Note 4 - Investment Securities

Trading

QNB engaged in trading activities for its own account, comprised of municipal securities that were held principally for resale in the near term are recorded in the trading account at fair value with changes in fair value recorded in net gain on trading activities in non-interest income. Interest and dividends are included in interest income. During the second quarter 2017, QNB Bank redeemed the trading securities portfolio, as lack of volatility and the interest rate environment resulted in declining performance of the portfolio. There were net realized gains of $27,000, and net unrealized losses of $40,000 for the years ended December 31, 2017 and 2016, respectively. Unrealized gains on trading activity related to trading securities held at December 31, 2016 totaled $69,000.

Trading securities, at fair value, at December 31, 2017 and 2016 were as follows:

Fair Value
Year ended December 31,	2017		2016
State and municipal securities	$	—	$	3,596

Available-For-Sale

The amortized cost and fair values of investment securities available-for-sale at December 31, 2017 and 2016 were as follows:

			Gross		Gross
			unrealized		unrealized
	Fair		holding		holding			Amortized
December 31, 2017	value		gains		losses			cost
U.S. Government agency	$	70,524	$	—	$	(1,948	)	$	72,472
State and municipal		76,804		717		(113	)		76,200
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed		142,703		195		(2,401	)		144,909
Collateralized mortgage obligations (CMOs)		76,302		29		(2,292	)		78,565
Pooled trust preferred		215		—		(26	)		241
Corporate debt		8,022		6		(37	)		8,053
Equity		4,975		28		(349	)		5,296
Total investment securities available-for-sale	$	379,545	$	975	$	(7,166	)	$	385,736

			Gross		Gross
			unrealized		unrealized
	Fair		holding		holding			Amortized
December 31, 2016	value		gains		losses			cost
U.S. Government agency	$	76,650	$	36	$	(2,118	)	$	78,732
State and municipal		72,295		614		(398	)		72,079
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed		145,301		561		(2,241	)		146,981
Collateralized mortgage obligations (CMOs)		77,415		109		(1,846	)		79,152
Pooled trust preferred		2,281		263		(891	)		2,909
Corporate debt		8,030		16		(57	)		8,071
Equity		8,503		587		(328	)		8,244
Total investment securities available-for-sale	$	390,475	$	2,186	$	(7,879	)	$	396,168

The amortized cost and fair value of securities available-for-sale by contractual maturity at December 31, 2017 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 state and municipal securities which are based on pre-refunded date, if applicable.

			Amortized
December 31, 2017	Fair value		cost
Due in one year or less	$	9,925	$	9,924
Due after one year through five years		206,877		210,575
Due after five years through ten years		133,454		135,725
Due after ten years		24,314		24,216
Equity securities		4,975		5,296
Total investment securities available-for-sale	$	379,545	$	385,736

Proceeds from sales of investment securities available-for-sale were $42,509,000, $32,573,000 and $47,960,000 for the years ended December 31, 2017, 2016, and 2015, respectively.

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 (OTTI) of these investments.

December 31,	2017
						Other-than-
	Gross		Gross			temporary
	realized		realized			impairment
	gains		losses			losses			Net gains
Equity securities	$	1,557		—		$	(80	)	$	1,477
Debt securities		581	$	(558	)		—			23
Total	$	2,138	$	(558	)	$	(80	)	$	1,500


December 31,	2016
						Other-than-
	Gross		Gross			temporary
	realized		realized			impairment
	gains		losses			losses			Net gains
Equity securities	$	758		—		$	(192	)	$	566
Debt securities		181	$	(73	)		—			108
Total	$	939	$	(73	)	$	(192	)	$	674


December 31,	2015
						Other-than-
	Gross		Gross			temporary
	realized		realized			impairment
	gains		losses			losses			Net gains
Equity securities	$	714	$	(23	)	$	(55	)	$	636
Debt securities		229		(82	)		—			147
Total	$	943	$	(105	)	$	(55	)	$	783

The tax expense applicable to the net realized gains were $510,000, $229,000 and $266,000 for the years ended December 31, 2017, 2016, and 2015, respectively.

There were no other-than-temporary impairment charges recognized for debt securities still held by QNB for the years ended December 31, 2017, 2016, or 2015.

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 consolidated statement of income, but is recognized in other comprehensive income (loss). 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 (loss).

The following table presents a rollforward 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 in 2017, 2016, or 2015. 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:

Year ended December 31,	2017			2016		2015
Balance, beginning of year	$	1,153		$	1,153	$	1,153
Reductions: sale, collateralized debt obligation		(1,152	)		—		—
Additions:
Initial credit impairments		—			—		—
Subsequent credit impairments		—			—		—
Balance, end of year	$	1		$	1,153	$	1,153

At December 31, 2017 and 2016, investment securities available-for-sale totaling $202,887,000 and $166,628,000, respectively, were pledged as collateral for repurchase agreements and deposits of public funds.

Securities that have been in a continuous unrealized loss position are as follows:

December 31, 2017
			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		53	$	10,828	$	(155	)	$	59,696	$	(1,793	)	$	70,524	$	(1,948	)
State and municipal		37		10,577		(49	)		4,446		(64	)		15,023		(113	)
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed		99		61,069		(705	)		72,318		(1,696	)		133,387		(2,401	)
Collateralized mortgage obligations (CMOs)		70		21,660		(349	)		52,833		(1,943	)		74,493		(2,292	)
Pooled trust preferred		1		—		—			215		(26	)		215		(26	)
Corporate debt		4		3,018		(20	)		988		(17	)		4,006		(37	)
Equity		11		2,727		(277	)		275		(72	)		3,002		(349	)
Total		275	$	109,879	$	(1,555	)	$	190,771	$	(5,611	)	$	300,650	$	(7,166	)

December 31, 2016
			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		55	$	72,626	$	(2,118	)	$	—	$	—		$	72,626	$	(2,118	)
State and municipal		70		29,280		(398	)		—		—			29,280		(398	)
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed		88		123,087		(2,241	)		—		—			123,087		(2,241	)
Collateralized mortgage obligations (CMOs)		68		56,853		(1,269	)		15,426		(577	)		72,279		(1,846	)
Pooled trust preferred		5		—		—			1,952		(891	)		1,952		(891	)
Corporate debt		4		4,002		(57	)		—		—			4,002		(57	)
Equity		16		2,985		(268	)		888		(60	)		3,873		(328	)
Total		306	$	288,833	$	(6,351	)	$	18,266	$	(1,528	)	$	307,099	$	(7,879	)

Management evaluates debt securities, which are comprised of U.S. Government Agencies, state and municipalities, mortgage-backed securities, CMOs and other issuers, for OTTI 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 December 31, 2017 in U.S. Government securities, state and municipal securities, mortgage-backed securities, CMOs and corporate debt securities 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. QNB 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. QNB evaluated the near-term prospects of the issuers in relation to the severity and duration of the impairment as well as the individual issuer’s financial condition, industry, geographic and legal environment. Based on that evaluation the Company recorded impairment charges of $80,000 to non-interest income for equity holdings during 2017. QNB has the ability and intent to hold the remaining securities in an unrealized loss position at December 31, 2017 until recovery and does not consider the remaining equity securities to be other-than-temporarily impaired.

QNB holds one trust preferred security, PreTSL IV. In 2017, PreTSL IV was reclassified from impaired to a performing asset: all capitalized interest has been repaid, no cashflows are being diverted to any senior tranche, and the bond has excess subordination, which represents cushion to absorb future defaults or deferrals. This security has been in an unrealized loss position for more than twelve months. 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 security (PreTSLs) as of December 31, 2017:

Deal

Class

Book

value

Fair

value

Unrealized

gains (losses)

Realized

OTTI

credit

loss

(YTD 2017)

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

241

215

(26

)

Ba1/BB

—

18.0

143.0

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

In June 2017, QNB Bank sold five non-performing pooled trust preferred securities, with $2,235,000 carrying value, recording a loss on sale of $15,000, included in non-interest income in the consolidated statement of income. Several years ago, QNB had recorded $1,152,000 in OTTI for four of these five these bonds, and subsequently applied any cashflow received to the balance of these non-performing, nonaccrual assets. Improvement in market prices for these securities during the second quarter 2017 reduced realized losses, and the reduction of approximately $19,000,000 in risk-based assets required for the bonds drove the decision to redeem these debt 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 impairment 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 quarter and twelve months ended December 31, 2017 and 2016, no other-than-temporary impairment charges representing credit impairment were recognized on our pooled trust preferred collateralized debt obligations.

PreTSL IV is rated lower than AA and 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). In addition to discounted cash-flows, QNB considers trends in the financial performance ratios of the bond’s underlying issuers, as well as the bond’s structure (QNB holds the senior-most obligation of the trust for PreTSL IV), determining there is little likelihood of default. 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. Lack of liquidity in the market for trust preferred collateralized debt obligations contributed to the temporary impairment of this security. Although classified as available-for-sale, the Company has the intent to hold PreTSL IV and does not believe it will be required to sell it before recovery occurs. QNB could be subject to additional write-downs in the future if additional deferrals and defaults occur.