Note 7 - Investment Securities

6 Months Ended

Jun. 30, 2013

Investments, Debt and Equity Securities [Abstract]

Investments in Debt and Marketable Equity Securities (and Certain Trading Assets) Disclosure [Text Block]

7. INVESTMENT SECURITIES

The amortized cost and estimated fair values of investment securities available-for-sale at June 30, 2013 and December 31, 2012 were as follows:

June 30, 2013	Fair value		Gross unrealized holding gains		Gross unrealized holding losses		Amortized cost
U.S. Government agency securities	$	70,474	$	251	$	1,455	$	71,678
State and municipal securities		86,715		1,472		1,331		86,574
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed securities		126,945		1,493		1,694		127,146
Collateralized mortgage obligations (CMOs)		85,678		679		1,483		86,482
Pooled trust preferred securities		2,091		81		1,509		3,519
Corporate debt securities		3,991		16		31		4,006
Equity securities		4,470		526		70		4,014
Total investment securities available-for-sale	$	380,364	$	4,518	$	7,573	$	383,419

December 31, 2012	Fair value		Gross unrealized holding gains		Gross unrealized holding losses		Amortized cost
U.S. Government agency securities	$	104,130	$	750	$	19	$	103,399
State and municipal securities		86,789		3,141		91		83,739
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed securities		107,973		3,169		33		104,837
Collateralized mortgage obligations (CMOs)		94,091		1,188		155		93,058
Pooled trust preferred securities		1,962		51		1,608		3,519
Corporate debt securities		2,502		44		-		2,458
Equity securities		4,055		402		87		3,740
Total investment securities available-for-sale	$	401,502	$	8,745	$	1,993	$	394,750

The amortized cost and estimated fair value of securities available-for-sale by contractual maturity at June 30, 2013 are shown in the following table. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities are assigned to categories based on contractual maturity except for mortgage-backed securities and CMOs which are based on the estimated average life of these securities and municipal securities that have been pre-refunded.

June 30, 2013	Fair value		Amortized cost
Due in one year or less	$	9,498	$	9,349
Due after one year through five years		202,245		201,228
Due after five years through ten years		119,304		122,291
Due after ten years		44,847		46,537
Equity securities		4,470		4,014
Total investment securities available-for-sale	$	380,364	$	383,419

Proceeds from sales of investment securities available-for-sale were approximately $12,387,000 and $15,798,000 for the six months ended June 30, 2013 and 2012, respectively.

At June 30, 2013 and December 31, 2012, investment securities available-for-sale totaling approximately $163,410,000 and $170,433,000, respectively, were pledged as collateral for repurchase agreements and deposits of public funds.

The following table presents information related to the Company’s gains and losses on the sales of equity and debt securities, and losses recognized for the other-than-temporary impairment of these investments. Gains and losses on available-for-sale securities are computed on the specific identification method and included in non-interest income. Gross realized losses on equity and debt securities are net of other-than-temporary impairment charges:

	Six months ended June 30, 2013									Six months ended June 30, 2012
	Gross realized gains		Gross realized losses		Other-than- temporary impairment losses			Net gains		Gross realized gains		Gross realized losses			Other-than- temporary impairment losses		Net gains
Equity securities	$	369	$	-	$	(43	)	$	326	$	427	$	-		$	-	$	427
Debt securities		190		-		-			190		107		(4	)		-		103
Total	$	559	$	-	$	(43	)	$	516	$	534	$	(4	)	$	-	$	530

The tax expense applicable to the net realized gains for the six-month periods ended June 30, 2013 and 2012 amounted to approximately $176,000 and $180,000, respectively.

QNB recognizes OTTI for debt securities classified as available-for-sale in accordance with FASB ASC 320, Investments – Debt and Equity Securities, which requires that we assess whether we intend to sell or it is more likely than not that the Company will be required to sell a security before recovery of its amortized cost basis less any current-period credit losses. For debt securities that are considered other-than-temporarily impaired and that we do not intend to sell and will not be required to sell prior to recovery of our amortized cost basis, the amount of the impairment is separated into the amount that is credit related (credit loss component) and the amount due to all other factors. The credit loss component is recognized in earnings and is the difference between the security’s amortized cost basis and the present value of its expected future cash flows discounted at the security’s effective yield. The remaining difference between the security’s fair value and the present value of future expected cash flows is due to factors that are not credit related and, therefore, is not required to be recognized as a loss in the income statement, but is recognized in other comprehensive income. For equity securities, once a decline in value is determined to be other-than-temporary, the value of the equity security is reduced to fair value and a corresponding charge to earnings is recognized. QNB believes that we will fully collect the carrying value of securities on which we have recorded a non-credit related impairment in other comprehensive income.

The following table presents a roll forward of the credit loss component recognized in earnings. The credit loss component of the amortized cost represents the difference between the present value of expected future cash flows and the amortized cost basis of the security prior to considering credit losses. The beginning balance represents the credit loss component for debt securities for which OTTI occurred prior to the beginning of the year. Credit-impaired debt securities must be presented in two components based upon whether the current period is the first time the debt security was credit-impaired (initial credit impairment) or is not the first time the debt security was credit-impaired (subsequent credit impairments). No credit impairments were recognized on debt securities in the first six months of 2013 or 2012.

The following table presents a summary of the cumulative credit-related other-than-temporary impairment charges recognized as components of earnings for debt securities still held by QNB:

Six months ended June 30,	2013		2012
Balance, beginning of period	$	1,271	$	1,279
Reductions: gain on payoff		-		-
Additions:
Initial credit impairments		-		-
Subsequent credit impairments		-		-
Balance, end of period	$	1,271	$	1,279

The amortized cost and estimated fair values of investment securities held-to-maturity at June 30, 2013 and December 31, 2012 were as follows:

Held-To-Maturity
	June 30, 2013								December 31, 2012
	Amortized cost		Gross unrealized holding gains		Gross unrealized holding losses		Fair value		Amortized cost		Gross unrealized holding gains		Gross unrealized holding losses		Fair value
State and municipal securities	$	146	$	17		-	$	163	$	146	$	20		-	$	166

The amortized cost and estimated fair value of securities held-to-maturity by contractual maturity at June 30, 2013 are shown in the following table. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

June 30, 2013	Fair value		Amortized cost
Due in one year or less		-		-
Due after one year through five years	$	163	$	146
Due after five years through ten years		-		-
Due after ten years		-		-
Total investment securities held-to-maturity	$	163	$	146

There were no sales of investment securities classified as held-to-maturity during the six months ended June 30, 2013 or 2012.

The following table indicates the length of time individual securities have been in a continuous unrealized loss position at June 30, 2013 and December 31, 2012:

June 30, 2013
			Less than 12 months				12 months or longer				Total
	No. of securities		Fair value		Unrealized losses		Fair value		Unrealized losses		Fair value		Unrealized losses
U.S. Government agency securities		43	$	53,172	$	1,455		-		-	$	53,172	$	1,455
State and municipal securities		73		32,706		1,331		-		-		32,706		1,331
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed securities		45		68,335		1,694		-		-		68,335		1,694
Collateralized mortgage obligations (CMOs)		45		57,461		1,458	$	1,507	$	25		58,968		1,483
Pooled trust preferred securities		5		-		-		1,708		1,509		1,708		1,509
Corporate debt securities		3		2,972		31		-		-		2,972		31
Equity securities		6		675		47		133		23		808		70
Total		220	$	215,321	$	6,016	$	3,348	$	1,557	$	218,669	$	7,573

December 31, 2012
			Less than 12 months				12 months or longer				Total
	No. of securities		Fair value		Unrealized losses		Fair value		Unrealized losses		Fair value		Unrealized losses
U.S. Government agency securities		4	$	3,992	$	19		-		-	$	3,992	$	19
State and municipal securities		15		6,472		91		-		-		6,472		91
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed securities		9		13,439		33		-		-		13,439		33
Collateralized mortgage obligations (CMOs)		19		28,396		155		-		-		28,396		155
Pooled trust preferred securities		5		-		-	$	1,609	$	1,608		1,609		1,608
Equity securities		7		587		45		272		42		859		87
Total		59	$	52,886	$	343	$	1,881	$	1,650	$	54,767	$	1,993

Management evaluates debt securities, which are comprised of U.S. Government agencies, state and municipalities, mortgage-backed securities, CMOs and corporate debt securities, for other-than-temporary impairment and considers the current economic conditions, the length of time and the extent to which the fair value has been less than cost, interest rates and the bond rating of each security. The unrealized losses at June 30, 2013 in U.S. Government securities, state and municipal securities, mortgage-backed securities, CMOs and corporate debt securities are primarily the result of rising interest rates late in the second quarter. If held to maturity, these bonds will mature at par, and QNB will not realize a loss. The Company has the intent to hold the securities and does not believe it will be required to sell the securities before recovery occurs.

QNB holds seven pooled trust preferred securities as of June 30, 2013. These securities have a total amortized cost of approximately $3,519,000 and a fair value of $2,091,000. Five of the seven securities have been in an unrealized loss position for more than twelve months. All of the pooled trust preferred securities are available-for-sale securities and are carried at fair value.

The following table provides additional information related to pooled trust preferred securities (PreTSLs) as of June 30, 2013:

Deal	Class	Book value		Fair value		Unrealized gains (losses)			Realized OTTI credit loss (YTD 2013)		Total recognized OTTI credit loss			Moody's /Fitch ratings	Current number of performing banks		Current number of performing insurance companies		Actual deferrals and defaults as a % of total collateral			Total performing collateral as a % of outstanding bonds
PreTSL IV	Mezzanine*	$	243	$	201	$	(42	)	$	-	$	(1	)	Caa2/CCC		5		-		18.0	%		139.5	%
PreTSL V	Mezzanine*		-		-		-			-		(118	)	C/D		-		-		100.0			12.5
PreTSL XVII	Mezzanine		752		439		(313	)		-		(222	)	C/C		30		4		38.8			71.2
PreTSL XIX	Mezzanine		988		431		(557	)		-		-		C/C		35		13		22.9			81.8
PreTSL XXV	Mezzanine		766		356		(410	)		-		(222	)	C/C		41		6		33.5			79.8
PreTSL XXVI	Mezzanine		469		282		(187	)		-		(270	)	C/C		40		7		30.2			83.5
PreTSL XXVI	Mezzanine		301		382		81			-		(438	)	C/C		40		7		30.2			83.5
		$	3,519	$	2,091	$	(1,428	)	$	-	$	(1,271	)

Mezzanine* - only class of bonds still outstanding (represents the senior-most obligation of the trust)

The market for these securities at June 30, 2013 is not active and markets for similar securities also are not active. The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which pooled trust preferred securities trade and then by a significant decrease in the volume of trades relative to historical levels. The new issue market is also inactive and the market values for these securities (and any securities other than those issued or guaranteed by U.S. Government agencies) are depressed relative to historical levels. In today’s market, a low market price for a particular bond may only provide evidence of a recent widening of corporate spreads in general versus being an indicator of credit problems with a particular issuer. Lack of liquidity in the market for trust preferred collateralized debt obligations, credit rating downgrades and market uncertainties related to the financial industry are all factors contributing to the temporary impairment of these securities. Although these securities are classified as available-for-sale, the Company has the intent to hold the securities and does not believe it will be required to sell the securities before recovery occurs. As illustrated in the table above, these securities are comprised mainly of securities issued by banks, and to a lesser degree, insurance companies. QNB owns the mezzanine tranches of these securities.

On a quarterly basis we evaluate our debt securities for other-than-temporary impairment (OTTI), which involves the use of a third-party valuation firm to assist management with the valuation. When evaluating these investments a credit-related portion and a non-credit related portion of OTTI are determined. The credit related portion is recognized in earnings and represents the expected shortfall in future cash flows. The non-credit related portion is recognized in other comprehensive income and represents the difference between the book value and the fair value of the security less any current quarter credit related impairment. For the six months ended June 30, 2013, no other-than-temporary impairment charges representing credit impairment were recognized on our pooled trust preferred collateralized debt obligations. A discounted cash flow analysis provides the best estimate of credit related OTTI for these securities. Additional information related to this analysis follows:

All of the pooled trust preferred collateralized debt obligations held by QNB are rated lower than AA and are measured for OTTI within the scope of ASC 325 (formerly known as EITF 99-20), Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to be Held by a Transferor in Securitized Financial Assets, and Amendments to the Impairment Guidance of EITF Issue No. 99-20 (formerly known as EITF 99-20-1). QNB performs a discounted cash flow analysis on all of its impaired debt securities to determine if the amortized cost basis of an impaired security will be recovered. In determining whether a credit loss exists, QNB uses its best estimate of the present value of cash flows expected to be collected from the debt security and discounts them at the effective yield implicit in the security at the date of acquisition or the prospective yield for those securities with prior OTTI charges. The discounted cash flow analysis is considered to be the primary evidence when determining whether credit related other-than-temporary impairment exists.

Results of a discounted cash flow test are significantly affected by other variables such as the estimate of future cash flows (including prepayments), credit worthiness of the underlying banks and insurance companies and determination of probability and severity of default of the underlying collateral. The following provides additional information for each of these variables:

● Estimate of Future Cash Flows – Cash flows are constructed in an INTEXcalc valuation model. INTEX is a proprietary cash flow model recognized as the industry standard for analyzing all types of structured debt products. It includes each deal’s structural features updated with trustee information, including asset-by-asset detail, as it becomes available. The modeled cash flows are then used to determine if all the scheduled principal and interest payments of the investments will be returned. For purposes of the cash flow analysis, relatively modest rates of prepayment were forecasted (ranging from 0-1%). In addition to the base prepayment assumption, due to the recent enactment of the Dodd-Frank financial legislation additional prepayment analysis was performed. First, trust preferred securities issued by banks with more than $15 billion in total assets at December 31, 2009 were identified. The current credit rating of these institutions was reviewed and it was assumed that any issuer with an investment grade credit rating would prepay their issuance as soon as possible, or July 1, 2015 for bank holding company subsidiaries of foreign banking organizations that have relied on Supervision and Regulation Letter SR-01-1. For those institutions rated below investment grade the holding companies’ approximate cost of long-term funding given their rating and marketplace interest rate was estimated. The following assumption was made; any holding company that could refinance for a cost savings of more than 2% will refinance and will do so as soon as possible, or July 1, 2015. Finally, for issuers not impacted by the Tier 1 regulatory capital legislation enacted by the Dodd-Frank act, we identified the issuers that have shown a recent history of prepayment of both floating rate and fixed rate issues and assumed these issuers will prepay as soon as possible.

● Credit Analysis – A quarterly credit evaluation is performed for the companies comprising the collateral across the various pooled trust preferred securities. This credit evaluation considers all available evidence and focuses on capitalization, asset quality, profitability, liquidity, stock price performance, whether the institution has received TARP funding and whether the institution has shown the ability to raise capital.

● Probability of Default – A near-term probability of default is determined for each issuer based on its financial condition and is used to calculate the expected impact of future deferrals and defaults on the expected cash flows. Each issuer in the collateral pool is assigned a near-term probability of default based on individual performance and financial characteristics. Various studies suggest that the rate of bank failures between 1934 and 2008 were approximately 0.36%. Thus, in addition to the specific bank default assumptions used for the near term, future defaults on the individual banks in the analysis for 2013 and beyond the rate used is calculated based on using the above mentioned thirty-six basis points and factoring that number based on a comparison of key financial ratios of active individual issuers without a short-term probability of default compared to all FDIC insured banks.

● Severity of Loss – In addition to the probability of default discussed above, a severity of loss (projected recovery) is determined in all cases. In the current analysis, the severity of loss ranges from 0% to 100% depending on the estimated credit worthiness of the individual issuer, with a 95% severity of loss utilized for defaults projected in 2013 and thereafter.

In addition to the above factors, the evaluation of impairment also includes a stress test analysis which provides an estimate of future risk for each tranche. This stressed breakpoint is then compared to the level of assets with credit concerns in each tranche. This comparison allows management to identify those pools that are at a greater risk for a future adverse change in cash flows so the asset quality in those pools can be monitored more closely for potential deterioration of credit quality.

Based upon the analysis performed by management as of June 30, 2013, it is probable that we will collect all contractual principal and interest payments on one of our seven pooled trust preferred securities, PreTSL XIX. The expected principal shortfall on the remaining pooled trust preferred securities has resulted in credit related other-than-temporary impairment charges in previous years. All of these pooled trust preferred securities held by QNB could be subject to additional writedowns in the future if additional deferrals and defaults occur.