10-Q 1 egbn-10q_093017.htm QUARTERLY REPORT

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

FORM 10-Q

 

(Mark One)

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Quarterly Period Ended September 30, 2017

 

OR

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from _________ to _________

 

Commission File Number 0-25923

 

Eagle Bancorp, Inc.

(Exact name of registrant as specified in its charter)

 

                 Maryland        52-2061461
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification No.)
     
7830 Old Georgetown Road, Third Floor, Bethesda, Maryland        20814
(Address of principal executive offices)   (Zip Code)

 

(301) 986-1800

(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report)

 

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

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definition of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer ☒

Accelerated filer ☐

Non-accelerated filer ☐  (Do not mark if a smaller reporting company)

Smaller Reporting Company ☐

Emerging Growth Company ☐

 

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

 

As of October 31, 2017, the registrant had 34,178,014 shares of Common Stock outstanding.

 

 

 

 

 

 

EAGLE BANCORP, INC.

TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION    
       
Item 1. Financial Statements (Unaudited)    
  Consolidated Balance Sheets   3
  Consolidated Statements of Operations   4
  Consolidated Statements of Comprehensive Income   5
  Consolidated Statements of Changes in Shareholders’ Equity   6
  Consolidated Statements of Cash Flows   7
  Notes to Consolidated Financial Statements   8
       
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations   49
       
Item 3. Quantitative and Qualitative Disclosures About Market Risk   77
       
Item 4. Controls and Procedures   77
       
PART II. OTHER INFORMATION   78
       
Item 1. Legal Proceedings   78
       
Item 1A. Risk Factors   78
       
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds   78
       
Item 3. Defaults Upon Senior Securities   78
       
Item 4. Mine Safety Disclosures   78
       
Item 5. Other Information   78
       
Item 6. Exhibits   78
       
Signatures   81

 

 2

 

 

PART I. FINANCIAL INFORMATION

 

Item 1 – Financial Statements (Unaudited)

 

EAGLE BANCORP, INC.

Consolidated Balance Sheets (Unaudited)

(dollars in thousands, except per share data)

 

Assets  September 30, 2017   December 31, 2016   September 30, 2016 
Cash and due from banks  $8,246   $10,285   $8,678 
Federal funds sold   8,548    2,397    5,262 
Interest bearing deposits with banks and other short-term investments   432,156    355,481    505,087 
Investment securities available-for-sale, at fair value   556,026    538,108    430,668 
Federal Reserve and Federal Home Loan Bank stock   30,980    21,600    19,920 
Loans held for sale   25,980    51,629    78,118 
Loans   6,084,204    5,677,893    5,481,975 
Less allowance for credit losses   (62,967)   (59,074)   (56,864)
Loans, net   6,021,237    5,618,819    5,425,111 
Premises and equipment, net   19,546    20,661    19,370 
Deferred income taxes   45,432    48,220    41,065 
Bank owned life insurance   61,238    60,130    59,747 
Intangible assets, net   107,150    107,419    107,694 
Other real estate owned   1,394    2,694    5,194 
Other assets   75,723    52,653    56,218 
Total Assets  $7,393,656   $6,890,096   $6,762,132 
                
Liabilities and Shareholders’ Equity               
Liabilities               
Deposits:               
Noninterest bearing demand  $1,843,157   $1,775,684   $1,668,271 
Interest bearing transaction   429,247    289,122    297,973 
Savings and money market   2,818,871    2,902,560    2,802,519 
Time, $100,000 or more   482,325    464,842    452,015 
Other time   340,352    283,906    337,371 
Total deposits   5,913,952    5,716,114    5,558,149 
Customer repurchase agreements   73,569    68,876    71,642 
Other short-term borrowings   200,000        50,000 
Long-term borrowings   216,807    216,514    216,419 
Other liabilities   55,346    45,793    50,283 
Total Liabilities   6,459,674    6,047,297    5,946,493 
                
Shareholders’ Equity               
Common stock, par value $.01 per share; shares authorized 100,000,000, shares issued and outstanding 34,174,009, 34,023,850, and 33,590,880, respectively   340    338    333 
Warrant           946 
Additional paid in capital   518,616    513,531    509,706 
Retained earnings   415,975    331,311    305,594 
Accumulated other comprehensive loss   (949)   (2,381)   (940)
Total Shareholders’ Equity   933,982    842,799    815,639 
Total Liabilities and Shareholders’ Equity  $7,393,656   $6,890,096   $6,762,132 

 

See notes to consolidated financial statements.

 

 3

 

 

EAGLE BANCORP, INC.

Consolidated Statements of Operations (Unaudited)

(dollars in thousands, except per share data)

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
   2017   2016   2017   2016 
Interest Income                    
Interest and fees on loans  $78,176   $69,869   $226,543   $202,002 
Interest and dividends on investment securities   3,194    2,177    8,854    7,121 
Interest on balances with other banks and short-term investments   991    376    2,084    856 
Interest on federal funds sold   9    9    27    31 
Total interest income   82,370    72,431    237,508    210,010 
Interest Expense                    
Interest on deposits   7,233    4,840    19,466    13,513 
Interest on customer repurchase agreements   58    39    136    115 
Interest on short-term borrowings   164    383    441    727 
Interest on long-term borrowings   2,979    2,441    8,937    4,515 
Total interest expense   10,434    7,703    28,980    18,870 
Net Interest Income   71,936    64,728    208,528    191,140 
Provision for Credit Losses   1,921    2,288    4,884    9,219 
Net Interest Income After Provision For Credit Losses   70,015    62,440    203,644    181,921 
                     
Noninterest Income                    
Service charges on deposits   1,626    1,431    4,641    4,303 
Gain on sale of loans   2,173    3,009    6,740    8,464 
Gain on sale of investment securities   11    1    542    1,123 
Increase in the cash surrender value of  bank owned life insurance   369    391    1,108    1,171 
Other income   2,605    1,573    6,846    5,209 
Total noninterest income   6,784    6,405    19,877    20,270 
Noninterest Expense                    
Salaries and employee benefits   16,905    17,130    50,451    49,157 
Premises and equipment expenses   3,846    3,786    11,613    11,419 
Marketing and advertising   732    857    2,873    2,551 
Data processing   2,019    1,879    6,057    5,716 
Legal, accounting and professional fees   1,240    771    3,539    2,845 
FDIC insurance   929    629    2,063    2,193 
Other expenses   3,845    3,786    12,153    11,354 
Total noninterest expense   29,516    28,838    88,749    85,235 
Income Before Income Tax Expense   47,283    40,007    134,772    116,956 
Income Tax Expense   17,409    15,484    50,109    44,966 
Net Income  $29,874   $24,523   $84,663   $71,990 
                     
Earnings Per Common Share                    
Basic  $0.87   $0.73   $2.48   $2.14 
Diluted  $0.87   $0.72   $2.47   $2.11 

 

See notes to consolidated financial statements.

 

 4

 

 

EAGLE BANCORP, INC.

Consolidated Statements of Comprehensive Income (Unaudited)

(dollars in thousands)

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
   2017   2016   2017   2016 
                 
Net Income  $29,874   $24,523   $84,663   $71,990 
                     
Other comprehensive income, net of tax:                    
Unrealized gain (loss) on securities available for sale   15    (907)   1,243    4,110 
Reclassification adjustment for net gains included in net income   (7)   1   (340)   (674)
Total unrealized gain (loss) on investment securities   8    (906)   903    3,436 
Unrealized gain (loss) on derivatives   347    1,756    1,350    (5,478)
Reclassification adjustment for amounts included in net income   (183)   (466)   (821)   911 
Total unrealized gain (loss) on derivatives   164    1,290    529    (4,567)
Other comprehensive income (loss)   172    384    1,432    (1,131)
Comprehensive Income  $30,046   $24,907   $86,095   $70,859 

 

See notes to consolidated financial statements.

 

 5

 

 

EAGLE BANCORP, INC.

Consolidated Statements of Changes in Shareholders’ Equity (Unaudited)

(dollars in thousands except share data)

 

                       Accumulated     
                       Other   Total 
   Common       Additional Paid   Retained   Comprehensive   Shareholders’ 
   Shares   Amount   Warrant   in Capital   Earnings   Income (Loss)   Equity 
                             
Balance January 1, 2017   34,023,850   $338   $   $513,531   $331,311   $(2,381)  $842,799 
                                    
Net Income                   84,663        84,663 
Other comprehensive gain, net of tax                       1,432    1,432 
Stock-based compensation expense               4,198    1        4,199 
Issuance of common stock related to options exercised, net of shares withheld for payroll taxes   60,925    1        258            259 
Vesting of time based stock awards issued at date of grant, net of shares withheld for payroll taxes   (16,962)   1        (2)           (1)
Vesting of performance based stock awards, net of shares withheld for payroll taxes   3,589                         
Time based stock awards granted   91,097                         
Issuance of common stock related to employee stock purchase plan  11,510            631            631 
Balance September 30, 2017   34,174,009   $340   $   $518,616   $415,975   $(949)  $933,982 
                                    
Balance January 1, 2016   33,467,893   $331   $946   $503,529   $233,604   $191   $738,601 
                                    
Net Income                   71,990        71,990 
Other comprehensive loss, net of tax                       (1,131)   (1,131)
Stock-based compensation expense               5,159            5,159 
Issuance of common stock related to options exercised,   23,614            282            282 
net of shares withheld for payroll taxes                             
Excess tax benefits realized from stock compensation               166            166 
Vesting of time based stock awards issued at date of grant,   (17,556)   2        (2)            
net of shares withheld for payroll taxes                            
Time based stock awards granted   104,775                         
Issuance of common stock related to employee stock purchase plan   12,154            572            572 
                                    
Balance September 30, 2016   33,590,880   $333   $946   $509,706   $305,594   $(940)  $815,639 

 

See notes to consolidated financial statements.

 

 6

 

 

EAGLE BANCORP, INC.

Consolidated Statements of Cash Flows (Unaudited)

(dollars in thousands)

 

   Nine Months Ended September 30, 
   2017   2016 
Cash Flows From Operating Activities:          
Net Income  $84,663   $71,990 
Adjustments to reconcile net income to net cash provided by (used in) operating activities:          
Provision for credit losses   4,884    9,219 
Depreciation and amortization   4,868    4,628 
Gains on sale of loans   (6,740)   (8,464)
Securities premium amortization (discount accretion), net   2,799    3,412 
Origination of loans held for sale   (481,917)   (606,213)
Proceeds from sale of loans held for sale   514,306    584,051 
Net increase in cash surrender value of BOLI   (1,108)   (1,171)
Decrease (increase) deferred income tax benefit   1,293    (754)
Decrease in value of other real estate owned       200 
Net loss (gain) on sale of other real estate owned   301    (657)
Net gain on sale of investment securities   (542)   (1,123)
Stock-based compensation expense   4,199    5,159 
Net tax benefits from stock compensation   460     
Excess tax benefits realized from stock compensation       (166)
Increase in other assets   (23,059)   (8,590)
Increase in other liabilities   9,553    13,035 
Net cash provided by operating activities   113,960    64,556 
Cash Flows From Investing Activities:          
Decrease in interest bearing deposits with other banks and short-term investments       784 
Purchases of available for sale investment securities   (144,554)   (106,163)
Proceeds from maturities of available for sale securities   55,732    65,727 
Proceeds from sale/call of available for sale securities   70,079    94,217 
Purchases of Federal Reserve and Federal Home Loan Bank stock   (27,665)   (3,017)
Proceeds from redemption of Federal Reserve and Federal Home Loan Bank stock   18,285     
Net increase in loans   (408,447)   (491,720)
Proceeds from sale of other real estate owned   2,144    3,614 
Bank premises and equipment acquired   (2,459)   (4,836)
Net cash used in investing activities   (436,885)   (441,394)
Cash Flows From Financing Activities:          
Increase in deposits   197,838    399,705 
Increase (decrease) in customer repurchase agreements   4,693    (714)
Increase in short-term borrowings   200,000    50,000 
Increase in long-term borrowings   293    147,491 
Proceeds from exercise of equity compensation plans   257    282 
Excess tax benefits realized from stock compensation       166 
Proceeds from employee stock purchase plan   631    572 
Net cash provided by financing activities   403,712    597,502 
Net Increase In Cash and Cash Equivalents   80,787    220,664 
Cash and Cash Equivalents at Beginning of Period   368,163    298,363 
Cash and Cash Equivalents at End of Period  $448,950   $519,027 
Supplemental Cash Flows Information:          
Interest paid  $31,257   $18,196 
Income taxes paid  $52,800   $47,950 
Non-Cash Investing Activities          
Transfers from loans to other real estate owned  $1,145   $2,500 
Transfers from other real estate owned to loans  $   $ 

 

See notes to consolidated financial statements.

 

 7

 

 

EAGLE BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Note 1. Summary of Significant Accounting Policies

 

Basis of Presentation

 

The Consolidated Financial Statements include the accounts of Eagle Bancorp, Inc. and its subsidiaries (the “Company”), EagleBank (the “Bank”), Eagle Commercial Ventures, LLC (“ECV”), Eagle Insurance Services, LLC, and Bethesda Leasing, LLC, with all significant intercompany transactions eliminated.

 

The Consolidated Financial Statements of the Company included herein are unaudited. The Consolidated Financial Statements reflect all adjustments, consisting of normal recurring accruals that in the opinion of management, are necessary to present fairly the results for the periods presented. The amounts as of and for the year ended December 31, 2016 were derived from audited Consolidated Financial Statements. Certain information and note disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. There have been no significant changes to the Company’s Accounting Policies as disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016. The Company believes that the disclosures are adequate to make the information presented not misleading. Certain reclassifications have been made to amounts previously reported to conform to the current period presentation.

 

These statements should be read in conjunction with the audited Consolidated Financial Statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016. Operating results for the three and nine months ended September 30, 2017 are not necessarily indicative of the results of operations to be expected for the remainder of the year, or for any other period.

 

Nature of Operations

 

The Company, through the Bank, conducts a full service community banking business, primarily in the metropolitan Washington, D.C area. The primary financial services offered by the Bank include real estate, commercial and consumer lending, as well as traditional deposit and repurchase agreement products. The Bank is also active in the origination and sale of residential mortgage loans, the origination of small business loans, and the origination, securitization and sale of FHA loans. The Bank offers its products and services through twenty-one banking offices, five lending centers and various electronic capabilities, including remote deposit services and mobile banking services. Eagle Insurance Services, LLC, a subsidiary of the Bank, offers access to insurance products and services through a referral program with a third party insurance broker. Eagle Commercial Ventures, LLC, a direct subsidiary of the Company, provides subordinated financing for the acquisition, development and construction of real estate projects; these transactions involve higher levels of risk, together with commensurate higher returns. Refer to Higher Risk Lending – Revenue Recognition below.

 

Use of Estimates

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts in the financial statements and accompanying notes. Actual results may differ from those estimates and such differences could be material to the financial statements.

 

Cash Flows

 

For purposes of reporting cash flows, cash and cash equivalents include cash and due from banks, federal funds sold, and interest bearing deposits with other banks which have an original maturity of three months or less.

 

Investment Securities

 

The Company has no securities classified as trading, or as held to maturity. Securities available-for-sale are acquired as part of the Company’s asset/liability management strategy and may be sold in response to changes in interest rates, current market conditions, loan demand, changes in prepayment risk and other factors. Securities available-for-sale are carried at fair value, with unrealized gains or losses being reported as accumulated other comprehensive income/(loss), a separate component of shareholders’ equity, net of deferred income tax. Realized gains and losses, using the specific identification method, are included as a separate component of noninterest income in the Consolidated Statements of Operations.

 

 8

 

 

Premiums and discounts on investment securities are amortized/accreted to the earlier of call or maturity based on expected lives, which lives are adjusted based on prepayment assumptions and call optionality if any. Declines in the fair value of individual available-for-sale securities below their cost that are other-than-temporary in nature result in write-downs of the individual securities to their fair value. Factors affecting the determination of whether other-than-temporary impairment has occurred include a downgrading of the security by a rating agency, a significant deterioration in the financial condition of the issuer, or a change in management’s intent and ability to hold a security for a period of time sufficient to allow for any anticipated recovery in fair value. Management systematically evaluates investment securities for other-than-temporary declines in fair value on a quarterly basis. This analysis requires management to consider various factors, which include the: (1) duration and magnitude of the decline in value; (2) financial condition of the issuer or issuers; and (3) structure of the security.

 

The entire amount of an impairment loss is recognized in earnings only when: (1) the Company intends to sell the security; or (2) it is more likely than not that the Company will have to sell the security before recovery of its amortized cost basis; or (3) the Company does not expect to recover the entire amortized cost basis of the security. In all other situations, only the portion of the impairment loss representing the credit loss must be recognized in earnings, with the remaining portion being recognized in shareholders’ equity as comprehensive income, net of deferred taxes.

 

Loans Held for Sale

 

The Company regularly engages in sales of residential mortgage loans held for sale and the guaranteed portion of small business loans, guaranteed by the Small Business Administration (“SBA”), and originated by the Bank. The Company has elected to carry loans held for sale at fair value. Fair value is derived from secondary market quotations for similar instruments. Gains and losses on sales of these loans are recorded as a component of noninterest income in the Consolidated Statements of Operations.

 

The Company’s current practice is to sell residential mortgage loans held for sale on a servicing released basis, and, therefore, it has no intangible asset recorded in the normal course of business for the value of such servicing as of September 30, 2017, December 31, 2016 and September 30, 2016. The sale of the guaranteed portion of SBA loans on a servicing retained basis, in a transaction apart from the loan’s origination, gives rise to an excess servicing asset, which is computed on a loan by loan basis with the unamortized amount being included in intangible assets in the Consolidated Balance Sheets. This excess servicing asset is being amortized on a straight-line basis (with adjustment for prepayments) as an offset to servicing fees collected and is included in other income in the Consolidated Statements of Operations.

 

The Company enters into commitments to originate residential mortgage loans whereby the interest rate on the loan is determined prior to funding (i.e. interest rate lock commitments). Such interest rate lock commitments on mortgage loans to be sold in the secondary market are considered to be derivatives. To protect against the price risk inherent in residential mortgage loan commitments, the Company utilizes both “best efforts” and “mandatory delivery” forward loan sale commitments to mitigate the risk of potential decreases in the values of loans that would result from the exercise of the derivative loan commitments. Under a “best efforts” contract, the Company commits to deliver an individual mortgage loan of a specified principal amount and quality to an investor and the investor commits to a price that it will purchase the loan from the Company if the loan to the underlying borrower closes. The Company protects itself from changes in interest rates through the use of best efforts forward delivery commitments, whereby the investor commits to purchase a loan at a price representing a premium on the day the borrower commits to an interest rate with the intent that the buyer/investor has assumed the interest rate risk on the loan. As a result, the Bank is not generally exposed to losses on loans sold utilizing best efforts, nor will it realize gains related to rate lock commitments due to changes in interest rates. The market values of interest rate lock commitments and best efforts contracts are not readily ascertainable with precision because rate lock commitments and best efforts contracts are not actively traded. Because of the high correlation between rate lock commitments and best efforts contracts, no gain or loss should occur on the interest rate lock commitments. Under a “mandatory delivery” contract, the Company commits to deliver a certain principal amount of mortgage loans to an investor at a specified price on or before a specified date. If the Company fails to deliver the amount of mortgages necessary to fulfill the commitment by the specified date, it is obligated to pay the investor a “pair-off” fee, based on then-current market prices, to compensate the investor for the shortfall. The Company manages the interest rate risk on interest rate lock commitments by entering into forward sale contracts of mortgage backed securities, whereby the Company obtains the right to deliver securities to investors in the future at a specified price. Such contracts are accounted for as derivatives and are recorded at fair value in derivative assets or liabilities, carried on the Consolidated Balance Sheet within other assets or other liabilities with changes in fair value recorded in other income within the Consolidated Statements of Operations. The period of time between issuance of a loan commitment to the customer and closing and sale of the loan to an investor generally ranges from 30 to 90 days under current market conditions. The gross gains on loan sales are recognized based on new loan commitments with adjustment for price and pair-off activity. Commission expenses on loans held for sale are recognized based on loans closed.

 

 9

 

 

In circumstances where the Company does not deliver the whole loan to an investor, but rather elects to retain the loan in its portfolio, the loan is transferred from held for sale to loans at fair value at date of transfer.

 

The Company originates a small number of FHA loans through the Department of Housing and Urban Development’s Multifamily Accelerated Program (“MAP”). The Company securitizes these loans through the Government National Mortgage Association (“Ginnie Mae”) MBS I program and sells the resulting securities in the open market to authorized dealers in the normal course of business and generally retains the servicing rights. When servicing is retained on FHA loans securitized and sold, the Company computes an excess servicing asset on a loan by loan basis with the unamortized amount being included in intangible assets in the Consolidated Balance Sheets. Revenue represents gains from the sale of the Ginnie Mae securities and net revenues earned on the servicing of FHA loans securitizing the Ginnie Mae securities. The gains on Ginnie Mae securities include the realized and unrealized gains and losses on sales of FHA mortgage loans, as well as the changes in fair value of FHA interest rate lock commitments and FHA forward loan sale commitments. Revenue from servicing commercial FHA mortgages is recognized as earned based on the specific contractual terms of the underlying servicing agreements, along with amortization of and changes in impairment of mortgage servicing rights.

 

Loans

 

Loans are stated at the principal amount outstanding, net of unamortized deferred costs and fees. Interest income on loans is accrued at the contractual rate on the principal amount outstanding. It is the Company’s policy to discontinue the accrual of interest when circumstances indicate that collection is doubtful. Deferred fees and costs are being amortized on the interest method over the term of the loan.

 

Management considers loans impaired when, based on current information, it is probable that the Company will not collect all principal and interest payments according to contractual terms. Loans are evaluated for impairment in accordance with the Company’s portfolio monitoring and ongoing risk assessment procedures. Management considers the financial condition of the borrower, cash flow of the borrower, payment status of the loan, and the value of the collateral, if any, securing the loan. Generally, impaired loans do not include large groups of smaller balance homogeneous loans such as residential real estate and consumer type loans which are evaluated collectively for impairment and are generally placed on nonaccrual when the loan becomes 90 days past due as to principal or interest. Loans specifically reviewed for impairment are not considered impaired during periods of “minimal delay” in payment (90 days or less) provided eventual collection of all amounts due is expected. The impairment of a loan is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral if repayment is expected to be provided solely by the collateral. In appropriate circumstances, interest income on impaired loans may be recognized on a cash basis.

 

Higher Risk Lending – Revenue Recognition

 

The Company had occasionally made higher risk acquisition, development, and construction (“ADC”) loans that entailed higher risks than ADC loans made following normal underwriting practices (“higher risk loan transactions”). These higher risk loan transactions were made through the Company’s subsidiary, ECV. This activity was limited as to individual transaction amount and total exposure amounts, based on capital levels, and is carefully monitored. The loans are carried on the balance sheet at amounts outstanding. ECV had three higher risk loan transactions outstanding as of September 30, 2017 and December 31, 2016, amounting to $9.5 million and $9.3 million, respectively.

 

 10

 

 

Allowance for Credit Losses

 

The allowance for credit losses represents an amount which, in management’s judgment, is adequate to absorb probable losses on loans and other extensions of credit that may become uncollectible. The adequacy of the allowance for credit losses is determined through careful and continuous review and evaluation of the loan portfolio and involves the balancing of a number of factors to establish a prudent level of allowance. Among the factors considered in evaluating the adequacy of the allowance for credit losses are lending risks associated with growth and entry into new markets, loss allocations for specific credits, the level of the allowance to nonperforming loans, historical loss experience, economic conditions, portfolio trends and credit concentrations, changes in the size and character of the loan portfolio, and management’s judgment with respect to current and expected economic conditions and their impact on the existing loan portfolio. Allowances for impaired loans are generally determined based on collateral values. Loans or any portion thereof deemed uncollectible are charged against the allowance, while recoveries are credited to the allowance. Management adjusts the level of the allowance through the provision for credit losses, which is recorded as a current period operating expense. The allowance for credit losses consists of allocated and unallocated components.

 

The components of the allowance for credit losses represent an estimation done pursuant to Accounting Standards Codification (“ASC”) Topic 450, “Contingencies,” or ASC Topic 310, “Receivables.” Specific allowances are established in cases where management has identified significant conditions or circumstances related to a specific credit that management believes indicate the probability that a loss may be incurred. For potential problem credits for which specific allowance amounts have not been determined, the Company establishes allowances according to the application of credit risk factors. These factors are set by management and approved by the appropriate Board committee to reflect its assessment of the relative level of risk inherent in each risk grade. A third component of the allowance computation, termed a nonspecific or environmental factors allowance, is based upon management’s evaluation of various environmental conditions that are not directly measured in the determination of either the specific allowance or formula allowance. Such conditions include general economic and business conditions affecting key lending areas, credit quality trends (including trends in delinquencies and nonperforming loans expected to result from existing conditions), loan volumes and concentrations, specific industry conditions within portfolio categories, recent loss experience in particular loan categories, duration of the current business cycle, bank regulatory examination results, findings of outside review consultants, and management’s judgment with respect to various other conditions including credit administration and management and the quality of risk identification systems. Executive management reviews these environmental conditions quarterly, and documents the rationale for all changes.

 

Management believes that the allowance for credit losses is adequate; however, determination of the allowance is inherently subjective and requires significant estimates. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. Evaluation of the potential effects of these factors on estimated losses involves a high degree of uncertainty, including the strength and timing of economic cycles and concerns over the effects of a prolonged economic downturn in the current cycle. In addition, various banking agencies, as an integral part of their examination process, and independent consultants engaged by the Bank, periodically review the Bank’s loan portfolio and allowance for credit losses. Such review may result in recognition of additions to the allowance based on their judgments of information available to them at the time of their examination.

 

Premises and Equipment

 

Premises and equipment are stated at cost less accumulated depreciation and amortization computed using the straight-line method for financial reporting purposes. Premises and equipment are depreciated over the useful lives of the assets, which generally range from three to seven years for furniture, fixtures and equipment, three to five years for computer software and hardware, and five to twenty years for building improvements. Leasehold improvements are amortized over the terms of the respective leases, which may include renewal options where management has the positive intent to exercise such options, or the estimated useful lives of the improvements, whichever is shorter. The costs of major renewals and betterments are capitalized, while the costs of ordinary maintenance and repairs are expensed as incurred. These costs are included as a component of premises and equipment expenses on the Consolidated Statements of Operations.

 

Other Real Estate Owned (OREO)

 

Assets acquired through loan foreclosure are held for sale and are recorded at fair value less estimated selling costs when acquired, establishing a new cost basis. The new basis is supported by appraisals that are generally no more than twelve months old. Costs after acquisition are generally expensed. If the fair value of the asset declines, a write-down is recorded through noninterest expense. The valuation of foreclosed assets is subjective in nature and may be adjusted in the future because of changes in market conditions or appraised values.

 

 11

 

 

Goodwill and Other Intangible Assets

 

Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired. Other intangible assets represent purchased assets that lack physical substance but can be distinguished from goodwill because of contractual or other legal rights. Intangible assets that have finite lives, such as core deposit intangibles, are amortized over their estimated useful lives and subject to periodic impairment testing. Intangible assets (other than goodwill) are amortized to expense using accelerated or straight-line methods over their respective estimated useful lives.

 

Goodwill is subject to impairment testing at the reporting unit level, which must be conducted at least annually. The Company performs impairment testing during the fourth quarter of each year or when events or changes in circumstances indicate the assets might be impaired.

 

The Company performs a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing updated qualitative factors, the Company determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, it does not have to perform the two-step goodwill impairment test. Determining the fair value of a reporting unit under the first step of the goodwill impairment test and determining the fair value of individual assets and liabilities of a reporting unit under the second step of the goodwill impairment test are judgmental and often involve the use of significant estimates and assumptions. Similarly, estimates and assumptions are used in determining the fair value of other intangible assets. Estimates of fair value are primarily determined using discounted cash flows, market comparisons and recent transactions. These approaches use significant estimates and assumptions including projected future cash flows, discount rates reflecting the market rate of return, projected growth rates and determination and evaluation of appropriate market comparables. Based on the results of qualitative assessments of all reporting units, the Company concluded that no impairment existed at December 31, 2016. However, future events could cause the Company to conclude that goodwill or other intangibles have become impaired, which would result in recording an impairment loss. Any resulting impairment loss could have a material adverse impact on the Company’s financial condition and results of operations.

 

Interest Rate Swap Derivatives

 

The Company is exposed to certain risks arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity, and credit risk, primarily by managing the amount, sources, and duration of its assets and liabilities and through the use of derivative financial instruments. Specifically, the Company enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. The Company’s derivative financial instruments designated as cash flow hedges are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally related to certain variable rate deposits. Refer to the “Loans Held for Sale” section for a discussion on forward commitment contracts, which are also considered derivatives.

 

At the inception of a derivative contract, the Company designates the derivative as one of three types based on the Company’s intentions and belief as to likely effectiveness as a hedge. These three types are (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (“fair value hedge”), (2) a hedge of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability (“cash flow hedge”), or (3) an instrument with no hedging designation (“stand-alone derivative”). Regarding Interest Rate Swap Derivatives, the Company has no fair value hedges, only cash flow hedges. For a cash flow hedge, the gain or loss on the derivative is reported in other comprehensive income and is reclassified into earnings in the same period(s) during which the hedged transaction affects earnings (i.e. the period when cash flows are exchanged between counterparties). For both fair value and cash flow hedges, changes in the fair value of derivatives that are not highly effective in hedging the changes in fair value or expected cash flows of the hedged item are recognized immediately in current earnings. Changes in the fair value of derivatives that do not qualify for hedge accounting are reported currently in earnings, as noninterest income.

 

 12

 

 

Net cash settlements on derivatives that qualify for hedge accounting are recorded in interest income or interest expense, based on the item being hedged. Net cash settlements on derivatives that do not qualify for hedge accounting are reported in noninterest income. Cash flows on hedges are classified in the cash flow statement the same as the cash flows of the items being hedged.

 

The Company formally documents the relationship between derivatives and hedged items, as well as the risk-management objective and the strategy for undertaking hedge transactions at the inception of the hedging relationship. This documentation includes linking fair value or cash flow hedges to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions. The Company also formally assesses, both at the hedge’s inception and on an ongoing basis, whether the derivative instruments that are used are highly effective in offsetting changes in fair values or cash flows of the hedged items. The Company discontinues hedge accounting when it determines that the derivative is no longer highly effective in offsetting changes in the fair value or cash flows of the hedged item, the derivative is settled or terminates, a hedged forecasted transaction is no longer probable, a hedged firm commitment is no longer firm, or treatment of the derivative as a hedge is no longer appropriate or intended.

 

When hedge accounting is discontinued, subsequent changes in fair value of the derivative are recorded as noninterest income or expense. When a fair value hedge is discontinued, the hedged asset or liability is no longer adjusted for changes in fair value and the existing basis adjustment is amortized or accreted over the remaining life of the asset or liability. When a cash flow hedge is discontinued but the hedged cash flows or forecasted transactions are still expected to occur, gains or losses that were accumulated in other comprehensive income are amortized into earnings over the same periods in which the hedged transactions will affect earnings.

 

Customer Repurchase Agreements

 

The Company enters into agreements under which it sells securities subject to an obligation to repurchase the same securities. Under these arrangements, the Company may transfer legal control over the assets but still retain effective control through an agreement that both entitles and obligates the Company to repurchase the assets. As a result, securities sold under agreements to repurchase are accounted for as collateralized financing arrangements and not as a sale and subsequent repurchase of securities. The agreements are entered into primarily as accommodations for large commercial deposit customers. The obligation to repurchase the securities is reflected as a liability in the Company’s Consolidated Balance Sheets, while the securities underlying the securities sold under agreements to repurchase remain in the respective assets accounts and are delivered to and held as collateral by third party trustees.

 

Marketing and Advertising

 

Marketing and advertising costs are generally expensed as incurred.

 

Income Taxes

 

The Company employs the asset and liability method of accounting for income taxes as required by ASC Topic 740, “Income Taxes.” Under this method, deferred tax assets and liabilities are determined based on differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities (i.e., temporary timing differences) and are measured at the enacted rates that will be in effect when these differences reverse. In accordance with ASC Topic 740, the Company may establish a reserve against deferred tax assets in those cases where realization is less than certain, although no such reserves exist at September 30, 2017, December 31, 2016, or September 30, 2016.

 

Transfer of Financial Assets

 

Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. In certain cases, the recourse to the Bank to repurchase assets may exist but is deemed immaterial based on the specific facts and circumstances.

 

 13

 

 

Earnings per Common Share

 

Basic net income per common share is derived by dividing net income by the weighted-average number of common shares outstanding during the period measured. Diluted earnings per common share is computed by dividing net income by the weighted-average number of common shares outstanding during the period measured including the potential dilutive effects of common stock equivalents.

 

Stock-Based Compensation

 

In accordance with ASC Topic 718, “Compensation,” the Company records as compensation expense an amount equal to the amortization (over the remaining service period) of the fair value of option and restricted stock awards computed at the date of grant. Compensation expense on performance based grants is recorded based on the probability of achievement of the goals underlying the performance grant. Refer to Note 10 for a description of stock-based compensation awards, activity and expense.

 

New Authoritative Accounting Guidance

 

ASU 2014-09, “Revenue from Contracts with Customers (Topic 606).” In May 2014, the FASB and the International Accounting Standards Board (the “IASB”) jointly issued a comprehensive new revenue recognition standard that will supersede nearly all existing revenue recognition guidance under GAAP and International Financial Reporting Standards (“IFRS”). Previous revenue recognition guidance in GAAP consisted of broad revenue recognition concepts together with numerous revenue requirements for particular industries or transactions, which sometimes resulted in different accounting for economically similar transactions. In contrast, IFRS provided limited revenue recognition guidance and, consequently, could be difficult to apply to complex transactions. Accordingly, the FASB and the IASB initiated a joint project to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP and IFRS that would: (1) remove inconsistencies and weaknesses in revenue requirements; (2) provide a more robust framework for addressing revenue issues; (3) improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets; (4) provide more useful information to users of financial statements through improved disclosure requirements; and (5) simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer. To meet those objectives, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers.” The standard’s core principle is that a company will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. In doing so, companies generally will be required to use more judgment and make more estimates than under current guidance. These may include identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. The standard was initially effective for public entities for interim and annual reporting periods beginning after December 15, 2016; early adoption was not permitted. However, in August 2015, the FASB issued ASU No. 2015-14, “Revenue from Contracts with Customers - Deferral of the Effective Date” which deferred the effective date by one year (i.e., interim and annual reporting periods beginning after December 15, 2017). For financial reporting purposes, the standard allows for either full retrospective adoption, meaning the standard is applied to all of the periods presented, or modified retrospective adoption, meaning the standard is applied only to the most current period presented in the financial statements with the cumulative effect of initially applying the standard recognized at the date of initial application. In addition, the FASB has begun to issue targeted updates to clarify specific implementation issues of ASU 2014-09. These updates include ASU No. 2016-08, “Principal versus Agent Considerations (Reporting Revenue Gross versus Net),” ASU No. 2016-10, “Identifying Performance Obligations and Licensing,” ASU No. 2016-12, “Narrow-Scope Improvements and Practical Expedients,” and ASU No. 2016-20 “Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers.” Since the guidance does not apply to revenue associated with financial instruments, including loans and securities that are accounted for under other GAAP, the Company does not expect the new guidance to have a material impact on revenue most closely associated with financial instruments, including interest income and expense. The Company is substantially complete with its overall assessment of revenue streams and reviewing of related contracts potentially affected by the ASU including deposit related fees, sale of OREO, interchange fees, and other fee income. The Company’s assessment suggests that adoption of this ASU should not materially change the method in which we currently recognize revenue for these revenue streams. The Company is also substantially complete with its evaluation of certain costs related to these revenue streams to determine whether such costs should be presented as expenses or contra-revenue (i.e., gross vs. net). In addition, the Company is evaluating the ASU’s expanded disclosure requirements. The Company plans to adopt ASU No. 2014-09 on January 1, 2018 utilizing the modified retrospective approach with a cumulative effect adjustment to opening retained earnings, if such adjustment is deemed to be material.

 

 14

 

 

ASU 2016-01, “Financial Instruments—(Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.” ASU 2016-01 addresses certain aspects of recognition, measurement, presentation, and disclosure of financial instruments by making targeted improvements to GAAP as follows: (1) require equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. However, an entity may choose to measure equity investments that do not have readily determinable fair values at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer; (2) simplify the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment. When a qualitative assessment indicates that impairment exists, an entity is required to measure the investment at fair value; (3) eliminate the requirement to disclose the fair value of financial instruments measured at amortized cost for entities that are not public business entities; (4) eliminate the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet; (5) require public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; (6) require an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments; (7) require separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (that is, securities or loans and receivables) on the balance sheet or the accompanying notes to the financial statements; and (8) clarify that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets. ASU No. 2016-01 is effective for interim and annual reporting periods beginning after December 15, 2017. The Company has performed a preliminary evaluation of the provisions of ASU No. 2016-01. Based on this evaluation, the Company has determined that ASU No. 2016-01 is not expected to have a material impact on the Company’s Consolidated Financial Statements; however, the Company will continue to closely monitor developments and additional guidance.

 

ASU 2016-02, “Leases (Topic 842).” Under the new guidance, lessees will be required to recognize the following for all leases (with the exception of short-term leases): (1) a lease liability, which is the present value of a lessee’s obligation to make lease payments, and (2) a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. Lessor accounting under the new guidance remains largely unchanged as it is substantially equivalent to existing guidance for sales-type leases, direct financing leases, and operating leases. Leveraged leases have been eliminated, although lessors can continue to account for existing leveraged leases using the current accounting guidance. Other limited changes were made to align lessor accounting with the lessee accounting model and the new revenue recognition standard. All entities will classify leases to determine how to recognize lease-related revenue and expense. Quantitative and qualitative disclosures will be required by lessees and lessors to meet the objective of enabling users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases. The intention is to require enough information to supplement the amounts recorded in the financial statements so that users can understand more about the nature of an entity’s leasing activities. ASU 2016-02 is effective for interim and annual reporting periods beginning after December 15, 2018; early adoption is permitted. All entities are required to use a modified retrospective approach for leases that exist or are entered into after the beginning of the earliest comparative period in the financial statements. They have the option to use certain relief; full retrospective application is prohibited. The Company is currently evaluating the provisions of ASU 2016-02 and will be closely monitoring developments and additional guidance to determine the potential impact the new standard will have on the Company’s Consolidated Financial Statements.

 

ASU 2016-09, “Improvements to Employee Share-Based Payment Accounting (Topic 718).” ASU 2016-09 includes provisions intended to simplify various aspects related to how share-based payments are accounted for and presented in the financial statements. Some of the key provisions of this new ASU include: (1) companies will no longer record excess tax benefits and certain tax deficiencies in additional paid-in capital (“APIC”). Instead, they will record all excess tax benefits and tax deficiencies as income tax expense or benefit in the income statement, and APIC pools will be eliminated. The guidance also eliminates the requirement that excess tax benefits be realized before companies can recognize them. In addition, the guidance requires companies to present excess tax benefits as an operating activity on the statement of cash flows rather than as a financing activity; (2) increase the amount an employer can withhold to cover income taxes on awards and still qualify for the exception to liability classification for shares used to satisfy the employer’s statutory income tax withholding obligation. The new guidance also requires an employer to classify the cash paid to a tax authority when shares are withheld to satisfy its statutory income tax withholding obligation as a financing activity on its statement of cash flows (prior guidance did not specify how these cash flows should be classified); and (3) permit companies to make an accounting policy election for the impact of forfeitures on the recognition of expense for share-based payment awards. Forfeitures can be estimated, as required today, or recognized when they occur. ASU 2016-09 was effective for the Company on January 1, 2017 and the adoption of this new standard (ASU 2016-09) resulted in a net $460 thousand, or $0.01 per basic common share, reduction to income tax expense for the nine months ended September 30, 2017.

 

 15

 

 

ASU 2016-13, “Measurement of Credit Losses on Financial Instruments (Topic 326).” This ASU significantly changes how entities will measure credit losses for most financial assets and certain other instruments that are not measured at fair value through net income. In issuing the standard, the FASB is responding to criticism that today’s guidance delays recognition of credit losses. The standard will replace today’s “incurred loss” approach with an “expected loss” model. The new model, referred to as the current expected credit loss (“CECL”) model, will apply to: (1) financial assets subject to credit losses and measured at amortized cost, and (2) certain off-balance sheet credit exposures. This includes, but is not limited to, loans, leases, held-to-maturity securities, loan commitments, and financial guarantees. The CECL model does not apply to available-for-sale (“AFS”) debt securities. For AFS debt securities with unrealized losses, entities will measure credit losses in a manner similar to what they do today, except that the losses will be recognized as allowances rather than reductions in the amortized cost of the securities. As a result, entities will recognize improvements to estimated credit losses immediately in earnings rather than as interest income over time, as they do today. The ASU also simplifies the accounting model for purchased credit-impaired debt securities and loans. ASU 2016-13 also expands the disclosure requirements regarding an entity’s assumptions, models, and methods for estimating the allowance for loan and lease losses. In addition, entities will need to disclose the amortized cost balance for each class of financial asset by credit quality indicator, disaggregated by the year of origination. ASU No. 2016-13 is effective for interim and annual reporting periods beginning after December 15, 2019; early adoption is permitted for interim and annual reporting periods beginning after December 15, 2018. Entities will apply the standard’s provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective (i.e., modified retrospective approach). The Company is currently evaluating the provisions of ASU No. 2016-13 to determine the potential impact the new standard will have on the Company’s Consolidated Financial Statements.

 

ASU No. 2016-15, “Classification of Certain Cash Receipts and Cash Payments.” FASB issued this update in August 2016. Current GAAP is unclear or does not include specific guidance on how to classify certain transactions in the statement of cash flows. This ASU is intended to reduce diversity in practice in how eight particular transactions are classified in the statement of cash flows. ASU No. 2016-15 is effective for interim and annual reporting periods beginning after December 15, 2017. Early adoption is permitted, provided that all of the amendments are adopted in the same period. Entities will be required to apply the guidance retrospectively. If it is impracticable to apply the guidance retrospectively for an issue, the amendments related to that issue would be applied prospectively. As this guidance only affects the classification within the statement of cash flows, ASU No. 2016-15 is not expected to have a material impact on the Company’s Consolidated Financial Statements.

 

ASU No. 2017-04, “Simplifying the Test for Goodwill Impairment.” FASB issued this update in January 2017. The guidance removes Step 2 of the goodwill impairment test, which requires a hypothetical purchase price allocation. Goodwill impairment will now be the amount by which a reporting unit’s carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. All other goodwill impairment guidance will remain largely unchanged. ASU No. 2017-04 is effective for interim and annual reporting periods beginning after December 15, 2019, applied prospectively. Early adoption is permitted for any impairment tests performed after January 1, 2017. The Company expects to early adopt upon the next goodwill impairment test in 2017. ASU No. 2017-04 is not expected to have a material impact on the Company’s Consolidated Financial Statements.

 

ASU 2017-12, “Derivatives and Hedging: Targeted Improvements to Accounting for Hedging Activities (ASU 2017-12). The Financial Accounting Standards Board issued this update in August 2017. The purpose of this updated guidance is to better align a company’s financial reporting for hedging activities with the economic objectives of those activities. ASU 2017-12 is effective for public business entities for fiscal years beginning after December 15, 2018, with early adoption, including adoption in an interim period, permitted. The Company plans to adopt ASU 2017-12 on January 1, 2019. ASU 2017-12 requires a modified retrospective transition method in which the Company will recognize the cumulative effect of the change on the opening balance of each affected component of equity in the statement of financial position as of the date of adoption. While the Company continues to assess all potential impacts of the standard, we currently expect adoption to have an immaterial impact on our consolidated financial statements.

 

 16

 

 

Note 2. Cash and Due from Banks

 

Regulation D of the Federal Reserve Act requires that banks maintain noninterest reserve balances with the Federal Reserve Bank based principally on the type and amount of their deposits. During 2017, the Bank maintained balances at the Federal Reserve sufficient to meet reserve requirements, as well as significant excess reserves, on which interest is paid.

 

Additionally, the Bank maintains interest bearing balances with the Federal Home Loan Bank of Atlanta and noninterest bearing balances with domestic correspondent banks as compensation for services they provide to the Bank.

 

Note 3. Investment Securities Available-for-Sale

 

Amortized cost and estimated fair value of securities available-for-sale are summarized as follows:

                 
       Gross   Gross   Estimated 
September 30, 2017  Amortized   Unrealized   Unrealized   Fair 
(dollars in thousands)  Cost   Gains   Losses   Value 
U. S. agency securities  $179,100   $342   $1,524   $177,918 
Residential mortgage backed securities   303,822    374    2,670    301,526 
Municipal bonds   61,593    1,673    119    63,147 
Corporate bonds   13,011    206        13,217 
Other equity investments   218            218 
   $557,744   $2,595   $4,313   $556,026 
                     
          Gross      Gross      Estimated  
December 31, 2016    Amortized      Unrealized      Unrealized      Fair  
(dollars in thousands)    Cost      Gains      Losses      Value  
U. S. agency securities  $107,425   $519   $1,802   $106,142 
Residential mortgage backed securities   329,606    324    3,691    326,239 
Municipal bonds   94,607    1,723    400    95,930 
Corporate bonds   9,508    82    11    9,579 
Other equity investments   218            218 
   $541,364   $2,648   $5,904   $538,108 

 

In addition, at September 30, 2017, the Company held $31.0 million in equity securities in a combination of Federal Reserve Bank (“FRB”) and Federal Home Loan Bank (“FHLB”) stocks, which are required to be held for regulatory purposes and which are not marketable, and therefore are carried at cost.

  

 17

 

 

Gross unrealized losses and fair value by length of time that the individual available-for-sale securities have been in a continuous unrealized loss position are as follows:

 

       Less than   12 Months     
       12 Months   or Greater   Total 
       Estimated       Estimated       Estimated     
September 30, 2017  Number of   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
(dollars in thousands)  Securities   Value   Losses   Value   Losses   Value   Losses 
U. S. agency securities   32   $97,832   $1,101   $28,299   $423   $126,131   $1,524 
Residential mortgage backed securities   113    198,670    1,523    55,920    1,147    254,590    2,670 
Municipal bonds   5    13,301    119            13,301    119 
    150   $309,803   $2,743   $84,219   $1,570   $394,022   $4,313 
                                    
          Less than      12 Months            
          12 Months      or Greater      Total  
        Estimated        Estimated        Estimated      
December 31, 2016  Number of    Fair    Unrealized   Fair    Unrealized   Fair    Unrealized 
(dollars in thousands)  Securities    Value   Losses   Value   Losses   Value   Losses 
U. S. agency securities   27   $88,991   $1,764   $3,768   $38   $92,759   $1,802 
Residential mortgage backed securities   112    232,347    3,110    19,402    581    251,749    3,691 
Municipal bonds   16    34,743    400            34,743    400 
Corporate bonds   2    4,998    11            4,998    11 
    157   $361,079   $5,285   $23,170   $619   $384,249   $5,904 

 

The unrealized losses that exist are generally the result of changes in market interest rates and interest spread relationships since original purchases. The weighted average duration of debt securities, which comprise 99.9% of total investment securities, is relatively short at 3.5 years. If quoted prices are not available, fair value is measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. The Company does not believe that the investment securities that were in an unrealized loss position as of September 30, 2017 represent an other-than-temporary impairment. The Company does not intend to sell the investments and it is more likely than not that the Company will not have to sell the securities before recovery of its amortized cost basis, which may be at maturity.

 

The amortized cost and estimated fair value of investments available-for-sale at September 30, 2017 and December 31, 2016 by contractual maturity are shown in the table below. Expected maturities for residential mortgage backed securities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

   September 30, 2017   December 31, 2016 
   Amortized   Estimated   Amortized   Estimated 
(dollars in thousands)  Cost   Fair Value   Cost   Fair Value 
U. S. agency securities maturing:                    
One year or less  $90,495   $89,503   $83,885   $82,548 
After one year through five years   74,481    74,433    20,736    20,897 
Five years through ten years   14,124    13,982    2,804    2,697 
Residential mortgage backed securities   303,822    301,526    329,606    326,239 
Municipal bonds maturing:                    
One year or less   2,537    2,586    1,056    1,070 
After one year through five years   21,116    21,875    45,808    46,865 
Five years through ten years   36,868    37,493    46,668    46,839 
After ten years   1,072    1,193    1,075    1,156 
Corporate bonds                    
After one year through five years   11,511    11,717    8,008    8,079 
After ten years   1,500    1,500    1,500    1,500 
Other equity investments   218    218    218    218 
   $557,744   $556,026   $541,364   $538,108 

 

For the nine months ended September 30, 2017, gross realized gains on sales of investments securities were $795 thousand and gross realized losses on sales of investment securities were $254 thousand. For the nine months ended September 30, 2016, gross realized gains on sales of investments securities were $1.3 million and gross realized losses on sales of investment securities were $202 thousand.

 

 18

 

 

Proceeds from sales and calls of investment securities for the nine months ended September 30, 2017 were $70.1 million, and in 2016 were $94.2 million.

 

The carrying value of securities pledged as collateral for certain government deposits, securities sold under agreements to repurchase, and certain lines of credit with correspondent banks at September 30, 2017 was $459.9 million, which is well in excess of required amounts in order to operationally provide significant reserve amounts for new business. As of September 30, 2017 and December 31, 2016, there were no holdings of securities of any one issuer, other than the U.S. Government and U.S. agency securities, which exceeded ten percent of shareholders’ equity.

 

Note 4. Mortgage Banking Derivative

 

As part of its mortgage banking activities, the Bank enters into interest rate lock commitments, which are commitments to originate loans where the interest rate on the loan is determined prior to funding and the customers have locked into that interest rate. The Bank then locks in the loan and interest rate with an investor and commits to deliver the loan if settlement occurs (“best efforts”) or commits to deliver the locked loan in a binding (“mandatory”) delivery program with an investor. Certain loans under interest rate lock commitments are covered under forward sales contracts of mortgage backed securities (“MBS”). Forward sales contracts of MBS are recorded at fair value with changes in fair value recorded in noninterest income. Interest rate lock commitments and commitments to deliver loans to investors are considered derivatives. The market value of interest rate lock commitments and best efforts contracts are not readily ascertainable with precision because they are not actively traded in stand-alone markets. The Bank determines the fair value of interest rate lock commitments and delivery contracts by measuring the fair value of the underlying asset, which is impacted by current interest rates, taking into consideration the probability that the interest rate lock commitments will close or will be funded.

 

Certain additional risks arise from these forward delivery contracts in that the counterparties to the contracts may not be able to meet the terms of the contracts. The Bank does not expect any counterparty to any MBS to fail to meet its obligation. Additional risks inherent in mandatory delivery programs include the risk that, if the Bank does not close the loans subject to interest rate risk lock commitments, it will still be obligated to deliver MBS to the counterparty under the forward sales agreement. Should this be required, the Bank could incur significant costs in acquiring replacement loans or MBS and such costs could have an adverse effect on mortgage banking operations.

 

The fair value of the mortgage banking derivatives is recorded as a freestanding asset or liability with the change in value being recognized in current earnings during the period of change.

 

At September 30, 2017 the Bank had mortgage banking derivative financial instruments with a notional value of $59.6 million related to its forward contracts as compared to $81.7 million at September 30, 2016. The fair value of these mortgage banking derivative instruments at September 30, 2017 was $63 thousand included in other assets and $36 thousand included in other liabilities as compared to $217 thousand included in other assets and $222 thousand included in other liabilities at September 30, 2016.

 

Included in other noninterest income for the three and nine months ended September 30, 2017 was a net gain of $71 thousand and a net gain of $335 thousand, relating to mortgage banking derivative instruments as compared to a net loss of $46 thousand and a net gain of $274 thousand for the three and nine months ended September 30, 2016. The amount included in other noninterest income for the three and nine months ended September 30, 2017 pertaining to its mortgage banking hedging activities was a net realized loss of $14 thousand and $912 thousand as compared to a net realized gain of $151 thousand and net unrealized loss of $156 thousand for the same periods in September 30, 2016.

 

Note 5. Loans and Allowance for Credit Losses

 

The Bank makes loans to customers primarily in the Washington, D.C. metropolitan area and surrounding communities. A substantial portion of the Bank’s loan portfolio consists of loans to businesses secured by real estate and other business assets.

 

 19

 

 

Loans, net of unamortized net deferred fees, at September 30, 2017, December 31, 2016, and September 30, 2016 are summarized by type as follows:

 

   September 30, 2017   December 31, 2016   September 30, 2016 
(dollars in thousands)  Amount   %   Amount   %   Amount   % 
Commercial  $1,244,184    20%  $1,200,728    21%  $1,130,042    21%
Income producing - commercial real estate   2,898,948    48%   2,509,517    44%   2,551,186    46%
Owner occupied - commercial real estate   749,580    12%   640,870    12%   590,427    11%
Real estate mortgage - residential   109,460    2%   152,748    3%   154,439    3%
Construction - commercial and residential*   915,493    15%   932,531    16%   838,137    15%
Construction - C&I (owner occupied)   55,828    1%   126,038    2%   104,676    2%
Home equity   101,898    2%   105,096    2%   106,856    2%
Other consumer   8,813        10,365        6,212     
Total loans   6,084,204    100%   5,677,893    100%   5,481,975    100%
Less: allowance for credit losses   (62,967)        (59,074)        (56,864)     
Net loans  $6,021,237        $5,618,819        $5,425,111      

 

*Includes land loans.

 

Unamortized net deferred fees amounted to $23.3 million, $22.3 million, and $20.9 million at September 30, 2017, December 31, 2016, and September 30, 2016, respectively.

 

As of September 30, 2017 and December 31, 2016, the Bank serviced $176.5 million and $128.8 million, respectively, of FHA loans, SBA loans and other loan participations which are not reflected as loan balances on the Consolidated Balance Sheets.

 

Loan Origination / Risk Management

 

The Company’s goal is to mitigate risks in the event of unforeseen threats to the loan portfolio as a result of economic downturn or other negative influences. Plans for mitigating inherent risks in managing loan assets include: carefully enforcing loan policies and procedures, evaluating each borrower’s business plan during the underwriting process and throughout the loan term, identifying and monitoring primary and alternative sources for loan repayment, and obtaining collateral to mitigate economic loss in the event of liquidation. Specific loan reserves are established based upon credit and/or collateral risks on an individual loan basis. A risk rating system is employed to proactively estimate loss exposure and provide a measuring system for setting general and specific reserve allocations.

 

The composition of the Company’s loan portfolio is heavily weighted toward commercial real estate, both owner occupied and income producing real estate. At September 30, 2017, owner occupied - commercial real estate and construction - C&I (owner occupied) represent approximately 13% of the loan portfolio. At September 30, 2017, non-owner occupied commercial real estate and real estate construction represented approximately 63% of the loan portfolio. The combined owner occupied and commercial real estate loans represent approximately 76% of the loan portfolio. These loans are underwritten to mitigate lending risks typical of this type of loan such as declines in real estate values, changes in borrower cash flow and general economic conditions. The Bank typically requires a maximum loan to value of 80% and minimum cash flow debt service coverage of 1.15 to 1.0. Personal guarantees may be required, but may be limited. In making real estate commercial mortgage loans, the Bank generally requires that interest rates adjust not less frequently than five years.

 

The Company is also an active traditional commercial lender providing loans for a variety of purposes, including working capital, equipment and account receivable financing. This loan category represents approximately 20% of the loan portfolio at September 30, 2017 and was generally variable or adjustable rate. Commercial loans meet reasonable underwriting standards, including appropriate collateral and cash flow necessary to support debt service. Personal guarantees are generally required, but may be limited. SBA loans represent approximately 2% of the commercial loan category of loans. In originating SBA loans, the Company assumes the risk of non-payment on the unguaranteed portion of the credit. The Company generally sells the guaranteed portion of the loan generating noninterest income from the gains on sale, as well as servicing income on the portion participated. SBA loans are subject to the same cash flow analyses as other commercial loans. SBA loans are subject to a maximum loan size established by the SBA.

 

 20

 

 

Approximately 2% of the loan portfolio at September 30, 2017 consists of home equity loans and lines of credit and other consumer loans. These credits, while making up a small portion of the loan portfolio, demand the same emphasis on underwriting and credit evaluation as other types of loans advanced by the Bank.

 

Approximately 2% of the loan portfolio consists of residential mortgage loans. The repricing duration of these loans was 15 months. These credits represent first liens on residential property loans originated by the Bank. While the Bank’s general practice is to originate and sell (servicing released) loans made by its Residential Lending department, from time to time certain loan characteristics do not meet the requirements of third party investors and these loans are instead maintained in the Bank’s portfolio until they are resold to another investor at a later date or mature.

 

Loans are secured primarily by duly recorded first deeds of trust or mortgages. In some cases, the Bank may accept a recorded junior trust position. In general, borrowers will have a proven ability to build, lease, manage and/or sell a commercial or residential project and demonstrate satisfactory financial condition. Additionally, an equity contribution toward the project is customarily required.

 

Construction loans require that the financial condition and experience of the general contractor and major subcontractors be satisfactory to the Bank. Guaranteed, fixed price contracts are required whenever appropriate, along with payment and performance bonds or completion bonds for larger scale projects.

 

Loans intended for residential land acquisition, lot development and construction are made on the premise that the land: 1) is or will be developed for building sites for residential structures, and; 2) will ultimately be utilized for construction or improvement of residential zoned real properties, including the creation of housing. Residential development and construction loans will finance projects such as single family subdivisions, planned unit developments, townhouses, and condominiums.

 

Commercial land acquisition and construction loans are secured by real property where loan funds will be used to acquire land and to construct or improve appropriately zoned real property for the creation of income producing or owner user commercial properties. Borrowers are generally required to put equity into each project at levels determined by the appropriate Loan Committee.

 

Substantially all construction draw requests must be presented in writing on American Institute of Architects documents and certified either by the contractor, the borrower and/or the borrower’s architect. Each draw request shall also include the borrower’s soft cost breakdown certified by the borrower or their Chief Financial Officer. Prior to an advance, the Bank or its contractor inspects the project to determine that the work has been completed, to justify the draw requisition.

 

Commercial permanent loans are generally secured by improved real property which is generating income in the normal course of operation. Debt service coverage, assuming stabilized occupancy, must be satisfactory to support a permanent loan. The debt service coverage ratio is ordinarily at least 1.15 to 1.0. As part of the underwriting process, debt service coverage ratios are stress tested assuming a 200 basis point increase in interest rates from their current levels.

 

Commercial permanent loans generally are underwritten with a term not greater than 10 years or the remaining useful life of the property, whichever is lower. The preferred term is between 5 to 7 years, with amortization to a maximum of 25 years.

 

 21

 

 

The Company’s loan portfolio includes ADC real estate loans including both investment and owner occupied projects. ADC loans amounted to $1.44 billion at September 30, 2017. A portion of the ADC portfolio, both speculative and non-speculative, includes loan funded interest reserves at origination. ADC loans are serviced by loan funded interest reserves and represent approximately 79% of the outstanding ADC loan portfolio at September 30, 2017. The decision to establish a loan-funded interest reserve is made upon origination of the ADC loan and is based upon a number of factors considered during underwriting of the credit including: (1) the feasibility of the project; (2) the experience of the sponsor; (3) the creditworthiness of the borrower and guarantors; (4) borrower equity contribution; and (5) the level of collateral protection. When appropriate, an interest reserve provides an effective means of addressing the cash flow characteristics of a properly underwritten ADC loan. The Company does not significantly utilize interest reserves in other loan products. The Company recognizes that one of the risks inherent in the use of interest reserves is the potential masking of underlying problems with the project and/or the borrower’s ability to repay the loan. In order to mitigate this inherent risk, the Company employs a series of reporting and monitoring mechanisms on all ADC loans, whether or not an interest reserve is provided, including: (1) construction and development timelines which are monitored on an ongoing basis which track the progress of a given project to the timeline projected at origination; (2) a construction loan administration department independent of the lending function; (3) third party independent construction loan inspection reports; (4) monthly interest reserve monitoring reports detailing the balance of the interest reserves approved at origination and the days of interest carry represented by the reserve balances as compared to the then current anticipated time to completion and/or sale of speculative projects; and (5) quarterly commercial real estate construction meetings among senior Company management, which includes monitoring of current and projected real estate market conditions. If a project has not performed as expected, it is not the customary practice of the Company to increase loan funded interest reserves.

 

From time to time the Company may make loans for its own portfolio or through its higher risk loan affiliate, ECV. Such loans, which are made to finance projects (which may also be financed at the Bank level), may have higher risk characteristics than loans made by the Bank, such as lower priority interests and/or higher loan to value ratios. The Company seeks an overall financial return on these transactions commensurate with the risks and structure of each individual loan. Certain transactions may bear current interest at a rate with a significant premium to normal market rates. Other loan transactions may carry a standard rate of current interest, but also earn additional interest based on a percentage of the profits of the underlying project or a fixed accrued rate of interest.

 

 22

 

 

Allowance for Credit Losses

 

The following tables detail activity in the allowance for credit losses by portfolio segment for the three and nine months ended September 30, 2017 and 2016. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories.

 

       Income Producing -   Owner Occupied -   Real Estate   Construction -             
       Commercial   Commercial   Mortgage   Commercial and   Home   Other     
(dollars in thousands)  Commercial   Real Estate   Real Estate   Residential   Residential   Equity   Consumer   Total 
Three months ended September 30, 2017                                        
Allowance for credit losses:                                        
Balance at beginning of period  $14,225   $23,308   $4,189   $1,081   $16,727   $1,216   $301   $61,047 
Loans charged-off   (522)               (39)       (32)   (593)
Recoveries of loans previously charged-off   407    30        2    146    1    6    592 
Net loans (charged-off) recoveries   (115)   30        2    107    1    (26)   (1)
Provision for credit losses   (2,266)   (963)   1,273    (126)   4,052    (120)   71    1,921 
Ending balance  $11,844   $22,375   $5,462   $957   $20,886   $1,097   $346   $62,967 
Nine months ended September 30, 2017                                        
Allowance for credit losses:                                        
Balance at beginning of period  $14,700   $21,105   $4,010   $1,284   $16,487   $1,328   $160   $59,074 
Loans charged-off   (659)   (1,470)           (39)       (98)   (2,266)
Recoveries of loans previously charged-off   675    80    2    5    491    4    18    1,275 
Net loans charged-off   16    (1,390)   2    5    452    4    (80)   (991)
Provision for credit losses   (2,872)   2,660    1,450    (332)   3,947    (235)   266    4,884 
Ending balance  $11,844   $22,375   $5,462   $957   $20,886   $1,097   $346   $62,967 
As of September 30, 2017                                        
Allowance for credit losses:                                        
Individually evaluated for impairment  $3,246   $1,378   $1,005   $   $2,900   $90   $81   $8,700 
Collectively evaluated for impairment   8,598    20,997    4,457    957    17,986    1,007    265    54,267 
Ending balance  $11,844   $22,375   $5,462   $957   $20,886   $1,097   $346   $62,967 
Three months ended September 30, 2016                                        
Allowance for credit losses:                                        
Balance at beginning of period  $13,386   $19,072   $4,202   $1,061   $17,024   $1,556   $235   $56,536 
Loans charged-off   (109)   (1,751)               (121)   (12)   (1,993)
Recoveries of loans previously charged-off   7    10        2    3    3    8    33 
Net loans (charged-off) recoveries   (102)   (1,741)       2    3    (118)   (4)   (1,960)
Provision for credit losses   (523)   3,178    59    47    (513)   (69)   109    2,288 
Ending balance  $12,761   $20,509   $4,261   $1,110   $16,514   $1,369   $340   $56,864 
Nine months ended September 30, 2016                                        
Allowance for credit losses:                                        
Balance at beginning of period  $11,563   $14,122   $3,279   $1,268   $21,088   $1,292   $75   $52,687 
Loans charged-off   (2,802)   (2,342)               (217)   (37)   (5,398)
Recoveries of loans previously charged-off   93    14    2    5    207    11    24    356 
Net loans charged-off   (2,709)   (2,328)   2    5    207    (206)   (13)   (5,042)
Provision for credit losses   3,907    8,715    980    (163)   (4,781)   283    278    9,219 
Ending balance  $12,761   $20,509   $4,261   $1,110   $16,514   $1,369   $340   $56,864 
As of September 30, 2016                                        
Allowance for credit losses:                                        
Individually evaluated for impairment  $1,997   $1,714   $360   $   $300   $   $100   $4,471 
Collectively evaluated for impairment   10,764    18,795    3,901    1,110    16,214    1,369    240    52,393 
Ending balance  $12,761   $20,509   $4,261   $1,110   $16,514   $1,369   $340   $56,864 

 

 23

 

 

The Company’s recorded investments in loans as of September 30, 2017, December 31, 2016 and September 30, 2016 related to each balance in the allowance for loan losses by portfolio segment and disaggregated on the basis of the Company’s impairment methodology was as follows:

 

       Income Producing -   Owner occupied -   Real Estate   Construction -             
       Commercial   Commercial   Mortgage   Commercial and   Home   Other     
(dollars in thousands)  Commercial   Real Estate   Real Estate   Residential   Residential   Equity   Consumer   Total 
                                 
September 30, 2017                                        
Recorded investment in loans:                                        
Individually evaluated for impairment  $8,309   $10,241   $6,570   $   $7,728   $594   $92   $33,534 
Collectively evaluated for impairment   1,235,875    2,888,707    743,010    109,460    963,593    101,304    8,721    6,050,670 
Ending balance  $1,244,184   $2,898,948   $749,580   $109,460   $971,321   $101,898   $8,813   $6,084,204 
                                         
December 31, 2016                                        
Recorded investment in loans:                                        
Individually evaluated for impairment  $10,437   $15,057   $2,093   $241   $6,517   $   $126   $34,471 
Collectively evaluated for impairment   1,190,291    2,494,460    638,777    152,507    1,052,052    105,096    10,239    5,643,422 
Ending balance  $1,200,728   $2,509,517   $640,870   $152,748   $1,058,569   $105,096   $10,365   $5,677,893 
                                         
September 30, 2016                                        
Recorded investment in loans:                                        
Individually evaluated for impairment  $12,448   $14,648   $2,517   $244   $4,878   $113   $   $34,848 
Collectively evaluated for impairment   1,117,594    2,536,538    587,910    154,195    937,935    106,743    6,212    5,447,127 
Ending balance  $1,130,042   $2,551,186   $590,427   $154,439   $942,813   $106,856   $6,212   $5,481,975 

 

At September 30, 2017, nonperforming loans acquired from Fidelity & Trust Financial Corporation (“Fidelity”) and Virginia Heritage Bank (“Virginia Heritage”) have a carrying value of $476 thousand and $507 thousand, and an unpaid principal balance of $533 thousand and $1.5 million, respectively, and were evaluated separately in accordance with ASC Topic 310-30, “Loans and Debt Securities Acquired with Deteriorated Credit Quality.” The various impaired loans were recorded at estimated fair value with any excess being charged-off or treated as a non-accretable discount. Subsequent downward adjustments to the valuation of impaired loans acquired will result in additional loan loss provisions and related allowance for credit losses.

 

 24

 

 

Credit Quality Indicators

 

The Company uses several credit quality indicators to manage credit risk in an ongoing manner. The Company’s primary credit quality indicators are to use an internal credit risk rating system that categorizes loans into pass, watch, special mention, or classified categories. Credit risk ratings are applied individually to those classes of loans that have significant or unique credit characteristics that benefit from a case-by-case evaluation. These are typically loans to businesses or individuals in the classes which comprise the commercial portfolio segment. Groups of loans that are underwritten and structured using standardized criteria and characteristics, such as statistical models (e.g., credit scoring or payment performance), are typically risk rated and monitored collectively. These are typically loans to individuals in the classes which comprise the consumer portfolio segment.

 

The following are the definitions of the Company’s credit quality indicators:

 

Pass:Loans in all classes that comprise the commercial and consumer portfolio segments that are not adversely rated, are contractually current as to principal and interest, and are otherwise in compliance with the contractual terms of the loan agreement. Management believes that there is a low likelihood of loss related to those loans that are considered pass.

 

Watch:Loan paying as agreed with generally acceptable asset quality; however the obligor’s performance has not met expectations. Balance sheet and/or income statement has shown deterioration to the point that the obligor could not sustain any further setbacks. Credit is expected to be strengthened through improved obligor performance and/or additional collateral within a reasonable period of time.

 

Special Mention:Loans in the classes that comprise the commercial portfolio segment that have potential weaknesses that deserve management’s close attention. If not addressed, these potential weaknesses may result in deterioration of the repayment prospects for the loan. The special mention credit quality indicator is not used for classes of loans that comprise the consumer portfolio segment. Management believes that there is a moderate likelihood of some loss related to those loans that are considered special mention.

 

Classified:Classified (a) Substandard - Loans inadequately protected by the current sound 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 company will sustain some loss if the deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard loans, does not have to exist in individual loans classified substandard.

 

Classified (b) Doubtful - Loans that have all the weaknesses inherent in a loan classified substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. The possibility of loss is extremely high, but because of certain important and reasonably specific pending factors, which may work to the advantage and strengthening of the assets, its classification as an estimated loss is deferred until its more exact status may be determined.

 

 25

 

 

The Company’s credit quality indicators are updated generally on a quarterly basis, but no less frequently than annually. The following table presents by class and by credit quality indicator, the recorded investment in the Company’s loans and leases as of September 30, 2017, December 31, 2016 and September 30, 2016.

 

       Watch and           Total 
(dollars in thousands)  Pass   Special Mention   Substandard   Doubtful   Loans 
                     
September 30, 2017                         
Commercial  $1,204,850   $31,025   $8,309   $   $1,244,184 
Income producing - commercial real estate   2,861,346    27,361    10,241        2,898,948 
Owner occupied - commercial real estate   720,693    22,317    6,570        749,580 
Real estate mortgage – residential   108,797    663            109,460 
Construction - commercial and residential   963,593        7,728        971,321 
Home equity   100,618    686    594        101,898 
Other consumer   8,719    2    92        8,813 
          Total  $5,968,616   $82,054   $33,534   $   $6,084,204 
                          
December 31, 2016                         
Commercial  $1,160,185   $30,106   $10,437   $   $1,200,728 
Income producing - commercial real estate   2,489,407    5,053    15,057        2,509,517 
Owner occupied - commercial real estate   630,827    7,950    2,093        640,870 
Real estate mortgage – residential   151,831    676    241        152,748 
Construction - commercial and residential   1,051,445    607    6,517        1,058,569 
Home equity   103,484    1,612            105,096 
Other consumer   10,237    2    126        10,365 
          Total  $5,597,416   $46,006   $34,471   $   $5,677,893 
                          
September 30, 2016                         
Commercial  $1,099,894   $18,599   $11,549   $   $1,130,042 
Income producing - commercial real estate   2,527,318    9,220    14,648        2,551,186 
Owner occupied - commercial real estate   577,925    10,399    2,103        590,427 
Real estate mortgage – residential   153,515    680    244        154,439 
Construction - commercial and residential   937,198    737    4,878        942,813 
Home equity   105,126    1,617    113        106,856 
Other consumer   6,209    3            6,212 
          Total  $5,407,185   $41,255   $33,535   $   $5,481,975 

 

Nonaccrual and Past Due Loans

 

Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on nonaccrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on nonaccrual status regardless of whether or not such loans are considered past due. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

 

 26

 

 

The following table presents, by class of loan, information related to nonaccrual loans as of September 30, 2017, December 31, 2016 and September 30, 2016.

 

(dollars in thousands)  September 30, 2017   December 31, 2016   September 30, 2016 
             
Commercial  $3,242   $2,490   $2,986 
Income producing - commercial real estate   880    10,539    10,098 
Owner occupied - commercial real estate   6,570    2,093    2,103 
Real estate mortgage - residential   301    555    562 
Construction - commercial and residential   4,930    2,072    6,412 
Home equity   594        113 
Other consumer   92    126     
Total nonaccrual loans (1)(2)  $16,609   $17,875   $22,274 

 

(1)Excludes troubled debt restructurings (“TDRs”) that were performing under their restructured terms totaling $12.3 million at September 30, 2017, as compared to $7.9 million at December 31, 2016 and $2.9 million at September 30, 2016.

(2)Gross interest income of $176 thousand and $802 thousand would have been recorded for the three and nine months ended September 30, 2017, if nonaccrual loans shown above had been current and in accordance with their original terms while interest actually recorded on such loans was $31 thousand and $56 thousand for the three and nine months ended September 30, 2017. See Note 1 to the Consolidated Financial Statements for a description of the Company’s policy for placing loans on nonaccrual status.

 

 27

 

 

The following table presents, by class of loan, an aging analysis and the recorded investments in loans past due as of September 30, 2017 and December 31, 2016.

 

   Loans   Loans   Loans           Total Recorded 
   30-59 Days   60-89 Days   90 Days or   Total Past   Current   Investment in 
(dollars in thousands)  Past Due   Past Due   More Past Due   Due Loans   Loans   Loans 
                         
September 30, 2017                              
Commercial  $401   $662   $3,242   $4,305   $1,239,879   $1,244,184 
Income producing - commercial real estate   3,160    770    880    4,810    2,894,138    2,898,948 
Owner occupied - commercial real estate   817    3,268    6,570    10,655    738,925    749,580 
Real estate mortgage – residential   1,480    2,123    301    3,904    105,556    109,460 
Construction - commercial and residential   197        4,930    5,127    966,194    971,321 
Home equity   637    100    594    1,331    100,567    101,898 
Other consumer   21    4    92    117    8,696    8,813 
          Total  $6,713   $6,927   $16,609   $30,249   $6,053,955   $6,084,204 
                               
December 31, 2016                              
Commercial  $1,634   $757   $2,490   $4,881   $1,195,847   $1,200,728 
Income producing - commercial real estate   511        10,539    11,050    2,498,467    2,509,517 
Owner occupied - commercial real estate   3,987    3,328    2,093    9,408    631,462    640,870 
Real estate mortgage – residential   1,015    163    555    1,733    151,015    152,748 
Construction - commercial and residential   360    1,342    2,072    3,774    1,054,795    1,058,569 
Home equity                   105,096    105,096 
Other consumer   101    9    126    236    10,129    10,365 
          Total  $7,608   $5,599   $17,875   $31,082   $5,646,811   $5,677,893 
                               
September 30, 2016                              
Commercial  $1,173   $495   $2,986   $4,654   $1,125,388   $1,130,042 
Income producing - commercial real estate           10,098    10,098    2,541,088    2,551,186 
Owner occupied - commercial real estate       3,338    2,103    5,441    584,986    590,427 
Real estate mortgage – residential       164    562    726    153,713    154,439 
Construction - commercial and residential           6,412    6,412    936,401    942,813 
Home equity   562    620    113    1,295    105,561    106,856 
Other consumer   8    16        24    6,188    6,212 
          Total  $1,743   $4,633   $22,274   $28,650   $5,453,325   $5,481,975 

 

Impaired Loans

 

Loans are considered impaired when, based on current information and events, it is probable the Company will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impairment is evaluated in total for smaller-balance loans of a similar nature and on an individual loan basis for other loans. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible.

 

 28

 

 

The following table presents, by class of loan, information related to impaired loans for the periods ended September 30, 2017, December 31, 2016 and September 30, 2016.

 

   Unpaid   Recorded   Recorded                         
   Contractual   Investment   Investment   Total       Average Recorded Investment   Interest Income Recognized 
   Principal   With No   With   Recorded   Related   Quarter   Year   Quarter   Year 
(dollars in thousands)  Balance   Allowance   Allowance   Investment   Allowance   To Date   To Date   To Date   To Date 
                                     
September 30, 2017                                             
Commercial  $6,047   $2,363   $3,640   $6,003   $3,246   $5,977   $5,790   $31   $97 
Income producing - commercial real estate   10,092    828    9,264    10,092    1,378    10,222    11,350    121    373 
Owner occupied - commercial real estate   6,890    1,612    5,278    6,890    1,005    5,623    4,182    26    46 
Real estate mortgage – residential   301    301        301        304    368         
Construction - commercial and residential   4,930    1,534    3,396    4,930    2,900    4,808    3,736        14 
Home equity   594    494    100    594    90    446    223        2 
Other consumer   92        92    92    81    93    101         
   Total  $28,946   $7,132   $21,770   $28,902   $8,700   $27,473   $25,750   $178   $532 
                                              
December 31, 2016                                             
Commercial  $8,296   $2,532   $3,095   $5,627   $2,671   $12,620   $12,755   $79   $191 
Income producing - commercial real estate   14,936    5,048    9,888    14,936    1,943    16,742    17,533    54    198 
Owner occupied - commercial real estate   2,483    1,691    792    2,483    350    2,233    2,106        13 
Real estate mortgage – residential   555    555        555        246    249         
Construction - commercial and residential   2,072    1,535    537    2,072    522    5,091    5,174         
Home equity                       78    89         
Other consumer   126        126    126    113    42    32    2    4 
   Total  $28,468   $11,361   $14,438   $25,799   $5,599   $37,052   $37,938   $135   $406 
                                              
September 30, 2016                                             
Commercial  $15,517   $2,370   $10,078   $12,448   $1,997   $12,838   $12,879   $54   $112 
Income producing - commercial real estate   14,648        14,648    14,648    1,714    17,584    15,298    28    144 
Owner occupied - commercial real estate   2,517        2,517    2,517    360    2,108    1,923    13    13 
Real estate mortgage – residential   244    244        244        249    271         
Construction - commercial and residential   4,878    4,340    538    4,878    300    5,146    6,542         
Home equity   113        113    113    100    117    129    2    2 
Other consumer                           6         
   Total  $37,917   $6,954   $27,894   $34,848   $4,471   $38,042   $37,048   $97   $271 

 

Modifications

 

A modification of a loan constitutes a TDR when a borrower is experiencing financial difficulty and the modification constitutes a concession. The Company offers various types of concessions when modifying a loan. Commercial and industrial loans modified in a TDR often involve temporary interest-only payments, term extensions, and converting revolving credit lines to term loans. Additional collateral, a co-borrower, or a guarantor is often requested. Commercial mortgage and construction loans modified in a TDR often involve reducing the interest rate for the remaining term of the loan, extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, or substituting or adding a new borrower or guarantor. Construction loans modified in a TDR may also involve extending the interest-only payment period. As of September 30, 2017, all performing TDRs were categorized as interest-only modifications.

 

Loans modified in a TDR for the Company may have the financial effect of increasing the specific allowance associated with the loan. An allowance for impaired consumer and commercial loans that have been modified in a TDR is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the estimated fair value of the collateral, less any selling costs, if the loan is collateral dependent. Management exercises significant judgment in developing these estimates.

 

 29

 

 

The following table presents by class, the recorded investment of loans modified in a TDR during the three months ended September 30, 2017 and 2016.

 

   For the Three Months Ended September 30, 2017 
          Income
Producing -
   Owner
Occupied -
   Construction -     
(dollars in thousands)  Number of
Contracts
   Commercial   Commercial
Real Estate
   Commercial
Real Estate
   Commercial
Real Estate
   Total 
Troubled debt restructings                              
                               
Restructured accruing      $(356)  $   $(23)  $   $(379)
Restructured nonaccruing   2    586    (560)           26 
Total   2   $230   $(560)  $(23)  $   $(353)
                               
Specific allowance       $(185)  $(559)  $   $   $(744)
                               
Restructured and subsequently defaulted       $   $   $   $   $ 
                               
   For the Three Months Ended September 30, 2016 
            Income
Producing - 
   Owner
Occupied - 
   Construction -      
(dollars in thousands)  Number of
Contracts
   Commercial   Commercial
Real Estate 
   Commercial
Real Estate 
   Commercial
Real Estate 
   Total 
Troubled debt restructings                              
                               
Restructured accruing   1   $801   $   $   $   $801 
Restructured nonaccruing                        
Total   1   $801   $   $   $   $801 
                               
Specific allowance       $363   $   $   $   $363 
                               
Restructured and subsequently defaulted       $   $   $   $   $ 

 

 30

 

 

The following table presents by class, the recorded investment of loans modified in TDRs held by the Company at September 30, 2017 and September 30, 2016.

 

   September 30, 2017 
          Income
Producing -
   Owner
Occupied -
   Construction -     
(dollars in thousands)  Number of
Contracts
   Commercial   Commercial
Real Estate
   Commercial
Real Estate
   Commercial
Real Estate
   Total 
Troubled debt restructings                              
                               
Restructured accruing   9   $2,761   $9,212   $320   $   $12,293 
Restructured nonaccruing   4    776    136            912 
Total   13   $3,537   $9,348   $320   $   $13,205 
                               
Specific allowance       $685   $1,341   $   $   $2,026 
                               
Restructured and subsequently defaulted       $237   $   $   $   $237 

 

   September 30, 2016 
          Income
Producing -
   Owner
Occupied -
   Construction -     
(dollars in thousands)  Number of
Contracts
   Commercial   Commercial
Real Estate
   Commercial
Real Estate
   Commercial
Real Estate
   Total 
Troubled debt restructings                              
                               
Restructured accruing   7   $1,725   $742   $414   $   $2,881 
Restructured nonaccruing   2    199            4,948    5,147 
Total   9   $1,924   $742   $414   $4,948   $8,028 
                               
Specific allowance       $456   $   $   $   $456 
                               
Restructured and subsequently defaulted       $   $   $   $4,948   $4,948 

 

The Company had thirteen TDR’s at September 30, 2017 totaling approximately $13.2 million. Nine of these loans, totaling approximately $12.3 million, are performing under their modified terms. During the nine months of 2017, there was one default on a $237 thousand restructured loan which was charged off, as compared to the same period in 2016, which had one default on a $5.0 million restructured loan. A default is considered to have occurred once the TDR is past due 90 days or more or it has been placed on nonaccrual. There were two nonperforming TDRs totaling $588 thousand reclassified to nonperforming loans during the nine months ended September 30, 2017. There was one nonperforming TDR totaling $5.0 million reclassified to nonperforming loans during the nine months ended September 30, 2016. Commercial and consumer loans modified in a TDR are closely monitored for delinquency as an early indicator of possible future default. If loans modified in a TDR subsequently default, the Company evaluates the loan for possible further impairment. The allowance may be increased, adjustments may be made in the allocation of the allowance, or partial charge-offs may be taken to further write-down the carrying value of the loan. There were two loans totaling $251 thousand modified in a TDR during the three months ended September 30, 2017, as compared to the three months ended September 30, 2016 which had one loan totaling $801 thousand modified in a TDR.

 

Note 6. Interest Rate Swap Derivatives

 

The Company uses interest rate swap agreements to assist in its interest rate risk management. The Company’s objective in using interest rate derivatives designated as cash flow hedges is to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company entered into forward starting interest rate swaps in April 2015 as part of its interest rate risk management strategy intended to mitigate the potential risk of rising interest rates on the Bank’s cost of funds. The notional amounts of the interest rate swaps designated as cash flow hedges do not represent amounts exchanged by the counterparties, but rather, the notional amount is used to determine, along with other terms of the derivative, the amounts to be exchanged between the counterparties. The interest rate swaps are designated as cash flow hedges and involve the receipt of variable rate amounts from two counterparties in exchange for the Company making fixed payments beginning in April 2016. The Company’s intent is to hedge its exposure to the variability in potential future interest rate conditions on existing financial instruments.

 

 31

 

 

As of September 30, 2017, the Company had three forward starting designated cash flow hedge interest rate swap transactions outstanding that had an aggregate notional amount of $250 million associated with the Company’s variable rate deposits. The net unrealized gain before income tax on the swaps was $167 thousand at September 30, 2017 compared to a net unrealized loss before income tax of $692 thousand at December 31, 2016. The net unrealized gain at September 30, 2017 compared to the net unrealized loss at December 31, 2016 is due to the increase in current market expectation of short term interest rates for the remaining term of the designated cash flow hedge interest rate swap.

 

For derivatives designated as cash flow hedges, the effective portion of changes in the fair value of the derivative is initially reported in other comprehensive income (outside of earnings), net of tax, and subsequently reclassified to earnings when the hedged transaction affects earnings, and the ineffective portion of changes in the fair value of the derivative is recognized directly in earnings. The Company assesses the effectiveness of each hedging relationship by comparing the changes in cash flows of the derivative hedging instrument with the changes in cash flows of the designated hedged transactions. The Company recognized an immaterial amount in earnings due to hedge ineffectiveness during both the nine month periods ended September 30, 2017 and September 30, 2016.

 

Amounts reported in accumulated other comprehensive income related to designated cash flow hedge derivatives will be reclassified to interest income/expense as interest payments are made/received on the Company’s variable-rate assets/liabilities. During the quarter ended September 30, 2017, the Company reclassified $307 thousand related to designated cash flow hedge derivatives from accumulated other comprehensive income to interest expense. During the next twelve months, the Company estimates (based on existing interest rates) that $657 thousand will be reclassified as an increase in interest expense.

 

The Company is exposed to credit risk in the event of nonperformance by the interest rate swap counterparty. The Company minimizes this risk by entering into derivative contracts with only large, stable financial institutions, and the Company has not experienced, and does not expect, any losses from counterparty nonperformance on the interest rate swaps. The Company monitors counterparty risk in accordance with the provisions of ASC Topic 815, “Derivatives and Hedging.” In addition, the interest rate swap agreements contain language outlining collateral-pledging requirements for each counterparty. Collateral must be posted when the market value exceeds certain threshold limits.

 

The designated cash flow hedge interest rate swap agreements detail: 1) that collateral be posted when the market value exceeds certain threshold limits associated with the secured party’s exposure; 2) if the Company defaults on any of its indebtedness (including default where repayment of the indebtedness has not been accelerated by the lender), then the Company could also be declared in default on its derivative obligations; 3) if the Company fails to maintain its status as a well/adequately capitalized institution then the counterparty could terminate the derivative positions and the Company would be required to settle its obligations under the agreements.

 

As of September 30, 2017, the aggregate fair value of all designated cash flow hedge derivative contracts with credit risk contingent features (i.e., those containing collateral posting or termination provisions based on our capital status) were in a net asset position of $167 thousand (none of these contracts were in a net liability position as of September 30, 2017). As of September 30, 2017, the Company has minimum collateral posting thresholds with certain of its derivative counterparties and has posted collateral of $890 thousand against its obligations under these agreements. If the Company had breached any provisions under the agreements at September 30, 2017, it could have been required to settle its obligations under the agreements at the termination value.

 

 32

 

 

The table below identifies the balance sheet category and fair values of the Company’s designated cash flow hedge derivative instruments as of September 30, 2017 and December 31, 2016.

 

   Swap   Notional       Balance Sheet           
September 30, 2017  Number   Amount   Fair Value   Category  Receive Rate  Pay Rate   Maturity 
                           
(dollars in thousands)                              
Interest rate swap   (1)  $75,000   $116   Other Assets  1 month USD-LIBOR-BBA w/ -1 day lookback +10 basis points   1.71%  March 31, 2020 
Interest rate swap   (2)   100,000    (24)  Other Liabilities  Federal Funds Effective Rate +10 basis points   1.74%  April 15, 2021 
Interest rate swap   (3)   75,000    75   Other Assets  1 month USD-LIBOR-BBA w/ -1 day lookback +10 basis points   1.92%  March 31, 2022 
     Total    $250,000   $167                

 

   Swap   Notional       Balance Sheet           
December 31, 2016  Number   Amount   Fair Value   Category  Receive Rate  Pay Rate   Maturity 
                           
(dollars in thousands)                              
Interest rate swap   (1)  $75,000   $(197)  Other Liabilities  1 month USD-LIBOR-BBA w/ -1 day lookback +10 basis points   1.71%  March 31, 2020 
Interest rate swap   (2)   100,000    (514)  Other Liabilities  Federal Funds Effective Rate +10 basis points   1.74%  April 15, 2021 
Interest rate swap   (3)   75,000    19   Other Assets  1 month USD-LIBOR-BBA w/ -1 day lookback +10 basis points   1.92%  March 31, 2022 
     Total    $250,000   $(692)               

 

The table below presents the pre-tax net gains (losses) of the Company’s cash flow hedges for the nine months ended September 30, 2017 and for the year ended December 31, 2016.

 

       Nine Months Ended September 30, 2017 
       Effective Portion   Ineffective Portion  
           Reclassified from AOCI    Recognized in Income  
       Amount of   into income    on Derivatives  
   Swap   Pre-tax gain (loss)      Amount of      Amount of 
   Number   Recognized in OCI   Category  Gain (Loss)   Category  Gain (Loss) 
                       
(dollars in thousands)                          
Interest rate swap   (1)  $116    Interest Expense  $(338)   Other Expense  $ 
Interest rate swap   (2)   (24)   Interest Expense   (525)   Other Expense    
Interest rate swap   (3)   75    Interest Expense   (458)   Other Expense   (1)
     Total    $167      $(1,321)     $(1)

 

       Year Ended December 31, 2016 
       Effective Portion   Ineffective Portion  
           Reclassified from AOCI    Recognized in Income  
       Amount of   into income    on Derivatives
   Swap   Pre-tax gain (loss)      Amount of      Amount of 
   Number   Recognized in OCI   Category  Gain (Loss)   Category  Gain (Loss) 
                       
(dollars in thousands)                          
Interest rate swap   (1)  $(197)   Interest Expense  $(628)   Other Expense  $ 
Interest rate swap   (2)   (514)   Interest Expense   (880)   Other Expense    
Interest rate swap   (3)   19    Interest Expense   (747)   Other Expense   1 
     Total    $(692)     $(2,255)     $1 

 

 33

 

 

Balance Sheet Offsetting: Our designated cash flow hedge interest rate swap derivatives are eligible for offset in the Consolidated Balance Sheets and are subject to master netting arrangements. Our derivative transactions with counterparties are generally executed under International Swaps and Derivative Association (“ISDA”) master agreements which include “right of set-off” provisions. In such cases there is generally a legally enforceable right to offset recognized amounts and there may be an intention to settle such amounts on a net basis. The Company generally offsets such financial instruments for financial reporting purposes.

 

Nine Months Ended September 30, 2017
Offsetting of Derivative Liabilities (dollars in thousands)                
                  Gross Amounts Not Offset in the Balance Sheet
   Gross Amounts of Recognized Liabilities   Gross Amounts Offset in the Balance Sheet   Net Amounts of Liabilities presented in the Balance Sheet   Financial Instruments   Cash Collateral Posted   Net Amount 
Counterparty 1  $24   $(75)  $(51)  $   $(560)  $(611)
Counterparty 2   (116)       (116)       (330)   (446)
   $(92)  $(75)  $(167)  $   $(890)  $(1,057)

 

Year Ended December 31, 2016
Offsetting of Derivative Liabilities (dollars in thousands)                
                  Gross Amounts Not Offset in the Balance Sheet
   Gross Amounts of Recognized Liabilities   Gross Amounts Offset in the Balance Sheet   Net Amounts of Liabilities presented in the Balance Sheet   Financial Instruments   Cash Collateral Posted   Net Amount 
Counterparty 1  $514   $(19)  $495   $   $(380)  $115 
Counterparty 2   197        197        (170)   27 
   $711   $(19)  $692   $   $(550)  $142 

 

Note 7. Other Real Estate Owned

 

The activity within Other Real Estate Owned (“OREO”) for the three and nine months ended September 30, 2017 and 2016 is presented in the table below. There were no residential real estate loans in the process of foreclosure as of September 30, 2017. For the three and nine months ended September 30, 2017, proceeds on sale of OREO were $1.2 million and $2.1 million. For the three months ended September 30, 2017, there were two OREO properties with a total carrying value of $1.1 million were sold for a net gain of $60 thousand. For the nine months ended September 30, 2017, there were a total of three OREO properties sold for a net loss of $301 thousand.

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
(dollars in thousands)  2017   2016   2017   2016 
                 
Balance beginning of period  $1,394   $3,152   $2,694   $5,852 
Real estate acquired from borrowers   1,145    2,500    1,145    2,500 
Valuation allowance               (200)
Properties sold   (1,145)   (458)   (2,445)   (2,958)
Balance end of period  $1,394   $5,194   $1,394   $5,194 

 

 34

 

 

Note 8. Long-Term Borrowings

 

The following table presents information related to the Company’s long-term borrowings as of September 30, 2017, December 31, 2016 and September 30, 2016.

 

(dollars in thousands)  September 30, 2017   December 31, 2016   September 30, 2016 
             
Subordinated Notes, 5.75%  $70,000   $70,000   $70,000 
Subordinated Notes, 5.0%   150,000    150,000    150,000 
Less: debt issuance costs   (3,193)   (3,486)   (3,581)
Long-term borrowings  $216,807   $216,514   $216,419 

 

On August 5, 2014, the Company completed the sale of $70.0 million of its 5.75% subordinated notes, due September 1, 2024 (the “Notes”). The Notes were offered to the public at par and qualify as Tier 2 capital for regulatory purposes to the fullest extent permitted under the Basel III Rule capital requirements. The net proceeds were approximately $68.8 million, which includes $1.2 million in deferred financing costs which are being amortized over the life of the Notes.

 

On July 26, 2016, the Company completed the sale of $150.0 million of its 5.00% Fixed-to-Floating Rate Subordinated Notes, due August 1, 2026 (the “2026 Notes”). The 2026 Notes were offered to the public at par and qualify as Tier 2 capital for regulatory purposes to the fullest extent permitted under the Basel III Rule capital requirements. The net proceeds were approximately $147.35 million, which includes $2.6 million in deferred financing costs which are being amortized over the life of the 2026 Notes.

 

Note 9. Net Income per Common Share

 

The calculation of net income per common share for the three and nine months ended September 30, 2017 and 2016 was as follows.

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
(dollars and shares in thousands, except per share data)  2017   2016   2017   2016 
Basic:                
Net income  $29,874   $24,523   $84,663   $71,990 
Average common shares outstanding   34,174    33,590    34,124    33,566 
Basic net income per common  share  $0.87   $0.73   $2.48   $2.14 
                     
Diluted:                    
Net income  $29,874   $24,523   $84,663   $71,990 
Average common shares outstanding   34,174    33,590    34,124    33,566 
Adjustment for common share equivalents   164    597    192    596 
Average common shares outstanding-diluted   34,338    34,187    34,316    34,162 
Diluted net income per common share  $0.87   $0.72   $2.47   $2.11 
                     
Anti-dilutive shares       8        8 

 

Note 10. Stock-Based Compensation

 

The Company maintains the 2016 Stock Plan (“2016 Plan”), the 2006 Stock Plan (“2006 Plan”) and the 2011 Employee Stock Purchase Plan (“2011 ESPP”).

 

In connection with the acquisition of Virginia Heritage, the Company assumed the Virginia Heritage 2006 Stock Option Plan and the 2010 Long Term Incentive Plan (the “Virginia Heritage Plans”).

 

No additional options may be granted under the 2006 Plan or the Virginia Heritage Plans.

 

 35

 

 

The Company adopted the 2016 Plan upon approval by the shareholders at the 2016 Annual Meeting held on May 12, 2016. The 2016 Plan provides directors and selected employees of the Bank, the Company and their affiliates with the opportunity to acquire shares of stock, through awards of options, time vested restricted stock, performance-based restricted stock and stock appreciation rights. Under the 2016 Plan, 1,000,000 shares of common stock were initially reserved for issuance.

 

For awards that are service based, compensation expense is being recognized over the service (vesting) period based on fair value, which for stock option grants is computed using the Black-Scholes model. For restricted stock awards granted under the 2006 plan, fair value is based on the average of the high and low stock price of the Company’s shares on the date of grant. For restricted stock awards granted under the 2016 plan, fair value is based on the Company’s closing price on the date of grant. For awards that are performance-based, compensation expense is recorded based on the probability of achievement of the goals underlying the grant.

 

In February 2017, the Company awarded 91,097 shares of time vested restricted stock to senior officers, directors, and certain employees. The shares vest in three substantially equal installments beginning on the first anniversary of the date of grant.

 

In February 2017, the Company awarded senior officers a targeted number of 36,523 performance vested restricted stock units (PRSUs). The vesting of PRSUs is 100% after three years with payouts based on threshold, target or maximum average performance targets over the three year period relative to a peer index. There are three performance metrics: 1) average annual earnings per share growth; 2) average annual total shareholder return; and 3) average annual return on average assets. Each metric is measured against companies in the KBW Regional Banking Index.

 

The Company has unvested restricted stock awards and PRSU grants of 227,324 shares at September 30, 2017. Unrecognized stock based compensation expense related to restricted stock awards totaled $9.3 million at September 30, 2017. At such date, the weighted-average period over which this unrecognized expense was expected to be recognized was 2.13 years. The following tables summarize the unvested restricted stock awards at September 30, 2017 and 2016.

 

   Nine Months Ended September 30, 
   2017   2016 
Perfomance Awards  Shares   Weighted-Average Grant Date Fair Value   Shares   Weighted-Average Grant Date Fair Value 
                 
Unvested at beginning   33,226   $42.60       $ 
Issued   36,523    57.49    34,957    42.60 
Forfeited   (3,097)   42.60    (1,731)   42.60 
Vested   (4,314)   54.92         
Unvested at end   62,338   $50.45    33,226   $42.60 

 

 

   Nine Months Ended September 30, 
   2017   2016 
Time Vested Awards  Shares   Weighted-Average Grant Date Fair Value   Shares   Weighted-Average Grant Date Fair Value 
                 
Unvested at beginning   262,966   $33.60    369,093   $24.43 
Issued   91,097    62.70    104,775    46.39 
Forfeited   (1,477)   47.69    (7,815)   40.17 
Vested   (187,600)   30.07    (195,738)   22.53 
Unvested at end   164,986   $53.56    270,315   $33.87 

 

 36

 

 

Below is a summary of stock option activity for the nine months ended September 30, 2017 and 2016. The information excludes restricted stock units and awards.

 

   Nine Months Ended September 30, 
   2017   2016 
   Shares   Weighted-Average Exercise Price   Shares   Weighted-Average Exercise Price 
                 
Beginning balance   216,859   $8.80    298,740   $9.97 
Issued           3,000    49.49 
Exercised   (64,420)   7.46    (24,458)   13.10 
Forfeited           (1,100)   15.48 
Expired           (6,637)   12.87 
Ending balance   152,439   $9.36    269,545   $10.03 

 

The following summarizes information about stock options outstanding at September 30, 2017. The information excludes restricted stock units and awards.

 

                Weighted-Average 
Outstanding:   Stock Options   Weighted-Average   Remaining 
Range of Exercise Prices   Outstanding   Exercise Price   Contractual Life 
$5.76   $10.72    101,075   $5.76    1.26 
$10.73   $11.40    41,389    10.84    0.77 
$11.41   $24.86    3,225    22.79    6.02 
$24.87   $49.91    6,750    47.83    8.37 
         152,439   $9.36    1.54 

 

Exercisable:   Stock Options   Weighted-Average 
Range of Exercise Prices   Exercisable   Exercise Price 
$5.76   $10.72    66,377   $5.76 
$10.73   $11.40    41,389    10.84 
$11.41   $24.86    2,065    23.18 
$24.87   $49.91    750    49.49 
         110,581   $8.28 

 

The fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option pricing model with the assumptions as shown in the table below used for grants during the years ended December 31, 2016 and 2015. There were no grants of stock options during the nine months ended September 30, 2017.

 

   Nine Months Ended   Years Ended December 31, 
   September 30, 2017   2016   2015 
Expected volatility   n/a    24.23%   31.21%
Weighted-Average volatility   n/a    24.23%   31.21%
Expected dividends            
Expected term (in years)   n/a    7.0    7.0 
Risk-free rate   n/a    1.37%   1.64%
Weighted-average fair value (grant date)   n/a   $14.27   $16.73 

 

 37

 

 

The total intrinsic value of outstanding stock options was $8.8 million at September 30, 2017. The total intrinsic value of stock options exercised during the nine months ended September 30, 2017 and 2016 was $3.5 million and $855 thousand, respectively. The total fair value of stock options vested was $50 thousand and $45 thousand for the nine months ended September 30, 2017 and 2016, respectively. Unrecognized stock-based compensation expense related to stock options totaled $90 thousand at September 30, 2017. At such date, the weighted-average period over which this unrecognized expense was expected to be recognized was 2.09 years.

 

Approved by shareholders in May 2011, the 2011 ESPP reserved 550,000 shares of common stock (as adjusted for stock dividends) for issuance to employees. Whole shares are sold to participants in the plan at 85% of the lower of the stock price at the beginning or end of each quarterly offering period. The 2011 ESPP is available to all eligible employees who have completed at least one year of continuous employment, work at least 20 hours per week and at least five months a year. Participants may contribute a minimum of $10 per pay period to a maximum of $6,250 per offering period or $25,000 annually (not to exceed more than 10% of compensation per pay period). At September 30, 2017, the 2011 ESPP had 406,081 shares remaining for issuance.

 

Included in salaries and employee benefits in the accompanying Consolidated Statements of Operations, the Company recognized $4.2 million and $5.2 million in stock-based compensation expense for the nine months ended September 30, 2017 and 2016, respectively. Stock-based compensation expense is recognized ratably over the requisite service period for all awards.

 

 38

 

 

Note 11. Other Comprehensive Income

 

The following table presents the components of other comprehensive income (loss) for the three and nine months ended September 30, 2017 and 2016.

 

(dollars in thousands)  Before Tax   Tax Effect   Net of Tax 
             
Three Months Ended September 30, 2017               
Net unrealized gain on securities available-for-sale  $25   $10   $15 
Less: Reclassification adjustment for net gains included in net income   (11)   (4)   (7)
Total unrealized gain   14    6    8 
                
Net unrealized gain on derivatives   557    210    347 
Less: Reclassification adjustment for gain included in net income   (289)   (106)   (183)
Total unrealized gain   268    104    164 
                
Other Comprehensive Income  $282   $110   $172 
                
Three Months Ended September 30, 2016               
Net unrealized loss on securities available-for-sale  $(1,512)  $(605)  $(907)
Less: Reclassification adjustment for net gains included in net income   1       1
Total unrealized loss   (1,511)   (605)   (906)
                
Net unrealized gain on derivatives   2,927    1,171    1,756 
Less: Reclassification adjustment for losses included in net income   (777)   (311)   (466)
Total unrealized gain   2,150    860    1,290 
                
Other Comprehensive Income  $639   $255   $384 
                
Nine Months Ended September 30, 2017               
Net unrealized gain on securities available-for-sale  $2,080   $837   $1,243 
Less: Reclassification adjustment for net gains included in net income   (542)   (202)   (340)
Total unrealized gain   1,538    635    903 
                
Net unrealized gain on derivatives   2,186    836    1,350 
Less: Reclassification adjustment for gain included in net income   (1,308)   (487)   (821)
Total unrealized gain   878    349    529 
                
Other Comprehensive Income  $2,416   $984   $1,432 
                
Nine Months Ended September 30, 2016               
Net unrealized gain on securities available-for-sale  $6,850   $2,740   $4,110 
Less: Reclassification adjustment for net gains included in net income   (1,123)   (449)   (674)
Total unrealized gain   5,727    2,291    3,436 
                
Net unrealized loss on derivatives   (9,132)   (3,654)   (5,478)
Less: Reclassification adjustment for losses included in net income   (1,519)   (608)   (911)
Total unrealized loss   (7,613)   (3,046)   (4,567)
                
Other Comprehensive Loss  $(1,886)  $(755)  $(1,131)

  

 39

 

 

The following table presents the changes in each component of accumulated other comprehensive (loss) income, net of tax, for the three and nine months ended September 30, 2017 and 2016.

 

   Securities       Accumulated Other 
(dollars in thousands)  Available For Sale   Derivatives   Comprehensive (Loss) Income 
             
Three Months Ended September 30, 2017               
Balance at Beginning of Period  $(1,060)  $(61)  $(1,121)
Other comprehensive income before reclassifications   15    347