10-Q 1 mbvt-20120630x10q.htm 10-Q b36f0153770c4c5

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

 

[ X ] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

 

For the quarterly period ended June 30, 2012

 

or

 

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

 

 

 

 

 

 

For the transition period from

 

 

to

 

 

Commission File Number:

0-11595

 

Merchants Bancshares, Inc.

(Exact name of registrant as specified in its charter)

 

Delaware 

 

03-0287342

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

 

275 Kennedy Drive, South Burlington, VT

 

 

05403

(Address of principal executive offices)

 

(Zip Code)

 

802-658-3400

(Registrant’s telephone number,  including area code)

 

Not Applicable

(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.    [ X ] 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).  [X] Yes            [  ] No

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

Large Accelerated Filer [   ]            Accelerated Filer [ X ]            Nonaccelerated Filer [   ]  Smaller Reporting Company [  ]

 

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).

[  ] Yes                                       [ X ] No

 

As of July 31, 2012, there were 6,270,611 shares of the registrant’s common stock, par value $0.01 per share, outstanding.

 


 

MERCHANTS BANCSHARES, INC.

FORM 10-Q

TABLE OF CONTENTS

 

PART I – FINANCIAL INFORMATION

 

Item 1.

Interim Consolidated Financial Statements (Unaudited)

 

 

 

 

 

Consolidated Balance Sheets

 

 

As of June 30, 2012 and December 31, 2011

3

 

 

 

 

Consolidated Statements of Income

 

 

Three and six months ended June 30, 2012 and 2011

4

 

 

 

 

Consolidated Statements of Comprehensive Income

 

 

Three and six months ended June 30, 2012 and 2011

5

 

 

 

 

Consolidated Statements of Cash Flows

 

 

Three and six months ended June 30, 2012 and 2011

6

 

 

 

 

Notes to Interim Unaudited Consolidated Financial Statements

8

 

 

 

Item 2.

Management's Discussion and Analysis of Financial

 

 

Condition and Results of Operations

28

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

41

Item 4.

Controls and Procedures

43

 

 

 

PART II – OTHER INFORMATION

 

Item 1.

Legal Proceedings

44

Item 1A.

Risk Factors

44

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

44

Item 3.

Defaults upon Senior Securities

44

Item 4.

Mine Safety Disclosure

44

Item 5.

Other Information

44

Item 6.

Exhibits

44

 

Signatures

45

 

Exhibits

 

 

 

 

 

 

 


 

 

ITEM 1. Financial Statements

 

Merchants Bancshares, Inc.

Consolidated Balance Sheets

(unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

June 30,

December 31,

(In thousands except share and per share data)

2012

2011

ASSETS

 

 

 

 

Cash and due from banks

$

30,459 

$

10,392 

Interest earning deposits with banks and other short-term investments

 

17,000 

 

27,420 

Total cash and cash equivalents

 

47,459 

 

37,812 

Investments:

 

 

 

 

Securities available for sale, at fair value

 

494,822 

 

511,751 

Securities held to maturity (fair value of $537 and $624)

 

481 

 

558 

Total investments

 

495,303 

 

512,309 

Loans

 

1,025,665 

 

1,027,626 

Less: Allowance for loan losses

 

11,203 

 

10,619 

Net loans

 

1,014,462 

 

1,017,007 

Federal Home Loan Bank stock

 

8,145 

 

8,630 

Bank premises and equipment, net

 

14,337 

 

14,232 

Investment in real estate limited partnerships

 

5,553 

 

5,189 

Other assets

 

16,506 

 

16,690 

Total assets

$

1,601,765 

$

1,611,869 

LIABILITIES

 

 

 

 

Deposits:

 

 

 

 

Demand (noninterest bearing)

$

211,916 

$

197,522 

Savings, interest bearing checking and money market accounts

 

680,803 

 

632,110 

Time deposits $100 thousand and greater

 

132,967 

 

127,303 

Other time deposits

 

214,460 

 

220,945 

Total deposits

 

1,240,146 

 

1,177,880 

Short-term borrowings

 

52,000 

 

Securities sold under agreements to repurchase

 

153,700 

 

262,527 

Other long-term debt

 

12,522 

 

22,562 

Junior subordinated debentures issued to unconsolidated subsidiary trust

 

20,619 

 

20,619 

Other liabilities

 

8,719 

 

18,744 

Total liabilities

 

1,487,706 

 

1,502,332 

Commitments and contingencies (Note 8)

 

 

 

 

SHAREHOLDERS' EQUITY

 

 

 

 

Preferred stock

 

 

 

 

Class A non-voting shares authorized - 200,000, none outstanding

 

 

Class B voting shares authorized - 1,500,000, none outstanding

 

 

Common stock, $.01 par value

 

67 

 

67 

Authorized 10,000,000 shares; issued 6,651,760 at June 30, 2012 and December 31, 2011

 

 

 

 

Outstanding: 5,942,064 at June 30, 2012 and 5,907,080 at December 31, 2011

 

 

 

 

Capital in excess of par value

 

36,649 

 

36,544 

Retained earnings

 

83,248 

 

79,393 

Treasury stock, at cost (709,696 shares at June 30, 2012 and 744,680 shares at December 31, 2011)

 

(15,128)

 

(15,817)

Deferred compensation arrangements

 

6,005 

 

6,248 

Accumulated other comprehensive income

 

3,218 

 

3,102 

Total shareholders' equity

 

114,059 

 

109,537 

Total liabilities and shareholders' equity

$

1,601,765 

$

1,611,869 

 

 

 

 

 

See accompanying notes to interim unaudited consolidated financial statements

 

3

 


 

Merchants Bancshares, Inc.

Consolidated Statements of Income

(Unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended

Six Months Ended

 

June 30,

June 30,

(In thousands except per share data)

2012

2011

2012

2011

INTEREST AND DIVIDEND INCOME

 

 

 

 

 

 

 

 

Interest and fees on loans

$

11,253 

$

11,190 

$

22,582 

$

22,189 

Investment income:

 

 

 

 

 

 

 

 

Interest and dividends on investment securities

 

2,983 

 

3,508 

 

6,063 

 

6,530 

Interest on interest earning deposits with banks and other short-term investments

 

10 

 

14 

 

20 

 

44 

Total interest and dividend income

 

14,246 

 

14,712 

 

28,665 

 

28,763 

INTEREST EXPENSE

 

 

 

 

 

 

 

 

Savings, interest bearing checking and money market accounts

 

201 

 

292 

 

427 

 

616 

Time deposits $100 thousand and greater

 

301 

 

296 

 

581 

 

608 

Other time deposits

 

426 

 

544 

 

880 

 

1,109 

Securities sold under agreement to repurchase and other short-term debt

 

537 

 

572 

 

1,113 

 

1,164 

Long-term debt

 

442 

 

515 

 

889 

 

1,021 

Total interest expense

 

1,907 

 

2,219 

 

3,890 

 

4,518 

Net interest income

 

12,339 

 

12,493 

 

24,775 

 

24,245 

Provision for credit losses

 

200 

 

250 

 

450 

 

250 

Net interest income after provision for credit losses

 

12,139 

 

12,243 

 

24,325 

 

23,995 

NONINTEREST INCOME

 

 

 

 

 

 

 

 

Net gains on investment securities

 

372 

 

137 

 

448 

 

127 

Trust division income

 

673 

 

632 

 

1,330 

 

1,255 

Service charges on deposits

 

991 

 

1,072 

 

1,968 

 

2,034 

Equity in losses of real estate limited partnerships

 

(409)

 

(426)

 

(819)

 

(883)

Gain on sale of other assets

 

334 

 

 

334 

 

Other

 

1,202 

 

1,145 

 

2,263 

 

2,120 

Total noninterest income

 

3,163 

 

2,560 

 

5,524 

 

4,653 

NONINTEREST EXPENSE

 

 

 

 

 

 

 

 

Compensation and benefits

 

4,759 

 

5,134 

 

9,947 

 

10,293 

Occupancy expense

 

923 

 

951 

 

1,897 

 

1,992 

Equipment expense

 

889 

 

813 

 

1,793 

 

1,602 

Legal and professional fees

 

666 

 

774 

 

1,277 

 

1,377 

Marketing

 

493 

 

445 

 

904 

 

784 

State franchise  taxes

 

316 

 

317 

 

644 

 

630 

FDIC insurance

 

212 

 

194 

 

427 

 

546 

Prepayment penalty

 

686 

 

 

686 

 

Other Real Estate Owned ("OREO") expenses

 

31 

 

65 

 

64 

 

81 

Other

 

1,670 

 

1,513 

 

3,109 

 

3,012 

Total noninterest expense

 

10,645 

 

10,206 

 

20,748 

 

20,317 

Income before provision for income taxes

 

4,657 

 

4,597 

 

9,101 

 

8,331 

Provision for income taxes

 

921 

 

968 

 

1,752 

 

1,601 

NET INCOME

$

3,736 

$

3,629 

$

7,349 

$

6,730 

 

 

 

 

 

 

 

 

 

Basic earnings per common share

$

0.60 

$

0.58 

$

1.18 

$

1.09 

Diluted earnings per common share

$

0.60 

$

0.58 

$

1.17 

$

1.08 

 

 

 

 

 

 

 

 

 

See accompanying notes to interim unaudited consolidated financial statements

 

4

 


 

 

 

Merchants Bancshares, Inc.

Consolidated Statements of Comprehensive Income

(Unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended

Six Months Ended

 

June 30, 

June 30, 

(In thousands)

2012

2011

2012

2011

Net income

$

3,736 

$

3,629 

$

7,349 

$

6,730 

Other comprehensive (loss) income,  net of tax:

 

 

 

 

 

 

 

 

Change in net unrealized (loss) gain on securities available for sale, net of taxes of $(88), $1,034, $118 and $869

 

(164)

 

1,921 

 

219 

 

1,614 

Reclassification adjustments for net securities gain included in net income, net of taxes of  $(131), $(48), $(157) and $(44)

 

(241)

 

(89)

 

(291)

 

(83)

Change in net unrealized loss on interest rate swaps, net of taxes of $1, $(72), $44 and $3

 

 

(134)

 

82 

 

Pension liability adjustment, net of taxes of $35, $25, $57 and $49

 

65 

 

45 

 

106 

 

91 

Other comprehensive (loss) income

 

(338)

 

1,743 

 

116 

 

1,627 

Comprehensive income

$

3,398 

$

5,372 

$

7,465 

$

8,357 

 

 

 

 

 

 

 

 

 

See accompanying notes to unaudited interim consolidated financial statements

 

 

 

5

 


 

 

 

 

 

 

Merchants Bancshares, Inc.

Consolidated Statements of Cash Flows

(Unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

Six Months Ended June 30,

(In thousands)

2012

2011

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

Net income

$

7,349 

$

6,730 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

Provision for loan losses

 

450 

 

250 

Depreciation and amortization

 

986 

 

918 

Amortization of investment security premiums and accretion of discounts, net

 

1,289 

 

2,784 

Stock option expense

 

96 

 

72 

Net gains on sales of investment securities

 

(448)

 

(127)

Net gains on sale of loans

 

 

(16)

Net losses (gains) on sale of premises and equipment

 

32 

 

(7)

Gain on sale of other assets

 

(334)

 

Gains on sale of other real estate owned

 

 

(33)

Equity in losses of real estate limited partnerships, net

 

819 

 

883 

Changes in assets and liabilities:

 

 

 

 

Increase in interest receivable

 

990 

 

414 

(Increase) decrease in other assets

 

(842)

 

1,132 

Decrease in interest payable

 

(38)

 

(37)

Decrease in other liabilities

 

(9,578)

 

(365)

Net cash provided by operating activities

 

771 

 

12,598 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

Proceeds from sales of investment securities available for sale

 

41,664 

 

77,030 

Proceeds from maturities of investment securities available for sale

 

105,423 

 

94,507 

Proceeds from maturities of investment securities held to maturity

 

77 

 

143 

Proceeds from redemption of Federal Home Loan Bank stock

 

485 

 

Purchases of investment securities available for sale

 

(131,110)

 

(110,758)

Loan originations less than (in excess of) principal payments

 

1,836 

 

(32,696)

Proceeds from sales of loans, net

 

 

53 

Proceeds from sale of other assets

 

334 

 

Proceeds from sale of premises and equipment

 

 

51 

Proceeds from sales of other real estate owned

 

112 

 

224 

Real estate limited partnership investments

 

(1,183)

 

(588)

Purchases of bank premises and equipment

 

(1,123)

 

(696)

Net cash provided by investing activities

 

16,515 

 

27,270 

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

Net increase in deposits

 

62,266 

 

10,902 

Net increase (decrease) in short-term borrowings

 

52,000 

 

(750)

Net decrease in securities sold under agreement to repurchase, short-term

 

(108,827)

 

(71,699)

Principal payments on long-term debt

 

(10,040)

 

(39)

Cash dividends paid

 

(3,149)

 

(3,097)

Sale of treasury stock

 

 

10 

Increase in deferred compensation arrangements

 

105 

 

112 

Net cash used in financing activities

 

(7,639)

 

(64,561)

Increase (decrease) in cash and cash equivalents

 

9,647 

 

(24,693)

Cash and cash equivalents beginning of period

 

37,812 

 

74,026 

Cash and cash equivalents end of period

$

47,459 

$

49,333 

 

 

 

 

 

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:

 

 

 

 

Total interest payments

$

3,928 

$

4,555 

Total income tax payments

 

2,850 

 

500 

SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES

 

 

 

 

Distribution of stock under deferred compensation arrangements

$

391 

$

432 

Distribution of treasury stock in lieu of cash dividend

 

344 

 

353 

Transfer of loans to other real estate owned

 

140 

 

Decrease in payable for investments purchased

 

(9,461)

 

 

 

 

 

 

See accompanying notes to unaudited interim consolidated financial statements

6

 


 

 

7

 


 

 

Notes To Interim Unaudited Consolidated Financial Statements

For additional information, see the Merchants Bancshares, Inc. (“Merchants, “we,” “us,” “our”) Annual Report on Form 10-K for the fiscal year ended December 31, 2011, filed with the Securities and Exchange Commission (the “SEC”) on March 8, 2012.

Note 1: Financial Statement Presentation

Principles of Consolidation

The accompanying unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to the Quarterly Report on Form 10-Q and Rule 10-01 of Regulation S-X promulgated under the Securities Exchange Act of 1934, as amended. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements. All adjustments necessary for a fair presentation of our interim consolidated financial statements as of June 30, 2012 and December 31, 2011 and for the three and six months ended June 30, 2012 and 2011 have been included. The information was prepared from our unaudited financial statements and the unaudited financial statements of our subsidiaries, Merchants Bank and MBVT Statutory Trust I.  Amounts reported for prior periods are reclassified, where necessary, to be consistent with the current period presentation.

Management’s Use of Estimates in Preparation of Financial Statements

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of income and expenses during the reporting periods. The most significant estimates include those used in determining the allowance for loan losses, income taxes, interest income recognition on loans and investments and analysis of other-than-temporary impairment of investment securities. Operating results in the future may vary from the amounts derived from our estimates and assumptions.

 

 

Note 2: Recent Accounting Pronouncements

In June 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2011-05, “Comprehensive Income (Topic 220) - Presentation of Comprehensive Income.” ASU 2011-05 requires that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements.  In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income.  In December 2011, FASB issued ASU 2011-12, which defers the effective date of the requirement in ASU 2011-05 to present items that are reclassified from accumulated other comprehensive income to net income alongside their respective components of net income and other comprehensive income. ASU 2011-05 was effective for us beginning January 1, 2012. Adoption of these updates did not have a material impact on our financial condition or results of operations.

In December 2011, the FASB issued ASU 2011-11, “Balance Sheet (Topic 210) – Disclosures about Offsetting Assets and Liabilities.” The amendments in this ASU require an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. The amendments in this ASU affect all entities that have financial instruments and derivative instruments that are either (1) offset in accordance with either Section 210-20-45 or Section 815-10-45 or (2) subject to an enforceable master netting arrangement or similar agreement. The requirements amend the disclosure requirements on offsetting in Section 210-20-50. An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented. We do not expect that this update will have a material impact on our financial condition or results of operations.

 

8

 


 

 

Note 3: Investment Securities

Investments in securities are classified as available for sale or held to maturity as of June 30, 2012.  The amortized cost and fair values of the securities classified as available for sale and held to maturity as of June 30, 2012 are as follows:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross

Gross

 

 

 

Amortized

Unrealized

Unrealized

Fair

(In thousands)

Cost

Gains

Losses

Value

Available for Sale:

 

 

 

 

 

 

 

 

U.S. Treasury Obligations

$

250 

$

$

$

250 

U.S. Agency Obligations

 

63,983 

 

816 

 

 

64,799 

Federal Home Loan Bank ("FHLB") Obligations

 

4,581 

 

68 

 

 

4,649 

Residential Real Estate Mortgage-backed Securities ("Agency MBSs")

 

166,709 

 

6,930 

 

 

173,639 

Agency Collateralized Mortgage Obligations ("Agency CMOs")

 

243,819 

 

2,591 

 

73 

 

246,337 

Non-agency Collateralized Mortgage Obligations ("Non-agency CMOs")

 

4,899 

 

 

170 

 

4,729 

Asset Backed Securities ("ABSs")

 

357 

 

62 

 

 

419 

Total Available for Sale

$

484,598 

$

10,467 

$

243 

$

494,822 

Held to Maturity:

 

 

 

 

 

 

 

 

Agency MBSs

$

481 

$

56 

$

$

537 

Total Held to Maturity

$

481 

$

56 

$

$

537 

 

 

The amortized cost and fair values of the securities classified as available for sale and held to maturity as of December 31, 2011 are as follows:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross

Gross

 

 

 

Amortized

Unrealized

Unrealized

Fair

(In thousands)

Cost

Gains

Losses

Value

Available for Sale:

 

 

 

 

 

 

 

 

U.S. Treasury Obligations

$

250 

$

$

$

250 

U.S. Agency Obligations

 

89,597 

 

828 

 

 

90,419 

FHLB Obligations

 

16,545 

 

134 

 

 

16,676 

Agency MBSs

 

176,756 

 

7,100 

 

18 

 

183,838 

Agency CMOs

 

211,749 

 

2,976 

 

245 

 

214,480 

Non-agency CMOs

 

5,346 

 

 

493 

 

4,855 

ABSs

 

1,172 

 

61 

 

 

1,233 

Total Available for Sale

$

501,415 

$

11,101 

$

765 

$

511,751 

Held to Maturity:

 

 

 

 

 

 

 

 

Agency MBSs

$

558 

$

66 

$

$

624 

Total Held to Maturity

$

558 

$

66 

$

$

624 

 

 

 

9

 


 

 

The contractual final maturity distribution of the debt securities classified as available for sale and held to maturity as of June 30, 2012 are as follows:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

After One

After Five

 

 

 

 

 

Within

But Within

But Within

After Ten

 

 

(In thousands)

One Year

Five Years

Ten Years

Years

Total

Available for Sale (at fair value):

 

 

 

 

 

 

 

 

 

 

U.S. Treasury Obligations

$

250 

$

$

$

$

250 

U.S. Agency Obligations

 

 

7,535 

 

57,264 

 

 

64,799 

FHLB Obligations

 

 

 

4,649 

 

 

4,649 

Agency MBSs

 

213 

 

4,162 

 

28,682 

 

140,582 

 

173,639 

Agency CMOs

 

 

 

6,427 

 

239,910 

 

246,337 

Non-agency CMOs

 

 

 

 

4,729 

 

4,729 

ABSs

 

 

 

 

419 

 

419 

Total Available for Sale

$

463 

$

11,697 

$

97,022 

$

385,640 

$

494,822 

Held to Maturity (at amortized cost):

 

 

 

 

 

 

 

 

 

 

Agency MBSs

$

$

114 

$

$

362 

$

481 

Total Held to Maturity

$

$

114 

$

$

362 

$

481 

 

 

The contractual final maturity distribution of the debt securities classified as available for sale and held to maturity as of December 31, 2011, are as follows:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

After One

After Five

 

 

 

 

 

Within

But Within

But Within

After Ten

 

 

(In thousands)

One Year

Five Years

Ten Years

Years

Total

Available for Sale (at fair value):

 

 

 

 

 

 

 

 

 

 

U.S. Treasury Obligations

$

250 

$

$

$

$

250 

U.S. Agency Obligations

 

3,023 

 

12,567 

 

69,823 

 

5,006 

 

90,419 

FHLB Obligations

 

3,389 

 

 

13,287 

 

 

16,676 

Agency MBSs

 

20 

 

6,118 

 

32,897 

 

144,803 

 

183,838 

Agency CMOs

 

 

 

3,056 

 

211,424 

 

214,480 

Non-agency CMOs

 

 

 

50 

 

4,805 

 

4,855 

ABSs

 

 

 

 

1,233 

 

1,233 

Total Available for Sale

$

6,682 

$

18,685 

$

119,113 

$

367,271 

$

511,751 

Held to Maturity (at amortized cost):

 

 

 

 

 

 

 

 

 

 

Agency MBSs

$

$

158 

$

$

400 

$

558 

Total Held to Maturity

$

$

158 

$

$

400 

$

558 

 

 

Actual maturities will differ from contractual maturities because borrowers may have rights to call or prepay obligations.  Maturities of Agency MBSs and Agency CMOs are based on final contractual maturities.

 

Proceeds from sales of available for sale debt securities were $27.03 million and $41.66 million for the three and six months ended June 30, 2012, respectively.  Gross gains of $372 thousand and $494 thousand and gross losses of zero and $46 thousand were realized from these sales for the three and six months ended June 30, 2012. Proceeds from sales of available for sale debt securities were $54.54 million and $77.03 million during the three and six months ended June 30, 2011, respectively. Gross gains of $204 thousand and $218 thousand and gross losses of $67 thousand and $91 thousand were realized from these sales during the three and six months ended June 30, 2011, respectively.

10

 


 

 

Gross unrealized losses on investment securities available for sale and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in continuous unrealized loss position, at June 30, 2012 and December 31, 2011, were as follows:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Less than 12 months

12 months or more

Total

(In thousands)

Fair Value

Loss

Fair Value

Loss

 

Fair Value

Loss

As of June 30, 2012

 

 

 

 

 

 

 

 

 

 

 

 

Agency CMOs

$

31,773 

$

73 

$

$

$

31,773 

$

73 

Non-agency CMOs

 

 

 

4,728 

 

170 

 

4,728 

 

170 

 

$

31,773 

$

73 

$

4,728 

$

170 

$

36,501 

$

243 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Less than 12 months

12 months or more

Total

(In thousands)

Fair Value

Loss

Fair Value

Loss

Fair Value

Loss

As of December 31, 2011

 

 

 

 

 

 

 

 

 

 

 

 

U.S. Agency Obligations

$

2,536 

$

$

$

$

2,536 

$

FHLB Obligations

 

5,047 

 

 

 

 

5,047 

 

Agency MBSs

 

10,452 

 

18 

 

 

 

10,452 

 

18 

Agency CMOs

 

43,708 

 

205 

 

2,861 

 

40 

 

46,569 

 

245 

Non-agency CMOs

 

 

 

4,805 

 

493 

 

4,805 

 

493 

 

$

61,743 

$

232 

$

7,666 

$

533 

$

69,409 

$

765 

 

 

 

 

There were no securities held to maturity with unrealized losses as of June 30, 2012 and December 31, 2011.

Unrealized losses on investment securities result from the cost basis of the security being higher than its current fair value. These discrepancies generally occur because of changes in interest rates since the time of purchase, or because the credit quality of the issuer has deteriorated. We perform a quarterly analysis of each security in our portfolio to determine if impairment exists, and if it does, whether that impairment is other-than-temporary.  

Agency MBSs and Agency CMOs consist of pools of residential mortgages which are guaranteed by the Federal National Mortgage Association (“FNMA”), Federal Home Loan Mortgage Corporation (“FHLMC”), or the Government National Mortgage Association (“GNMA”) with various origination dates and maturities.  Non-Agency CMOs are tracked individually and their performance is tracked at least quarterly. 

We use an external pricing service to obtain fair market values for our investment portfolio.  We have obtained and reviewed the service provider’s pricing and reference data document. Evaluations are based on market data and vary by asset class and incorporate available trade, bid and other market information.  Because many fixed income securities do not trade on a daily basis, the service provider’s evaluated pricing applications apply available information through processes such as benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing, to prepare evaluations.  In addition, model processes, such as the Option Adjusted Spread model are used to assess interest rate impact and develop prepayment scenarios. We test the values provided to us by the pricing service through a combination of back testing on actual sales of securities and by obtaining prices on all bonds from an alternative pricing source.

Our investment portfolio consists almost entirely of U.S. Treasury and Agency obligations, or Agency-guaranteed mortgage securities.  We have two non-agency CMOs with a current cost basis of $4.90 million.  Management, with the help of outside experts, has performed impairment analyses on these bonds.

One of the non-Agency CMOs, with a cost basis of $3.27 million and a fair value of $3.17 million at June 30, 2012, is rated BBB by Fitch and Ba3 by Moody’s.  Delinquencies have been fairly low and prepayments on the bond have led to increased credit support.  We own a senior tranche in this bond. Although losses are expected in the bond overall, our position in the structure of the bond is expected to protect us from realizing losses. The second bond has a cost basis of $1.63 million and a fair value of $1.56 million.  This bond is rated CCC by Fitch and S&P. We own a super senior tranche in this bond. Although losses are expected in the bond overall, our super senior position in the structure is expected to protect us from realizing a material loss. 

We do not intend to sell the investment securities that are in an unrealized loss position, and it is unlikely that we will be required to sell the investment securities before recovery of their amortized cost bases, which may be maturity. 

As a member of the FHLB system, we are required to invest in stock of the FHLB of Boston (the “FHLBB”) in an amount determined based on our borrowings from the FHLBB.  At June 30, 2012, our investment in FHLBB stock totaled $8.15 million, a decrease of $485 thousand from our year end balance of $8.63 million.  We received dividend income totaling $8 thousand and $25 thousand during the three and six months ended June 30, 2012, respectively. We received $6 thousand and $13 thousand for the three and six months ended June 30, 2011, respectively. 

 

11

 


 

 

Note 4: Loans and the Allowance for Credit Losses

Loans

We primarily originate residential real estate, commercial, commercial real estate, municipal obligations and installment loans to customers throughout the state of Vermont. There are no significant industry concentrations in the loan portfolio. Loans totaled $1.03 billion at June 30, 2012 and $1.03 billion at December 31, 2011.  At June 30, 2012 and December 31, 2011, total loans included  $(30) thousand and $11 thousand, respectively, of net deferred loan origination fees (costs). The aggregate amount of overdrawn deposit balances classified as loan balances was $356 thousand and $399 thousand at June 30, 2012 and December 31, 2011, respectively.

 

Allowance for Credit Losses

We have divided the loan portfolio into portfolio segments, each with different risk characteristics and methodologies for assessing risk.  Each portfolio segment is broken down into class segments where appropriate.  Class segments contain unique measurement attributes, risk characteristics and methods for monitoring and assessing risk that are necessary to develop the allowance for loan and lease losses.  Unique characteristics such as borrower type, loan type, collateral type, and risk characteristics define each class segment.  A description of the segments follows:

Commercial, financial and agricultural:  We offer a variety of loan options to meet the specific needs of commercial customers including term loans and lines of credit.  Such loans are made available to businesses to finance inventory and receivables, business expansion and equipment purchases. Generally, a collateral lien is placed on equipment, receivables, inventory or other assets owned by the borrower.  These loans require different monitoring than commercial real estate loans because of the nature of the underlying collateral, and the fact that collateral values may change daily.  Management generally employs enhanced monitoring requirements, obtains personal guarantees and, where appropriate, may also attempt to secure real estate as collateral.

Municipal: Municipal loans consist of short and long term loans issued on a taxable and tax-exempt basis which are general obligations of the municipality. These loans are generally viewed as lower risk as municipalities have taxing power to meet their financial obligations.  Included in municipal loans are longer term loans under the federal Qualified School Construction Bond program. Proceeds are used for the construction, rehabilitation or repair of public school properties and we receive a federal tax credit in lieu of interest income on these loans.

Real Estate – Residential: Residential real estate loans consist primarily of loans secured by first or second mortgages on primary residences.  We originate adjustable-rate and fixed-rate, one- to four-family residential real estate loans for the construction, purchase or refinancing of a mortgage.  These loans are collateralized by owner-occupied properties located in our market area.  Loans on one- to four-family residential real estate are generally originated in amounts of no more than 80 percent of the purchase price or appraised value (whichever is lower).   Mortgage title insurance and hazard insurance are required.

Real Estate – Commercial: We offer commercial real estate loans to finance real estate purchases and refinancing of existing commercial properties.   These commercial real estate loans are secured by first liens on the real estate, which may include both owner occupied and non owner occupied facilities.  The types of facilities financed include apartments, hotels, warehouses, retail facilities, manufacturing facilities and office buildings.

Real Estate – Construction: We offer construction loans for the construction, expansion and improvement of residential and commercial properties which are secured by the real estate being developed. A review of all plans and budgets is performed prior to approval, third party progress documents are usually required during construction, and an independent approval process for all draw and release requests is maintained  to ensure that funding is prudently administered and that funds are sufficient to complete the project.

Installment - We offer traditional direct consumer installment loans for various personal needs, including vehicle financing. The vast majority of these loans are secured by a lien on the purchased vehicle and are underwritten using credit scores and income verification. We do not provide any indirect consumer lending activities.

For purposes of evaluating the adequacy of the allowance for credit losses, we consider a number of significant factors that affect the collectability of the portfolio. For individually evaluated loans, these include estimates of loss exposure, which reflect the facts and circumstances that affect the likelihood of repayment of such loans as of the evaluation date. For homogeneous pools of loans and leases, estimates of our exposure to credit loss reflect a current assessment of a number of factors, which could affect collectability.  These factors include:  past loss experience; size, trend, composition, and nature of loans; changes in lending policies and procedures, including underwriting standards and collection, charge-offs and recoveries; trends experienced in nonperforming and delinquent loans; current economic conditions in our market; the effect of external factors such as competition, legal and regulatory requirements; and the experience, ability, and depth of lending management and staff. Qualitative factors used in the evaluation of the adequacy of the allowance are reviewed and updated on a quarterly basis, these factors directly impact the allocation of the allowance. Past loss experience is based on net loan losses as a percentage of portfolio balances, using a five year weighted average.  An external loan review firm and various regulatory agencies periodically review our allowance for credit losses.  

After a thorough consideration of the factors discussed above, any required additions to the allowance for credit losses are made periodically by charges to the provision for credit losses. These charges are necessary to maintain the allowance for credit losses at a

12

 


 

level which Management believes is reasonable for the overall inherent risk of probable loss in the portfolio. While Management uses available information to recognize losses on loans, additions may fluctuate from one reporting period to another.  These fluctuations are reflective of changes in risk associated with portfolio content and/or changes in Management’s assessment of any or all of the determining factors discussed above. 

The following table reflects our loan loss experience and activity in the allowance for credit losses for the three months ended June 30, 2012:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(In thousands)

Commercial, financial and agricultural

Municipal

Real estate- residential

Real estate- commercial

Real estate-construction

Installment

All other

Totals

Allowance for credit losses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Beginning balance

$

2,733 

$

542 

$

3,374 

$

4,684 

$

280 

$

18 

$

$

11,632 

Charge-offs

 

(9)

 

 

(20)

 

 

 

 

 

(29)

Recoveries

 

(2)

 

 

12 

 

(1)

 

 

 

 

14 

Provision (credit)

 

380 

 

(132)

 

110 

 

(126)

 

(52)

 

 

17 

 

200 

Ending balance

$

3,102 

$

410 

$

3,476 

$

4,557 

$

233 

$

21 

$

18 

$

11,817 

 

The following table reflects our loan loss experience and activity in the allowance for credit losses for the six months ended June 30, 2012, and our loan portfolio as of June 30, 2012:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(In thousands)

Commercial, financial and agricultural

Municipal

Real estate- residential

Real estate- commercial

Real estate-construction

Installment

All other

Totals

Allowance for credit losses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Beginning balance

$

2,905 

$

309 

$

3,138 

$

4,484 

$

477 

$

23 

$

17 

$

11,353 

Charge-offs

 

(9)

 

 

(20)

 

 

 

 

 

(29)

Recoveries

 

18 

 

 

12 

 

 

13 

 

 

 

43 

Provision (credit)

 

188 

 

101 

 

346 

 

73 

 

(257)

 

(2)

 

 

450 

Ending balance

$

3,102 

$

410 

$

3,476 

$

4,557 

$

233 

$

21 

$

18 

$

11,817 

Ending balance individually

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

evaluated for impairment

$

$

$

201 

$

$

$

$

$

204 

Ending balance collectively

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

evaluated for impairment

 

3,099 

 

410 

 

3,275 

 

4,557 

 

233 

 

21 

 

18 

 

11,613 

Totals

$

3,102 

$

410 

$

3,476 

$

4,557 

$

233 

$

21 

$

18 

$

11,817 

Financing receivables:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Ending balance individually

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

evaluated for impairment

$

69 

$

$

2,479 

$

582 

$

$

$

$

3,130 

Ending balance collectively

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

evaluated for impairment

 

173,045 

 

42,578 

 

461,723 

 

329,116 

 

9,875 

 

5,842 

 

356 

 

1,022,535 

Totals

$

173,114 

$

42,578 

$

464,202 

$

329,698 

$

9,875 

$

5,842 

$

356 

$

1,025,665 

Components:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Allowance for loan losses

$

2,673 

$

408 

$

3,384 

$

4,520 

$

179 

$

21 

$

18 

$

11,203 

Reserve for undisbursed

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

lines of credit

 

429 

 

 

92 

 

37 

 

54 

 

 

 

614 

Total allowance for credit

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

losses

$

3,102 

$

410 

$

3,476 

$

4,557 

$

233 

$

21 

$

18 

$

11,817 

 

 

 

13

 


 

The following table reflects our loan loss experience and activity in the allowance for credit losses for the three months ended June 30, 2011:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(In thousands)

Commercial, financial and agricultural

Municipal

Real estate- residential

Real estate- commercial

Real estate-construction

Installment

All other

Totals

Allowance for credit losses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Beginning balance

$

2,689 

$

289 

$

2,683 

$

4,708 

$

248 

$

28 

$

111 

$

10,756 

Charge-offs

 

(34)

 

 

(41)

 

(60)

 

 

 

 

(135)

Recoveries

 

23 

 

 

 

 

 

 

 

30 

Provision (credit)

 

444 

 

(174)

 

(79)

 

208 

 

(61)

 

(4)

 

(84)

 

250 

Ending balance

$

3,122 

$

115 

$

2,563 

$

4,856 

$

193 

$

25 

$

27 

$

10,901 

 

 

 

The following table reflects our loan loss experience and activity in the allowance for credit losses for the six months ended June 30, 2011, and our loan portfolio as of June 30, 2011:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(In thousands)

Commercial, financial and agricultural

Municipal

Real estate- residential

Real estate- commercial

Real estate-construction

Installment

All other

Totals

Allowance for credit losses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Beginning balance

$

2,617 

$

236 

$

2,428 

$

5,143 

$

283 

$

24 

$

23 

$

10,754 

Charge-offs

 

(77)

 

 

(49)

 

(60)

 

(11)

 

(8)

 

 

(205)

Recoveries

 

44 

 

 

 

43 

 

11 

 

 

 

102 

Provision (credit)

 

538 

 

(121)

 

183 

 

(270)

 

(90)

 

 

 

250 

Ending balance

$

3,122 

$

115 

$

2,563 

$

4,856 

$

193 

$

25 

$

27 

$

10,901 

Ending balance individually

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

evaluated for impairment

$

130 

$

$

79 

$

$

$

$

$

209 

Ending balance collectively

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

evaluated for impairment

 

2,992 

 

115 

 

2,484 

 

4,856 

 

193 

 

25 

 

27 

 

10,692 

Totals

$

3,122 

 

115 

$

2,563 

$

4,856 

$

193 

$

25 

$

27 

$

10,901 

Financing receivables:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Ending balance individually

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

evaluated for impairment

$

428 

$

$

2,199 

$

656 

$

158 

$

$

$

3,444 

Ending balance collectively

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

evaluated for impairment

 

165,237 

 

37,933 

 

416,047 

 

303,691 

 

10,145 

 

6,316 

 

537 

 

939,906 

Totals

$

165,665 

$

37,933 

$

418,246 

$

304,347 

$

10,303 

$

6,319 

$

537 

$

943,350 

Components:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Allowance for loan losses

$

2,806 

$

115 

$

2,492 

$

4,796 

$

177 

$

25 

$

27 

$

10,438 

Reserve for undisbursed

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

lines of credit

 

316 

 

 

71 

 

60 

 

16 

 

 

 

463 

Total allowance for credit

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

losses

$

3,122 

$

115 

$

2,563 

$

4,856 

$

193 

$

25 

$

27 

$

10,901 

 

 

 

14

 


 

 

Presented below is an aging of past due loans, including both non-accrual and restructured loans, by class as of June 30, 2012:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

30-59 Days

60-89 Days

Over 90 Days

Total Past

 

 

Greater Than 90 Days and

(In thousands)

Past Due

Past Due

Past Due

Due

Current

Total

Accruing

Commercial, financial and agricultural

$

$

$

$

$

173,105 

$

173,114 

$

Municipal

 

 

 

 

 

42,578 

 

42,578 

 

Real estate-residential:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

First mortgage

 

 

413 

 

603 

 

1,016 

 

424,524 

 

425,540 

 

Second mortgage

 

700 

 

 

204 

 

904 

 

37,758 

 

38,662 

 

Real estate-commercial:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Owner occupied

 

 

76 

 

325 

 

401 

 

219,602 

 

220,003 

 

Non-owner occupied

 

 

 

 

 

109,695 

 

109,695 

 

Real estate-construction:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Residential

 

 

 

 

 

1,749 

 

1,749 

 

Commercial

 

 

 

 

 

8,126 

 

8,126 

 

Installment

 

 

 

 

 

5,842 

 

5,842 

 

Other

 

 

 

 

 

356 

 

356 

 

Total

$

700 

$

489 

$

1,141 

$

2,330 

$

1,023,335 

$

1,025,665 

$

 

 

Non-accruing and restructured loans make up $2.33 million of the total past due loans in the aging table above.  

 

Presented below is an aging of past due loans, including both non-accrual and restructured loans, by class as of December 31, 2011:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

30-59 Days

60-89 Days

Over 90 Days

Total Past

 

 

Greater Than 90 Days and

 

Past Due

Past Due

Past Due

Due

Current

Total

Accruing

Commercial, financial and agricultural

$

$

40 

$

$

48 

$

146,942 

$

146,990 

$

Municipal

 

 

 

 

 

101,705 

 

101,705 

 

Real estate-residential:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

First mortgage

 

39 

 

305 

 

731 

 

1,075 

 

400,256 

 

401,331 

 

Second mortgage

 

 

 

281 

 

281 

 

38,206 

 

38,487 

 

Real estate-commercial:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Owner occupied

 

 

325 

 

87 

 

412 

 

205,844 

 

206,256 

 

Non-owner occupied

 

 

 

 

 

107,659 

 

107,659 

 

Real estate-construction:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Residential

 

 

 

 

 

1,798 

 

1,798 

 

Commercial

 

 

 

 

 

17,195 

 

17,195 

 

Installment

 

 

 

 

 

5,806 

 

5,806 

 

Other

 

 

 

 

 

399 

 

399 

 

Total

$

39 

$

670 

$

1,107 

$

1,816 

$

1,025,810 

$

1,027,626 

$

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Non-accruing and restructured loans make up $1.60 million of the total past due loans in the aging table above.

 

15

 


 

 

Impaired loans by class at June 30, 2012 were as follows:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(In thousands)

Recorded Investment

Unpaid Principal Balance

Related Allowance

With no related allowance recorded

 

 

 

 

 

 

Commercial, financial and agricultural

$

49 

$

998 

$

Real estate – residential:

 

 

 

 

 

 

First mortgage

 

1,017 

 

1,281 

 

Second mortgage

 

904 

 

906 

 

Real estate – commercial:

 

 

 

 

 

 

Owner occupied

 

582 

 

743 

 

Non-owner occupied

 

 

70 

 

Real estate – construction:

 

 

 

 

 

 

Commercial

 

 

94 

 

Installment

 

 

45 

 

With related allowance recorded

 

 

 

 

 

 

Commercial, financial and agricultural

 

20 

 

33 

 

Real estate – residential:

 

 

 

 

 

 

First mortgage

 

558 

 

572 

 

201 

Second mortgage

 

 

 

Real estate – commercial:

 

 

 

 

 

 

Owner occupied

 

 

 

Total

 

 

 

 

 

 

Commercial, financial and agricultural

 

69 

 

1,031 

 

Real estate – residential

 

2,479 

 

2,759 

 

201 

Real estate – commercial

 

582 

 

813 

 

Real estate – construction

 

 

94 

 

Installment and other

 

 

45 

 

Total

$

3,130 

$

4,742 

$

204 

 

 

16

 


 

Impaired loans by class at June 30, 2011 were as follows:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(In thousands)

Recorded Investment

Unpaid Principal Balance

Related Allowance

With no related allowance recorded

 

 

 

 

 

 

Commercial, financial and agricultural

$

133 

$

1,196 

$

Real estate – residential:

 

 

 

 

 

 

First mortgage

 

1,131 

 

1,373 

 

Second mortgage

 

328 

 

328 

 

Real estate – commercial:

 

 

 

 

 

 

Owner occupied

 

475 

 

475 

 

Non-owner occupied

 

181 

 

251 

 

Real estate – construction:

 

 

 

 

 

 

Commercial

 

158 

 

325 

 

Installment

 

 

27 

 

With related allowance recorded

 

 

 

 

 

 

Commercial, financial and agricultural

 

295 

 

295 

 

130 

Real estate – residential:

 

 

 

 

 

 

First mortgage

 

681 

 

681 

 

76 

Second mortgage

 

59 

 

59 

 

Real estate – commercial:

 

 

 

 

 

 

Non-owner occupied

 

 

 

Total

 

 

 

 

 

 

Commercial, financial and agricultural

 

428 

 

1,491 

 

130 

Real estate – residential

 

2,199 

 

2,441 

 

79 

Real estate – commercial

 

656 

 

726 

 

Real estate – construction

 

158 

 

325 

 

Installment and other

 

 

27 

 

Total

$

3,444 

$

5,010 

$

209 

 

 

 

 

17

 


 

The average recorded investment and interest income recognized on impaired loans for the three and six months ended June 30, 2012 were as follows:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three months

 

Six months

(In thousands)

Average Recorded Investment

Interest Income Recognized

 

Average Recorded Investment

Interest Income Recognized

With no related allowance recorded

 

 

 

 

 

 

 

 

 

Commercial, financial and agricultural

$

54 

$

 

$

62 

$

Real estate – residential:

 

 

 

 

 

 

 

 

 

First mortgage

 

747 

 

16 

 

 

782 

 

20 

Second mortgage

 

443 

 

27 

 

 

321 

 

27 

Real estate – commercial:

 

 

 

 

 

 

 

 

 

Owner occupied

 

531 

 

 

 

433 

 

Non-owner occupied

 

 

 

 

 

Real estate – construction:

 

 

 

 

 

 

 

 

 

Commercial

 

 

 

 

 

Installment

 

 

 

 

 

With related allowance recorded

 

 

 

 

 

 

 

 

 

Commercial, financial and agricultural

 

24 

 

 

 

28 

 

Real estate – residential:

 

 

 

 

 

 

 

 

 

First mortgage

 

624 

 

 

 

704 

 

Second mortgage

 

17 

 

 

 

50 

 

Real estate – commercial:

 

 

 

 

 

 

 

 

 

Owner occupied

 

 

 

 

54 

 

Total

 

 

 

 

 

 

 

 

 

Commercial, financial and agricultural

 

78 

 

 

 

90 

 

Real estate – residential

 

1,831 

 

43 

 

 

1,857 

 

47 

Real estate – commercial

 

531 

 

 

 

487 

 

Real estate – construction

 

 

 

 

 

Installment and other

 

 

 

 

 

Total

$

2,440 

$

46 

 

$

2,434 

$

51 

 

 

 

18

 


 

The average recorded investment and interest income recognized on impaired loans for the three and six months ended June 30, 2011 were as follows:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three months

 

Six months

(In thousands)

Average Recorded Investment

Interest Income Recognized

 

Average Recorded Investment

Interest Income Recognized

With no related allowance recorded

 

 

 

 

 

 

 

 

 

Commercial, financial and agricultural

$

145 

$

 

$

186 

$

Real estate – residential:

 

 

 

 

 

 

 

 

 

First mortgage

 

1,167 

 

 

 

1,180 

 

Second mortgage

 

411 

 

 

 

443 

 

Real estate – commercial:

 

 

 

 

 

 

 

 

 

Owner occupied

 

483 

 

 

 

474 

 

Non-owner occupied

 

60 

 

 

 

69 

 

Real estate – construction:

 

 

 

 

 

 

 

 

 

Commercial

 

158 

 

 

 

161 

 

Installment

 

 

 

 

 

With related allowance recorded

 

 

 

 

 

 

 

 

 

Commercial, financial and agricultural

 

306 

 

 

 

390 

 

Real estate – residential:

 

 

 

 

 

 

 

 

 

First mortgage

 

637 

 

 

 

628 

 

Second mortgage

 

20 

 

 

 

10 

 

Real estate – commercial:

 

 

 

 

 

 

 

 

 

Non-owner occupied

 

122 

 

 

 

92 

 

Total

 

 

 

 

 

 

 

 

 

Commercial, financial and agricultural

 

451 

 

 

 

576 

 

Real estate – residential

 

2,235 

 

 

 

2,261 

 

Real estate – commercial

 

665 

 

 

 

635 

 

Real estate – construction

 

158 

 

 

 

161 

 

Installment and other

 

 

 

 

 

Total

$

3,512 

$

 

$

3,637 

$

 

 

 

 

Impaired loans at June 30, 2012 consisted predominantly of residential real estate loans. Impaired loans totaled $3.13 million and $2.51 million at June 30, 2012 and December 31, 2011, respectively.  At June 30, 2012, $578 thousand of the impaired loans had a specific reserve allocation of $204 thousand, and $2.55 million of the impaired loans had no specific reserve allocation. At December 31, 2011, $885 thousand of the impaired loans had a specific reserve allocation of $227 thousand, and $1.63 million of the impaired loans had no specific reserve allocation.

We recorded interest income on impaired loans of approximately $46 thousand and $51 thousand during the three and six months ended June 30, 2012, respectively. No interest was recorded on a cash basis during the period the loan was impaired.  We recorded interest income on impaired loans of approximately $4 thousand and $7 thousand during the three and six months ended June 30, 2011, respectively. No interest was recorded on a cash basis during the period the loan was impaired. The average balance of impaired loans was $2.43 million and $3.64 million during the first six months of 2012 and the first six months of 2011, respectively

19

 


 

Nonperforming loans at June 30, 2012 and December 31, 2011 were as follows:

 

 

 

 

 

 

 

 

 

 

(In thousands)

June 30, 2012

December 31, 2011

Nonaccrual  loans

$

2,559 

$

1,953 

Loans greater than 90 days and accruing

 

 

Troubled debt restructured loans (“TDRs”)

 

571 

 

558 

Total nonperforming loans

$

3,130 

$

2,511 

 

 

Of the total TDRs in the table above, $145 thousand at June 30, 2012 and $224 thousand at December 31, 2011, are non-accruing.

The loans in the table below are considered impaired under the guidance in ASC 310-10-35.  Included in the total TDRs of $571  thousand at June 30, 2012 are $297 thousand of TDRs that were restructured prior to January 1, 2012. The TDRs above have been individually evaluated for impairment. There were no TDRs for which the allowance for credit losses was measured under a general allowance for credit losses methodology.

 

Presented below is a summary of our restructurings during the three months and six months ended June 30, 2012:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three months ended

 

Six months ended

 

 

Pre-modification

Post-modification

 

 

Pre-modification

Post-modification

 

 

Outstanding

Outstanding

 

 

Outstanding

Outstanding

 

Number

Recorded

Recorded

 

Number

Recorded

Recorded

(Dollars in thousands)

of Loans

Investment

Investment

 

of Loans

Investment

Investment

Real estate – residential:

 

 

 

 

 

 

 

 

 

 

 

First mortgage

$

93 

$

93 

 

$

93 

$

93 

Real estate - commercial:

 

 

 

 

 

 

 

 

 

 

 

Owner occupied

$

$

 

 

182 

 

182 

 

 

 

The loans in the table above were classified as TDRs because the borrowers experienced financial difficulties and the bank granted concessions in loan terms. As of June 30, 2012 one loan  classified as TDR in 2012 totaling $25 thousand was  in nonaccrual and the remaining loans were accruing.

TDRs consist of eight residential real estate loans and one commercial real estate loan at June 30, 2012. All nine borrowers experienced financial difficulties that led to the restructure of their respective loans. At the time of restructure, seven were in payment default and all nine demonstrated cash flow insufficient to service their debt as well as an inability to obtain funds at market rates from other sources.  At June 30, 2012, six of the restructured loans were performing in accordance with modified agreements, while three residential loans totaling $145 thousand were in default and in non-accrual. One loan that was restructured in a prior period with a balance of $207 thousand paid off during the first quarter of 2012.    

There was one loan restructured during the three months ended June 30, 2011.  TDRs at June 30, 2011, consisted of three residential real estate loans. One of the loans was restructured with longer terms at market rates and two were restructured with rate concessions; all were performing in accordance with modified agreements with the borrowers at June 30, 2011.  At June 30, 2011 there were no defaults on TDRs. 

There were no commitments to lend additional funds to borrowers whose loans were modified in a troubled debt restructuring at June 30, 2012 or at June 30, 2011.  We had no commitments to lend additional funds to borrowers whose loans were in non-accrual status or to borrowers whose loans were 90 days past due and still accruing at June 30, 2012 or at June 30, 2011. 

We recorded interest income on restructured loans of $18 thousand and $22 thousand for the three and six months ended June 30, 2012, respectively, and $1 thousand and $4 thousand for the three and six months ended June 30, 2011, respectively. 

We had $386 thousand in OREO at June 30, 2012, compared with $358 thousand at December 31, 2011 consisting of three properties plus equipment. Two properties and the equipment are expected to be sold in the third quarter of 2012. Our OREO balance was $0 at June 30, 2011.

20

 


 

Non-accrual loans by class as of June 30, 2012 and December 31, 2011 were as follows:

 

 

 

 

 

 

 

 

 

 

(In thousands)

June 30, 2012

December 31, 2011

Commercial, financial and agricultural

$

69 

$

114 

Real estate - residential:

 

 

 

 

First mortgage

 

1,186 

 

1,146 

Second mortgage

 

903 

 

281 

Real estate - commercial:

 

 

 

 

Owner occupied

 

401 

 

412 

Nonaccrual non-TDR loans

$

2,559 

$

1,953 

Nonaccruing TDR’s

 

 

 

 

Real estate – residential:

 

 

 

 

First mortgage

 

145 

 

224 

Total nonaccrual loans

$

2,704 

$

2,177 

 

 

Commercial Grading System

We use risk rating definitions for our commercial loan portfolios and certain residential loans which are generally consistent with regulatory and banking industry norms. Loans are assigned a credit quality grade which is based upon management’s on-going assessment of risk based upon an evaluation of the quantitative and qualitative aspects of each credit. This assessment is a dynamic process and risk ratings are adjusted as each borrower’s financial situation changes. This process is designed to provide timely recognition of a borrower’s financial condition and appropriately focus management resources.

Pass rated loans exhibit acceptable risk to the bank in terms of financial capacity to repay their loans as well as possessing acceptable fallback repayment sources, typically collateral and personal guarantees. These loans are subject to a formal annual review process, additionally, Management reviews the risk rating at the time of any late payments, overdrafts or other sign of deterioration in the interim.

Loans rated Pass-Watch require more than usual attention and monitoring by the account officer, though not to the extent that a formal remediation plan is warranted. Borrowers can be rated Pass-Watch based upon a weakened capital structure, adequate but low cash flow and/or collateral coverage or early-stage declining trends in operations or financial condition.

Loans rated Special Mention possess potential weakness that may expose the bank to some risk of loss in the future. These loans require more frequent monitoring and formal reporting to Management.

Substandard loans reflect well-defined weaknesses in the current repayment capacity, collateral or net worth of the borrower with the possibility of some loss to the Bank if these weaknesses are not corrected. Action plans are required for these loans to address the inherent weakness in the credit and are formally reviewed.

Below is a summary of loans by credit quality indicator as of June 30, 2012:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unrated

 

 

 

 

 

 

 

 

 

 

 

Residential

 

 

 

 

 

 

 

 

 

 

 

and

 

 

Pass-

Special

Sub-

 

 

(In thousands)

 Consumer

Pass

Watch

Mention

Standard

Total

Commercial, financial and agricultural

$

$

161,577 

$

8,623 

$

187 

$

2,727 

$

173,114 

Municipal

 

 

42,578 

 

 

 

 

42,578 

Real estate – residential:

 

 

 

 

 

 

 

 

 

 

 

 

First mortgage

 

400,406 

 

22,150 

 

1,257 

 

628 

 

1,099 

 

425,540 

Second mortgage

 

36,697 

 

1,167 

 

 

 

798 

 

38,662 

Real estate – commercial:

 

 

 

 

 

 

 

 

 

 

 

 

Owner occupied

 

 

194,521 

 

6,747 

 

5,643 

 

13,092 

 

220,003 

Non-owner occupied

 

 

101,257 

 

5,409 

 

1,505 

 

1,524 

 

109,695 

Real estate – construction:

 

 

 

 

 

 

 

 

 

 

 

 

Residential

 

139 

 

1,610 

 

 

 

 

1,749 

Commercial

 

72 

 

7,525 

 

529 

 

 

 

8,126 

Installment

 

5,842 

 

 

 

 

 

5,842 

All other loans

 

356 

 

 

 

 

 

356 

Total

$

443,512 

$

532,385 

$

22,565 

$

7,963 

$

19,240 

$

1,025,665 

 

 

21

 


 

Below is a summary of loans by credit quality indicator as of December 31, 2011:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unrated

 

 

 

 

 

 

 

 

 

 

 

Residential

 

 

 

 

 

 

 

 

 

 

 

and

 

 

Pass-

Special

Sub-

 

 

(In thousands)

 Consumer

Pass

Watch

Mention

Standard

Total

Commercial, financial and agricultural

$

$

117,772 

$

28,326 

$

170 

$

720 

$

146,990 

Municipal

 

 

101,705 

 

 

 

 

101,705 

Real estate – residential:

 

 

 

 

 

 

 

 

 

 

 

 

First mortgage

 

379,512 

 

18,647 

 

1,569 

 

641 

 

962 

 

401,331 

Second mortgage

 

38,020 

 

146 

 

 

 

321 

 

38,487 

Real estate – commercial:

 

 

 

 

 

 

 

 

 

 

 

 

Owner occupied

 

 

175,878 

 

14,001 

 

7,355 

 

9,022 

 

206,256 

Non-owner occupied

 

 

95,239 

 

8,891 

 

1,195 

 

2,334 

 

107,659 

Real estate – construction:

 

 

 

 

 

 

 

 

 

 

 

 

Residential

 

99 

 

 

1,699 

 

 

 

1,798 

Commercial

 

81 

 

15,925 

 

573 

 

 

616 

 

17,195 

Installment

 

5,806 

 

 

 

 

 

5,806 

All other loans

 

399 

 

 

 

 

 

399 

Total

$

423,919 

$

525,312 

$

55,059 

$

9,361 

$

13,975 

$

1,027,626 

 

 

The amount of interest which was not earned, but which would have been earned had our non-accrual and restructured loans performed in accordance with their original terms and conditions, was approximately $33 thousand and $69 thousand for the three and six months ended June 30, 2012, and was approximately $55 thousand and $108 thousand for the three and six months ended June 2011, respectively.

It is our policy to make loans to directors, executive officers, and associates of such persons on substantially the same terms, including interest rates and collateral, as those prevailing for comparable lending transactions with other persons.

 

 

Note 5: Pension

We formerly had a noncontributory defined benefit pension plan (the “Plan”) covering all eligible employees. The Plan was a final average pay plan with benefits based on the average salary rates using the five consecutive Plan years of the last ten years that produce the highest average salary. The Plan was curtailed in 1995; all accrued benefits were fully vested and no additional years of service or age will be accrued.

The following table summarizes the components of net periodic benefit costs for the periods indicated:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended June 30,

Six Months Ended June 30,

(In thousands)

2012

2011

2012

2011

Interest cost

$

130 

$

122 

$

239 

$

244 

Service cost

 

11 

 

14 

 

24 

 

28 

Expected return on Plan assets

 

(156)

 

(156)

 

(300)

 

(312)

Amortization of net loss

 

62 

 

70 

 

163 

 

140 

Net periodic benefit cost

$

47 

$

50 

$

126 

$

100 

 

We do not expect to make a contribution to the pension plan during 2012.

Our Pension Plan Investment Policy Statement sets forth the investment objectives and constraints of the Plan.  The purpose of the policy is to assist our Retirement Plan Committee in effectively supervising, monitoring and evaluating the investments of the Plan.

 

22

 


 

Note 6: Earnings Per Share

The following table presents reconciliations of the calculations of basic and diluted earnings per common share for the periods indicated:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended

Six Months Ended

 

June 30,

June 30,

(In thousands except per share data)

2012

2011

2012

2011

Net income

$

3,736 

$

3,629 

$

7,349 

$

6,730 

Weighted average common shares outstanding

 

6,249 

 

6,206 

 

6,243 

 

6,199 

Dilutive effect of common stock equivalents

 

11 

 

10 

 

13 

 

11 

Weighted average common and common equivalent

 

 

 

 

 

 

 

 

shares outstanding

 

6,260 

 

6,216 

 

6,256 

 

6,210 

Basic earnings per common share

$

0.60 

$

0.58 

$

1.18 

$

1.09 

Diluted earnings per common share

$

0.60 

$

0.58 

$

1.17 

$

1.08 

 

 

Basic earnings per common share were computed by dividing net income by the weighted average number of shares of common stock outstanding for the three and six months ended June 30, 2012. For the three and six months ended June 30, 2012, there were no anti-dilutive stock options outstanding which were not considered in the calculation of diluted earnings per share because the stock options’ exercise price was greater than the average market price during these periods. 

 

Note 7: Stock Repurchase Program

We extended, through January 2013, our stock buyback program, originally adopted in January 2007.  Under the program we may repurchase up to 200,000 shares of our common stock on the open market from time to time, and have purchased 143,475 shares at an average price per share of $22.94 since the program’s adoption.  We did not repurchase any of our shares during 2011 or during the first six months of 2012, and do not expect to repurchase shares in the near future.

 

 

Note 8: Commitments and Contingencies

We are a party to financial instruments with off balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments primarily include commitments to extend credit and financial guarantees. Such instruments involve, to varying degrees, elements of credit and interest rate risk that are not recognized in the accompanying consolidated balance sheets.

We do not issue any guarantees that would require liability recognition or disclosure, other than our standby letters of credit. Standby letters of credit are conditional commitments issued by us to guarantee the performance of a customer to a third party. Standby letters of credit generally arise in connection with lending relationships. The credit risk involved in issuing these instruments is essentially the same as that involved in extending loans to customers. Contingent obligations under standby letters of credit totaled approximately $4.64 million at June 30, 2012 and represent the maximum potential future payments we could be required to make. Typically, these instruments have terms of 12 months or less and expire unused; therefore, the total amounts do not necessarily represent future cash requirements. Each customer is evaluated individually for creditworthiness under the same underwriting standards used for commitments to extend credit for on-balance sheet instruments. Our policies governing loan collateral apply to standby letters of credit at the time of credit extension. Loan-to-value ratios are generally consistent with loan-to-value requirements for other commercial loans secured by similar types of collateral. The fair value of our standby letters of credit at June 30, 2012 was insignificant.

We may enter into commitments to sell loans, which involve market and interest rate risk. There were no such commitments at June 30, 2012 or 2011.

We are involved in routine legal proceedings that occur in the ordinary course of business, which, individually and in the aggregate, are believed by Management to be immaterial to our financial condition and results of operations.

 

 

Note 9: Fair Value of Financial Instruments

We record certain assets and liabilities at fair value.  Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  Fair value measurements are also utilized to determine the initial value of certain assets and liabilities, to perform impairment assessments, and for disclosure purposes.  We use quoted market prices and observable inputs to the maximum extent possible when measuring fair value.  In the absence of quoted market prices, various valuation techniques are utilized to measure fair value.  When possible, observable market data for

23

 


 

identical or similar financial instruments are used in the valuation.  When market data is not available, fair value is determined using valuation models that incorporate Management’s estimates of the assumptions a market participant would use in pricing the asset or liability.

Our valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While Management believes our valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Furthermore, the reported fair value amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein.  A more detailed description of the valuation methodologies used for assets and liabilities measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.

The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described below: 

Ø

Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Ø

Level 2 -  Quoted prices for similar assets or liabilities in active markets, quoted prices in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability. 

Ø

Level 3 - Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity).

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

 

Financial instruments on a recurring basis

The table below presents the balance of financial assets and liabilities at June 30, 2012 measured at fair value on a recurring basis:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fair Value Measurements at Reporting Date Using

 

 

 

Quoted Prices in Active Markets for Identical Assets

Significant Other Observable Inputs

Significant Unobservable Inputs

(In thousands)

Total

(Level 1)

(Level 2)

(Level 3)

Assets

 

 

 

 

 

 

 

 

U.S. Treasury Obligations

$

250 

$

$

250 

$

U.S. Agency Obligations

 

64,799 

 

 

64,799 

 

FHLB Obligations

 

4,649 

 

 

4,649 

 

Agency MBSs

 

173,639 

 

 

173,639 

 

Agency CMOs

 

246,337 

 

 

246,337 

 

Non-Agency CMOs

 

4,729 

 

 

4,729 

 

ABSs

 

419 

 

 

419 

 

Interest rate swap agreements

 

488 

 

 

488 

 

    Total assets

$

495,310 

$

$

495,310 

$

Liabilities

 

 

 

 

 

 

 

 

Interest rate swap agreements

 

1,767 

 

 

1,767 

 

    Total liabilities

$

1,767 

$

$

1,767 

$

 

 

 

24

 


 

The table below presents the balance of financial assets and liabilities at December 31, 2011 measured at fair value on a recurring basis:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fair Value Measurements at Reporting Date Using

 

 

 

Quoted Prices in Active Markets for Identical Assets

Significant Other Observable Inputs

Significant Unobservable Inputs

(In thousands)

Total

(Level 1)

(Level 2)

(Level 3)

Assets

 

 

 

 

 

 

 

 

U.S. Treasury Obligations

$

250 

$

$

250 

$

U.S. Agency Obligations

 

90,419 

 

 

90,419 

 

FHLB Obligations

 

16,676 

 

 

16,676 

 

Agency MBSs

 

183,838 

 

 

183,838 

 

Agency CMOs

 

214,480 

 

 

214,480 

 

Non-Agency CMOs

 

4,855 

 

 

4,855 

 

ABSs

 

1,233 

 

 

1,233 

 

Interest rate swap agreements

 

207 

 

 

207 

 

Total assets

$

511,958 

$

$

511,958 

$

Liabilities

 

 

 

 

 

 

 

 

Interest rate swap agreements

 

1,613 

 

 

1,613 

 

Total liabilities

$

1,613 

$

$

1,613 

$

 

 

Investment securities are reported at fair value utilizing Level 2 inputs. The prices for these instruments are obtained through an independent pricing service or dealer market participant with whom we have historically transacted both purchases and sales of investment securities.  Prices obtained from these sources include market quotations and matrix pricing. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.  More information regarding our investment securities can be found in Footnote 3 to these Consolidated Financial Statements.

The interest rate swaps are reported at their fair value utilizing Level 2 inputs from third parties. The fair value of our interest rate swaps are determined using prices obtained from a third party advisor.  The fair value measurement of the interest rate swap is determined by netting the discounted future fixed cash payments and the discounted expected variable cash receipts.  The variable cash receipts are based on the expectation of future interest rates derived from observed market interest rate curves.

There were no transfers between Level 1 and Level 2 for the three or six months ended June 30, 2012.  There were no Level 3 assets measured at fair value on a recurring basis during the three or six months ended June 30, 2012 and 2011.

Financial instruments on a non-recurring basis

Certain assets are also measured at fair value on a non-recurring basis.  These other financial assets include impaired loans and OREO.  The table below presents the balance of financial assets at June 30, 2012 measured at fair value on a non-recurring basis:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fair Value Measurements at Reporting Date Using

 

 

 

Quoted Prices in Active Markets for Identical Assets

Significant Other Observable Inputs

Significant Unobservable Inputs

(In thousands)

Total

(Level 1)

(Level 2)

(Level 3)

OREO

$

386 

$

$

$

386 

Impaired loans

 

3,130 

 

 

 

3,130 

Total

$

3,516 

$

$

$

3,516 

 

 

The OREO balance at June 30, 2012 of $386 thousand consists of $28 thousand in commercial loans; $297 thousand in residential real estate loans; and $61 thousand in construction loans.

25

 


 

The table below presents the balance of financial assets at December 31, 2011 measured at fair value on a non-recurring basis:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fair Value Measurements at Reporting Date Using

 

 

 

Quoted Prices in Active Markets for Identical Assets

Significant Other Observable Inputs

Significant Unobservable Inputs

(In thousands)

Total

(Level 1)

(Level 2)

(Level 3)

OREO

$

358 

$

$

$

358 

Impaired loans

 

2,511 

 

 

 

2,511 

Total

$

2,869 

$

$

$

2,869 

 

 

The OREO balance at December 31, 2011 of $358 thousand consists of $28 thousand in commercial loans; $257 thousand in residential real estate loans; and $73 thousand in construction loans.

We use the fair value of underlying collateral to estimate the specific reserves for collateral dependent impaired loans.  Collateral may be real estate and/or business assets including equipment, inventory and accounts receivable.  Real estate values are determined based on appraisals by qualified licensed appraisers we have hired.  These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach.  Management’s ongoing review of appraisal information may result in additional discounts or adjustments to valuation based upon more recent market sales activity or more current appraisal information derived from properties of similar type and/or locale.  Other business assets are valued using a variety of approaches including appraisals, depreciated book value, purchase price and independent confirmation of accounts receivable.  OREO in the table above consists of property acquired through foreclosure and settlements of loans.  Property acquired is carried at the lower of cost or the estimated fair value of the property, determined by an independent appraisal, and is adjusted for estimated disposal costs. Certain inputs used in appraisals, and possible subsequent adjustments, are not always observable, and therefore, collateral dependent impaired loans and OREO are categorized as Level 3 within the fair value hierarchy.  

The table below presents the valuation methodology and unobservable inputs for Level 3 assets measured at fair value on a non-recurring basis at June 30, 2012:

 

 

 

 

 

 

 

 

 

 

 

 

(Dollars in thousands)

Fair value

Valuation Methodology

Unobservable Inputs

Range of Inputs

OREO

$

386 

Appraisal of collateral

Appraisal adjustments

0%-35%

Impaired loans

 

3,130 

Appraisal of collateral

Appraisal adjustments

0%-35%

 

 

Changes to our assumptions about unobservable inputs will impact our estimate of fair value.  Discounts to appraised values reflect the age of the appraisal and estimated costs of disposition.

GAAP requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring or non-recurring basis.

The fair values of our financial instruments as of June 30, 2012 are summarized in the table below:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Carrying

 

 

 

 

 

 

 

(In thousands)

Amount

Fair Value

 

Level 1

 

Level 2

 

Level 3

Cash and cash equivalents

$

47,459 

$

47,459 

$

47,459 

$

$

Securities available for sale

 

494,822 

 

494,822 

 

 

494,822 

 

Securities held to maturity

 

481 

 

537 

 

 

537 

 

FHLB stock

 

8,145 

 

8,145 

 

 

8,145 

 

Loans, net of allowance for loan losses

 

1,014,462 

 

1,035,189 

 

 

 

1,035,189 

Interest rate contract-cash flow hedge

 

488 

 

488 

 

 

488 

 

Accrued interest receivable

 

4,131 

 

4,131 

 

4,131 

 

 

Total assets

$

1,569,988 

$

1,590,771 

$

51,590 

$

503,992 

$

1,035,189 

Deposits

$

1,240,146 

$

1,243,014 

$

892,719 

$

350,295 

$

Short-term borrowings

 

52,000 

 

52,000 

 

 

52,000 

 

Securities sold under agreement to repurchase

 

153,700 

 

153,700 

 

 

153,700 

 

Other long-term debt

 

12,522 

 

13,050 

 

 

13,050 

 

Junior subordinated debentures issued to

 

 

 

 

 

 

 

 

 

 

unconsolidated subsidiary trust

 

20,619 

 

15,376 

 

 

15,376 

 

Interest rate contract-cash flow hedge

 

1,767 

 

1,767 

 

 

1,767 

 

Accrued interest payable

 

295 

 

295 

 

295 

 

 

Total liabilities

$

1,481,049 

$

1,479,202 

$

893,014 

$

586,188 

$

26

 


 

 

 

 

The fair values of our financial instruments as of December 31, 2011 are summarized in the table below:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Carrying

 

 

 

 

 

 

 

(In thousands)

Amount

Fair Value

 

Level 1

 

Level 2

 

Level 3

Cash and cash equivalents

$

37,812 

$

37,812 

$

37,812 

$

$

Securities available for sale

 

511,751 

 

511,751 

 

 

511,751 

 

Securities held to maturity

 

558 

 

624 

 

 

624 

 

FHLB stock

 

8,630 

 

8,630 

 

 

8,630 

 

Loans, net of allowance for loan losses

 

1,017,007 

 

1,035,131 

 

 

 

1,035,131 

Interest rate contract-cash flow hedge

 

207 

 

207 

 

 

207 

 

Accrued interest receivable

 

5,121 

 

5,121 

 

5,121 

 

 

Total assets

$

1,581,086 

$

1,599,276 

$

42,933 

$

521,212 

$

1,035,131 

Deposits

$

1,177,880 

$

1,181,066 

$

829,632 

$

351,434 

$

Short-term borrowings

 

 

 

 

 

Securities sold under agreement to repurchase

 

262,527 

 

263,062 

 

 

263,062 

 

Other long-term debt

 

22,562 

 

23,594 

 

 

23,594 

 

Junior subordinated debentures issued to

 

 

 

 

 

 

 

 

 

 

unconsolidated subsidiary trust

 

20,619 

 

15,268 

 

 

15,268 

 

Interest rate contract-cash flow hedge

 

1,613 

 

1,613 

 

 

1,613 

 

Accrued interest payable

 

282 

 

282 

 

282 

 

 

Total liabilities

$

1,485,483 

$

1,484,885 

$

829,914 

$

654,971 

$

 

 

 

 

The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents,  FHLBB stock, accrued interest receivable and accrued interest payable approximate fair value.  

The methodologies for other financial assets and financial liabilities are discussed below.

Loans - The fair value for loans is estimated using discounted cash flow analyses, using interest rates and spreads currently being offered for loans with similar terms to borrowers of similar credit quality. The fair value estimates, methods and assumptions set forth above for our financial instruments, including those financial instruments carried at cost, are made solely to comply with disclosures required by generally accepted accounting principles in the United States and do not incorporate the exit-price concept of fair value proscribed by ASC 820-10 and should be read in conjunction with the financial statements and associated footnotes.

Deposits -  The fair value for all deposits other than time deposits are equal to the amounts payable on demand (the carrying value). The fair value of fixed rate and fixed term certificates of deposit is estimated using a discounted cash flow method which applies interest rates currently being offered for deposits of similar remaining maturities.

Debt - The fair value of debt is estimated using current market rates for borrowings of similar remaining maturity.

Commitments to extend credit and standby letters of credit - The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of financial standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties. The fair value of commitments to extend credit and standby letters of credit was approximately $46 thousand and $42 thousand as of June 30, 2012 and December 31, 2011, respectively. 

Limitations ‑ Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instruments.  Because no market exists for a significant portion of the financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other such factors.

These estimates do not reflect any premium or discount that could result from offering for sale at one time our entire holdings of a particular financial instrument.  These estimates are subjective in nature and require considerable judgment to interpret market data.  Accordingly, the estimates presented herein are not necessarily indicative of the amounts we could realize in a current market

27

 


 

exchange, nor are they intended to represent the fair value of us as a whole.  The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.  The fair value estimates presented herein are based on pertinent information available to management as of the respective balance sheet date.  Although we are not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein.

Other significant assets, such as premises and equipment, other assets, and liabilities not defined as financial instruments, are not included in the above disclosures.  Also, the fair value estimates for deposits do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market.

 

 

Note 10: Derivative Financial Instruments

At June 30, 2012, we held interest rate swaps with a combined notional amount of $20 million that were designated as cash flow hedges. The swaps were used to convert the floating rate interest on our trust preferred issuance to a fixed rate of interest.  The purpose of the hedge was to protect us from the risk of variability arising from the floating rate interest on the debentures.  The effective portion of unrealized changes in the fair value of derivatives accounted for as cash flow hedges is reported in other comprehensive income and reclassified to earnings if gains or losses are realized.  Each quarter, we assess the effectiveness of the hedging relationships by comparing the changes in cash flows of the derivative hedging instruments with the changes in cash flows of the designated hedged item.  The ineffective portion of changes in the fair value of the derivatives is recognized directly in earnings.  There was no ineffective portion recognized in earnings during the second quarter of 2012 or 2011.  The fair values of the effective portion of the hedges of $(1.28) million and $(1.41) million were reflected in Other Comprehensive Income in the accompanying Consolidated Balance Sheets at June 30, 2012 and December 31, 2011, respectively.

At June 30, 2012, we had two interest rate derivative positions, with a combined notional amount of $29.12 million that were not designated as hedging instruments.  These derivative positions related to a transaction in which we entered into an interest rate swap with a customer while at the same time entering into an offsetting rate swap with another financial institution.  In connection with the transaction, we agreed to pay interest to the customer on a notional amount at a variable interest rate and receive interest from the customer on the same notional amount at a fixed interest rate.  At the same time, we agreed to pay another financial institution the same fixed interest rate on the same notional amount and receive the same variable interest rate on the same notional amount.  The transaction allows our customers to effectively convert a variable-rate loan to a fixed-rate loan.  Because the terms of the swap with our customer and the other financial institution offset each other, with the only difference being counterparty credit risk, changes in the fair value of the underlying derivative contracts are not materially different and do not significantly impact our results of operations.  The fair value of $488 thousand and $206 thousand at June 30, 2012 and December 31, 2011, respectively, was reflected in other assets and other liabilities in the accompanying Consolidated Balance Sheets. We assessed our counterparty risk at June 30, 2012 and determined any credit risk inherent in our derivative contracts was insignificant. Information about the fair value of derivative financial instruments can be found in Footnote 9 to these Consolidated Financial Statements. 

 

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

Forward Looking Statements

Certain statements contained in this Quarterly Report on Form 10-Q that are not historical facts may constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are intended to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve risks and uncertainties. These statements, which are based on certain assumptions and describe our future plans, strategies and expectations, can generally be identified by the use of the words “may,” “will,” “should,” “could,” “would,” “plan,” “potential,” “estimate,” “project,” “believe,” “intend,” “anticipate,” “expect,” “target” and similar expressions. Forward-looking statements are based on the current assumptions and beliefs of Management and are only expectations of future results. Our actual results could differ materially from those projected in the forward-looking statements as a result of, among others, general, national, regional or local economic conditions which are less favorable than anticipated, including continued global recession, impacting the performance of our investment portfolio, quality of credits or the overall demand for services; changes in loan default and charge-off rates which could affect the allowance for credit losses; declines in the equity and financial markets; reductions in deposit levels which could necessitate increased and/or higher cost borrowing to fund loans and investments; declines in mortgage loan refinancing, equity loan and line of credit activity which could reduce net interest and noninterest income; changes in the domestic interest rate environment and inflation; changes in the carrying value of investment securities and other assets; further actions by the U.S. government and Treasury Department that could have a negative impact on our investment portfolio and earnings; misalignment of our interest-bearing assets and liabilities; increases in loan repayment rates affecting interest income; changing business, banking, or regulatory conditions or policies, or new legislation affecting the financial services industry, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, that could lead to changes in the competitive balance among financial institutions, restrictions on bank activities, changes in costs (including deposit insurance premiums), increased regulatory scrutiny, or changes in the secondary market for bank loan and other products; and changes in accounting rules, federal and state laws,

28

 


 

IRS regulations, and other regulations and policies governing financial holding companies and their subsidiaries which may impact our ability to take appropriate action to protect our financial interests in certain loan situations.    

Investors should not place undue reliance on our forward-looking statements, and are cautioned that forward-looking statements are inherently uncertain. Actual performance and results of operations may differ materially from those projected or suggested in the forward-looking statements due to certain risks and uncertainties, which are included in more detail in our Annual Report on Form 10-K, as updated by our Quarterly Reports on Form 10-Q, and other filings submitted to the Securities and Exchange Commission.  We do not undertake any obligation to update any forward-looking statement to reflect circumstances or events that occur after the date the forward-looking statements are made.

 

Use of Non-GAAP Financial Measures

Certain information in Management’s Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this Report contains financial information determined by methods other than in accordance with accounting principles generally accepted in the United States of America (“GAAP”).  We use these “non-GAAP” measures in our analysis of our performance and believe that these non-GAAP financial measures provide a greater understanding of ongoing operations and enhance comparability of results with prior periods as well as demonstrating the effects of significant gains and charges in the current period. We believe that a meaningful analysis of our financial performance requires an understanding of the factors underlying that performance. We believe that investors may use these non-GAAP financial measures to analyze financial performance without the impact of unusual items that may obscure trends in our underlying performance. These disclosures should not be viewed as a substitute for operating results determined in accordance with GAAP, nor are they necessarily comparable to non-GAAP performance measures that may be presented by other companies.

In several places net interest income is presented on a fully taxable equivalent basis. Specifically included in interest income is tax-exempt interest income from certain tax-exempt loans. An amount equal to the tax benefit derived from this tax exempt income is added back to the interest income total, to produce net interest income on a fully taxable equivalent basis. We believe the disclosure of tax-equivalent net interest income information improves the clarity of financial analysis, and is particularly useful to investors in understanding and evaluating the changes and trends in our results of operations. Other financial institutions commonly present net interest income on a tax-equivalent basis. This adjustment is considered helpful in the comparison of one financial institution’s net interest income to that of another, as each will have a different proportion of tax-exempt interest from its earning assets. Moreover, net interest income is a component of a second financial measure commonly used by financial institutions, net interest margin, which is the ratio of net interest income to average earning assets. For purposes of this measure as well, other financial institutions generally use tax-equivalent net interest income to provide a better basis of comparison from institution to institution. We follow these practices. A reconciliation of tax-equivalent financial information to our consolidated financial statements prepared in accordance with GAAP appears at the bottom of the table entitled “Average Balance Sheets and Average Rates.” A 35.0% tax rate was used in both 2012 and 2011.

 

General

All adjustments necessary for a fair presentation of our interim consolidated financial statements as of June 30, 2012, and for the three and six months ended June 30, 2012 and 2011 have been included. The information was prepared from our unaudited financial statements and financial statements of our subsidiaries, Merchants Bank (the “Bank”) and MBVT Statutory Trust I.      

Results of Operations

Overview

Net income was $3.74 million and $7.35 million for the three and six months ended June 30, 2012, compared to $3.63 million and $6.73 million for the same periods in 2011.  The return on average assets was 0.91% and 0.90% for the three and six months ended June 30, 2012, respectively, compared to 0.98% and 0.91% for the same periods last year, and the return on average equity was 13.31% and 13.23% for the three and six months ended June 30, 2012, respectively, compared to 14.20% and 13.38% for the same periods in 2011.  

The following were the major factors contributing to our results for the three and six months ended June 30, 2012 compared to the same periods in 2011:

·

Net interest income on a fully taxable equivalent (“FTE”) basis was $12.85 million for the second quarter of 2012, $95 thousand lower than the same period last year and $112 thousand lower than the first quarter of 2012.  The net interest margin for the second quarter was 3.27%, 35 basis points lower than the second quarter of last year and seven basis points lower than the first quarter of 2012;

·

We recorded a $200 thousand provision for credit losses during the second quarter of 2012 compared to $250 thousand provision for credit losses during the second quarter of 2011.  Our provision for credit losses for the first six months of 2012 was $450 thousand, compared to $250 thousand for the same period last year;

·

We recognized pre-tax security gains of $372 thousand and $448 thousand for the three and six months ended June 30, 2012, compared to $137 thousand and $127 thousand for the same periods last year.  We also recorded a gain of $334 thousand on an asset sale during the second quarter of 2012;

29

 


 

·

We prepaid $10 million in FHLB debt during the second quarter of 2012, and incurred a prepayment penalty of $686 thousand. There were no prepayment penalties during the first six months of last year;

·

Loans ended the quarter at $1.03 billion, a slight decrease from year end balances, but a $82.32 million increase over balances at June 30, 2011. Seasonal fluctuations in municipal cash flows reduced June 30, 2012 loan balances by approximately $58 million;

·

Total deposits ended the quarter at $1.24 billion, an increase of $62.27 million over year end deposit balances of $1.18 billion, and a $137.05 million increase over balances at June 30, 2011.

Net Interest Income

This discussion should be read in conjunction with the tables on the following three pages.  Our taxable equivalent net interest income was $12.85 million and $25.82 million for the three and six months ended June 30, 2012, respectively, compared to $12.95 million and $25.11 million for the same periods in 2011, and $12.97 million for the first quarter of 2012. Our taxable equivalent net interest margin decreased 35 basis points to 3.27% for the second quarter of 2012 compared to 3.62% for the same period in 2011, and decreased 22 basis points to 3.31% for the six months ended June 30, 2012 compared to 3.53% for the same period in 2011.  The net interest margin decreased seven basis points for the second quarter of 2012 compared to the first quarter of 2012. Our continued growth in earning assets has helped to offset margin compression and allowed us to increase net interest income for the first half of 2012 compared to the first half of 2011. Average earning assets for the first three and six months of 2012 were $1.58 billion and $1.57 billion, respectively, an increase of $146.07 million and $137.98 million over the same periods in 2011, and an increase of $19.33 million over the first quarter of 2012. 

The extended low interest rate environment continues to present a challenge as our assets reprice down at a steady rate, and new assets come on at lower rates.  The average rate on our loan portfolio was 4.48% for the second quarter of 2012, compared to 4.94% for the second quarter of 2011, 4.68% for the fourth quarter of 2011 and 4.61% for the first quarter of 2012.  The average rate on our investment portfolio for the second quarter of 2012 was 2.37% compared to 3.11% for the second quarter of 2011, 2.57% for the fourth quarter of 2011, and 2.45% for the first quarter of 2012. These decreases were offset, in part, by decreases in the cost of our interest bearing liabilities. The average cost of interest bearing liabilities for the second quarter of 2012 was 58 basis points, a 15 basis point decrease from the second quarter of 2011, a five basis point decrease from the fourth quarter of last year, and a three basis point drop from the first quarter of this year.  We prepaid $10.00 million in long-term FHLB debt during June which will reduce our overall cost of funds going forward.  The rate on the borrowing was 2.75% and we paid $686 thousand in prepayment penalties.        

The following tables attribute changes in our net interest income (on a fully taxable equivalent basis) to changes in either average balances or average rates for the three and six months ended June 30, 2012 compared to the three and six months ended June 30, 2011.  Changes due to both interest rate and volume have been allocated to change due to volume and change due to rate in proportion to the relationship of the absolute dollar amounts of the change in each category:

 

 

 

 

 

 

 

Three Months Ended

 

 

 

June 30,

June 30,

Increase

Due to

(In thousands)

2012

2011

(Decrease)

Volume

Rate

Fully taxable equivalent interest income:

 

 

 

 

 

Loans

$
11,769 
$
11,647 
$
122 
$
1,280 
$
(1,158)

Investments

2,983 
3,507 
(524)
379 
(903)

Interest earning deposits with banks and other short-term investments

10 
14 
(4)
(6)

   Total interest income

14,762 
15,168 
(406)
1,653 
(2,059)

Less interest expense:

 

 

 

 

 

Savings, interest bearing checking and money market accounts

201 
292 
(91)
34 
(125)

Time deposits

727 
840 
(113)
(27)
(86)

Short-term borrowings

23 
22 
20 

Securities sold under agreements to repurchase, short-term 

514 
515 
(1)
45 
(46)

Securities sold under agreements to repurchase, long term

56 
(56)
(28)
(28)

Other long-term debt

142 
214 
(72)
(70)
(2)

Junior subordinated debentures issued to

     unconsolidated subsidiary trust

300 
301 
(1)
(1)

    Total interest expense

1,907 
2,219 
(312)
(26)
(286)

    Net interest income

$
12,855 
$
12,949 
$
(94)
$
1,679 
$
(1,773)

 

30

 


 

 

 

 

 

 

 

 

Six Months Ended

 

 

 

June 30,

June 30,

Increase

Due to

(In thousands)

2012

2011

(Decrease)

Volume

Rate

Fully taxable equivalent interest income:

 

 

 

 

 

Loans

$
23,627 
$
23,055 
$
572 
$
2,754 
$
(2,182)

Investments

6,063 
6,530 
(467)
605 
(1,072)

Interest earning deposits with banks and other

   short-term investments

20 
44 
(24)
(21)
(3)

   Total interest income

29,710 
29,629 
81 
3,338 
(3,257)

Less interest expense:

 

 

 

 

 

Savings, interest bearing checking and money market accounts

427 
616 
(189)
62 
(251)

Time deposits

1,461 
1,717 
(256)
(67)
(189)

Short-term borrowings

38 
37 
31 

Securities sold under agreements to repurchase, short-term 

1,075 
1,052 
23 
120 
(97)

Securities sold under agreements to repurchase, long term

111 
(111)
(56)
(55)

Other long-term debt

294 
427 
(133)
(127)
(6)

Junior subordinated debentures issued to

     unconsolidated subsidiary trust

595 
594 

    Total interest expense

3,890 
4,518 
(628)
(37)
(591)

    Net interest income

$
25,820 
$
25,111 
$
709 
$
3,375 
$
(2,666)

 

31

 


 

The following table presents an analysis of net interest income and illustrates interest income earned and interest expense charged for each major component of interest earning assets and interest bearing liabilities.  Yields/rates are computed on a fully taxable-equivalent (“FTE”) basis, using a 35% rate.  Non-accrual loans are included in the average loan balance outstanding.

 

 

 

 

 

 

 

 

 

 

Merchants Bancshares, Inc.

Average Balance Sheets and Average Rates

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended

 

 

June 30, 2012

 

June 30, 2011

 

 

 

Interest

 

 

 

Interest

 

 

 

Average

Income/

Average

 

Average

Income/

Average

(In thousands, fully taxable equivalent)

 

Balance

Expense

Rate

 

Balance

Expense

Rate

ASSETS:

 

 

 

 

 

 

 

 

Loans, including fees on loans  (a)

 

$
1,056,735 
$
11,769 
4.48% 

 

$
944,813 
$
11,647 
4.94% 

Investments (b)

 

506,005 
2,983 
2.37% 

 

452,309 
3,507 
3.11% 

Interest-earning deposits with banks and other
  short-term investments

 

17,461 
10 
0.23% 

 

37,005 
14 
0.16% 

     Total earning assets

 

1,580,201 
$
14,762 
3.76% 

 

1,434,127 
$
15,168 
4.24% 

Allowance for loan losses

 

(11,135)

 

 

 

(10,329)

 

 

Cash and cash equivalents

 

24,968 

 

 

 

11,696 

 

 

Bank premises and equipment, net

 

14,328 

 

 

 

14,201 

 

 

Other assets

 

33,708 

 

 

 

31,938 

 

 

     Total assets

 

$
1,642,070 

 

 

 

$
1,481,633 

 

 

 

 

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS' EQUITY:

 

 

 

 

 

 

 

 

Interest-bearing deposits:

 

 

 

 

 

 

 

 

  Savings, interest bearing checking and money market accounts

 

$
662,713 
$
201 
0.12% 

 

$
588,759 
$
292 
0.20% 

  Time deposits

 

350,075 
727 
0.84% 

 

360,895 
840 
0.93% 

     Total interest bearing deposits

 

1,012,788 
928 
0.37% 

 

949,654 
1,132 
0.48% 

Short-term borrowings

 

35,773 
23 
0.26% 

 

3,434 
0.12% 

Securities sold under agreements to repurchase, short-term

 

225,797 
514 
0.91% 

 

206,796 
515 
1.00% 

Securities sold under agreements to repurchase, long-term

 

0.00% 

 

7,500 
56 
2.97% 

Other long-term debt

 

20,771 
142 
2.74% 

 

31,108 
214 
2.77% 

Junior subordinated debentures issued to

 

 

 

 

 

 

 

 

   unconsolidated subsidiary trust

 

20,619 
300 
5.94% 

 

20,619 
301 
5.85% 

     Total borrowed funds

 

302,960 
979 
1.30% 

 

269,457 
1,087 
1.62% 

     Total interest bearing liabilities

 

1,315,748 
$
1,907 
0.58% 

 

1,219,111 
$
2,219 
0.73% 

Noninterest bearing deposits

 

205,072 

 

 

 

149,522 

 

 

Other liabilities

 

9,015 

 

 

 

10,748 

 

 

Shareholders' equity

 

112,235 

 

 

 

102,252 

 

 

     Total liabilities and shareholders' equity

 

$
1,642,070 

 

 

 

$
1,481,633 

 

 

 

 

 

 

 

 

 

 

 

Net earning assets

 

$
264,453 

 

 

 

$
215,016 

 

 

 

 

 

 

 

 

 

 

 

Net interest income, FTE (a)

 

 

$
12,855 

 

 

 

$
12,949 

 

Tax equivalent adjustment

 

 

(516)

 

 

 

(457)

 

Net interest income, GAAP

 

 

$
12,339 

 

 

 

$
12,492 

 

 

 

 

 

 

 

 

 

 

Yield spread

 

 

 

3.17% 

 

 

 

3.51% 

 

 

 

 

 

 

 

 

 

Net interest margin (a)

 

 

 

3.27% 

 

 

 

3.62% 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(a) Tax exempt interest has been converted to a tax equivalent basis using the Federal tax rate of 35%.

 

 

(b) Includes available for sale securities and held to maturity securities both at amortized cost.  Includes FHLB stock.

 

 

 

 

32

 


 

33

 


 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Merchants Bancshares, Inc.

Average Balance Sheets and Average Rates

 

 

 

 

 

 

 

 

 

 

 

 

Six Months Ended

 

 

June 30, 2012

 

June 30, 2011

 

 

 

Interest

 

 

 

Interest

 

 

 

Average

Income/

Average

 

Average

Income/

Average

(In thousands, fully taxable equivalent)

 

Balance

Expense

Rate

 

Balance

Expense

Rate

ASSETS:

 

 

 

 

 

 

 

 

Loans, including fees on loans  (a)

 

$
1,045,507 
$
23,627 
4.54% 

 

$
930,677 
$
23,055 
5.00% 

Investments (b)

 

505,458 
6,063 
2.41% 

 

460,990 
6,530 
2.86% 

Interest-earning deposits with banks and other
  short-term investments

 

19,573 
20 
0.20% 

 

40,889 
44 
0.22% 

     Total earning assets

 

1,570,538 
$
29,710 
3.80% 

 

1,432,556 
$
29,629 
4.17% 

Allowance for loan losses

 

(10,936)

 

 

 

(10,294)

 

 

Cash and cash equivalents

 

23,150 

 

 

 

12,990 

 

 

Bank premises and equipment, net

 

14,346 

 

 

 

14,263 

 

 

Other assets

 

33,429 

 

 

 

31,601 

 

 

     Total assets

 

$
1,630,527 

 

 

 

$
1,481,116 

 

 

 

 

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS' EQUITY:

 

 

 

 

 

 

 

 

Interest-bearing deposits:

 

 

 

 

 

 

 

 

  Savings, interest bearing checking and money market accounts

 

$
651,825 
$
427 
0.13% 

 

$
586,968 
$
616 
0.21% 

  Time deposits

 

348,934 
1,461 
0.84% 

 

363,366 
1,717 
0.95% 

     Total interest bearing deposits

 

1,000,759 
1,888 
0.38% 

 

950,334 
2,333 
0.49% 

Short-term borrowings

 

29,238 
38 
0.26% 

 

2,618 
0.08% 

Securities sold under agreements to repurchase, short-term

 

237,403 
1,075 
0.91% 

 

212,574 
1,052 
1.00% 

Securities sold under agreements to repurchase, long-term

 

0.00% 

 

7,500 
111 
2.98% 

Other long-term debt

 

21,660 
294 
2.72% 

 

31,117 
427 
2.77% 

Junior subordinated debentures issued to

 

 

 

 

 

 

 

 

   unconsolidated subsidiary trust

 

20,619 
595 
5.89% 

 

20,619 
594 
5.81% 

     Total borrowed funds

 

308,920 
2,002 
1.30% 

 

274,428 
2,185 
1.61% 

     Total interest bearing liabilities

 

1,309,679 
$
3,890 
0.60% 

 

1,224,762 
$
4,518 
0.74% 

Noninterest bearing deposits

 

200,248 

 

 

 

144,623 

 

 

Other liabilities

 

9,537 

 

 

 

11,142 

 

 

Shareholders' equity

 

111,063 

 

 

 

100,589 

 

 

     Total liabilities and shareholders' equity

 

$
1,630,527 

 

 

 

$
1,481,116 

 

 

 

 

 

 

 

 

 

 

 

Net earning assets

 

$
260,859 

 

 

 

$
207,794 

 

 

 

 

 

 

 

 

 

 

 

Net interest income, FTE (a)

 

 

$
25,820 

 

 

 

$
25,111 

 

Tax equivalent adjustment

 

 

(1,045)

 

 

 

(866)

 

Net interest income, GAAP

 

 

$
24,775 

 

 

 

$
24,245 

 

 

 

 

 

 

 

 

 

 

Yield spread

 

 

 

3.21% 

 

 

 

3.43% 

 

 

 

 

 

 

 

 

 

Net interest margin (a)

 

 

 

3.31% 

 

 

 

3.53% 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(a) Tax exempt interest has been converted to a tax equivalent basis using the Federal tax rate of 35%.

 

 

(b) Includes available for sale securities and held to maturity securities both at amortized cost.  Includes FHLB stock.

 

 

 

 

 

34

 


 

 

Provision for Credit Losses:    We recorded a provision for credit losses of $200 thousand and $450 thousand for the three and six months ended June 30, 2012, respectively, compared to $0 and $250 thousand for the three and six months ended June 30, 2011.  Although asset quality remains high, our continued loan growth during 2012 was the primary factor for the provision during the quarter.  Our nonperforming assets totals increased to $3.52 million at June 30, 2012,  compared to $2.67 million at March 31, 2012 and $2.87 million at December 31, 2011.  Accruing substandard loans also increased to $17.11 million at June 30, 2012 compared to $15.66 million at March 31, 2012, and $12.41 million at December 31, 2011.   Approximately $292 thousand in non-accruing loans carry some form of government guarantee. All of these factors are taken into consideration during Management’s quarterly review of the allowance for credit losses. We  consider the allowance for credit losses to be reasonable at June 30, 2012.  See  “Credit Quality and the Allowance for Credit Losses” for additional information on the provision, the allowance for credit losses and the allowance for loan losses.

Noninterest Income: Total noninterest income increased $603 thousand to $3.16 million for the second quarter of 2012 compared to 2011, and increased $871 thousand for the first half of 2012 compared to 2011. During the second quarter of 2012, we recognized a gain of $334 thousand on the sale of the mineral rights that we owned on properties in Oklahoma which we acquired in a bank acquisition in 1971. We recognized pre-tax security gains of $372 thousand and $448 thousand during the three and six months ended June 30, 2012.  Excluding net gains on security sales, and the gain on the sale of the mineral rights, noninterest income increased $34 thousand to $2.46 million for the second quarter of 2012 compared to $2.42 million for the second quarter of 2011, and increased $216 thousand to $4.74 million for the first six months of 2012 compared to $4.53 million for the first six months of 2011.  The increase for the three and six months ended June 30, 2012 compared to the three and six months ended June 30, 2011 is primarily a result of increases in net debit card income and Trust division income, offset in part by decreased overdraft fee revenue. Trust assets under management have continued to grow through 2012 and now total $518 million.

Noninterest Expense: Total noninterest expense increased $439 thousand to $10.65 million for the second quarter of 2012 compared to 2011, and $431 thousand to $20.75 million for the first half of 2012 compared to 2011.  As mentioned previously, we prepaid $10 million in FHLB long term debt during the quarter and incurred prepayment penalties totaling $686 thousand.  Excluding the prepayment penalties, noninterest expense decreased $247 thousand for the second quarter of 2012 compared to 2011 and decreased $255 thousand for the first half of 2012 compared to 2011. Compensation and benefits were lower for both the three and six months ended June 30, 2012.  Normal salary increases and an increased incentive accrual were offset by credits related to loan origination fees.  A change to our health insurance plan for 2012 resulted in a $123 thousand reduction in health and group insurance expense for the first half of 2012 compared to 2011. Occupancy expenses continue to run below 2011 levels, in part a result of our mild winter.  Equipment expenses for 2012 are higher than 2011 levels resulting from capital investments made during 2011.  Marketing expenses for 2012 are running higher than 2011 as we have added television media to our overall marketing mix.

Balance Sheet Analysis

Quarterly average loans for the second quarter of 2012 increased to $1.06 billion compared to $1.01 billion for the fourth quarter of 2011, and $945 million for the second quarter of 2011.  Ending loan balances at June 30, 2012 were $1.03 billion, unchanged from December 31, 2011 balances of $1.03 billion. During the second quarter, growth in average monthly loan balances was strong with average monthly loan balances for April 2012 at $1.04 billion, increasing to $1.06 billion for May 2012 and $1.07 billion for June 2012. Our strong growth in our commercial, financial and agricultural loan portfolio reflects the acquisition of new customers and expansion of existing relationships, approximately half of the growth is a result of the expansion of one existing relationship. Growth in our residential real estate loan portfolio continues to be driven by increased mortgage refinance volume due to the low interest rate environment. Seasonal fluctuations in municipal cash flows, combined with reduced loan demand by our municipal customers, reduced ending June 30, 2012 loan balances by $57.79 million from ending balances at March 31, 2012; as of July 5, 2012 municipal loan balances had increased to $78.50 million.

The following table summarizes the components of our loan portfolio as of the dates indicated:

 

 

 

 

(In thousands)

June 30,

2012

March 31, 2012

December 31, 2011

Commercial, financial and agricultural

$
173,114 
$
146,660 
$
146,990 

Municipal loans

42,578 
100,371 
101,705 

Real estate loans – residential

464,202 
446,480 
439,818 

Real estate loans – commercial

329,698 
330,873 
313,915 

Real estate loans – construction

9,875 
11,884 
18,993 

Installment loans

5,842 
4,411 
5,806 

All other loans

356 
330 
399 

Total loans

$
1,025,665 
$
1,041,009 
$
1,027,626 

 

Total deposits at June 30, 2012 were $1.24 billion compared to $1.18 billion at December 31, 2011.    Growth during 2012 has been concentrated in our demand deposit and money market categories. Securities sold under agreement to repurchase declined by $108.83 million to $153.70 million at June 30, 2012 from $262.53 million at December 31, 2011 primarily a result of seasonal fluctuations concentrated in municipal cash flows. As mentioned previously we prepaid $10 million in long-term FHLB debt during the quarter. 

35

 


 

The rate on the borrowing was 2.75% and we paid $686 thousand in prepayment penalties as a result.  Short-term debt was $52.00 million at June 30, 2012 compared to zero at December 31, 2011.

The investment portfolio is used to generate interest income, manage liquidity and mitigate interest rate sensitivity. Our investment portfolio totaled $495.30 million at June 30, 2012, a slight decrease from the December 31, 2011 ending balance of $512.31 million.

We sold bonds with a book value of $27.41 million during the second quarter for a pre-tax gain of $372 thousand.  The bonds we sold were low-yielding faster paying bonds which we were able to reinvest into bonds with a more stable payment profile. Our investment portfolio at June 30, 2012, including both held-to-maturity and available-for-sale securities, consisted of the following:

 

 

 

 

(In thousands)

Amortized Cost

Fair

Value

U.S. Treasury Obligations

$
250 
$
250 

U.S. Agency Obligations

63,983 
64,799 

FHLB Obligations

4,581 
4,649 

Agency MBS

167,190 
174,176 

Agency CMO

243,819 
246,337 

Non-agency CMO

4,899 
4,729 

ABS

357 
419 

 Total investments

$
485,079 
$
495,359 

 

Agency MBSs and Agency CMOs consist of pools of residential mortgages which are guaranteed by FNMA, FHLMC, or GNMA with various origination dates and maturities.  Non-Agency CMOs and ABSs are tracked individually with updates on the performance of the underlying collateral provided at least quarterly.    

Our investment portfolio consists almost entirely of U.S. Treasury and Agency obligations, or Agency-guaranteed mortgage securities.  We have two non-agency CMOs with a current cost basis of $4.90 million.  Management, with the help of outside experts, has performed impairment analyses on these bonds.

One of the non-Agency CMOs, with a cost basis of $3.27 million and a fair value of $3.17 million at June 30, 2012, is rated BBB by Fitch and Ba3 by Moody’s.  Delinquencies have been fairly low and prepayments on the bond have led to increased credit support.  We own a senior tranche in this bond. Although losses are expected in the bond overall, our position in the structure of the bond is expected to protect us from realizing losses. The second bond has a cost basis of $1.63  million and a fair value of $1.56 million.  This bond is rated CCC by Fitch and S&P. We own a super senior tranche in this bond. Although losses are expected in the bond overall, our super senior position in the structure is expected to protect us from realizing a material loss

As a member of the FHLB system, we are required to invest in stock of the FHLB of Boston (the “FHLBB”) in an amount determined based on our borrowings from the FHLBB.  At June 30, 2012, our investment in FHLBB stock totaled $8.15 million, a decrease of $485 thousand from our year end balance of $8.63 million.  We received dividend income totaling $25 thousand and $13 thousand during the six months ended June 30, 2012, and 2011, respectively.

We do not intend to sell the investment securities that are in an unrealized loss position, and it is unlikely that we will be required to sell the investment securities before recovery of their amortized cost bases, which may be maturity. 

In the ordinary course of business, we make commitments for possible future extensions of credit. At June 30, 2012, we were obligated to fund $4.64 million of standby letters of credit. No losses are anticipated in connection with these commitments.

 

Income Taxes

Our effective tax rate for the three and six months ended June 30, 2012 was 19.8% and 19.2%, respectively, compared to 21.0% and 19.2% for the three and six months ended June 30, 2011.  Our income tax provisions for these periods were less than the expense that would result from applying the federal statutory rate of 35% to income before income taxes principally because of the impact of federal affordable housing tax credits, historic rehabilitation credits and qualified school construction bond credits combined with tax exempt interest income on certain loans. 

 

Liquidity and Capital Resources

Our liquidity is monitored by the Asset and Liability Committee (“ALCO”) of our Bank’s Board of Directors, based upon our Bank’s policies. As of June 30, 2012,  we could borrow up to $41 million in overnight funds, of which $36 million consists of unsecured borrowing lines established with correspondent banks. The balance of $5 million is in the form of an overnight line of credit with the FHLBB.  FHLBB borrowings are secured by residential mortgage loans. The total amount of loans pledged to the FHLBB for both short- and long-term borrowing arrangements totaled $308.20  million at June 30, 2012. We have additional borrowing capacity with the FHLBB  of $151.01 million as of June 30, 2012.  Additionally, we have established a borrowing facility with the FRB which will enable us to borrow at the discount window. 

 

We also have the ability to borrow through the use of repurchase agreements, collateralized by Agency MBSs and Agency CMOs, with certain approved counterparties. The carrying value of the securities sold under repurchase agreements was $270.57 million and the market value was $277.06 million at June 30, 2012.  We maintain effective control over the securities underlying the agreements. 

36

 


 

Our investment portfolio, which is managed by the ALCO, has a book value of $495.30 million at June 30, 2012, of which $295.27 million was pledged.  The portfolio is a reliable source of cash flow for us. We closely monitor our short-term cash position.  Any excess funds are either left on deposit at the FRB, or are in a fully insured account with one of our correspondent banks.

FHLBB short-term borrowings mature daily. There was $36.00 million in outstanding balances at June 30, 2012.

The following table provides certain information regarding other short-term borrowed funds for the three and six months ended June 30, 2012: 

 

 

 

(In thousands)

Three Months Ended June 30, 2012

Six Months Ended June 30, 2012

FHLBB and other short-term borrowings

 

 

   Amount outstanding at end of period

$
52,000 
$
52,000 

   Maximum during the period amount outstanding

62,700 
62,700 

   Average amount outstanding

35,773 
29,238 

   Weighted average  rate during the period

0.26% 
0.26% 

   Weighted average rate at period end

0.23% 
0.23% 

Securities sold under agreement to repurchase, short-term

 

 

       Amount outstanding at end of period

$
153,700 
$
153,700 

   Maximum during the period amount outstanding

253,718 
262,970 

   Average amount outstanding

225,797 
237,403 

   Weighted average rate during the period

0.91% 
0.91% 

   Weighted average rate at period end

0.51% 
0.51% 

 

We extended, through January 2013, our stock buyback program, originally adopted in January 2007.  Under the program, we may repurchase up to 200,000 shares of our common stock on the open market from time to time, and have purchased 143,475 shares at an average price per share of $22.94 since the program’s adoption.  We did not repurchase any of our shares during 2011 or the first six months of 2012, and we do not expect to repurchase shares in the near future.

As of June 30, 2012, we exceeded all current applicable regulatory capital requirements. We continue to be considered well capitalized under current applicable regulations.  Our tangible equity ratio at June 30, 2012 was 7.12% compared to 6.80% at December 31, 2011. Because we have no intangible assets, our tangible equity is the same as our book equity. The following table represents our actual capital ratios and capital adequacy requirements as of June 30, 2012.

 

 

 

 

 

 

 

 

 

Actual

For Capital Adequacy Purposes

To Be Well Capitalized Under Prompt Corrective Action Provisions

(Dollars in thousands)

Amount

Percent

Amount

Percent

Amount

Percent

Merchants Bancshares, Inc.

 

 

 

 

 

 

  Tier 1 leverage capital

$
130,841 
7.97% 
$
65,683 
4.00% 

N/A

N/A

  Tier 1 risk-based capital

130,841 
14.61% 
35,820 
4.00% 

N/A

N/A

  Total risk-based capital

141,973 
15.85% 
71,641 
8.00% 

N/A

N/A

  Tangible capital

114,058 
7.12% 

N/A

N/A

N/A

N/A

Merchants Bank

 

 

 

 

 

 

  Tier 1 leverage capital

$
127,494 
7.74% 
$
65,849 
4.00% 
$
82,311 
5.00% 

  Tier 1 risk-based capital

127,494 
14.15% 
36,049 
4.00% 
54,074 
6.00% 

  Total risk-based capital

138,697 
15.39% 
72,099 
8.00% 
90,123 
10.00% 

  Tangible capital

131,544 
8.20% 

N/A

N/A

N/A

N/A

·

Capital for Merchants Bancshares, Inc. includes $20 million in trust preferred securities issued in December 2004. These hybrid securities qualify as regulatory capital up to certain limits.

 

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CREDIT QUALITY AND THE ALLOWANCE FOR CREDIT LOSSES

 

Credit Quality

Stringent credit quality is a major strategic focus of ours, and Management monitors asset quality on a continuous basis. We cannot assure that problem assets will remain at current levels, particularly in light of current or future economic conditions.  The asset balances in this category will be dynamic and subject to change as problem loans are either resolved or moved to nonperforming status based upon current developments and the latest available information.

The following table summarizes our nonperforming assets at the dates indicated:

 

 

 

 

 

 

(In thousands)

June 30,

2012

March 31,

2012

December 31, 2011

June  30,

2011

Non-accrual  loans

$
2,559 
$
1,787 
$
1,953 
$
2,954 

Loans past due 90 days or more and still

     accruing interest

Troubled debt restructuring

571 
528 
558 
490 

  Total nonperforming loans (“NPL”)

3,130 
2,315 
2,511 
3,444 

OREO

386 
350 
358 

  Total nonperforming assets (“NPA”)

$
3,516 
$
2,665 
$
2,869 
$
3,444 

 

Nonperforming assets at June 30, 2012 totaled $3.52 million, an increase of $647 thousand from balances at December 31, 2011.   There were no loans past due 90 days and still accruing at June 30, 2012.   Of the total $3.13 million in nonperforming loans above, $2.48 million are residential mortgages, compared to $1.99 million at December 31, 2011.  The increase in nonperforming residential real estate loans is the result of the transfer of a $1.0 million residential relationship to nonaccrual during the quarter, which offset the declines in this category resulting from the resolution of several loans.  Our residential first lien mortgage portfolio consists of traditional mortgages which are underwritten, using loan-to-value and debt-to-income thresholds.  We believe that additional loss exposure on current non-accruing loans is mitigated by a combination of collateral and, where needed, an appropriate reserve allocation.

TDRs consist of eight residential real estate loans and one commercial real estate loan at June 30, 2012. All nine borrowers experienced financial difficulties that led to the restructure of their respective loans. At the time of restructure, six were in payment default and all nine demonstrated cash flow insufficient to service their debt as well as an inability to obtain funds at market rates from other sources.  As of June 30, 2012, seven of the restructured loans were performing in accordance with modified agreements, while three loans totaling $145 thousand were in default and in non-accrual.  There were no commitments to lend additional funds to borrowers whose loans have been modified in a troubled debt restructuring at June 30, 2012. We had no commitments to lend additional funds to borrowers whose loans were in non-accrual status or to borrowers whose loans were 90 days past due and still accruing.

We had $386 thousand in OREO at June 30, 2012, compared with $358 thousand at December 31, 2011 and none at June 30, 2011. Two were residential borrowers and one was a commercial borrower. One new residential property was put into OREO during the second quarter of 2012 and one was removed through payoff.

Excluded from the non-accrual balances discussed above are our loans that are 30 to 89 days past due, which are not necessarily considered classified or impaired. Accruing loans 30 to 89 days past due as a percentage of total loans as of the periods indicated are presented in the following table: 

 

 

 

Quarter Ended:

30-89 Days

June 30, 2012

0.00%

March  31, 2012 

0.01%

December 31, 2011

0.02%

June 30, 2011

0.11%

 

Our residential mortgage loan portfolio continues to perform well, even under the currently stressed economic conditions. Residential loans 30 to 89 days past due at June 30, 2012 totaled $52 thousand, equal to 1 basis point as a percentage of residential loans.

Our policy is to classify a loan 90 days or more past due with respect to principal or interest, as well as any loan where Management does not believe it will collect all principal and interest in accordance with contractual terms, as a non-accruing loan, unless the ultimate collectability of principal and interest is assured.  Income accruals are suspended on all non-accruing loans, and all previously accrued and uncollected interest is charged against current income.  A loan remains in non-accruing status until the factors which suggest doubtful collectability no longer exist, the loan is liquidated, or the loan is determined to be uncollectible, and is charged off against the allowance for loan losses.  In those cases where a non-accruing loan is secured by real estate typically initiate foreclosure or replevin proceedings.  The result of such action will either be to cause repayment of the loan with the proceeds of a public sale or to give us possession of the collateral in order to manage a future resale of the asset.  Repossessed property is recorded at the lower of its

38

 


 

cost or estimated fair value, less any estimated costs to sell.  Any cost in excess of the estimated fair value on the transfer date is charged to the allowance for loan losses, while further declines in market values are recorded as OREO expense. Impaired loans, which primarily consist of non-accruing residential mortgage and commercial real estate loans, totaled $3.13 million at June 30, 2012 and $2.51 million at December 31, 2011 and are included as nonperforming loans in the table above.  At June 30, 2012, $578 thousand of impaired loans had specific reserve allocations totaling $204 thousand.  

Management monitors asset quality closely and continuously performs detailed and extensive reviews on larger credits and problematic credits identified on the watched asset list, nonperforming asset listings and internal credit rating reports. In addition to frequent financial analysis and review of well-rated and adversely graded loans, we incorporate active monitoring of key credit and non-credit risks for each customer, assessing risk through the daily reviews of overdrafts, delinquencies and usage of electronic banking products and tracking for timely receipt of all required financial statements. A management committee reviews the status of these loans each quarter and determines or confirms the appropriate risk rating, accrual status and loan loss reserve allocation.  The findings of this review process are instrumental in determining the adequacy of the allowance for credit losses.

Substandard accruing loans totaled $17.11 million at June 30, 2012, an increase of $4.7 million since December 31, 2011.  Of the total substandard accruing loans, $2.75 million are subject to federal loan guarantees. The listing of substandard accruing borrowers at June 30, 2012 includes borrowers operating in a variety of different industries and locations. Three borrowers represent 41% of performing classified loans.  Loans identified as substandard have well-defined weaknesses that, if not addressed, could result in a loss to the Bank.  These accruing substandard loans have generally continued to pay promptly and Management conducts regularly scheduled comprehensive reviews of the borrowers’ financial condition, payment performance, accrual status and collateral.  These reviews also ensure that these troubled accounts are properly administered with a focus on loss mitigation and that any potential loss exposures are appropriately quantified, and reserved for. The findings of this review process are a key component in assessing the adequacy of our Allowance for Loan Losses.

Concentrations by collateral exposure are also monitored as part of our risk management process. The composition of substandard accruing loans at June 30, 2012 consists of $11.42 million in loans secured by owner occupied commercial real estate, of which $2.31 million is subject to federal loan guarantees; and $1.52 million in commercial investment real estate, of which none is government guaranteed.  The balance consists of $2.66 million in loans to commercial borrowers, of which $400 thousand is government guaranteed, $1.27 million in loans secured by multi-family residential properties and $236 thousand in residential and home equity loans.

 

Allowance for Credit Losses

The allowance for credit losses is made up of two components - the Allowance for Loan Losses (“ALL”) and the Reserve for Undisbursed Lines.  The ALL is based on our estimate of the amount required to reflect the known and inherent risks in the loan portfolio, based on circumstances and conditions known at each reporting date. We review the adequacy of the ALL quarterly. Factors considered in evaluating the adequacy of the ALL include previous loss experience, the size and composition of the portfolio, risk rating composition, current economic and real estate market conditions and their effect on the borrowers, the performance of individual loans in relation to contractual terms and estimated fair values of properties that secure impaired loans.

The adequacy of the ALL is determined using a consistent, systematic methodology, consisting of a review of both specific reserves for loans identified as impaired and general reserves for the various loan portfolio classifications.  When a loan is impaired, we determine its impairment loss by comparing the excess, if any, of the loan’s carrying amount over (1) the present value of expected future cash flows discounted at the loan’s original effective interest rate, (2) the observable market price of the impaired loan, or (3) the fair value of the collateral securing a collateral-dependent loan.  When a loan is deemed to have an impairment loss, the loan is either charged down to its estimated net realizable value, or a specific reserve is established as part of the overall ALL if Management needs more time to evaluate all of the facts and circumstances relevant to that particular loan. 

The general ALL is a percentage-based reflection of historical loss experience and assigns a required allocation by loan classification based on a fixed percentage of all outstanding loan balances. The general allowance for loan losses employs a risk-rating model that grades loans based on their general characteristics of credit quality and relative risk. Appropriate reserve levels are estimated based on Management’s judgments regarding the historical loss experience, current economic trends, trends in the portfolio mix, volume and trends in delinquencies and non-accrual loans. 

Losses are charged against the ALL when Management believes that the collectability of principal is doubtful. To the extent we determine the level of anticipated losses in the portfolio has significantly increased or diminished, the ALL is adjusted through current earnings. Overall, we believe that the ALL is maintained at an adequate level, in light of historical and current factors, to reflect the level of credit risk in the loan portfolio. Loan loss experience and nonperforming asset data are presented and discussed in relation to their impact on the adequacy of the ALL.

 

39

 


 

The following table summarizes year to date activity in our Allowance for Credit Losses through the dates indicated:

 

 

 

 

 

 

 

 

 

 

 

 

(In thousands)

June 30, 2012

March 31, 2012

December 31, 2011

June 30, 2011

Balance, beginning of year

$
11,353 
$
11,353 
$
10,754 
$
10,754 

Charge-offs:

 

 

 

 

  Commercial, financial and agricultural

(9)
(80)
(77)

  Real estate – residential

(20)
(83)
(49)

  Real estate – commercial

(60)
(60)

  Real estate – construction

(96)
(11)

  Installment

(10)
(8)

  Total charge-offs

(29)
(329)
(205)

Recoveries:

 

 

 

 

  Commercial, financial and agricultural

18 
20 
101 
44 

  Real estate – residential

11 

  Real estate – commercial

44 
43 

  Real estate – construction

13 
25 
11 

  Installment

  Total recoveries

43 
29 
178 
102 

Net (charge-offs) recoveries

14 
29 
(151)
(103)

Provision for credit losses

450 
250 
750 
250 

Balance end of period

$
11,817 
$
11,632 
$
11,353 
$
10,901 

Components:

 

 

 

 

Allowance for loan losses

$
11,203 
$
11,049 
$
10,619 
$
10,438 

Reserve for undisbursed lines of credit

614 
583 
734 
463 

  Allowance for credit losses

$
11,817 
$
11,632 
$
11,353 
$
10,901 

 

We recorded a provision for credit losses of $200 thousand and $450 thousand during the three and six months ended June 30, 2012, respectively. We recorded a provision of $250 thousand during the three and six months ended June 30, 2011

The following table reflects our nonperforming asset and coverage ratios as of the dates indicated:

 

 

 

 

 

 

 

 

June 30, 2012

March 31, 2012

December 31, 2011

June  30, 2011

NPL to total loans

0.31%

0.22%

0.24%

0.37%

NPA to total assets

0.22%

0.16%

0.18%

0.24%

Allowance for loan losses to total loans

1.09%

1.06%

1.03%

1.11%

Allowance for loan losses to NPL

358%

477%

423%

303%

 

We will continue to take appropriate measures to restore nonperforming assets to performing status or otherwise liquidate these assets in an orderly fashion so as to maximize their value to us. There can be no assurances that we will be able to complete the disposition of nonperforming assets without incurring further losses.

 

Loan Portfolio Monitoring

Our Board of Directors grants each loan officer the authority to originate loans on our behalf, subject to certain limitations. The Board of Directors also establishes restrictions regarding the types of loans that may be granted and the distribution of loan types within our portfolio, and sets loan authority limits for each lender. These authorized lending limits are reviewed at least annually and are based upon the lender's knowledge and experience. Loan requests that exceed a lender's authority require the signature of our Senior Credit Officer, Senior Lender, and/or our President. All extensions of credit of $4.0 million or greater to any one borrower, or related party interest, are reviewed and approved by the Loan Committee of our Bank’s Board of Directors.

The Loan Committee and the credit department regularly monitor our loan portfolio. The entire loan portfolio and individual loans are reviewed for loan performance, compliance with internal policy requirements and banking regulations, creditworthiness, and strength of documentation. We monitor loan concentrations by individual borrowers, industries and loan types. As part of the annual credit policy review process, targets are set by loan type for the total portfolio. Credit risk ratings assessing inherent risk in individual loans are assigned to commercial loans at origination and are routinely reviewed by lenders and Management on a periodic basis according to total exposure and risk rating. These internal reviews assess the adequacy of all aspects of credit administration; additionally, we maintain an on-going active monitoring process of loan performance during the year.  We have also hired external loan review firms to assist in monitoring both the commercial and residential loan portfolios. The commercial loan review firm reviews, at a minimum, 60% in dollar volume of our commercial loan portfolio each year.  These comprehensive reviews assess the accuracy of the Bank’s risk rating system as well as the effectiveness of credit administration in managing overall credit risks.  

40

 


 

All loan officers are required to service their loan portfolios and account relationships. Loan officers, a commercial workout officer, or credit department personnel take remedial actions to assure full and timely payment of loan balances as necessary, with the supervision of the Senior Lender and the Senior Credit Officer.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

General

Our Management and Board of Directors are committed to sound risk management practices throughout the organization. We have developed and implemented a centralized risk management monitoring program. Risks associated with our business activities and products are identified and measured as to probability of occurrence and impact on us (low, moderate, or high), and the control or other activities in place to manage those risks are identified and assessed. Periodically, department-level and senior managers re-evaluate and report on the risk management processes for which they are responsible. This documented program provides Management with a comprehensive framework for monitoring our risk profile from a macro perspective; it also serves as a tool for assessing internal controls over financial reporting as required under the Federal Deposit Insurance Corporation Improvement Act and the Sarbanes-Oxley Act of 2002.

 

Liquidity Risk

Our liquidity is measured by our ability to raise cash when needed at a reasonable cost.  We must be capable of meeting expected and unexpected obligations to customers at any time.  Given the uncertain nature of customer demands as well as the need to maximize earnings, we must have available reasonably priced sources of funds that can be accessed quickly in time of need.  As discussed previously under “Liquidity and Capital Resources,” we have several sources of readily available funds, including the ability to borrow using our investment portfolio as collateral.  We also monitor our liquidity on a quarterly basis in compliance with our Liquidity Contingency Plan.  We have expanded our liquidity monitoring process over the last year and have partnered with our ALCO consultant to provide a more robust modeling process that monitors early liquidity stress triggers, and also allows us to model worst case liquidity scenarios, and various responses to those scenarios.

 

Market Risk – Interest Rate Risk

Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates or prices such as interest rates, foreign currency exchange rates, commodity prices, and equity prices. Our primary market risk exposure is interest rate risk. An important component of our asset and liability management process is the ongoing monitoring and management of this risk, which is governed by established policies that are reviewed and approved annually by our Bank’s Board of Directors. The Investment policy details the types of securities that may be purchased, and establishes portfolio limits and maturity limits for the various sectors. The Investment policy also establishes specific investment quality limits. Our Bank’s Board of Directors has established a Board-level Asset and Liability Committee, which delegates responsibility for carrying out the asset/liability management policies to the Management-level Asset and Liability Committee (“ALCO”). The ALCO, chaired by the Chief Financial Officer and composed of members of senior management, develops guidelines and strategies impacting our asset and liability management related activities based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends. The ALCO manages the investment portfolio. Our goal is to maximize net interest income while mitigating market and interest rate risk.  We accomplish this through careful monitoring of the overall duration and average life of the portfolio, thorough analysis of securities we are considering for purchase, monitoring of individual securities, occasional repositioning of the investment portfolio, as well as selective sales of specific securities.

The ALCO is responsible for evaluating and managing the interest rate risk which arises naturally from imbalances in repricing, maturity and cash flow characteristics of our assets and liabilities. Techniques used by the ALCO take into consideration the cash flow and repricing attributes of balance sheet and off-balance sheet items and their relation to possible changes in interest rates. The ALCO manages interest rate exposure primarily by using on-balance sheet strategies, generally accomplished through the management of the duration, rate sensitivity and average lives of our various investments, and by extending or shortening maturities of borrowed funds, as well as carefully managing and monitoring the pricing of loans and deposits. The ALCO also considers the use of off-balance sheet strategies, such as interest rate caps and floors and interest rate swaps, to help minimize our exposure to changes in interest rates.  By using derivative financial instruments to hedge exposures to changes in interest rates we expose ourselves to credit risk and market risk.  Credit risk is the failure of the counterparty to perform under the terms of the derivative contract.  When the fair value of a derivative contract is positive, the counterparty owes us, which creates credit risk for us.  We minimize the credit risk in derivative instruments by entering into transactions only with high-quality counterparties.  The market risk associated with interest rate contracts is managed by establishing and monitoring parameters that limit the types and degree of market risk that may be undertaken.

The ALCO is responsible for ensuring that our Bank’s Board of Directors receives accurate information regarding our interest rate risk position at least quarterly. The ALCO uses an outside consultant to perform rate shocks of our balance sheet, and to perform a variety of other analyses. The ALCO consultant meets with the Board and Management-level ALCOs on a quarterly basis. During these meetings, the ALCO consultant reviews our current position and discusses future strategies, as well as reviewing the result of rate shocks of our balance sheet and a variety of other analyses. The consultant’s most recent review was as of June 30, 2012. The consultant ran a base simulation assuming no changes in rates as well as a 200 basis point rising and, because rates are quite low, a 100 basis point falling interest rate scenario which assumes a parallel and pro rata shift of the yield curve over a one-year period, and no growth assumptions.  Additionally, the consultant ran a 400 basis point rising simulation which assumed a parallel shift of the

41

 


 

curve over 24 months, and a 500 basis point rising simulation which assumed the curve flattened over a 24 month time frame.   A summary of the results is as follows:

Current/Flat Rates: Net interest income is projected to trend downward in the current rate scenario as the expected replacement rates on assets are lower than the current portfolio, and opportunities to reduce rates on deposits and term funding are limited. This downward trend becomes more pronounced each quarter as interest rates remain very low.    

Falling Rates: If rates fall, net interest income is projected to trend in line with the base case scenario initially as rate reductions in the funding base offset lower asset yields.  Thereafter net interest income trends downward rapidly as funding rate reductions subside while asset cash flow continues to reset at reduced yields.  Accelerated prepayment speeds on mortgage-based assets exacerbate the impact of lower rates. 

Rising Rates:    Higher rates are better for us under all scenarios as our low cost deposits are worth more to us when they can be invested at higher rates. In the up 200 basis points scenario, net interest income is projected to move up quickly as asset yields reprice up more quickly than funding costs and asset cash flows are reinvested at higher rates. A more pronounced rising rate scenario is projected to trend slightly lower than the up 200 basis points scenario over the first three years due to additional pricing pressure on deposit rates, but eventually moves higher.  

The change in net interest income for the next twelve months from our expected or “most likely” forecast at the June 30, 2012 review is shown in the following table. The degree to which this exposure materializes will depend, in part, on our ability to manage deposit rates as interest rates rise or fall. 

 

 

Rate Change

Percent Change in

Net Interest Income

Up 200 basis points

1.84%

Down 100 basis points

(0.20)%

 

The ALCO uses off-balance sheet strategies, such as interest rate caps and floors and interest rate swaps, as well as borrowings with embedded caps and floors to help minimize our exposure to changes in interest rates.  As mentioned previously, we entered into interest rate swap arrangements to fix the cost of our trust preferred issuance that switched to a floating interest rate in December 2009.   See Note 10 to the accompanying Interim Unaudited Consolidated Financial Statements for further details on the interest rate swap.

The preceding sensitivity analysis does not represent our forecast and should not be relied upon as indicative of expected operating results. These estimates are based upon numerous assumptions, including, among others, the nature and timing of interest rate levels including yield curve shape, prepayments on loans and securities, deposit run-off rates, pricing decisions on loans and deposits and reinvestment/replacement of asset and liability cash flows. While assumptions are developed based upon current economic and local market conditions, as well as historical behavior, we cannot make any assurances as to the predictive nature of these assumptions, including how customer preferences or competitor influences might change.

The most significant ongoing factor affecting market risk exposure of net interest income during the second quarter of 2012 was the sustained low interest rate environment   Interest rates plummeted during 2008 and have remained low as the global economy slowed at unprecedented levels, unemployment levels soared, delinquencies on all types of loans increased along with decreased consumer confidence and dramatic declines in housing prices. Net interest income exposure is also significantly affected by the shape and level of the U.S. Government securities and interest rate swap yield curves, and changes in the size and composition of the loan, investment and deposit portfolios.  Interest rates have decreased further during 2012.  The ten-year treasury decreased 22 basis points to 1.67% during the first six months of 2012 and has decreased another 10-15 basis points since the end of the second quarter. The two-year treasury has remained in a range of about 0.27% to 0.37% during 2012.   

The model used to perform the base case balance sheet simulation assumes a parallel shift of the yield curve over twelve months and reprices every interest earning asset and interest bearing liability on our balance sheet. Prepayment assumptions for all residential mortgage products take into account prepayment assumptions most recently published by Applied Financial Technologies. Prepayment assumptions for commercial loan and commercial mortgage products are derived through an analysis of historical prepayment patterns combined with analysis of the current characteristics of the portfolio. Investment securities with call provisions are examined on an individual basis in each rate environment to estimate the likelihood of a call. The model uses product-specific assumptions for deposits which are subject to repricing based on current market conditions

As market conditions vary from those assumed in the sensitivity analysis, actual results will likely differ due to: the varying impact of changes in the balances and mix of loans and deposits differing from those assumed, the impact of possible off balance sheet hedging strategies, and other internal/external variables. Furthermore, the sensitivity analysis does not reflect all actions that the ALCO might take in responding to or anticipating changes in interest rates.

 

Credit Risk

Our Bank’s Board of Directors reviews and approves our Bank’s investment and loan policies on an annual basis. The investment policy establishes minimum investment quality guidelines, as well as specific limits on asset classes within the investment portfolio.  The loan policy establishes restrictions regarding the types of loans that may be granted, and the distribution of loan types within our

42

 


 

portfolio. Our Bank’s Board of Directors grants each loan officer the authority to originate loans on our behalf, subject to certain limitations. These authorized lending limits are reviewed at least annually and are based upon the officer’s knowledge and experience. Loan requests that exceed an officer’s authority require the signature of our Senior Credit Officer, Senior Lender, and/or President. All extensions of credit of $4.0 million or greater to any one borrower or related party are reviewed and approved by the Loan Committee of our Bank’s Board of Directors. Our loan portfolio is continuously monitored for performance, creditworthiness and strength of documentation through the use of a variety of management reports and with the assistance of an external loan review firm.  Credit ratings are assigned to commercial loans and are routinely reviewed. Loan officers or the loan workout function take remedial actions to assure full and timely payment of loan balances when necessary.

 

Item 4.  Controls and Procedures

Our principal executive officer, principal financial officer, and other members of our senior management have evaluated our disclosure controls and procedures as of the end of the period covered by this quarterly report. Based on this evaluation, our principal executive officer and principal financial officer have concluded that the disclosure controls and procedures effectively ensure that information required to be disclosed in our filings and submissions with the SEC under the Securities Exchange Act of 1934, as amended, is accumulated and communicated to our management (including the principal executive officer and principal financial officer), and is recorded, processed, summarized and reported within the time periods specified by the SEC. In addition, we have reviewed our internal control over financial reporting and there have been no changes in our internal control over financial reporting during the quarter ended June 30, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

43

 


 

 

 

MERCHANTS BANCSHARES, INC.

PART II – OTHER INFORMATION

Item 1. Legal Proceedings

None.

Item 1A. Risk Factors

Please read the factors discussed in Part I – Item 1A, "Risk Factors" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011 filed with the SEC on March 8, 2012, which could materially adversely affect our business, financial condition and operating results. These risks are not the only ones facing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and operating results.

General economic and market conditions in the United States of America and abroad may materially and adversely affect the market price of shares of our common stock.  Because of these and other factors, past financial performance should not be considered an indicator of future performance.  The forward-looking statements contained herein represent our judgments as of the date of this Quarterly Report on Form 10-Q and we undertake no duty to update these forward-looking statements.  We caution readers not to place undue reliance on such statements.

Item  2.  Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3. Defaults Upon Senior Securities

None.

Item 4. Mine Safety Disclosure

Not applicable.

Item 5. Other Information

None.

Item 6.  Exhibits   

(a)

Exhibits: 

31.1*     Certification of Chief Executive Officer Pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as amended

31.2*     Certification of Chief Financial Officer Pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as amended

32.1**    Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2**    Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

101**     The following materials from Merchants Bancshares, Inc.’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2012 formatted in XBRL:  (i) Consolidated Balance Sheets at June 30, 2012 and December 31, 2011; (ii) Consolidated Statements of Income for the three and six months ended June 30, 2012 and 2011; (iii) Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2012 and 2011; (iv) Consolidated Statements of Cash Flows for the three and six months ended June 30, 2012 and 2011; and (v) Notes to Interim Unaudited Consolidated Financial Statements.

_______________________________

*          Filed herewith

**         Furnished herewith

 

 

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MERCHANTS BANCSHARES, INC.

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

Merchants Bancshares, Inc.

 

/s/ Michael R. Tuttle                        

Michael R. Tuttle 

President & Chief Executive Officer

 

/s/ Janet P. Spitler                        

Janet P. Spitler

Chief Financial Officer & Treasurer

Principal Accounting Officer

 

 

August 7, 2012

Date

 

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