
Municipal and other obligations  $48,975   $1,693   $(25)  $50,643 

 

The amortized cost and fair value of debt securities and carrying amount, if different, at September 30, 2012 by contractual maturity were as follows (in thousands), with securities not due at a single maturity date, primarily mortgage-backed securities, shown separately.

 

   Available-for-Sale   Held-to-Maturity 
   Amortized   Fair   Amortized   Fair 
   Cost   Value   Cost   Value 
Due in one year or less  $610   $616   $3,353   $3,368 
Due after one year through five years   51,409    52,076    29,592    30,780 
Due after five years through ten years   60,454    61,071    19,444    20,302 
Due after ten years   1,060    1,060    5,925    5,925 
U.S. Government agency mortgage-backed   181,429    187,721    -    - 
                     
   $294,962   $302,544   $58,314   $60,375 

 

Proceeds on the sale of $6,944,000 of available-for-sale securities resulted in gains of $203,000 for the first nine months of 2012. No securities were sold with losses in the first nine months of 2012. Proceeds on the sale of $13,367,000 of available-for-sale securities resulted in gains of $231,000 for the first nine months of 2011, with no losses.

 

Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. Investment securities classified as available-for-sale or held-to-maturity are evaluated for OTTI under ASC 320, Accounting for Certain Investments in Debt and Equity Securities.

 

10
 

 

In determining OTTI, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions and (4) whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an other-than temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.

 

When OTTI occurs, the amount of the OTTI recognized in earnings depends on whether an entity 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. If an entity intends to sell 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 shall 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. Otherwise, the OTTI shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total 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 total OTTI related to other factors shall be recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings shall become the new amortized cost basis of the investment.

 

As of September 30, 2012, the Bank’s security portfolio consisted of 227 securities, 11 of which were in an unrealized loss position of $131,000. There was no OTTI of securities at September 30, 2012. Unrealized losses have not been recognized into income because the issuers’ bonds are of high credit quality (U.S. government agencies and government sponsored enterprises and “A” rated or better Kentucky municipalities), management does not have the intent to sell these securities and it is likely that it will not be required to sell the securities before their anticipated recovery.

 

Mortgage-backed Securities

 

At September 30, 2012, 100% of the mortgage-backed securities held by the Bank were issued by U.S. government sponsored entities and agencies, primarily Fannie Mae and Freddie Mac, institutions which the government has affirmed its commitment to support. Because a decline in market value would be attributable to changes in interest rates and illiquidity, and not credit quality, and because the Bank does not have the intent to sell these mortgage-backed securities and it is likely that it will not be required to sell the securities before their anticipated recovery, the Bank does not consider these securities to be other than temporarily impaired at September 30, 2012.

 

At September 30, 2012 and December 31, 2011, securities with a carrying value of $327,242,000 and $342,288,000 were pledged to secure public deposits and repurchase agreements.

 

11
 

 

Securities with unrealized losses at September 30, 2012 and December 31, 2011, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows (in thousands):

 

   Less than 12 Months   12 Months or More   Total 
   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
Description of Securities  Value   Loss   Value   Loss   Value   Loss 
September 30, 2012                              
U.S. government, federal agencies and government sponsored enterprises  $4,992   $(23)  $-   $-   $4,992   $(23)
Municipal & other obligations   5,518    (108)   -    -    5,518    (108)
Total temporarily impaired  $10,510   $(131)  $-   $-   $10,510   $(131)
                               
December 31, 2011                              
U.S. government, federal agencies and government sponsored enterprises  $18,734   $(12)  $-   $-   $18,734   $(12)
U.S government residential mortgage-backed   36,707    (64)   -    -    36,707    (64)
Municipal & other obligations   3,225    (24)   388    (1)   3,613    (25)
Total temporarily impaired  $58,666   $(100)  $388   $(1)  $59,054   $(101)

 

Note 9 - Loans

 

Loan balances were as follows (in thousands):

 

   9/30/2012   12/31/2011 
         
Commercial  $181,170   $193,176 
Residential real estate   281,745    266,268 
Nonresidential real estate   555,234    523,485 
Construction   98,609    104,788 
Consumer   16,170    16,618 
Municipal obligations   27,603    27,066 
Gross loans   1,160,531    1,131,401 
Less: Deferred loan origination fees and discount   (1,457)   (1,447)
Allowance for loan losses   (16,585)   (18,288)
           
Net loans  $1,142,489   $1,111,666 

 

12
 

 

The following tables present the activity in the allowance for loan losses for the three months ending September 30, 2012 and 2011, and the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of September 30, 2011 (in thousands):

 

           Non                 
       Residential   Residential           Municipal     
  Commercial   Real estate   Real estate   Construction   Consumer   Obligations   Total 
September 30, 2012                            
Allowance for loan losses                                   
Beginning balance  $2,159   $3,786   $6,666   $5,167   $392   $176   $18,346 
Provision for loan losses   (215)   2,095    875    (729)   325    (151)   2,200 
Loans charged off   (89)   (1,051)   (436)   (2,292)   (371)   -    (4,239)
Recoveries   18    3    183    2    72    -    278 
                                    
Total ending allowance balance  $1,873   $4,833   $7,288   $2,148   $418   $25   $16,585 
                                    
Ending allowance balance attributable to loans                                   
Individually evaluated for impairment  $317   $1,729   $2,993   $1,215   $-   $-   $6,254 
Collectively evaluated for impairment   1,556    3,104    4,295    933    418    25    10,331 
                                    
Total ending allowance balance  $1,873   $4,833   $7,288   $2,148   $418   $25   $16,585 
                                    
Loans                                   
Loans individually evaluated for impairment  $1,118   $8,500   $19,111   $5,774   $-   $-   $34,503 
Loans collectively evaluated for impairment   180,052    273,245    536,123    92,835    16,170    27,603    1,126,028 
                                    
Total ending loans balance  $181,170   $281,745   $555,234   $98,609   $16,170   $27,603   $1,160,531 

 

           Non                 
       Residential   Residential           Municipal     
  Commercial   Real estate   Real estate   Construction   Consumer   Obligations   Total 
September 30, 2011                            
Allowance for loan losses                                   
Beginning balance  $3,931   $2,403   $6,782   $4,496   $167   $37   $17,816 
Provision for loan losses   262    384    1,590    181    154    (21)   2,550 
Loans charged off   (1,014)   (210)   (586)   (501)   (253)   -    (2,564)
Recoveries   28    2    16    -    93    -    139 
                                    
Total ending allowance balance  $3,207   $2,579   $7,802   $4,176   $161   $16   $17,941 

 

13
 

 

The following tables present the activity in the allowance for loan losses for the nine months ending September 30, 2012 and 2011, and the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of September 30, 2012 and December 31, 2011 (in thousands):

  

           Non                 
       Residential   Residential           Municipal     
  Commercial   Real estate   Real estate   Construction   Consumer   Obligations   Total 
September 30, 2012                            
Allowance for loan losses                                   
Beginning balance  $3,207   $2,591   $7,614   $4,701   $162   $13   $18,288 
Provision for loan losses   (892)   3,782    1,095    977    726    12    5,700 
Loans charged off   (461)   (1,573)   (1,609)   (3,538)   (696)   -    (7,877)
Recoveries   19    33    188    8    226    -    474 
                                    
Total ending allowance balance  $1,873   $4,833   $7,288   $2,148   $418   $25   $16,585 
                                    
Ending allowance balance attributable to loans                                   
Individually evaluated for impairment  $317   $1,729   $2,993   $1,215   $-   $-   $6,254 
Collectively evaluated for impairment   1,556    3,104    4,295    933    418    25    10,331 
                                    
Total ending allowance balance  $1,873   $4,833   $7,288   $2,148   $418   $25   $16,585 
                                    
Loans                                   
Loans individually evaluated for impairment  $1,118   $8,500   $19,111   $5,774   $-   $-   $34,503 
Loans collectively evaluated for impairment   180,052    273,245    536,123    92,835    16,170    27,603    1,126,028 
                                    
Total ending loans balance  $181,170   $281,745   $555,234   $98,609   $16,170   $27,603   $1,160,531 

 

           Non                 
       Residential   Residential           Municipal     
  Commercial   Real estate   Real estate   Construction   Consumer   Obligations   Total 
September 30, 2011                            
Allowance for loan losses                                   
Beginning balance  $3,440   $2,431   $8,126   $3,150   $166   $55   $17,368 
Provision for loan losses   1,649    780    2,728    3,025    407    (39)   8,550 
Loans charged off   (1,934)   (674)   (3,070)   (2,000)   (715)   -    (8,393)
Recoveries   52    42    18    1    303    -    416 
                                    
Total ending allowance balance  $3,207   $2,579   $7,802   $4,176   $161   $16   $17,941 

 

14
 

 

           Non                 
       Residential   Residential           Municipal     
  Commercial   Real estate   Real estate   Construction   Consumer   Obligations   Total 
December 31, 2011                            
Ending allowance balance attributable to loans                                   
Individually evaluated for impairment  $224   $477   $2,994   $3,748   $-   $-   $7,443 
Collectively evaluated for impairment   2,983    2,114    4,620    953    162    13    10,845 
                                    
   $3,207   $2,591   $7,614   $4,701   $162   $13   $18,288 
Loans                                   
Loans individually evaluated for impairment  $917   $6,100   $20,390   $7,854   $-   $-   $35,261 
Loans collectively evaluated for impairment   192,259    260,168    503,095    96,934    16,618    27,066    1,096,140 
                                    
Total ending loans balance  $193,176   $266,268   $523,485   $104,788   $16,618   $27,066   $1,131,401 

 

15
 

 

The following table presents individually impaired loans by class of loans as of and for the three months ended September 30, 2012 (in thousands):

 

   Unpaid       Allowance for   Average   Interest     
   Principal   Recorded   Loan Losses   Recorded   Income   Interest 
   Balance   Investment   Allocated   Investment   Recognized   Received 
                         
With no related allowance recorded                              
Commercial  $30   $30   $-   $170   $-   $- 
                               
Residential real estate                              
Home equity lines of credit   50    50    -    50    -    - 
Multifamily properties   379    48    -    24    -    - 
Other   2,869    2,626    -    2,336    -    - 
                               
Nonresidential real estate                              
Owner occupied properties   802    792    -    490    -    - 
Non owner occupied properties   6,206    5,701    -    3,797    -    - 
                               
Construction   809    509    -    432    -    - 
                               
With an allowance recorded                              
Commercial   1,088    1,088    317    823    4    4 
                               
Residential real estate                              
Home equity lines of credit   1,488    1,488    1,341    813    12    12 
Multifamily properties   1,324    1,324    243    1,554    11    11 
Other   3,109    2,964    145    3,309    31    24 
                               
Nonresidential real estate                              
Owner occupied properties   8,544    8,543    2,651    8,774    81    81 
Non owner occupied properties   4,595    4,074    342    6,449    34    34 
                               
Construction   6,387    5,266    1,215    6,494    45    45 
                               
Total  $37,680   $34,503   $6,254   $35,515   $218   $211 

 

16
 

 

The following table presents individually impaired loans by class of loans as of and for the nine months ended September 30, 2012 (in thousands):

 

   Unpaid       Allowance for   Average   Interest     
   Principal   Recorded   Loan Losses   Recorded   Income   Interest 
   Balance   Investment   Allocated   Investment   Recognized   Received 
                         
With no related allowance recorded                              
Commercial  $30   $30   $-   $263   $-   $- 
                               
Residential real estate                              
Home equity lines of credit   50    50    -    50    -    - 
Multifamily properties   379    48    -    273    -    - 
Other   2,869    2,626    -    2,094    -    - 
                               
Nonresidential real estate                              
Owner occupied properties   802    792    -    698    -    - 
Non owner occupied properties   6,206    5,701    -    2,848    -    - 
                               
Construction   809    509    -    256    -    - 
                               
With an allowance recorded                              
Commercial   1,088    1,088    317    950    7    5 
                               
Residential real estate                              
Home equity lines of credit   1,488    1,488    1,341    339    12    12 
Multifamily properties   1,324    1,324    243    815    22    22 
Other   3,109    2,964    145    3,557    76    64 
                               
Nonresidential real estate                              
Owner occupied properties   8,544    8,543    2,651    9,081    239    237 
Non owner occupied properties   4,595    4,074    342    7,406    143    106 
                               
Construction   6,387    5,266    1,215    8,017    163    155 
                               
Total  $37,680   $34,503   $6,254   $36,647   $662   $601 

 

17
 

 

The following table presents individually impaired loans by class of loans as of, and for the three months ended September 30, 2011:

 

   Unpaid       Allowance for   Average   Interest     
   Principal   Recorded   Loan Losses   Recorded   Income   Interest 
   Balance   Investment   Allocated   Investment   Recognized   Received 
                         
With no related allowance recorded                              
Commercial  $349   $310   $-   $371   $-   $- 
                               
Residential real estate                              
Home equity lines of credit   -    -    -    -    -    - 
Multifamily properties   -    -    -    -    -    - 
                               
Other   2,121    2,121    -    2,325    -    - 
                               
Nonresidential real estate                              
Owner occupied properties   1,011    955    -    587    -    - 
Non owner occupied properties   897    897    -    1,044    -    - 
                               
Construction   2,036    889    -    909    -    - 
                               
With an allowance recorded                              
Commercial   1,379    1,379    504    2,370    10    5 
                               
Residential real estate                              
Home equity lines of credit   -    -    -    -    -    - 
Multifamily properties   868    868    291    869    14    9 
Other   2,869    2,850    433    2,755    18    17 
                               
Nonresidential real estate                              
Owner occupied properties   9,471    9,348    1,093    5,123    80    25 
Non owner occupied properties   13,667    11,830    2,185    9,870    90    90 
                               
Construction   8,962    7,726    3,256    8,459    76    75 
                               
Total  $43,630   $39,173   $7,762   $34,682   $288   $221 

 

 

18
 

 

 

 

The following table presents individually impaired loans by class of loans as of and for the nine months ended September 30, 2011 (in thousands):

 

   Unpaid       Allowance for   Average   Interest     
   Principal   Recorded   Loan Losses   Recorded   Income   Interest 
   Balance   Investment   Allocated   Investment   Recognized   Received 
                         
With no related allowance recorded                              
Commercial  $349   $310   $-   $351   $-   $- 
                               
Residential real estate                              
Home equity lines of credit   -    -    -    -    -    - - 
Multifamily properties   -    -    -    17    -    - 
Other   2,121    2,121    -    1,288    -    - 
                               
Nonresidential real estate                              
Owner occupied properties   1,011    955    -    503    -    - 
Non owner occupied properties   897    897    -    848    -    - 
                               
Construction   2,036    889    -    559    -    - 
                               
With an allowance recorded                              
Commercial   1,379    1,379    504    1,959    17    9 
                               
Residential real estate                              
Home equity lines of credit   -    -    -    -    -    - 
Multifamily properties   868    868    291    922    42    28 
Other   2,869    2,850    433    2,441    54    51 
                               
Nonresidential real estate                              
Owner occupied properties   9,471    9,348    1,093    2,884    81    26 
Non owner occupied properties   13,667    11,830    2,185    10,044    215    210 
                               
Construction   8,962    7,726    3,256    8,035    203    189 
                               
Total  $43,630   $39,173   $7,762   $29,851   $612   $513 

 

19
 

 

The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2011 (in thousands):

 

   Unpaid       Allowance for 
   Principal   Recorded   Loan Losses 
   Balance   Investment   Allocated 
             
With no related allowance recorded               
Commercial  $350   $310   $- 
                
Residential real estate               
Home equity lines of credit   50    50    - 
Multifamily properties   538    538    - 
Other   1,703    1,703    - 
                
Nonresidential real estate               
Owner occupied properties   1,101    1,101    - 
Non owner occupied properties   2,122    2,116    - 
                
Construction   356    319    - 
                
With an allowance recorded               
Commercial   733    607    224 
                
Residential real estate               
Home equity lines of credit   -    -    - 
Multifamily properties   -    -    - 
Other   3,859    3,809    477 
                
Nonresidential real estate               
Owner occupied properties   10,771    9,798    1,477 
Non owner occupied properties   8,476    7,375    1,517 
                
Construction   8,267    7,535    3,748 
                
Total  $38,326   $35,261   $7,443 

 

20
 

 

The following table presents the aging of the recorded investment in past due loans by class of loans as of September 30, 2012 and December 31, 2011 (in thousands):

 

   Loans   Loans over             
   30-90 days   90 days       Loans not     
   past due   past due   Nonaccrual   past due   Total 
September 30, 2012                    
Commercial  $599   $-   $968   $179,603   $181,170 
Residential real estate                         
Home equity lines of credit   827    39    768    98,658    100,292 
Multifamily properties   111    -    48    46,624    46,783 
Other residential real estate   3,657    -    3,676    127,337    134,670 
                          
Nonresidential real estate                         
Owner occupied properties   3,591    -    1,368    273,240    278,199 
Non owner occupied properties   1,881    -    6,305    268,849    277,035 
Construction   737    -    1,601    96,271    98,609 
                          
Consumer                         
Credit card balances   32    66    -    6,399    6,497 
Other consumer   13    -    79    9,581    9,673 
                          
Municipal obligations   -    -    -    27,603    27,603 
                          
Total  $11,448   $105   $14,813   $1,134,165   $1,160,531 

 

   Loans   Loans over             
   30-90 days   90 days       Loans not     
   past due   past due   Nonaccrual   past due   Total 
December 31, 2011                    
Commercial  $692   $74   $1,175   $191,235   $193,176 
Residential real estate                         
Home equity lines of credit   1,094    -    910    92,676    94,680 
Multifamily properties   -    -    -    36,756    36,756 
Other residential real estate   5,854    112    4,415    124,451    134,832 
                          
Nonresidential real estate                         
Owner occupied properties   2,623    -    2,270    247,875    252,768 
Non owner occupied properties   3,942    -    4,358    262,417    270,717 
Construction   265    -    1,897    102,626    104,788 
                          
Consumer                         
Credit card balances   60    32    -    6,400    6,492 
Other consumer   37    1    626    9,462    10,126 
                          
Municipal obligations   -    -    -    27,066    27,066 
                          
Total  $14,567   $219   $15,651   $1,100,964   $1,131,401 

 

21
 

 

Troubled Debt Restructurings:

 

The Company has allocated $2,837,000 and $2,074,000 of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of September 30, 2012 and December 31, 2011, respectively. Troubled debt restructurings totaled $17,129,911 and $15,229,000 as of September 30, 2012 and December 31, 2011, respectively. The Company has not committed to lend additional amounts as of September 30, 2012 and December 31, 2011 to customers with outstanding loans that are classified as troubled debt restructurings.

 

Modifications involving a reduction of the stated interest rate of the loan were for periods up to three years. Modifications involving an extension of the maturity date were for periods ranging from eight months to twelve months.

  

The following table presents loans by class modified as troubled debt restructurings that occurred during the three months ending September 30, 2012 and 2011:

  

   2012   2011 
   Number
Of
Loans
   Pre-Modification
Outstanding
Recorded
Investment
   Post-Modification
Outstanding
Recorded
Investment
   Number
Of
Loans
   Pre-Modification
Outstanding
Recorded
Investment
   Post-Modification
Outstanding
Recorded
Investment
 
Troubled Debt Restructurings:                              
                               
Commercial   1   $31,757   $29,979    -   $-   $- 
Residential real estate                              
Home equity lines of credit   -    -    -    -    -    - 
Multifamily properties   -    -    -    -    -    - 
Other residential real estate   -    -    -    1    568,000    568,000 
Nonresidential real estate                              
Owner occupied properties   -    -    -    1    1,700,000    1,700,000 
Non owner occupied properties   -    -    -    -    -    - 
Construction   -    -    -    -    -    - 
Consumer                              
Credit card balances   -    -    -    -    -    - 
Other consumer   -    -    -    -    -    - 
Municipal obligations   -    -    -    -    -    - 
Total   1   $31,757   $29,979    2   $2,268,000   $2,268,000 

 

 

22
 

  

 

The following table presents loans by class modified as troubled debt restructurings that occurred during the nine months ending September 30, 2012 and 2011:

 

   2012   2011 
   Number
Of
Loans
   Pre-Modification
Outstanding
Recorded
Investment
   Post-Modification
Outstanding
Recorded
Investment
   Number
Of
Loans
   Pre-Modification
Outstanding
Recorded
Investment
   Post-Modification
Outstanding
Recorded
Investment
 
Troubled Debt Restructurings:                              
                               
Commercial   2   $190,168   $184,336    -   $-   $- 
Residential real estate                              
Home equity lines of credit   -    -    -    -    -    - 
Multifamily properties   1    485,000    48,238    -    -    - 
Other residential real estate   1    187,105    186,074    1    568,000    568,000 
Nonresidential real estate                              
Owner occupied properties   1    153,891    153,891    1    1,700,000    1,700,000 
Non owner occupied properties   -    -    -    3    10,881,848    10,839,519 
Construction   5    3,204,872    2,957,005    -    -    - 
Consumer                              
Credit card balances   -    -    -    -    -    - 
Other consumer   -    -    -    -    -    - 
Municipal obligations   -    -    -    -    -    - 
Total   10   $4,221,036   $3,529,544    5   $13,149,848   $13,107,519 

  

The troubled debt restructurings described above increased the allowance for loan losses by $2,871 and resulted in charge-offs of $0 during the third quarter ending September 30, 2012 and charge offs of $1,112,147 for the nine months ending September 30, 2012.

 

The following table presents loans by class modified as troubled debt restructurings for which there was a payment default within twelve months following the modification during the period ending September 30, 2012:

 

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Troubled Debt Restructurings        
That Subsequently Defaulted:  Number of Loans   Recorded Investment 
         
Commercial   1   $154,357 
Residential real estate          
Home equity lines of credit          
Multifamily properties   1    48,238 
Other residential real estate   1    465,293 
Nonresidential real estate          
Owner occupied properties          
Non owner occupied properties   3    3,234,737 
Construction   2    1,616,100 
Consumer          
Credit card balances          
Other consumer          
Municipal obligations   -    - 
           
Total   8   $5,518,725 

 

A loan is considered to be in payment default once it is 30 days contractually past due under the modified terms.

 

The troubled debt restructurings that subsequently defaulted described above increased the allowance for loan losses by $0 and resulted in charge-offs of $477,091 during the third quarter ending September 30, 2012 and $1,739,238 for the nine months ending September 30, 2012.

 

Credit Quality Indicators:

 

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt, including: current financial information, historical payment experience, credit documentation, public information and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis includes loans with an outstanding balance greater than $100,000 and non-homogeneous loans, such as commercial and commercial real estate loans. This analysis is performed on a quarterly basis. Loans with balances below $100,000 and homogenous loans, such as residential real estate and consumer loans, are analyzed for credit quality based on aging status, which was previously presented. The Company uses the following definitions for risk ratings:

 

Special Mention. Loans classified as special mention have a potential weakness that deserves management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution's credit position at some future date.

 

Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

 

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Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as 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.

 

Based on the most recent analysis performed, the risk category of loans by class of loans is as follows (in thousands):

 

      Special                 
   Pass   Mention   Substandard   Doubtful   Not Rated(1)   Total 
September 30, 2012                              
Commercial  $166,935   $10,448   $3,787   $-   $-   $181,170 
Residential real estate                              
Home equity lines of credit   11,827    781    1,953    -    85,731    100,292 
Multifamily properties   45,311    100    1,372    -    -    46,783 
Other residential real estate   40,607    1,143    10,496    -    82,424    134,670 
                               
Nonresidential real estate                              
Owner occupied properties   248,156    10,909    19,134    -    -    278,199 
Non owner occupied properties   255,141    7,304    14,590    -    -    277,035 
Construction   87,924    2,264    8,421    -    -    98,609 
                               
Consumer                              
Credit card balances   -    -    -    -    6,497    6,497 
Other consumer   -    -    19    -    9,654    9,673 
Municipal obligations   27,603    -    -    -    -    27,603 
                               
Total  $883,504   $32,949   $59,772   $0   $184,306   $1,160,531 

 

(1) Not rated loans represent the homogenous pools risk category.

 

      Special                 
   Pass   Mention   Substandard   Doubtful   Not Rated(1)   Total 
December 31, 2011                              
Commercial  $170,394   $9,684   $13,098   $-   $-   $193,176 
Residential real estate                              
Home equity lines of credit   -    712    976    84    92,908    94,680 
Multifamily properties   36,115    103    538    -    -    36,756 
Other residential real estate   38,725    1,357    10,843    -    83,907    134,832 
                               
Nonresidential real estate                              
Owner occupied properties   221,941    7,754    23,073    -    -    252,768 
Non owner occupied properties   246,614    8,902    15,201    -    -    270,717 
Construction   90,297    3,398    11,093    -    -    104,788 
                               
Consumer                              
Credit card balances   -    -    -    -    6,492    6,492 
Other consumer   -    -    22    -    10,104    10,126 
Municipal obligations   27,066    -    -    -    -    27,066 
                               
Total  $831,152   $31,910   $74,844   $84   $193,411   $1,131,401 

 

(1) Not rated loans represent the homogenous pools risk category.

 

25
 

 

Note 10 –Fair Value:

Accounting guidance 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 (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

 

Level 2: Significant other 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.

 

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

 

Investment Securities: The fair values of securities available-for-sale are determined by matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs). One corporate security is valued using Level 3 inputs as there is no readily observable market activity. Management determines the value of this security based on expected cash flows, the credit quality of the security and current market interest rates.

 

Derivatives: The Bank’s derivative instruments consist of over-the-counter interest-rate swaps that trade in liquid markets. The fair value of the derivative instruments is primarily measured by obtaining pricing from broker-dealers recognized to be market participants. The pricing is derived from market observable inputs that can generally be verified and do not typically involve significant judgment by the Bank. This valuation method is classified as Level 2 in the fair value hierarchy.

 

Impaired Loans: At the time a loan is considered impaired, it is recorded at the lower of cost or fair value. Impaired loans carried at fair value generally receive specific allocations of the allowance for loan losses. For collateral dependent loans, fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly.

 

Other Real Estate Owned: Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at the lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

 

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Loans Held For Sale: Loans held for sale are carried at the lower of cost or fair value, which is evaluated on a pool-level basis. The fair value of loans held for sale is determined using quoted prices for similar assets, adjusted for specific attributes of that loan or other observable market data, such as outstanding commitments from third party investors (Level 2).

 

Assets and Liabilities Measured on a Recurring Basis

Assets and liabilities measured at fair value on a recurring basis are summarized below (in thousands):

       Fair Value Measurements at 
       September 30, 2012 Using: 
           Significant     
       Quoted Prices in   Other   Significant 
   Total   Active Markets for   Observable   Unobservable 
   September 30,   Identical Assets   Inputs   Inputs 
   2012   (Level 1)   (Level 2)   (Level 3) 
Assets                    
Investment securities available-for-sale                    
U.S. government sponsored entities and agencies  $113,763   $-   $113,763   $- 
U.S. government agency mortgage backed   187,721    -    187,721    - 
Corporate   1,060    -    -    1,060 
Derivatives   1,841    -    1,841    - 
Total  $304,385   $-   $303,325   $1,060 
                     
Liabilities                    
Derivatives  $1,841   $-   $1,841   $- 
Total  $1,841   $-   $1,841   $- 

 

       Fair Value Measurements at 
       December 31, 2011 Using: 
           Significant     
       Quoted Prices in   Other   Significant 
   Total   Active Markets for   Observable   Unobservable 
   December 31,   Identical Assets   Inputs   Inputs 
   2011   (Level 1)   (Level 2)   (Level 3) 
Assets                    
Investment securities available-for-sale                    
U.S. government sponsored entities and agencies  $169,460    -    169,460    - 
U.S. government agency mortgage backed   151,992    -    151,992    - 
Corporate   1,060    -    -    1,060 
Derivatives   1,349    -    1,349    - 
Total  $323,861    -    322,801    1,060 
                     
Liabilities                    
Derivatives  $1,349    -    1,349    - 
Total  $1,349    -    1,349    - 

 

27
 

 

There were no transfers between Level 1 and Level 2 during 2012 or 2011.

 

There were no gains or losses for assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the quarter ended September 30, 2012.

 

There were no changes in unrealized gains and losses recorded in earnings for the quarter ended September 30, 2012 for Level 3 assets and liabilities that are still held at September 30, 2012.

 

The table below presents a reconciliation of all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the period ended September 30 (in thousands):

 

   Corporate Securities 
   9/30/12   12/31/11 
         
Balance of recurring Level 3 assets at January 1  $1,060   $1,060 
Total gains or losses for the period:          
Included in earnings          
Included in other comprehensive income          
Purchases   -    - 
Sales   -    - 
Issuances   -    - 
Settlements   -    - 
Transfers into Level 3   -    - 
Transfers out of Level 3   -    - 
           
Balance of recurring Level 3 assets at December 31  $1,060   $1,060 

 

The following table presents quantitative information about recurring Level 3 fair value measurements at September 30, 2012 (in thousands):

 

       Valuation       
   Fair value   Technique(s)  Unobservable Input(s)  Value 
               
Corporate security  $1,060   Discounted cash flow  Probability of default   0%

 

The interest rate on this security is based on interest rates paid for securities with similar credit characteristics, but the probability of default is determined through a credit quality review rather than formal ratings or other observable inputs. The interest rate adjusts to reflect current market conditions of highly rated investments, if probability of default changed significantly, the interest rate would adjust accordingly and the fair value would be updated. Management reviews this interest rate and the security’s credit quality quarterly and a market value adjustment is made if necessary pursuant to this review.

 

28
 

 

Assets and Liabilities Measured on a Non-Recurring Basis

(Dollars in thousands)

Assets and liabilities measured at fair value on a non-recurring basis are summarized below:

 

       Fair Value Measurements at 
       September 30, 2012 Using: 
           Significant     
       Quoted Prices in   Other   Significant 
   Total   Active Markets for   Observable   Unobservable 
   September 30   Identical Assets   Inputs   Inputs 
   2012   (Level 1)   (Level 2)   (Level 3) 
Assets                    
Impaired loans                    
Commercial  $771   $-   $-   $771 
Nonresidential real estate   -                
Owner occupied properties   5,892    -    -    5,892 
Non owner occupied properties   3,732    -    -    3,732 
Residential real estate                    
Home equity lines of credit   147    -    -    147 
Multifamily properties   1,081    -    -    1,081 
Other   2,819    -    -    2,819 
Construction   4,051    -    -    4,051 
Total  $18,493   $-   $-   $18,493 

 

       Fair Value Measurements at 
       December 31, 2011 Using: 
           Significant     
       Quoted Prices in   Other   Significant 
   Total   Active Markets for   Observable   Unobservable 
   December 31   Identical Assets   Inputs   Inputs 
   2011   (Level 1)   (Level 2)   (Level 3) 
Assets                    
Impaired loans                    
Commercial  $383   $-   $-   $383 
Nonresidential real estate   -                
Owner occupied properties   8,320    -    -    8,320 
Non owner occupied properties   5,858    -    375    5,483 
Residential real estate                    
Home equity lines of credit   -    -    -    - 
Multifamily properties   -    -    -    - 
Other   3,332    -    1,832    1,500 
Construction   3,787    -    214    3,573 
Total  $21,680   $-   $2,421   $19,259 

 

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a gross carrying amount of $24,747,000 with a valuation allowance of $6,254,000, resulting in a decrease in provision for loan losses of $1,189,000 for the first nine months of 2012. As of December 31, 2011, impaired loans had a gross carrying amount of $29,124,000, with a valuation allowance of $7,443,000, resulting in an increase in provision for loan losses of $1,699,000.

 

29
 

 

Values for collateral dependent loans are generally based on appraisals obtained from licensed real estate appraisers and in certain circumstances consideration of offers obtained to purchase properties prior to foreclosure or other factors management deems relevant to arrive at a representative fair value.  Appraisals for commercial real estate generally use three methods to derive value: cost, sales or market comparison and income approach.  The cost method bases value on the cost to replace the current property.  The market comparison approach evaluates the sales price of similar properties in the same market area.  The income approach considers net operating income generated by the property and an investor’s required return.  The final fair value is based on a reconciliation of these three approaches.

 

The following table presents quantitative information about recurring Level 3 fair value measurements at September 30, 2012 (in thousands):

 

    Fair
Value
  Valuation Technique(s)   Unobservable Input(s)   Discount
Assets                  
Impaired Loans:                  
Commercial   $ 875   Cost, sales, income approach   Adjustment for comparable properties, market conditions   5-10%
Nonresidential real estate                  
Owner occupied properties     8,255   Cost, sales, income approach   Adjustment for comparable properties, market conditions   5-10%
Non owner occupied properties     9,645   Cost, sales, income approach   Adjustment for comparable properties, market conditions   5-10%
Residential real estate                  
Home equity lines of credit                  
Multifamily properties     577   Cost, sales, income approach   Adjustment for comparable properties, market conditions   5-10%
Other     2,417   Cost, sales, income approach   Adjustment for comparable properties, market conditions   5-10%
Construction     4,470   Cost, sales, income approach   Adjustment for comparable properties, market conditions   5-10%
Total  

$

26,239            

 

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The carrying amounts and estimated fair values of financial instruments at September 30, 2012 and December 31, 2011 are as follows (in thousands):

 

       Fair Value Measurements at 
       September 30, 2012 Using: 
   Carrying Value   Level 1   Level 2   Level 3   Total 
(Dollars in thousands)                         
Financial assets                         
Cash and cash equivalents  $81,950   $81,950   $   $   $81,950 
Interest-bearing deposits with Banks   250         250         250 
Securities available-for-sale   302,544         301,484    1,060    302,544 
Securities held-to-maturity   58,314         60,375         60,375 
Federal Home Loan Bank stock   5,099    N/A              N/A 
Loans held for sale   19,314         19,314         19,314 
Loans, net   1,142,489              1,149,104    1,149,104 
Accrued interest receivable   4,428         4,428         4,428 
Derivative assets   1,841         1,841         1,841 
Financial liabilities                         
Deposits  $(1,471,246)  $(1,101,443)  $(366,976)  $   $(1,468,419)
Short-term borrowings   (22,142)        (22,142)        (22,142)
Notes payable   (48,721         (22,414)   (22,366)   (44,780)
Accrued interest payable   (1,082)        (1,082)        (1,082)
Standby letters of credit   (208)        (208)        (208)
Derivative liabilities   (1,841)        (1,841)        (1,841)

 

       Fair Value Measurements at 
       December 31, 2011 Using: 
   Carrying Value   Level 1   Level 2   Level 3   Total 
(Dollars in thousands)                         
Financial assets                         
Cash and cash equivalents  $135,964   $135,964   $   $   $135,964 
Interest-bearing deposits with Banks   250         250         250 
Securities available-for-sale   322,512         321,452    1,060    322,512 
Securities held-to-maturity   48,975         50,643         50,643 
Federal Home Loan Bank stock   5,099    N/A              N/A 
Loans held for sale   8,920         8,920         8,920 
Loans, net   1,111,666         1,093,529    19,259    1,112,788 
Accrued interest receivable   4,887         4,887         4,887 
Derivative assets   1,349         1,349         1,349 
Financial liabilities                         
Deposits  $(1,498,821)  $(1,092,434)  $(408,859)  $   $(1,501,293)
Short-term borrowings   (29,300)        (29,300)        (29,300)
Notes payable   (48,739)        (27,477)   (18,476)   (45,953)
Accrued interest payable   (1,582)        (1,582)        (1,582)
Standby letters of credit   (263)        (263)        (263)
Derivative liabilities   (1,349)        (1,349)        (1,349)

 

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The estimated fair value approximates carrying amounts for all items except those described below. The carrying amounts of cash and short-term instruments approximate fair values and are classified as either Level 1 or Level 2. Estimated fair value for both securities available-for-sale and held-to-maturity is as previously described for securities available-for-sale. It is not practicable to determine the fair value of Federal Home Loan Bank stock due to restrictions placed on its transferability. Fair values of loans, excluding loans held for sale, are estimated as set forth below:

 

For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price. The fair value of loans held for sale is estimated based upon binding contracts and quotes from third party investors resulting in a Level 2 classification. The fair values disclosed for demand deposits (e.g., interest and non-interest checking, passbook savings and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amount) resulting in a Level 1 classification. The carrying amounts of variable rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date resulting in a Level 2 classification. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification. The carrying amounts of federal funds purchased, borrowings under repurchase agreements and other short-term borrowings, generally maturing within ninety days, approximate their fair values resulting in a Level 2 classification. The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 2 classification. The fair values of the Company’s subordinated debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 3 classification. Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The fair value of commitments is not material. Estimated fair value of standby letters of credit are based on their current unearned fee balance. Estimated fair value for commitments to make loans and unused lines of credit are considered nominal. Estimated fair value for derivatives is determined as previously described above.

 

32
 

 

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

 

The objective of this section is to help shareholders and potential investors understand our views on our results of operations and financial condition. You should read this discussion in conjunction with the consolidated financial statements and notes to the consolidated financial statements that appear elsewhere in this quarterly report on form 10-Q (this “Quarterly Report”). References to “we,” “us,” and “our” in this section refer to the Bank of Kentucky Financial Corporation (“BKFC”) and its subsidiaries, including The Bank of Kentucky, Inc. (“the Bank”), unless otherwise specified or unless the context otherwise requires.

 

FORWARD-LOOKING STATEMENTS

 

Certain statements contained in this quarterly report which are not statements of historical fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Examples of forward-looking statements include, but are not limited to, projections of revenues, income or loss, earnings or loss per share, the payment or non-payment of dividends, capital structure and other financial items; statements of plans and objectives of us or our management or Board of Directors; and statements of future economic performance and statements of assumptions underlying such statements. Words such as “believes,” “anticipates,” “intends” and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements.

 

Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to, the following:

 

·indications of an improving economy may prove to be premature;

 

·general economic or industry conditions could be less favorable than expected, resulting in a deterioration in credit quality, a change in the allowance for credit losses or a reduced demand for credit or fee-based products and services;

 

·changes or volatility in interest rates may adversely impact the value of securities, loans, deposits and other financial instruments and the interest rate sensitivity of our balance sheet as well as our liquidity;

 

·our ability to determine accurate values of certain assets and liabilities;

 

·the impact of turmoil in the financial markets and the effectiveness of governmental actions taken in response, and the effect of such governmental actions on us, our competitors and counterparties, financial markets generally and availability of credit specifically;

 

·changes in the extensive laws, regulations and policies governing financial services companies, including the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), and any regulations promulgated thereunder;

 

33
 

 

·the potential need to adapt to industry changes in information technology systems, on which the Bank is highly dependent, could present operational issues or require significant capital spending;

 

·competitive pressures could intensify and affect the Bank’s profitability, including as a result of continued industry consolidation, the increased availability of financial services from non-banks, technological developments or bank regulatory reform; and

 

·acquisitions may not produce revenue enhancements or cost savings at levels or within timeframes originally anticipated, or may result in unforeseen integration difficulties.

 

Any forward-looking statements made by us or on our behalf speak only as of the date they are made, and we do not undertake any obligation to update any forward-looking statement to reflect the impact of subsequent events or circumstances. Before making an investment decision, you should carefully consider all risks and uncertainties disclosed in our other public documents on file with the Securities and Exchange Commission (“SEC”), including those described in Item 1A of our Annual Report on Form 10-K, for the year ended December 31, 2011.

 

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

 

BKFC has prepared all of the consolidated financial information in this Quarterly Report in accordance with GAAP. In preparing the consolidated financial statements in accordance with generally accepted accounting principles, BKFC makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. There can be no assurances that actual results will not differ from those estimates.

 

We have identified the accounting policy related to the allowance for loan losses as critical to the understanding of BKFC’s results of operations, since the application of this policy requires significant management assumptions and estimates that could result in reporting materially different amounts if conditions or underlying circumstances were to change.

 

The Bank maintains an allowance to absorb probable, incurred loan losses inherent in the loan portfolio. The allowance for loan losses is maintained at a level the Bank considers to be adequate and is based upon ongoing quarterly assessments and evaluations of the collectability and historical loss experience of loans. Loan losses are charged and recoveries are credited to the allowance for loan losses. Provisions for loan losses are based on the Bank’s review of its historical loan loss experience and such factors that, in management’s judgment, deserve consideration under existing economic conditions in estimating probable loan losses. The Bank’s strategy for credit risk management includes a combination of well-defined credit policies, uniform underwriting criteria and ongoing risk monitoring and review processes for all commercial and consumer credit exposures. The credit risk management strategy also includes assessments of compliance with commercial and consumer policies, risk ratings and other important credit information. The strategy also emphasizes regular credit examinations and management reviews of loans exhibiting deterioration in credit quality. The Bank strives to identify potential problem loans early and promptly undertake the appropriate actions necessary to mitigate or eliminate the increasing risk identified in these loans.

 

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The allowance for loan losses consists of two components, the specific reserve, pursuant to ASC 310, Accounting by Creditors for Impairment of a Loan, and the general reserve, pursuant to ASC 450-10, Accounting for Contingencies. A loan is considered impaired when, based upon current information and events, it is probable that the bank will be unable to collect all amounts due according to the contractual terms of the loan. The specific reserve component is an estimate of loss based upon an impairment review of larger loans that are considered impaired. The general reserve includes an estimate of commercial and consumer loans with similar characteristics. Depending on the set of facts with respect to a particular loan, the Bank utilizes one of the following methods for determining the proper impairment of a loan:

 

·the present value of expected future cash flows of a loan;
·the market price of the loan based upon readily available information for that type of loan; and
·the fair value of collateral.

 

The allowance established for impaired loans is generally based, for all collateral-dependent loans, on the fair market value of the collateral, less the estimated cost to liquidate. For non-collateral dependent loans (such as accruing troubled debt restructurings), the allowance is based on the present value of expected future cash flows discounted by the loan’s effective interest rate. A portion of the Bank’s loans which are impaired under the ASC 310 process carry no specific reserve allocation. These loans were reviewed for impairment and are considered adequately collateralized with respect to their respective outstanding principal loan balances. The majority of these loans are loans which have had their respective impairment (or specific reserve) amounts charged off. It is the Bank’s practice to maintain these impaired loans, as analyzed and provided for in the ASC 310 component of the allowance for loan losses, to avoid double counting of any estimated losses that may have been included in the ASC 450-10 component of the allowance for loan losses.

 

Generally, the Bank orders a new or updated appraisal on real estate properties which are subject to an impairment review. Upon completion of the impairment review, loan reserves are increased as warranted. Charge-offs, if necessary, are generally recognized in a period after the reserves were established. Adjustments to new or updated appraisal values are not typical, but in those cases when an adjustment is necessary, it is documented with supporting information and typically results in an adjustment to decrease the property’s value because of additional information obtained concerning the property after the appraisal or update has been received by the Bank. If a new or updated appraisal is not available at the time of a loan’s impairment review, the Bank typically applies a discount to the value of an old appraisal to reflect the property’s current estimated value if there is believed to be deterioration in either (i) the physical or economic aspects of the subject property or (ii) any market conditions. Updated valuations on 1 to 4 family residential properties with small to moderate values are generally accomplished by obtaining an Automated Valuation Model (“AVM”) or a Broker’s Price Opinion (“BPO”). Generally, an “as is” value is utilized in most of the Bank’s real estate based impairment analyses. However, under certain limited circumstances, an “as stabilized” valuation may be utilized, provided that the “as stabilized” value is tied to a well-justified action plan to bring the real estate project to a stabilized occupancy under a reasonable period of time.

 

35
 

 

If a partially charged-off loan has been restructured in a manner that is reasonably assured of repayment and performance according to prudently modified terms, and has sustained historical payment performance for a reasonable period of time prior to and/or after the restructuring, it may be returned to accrual status and classified as a TDR loan. However, if the above conditions cannot be reasonably met, the loan remains on non-accrual status.

 

In addition, the Bank evaluates the collectability of both principal and interest when assessing the need for loans to be placed on non-accrual status. Non-accrual status denotes loans in which, in the opinion of management, the collection of additional interest is unlikely. A loan is generally placed on non-accrual status if: (i) it becomes 90 days or more past due (120 days past due for consumer loans) or (ii) for which payment in full of both principal and interest cannot be reasonably expected.

 

Historical loss rates are applied to all other loans not subject to specific reserve allocations. The loss rates applied to loans are derived from analyzing the loss experience sustained on loans according to their internal risk rating. These loss rates may be adjusted to account for environmental factors. The general reserve also includes homogeneous loans, such as consumer installment, residential mortgage and home equity loans that are not individually risk graded. For these loans that are not individually risk graded, the historic loss experience of the portfolio is used to determine the appropriate allowance for the portfolios. Allocations for the allowance are established for each pool of loans based on the expected net charge-offs for one year.

 

In the second quarter of 2012 management developed a detailed approach to setting the environmental adjustments to the historic loss rates and discontinued the use of high and low range of reserve percentages. Management believes that this more detailed approach adds efficiencies and provides more precision to the allowance for loan losses estimations. Factors that management considers as part of this approach in setting the environmental adjustments include economic trends, loan policies, lender experience, loan growth, delinquency trend, non-performing asset trends, classified loan trends and credit concentrations.

 

Reserves on individual loans and historical loss rates are reviewed quarterly and adjusted as necessary based on changing borrower and/or collateral conditions, as well as actual collection and charge-off experience.

 

Charge-offs are recognized when it becomes evident that a loan or a portion of a loan is deemed uncollectible regardless of its delinquent status. The Bank generally charges off that portion of a loan that is determined to be unsupported by an obligor’s continued ability to repay the loan from income and/or assets, both pledged and unpledged as collateral.

 

36
 

 

OVERVIEW

 

Economic Overview

 

Despite positive economic news in the third quarter of 2012, the overall economic recovery remains muted after a very deep recession highlighted by high unemployment, depressed real estate values and high levels of problem assets in the banking industry. The third quarter of 2012 continued to show signs of positive growth as gross domestic product expanded at an anticipated rate of 1.8% from the previous quarter, which remains well below the historical normalized 3% growth rate. For the year, the U.S. economy is anticipated to grow at 2.1% over 2011’s output. The national unemployment rate fell during the third quarter by 0.10% to 8.07%. The economy also produced 437,000 non-farm jobs in the quarter, which was a substantial recovery from the previous quarters. The expectation for the remainder of 2012 is that the U.S. economy will continue to experience muted growth. The major risks for the remainder of 2012 with respect to the overall economy will be the severity of the recession in Europe, and the impact of food and energy inflation on the consumers. Interest rates remain low as a result of the continuing actions by the Federal Reserve with respect to the target fed funds rate.

 

2012 Third Quarter and Nine Month Performance Overview

 

The Company completed the third quarter and first nine months of 2012 with a 4% and a 20% increase in diluted earnings per share respectively. These results reflect overall improving credit metrics and continued revenue growth which was offset by higher non-interest expense. In the third quarter of 2012 total loans increased $15,341,000 (1%) from the previous quarter, which was the second sequential quarter of strong organic loan growth and the largest quarterly increase that the Company has experienced in the last three years. The third quarter and first nine months of 2012 results also benefited from the elimination of the Company’s preferred stock dividends and related amortization expense as a result of the Company’s repurchase of the remaining $17 million of Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the “Series A Preferred Stock”), previously issued to the U.S. Department of the Treasury (the “U.S. Treasury”) as part of the Troubled Asset Relief Program (“TARP”) Capital Purchase Program. The 4% increase in diluted earnings per share for the third quarter of 2012 as compared to the same period in 2011 was the result of a 14% reduction in the provision for loan losses, and a 2% growth in revenue, which was offset with a 10% increase in non-interest expense as compared to the same period in 2011. The reduction in the provision for loan losses was accompanied by lower levels of problem loans from both the previous year and on a sequential basis from the second quarter of 2012. While levels of problem loans decreased, charged off loans increased from both the previous year and on a sequential basis from the second quarter. The majority of loans charged off in the third quarter of 2012 were impaired in previous quarters, which resulted in a 10% decrease in the allowance for loan losses on the balance sheet as compared to June 30, 2012.

 

The following sections provide more detail on subjects presented in the overview.

 

37
 

 

FINANCIAL CONDITION

 

Total assets at September 30, 2012 were $1,721,954,000 as compared to $1,744,724,000 at December 31, 2011, a decrease of $22,770,000 (1%). Cash and cash equivalents decreased $54,014,000 (40%) from $135,964,000 at December 31, 2011 to $81,950,000 at September 30, 2012. Loans outstanding increased $29,120,000 from $1,129,954,000 at December 31, 2011 to $1,159,074,000 at September 30, 2012.

 

As Table 1 illustrates, the increase in the loan portfolio in 2012 was the result of an increase in commercial real estate loans of $31,749,000 (6%) and residential real estate loans of $15,477,000 (6%) and was offset with a decrease in commercial loans of $12,006,000 (6%). Management expects a steady, although slow, increase in loan demand in 2012, mirroring the current economic conditions as discussed above. The Bank intends to continue to work to make loans that meet its longstanding prudent lending standards.

 

As discussed above, the decrease in the allowance for loan loss of $1,703,000 (9%) was the result of loans that were charged off in the third quarter of 2012 that were previously reserved for in prior quarters.

 

Deposits decreased $27,575,000 to $1,471,246,000 at September 30, 2012, compared to $1,498,821,000 at December 31, 2011. The largest decrease in deposits came from interest bearing transaction deposits which decreased $42,002,000, or 9% from December 31, 2011. The Bank’s interest bearing transaction accounts include public fund accounts which decreased $66,471,000 or 18% from the end of 2011. Public funds are deposits of local municipalities, schools and other public entities, and tend to be cyclical in nature with higher balances in the fourth quarter of the year as a result of property tax receipts. Also, an increase in non-interest bearing deposits of $34,456,000 or 12% was offset with a $38,654,000, or 11%, decrease in certificates of deposits (CDs). Management believes the decrease in certificates of deposits is a result of the low rate environment.

 

Table 1 Composition of the Bank’s loans and deposits at the dates indicated:

 

   September 30, 2012   December 31, 2011 
   Amount   %   Amount   % 
   (Dollars in thousands) 
Type of Loan:                    
Commercial real estate loans  $555,234    47.8%  $523,485    46.3%
One- to four-family residential real estate loans   281,745    24.3    266,268    23.5 
Commercial loans   181,170    15.6    193,176    17.1 
Consumer loans   16,170    1.4    16,618    1.5 
Construction and land development loans   98,609    8.5    104,788    9.2 
Municipal obligations   27,603    2.4    27,066    2.4 
Total loans  $1,160,531    100.0%  $1,131,401    100.0%
Less:                    
Deferred loan fees   1,457         1,447      
Allowance for loan losses   16,585         18,288      
Net loans  $1,142,489        $1,111,666      
Type of Deposit:                    
Non-interest bearing deposits  $317,546    21.58%  $283,090    18.9%
Interest bearing transaction deposits   418,572    28.45    460,574    30.7 
Money market deposits   252,287    17.15    250,051    16.7 
Savings deposits   117,407    7.98    96,247    6.4 
Certificates of deposits   304,070    20.67    342,724    22.9 
Individual retirement accounts   61,364    4.17    66,135    4.4 
Total Deposits  $1,471,246    100.0%  $1,498,821    100.0%

 

38
 

 

RESULTS OF OPERATIONS

 

GENERAL

 

Net income available to common shareholders for the nine months ended September 30, 2012 increased from $10,803,000 ($1.45 diluted earnings per share) in 2011 to $13,135,000 ($1.74 diluted earnings per share) in 2012, an increase of $2,332,000 (22%). Net income available to common shareholders for the quarter ended September 30, 2012 was $4,196,000 ($.56 diluted earnings per share) as compared to $4,013,000 ($.54 diluted earnings per share) during the same period of 2011, an increase of $183,000 (5%). The primary reason for the increase in net income from the third quarter of 2011 as compared to the third quarter of 2012 was a $350,000 (14%) decrease in the provision for loan losses, which was reflective of overall improving credit metrics as compared to the third quarter of 2011. Additionally, total revenue increased by $450,000 (2%), which was offset by non-interest expense, which increased by $1,072,000 (10%) for the third quarter of 2012 as compared to the same period of 2011. As described above in the section entitled “Overview”, the third quarter 2012 results also reflect a decrease of $261,000 in preferred stock dividends and amortization resulting from the repurchase of the Company’s Series A Preferred Stock from the U.S. Treasury. The increase in revenue for the third quarter of 2012 as compared to the third quarter of 2011 included a $564,000 (11%) increase in non-interest income, which was offset by a $114,000 (1%) decrease in net interest income. Contributing to the increase in non-interest income were gains on the sale of real estate loans, which increased $214,000 (30%) and trust fee income which increased $80,000 (13%) from the third quarter of 2011, which were partially offset by a $145,000 (6%) decrease in service charges and fees in the same time period. Contributing to the increase in non-interest expense was a $558,000 (10%) increase in salaries and benefits expense. Contributing to the decrease in the provision for loan losses were lower non-performing loans, lower adversely classified loans and lower impaired loan reserves in the third quarter of 2012 versus the same period in 2011.

 

NET INTEREST INCOME

 

Net interest income decreased $114,000 (1%) in the third quarter of 2012 as compared to the same period in 2011, while the year to date total increased $402,000 (1%) from $41,451,000 in 2011 to $41,853,000 in 2012. As illustrated in Table 2, average earning assets increased $70,577,000 or 5% from the third quarter of 2011 to the third quarter of 2012, while average interest bearing liabilities only increased $41,458,000 or 3% in the same period. Table 4 shows that the net interest income on a fully tax equivalent basis was positively impacted by the volume additions to the balance sheet by $717,000, which was offset with a negative rate variance of $826,000. As further illustrated in Table 4, contributing to the favorable volume variance was the increase in interest income attributable to securities of $242,000. Driving the increase in interest income from securities was a $45,563,000 or 14% increase in the average balance of securities outstanding from the third quarter of 2011 to the third quarter of 2012.

 

39
 

 

As illustrated in Table 2, the cost of interest bearing liabilities is .47%, while the yield on earning assets is 4.02%. With the cost of interest bearing liabilities approaching “floor” levels, if rates were to continue to fall, the effect on the Company is expected to be negative, as shown and explained below.

 

As illustrated in Table 2 below, the net interest margin of 3.64% for the third quarter of 2012 was 19 basis points lower than the 3.83% net interest margin for the third quarter of 2011. The cost of interest-bearing liabilities decreased 26 basis points from .73% for the third quarter of 2011 to .47% in the third quarter of 2012, while the yield on earning assets decreased 40 basis points from 4.42% for the third quarter of 2011 to 4.02% for the third quarter of 2012. Contributing to the decrease in the net interest margin from the third quarter of 2011 was the mix of earning assets. The average balance in securities, which yielded 1.90% in the third quarter of 2012, increased on average $45,563,000 (14%) from the third quarter of 2011, while the average balance in loans, which yielded 4.78% in the third quarter of 2012, increased by only $31,954,000 (3%) from the third quarter of 2011.

 

The Company uses an earnings simulation model to estimate and evaluate the impact of changing interest rates on earnings. The model projects the effect of instantaneous movements in interest rates of both 100 and 200 basis points. By simulating the effects of movements in interest rates, the model can estimate the Company’s interest rate exposure. The results of the model are used by management to approximate the results of rate changes and do not indicate actual expected results. As shown below, the September 30, 2012 simulation analysis indicates that the Company is in a slightly liability interest rate sensitive position, with the net interest income negatively impacted by rising rates. As a result of the current historically low rate environment, the effects of a 100 basis point decrease in rates would also be negative to the net interest income. This is the result of a significant portion of the interest-bearing liabilities already having a cost below 1.00%.

 

Net interest income estimates are summarized below.

 

   Net Interest Income Change 
Increase 200 bp   (1.01)%
Increase 100 bp   (0.79)
Decrease 100 bp   (3.64)

 

Table 2 & 3 below set forth certain information relating to the Bank’s average balance sheet information and reflects the average yield on interest-earning assets, on a tax equivalent basis, and the average cost of interest-bearing liabilities for the periods indicated. Such yields and costs are derived by dividing income or expense by the average monthly balance of interest-earning assets or interest-bearing liabilities, respectively, for the periods presented. Average balances are daily averages for the Bank and include non-accruing loans in the loan portfolio, net of the allowance for loan losses.

 

40
 

 

Table 2- Average Balance Sheet Rates for Three Months Ended September 30, 2012 and 2011 (presented on a tax equivalent basis in thousands)

 

   Three Months ended September 30, 2012   Three Months ended September 30, 2011 
   Average
outstanding
balance
   Interest
earned/
paid
  
Yield/
rate
   Average
outstanding
balance
   Interest
earned/
paid
   Yield/
rate
 
                         
Interest-earning assets:                              
Loans receivable (1)(2)  $1,158,072   $13,926    4.78%  $1,126,118   $14,652    5.16%
Securities (2)   369,707    1,763    1.90    324,144    1,881    2.30 
Other interest-earning assets   32,781    71    0.86    39,721    69    0.69 
                               
Total interest-earning assets   1,560,560    15,760    4.02    1,489,983    16,602    4.42 
                               
Non-interest-earning assets   147,283              133,736           
Total assets  $1,707,843             $1,623,719           
                               
Interest-bearing liabilities:                              
Transaction accounts   796,346    418    0.21    711,046    524    0.29 
Time deposits   369,327    796    0.86    411,193    1,430    1.38 
Borrowings   70,445    257    1.45    72,421    250    1.37 
Total interest-bearing liabilities   1,236,118    1,471    0.47    1,194,660    2,204    0.73 
                               
Non-interest-bearing liabilities   305,689              261,219           
                               
Total liabilities   1,541,807              1,455,879           
                               
Shareholders’ equity   166,036              167,840           
                               
Total liabilities and shareholders’ equity  $1,707,843             $1,623,719           
                               
Net interest income       $14,289             $14,398      
Interest rate spread             3.55%             3.69%
Net interest margin (net interest income as a percent of average interest-earning assets)             3.64%             3.83%
Effect of net free funds (earning assets funded by non- interest bearing liabilities)             0.09%             0.14%
Average interest-earning assets to interest-bearing liabilities   126.25%             124.72%          

  

 

(1)Includes non-accrual loans.
(2)Income presented on a tax equivalent basis using a 35.00% tax rate in 2012 and 2011, respectively. The tax equivalent adjustment was $327,000 and $322,000 in 2012 and 2011, respectively.

 

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Table 3- Average Balance Sheet Rates for Nine Months Ended September 30, 2012 and 2011 (presented on a tax equivalent basis in thousands)

 

 

   Nine Months ended September 30, 2012   Nine Months ended September 30, 2011 
   Average
outstanding
balance
   Interest
earned/
paid
  
Yield/
rate
   Average
outstanding
balance
   Interest
earned/
paid
   Yield/
rate
 
                         
Interest-earning assets:                              
Loans receivable (1)(2)  $1,142,833   $41,832    4.89%  $1,118,185   $43,886    5.25%
Securities (2)   373,036    5,684    2.04    315,364    5,454    2.31 
Other interest-earning assets   63,895    242    0.51    69,341    291    0.56 
                               
Total interest-earning assets   1,579,764    47,758    4.04    1,502,890    49,631    4.40 
                               
Non-interest-earning assets   148,025              132,355           
Total assets  $1,727,789             $1,635,245           
                               
Interest-bearing liabilities:                              
Transaction accounts   810,382    1,313    0.22    720,339    1,708    0.32 
Time deposits   384,549    2,815    0.98    424,428    4,785    1.51 
Borrowings   75,657    801    1.41    72,879    758    1.39 
Total interest-bearing liabilities   1,270,588    4,929    0.52    1,217,646    7,251    0.80 
                               
Non-interest-bearing liabilities   295,194              252,033           
                               
Total liabilities   1,565,782              1,469,679           
                               
Shareholders’ equity   162,007              165,566           
                               
Total liabilities and shareholders’ equity  $1,727,789             $1,635,245           
                               
Net interest income       $42,829             $42,380      
Interest rate spread             3.52%             3.60%
Net interest margin (net interest income as a percent of average interest-earning assets)             3.62%             3.72%
Effect of net free funds (earning assets funded by non-interest bearing liabilities)             0.10%             0.12%
Average interest-earning assets to interest-bearing liabilities   124.33%             123.43%          

___________________________

(1)Includes non-accrual loans.