Note 7 - Investment Securities

9 Months Ended

Sep. 30, 2014

Investments, Debt and Equity Securities [Abstract]

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

7. INVESTMENT SECURITIES

QNB engages in trading activities for its own account. Securities that are held principally for resale in the near term are recorded in the trading account at fair value with changes in fair value recorded in non-interest income. There were net gains of $27,000 included in net gains on trading activity related to trading securities still held at September 30, 2014. Interest and dividends are included in interest income.

There were no trading securities held by QNB at December 31, 2013. Trading securities, at fair value, at September 30, 2014 were as follows:

	Fair
September 30, 2014	value
State and municipal securities	$	4,122

The amortized cost and estimated fair values of investment securities available-for-sale at September 30, 2014 and December 31, 2013 were as follows:

			Gross		Gross
			unrealized		unrealized
	Fair		holding		holding			Amortized
September 30, 2014	value		gains		losses			cost
U.S. Government agency	$	56,322	$	161	$	(768	)	$	56,929
State and municipal		74,133		1,604		(220	)		72,749
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed		139,171		1,595		(1,120	)		138,696
Collateralized mortgage obligations (CMOs)		77,027		391		(1,730	)		78,366
Pooled trust preferred		2,462		167		(1,224	)		3,519
Corporate debt		6,060		52		-			6,008
Equity		7,293		714		(60	)		6,639
Total investment securities available-for-sale	$	362,468	$	4,684	$	(5,122	)	$	362,906

			Gross		Gross
			unrealized		unrealized
	Fair		holding		holding			Amortized
December 31, 2013	value		gains		losses			cost
U.S. Government agency	$	71,639	$	195	$	(1,702	)	$	73,146
State and municipal		87,199		1,023		(1,627	)		87,803
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed		139,723		1,436		(2,361	)		140,648
Collateralized mortgage obligations (CMOs)		75,394		556		(2,334	)		77,172
Pooled trust preferred		2,069		85		(1,535	)		3,519
Corporate debt		6,021		24		(13	)		6,010
Equity		6,625		1,127		(44	)		5,542
Total investment securities available-for-sale	$	388,670	$	4,446	$	(9,616	)	$	393,840

The amortized cost and estimated fair value of securities available-for-sale by contractual maturity at September 30, 2014 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.

			Amortized
September 30, 2014	Fair value		cost
Due in one year or less	$	9,099	$	8,980
Due after one year through five years		231,661		231,970
Due after five years through ten years		87,737		88,139
Due after ten years		26,678		27,178
Equity securities		7,293		6,639
Total investment securities available-for-sale	$	362,468	$	362,906

Proceeds from sales of investment securities available-for-sale were approximately $19,504,000 and $13,552,000 for the nine months ended September 30, 2014 and 2013, respectively.

At September 30, 2014 and December 31, 2013, investment securities available-for-sale totaling approximately $241,559,000 and $207,868,000, 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:

Three months ended			September 30, 2014										September 30, 2013
						Other-than-									Other-than-
	Gross		Gross			temporary					Gross		Gross		temporary
	realized		realized			impairment					realized		realized		impairment
	gains		losses			losses		Net gains			gains		losses		losses		Net gains
Equity securities	$	181	$	-		$	-	$	181		$	303	$	-	$	-	$	303
Debt securities		-		(1	)		-		(1	)		-		-		-		-
Total	$	181	$	(1	)	$	-	$	180		$	303	$	-	$	-	$	303

The tax expense applicable to the net realized gains for the three-month periods ended September 30, 2014 and 2013 amounted to approximately $61,000 and $103,000, respectively.

Nine months ended			September 30, 2014									September 30, 2013
						Other-than-								Other-than-
	Gross		Gross			temporary				Gross		Gross		temporary
	realized		realized			impairment				realized		realized		impairment
	gains		losses			losses		Net gains		gains		losses		losses			Net gains
Equity securities	$	1,051	$	(6	)	$	-	$	1,045	$	672	$	-	$	(43	)	$	629
Debt securities		137		(95	)		-		42		190		-		-			190
Total	$	1,188	$	(101	)	$	-	$	1,087	$	862	$	-	$	(43	)	$	819

The tax expense applicable to the net realized gains for the nine-month periods ended September 30, 2014 and 2013 amounted to approximately $370,000 and $278,000, 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.

There were no credit-related OTTI charges in the first nine months of 2014. During the second quarter of 2013, there was a $43,000 other-than-temporary impairment (OTTI) charge on an equity security that had been in an unrealized loss position in excess of 20% for six months.

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 three and nine month periods ended September 30, 2014 or 2013.

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:

	Three months ended September 30,				Nine months ended September 30,
	2014		2013		2014		2013
Balance, beginning of period	$	1,271	$	1,271	$	1,271	$	1,271
Reductions: gain on payoff		-		-		-		-
Additions:
Initial credit impairments		-		-		-		-
Subsequent credit impairments		-		-		-		-
Balance, end of period	$	1,271	$	1,271	$	1,271	$	1,271

The amortized cost and estimated fair values of investment securities held-to-maturity at September 30, 2014 and December 31, 2013 were as follows:

Held-To-Maturity

September 30, 2014

December 31, 2013

Gross

Gross

Gross

Gross

unrealized

unrealized

unrealized

unrealized

Amortized

holding

holding

Fair

Amortized

holding

holding

Fair

cost

gains

losses

value

cost

gains

losses

value

State and municipal securities

$

146

$

12

-

$

158

$

146

$

16

-

$

162

The amortized cost and estimated fair value of securities held-to-maturity by contractual maturity at September 30, 2014 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.

			Amortized
September 30, 2014	Fair value		cost
Due in one year or less		-		-
Due after one year through five years	$	158	$	146
Due after five years through ten years		-		-
Due after ten years		-		-
Total investment securities held-to-maturity	$	158	$	146

There were no sales of investment securities classified as held-to-maturity during the three and nine months ended September 30, 2014 or 2013.

The following table indicates the length of time individual securities have been in a continuous unrealized loss position at September 30, 2014 and December 31, 2013:

September 30, 2014
			Less than 12 months					12 months or longer					Total
	No. of		Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
	securities		value		losses			value		losses			value		losses
U.S. Government agency		36	$	15,539	$	(49	)	$	27,668	$	(719	)	$	43,207	$	(768	)
State and municipal		49		5,772		(22	)		15,078		(198	)		20,850		(220	)
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed		55		31,717		(162	)		43,761		(958	)		75,478		(1,120	)
Collateralized mortgage obligations (CMOs)		49		16,313		(127	)		40,903		(1,603	)		57,216		(1,730	)
Pooled trust preferred		5		-		-			1,994		(1,224	)		1,994		(1,224	)
Equity		4		958		(60	)		-		-			958		(60	)
Total		198	$	70,299	$	(420	)	$	129,404	$	(4,702	)	$	199,703	$	(5,122	)

December 31, 2013
			Less than 12 months					12 months or longer					Total
	No. of		Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
	securities		value		losses			value		losses			value		losses
U.S. Government agency		44	$	54,563	$	(1,548	)	$	2,846	$	(154	)	$	57,409	$	(1,702	)
State and municipal		87		33,750		(1,379	)		4,288		(248	)		38,038		(1,627	)
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed		54		75,720		(2,238	)		1,884		(123	)		77,604		(2,361	)
Collateralized mortgage obligations (CMOs)		45		33,622		(1,413	)		18,567		(921	)		52,189		(2,334	)
Pooled trust preferred		5		-		-			1,683		(1,535	)		1,683		(1,535	)
Corporate debt		2		1,987		(13	)		-		-			1,987		(13	)
Equity		3		394		(24	)		136		(20	)		530		(44	)
Total		240	$	200,036	$	(6,615	)	$	29,404	$	(3,001	)	$	229,440	$	(9,616	)

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 September 30, 2014 in U.S. Government securities, state and municipal securities, mortgage-backed securities and CMOs are primarily the result of interest rate fluctuations. 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.

The Company’s investment in marketable equity securities primarily consists of investments in large cap stock companies. These equity securities are analyzed for impairment on an ongoing basis. Management believes these equity securities will recover in the foreseeable future. QNB evaluated the near-term prospects of the issuers in relation to the severity and duration of the impairment. Based on that evaluation and the Company’s ability and intent to hold those securities for a reasonable period of time sufficient for a forecasted recovery of fair value, the Company does not consider these equity securities to be other-than-temporarily impaired.

QNB holds seven pooled trust preferred securities as of September 30, 2014. These securities have a total amortized cost of approximately $3,519,000 and a fair value of $2,462,000. 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 September 30, 2014:

Deal	Class	Book value		Fair value		Unreal-ized gains (losses)			Realized OTTI credit loss (YTD 2014)		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	$	207	$	(36	)	$	-	$	(1	)	B1/B		5		-		18.0	%		140.1	%
PreTSL V	Mezzanine*		-		-		-			-		(118	)	C/D		-		-		100.0			13.4
PreTSL XVII	Mezzanine		752		506		(246	)		-		(222	)	C/C		32		5		29.1			84.6
PreTSL XIX	Mezzanine		988		512		(476	)		-		-		C/C		38		12		17.2			86.8
PreTSL XXV	Mezzanine		766		424		(342	)		-		(222	)	C/C		47		5		31.0			84.8
PreTSL XXVI	Mezzanine		469		345		(124	)		-		(270	)	C/C		42		7		26.3			90.2
PreTSL XXVI	Mezzanine		301		468		167			-		(438	)	C/C		42		7		26.3			90.2
		$	3,519	$	2,462	$	(1,057	)	$	-	$	(1,271	)

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

On December 10, 2013, Federal Banking Regulators issued final rules regarding implementation of Section 619 of the Dodd-Frank Act ("the Volcker rule") which stated that “a banking entity may not, as principal, directly or indirectly, acquire or retain any ownership interest in or sponsor a covered fund”. The interpretation of the final rules indicated that a very high percentage of pooled trust preferred securities would be considered "covered funds". The rules also required that banks dispose of their covered funds by July 21, 2015, subject to a regulatory extension of up to five years. This would have triggered accounting requirements to record pooled trust preferred securities to fair value through the income statement. As a result of this regulation there were some trades of pooled trust preferred securities during December of 2013. On January 14, 2014, Regulators released a final interim rule authorizing retention of pooled trust preferred securities backed primarily by bank-issued trust preferred securities which included the PreTSLs held by QNB. Due to the uncertainty invoked between the original release of the Volcker Rule and the final interim rule, there was a noticeable increase in trading activity. However, we believe most of these trades occurred under distress and do not represent trades made in an orderly market. Despite the trades that took place as discussed previously, the market for these securities at September 30, 2014 was 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 are depressed relative to historical levels. 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 previous table, 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, except for PreTSL IV and V which represent the senior-most obligation of the trust.

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 three and nine months ended September 30, 2014, 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 of 1% were forecasted. In addition to the base prepayment assumption, due to the enactment of the Dodd-Frank Act 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, the issuers that have shown a recent history of prepayment of both floating rate and fixed rate issues were identified and it was 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 any 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 generate additional capital either internally or externally.

● 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 2015 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. Based on information from various published studies, a 95% severity of loss was utilized for defaults projected in 2015 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 September 30, 2014, 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.