10-Q 1 v359017_10q.htm FORM 10-Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form 10-Q
 
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2013
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 0-25752
 
FNBH BANCORP, INC.
(Exact name of registrant as specified in its charter)
 
 
MICHIGAN
 
38-2869722
 
 
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
 
 
101 East Grand River, Howell, Michigan 48843
(Address of principal executive offices) (Zip Code)
 
Registrant’s telephone number, including area code: (517) 546-3150
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x  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 Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes x  No ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated 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 ¨
Non-accelerated filer ¨
Smaller reporting company x
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨  No x
 
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 455,115.
Shares of the Corporation’s Common Stock (no par value) were outstanding as of November 14, 2013.
 
 
 
TABLE OF CONTENTS
 
 
 
 
Page
 
 
Number
 
 
 
Part I  Financial Information (unaudited)
 
 
 
Item 1.
Financial Statements:
 
 
Consolidated Balance Sheets as of September 30, 2013 and December 31, 2012
1
 
Consolidated Statements of Income for the three and nine months ended September 30, 2013 and 2012
2
 
Consolidated Statements of Comprehensive Income (Loss) for the three and nine months ended
 
 
September 30, 2013 and 2012
3
 
Consolidated Statements of Shareholders’ Equity for the nine months ended September 30, 2013 and 2012
4
 
Consolidated Statements of Cash Flows for the nine months ended September 30, 2013 and 2012
5
 
Notes to Interim Consolidated Financial Statements
6
 
 
 
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
21
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
34
Item 4.
Controls and Procedures
34
 
 
 
Part II. Other Information
 
 
 
Item 1A
Risk Factors
34
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
35
Item 6.
Exhibits
35
  
  
 
Signatures
36
 
 
 
Discussions and statements in this report that are not statements of historical fact, including, without limitation, statements that include terms such as “will,” “may,” “should,” “believe,” “expect,” “forecast,” “anticipate,” “estimate,” “project,” “intend,” “likely,” “optimistic” and “plan,” and statements about future or projected financial and operating results, plans, projections, objectives, expectations, and intentions and other statements that are not historical facts, are forward-looking statements. Forward-looking statements include, but are not limited to, statements about the likelihood, timing, and terms of our ability to raise new capital; descriptions of plans and objectives for future operations, products or services; projections of our future revenue, earnings or other measures of economic performance; forecasts of credit losses and other asset quality trends; predictions as to our subsidiary bank’s ability to achieve or maintain certain regulatory capital standards; our expectation that we will have or be able to obtain sufficient cash to meet expected obligations; and descriptions of other steps we may take to improve our capital position. These forward-looking statements express our current expectations, forecasts of future events, or long-term goals and, by their nature, are subject to assumptions, risks, and uncertainties. Although we believe that the expectations, forecasts, and goals reflected in these forward-looking statements are reasonable, actual results could differ materially for a variety of reasons, including, among others:
 
     our ability to successfully raise new capital and/or our ability to implement our capital restoration and recovery plan;
     our ability to continue as a going concern in light of the uncertainty regarding the extent and timing of possible future regulatory enforcement action against our subsidiary bank;
     the failure of assumptions underlying the establishment of and provisions made to our allowance for loan losses;
     our ability to comply with the various requirements imposed by the regulatory Consent Order against our bank;
     the timing and pace of an economic recovery in Michigan and the United States in general, including regional and local real estate markets;
     the ability of our bank to attain and maintain certain regulatory capital standards;
     limitations on our ability to access and rely on wholesale funding sources;
     the continued services of our management team, particularly as we work through our asset quality issues and the implementation of our capital restoration plan; and
     implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act or other new legislation, which may have significant effects on us and the financial services industry
 
This list provides examples of factors that could affect the results described by forward-looking statements contained in this report, but the list is not intended to be all inclusive. The risk factors disclosed in Part I – Item A of our Annual Report on Form 10-K for the year ended December 31, 2012, as updated by any new or modified risk factors disclosed in Part II – Item 1A of any subsequently filed Quarterly Report on Form 10-Q, include all known risk our management believes could materially affect the results described by forward-looking statements in this report. However, those risks may not be the only risks we face. Our results of operations, cash flows, financial position, and prospects could also be materially and adversely affected by additional factors that are not presently known to us that we currently consider to be immaterial, or that develop after the date of this report. We cannot assure you that our future results will meet expectations. While we believe the forward-looking statements in this report are reasonable, you should not place undue reliance on any forward-looking statement. In addition, these statements speak only as of the date made. We do not undertake, and expressly disclaim, any obligation to update or alter any statements, whether as a result of new information, future events, or otherwise, except as required by applicable law.
 
 
 
Part I  –    Financial Information
Item 1.      Financial Statements
FNBH BANCORP, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
(Unaudited)
 
 
 
September 30, 2013
 
December 31, 2012
 
 
 
(in thousands, except share amounts)
 
Assets
 
 
 
 
 
 
 
Cash and due from banks
 
$
60,832
 
$
41,824
 
Short term investments
 
 
198
 
 
197
 
Total cash and cash equivalents
 
 
61,030
 
 
42,021
 
 
 
 
 
 
 
 
 
Investment securities:
 
 
 
 
 
 
 
Investment securities available for sale, at fair value
 
 
72,162
 
 
72,586
 
FHLBI and FRB stock, at cost
 
 
779
 
 
779
 
Total investment securities
 
 
72,941
 
 
73,365
 
 
 
 
 
 
 
 
 
Loans held for investment:
 
 
 
 
 
 
 
Commercial
 
 
138,791
 
 
152,152
 
Consumer
 
 
15,985
 
 
14,582
 
Real estate mortgage
 
 
12,331
 
 
13,457
 
Total loans held for investment
 
 
167,107
 
 
180,191
 
Less allowance for loan losses
 
 
(9,168)
 
 
(11,769)
 
Net loans held for investment
 
 
157,939
 
 
168,422
 
Premises and equipment, net
 
 
7,354
 
 
7,211
 
Other real estate owned, held for sale
 
 
690
 
 
3,427
 
Accrued interest and other assets
 
 
1,845
 
 
2,425
 
Total assets
 
$
301,799
 
$
296,871
 
 
 
 
 
 
 
 
 
Liabilities and Shareholders' Equity
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
Deposits:
 
 
 
 
 
 
 
Demand (non-interest bearing)
 
$
96,523
 
$
95,779
 
NOW
 
 
30,278
 
 
29,501
 
Savings and money market
 
 
83,367
 
 
79,566
 
Time deposits
 
 
79,175
 
 
81,716
 
Brokered certificates of deposit
 
 
1,122
 
 
1,120
 
Total deposits
 
 
290,465
 
 
287,682
 
Other borrowings
 
 
188
 
 
148
 
Accrued interest, taxes, and other liabilities
 
 
2,001
 
 
1,672
 
Total liabilities
 
 
292,654
 
 
289,502
 
 
 
 
 
 
 
 
 
Shareholders' Equity
 
 
 
 
 
 
 
Preferred stock, no par value. Authorized 30,000 shares; no shares issued and
    outstanding
 
 
-
 
 
-
 
Common stock, no par value. Authorized 11,000,000 shares at September 30, 2013
    and December 31, 2012; 455,115 shares issued and outstanding at September 30,
    2013 and 454,327 shares issued and outstanding at December 31, 2012.
 
 
7,321
 
 
7,202
 
Retained earnings (deficit)
 
 
2,446
 
 
(496)
 
Deferred directors' compensation
 
 
342
 
 
461
 
Accumulated other comprehensive income (loss)
 
 
(964)
 
 
202
 
Total shareholders' equity
 
 
9,145
 
 
7,369
 
Total liabilities and shareholders' equity
 
$
301,799
 
$
296,871
 
 
See accompanying notes to interim consolidated financial statements (unaudited).
 
 
1

 
FNBH BANCORP, INC. AND SUBSIDIARIES
Consolidated Statements of Income
Three and Nine Months Ended September 30, 2013 and 2012
(Unaudited)
 
 
 
Three months ended September 30,
 
Nine months ended September 30,
 
 
 
2013
 
2012
 
2013
 
2012
 
 
 
(in thousands, except per share amounts)
 
Interest and dividend income:
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest and fees on loans
 
$
2,345
 
$
2,433
 
$
7,112
 
$
7,624
 
Interest and dividends on investment securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency securities and CMOs
 
 
257
 
 
269
 
 
772
 
 
757
 
Obligations of states and political subdivisions
 
 
12
 
 
11
 
 
35
 
 
37
 
Other securities
 
 
6
 
 
6
 
 
20
 
 
18
 
Interest on short term investments
 
 
1
 
 
-
 
 
2
 
 
2
 
Total interest and dividend income
 
 
2,621
 
 
2,719
 
 
7,941
 
 
8,438
 
Interest expense
 
 
232
 
 
263
 
 
698
 
 
847
 
Net interest income
 
 
2,389
 
 
2,456
 
 
7,243
 
 
7,591
 
Provision for loan losses
 
 
-
 
 
300
 
 
(2,250)
 
 
1,200
 
Net interest income after provision for loan losses
 
 
2,389
 
 
2,156
 
 
9,493
 
 
6,391
 
Noninterest income:
 
 
 
 
 
 
 
 
 
 
 
 
 
Service charges and other fee income
 
 
687
 
 
691
 
 
1,898
 
 
2,073
 
Trust income
 
 
36
 
 
43
 
 
115
 
 
134
 
Loss on available for sale securities
 
 
-
 
 
-
 
 
-
 
 
(3)
 
Other
 
 
12
 
 
24
 
 
131
 
 
24
 
Total noninterest income
 
 
735
 
 
758
 
 
2,144
 
 
2,228
 
Noninterest expense:
 
 
 
 
 
 
 
 
 
 
 
 
 
Salaries and employee benefits
 
 
1,344
 
 
1,250
 
 
3,974
 
 
3,725
 
Net occupancy expense
 
 
222
 
 
187
 
 
685
 
 
590
 
Equipment expense
 
 
88
 
 
77
 
 
255
 
 
252
 
Professional and service fees
 
 
433
 
 
404
 
 
1,264
 
 
1,250
 
Loan collection and foreclosed property expenses
 
 
88
 
 
175
 
 
253
 
 
462
 
Computer service fees
 
 
123
 
 
109
 
 
348
 
 
334
 
Computer software amortization expense
 
 
11
 
 
9
 
 
29
 
 
71
 
FDIC assessment fees
 
 
263
 
 
257
 
 
772
 
 
760
 
Insurance
 
 
131
 
 
150
 
 
392
 
 
445
 
Printing and supplies
 
 
35
 
 
36
 
 
121
 
 
128
 
Director fees
 
 
-
 
 
21
 
 
-
 
 
61
 
Net gain on sale/writedown of OREO and
    repossessions
 
 
(29)
 
 
(23)
 
 
(75)
 
 
(4)
 
Other
 
 
178
 
 
163
 
 
573
 
 
489
 
Total noninterest expense
 
 
2,887
 
 
2,815
 
 
8,591
 
 
8,563
 
Income before federal income taxes
 
 
237
 
 
99
 
 
3,046
 
 
56
 
Federal income tax expense (benefit)
 
 
-
 
 
(19)
 
 
104
 
 
(19)
 
Net income
 
$
237
 
$
118
 
$
2,942
 
$
75
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Per share statistics:
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic and diluted EPS
 
$
0.52
 
$
0.26
 
$
6.43
 
$
0.16
 
Basic and diluted average shares outstanding
 
 
457,435
 
 
460,191
 
 
457,435
 
 
459,750
 
 
See accompanying notes to interim consolidated financial statements (unaudited).
 
 
2

 
FNBH BANCORP, INC. AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income (Loss)
Three and Nine Months Ended September 30, 2013 and 2012
 
 
 
Three months
ended
September 30,
 
Three months
ended
September 30,
 
Nine months
ended
September 30,
 
Nine months
ended
September 30,
 
 
 
2013
 
2012
 
2013
 
2012
 
 
 
(in thousands)
 
Net income
 
$
237
 
$
118
 
$
2,942
 
$
75
 
Other comprehensive income (loss):
 
 
 
 
 
 
 
 
 
 
 
 
 
Unrealized gains (losses):
 
 
 
 
 
 
 
 
 
 
 
 
 
Net change in unrealized gains (losses) on securities
    available for sale
 
 
(527)
 
 
193
 
 
(1,166)
 
 
258
 
Less: reclassification adjustment for loss recognized in
    earnings
 
 
-
 
 
-
 
 
-
 
 
3
 
Other comprehensive income (loss)
 
 
(527)
 
 
193
 
 
(1,166)
 
 
261
 
Comprehensive income (loss)
 
$
(290)
 
$
311
 
$
1,776
 
$
336
 
 
See accompanying notes to interim consolidated financial statements (unaudited).
 
 
3

 
FNBH BANCORP, INC. AND SUBSIDIARIES
Consolidated Statements of Shareholders' Equity
Nine Months Ended September 30, 2013 and 2012
(Unaudited)
 
 
 
Common
Stock
 
Retained
Earnings
(Deficit)
 
Deferred
Directors'
Compensation
 
Accumulated
Other
Comprehensive
Income (Loss)
 
Total
 
 
 
(in thousands)
 
Balances at January 1, 2012
 
$
7,082
 
$
(825)
 
$
577
 
$
(224)
 
$
6,610
 
Earned portion of long term incentive plan
 
 
2
 
 
 
 
 
 
 
 
 
 
 
2
 
Issued 774 shares for deferred directors' fees
 
 
116
 
 
 
 
 
(116)
 
 
 
 
 
-
 
Net income
 
 
 
 
 
75
 
 
 
 
 
 
 
 
75
 
Other comprehensive income
 
 
 
 
 
 
 
 
 
 
 
261
 
 
261
 
Balances at September 30, 2012
 
 
7,200
 
 
(750)
 
 
461
 
 
37
 
 
6,948
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balances at January 1, 2013
 
 
7,202
 
 
(496)
 
 
461
 
 
202
 
 
7,369
 
Issued 788 shares for deferred directors' fees
 
 
119
 
 
 
 
 
(119)
 
 
 
 
 
-
 
Net income
 
 
 
 
 
2,942
 
 
 
 
 
 
 
 
2,942
 
Other comprehensive loss
 
 
 
 
 
 
 
 
 
 
 
(1,166)
 
 
(1,166)
 
Balances at September 30, 2013
 
$
7,321
 
$
2,446
 
$
342
 
$
(964)
 
$
9,145
 
 
See accompanying notes to interim consolidated financial statements (unaudited).
 
 
4

 
FNBH BANCORP, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(Unaudited)
 
 
 
Nine months ended September 30,
 
 
 
2013
 
2012
 
 
 
(in thousands)
 
Cash flows from operating activities:
 
 
 
 
 
 
 
Net income
 
$
2,942
 
$
75
 
Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
 
 
 
Provision for loan losses
 
 
(2,250)
 
 
1,200
 
Depreciation and amortization
 
 
334
 
 
361
 
Deferred income tax expense (benefit)
 
 
104
 
 
(19)
 
Net amortization on investment securities
 
 
884
 
 
596
 
Loss on sale of available for sale securities
 
 
-
 
 
3
 
Earned portion of long term incentive plan
 
 
-
 
 
2
 
Net gain on sale/writedown of OREO and repossessions
 
 
(75)
 
 
(4)
 
Decrease (increase) in accrued interest income and other assets
 
 
564
 
 
(95)
 
Increase (decrease) in accrued interest, taxes, and other liabilities
 
 
329
 
 
(73)
 
Net cash provided by operating activities
 
 
2,832
 
 
2,046
 
Cash flows from investing activities
 
 
 
 
 
 
 
Purchases of available for sale securities
 
 
(20,684)
 
 
(61,540)
 
Proceeds from the sales of available for sale securities
 
 
-
 
 
247
 
Proceeds from maturities and calls of available for sale securities
 
 
3,000
 
 
6,990
 
Proceeds from mortgage-backed securities paydowns - available for sale
 
 
15,953
 
 
8,691
 
Proceeds from sale of OREO and repossessions
 
 
2,899
 
 
647
 
Net decrease in loans
 
 
12,647
 
 
19,229
 
Capital expenditures
 
 
(461)
 
 
(118)
 
Net cash used in investing activities
 
 
13,354
 
 
(25,854)
 
Cash flows from financing activities:
 
 
 
 
 
 
 
Net increase in deposits
 
 
2,783
 
 
13,482
 
Proceeds from other borrowings
 
 
40
 
 
79
 
Net cash used in financing activities
 
 
2,823
 
 
13,561
 
Net change in cash and cash equivalents
 
 
19,009
 
 
(10,247)
 
Cash and cash equivalents at beginning of year
 
 
42,021
 
 
50,217
 
Cash and cash equivalents at end of period
 
$
61,030
 
$
39,970
 
 
 
 
 
 
 
 
 
Supplemental disclosures:
 
 
 
 
 
 
 
Interest paid
 
$
707
 
$
880
 
Loans transferred to other real estate owned
 
 
86
 
 
619
 
Loans charged off
 
 
859
 
 
3,617
 
 
See accompanying notes to interim consolidated financial statements (unaudited).
 
 
5

 
Notes to Consolidated Financial Statements
 
1. Basis of Presentation
The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, these financial statements do not include all of the information and footnotes required by US GAAP for complete financial statements.  In the opinion of management of FNBH Bancorp, Inc. (the Corporation), all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation were included. The results of operations for the three and nine month period ended September 30, 2013 are not necessarily indicative of the results to be expected for the year ending December 31, 2013. For further information, refer to the consolidated financial statements and footnotes thereto included in the 2012 Annual Report contained in the Corporation’s report on Form 10-K filing. Certain reclassifications have been made to prior period financial statements to conform to the current period presentation. 
 
The consolidated financial statements included in this Form 10-Q have been prepared assuming our wholly-owned subsidiary bank, First National Bank in Howell (the Bank), continues to operate in the normal course of business for the foreseeable future, and do not include any adjustments to recorded assets or liabilities should we be unable to continue as a going concern.

2. Financial Condition and Management’s Plan
In light of the Bank’s significant losses since 2008, insufficient capital position at September 30, 2013 and noncompliance with a regulatory capital directive stipulated under a former Consent Order dated September 24, 2009 and new Consent Order executed on October 31, 2013 (as described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations”), management believes it is reasonable that further regulatory enforcement action may occur if the capital raise described below is not completed or the Corporation is unable to effect another recapitalization within the relatively near future. Management continues to pursue initiatives identified in its recovery plan to achieve full compliance with all requirements of the Consent Order in order to mitigate the impact of the regulatory challenges. In addition, execution of the recovery plan includes implementation of measures necessary to position the Bank to overcome current economic challenges. Management’s recovery plan is detailed in Note 2 of the consolidated financial statements included in the 2012 Annual Report within the Corporation’s Form 10-K filing.
 
Although management’s recovery plan is intended to restore the Bank’s regulatory standing and return the Bank to core profitability, there is uncertainty as to the plan’s ultimate effectiveness, the Bank’s ability to meet existing regulatory requirements, the ability of management to achieve the objectives of the recovery plan and the potential impact of future regulatory action against the Bank, which raises substantial doubt about the Corporation’s ability to continue as a going concern. The ability of the Corporation to continue as a going concern is dependent upon many factors, including regulatory action, the ability to complete the pending capital raise or some other recapitalization of the Corporation and the Bank, and the ability of management to achieve the other objectives in its recovery plan. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
 
As part of the recovery plan that was initiated in late 2008, management and the Board of Directors have been aggressively pursuing all available alternatives to improve the Bank’s capital ratios, including raising capital, reducing non-performing assets, and cutting expenses. The recovery plan was designed to improve the Bank’s financial health by completing a significant recapitalization, aggressively reducing credit risk exposure in the loan portfolio and improving the efficiency and effectiveness of core business processes. The most important objective of the recovery plan is to restore the Bank’s capital to a level sufficient to comply with the capital directive in the Consent Order and provide sufficient capital resources and liquidity to meet commitments and business needs. To date, the Bank has not raised the capital necessary to satisfy requirements of the Consent Order. 
 
As disclosed in a Current Report on Form 8-K filed with the Securities and Exchange Commission on June 14, 2013, the Corporation terminated certain subscription agreements related to a proposed capital raise by the Corporation due to lack of regulatory approval. However, in a continued effort to raise additional capital necessary to improve the capital position of its subsidiary bank, the Corporation initiated a second private placement offering to certain accredited investors. Unlike the previous transaction, the new offering does not involve the issuance of any debt by the Corporation. 
 
In a Current Report on Form 8-K filed with the Securities and Exchange Commission on August 8, 2013, the Corporation disclosed its acceptance of subscription agreements pursuant to which the Corporation has agreed to sell shares of a new series of mandatorily convertible preferred stock of the Corporation (the “Preferred Stock”) in exchange for approximately $17.1 million in cash from investors, subject to satisfaction of certain closing conditions. As structured, the Preferred Stock will be convertible into shares of the Corporation’s common stock at a rate reflecting a price per share of common stock of $0.70, subject to certain anti-dilution adjustments. The conversion into common stock will take place automatically upon the approval by the Corporation’s shareholders of additional shares of authorized common stock. Until converted into common stock, the Preferred Stock will have terms that will be substantially identical to the terms applicable to the outstanding common stock with respect to dividends, distributions, voting, and other matters. For matters submitted to a vote of the holders of the Corporation’s common stock, including the proposal to authorize additional shares of common stock, the Preferred Stock will vote with the common stock, as a single class, as if the Preferred Stock was already converted into common stock.
 
The closing of this new private placement offering (“Capital Raise”) is subject to material conditions, including a requirement to obtain the approval of the Federal Reserve and compliance by one or more investors with federal law applicable to the acquisition of "control" of a bank holding company. The Corporation believes these conditions have been satisfied. The Corporation currently expects to close the Capital Raise by year-end 2013, however there is no assurance this will take place at such time or at all.
 
 
6

 
The Corporation is hopeful that its ongoing efforts to complete a recapitalization of the Corporation in the near future will be successful. However, the Corporation cannot give any assurances that it will be successful in closing the Capital Raise or, if it is unable to close the Capital Raise, that it will be successful in completing some other recapitalization of the Corporation on a timely basis, or at all. Therefore, a reader of this Quarterly Report should not make a decision regarding whether to invest in the Corporation based on an assumption that the Capital Raise or some other recapitalization of the Corporation will close. 
 
Even if the Corporation is successful in closing the Capital Raise, the net proceeds from the Capital Raise are not expected to be sufficient to enable the Bank to meet the minimum capital ratios required by the Consent Order. In addition, even if the Bank is able to meet the minimum capital ratios following the closing of a recapitalization of the Corporation, it is possible that further losses at the Bank could cause its capital to once again fall below such minimum ratios. In any event, even if the Corporation closes a recapitalization of sufficient size to bring the Bank into compliance with the minimum capital ratios of the Consent Order, the Corporation currently expects that the Bank will continue to be subject to the Consent Order or some other regulatory enforcement action for some period following the closing of a recapitalization while the Bank works to comply with the provisions of the Consent Order and demonstrate a period of performance within the requirements of the Consent Order. Moreover, until the Bank’s regulatory condition improves and the Consent Order is modified, the Company’s financial performance will continue to be negatively impacted as a result of the additional costs and expenses associated with a formal enforcement action against the Bank.
 
There can be no assurance that the efforts of the Corporation to raise new capital, management's recovery plan, or related efforts will improve the Bank's financial condition; further deterioration of the Bank's capital position is possible. The current economic environment in southeast Michigan and local real estate market conditions, while improving, will continue to present challenges to the Bank's financial performance. Any further declines in the Bank’s capital levels may likely result in more regulatory oversight or enforcement action by either the Office of the Comptroller of the Currency (the “OCC”), as the Bank’s primary regulator, or the Federal Deposit Insurance Corporation (the “FDIC”), which insures the Bank’s deposits. See also the “Capital” section within “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in this Form 10-Q.

3. Securities
Securities available for sale consist of the following:
 
 
 
 
 
 
Unrealized
 
 
 
 
 
 
Amortized Cost
 
Gains
 
Losses
 
Fair Value
 
 
 
(in thousands)
 
September 30, 2013
 
 
 
 
 
 
 
 
 
 
 
 
 
Obligations of state and political subdivisions
 
$
1,794
 
$
11
 
$
(3)
 
$
1,802
 
Mortgage-backed/CMO
 
 
71,283
 
 
123
 
 
(1,522)
 
 
69,884
 
Preferred stock(1)
 
 
49
 
 
427
 
 
-
 
 
476
 
Total available for sale
 
$
73,126
 
$
561
 
$
(1,525)
 
$
72,162
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2012
 
 
 
 
 
 
 
 
 
 
 
 
 
Obligations of state and political subdivisions
 
$
1,534
 
$
46
 
$
-
 
$
1,580
 
U.S. agency
 
 
3,000
 
 
7
 
 
-
 
 
3,007
 
Mortgage-backed/CMO
 
 
67,697
 
 
349
 
 
(184)
 
 
67,862
 
Preferred stock(1)
 
 
49
 
 
88
 
 
-
 
 
137
 
Total available for sale
 
$
72,280
 
$
490
 
$
(184)
 
$
72,586
 
 
(1) Represents preferred stocks issued by Freddie Mac and Fannie Mae
 
Securities are reviewed quarterly for possible other-than-temporary impairment (OTTI) based on guidance included in ASC Topic 320, Investments–Debt and Equity Instruments. This guidance requires an entity to assess whether it intends to sell, or whether it is more likely than not that it will be required to sell, a security in an unrealized loss position before the recovery of the security’s amortized cost basis. If either of these criteria is met, the entire difference between the amortized cost and fair value is recognized in earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment recognized in earnings is limited to the amount related to credit losses, while impairment related to other factors is recognized in other comprehensive income.
 
Management’s review of the securities portfolio for the existence of OTTI considers various qualitative and quantitative factors regarding each investment category, including if the securities were U.S. Government issued, the credit rating on the securities, credit outlook, payment status and financial condition, the length of time the security has been in a loss position, the size of the loss position and other meaningful information.
 
At September 30, 2013, the Corporation had one mortgage-backed security which has been impaired for more than twelve months. At December 31, 2012, there was one non-agency mortgage-backed security impaired for more than twelve months.

A summary of the par value, book value, carrying value (fair value) and unrealized loss for the non-agency mortgage-backed security is presented below:
 
 
 
September 30, 2013
 
December 31, 2012
 
 
 
Amount
 
% of Par
 
Amount
 
% of Par
 
 
 
(dollars in thousands)
 
Par value
 
$
1,788
 
100.00
%
$
2,387
 
100.00
%
Book value
 
 
1,580
 
88.37
%
 
2,097
 
87.82
%
Carrying value
 
 
1,623
 
90.77
%
 
2,018
 
84.51
%
Unrealized gain (loss)
 
 
43
 
2.40
%
 
(79)
 
-3.31
%
 
The Corporation makes a quarterly assessment of OTTI on its non-agency mortgage-backed security primarily based on a quarterly cash flow analysis performed by an independent third-party specialist. The evaluation includes a comparison of the present value of the expected cash flows to previous estimates to determine whether adverse changes in cash flows resulted during the period. The analysis considers attributes of the security, such as its super tranche position, and specific loan level collateral underlying the security. Certain key attributes of the underlying loans supporting the security included the following:
 
 
7

 
 
 
September 30, 2013
 
December 31, 2012
 
Weighted average remaining credit score (based on original FICO)
 
738
 
738
 
Primary location of underlying loans:
 
 
 
 
 
California
 
71
%
72
%
Florida
 
3
%
4
%
Other
 
26
%
24
%
Delinquency status of underlying loans:
 
 
 
 
 
Past due 30-59 days
 
3.05
%
2.70
%
Past due 60-89 days
 
2.42
%
2.62
%
Past due 90 days or more
 
10.38
%
8.03
%
In process of foreclosure
 
3.07
%
3.58
%
Held as other real estate owned
 
0.68
%
0.75
%
 
The specialist calculates an estimate of the fair value of the security's cash flows using an INTEX valuation model, subject to certain assumptions regarding collateral related cash flows such as expected prepayment rates, default rates, loss severity estimates, and discount rates as key valuation inputs. Certain key attributes of the underlying loans supporting the security included the following:
 
 
 
September 30, 2013
 
December 31, 2012
 
Voluntary repayment rate (CRR)
 
13.27
%
10.14
%
Default rates:
 
 
 
 
 
Within next 24 months
 
7.86
%
6.87
%
Decreasing to (by month 37)
 
3.77
%
3.15
%
Decreasing to (by month 215)
 
0.00
%
0.00
%
Loss severity rates:
 
 
 
 
 
Initial loss upon default (Year 1)
 
45.10
%
50.70
%
Per annum decrease in loss rate (Years 2 - 11)
 
3.50
%
2.50
%
Floor (Year 12)
 
23.00
%
23.00
%
Discount rate (1):
 
6.00
%
7.00
%
Remaining credit support provided by
    other collateral pools of underlying
    loans within the security:
 
0.00
%
0.02
%
 
(1) Intended to reflect estimated uncertainty and liquidity premiums, after adjustment for estimated credit loss cash flows.
 
The prepayment assumptions used within the model consider borrowers’ incentive to prepay based on market interest rates and borrowers’ ability to prepay based on underlying assumptions for borrowers’ ability to qualify for a new loan based on their credit and appraised property value, by location. As such, prepayment speeds decrease as credit quality and home prices deteriorate, reflecting a diminished ability to refinance.
 
In addition, collateral cash flow assumptions utilize a valuation technique under a “Liquidation Scenario” whereby loans are evaluated by delinquency and are assigned probability of default and loss factors deemed appropriate in the current economic environment. The liquidation scenarios assume that all loans 60 or more days past due migrate to default, are liquidated, and losses are realized over a period of between six and twenty four months based in part upon initial loan to value ratios and estimated changes in both historical and future property values since origination as obtained from financial data sources.

At September 30, 2013, based on a present value at a prospective yield of future cash flows for the investment as provided by the specialist and after management’s evaluation of the reasonableness of the specialist's underlying assumptions regarding Level 2 and Level 3 inputs, the Corporation concluded that the security’s expected cash flows continued to support the amortized cost of the security and no additional other-than-temporary impairment had been incurred.

At September 30, 2013 the non-agency mortgage-backed security was in an unrealized gain position of approximately $43,000 and at December 31, 2012, the unrealized (non-credit) loss on the security was determined to be approximately $79,000, using the valuation methodology and applicable inputs and assumptions described above.

 
8

 
The following is a summary of the gross unrealized losses and fair value of securities by length of time that individual securities have been in a continuous loss position:
 
 
 
Less than 12 months
 
12 months or more
 
Total
 
 
 
Unrealized
 
 
 
Unrealized
 
 
 
Unrealized
 
 
 
 
 
losses
 
Fair Value
 
losses
 
Fair Value
 
losses
 
Fair Value
 
 
 
(in thousands)
 
September 30, 2013
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Obligations of state and political subdivisions
 
$
(3)
 
$
461
 
$
-
 
$
-
 
$
(3)
 
 
461
 
Mortgage-backed/CMO
 
 
(1,466)
 
 
54,706
 
 
(56)
 
 
1,489
 
 
(1,522)
 
 
56,195
 
Total
 
$
(1,469)
 
$
55,167
 
$
(56)
 
$
1,489
 
$
(1,525)
 
$
56,656
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2012
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Mortgage-backed/CMO
 
$
(105)
 
$
13,448
 
$
(79)
 
$
2,018
 
$
(184)
 
$
15,466
 
 
The amortized cost and fair value of securities available for sale, by contractual maturity, follow. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 
 
September 30, 2013
 
December 31, 2012
 
 
 
Amortized
 
Approximate
 
Amortized
 
Approximate Fair
 
 
 
Cost
 
Fair Value
 
Cost
 
Value
 
 
 
(in thousands)
 
Maturing within one year
 
$
-
 
$
-
 
$
-
 
$
-
 
Maturing after one year but within five years
 
 
762
 
 
761
 
 
500
 
 
501
 
Maturing after five years but within ten years
 
 
305
 
 
309
 
 
3,305
 
 
3,323
 
Maturing after ten years
 
 
776
 
 
1,208
 
 
778
 
 
900
 
 
 
$
1,843
 
$
2,278
 
$
4,583
 
$
4,724
 
Mortgage-backed/CMO securities
 
 
71,283
 
 
69,884
 
 
67,697
 
 
67,862
 
Totals
 
$
73,126
 
$
72,162
 
$
72,280
 
$
72,586
 
 
Proceeds from at-par calls of securities totaled $3.0 million and $7.0 million for the nine months ended September 30, 2013 and 2012, respectively.

At September 30, 2013 and December 31, 2012, the Corporation did not own any investment securities issued by states and political subdivisions in which the amortized cost and fair value of such securities individually exceeded 10% of shareholders’ equity.
 
Investment securities, with an amortized cost of approximately $67.8 million at September 30, 2013 were pledged to secure public deposits and for other purposes required or permitted by law, including approximately $22.3 million of securities pledged as collateral at the Federal Home Loan Bank of Indianapolis (FHLBI) to support potential liquidity needs of the Bank. At December 31, 2012, the amortized cost of pledged investment securities totaled $69.1 million of which $25.4 million of securities was pledged as collateral at the FHLBI for contingent liquidity needs of the Bank.

The Bank owns stock in both the Federal Home Loan Bank of Indianapolis (FHLBI) and the Federal Reserve Bank (FRB), both of which are recorded at cost. The Bank is required to hold stock in the FHLBI equal to 5% of the institution’s borrowing capacity with the FHLBI. The Bank’s investment in FHLBI stock amounted to $735,000 at September 30, 2013 and December 31, 2012. The Bank’s investment in FRB stock, which totaled $44,000 at September 30, 2013 and December 31, 2012, is a requirement for the Bank’s membership in the Federal Reserve System. These investments can only be resold to, or redeemed by, the issuer.

4. Loans
The recorded investment in portfolio loans consists of the following:
 
 
 
September 30, 2013
 
December 31, 2012
 
 
 
(in thousands)
 
Commercial
 
$
13,592
 
$
16,112
 
Commercial real estate:
 
 
 
 
 
 
 
Construction, land development, and other land
 
 
6,224
 
 
8,741
 
Owner occupied
 
 
51,378
 
 
51,202
 
Nonowner occupied
 
 
61,349
 
 
69,415
 
Consumer real estate:
 
 
 
 
 
 
 
Commercial purpose
 
 
6,461
 
 
6,911
 
Mortgage - Residential
 
 
13,212
 
 
14,604
 
Home equity and home equity lines of credit
 
 
8,934
 
 
8,307
 
Consumer and Other
 
 
6,142
 
 
5,103
 
Subtotal
 
 
167,292
 
 
180,395
 
Unearned income
 
 
(185)
 
 
(204)
 
Total Loans
 
$
167,107
 
$
180,191
 
 
Included in the consumer real estate loans above are residential first mortgages reported as “real estate mortgages” on the consolidated balance sheets. In addition, a portion of these consumer real estate loans include commercial purpose loans where the borrower has pledged a 1-4 family residential property as collateral. Loans also include the reclassification of demand deposit overdrafts, which amounted to $125,000 at September 30, 2013 and $116,000 at December 31, 2012, respectively.
 
 
9

 
Loans serviced for others, including commercial participations sold, are not reported as assets of the Bank and approximated $4.0 million at September 30, 2013 and $4.3 million at December 31, 2012.

5. Allowance for Loan Losses and Credit Quality of Loans
The Corporation separates its loan portfolio into segments to perform the calculation and analysis of the allowance for loan losses. The four segments analyzed are Commercial, Commercial Real Estate, Consumer Real Estate, and Consumer and Other. The Commercial segment includes loans to finance commercial and industrial businesses that are not secured by real estate. The Commercial Real Estate segment includes: i) construction real estate loans to finance construction and land development and/or loans secured by vacant land and ii) commercial real estate loans secured by non-farm, non-residential real estate which are further classified as either owner occupied or non-owner occupied based on the underlying collateral type. The Consumer Real Estate segment includes (commercial and non-commercial purpose) loans that are secured by 1 – 4 family residential real estate properties, including first mortgages on residential properties and home equity loans and lines of credit that are secured by first or second liens on residential properties. The Consumer and Other segment include all loans not included in any other segment. These are primarily loans to consumers for household, family, and other personal expenditures, such as autos, boats, and recreational vehicles.
 
Activity in the allowance for loan losses by portfolio segment for three and nine months ended:
 
 
 
 
 
 
Commercial
 
Consumer
 
Consumer
 
 
 
 
 
 
Commercial
 
Real Estate
 
Real Estate
 
and Other
 
Total
 
 
 
(in thousands)
 
Three months ended
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
September 30, 2013
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
 
$
770
 
$
6,803
 
$
1,733
 
$
177
 
$
9,483
 
Charge offs
 
 
-
 
 
(435)
 
 
(20)
 
 
(20)
 
 
(475)
 
Recoveries
 
 
60
 
 
55
 
 
24
 
 
21
 
 
160
 
Provision
 
 
(187)
 
 
636
 
 
(455)
 
 
6
 
 
-
 
Ending balance
 
$
643
 
$
7,059
 
$
1,282
 
$
184
 
$
9,168
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
September 30, 2012
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
 
$
674
 
$
9,326
 
$
2,071
 
$
91
 
$
12,162
 
Charge offs
 
 
(64)
 
 
(920)
 
 
(245)
 
 
(23)
 
 
(1,252)
 
Recoveries
 
 
138
 
 
386
 
 
12
 
 
19
 
 
555
 
Provision
 
 
128
 
 
56
 
 
81
 
 
35
 
 
300
 
Ending balance
 
$
876
 
$
8,848
 
$
1,919
 
$
122
 
$
11,765
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Nine months ended
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
September 30, 2013
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
 
$
908
 
$
8,682
 
$
2,036
 
$
143
 
$
11,769
 
Charge offs
 
 
(164)
 
 
(523)
 
 
(83)
 
 
(89)
 
 
(859)
 
Recoveries
 
 
114
 
 
67
 
 
243
 
 
84
 
 
508
 
Provision
 
 
(215)
 
 
(1,167)
 
 
(914)
 
 
46
 
 
(2,250)
 
Ending balance
 
$
643
 
$
7,059
 
$
1,282
 
$
184
 
$
9,168
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
September 30, 2012
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
 
$
636
 
$
9,113
 
$
2,680
 
$
261
 
$
12,690
 
Charge offs
 
 
(304)
 
 
(2,616)
 
 
(607)
 
 
(90)
 
 
(3,617)
 
Recoveries
 
 
250
 
 
1,066
 
 
116
 
 
60
 
 
1,492
 
Provision
 
 
294
 
 
1,285
 
 
(270)
 
 
(109)
 
 
1,200
 
Ending balance
 
$
876
 
$
8,848
 
$
1,919
 
$
122
 
$
11,765
 
 
 
10

 
The following presents the balance in allowance for loan losses and loan balances by portfolio segment based on impairment method:
 
 
 
 
 
 
Commercial
 
Consumer
 
Consumer
 
 
 
 
 
 
Commercial
 
Real Estate
 
Real Estate
 
and Other
 
Total
 
 
 
(in thousands)
 
September 30, 2013
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Individually evaluated for impairment
 
$
14
 
$
2,621
 
$
141
 
$
-
 
$
2,776
 
Collectively evaluated for impairment
 
 
629
 
 
4,438
 
 
1,141
 
 
184
 
 
6,392
 
Total allowance for loan losses
 
$
643
 
$
7,059
 
$
1,282
 
$
184
 
$
9,168
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Recorded investment in loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Individually evaluated for impairment
 
$
241
 
$
19,597
 
$
1,932
 
$
-
 
$
21,770
 
Collectively evaluated for impairment
 
 
13,351
 
 
99,354
 
 
26,675
 
 
6,142
 
 
145,522
 
Total recorded investment in loans
 
$
13,592
 
$
118,951
 
$
28,607
 
$
6,142
 
$
167,292
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2012
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Individually evaluated for impairment
 
$
49
 
$
1,245
 
$
377
 
$
-
 
$
1,671
 
Collectively evaluated for impairment
 
 
859
 
 
7,437
 
 
1,659
 
 
143
 
 
10,098
 
Total allowance for loan losses
 
$
908
 
$
8,682
 
$
2,036
 
$
143
 
$
11,769
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Recorded investment in loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Individually evaluated for impairment
 
$
710
 
$
19,853
 
$
2,380
 
$
-
 
$
22,943
 
Collectively evaluated for impairment
 
 
15,402
 
 
109,505
 
 
27,442
 
 
5,103
 
 
157,452
 
Total recorded investment in loans
 
$
16,112
 
$
129,358
 
$
29,822
 
$
5,103
 
$
180,395
 
 
Management’s on-going monitoring of the credit quality of the portfolio relies on an extensive credit risk monitoring process that considers several factors including: current economic conditions affecting the Bank’s customers, the payment performance of individual loans and pools of homogenous loans, portfolio seasoning, changes in collateral values, and detailed reviews of specific relationships.
 
Our internal loan grading system assigns a risk grade to all commercial loans. This grading system is similar to those employed by banking regulators. Grades 1 through 5 are considered “pass” credits and grade 6 are considered “watch” credits and are subject to greater scrutiny. Those loans graded 7 and higher are considered substandard and are individually evaluated for impairment if reported as nonaccrual and are greater than $100,000 or part of an aggregate relationship exceeding $100,000. All commercial loans are graded at inception and reviewed, and if appropriate, re-graded at various intervals thereafter. Additionally, our commercial loan portfolio and assigned risk grades are periodically subjected to review by external loan reviewers and banking regulators. Certain of the key factors considered in assigning loan grades include: cash flows, operating performance, financial condition, collateral, industry condition, management, and the strength, liquidity and willingness of guarantors’ support.
 
A description of the general characteristics of each risk grade follows:
 
 
·
RATING 1 (Satisfactory – Minimal Risk) - Loans in this category are to persons or entities of unquestioned financial strength, a highly liquid financial position, with collateral that is liquid and well margined. These borrowers have performed without question on past obligations, and the Bank expects their performance to continue. Internally generated cash flow covers current maturities of long-term debt by a substantial margin.
 
·
RATING 2 (Satisfactory – Modest Risk) – These loans to persons or entities with strong financial condition and above-average liquidity who have previously satisfactorily handled their obligations with the Bank. Collateral securing the Bank’s debt is margined in accordance with policy guidelines. Internally-generated cash flow covers current maturities of long-term debt more than adequately.
 
·
RATING 3 (Satisfactory - Average) – These are loans with average cash flow and ratios compared to peers. Usually RMA comparisons show where companies fall in the performance spectrum. Companies have consistent performance for 3 or more years.
 
·
RATING 4 (Satisfactory – Acceptable Risk) – Loans to persons or entities with an average financial condition, adequate collateral margins, adequate cash flow to service long-term debt, and net worth comprised mainly of fixed assets are included in this category. These entities are minimally profitable now, with projections indicating continued profitability into the foreseeable future. Overall, these loans are basically sound.
 
·
RATING 5 (Satisfactory - Acceptable – Monitor) -These loans are characterized by borrowers who have marginal, but adequate cash flow, marginal profitability, but currently have been meeting the obligations of their loan structure. However, adverse changes in the borrower’s circumstances and/ or current economic conditions are more likely to impair their capacity for repayment. The borrower has in the past satisfactorily handled debts with the Bank, but may be experiencing some minor delinquency in making payments, or other signs of temporary cash flow issues. Borrower may be experiencing declining margins or other negative financial trends, despite the borrower’s continued satisfactory condition and positive cash flow. Other characteristics of borrowers in this class include inadequate credit information, weakness of financial statement, or declining but positive repayment capacity. This classification includes loans to new or established borrowers with satisfactory loan structure, but where near term economic or business issues appears to remain stable and the near term projections would limit the ability for an improvement in the financial trends of the borrower.
 
 
11

 
 
·
RATING 6 (Special Mention - OAEM) - Loans in this class have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the Bank’s credit position at some future date. These potential weaknesses may result in a deterioration of the repayment of the loan and increase the credit risk. Special mention assets are not adversely classified and do not expose the Bank to sufficient risk to warrant adverse classification. Special mention credits may include a borrower that pays the Bank on a timely basis (occasional 30 day delinquent) and may be experiencing temporary cash flow deficiencies.
 
·
RATING 7 (Substandard) – A substandard loan is inadequately protected by the current sound worth and paying capacity of the borrower or of the collateral pledged, if any. Loans so classified must have a well-defined weakness, or weaknesses, that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard loans, does not have to exist in individual loans. Substandard credits may include a borrower that pays consistently past due, has significant cash flow shortages and may have a collateral shortfall that requires a specific reserve.
 
·
RATING 8 (Doubtful) -This risk rating class has all of the weaknesses inherent in the substandard rating but with the added characteristic that the weaknesses make collection in full or liquidation, on the basis of currently known existing facts, condition, and values, highly questionable and improbable. These are poor quality loans in which neither the collateral, if any, nor the financial condition of the borrower presently ensure collectability in full within a reasonable period of time; in fact, there is permanent impairment in the collateral securing the Bank’s loan. These loans are in a work-out status, must be non-accrual status and have a defined work-out strategy.
 
 
    
 
 
This is a transitional risk rating class while collateral value and other factors are assessed. Loans will remain in this class for the assessment period, but in no event for more than 1 year. If there is no improvement in the Bank’s position during that time, a charge-off will be taken to best reflect known asset collateral value. If the loan goes into a “Deeds in Redemption” status before 1 year, any shortfall will be recognized immediately.    
 
The assessment of compensating factors may result in a rating plus or minus one grade from those listed above. These factors include, but are not limited to collateral, guarantors, environmental conditions, history, plan/projection reasonableness, quality of information, and payment delinquency.
 
The internal loan grading system is applied to the residential real estate portion of our consumer loan portfolio upon certain triggering events (e.g., delinquency, bankruptcy, restructuring, etc.). However, large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans are collectively evaluated for impairment and they are not separately identified for impairment disclosures. The primary risk element for the residential real estate portion of consumer loans is the timeliness of borrowers’ scheduled payments. We rely primarily on our internal reporting system to monitor past due loans and have internal policies and procedures to pursue collection and protect our collateral interests in order to mitigate losses.
 
Our monitoring of credit quality is further denoted by classification of loans as nonperforming, which reflects loans where the accrual of interest has been discontinued and loans that are past due 90 days or more and still accruing interest. In addition, nonperforming loans include troubled debt restructured loans (as discussed below) that are on nonaccrual status or past due 90 days or more. Troubled debt restructured loans that are accruing interest and not past due 90 days or more are excluded from nonperforming loans.
 
 
12

 
The following presents the recorded investment in loans by risk grade and a summary of nonperforming loans, by class of loan:
 
 
 
Not
Rated
 
1
 
2
 
3
 
4
 
5
 
6
 
7
 
8
 
Total
 
Nonperforming
 
 
 
(in thousands)
 
September 30, 2013
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
 
$
125
 
$
463
 
$
28
 
$
1,776
 
$
4,678
 
$
5,672
 
$
629
 
$
221
 
$
-
 
$
13,592
 
$
15
 
Commercial Real Estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction, land development, and other land
 
 
-
 
 
-
 
 
-
 
 
-
 
 
2,080
 
 
2,052
 
 
-
 
 
618
 
 
1,474
 
 
6,224
 
 
1,870
 
Owner occupied
 
 
35
 
 
-
 
 
792
 
 
3,166
 
 
21,263
 
 
19,487
 
 
2,796
 
 
3,839
 
 
-
 
 
51,378
 
 
2,875
 
Nonowner occupied
 
 
-
 
 
-
 
 
408
 
 
1,380
 
 
20,312
 
 
25,928
 
 
4,486
 
 
8,835
 
 
-
 
 
61,349
 
 
4,048
 
Consumer real estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial Purpose
 
 
-
 
 
-
 
 
-
 
 
167
 
 
1,130
 
 
3,462
 
 
742
 
 
960
 
 
-
 
 
6,461
 
 
725
 
Mortgage - Residential
 
 
10,146
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
3,066
 
 
-
 
 
13,212
 
 
1,646
 
Home equity and home equity lines of credit