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AUBURN NATIONAL BANCORPORATION, INC - Quarter Report: 2017 March (Form 10-Q)

Form 10-Q
Table of Contents

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

[X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

For the quarterly period ended March 31, 2017

 

[  ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

For the transition period                      to                     

Commission File Number: 0-26486

 

 

Auburn National Bancorporation, Inc.

(Exact Name of Registrant as Specified in Its Charter)

 

 

 

   Delaware    63-0885779   
  

(State or other jurisdiction of

incorporation or organization)

  

(I.R.S. Employer

Identification No.)

  

100 N. Gay Street

Auburn, Alabama 36830

(334) 821-9200

(Address and telephone number of principal executive offices)

(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes ☒                                             No ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes ☒                                             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. (Check one):

 

Large Accelerated filer ☐    Accelerated filer ☐    Non-accelerated filer ☐      Smaller reporting company ☒
   (Do not check if a smaller reporting company)

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for the complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No ☒

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class      Outstanding at April 27, 2017
Common Stock, $0.01 par value per share      3,643,543 shares

  

 


Table of Contents

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

INDEX

 

PART I.  FINANCIAL INFORMATION

       PAGE

 

 

Item 1

  Financial Statements     
    Consolidated Balance Sheets (Unaudited)
as of March 31, 2017 and December 31, 2016
         3  
    Consolidated Statements of Earnings (Unaudited)
for the quarters ended March 31, 2017 and 2016
         4  
    Consolidated Statements of Comprehensive Income (Unaudited)
for the quarters ended March 31, 2017 and 2016
         5  
    Consolidated Statements of Stockholders’ Equity (Unaudited)
for the quarters ended March 31, 2017 and 2016
         6  
    Condensed Consolidated Statements of Cash Flows (Unaudited)
for the quarters ended March 31, 2017 and 2016
         7  
    Notes to Consolidated Financial Statements (Unaudited)          8  

Item 2

  Management’s Discussion and Analysis of Financial Condition and Results of Operations        28  
    Table 1 –   Explanation of Non-GAAP Financial Measures        47  
    Table 2 –   Selected Quarterly Financial Data        48  
    Table 3 –   Average Balances and Net Interest Income Analysis – for the quarters ended March 31, 2017 and 2016        49  
    Table 4 –   Loan Portfolio Composition        50  
    Table 5 –   Allowance for Loan Losses and Nonperforming Assets        51  
    Table 6 –   Allocation of Allowance for Loan Losses        52  
    Table 7 –   CDs and Other Time Deposits of $100,000 or more        53  

Item 3

  Quantitative and Qualitative Disclosures About Market Risk        54  

Item 4

  Controls and Procedures        54  

PART II.  OTHER INFORMATION

    

Item 1

  Legal Proceedings        54  

Item 1A

  Risk Factors        54  

Item 2

  Unregistered Sales of Equity Securities and Use of Proceeds        54  

Item 3

  Defaults Upon Senior Securities        54  

Item 4

  Mine Safety Disclosures        54  

Item 5

  Other Information        54  

Item 6

  Exhibits        55  


Table of Contents

PART 1. FINANCIAL INFORMATION    

ITEM 1. FINANCIAL STATEMENTS

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

(Unaudited)

 

(Dollars in thousands, except share data)   

March 31,

2017

   

December 31,

2016

 

 

 

Assets:

    

Cash and due from banks

   $ 15,791     $ 15,673    

Federal funds sold

     30,776       42,096    

Interest bearing bank deposits

     56,858       63,508    

 

 

Cash and cash equivalents

     103,425       121,277   

 

 

Securities available-for-sale

     273,853       243,572    

Loans held for sale

     1,026       1,497    

Loans, net of unearned income

     430,553       430,946    

Allowance for loan losses

     (4,588     (4,643)   

 

 

Loans, net

     425,965       426,303    

 

 

Premises and equipment, net

     12,504       12,602    

Bank-owned life insurance

     17,995       17,888    

Other real estate owned

     152       152    

Other assets

     7,861       8,652    

 

 

Total assets

   $ 842,781     $ 831,943    

 

 

Liabilities:

    

Deposits:

    

Noninterest-bearing

   $ 191,040     $ 181,890    

Interest-bearing

     559,262       557,253    

 

 

Total deposits

     750,302       739,143    

Federal funds purchased and securities sold under agreements to repurchase

     3,631       3,366    

Long-term debt

     3,217       3,217    

Accrued expenses and other liabilities

     2,265       4,040    

 

 

Total liabilities

     759,415       749,766    

 

 

Stockholders’ equity:

    

Preferred stock of $.01 par value; authorized 200,000 shares; no issued shares

     —         —      

Common stock of $.01 par value; authorized 8,500,000 shares; issued 3,957,135 shares

     39       39    

Additional paid-in capital

     3,767       3,767    

Retained earnings

     86,768       85,716    

Accumulated other comprehensive loss, net

     (571     (708)   

Less treasury stock, at cost - 313,592 shares and 313,612 shares at March 31, 2017 and December 31, 2016, respectively

     (6,637     (6,637)   

 

 

Total stockholders’ equity

     83,366       82,177    

 

 

Total liabilities and stockholders’ equity

   $           842,781     $           831,943    

 

 

See accompanying notes to consolidated financial statements    

 

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AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Consolidated Statements of Earnings

(Unaudited)

 

        Quarter ended March 31,  
(Dollars in thousands, except share and per share data)       2017           2016  

 

 

Interest income:

       

Loans, including fees

  $     4,981     $       5,096   

Securities

       

 Taxable

      1,021         898   

 Tax-exempt

      581         625   

Federal funds sold and interest bearing bank deposits

      201         126   

 

 

 Total interest income

      6,784         6,745   

 

 

Interest expense:

       

Deposits

      862         981   

Short-term borrowings

      4          

Long-term debt

      29         63   

 

 

 Total interest expense

      895         1,048   

 

 

Net interest income

      5,889         5,697   

Provision for loan losses

      —           (600)  

 

 

 Net interest income after provision for loan losses

      5,889         6,297   

 

 

Noninterest income:

       

Service charges on deposit accounts

      189         198   

Mortgage lending

      165         179   

Bank-owned life insurance

      107         112   

Other

      373         345   

Securities gains, net

      2         —    

 

 

 Total noninterest income

      836         834   

 

 

Noninterest expense:

       

Salaries and benefits

      2,381         2,405   

Net occupancy and equipment

      381         360   

Professional fees

      230         211   

FDIC and other regulatory assessments

      89         122   

Other real estate owned, net

      3         20   

Other

      1,034         991   

 

 

 Total noninterest expense

      4,118         4,109   

 

 

 Earnings before income taxes

      2,607         3,022   

Income tax expense

      717         831   

 

 

 Net earnings

  $     1,890     $       2,191   

 

 

Net earnings per share:

       

Basic and diluted

  $     0.52     $       0.60   

 

 

Weighted average shares outstanding:

       

Basic and diluted

      3,643,541         3,643,484   

 

 

See accompanying notes to consolidated financial statements

 

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AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income

(Unaudited)

 

          Quarter ended March 31,   
(Dollars in thousands)        2017          2016  

 

 

Net earnings

  $      1,890     $      2,191   

Other comprehensive income, net of tax:

         

Unrealized net holding gain on securities

       138          1,566   

Reclassification adjustment for net gain on securities recognized in net earnings

       (1        —    

 

 

Other comprehensive income

       137          1,566   

 

 

Comprehensive income

  $      2,027     $      3,757   

 

 

See accompanying notes to consolidated financial statements

 

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AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Consolidated Statements of Stockholders’ Equity

(Unaudited)

 

                            Accumulated              
                Additional           other              
    Common Stock     paid-in     Retained     comprehensive     Treasury        
(Dollars in thousands, except share data)   Shares     Amount     capital     earnings     income (loss)     stock     Total  

 

 

Balance, December 31, 2015

    3,957,135     $ 39     $           3,766     $           80,845     $         1,937     $ (6,638   $           79,949    

Net earnings

    —                    —          —          2,191       —                        —          2,191    

Other comprehensive income

    —          —          —          —          1,566       —          1,566    

Cash dividends paid ($0.225 per share)

    —          —          —          (820     —          —          (820)   

Sale of treasury stock (25 shares)

    —          —          1       —          —          —          1    

 

 

Balance, March 31, 2016

    3,957,135     $ 39     $ 3,767     $ 82,216     $ 3,503     $ (6,638   $ 82,887    

 

 

Balance, December 31, 2016

    3,957,135     $ 39     $ 3,767     $ 85,716     $ (708   $ (6,637   $ 82,177    

Net earnings

    —          —          —          1,890       —          —          1,890    

Other comprehensive income

    —          —          —          —          137       —          137    

Cash dividends paid ($0.23 per share)

    —          —          —          (838     —          —          (838)   

 

 

Balance, March 31, 2017

    3,957,135     $ 39     $ 3,767     $ 86,768     $ (571   $ (6,637   $ 83,366    

 

 

See accompanying notes to consolidated financial statements

 

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AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(Unaudited)

 

             Three months ended March 31,      
(In thousands)        2017     2016  

 

 

Cash flows from operating activities:

      

Net earnings

 

$

     1,890     $ 2,191    

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

      

Provision for loan losses

       —         (600)   

Depreciation and amortization

       284       248    

Premium amortization and discount accretion, net

       523       335    

Net gain on securities available-for-sale

       (2     —      

Net gain on sale of loans held for sale

       (99     (97)   

Decrease in MSR valuation allowance

       (1     —      

Net loss on other real estate owned

       —         5    

Loans originated for sale

       (5,918     (7,671)   

Proceeds from sale of loans

       6,435       6,925    

Increase in cash surrender value of bank-owned life insurance

       (107     (112)   

Net decrease in other assets

       618       176    

Net increase in accrued expenses and other liabilities

       (1,774     (69)   

 

 

  Net cash provided by operating activities

       1,849       1,331    

 

 

Cash flows from investing activities:

      

Proceeds from prepayments and maturities of securities available-for-sale

       7,973       10,848    

Purchase of securities available-for-sale

       (38,559     (1,123)   

Decrease (increase) in loans, net

       338       (4,468)   

Net purchases of premises and equipment

       (26     (7)   

Increase in FHLB stock

       (13     (25)   

Proceeds from sale of other real estate owned

       —         50    

 

 

  Net cash (used in) provided by investing activities

       (30,287     5,275    

 

 

Cash flows from financing activities:

      

Net increase in noninterest-bearing deposits

       9,150       15,826    

Net increase (decrease) in interest-bearing deposits

       2,009       (2,092)   

Net increase (decrease) in federal funds purchased and securities sold under agreements to repurchase

       265       (463)   

Dividends paid

       (838     (820)   

 

 

  Net cash provided by financing activities

       10,586       12,451    

 

 

Net change in cash and cash equivalents

       (17,852     19,057    

Cash and cash equivalents at beginning of period

       121,277       113,930    

 

 

Cash and cash equivalents at end of period

 

$

     103,425     $ 132,987    

 

 
      

 

 

Supplemental disclosures of cash flow information:

      

Cash paid during the period for:

      

Interest

 

$

     986     $ 1,097    

Income taxes

       717       403    

Supplemental disclosure of non-cash transactions:

      

Real estate acquired through foreclosure

       —         200    

 

 

See accompanying notes to consolidated financial statements

 

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Table of Contents

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Unaudited)

NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

General

Auburn National Bancorporation, Inc. (the “Company”) provides a full range of banking services to individual and corporate customers in Lee County, Alabama and surrounding counties through its wholly owned subsidiary, AuburnBank (the “Bank”). The Company does not have any segments other than banking that are considered material.

Basis of Presentation and Use of Estimates

The unaudited consolidated financial statements in this report have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information. Accordingly, these financial statements do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. The unaudited consolidated financial statements include, in the opinion of management, all adjustments necessary to present a fair statement of the financial position and the results of operations for all periods presented. All such adjustments are of a normal recurring nature. The results of operations in the interim statements are not necessarily indicative of the results of operations that the Company and its subsidiaries may achieve for future interim periods or the entire year. For further information, refer to the consolidated financial statements and footnotes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016.

The unaudited consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Auburn National Bancorporation Capital Trust I is an affiliate of the Company and was included in these unaudited consolidated financial statements pursuant to the equity method of accounting. Significant intercompany transactions and accounts are eliminated in consolidation.

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of the balance sheet date and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term include other-than-temporary impairment on investment securities, the determination of the allowance for loan losses, fair value of financial instruments, and the valuation of deferred tax assets and other real estate owned.

Subsequent Events

The Company has evaluated the effects of events and transactions through the date of this filing that have occurred subsequent to March 31, 2017. The Company does not believe there were any material subsequent events during this period that would have required further recognition or disclosure in the unaudited consolidated financial statements included in this report.

Accounting Developments

In the first quarter of 2017, the Company adopted no new accounting guidance.

NOTE 2: BASIC AND DILUTED NET EARNINGS PER SHARE

Basic net earnings per share is computed by dividing net earnings by the weighted average common shares outstanding for the quarters ended March 31, 2017 and 2016, respectively. Diluted net earnings per share reflect the potential dilution that could occur upon exercise of securities or other rights for, or convertible into, shares of the Company’s common stock. At March 31, 2017 and 2016, respectively, the Company had no such securities or rights issued or outstanding, and therefore, no dilutive effect to consider for the diluted net earnings per share calculation.

 

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Table of Contents

The basic and diluted net earnings per share computations for the respective periods are presented below.

 

     Quarter ended March 31,  
(Dollars in thousands, except share and per share data)    2017      2016  

 

 

Basic and diluted:

     

Net earnings

   $ 1,890      $ 2,191  

Weighted average common shares outstanding

         3,643,541            3,643,484  

 

 

 Net earnings per share

   $ 0.52      $ 0.60  

 

 

NOTE 3: VARIABLE INTEREST ENTITIES

Generally, a variable interest entity (“VIE”) is a corporation, partnership, trust, or other legal structure that does not have equity investors with substantive or proportional voting rights or has equity investors that do not provide sufficient financial resources for the entity to support its activities.

At March 31, 2017, the Company did not have any consolidated VIEs to disclose but did have one nonconsolidated VIE, discussed below.

Trust Preferred Securities

The Company owns the common stock of a subsidiary business trust, Auburn National Bancorporation Capital Trust I (the “Trust”), which issued mandatorily redeemable preferred capital securities (“trust preferred securities”) in the aggregate of approximately $7.0 million at the time of issuance. The Trust meets the definition of a VIE of which the Company is not the primary beneficiary; the Trust’s only assets are junior subordinated debentures issued by the Company, which were acquired by the trust using the proceeds from the issuance of the trust preferred securities and common stock.

In October 2016, the Company purchased $4.0 million par amount of outstanding trust preferred securities issued by the Trust. These securities were sold by the FDIC, as receiver of a failed bank that had held the trust preferred securities. The Company used dividends from the Bank to purchase these trust preferred securities and has deemed an equivalent amount of the related junior subordinated debentures issued by the Company as no longer outstanding. The remaining junior subordinated debentures of approximately $3.2 million are included in long-term debt and the Company’s equity interest of $0.2 million in the Trust is included in other assets. Interest expense on the junior subordinated debentures is included in interest expense on long-term debt.

The following table summarizes VIEs that are not consolidated by the Company as of March 31, 2017.

 

(Dollars in thousands)   

Maximum

 

Loss Exposure

    

Liability

 

Recognized

                         Classification                       

 

 

Type:

        

Trust preferred issuances

     N/A        $3,217        Long-term debt  

 

 

 

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NOTE 4: SECURITIES

At March 31, 2017 and December 31, 2016, respectively, all securities within the scope of Accounting Standards Codification (“ASC”) 320, Investments – Debt and Equity Securities, were classified as available-for-sale. The fair value and amortized cost for securities available-for-sale by contractual maturity at March 31, 2017 and December 31, 2016, respectively, are presented below.

 

  

 

 

 
     1 year      1 to 5      5 to 10      After 10      Fair      Gross Unrealized      Amortized  
(Dollars in thousands)    or less      years      years      years      Value      Gains      Losses      Cost  

 

 

March 31, 2017

                       

Agency obligations (a)

   $         3,015               27,536        24,650            —              55,201            302              846        $     55,745    

Agency RMBS (a)

     —             844        17,943        129,574        148,361        549          1,783          149,595    

State and political subdivisions

     —             2,122        10,460        57,709        70,291        1,534          662          69,419    

 

 

Total available-for-sale

   $ 3,015           30,502        53,053        187,283        273,853        2,385          3,291        $ 274,759    

 

 

December 31, 2016

                       

Agency obligations (a)

   $ 3,047           22,531        19,893        —          45,471        331          973        $ 46,113    

Agency RMBS (a)

     —             972        16,171        110,644        127,787        551          1,805          129,041    

State and political subdivisions

     —             2,480        10,210        57,624        70,314        1,509          734          69,539    

 

 

Total available-for-sale

   $ 3,047           25,983        46,274        168,268        243,572        2,391          3,512        $ 244,693    

 

 

(a) Includes securities issued by U.S. government agencies or government sponsored entities.

Securities with aggregate fair values of $174.6 million and $137.2 million at March 31, 2017 and December 31, 2016, respectively, were pledged to secure public deposits, securities sold under agreements to repurchase, Federal Home Loan Bank (“FHLB”) advances, and for other purposes required or permitted by law.

Included in other assets are cost-method investments. The carrying amounts of cost-method investments were $1.4 million at March 31, 2017 and December 31, 2016, respectively. Cost-method investments primarily include non-marketable equity investments, such as FHLB of Atlanta stock and Federal Reserve Bank (“FRB”) stock.

Gross Unrealized Losses and Fair Value

The fair values and gross unrealized losses on securities at March 31, 2017 and December 31, 2016, respectively, segregated by those securities that have been in an unrealized loss position for less than 12 months and 12 months or longer, are presented below.

 

         Less than 12 Months      12 Months or Longer           Total  
(Dollars in thousands)       

 

Fair

 

Value

    

 

Unrealized

 

Losses

    

 

Fair

 

Value

    

 

Unrealized

 

Losses

         

 

Fair

 

Value

    

 

Unrealized

 

Losses

 

 

 

March 31, 2017:

                      

Agency obligations

 

$

     20,437        846        —          —        $      20,437        846  

Agency RMBS

       108,713        1,783        —          —             108,713        1,783  

State and political subdivisions

       19,410        662        —          —             19,410        662  

 

 

  Total

 

$

         148,560            3,291            —              —        $          148,560            3,291  

 

 

December 31, 2016:

                      

Agency obligations

 

$

     20,352        973        —          —        $      20,352        973  

Agency RMBS

       89,062        1,805        —          —             89,062        1,805  

State and political subdivisions

       20,444        734        —          —             20,444        734  

 

 

  Total

 

$

     129,858        3,512        —          —        $      129,858        3,512  

 

 

 

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For the securities in the previous table, the Company does not have the intent to sell and has determined it is not more likely than not that the Company will be required to sell the security before recovery of the amortized cost basis, which may be maturity. On a quarterly basis, the Company assesses each security for credit impairment. For debt securities, the Company evaluates, where necessary, whether credit impairment exists by comparing the present value of the expected cash flows to the securities’ amortized cost basis. For cost-method investments, the Company evaluates whether an event or change in circumstances has occurred during the reporting period that may have a significant adverse effect on the fair value of the investment.

In determining whether a loss is temporary, the Company considers all relevant information including:

 

    the length of time and the extent to which the fair value has been less than the amortized cost basis;

 

    adverse conditions specifically related to the security, an industry, or a geographic area (for example, changes in the financial condition of the issuer of the security, or in the case of an asset-backed debt security, in the financial condition of the underlying loan obligors, including changes in technology or the discontinuance of a segment of the business that may affect the future earnings potential of the issuer or underlying loan obligors of the security or changes in the quality of the credit enhancement);

 

    the historical and implied volatility of the fair value of the security;

 

    the payment structure of the debt security and the likelihood of the issuer being able to make payments that increase in the future;

 

    failure of the issuer of the security to make scheduled interest or principal payments;

 

    any changes to the rating of the security by a rating agency; and

 

    recoveries or additional declines in fair value subsequent to the balance sheet date.

Agency obligations

The unrealized losses associated with agency obligations were primarily driven by changes in interest rates and not due to the credit quality of the securities. These securities were issued by U.S. government agencies or government-sponsored entities and did not have any credit losses given the explicit government guarantee or other government support.

Agency RMBS

The unrealized losses associated with agency residential mortgage-backed securities (“RMBS”) were primarily driven by changes in interest rates and not due to the credit quality of the securities. These securities were issued by U.S. government agencies or government-sponsored entities and did not have any credit losses given the explicit government guarantee or other government support.

Securities of U.S. states and political subdivisions

The unrealized losses associated with securities of U.S. states and political subdivisions were primarily driven by changes in interest rates and were not due to the credit quality of the securities. Some of these securities are guaranteed by a bond insurer, but management did not rely on the guarantee in making its investment decision. These securities will continue to be monitored as part of the Company’s quarterly impairment analysis, but are expected to perform even if the rating agencies reduce the credit rating of the bond insurers. As a result, the Company expects to recover the entire amortized cost basis of these securities.

Cost-method investments

At March 31, 2017, cost-method investments with an aggregate cost of $1.4 million were not evaluated for impairment because the Company did not identify any events or changes in circumstances that may have a significant adverse effect on the fair value of these cost-method investments.

 

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The carrying values of the Company’s investment securities could decline in the future if the financial condition of an issuer deteriorates and the Company determines it is probable that it will not recover the entire amortized cost basis for the security. As a result, there is a risk that other-than-temporary impairment charges may occur in the future.

Other-Than-Temporarily Impaired Securities

Credit-impaired debt securities are debt securities where the Company has written down the amortized cost basis of a security for other-than-temporary impairment and the credit component of the loss is recognized in earnings. At March 31, 2017 and December 31, 2016, the Company had no credit-impaired debt securities and there were no additions or reductions in the credit loss component of credit-impaired debt securities during the quarters ended March 31, 2017 and 2016, respectively.

Realized Gains and Losses

The following table presents the gross realized gains and losses on sales of securities.

 

                Quarter ended March 31,          
(Dollars in thousands)       2017          2016  

 

 

Gross realized gains

 

$

    2      $     —    

 

 

  Realized gains, net

  $     2      $     —    

 

 

NOTE 5: LOANS AND ALLOWANCE FOR LOAN LOSSES

 

(In thousands)   

March 31,

 

2017

    

December 31,

 

2016

 

 

 

Commercial and industrial

   $ 50,228       $ 49,850   

Construction and land development

     45,098         41,650   

Commercial real estate:

     

Owner occupied

     45,011         49,745   

Multi-family

     47,147         46,998   

Other

     126,581         123,696   

 

 

Total commercial real estate

     218,739         220,439   

Residential real estate:

     

Consumer mortgage

     63,741         65,564   

Investment property

     44,355         45,291   

 

 

Total residential real estate

     108,096         110,855   

Consumer installment

     9,032         8,712   

 

 

Total loans

     431,193         431,506   

Less: unearned income

     (640)        (560)  

 

 

Loans, net of unearned income

   $         430,553       $         430,946   

 

 

Loans secured by real estate were approximately 86.3% of the Company’s total loan portfolio at March 31, 2017. At March 31, 2017, the Company’s geographic loan distribution was concentrated primarily in Lee County, Alabama, and surrounding areas.

In accordance with ASC 310, a portfolio segment is defined as the level at which an entity develops and documents a systematic method for determining its allowance for loan losses. As part of the Company’s quarterly assessment of the allowance, the loan portfolio is disaggregated into the following portfolio segments: commercial and industrial, construction and land development, commercial real estate, residential real estate, and consumer installment. Where appropriate, the Company’s loan portfolio segments are further disaggregated into classes. A class is generally determined based on the initial measurement attribute, risk characteristics of the loan, and an entity’s method for monitoring and determining credit risk.

 

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The following describe the risk characteristics relevant to each of the portfolio segments and classes.

Commercial and industrial (“C&I”) — includes loans to finance business operations, equipment purchases, or other needs for small and medium-sized commercial customers. Also included in this category are loans to finance agricultural production. Generally, the primary source of repayment is the cash flow from business operations and activities of the borrower.

Construction and land development (“C&D”) — includes both loans and credit lines for the purpose of purchasing, carrying, and developing land into commercial developments or residential subdivisions. Also included are loans and credit lines for construction of residential, multi-family, and commercial buildings. Generally, the primary source of repayment is dependent upon the sale or refinance of the real estate collateral.

Commercial real estate (“CRE”) — includes loans disaggregated into three classes: (1) owner occupied, (2) multifamily and (3) other.

 

    Owner occupied – includes loans secured by business facilities to finance business operations, equipment and owner-occupied facilities primarily for small and medium-sized commercial customers. Generally, the primary source of repayment is the cash flow from business operations and activities of the borrower, who owns the property.

 

    Multi-family – primarily includes loans to finance income-producing multi-family properties. Loans in this class include loans for 5 or more unit residential property and apartments leased to residents. Generally, the primary source of repayment is dependent upon income generated from the real estate collateral. The underwriting of these loans takes into consideration the occupancy and rental rates, as well as the financial health of the borrower.

 

    Other – primarily includes loans to finance income-producing commercial properties that are not owner occupied. Loans in this class include loans for neighborhood retail centers, hotels, medical and professional offices, single retail stores, industrial buildings, and warehouses leased to local businesses. Generally, the primary source of repayment is dependent upon income generated from the real estate collateral. The underwriting of these loans takes into consideration the occupancy and rental rates, as well as the financial health of the borrower.

Residential real estate (“RRE”) — includes loans disaggregated into two classes: (1) consumer mortgage and (2) investment property.

 

    Consumer mortgage – primarily includes first or second lien mortgages and home equity lines of credit to consumers that are secured by a primary residence or second home. These loans are underwritten in accordance with the Bank’s general loan policies and procedures which require, among other things, proper documentation of each borrower’s financial condition, satisfactory credit history, and property value.

 

    Investment property – primarily includes loans to finance income-producing 1-4 family residential properties. Generally, the primary source of repayment is dependent upon income generated from leasing the property securing the loan. The underwriting of these loans takes into consideration the rental rates and property value, as well as the financial health of the borrower.

Consumer installment — includes loans to individuals both secured by personal property and unsecured. Loans include personal lines of credit, automobile loans, and other retail loans. These loans are underwritten in accordance with the Bank’s general loan policies and procedures which require, among other things, proper documentation of each borrower’s financial condition, satisfactory credit history, and, if applicable, property value.

 

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The following is a summary of current, accruing past due, and nonaccrual loans by portfolio segment and class as of March 31, 2017 and December 31, 2016.

 

(In thousands)    Current     

Accruing

 

30-89 Days

 

Past Due

    

Accruing

 

Greater than

 

90 days

    

Total

 

Accruing

 

Loans

    

Non-

 

Accrual

           

Total

 

Loans

 

 

       

March 31, 2017:

                    

Commercial and industrial

   $ 50,192        1        —          50,193        35      $        50,228  

Construction and land development

     45,073        3        —          45,076        22           45,098  

Commercial real estate:

                    

Owner occupied

     45,011        —          —          45,011        —             45,011  

Multi-family

     47,147        —          —          47,147        —             47,147  

Other

     124,731        —          —          124,731        1,850           126,581  

 

 

Total commercial real estate

     216,889        —          —          216,889        1,850           218,739  

Residential real estate:

                    

Consumer mortgage

     62,308        1,068        —          63,376        365           63,741  

Investment property

     44,211        118        —          44,329        26           44,355  

 

 

Total residential real estate

     106,519        1,186        —          107,705        391           108,096  

Consumer installment

     8,995        17        —          9,012        20           9,032  

 

 

Total

   $ 427,668        1,207        —          428,875        2,318      $        431,193  

 

 

December 31, 2016:

                    

Commercial and industrial

   $ 49,747        66        —          49,813        37      $        49,850  

Construction and land development

     41,223        395        —          41,618        32           41,650  

Commercial real estate:

                    

Owner occupied

     49,564        43        —          49,607        138           49,745  

Multi-family

     46,998        —          —          46,998        —             46,998  

Other

     121,608        199        —          121,807        1,889           123,696  

 

 

Total commercial real estate

     218,170        242        —          218,412        2,027           220,439  

Residential real estate:

                    

Consumer mortgage

     64,059        1,282        —          65,341        223           65,564  

Investment property

     45,243        19        —          45,262        29           45,291  

 

 

Total residential real estate

     109,302        1,301        —          110,603        252           110,855  

Consumer installment

     8,652        38        —          8,690        22           8,712  

 

 

Total

   $         427,094        2,042        —          429,136        2,370      $            431,506  

 

 

Allowance for Loan Losses

The Company assesses the adequacy of its allowance for loan losses prior to the end of each calendar quarter. The level of the allowance is based upon management’s evaluation of the loan portfolio, past loan loss experience, current asset quality trends, known and inherent risks in the portfolio, adverse situations that may affect a borrower’s ability to repay (including the timing of future payment), the estimated value of any underlying collateral, composition of the loan portfolio, economic conditions, industry and peer bank loan loss rates, and other pertinent factors, including regulatory recommendations. This evaluation is inherently subjective as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. Loans are charged off, in whole or in part, when management believes that the full collectability of the loan is unlikely. A loan may be partially charged-off after a “confirming event” has occurred, which serves to validate that full repayment pursuant to the terms of the loan is unlikely.

The Company deems loans impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Collection of all amounts due according to the contractual terms means that both the interest and principal payments of a loan will be collected as scheduled in the loan agreement.

 

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An impairment allowance is recognized if the fair value of the loan is less than the recorded investment in the loan. The impairment is recognized through the allowance. Loans that are impaired are recorded at the present value of expected future cash flows discounted at the loan’s effective interest rate, or if the loan is collateral dependent, the impairment measurement is based on the fair value of the collateral, less estimated disposal costs.

The level of allowance maintained is believed by management to be adequate to absorb probable losses inherent in the portfolio at the balance sheet date. The allowance is increased by provisions charged to expense and decreased by charge-offs, net of recoveries of amounts previously charged-off.

In assessing the adequacy of the allowance, the Company also considers the results of its ongoing internal and independent loan review processes. The Company’s loan review process assists in determining whether there are loans in the portfolio whose credit quality has weakened over time and evaluating the risk characteristics of the entire loan portfolio. The Company’s loan review process includes the judgment of management, the input from our independent loan reviewers, and reviews that may have been conducted by bank regulatory agencies as part of their examination process. The Company incorporates loan review results in the determination of whether or not it is probable that it will be able to collect all amounts due according to the contractual terms of a loan.

As part of the Company’s quarterly assessment of the allowance, management divides the loan portfolio into five segments: commercial and industrial, construction and land development, commercial real estate, residential real estate, and consumer installment. The Company analyzes each segment and estimates an allowance allocation for each loan segment.

The allocation of the allowance for loan losses begins with a process of estimating the probable losses inherent for each loan segment. The estimates for these loans are established by category and based on the Company’s internal system of credit risk ratings and historical loss data. The estimated loan loss allocation rate for the Company’s internal system of credit risk grades is based on its experience with similarly graded loans. For loan segments where the Company believes it does not have sufficient historical loss data, the Company may make adjustments based, in part, on loss rates of peer bank groups. At March 31, 2017 and December 31, 2016, and for the periods then ended, the Company adjusted its historical loss rates for the commercial real estate portfolio segment based, in part, on loss rates of peer bank groups.

The estimated loan loss allocation for all five loan portfolio segments is then adjusted for management’s estimate of probable losses for several “qualitative and environmental” factors. The allocation for qualitative and environmental factors is particularly subjective and does not lend itself to exact mathematical calculation. This amount represents estimated probable inherent credit losses which exist, but have not yet been identified, as of the balance sheet date, and are based upon quarterly trend assessments in delinquent and nonaccrual loans, credit concentration changes, prevailing economic conditions, changes in lending personnel experience, changes in lending policies or procedures, and other influencing factors. These qualitative and environmental factors are considered for each of the five loan segments and the allowance allocation, as determined by the processes noted above, is increased or decreased based on the incremental assessment of these factors.

 

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The Company regularly re-evaluates its practices in determining the allowance for loan losses. Beginning with the quarter ended December 31, 2016, the Company implemented certain refinements to its allowance for loan losses methodology in order to better capture the effects of the most recent economic cycle on the Company’s loan loss experience. First, the Company increased its look-back period for calculating average losses for all loan segments to 31 quarters. Prior to December 31, 2016, the Company calculated average losses for all loan segments using a rolling 20 quarter look-back period. For the quarter ended March 31, 2017, the Company increased its look-back period to 32 quarters to continue to include the losses incurred by the Company beginning with the first quarter of 2009. The Company will likely continue to increase its look-back period to incorporate the effects of at least one economic downturn in its loss history. The Company believes the extension of its look-back period is appropriate due to the risks inherent in the loan portfolio. Absent this extension, the early cycle periods in which the Company experienced significant losses would be excluded from the determination of the allowance for loan losses and its balance would decrease. Second, the Company increased the range of basis point adjustments allowed for qualitative and environmental factors to approximately 200 basis points, an increase of 65 basis points, or 48%, compared to the 135 basis point range used prior to December 31, 2016. After performing sensitivity testing of its calculation of the allowance for loan losses, the Company determined that it should increase the range of basis points allowed for qualitative and environmental factors in order to provide sufficient latitude in determining estimated probable credit losses during periods of economic stress. Third, the Company reduced the percentage allocation for qualitative and environmental factors on a weighted average basis to 21% of total basis points allocable at December 31, 2016, compared to 25% of total basis points allocable at September 30, 2016. The Company believes a decrease in the percentage allocation of qualitative environmental factors on a weighted average basis was appropriate due to the extension of its look-back period described above. If the Company did not make the changes described above, the Company’s calculated allowance for loan loss allocation would have decreased by approximately $0.9 million, or 0.21% of total loans, at December 31, 2016. Other than the changes discussed above, the Company has not made any material changes to its methodology that would impact the calculation of the allowance for loan losses or provision for loan losses for the periods included in the accompanying consolidated balance sheets and statements of earnings.

The following table details the changes in the allowance for loan losses by portfolio segment for the respective periods.

 

     March 31, 2017  
  

 

 

 
(In thousands)    Commercial and
industrial
    Construction
and land
development
    Commercial
real estate
    Residential
real estate
    Consumer
   installment   
      Total  

 

 

Quarter ended:

        

Beginning balance

   $ 540       812       2,071       1,107       113         $ 4,643   

Charge-offs

     —         —         —         (78     (1     (79)  

Recoveries

     2       5       —         14       3       24   

 

 

Net recoveries (charge-offs)

     2       5       —         (64     2       (55)  

Provision for loan losses

     (18     28       (67     21       36       —     

 

 

Ending balance

   $ 524       845       2,004       1,064       151         $             4,588   

 

 
     March 31, 2016  
  

 

 

 
(In thousands)    Commercial and
industrial
    Construction
and land
development
    Commercial
real estate
    Residential
real estate
    Consumer
installment
    Total  

 

 

Quarter ended:

        

Beginning balance

   $ 523       669       1,879       1,059       159         $ 4,289   

Charge-offs

     —         —         —         (118     (26     (144)  

Recoveries

     20       1,198       —         7       4       1,229   

 

 

Net recoveries (charge-offs)

     20       1,198       —         (111     (22     1,085   

Provision for loan losses

     (26     (1,172     524       78       (4     (600)  

 

 

Ending balance

   $ 517       695       2,403       1,026       133         $ 4,774   

 

 

 

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The following table presents an analysis of the allowance for loan losses and recorded investment in loans by portfolio segment and impairment methodology as of March 31, 2017 and 2016.

 

         Collectively evaluated (1)      Individually evaluated (2)      Total  
        

 

Allowance

    

 

Recorded

    

 

Allowance

    

 

Recorded

    

 

Allowance

    

 

Recorded

 
        

 

for loan

    

 

investment

    

 

for loan

    

 

investment

    

 

for loan

    

 

investment

 
(In thousands)       

 

losses

    

 

in loans

    

 

losses

    

 

in loans

    

 

losses

    

 

in loans

 

 

 

March 31, 2017:

                   

Commercial and industrial

  $      524        50,222         —          6        524        50,228   

Construction and land development

       845        45,076         —          22        845        45,098   

Commercial real estate

       1,977        216,701         27        2,038        2,004        218,739   

Residential real estate

       1,064        108,096         —          —          1,064        108,096   

Consumer installment

       151        9,032         —          —          151        9,032   

 

 

Total

  $      4,561        429,127         27        2,066        4,588        431,193   

 

 

March 31, 2016:

                   

Commercial and industrial

  $      517        50,152         —          40        517        50,192   

Construction and land development

       695        45,887         —          66        695        45,953   

Commercial real estate

       2,054        206,572         349        2,748        2,403        209,320   

Residential real estate

       1,026        117,046         —          —          1,026        117,046   

Consumer installment

       133        9,769         —          —          133        9,769   

 

 

Total

  $      4,425        429,426         349        2,854        4,774        432,280   

 

 

 

(1) Represents loans collectively evaluated for impairment in accordance with ASC 450-20, Loss Contingencies (formerly FAS 5), and pursuant to amendments by ASU 2010-20 regarding allowance for non-impaired loans.  
(2) Represents loans individually evaluated for impairment in accordance with ASC 310-30, Receivables (formerly FAS 114), and pursuant to amendments by ASU 2010-20 regarding allowance for impaired loans.  

Credit Quality Indicators

The credit quality of the loan portfolio is summarized no less frequently than quarterly using categories similar to the standard asset classification system used by the federal banking agencies. The following table presents credit quality indicators for the loan portfolio segments and classes. These categories are utilized to develop the associated allowance for loan losses using historical losses adjusted for qualitative and environmental factors and are defined as follows:

 

    Pass – loans which are well protected by the current net worth and paying capacity of the obligor (or guarantors, if any) or by the fair value, less cost to acquire and sell, of any underlying collateral.

 

    Special Mention – loans with potential weakness that may, if not reversed or corrected, weaken the credit or inadequately protect the Company’s position at some future date. These loans are not adversely classified and do not expose an institution to sufficient risk to warrant an adverse classification.

 

    Substandard Accruing – loans that exhibit a well-defined weakness which presently jeopardizes debt repayment, even though they are currently performing. These loans are characterized by the distinct possibility that the Company may incur a loss in the future if these weaknesses are not corrected.

 

    Nonaccrual – includes loans where management has determined that full payment of principal and interest is not expected.

 

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Table of Contents
(In thousands)    Pass             Special        
Mention        
    Substandard
Accruing
        Nonaccrual          Total loans      

 

 

March 31, 2017:

           

Commercial and industrial

   $ 49,760        223        210       35       $ 50,228   

Construction and land development

     44,463        315        298       22         45,098   

Commercial real estate:

           

Owner occupied

     44,247        409        355       —           45,011   

Multi-family

     47,147        —          —         —           47,147   

Other

     124,260        31        440       1,850         126,581   

 

 

Total commercial real estate

     215,654        440        795       1,850         218,739   

Residential real estate:

           

Consumer mortgage

     57,302        2,818        3,256       365         63,741   

Investment property

     43,059        241        1,029       26         44,355   

 

 

Total residential real estate

     100,361        3,059        4,285       391         108,096   

Consumer installment

     8,807        106        99       20         9,032   

 

 

Total

   $      419,045                    4,143        5,687       2,318       $ 431,193   

 

 

December 31, 2016:

           

Commercial and industrial

   $ 49,558        22        233       37       $ 49,850   

Construction and land development

     41,165        113        340       32         41,650   

Commercial real estate:

           

Owner occupied

     48,788        414        405       138         49,745   

Multi-family

     46,998        —          —         —           46,998   

Other

     121,326        32        449       1,889         123,696   

 

 

Total commercial real estate

     217,112        446        854       2,027         220,439   

Residential real estate:

           

Consumer mortgage

     59,450        2,613        3,278       223         65,564   

Investment property

     44,109        105        1,048       29         45,291   

 

 

Total residential real estate

     103,559        2,718        4,326       252         110,855   

Consumer installment

     8,580        20        90       22         8,712   

 

 

Total

   $      419,974                    3,319        5,843       2,370       $       431,506   

 

 

Impaired loans

The following tables present details related to the Company’s impaired loans. Loans that have been fully charged-off do not appear in the following tables. The related allowance generally represents the following components that correspond to impaired loans:

 

    Individually evaluated impaired loans equal to or greater than $500,000 secured by real estate (nonaccrual construction and land development, commercial real estate, and residential real estate loans).

 

    Individually evaluated impaired loans equal to or greater than $250,000 not secured by real estate (nonaccrual commercial and industrial and consumer installment loans).

 

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The following tables set forth certain information regarding the Company’s impaired loans that were individually evaluated for impairment at March 31, 2017 and December 31, 2016.

 

        March 31, 2017  
(In thousands)       Unpaid principal
balance (1)
    

 

Charge-offs and
payments applied
(2)

    Recorded
investment (3)
         Related allowance  

 

      

 

 

 

With no allowance recorded:

             

Commercial and industrial

  $     6        —         6       

Construction and land development

      132        (110     22       

Commercial real estate:

             

Other

      2,861        (1,011     1,850       

 

      

Total commercial real estate

      2,861        (1,011     1,850       

 

      

Total

  $     2,999        (1,121     1,878       

 

      

With allowance recorded:

             

Commercial real estate:

             

Owner occupied

  $     188        —         188      $     27  

 

      

 

 

 

Total commercial real estate

      188        —         188          27  

 

      

 

 

 

Total

      188        —         188          27  

 

      

 

 

 

Total impaired loans

  $     3,187        (1,121     2,066      $     27  

 

      

 

 

 

 

(1) Unpaid principal balance represents the contractual obligation due from the customer.
(2) Charge-offs and payments applied represents cumulative charge-offs taken, as well as interest payments that have been applied against the outstanding principal balance subsequent to the loans being placed on nonaccrual status.
(3) Recorded investment represents the unpaid principal balance less charge-offs and payments applied; it is shown before any related allowance for loan losses.

 

        December 31, 2016  
(In thousands)       Unpaid principal
balance (1)
    

 

Charge-offs and
payments applied
(2)

    Recorded
investment (3)
         Related allowance  

 

      

 

 

 

With no allowance recorded:

             

Commercial and industrial

  $     15        —         15       

Construction and land development

      140        (108     32       

Commercial real estate:

             

Other

      2,874        (984     1,890       

 

      

Total commercial real estate

      2,874        (984     1,890       

 

      

Total

  $     3,029        (1,092     1,937       

 

      

With allowance recorded:

             

Commercial real estate:

             

Owner occupied

  $     193        —         193      $     31  

 

      

 

 

 

Total commercial real estate

      193        —         193          31  

 

      

 

 

 

Total

      193        —         193          31  

 

      

 

 

 

Total impaired loans

  $     3,222        (1,092     2,130      $     31  

 

      

 

 

 

 

(1) Unpaid principal balance represents the contractual obligation due from the customer.
(2) Charge-offs and payments applied represents cumulative charge-offs taken, as well as interest payments that have been applied against the outstanding principal balance subsequent to the loans being placed on nonaccrual status.
(3) Recorded investment represents the unpaid principal balance less charge-offs and payments applied; it is shown before any related allowance for loan losses.

 

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The following table provides the average recorded investment in impaired loans and the amount of interest income recognized on impaired loans after impairment by portfolio segment and class during the respective periods.

 

        Quarter ended March 31, 2017     Quarter ended March 31, 2016  
        Average     Total interest     Average     Total interest  
       

 

recorded

   

 

income

   

 

recorded

   

 

income

 

(In thousands)

     

 

        investment        

   

 

        recognized        

   

 

        investment        

   

 

        recognized        

 

 

 

Impaired loans:

 

Commercial and industrial

    $ 10     $ —       $ 32     $ 1  

Construction and land development

      28       —         198       —    

Commercial real estate:

         

Owner occupied

      191       3       1,020       15  

Other

      1,870       —         1,742       —    

 

 

Total commercial real estate

      2,061       3       2,762       15  

Residential real estate:

         

 

 

Total

    $ 2,099     $ 3     $ 2,992     $ 16  

 

 

Troubled Debt Restructurings

Impaired loans also include troubled debt restructurings (“TDRs”). In the normal course of business, management may grant concessions to borrowers that are experiencing financial difficulty. A concession may include, but is not limited to, delays in required payments of principal and interest for a specified period, reduction of the stated interest rate of the loan, reduction of accrued interest, extension of the maturity date, or reduction of the face amount or maturity amount of the debt. A concession has been granted when, as a result of the restructuring, the Bank does not expect to collect all amounts due, including interest at the original stated rate. A concession may have also been granted if the debtor is not able to access funds elsewhere at a market rate for debt with similar risk characteristics as the restructured debt. In making the determination of whether a loan modification is a TDR, the Company considers the individual facts and circumstances surrounding each modification. As part of the credit approval process, the restructured loans are evaluated for adequate collateral protection in determining the appropriate accrual status at the time of restructure.

Similar to other impaired loans, TDRs are measured for impairment based on the present value of expected payments using the loan’s original effective interest rate as the discount rate, or the fair value of the collateral, less selling costs if the loan is collateral dependent. If the recorded investment in the loan exceeds the measure of fair value, impairment is recognized by establishing a valuation allowance as part of the allowance for loan losses or a charge-off to the allowance for loan losses. In periods subsequent to the modification, all TDRs are individually evaluated for possible impairment.

 

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The following is a summary of accruing and nonaccrual TDRs, which are included in the impaired loan totals, and the related allowance for loan losses, by portfolio segment and class as of March 31, 2017 and December 31, 2016.

 

        TDRs      
                              Related  
(In thousands)               Accruing                 Nonaccrual                     Total                       Allowance        

 

     

 

 

 

March 31, 2017

           

Commercial and industrial

 

$

          —              $     —     

Construction and land development

      —          22        22          —     

Commercial real estate:

           

Owner occupied

      188        —          188          27   

Other

      —          1,784        1,784          —     

 

     

 

 

 

Total commercial real estate

      188        1,784        1,972          27   

 

     

 

 

 

Total

  $     194        1,806        2,000          $     27   

 

     

 

 

 
           

December 31, 2016

           

Commercial and industrial

 

$

    15        —          15      $     —     

Construction and land development

      —          32        32          —     

Commercial real estate:

           

Owner occupied

      193        —          193          31   

Other

      —          1,818        1,818          —     

 

     

 

 

 

Total commercial real estate

      193        1,818        2,011          31   

 

     

 

 

 

Total

  $     208        1,850        2,058      $     31   

 

     

 

 

 

At March 31, 2017, there were no significant outstanding commitments to advance additional funds to customers whose loans had been restructured.

During the quarter ended March 31, 2017 and 2016, there were no loans modified in a TDR, and the Company had no loans modified in a TDR within the previous 12 months for which there was a payment default (defined as 90 days or more past due) during the respective periods.

NOTE 6: MORTGAGE SERVICING RIGHTS, NET

Mortgage servicing rights (“MSRs”) are recognized based on the fair value of the servicing rights on the date the corresponding mortgage loans are sold. An estimate of the Company’s MSRs is determined using assumptions that market participants would use in estimating future net servicing income, including estimates of prepayment speeds, discount rate, default rates, cost to service, escrow account earnings, contractual servicing fee income, ancillary income, and late fees. Subsequent to the date of transfer, the Company has elected to measure its MSRs under the amortization method. Under the amortization method, MSRs are amortized in proportion to, and over the period of, estimated net servicing income.

The Company has recorded MSRs related to loans sold without recourse to Fannie Mae. The Company generally sells conforming, fixed-rate, closed-end, residential mortgages to Fannie Mae. MSRs are included in other assets on the accompanying consolidated balance sheets.

The Company evaluates MSRs for impairment on a quarterly basis. Impairment is determined by stratifying MSRs into groupings based on predominant risk characteristics, such as interest rate and loan type. If, by individual stratum, the carrying amount of the MSRs exceeds fair value, a valuation allowance is established. The valuation allowance is adjusted as the fair value changes. Changes in the valuation allowance are recognized in earnings as a component of mortgage lending income.

 

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The change in amortized MSRs and the related valuation allowance for the quarters ended March 31, 2017 and 2016 are presented below.

 

             Quarter ended March 31,      
(Dollars in thousands)        2017      2016  

 

 

MSRs, net:

       

Beginning balance

 

$

     1,952      $ 2,316  

Additions, net

       53        57  

Amortization expense

       (144)        (138)  

Decrease in MSR valuation allowance

       1        —    

 

 

Ending balance

 

$

     1,862      $ 2,235  

 

 

Valuation allowance included in MSRs, net:

 

Beginning of period

 

$

     1      $ —    

End of period

       —          —    

 

 

Fair value of amortized MSRs:

 

Beginning of period

 

$

     2,678      $ 3,086  

End of period

       2,689        2,906  

 

 

NOTE 7: DERIVATIVE INSTRUMENTS

Financial derivatives are reported at fair value in other assets or other liabilities on the accompanying consolidated balance sheets. The accounting for changes in the fair value of a derivative depends on whether it has been designated and qualifies as part of a hedging relationship. For derivatives not designated as part of a hedging relationship, the gain or loss is recognized in current earnings within other noninterest income on the accompanying consolidated statements of earnings. From time to time, the Company may enter into interest rate swaps (“swaps”) to facilitate customer transactions and meet their financing needs. Upon entering into these swaps, the Company enters into offsetting positions in order to minimize the risk to the Company. These swaps qualify as derivatives, but are not designated as hedging instruments.

Interest rate swap agreements involve the risk of dealing with counterparties and their ability to meet contractual terms. When the fair value of a derivative instrument is positive, this generally indicates that the counterparty or customer owes the Company, and results in credit risk to the Company. When the fair value of a derivative instrument is negative, the Company owes the customer or counterparty and therefore, has no credit risk.

A summary of the Company’s interest rate swap agreements at March 31, 2017 and December 31, 2016 is presented below.

 

                Other      Other  
                Assets      Liabilities  
                Estimated      Estimated  
(Dollars in thousands)        Notional            Fair Value                  Fair Value        

 

 

March 31, 2017:

          

Pay fixed / receive variable

 

$

     3,879        —            185   

Pay variable / receive fixed

       3,879        185          —      

 

 

Total interest rate swap agreements

 

$

                 7,758        185          185   

 

 

December 31, 2016:

          

Pay fixed / receive variable

 

$

     3,967        —            241   

Pay variable / receive fixed

       3,967        241          —      

 

 

Total interest rate swap agreements

 

$

     7,934        241          241   

 

 

 

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NOTE 8: FAIR VALUE

Fair Value Hierarchy

“Fair value” is defined by ASC 820, Fair Value Measurements and Disclosures, as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction occurring in the principal market (or most advantageous market in the absence of a principal market) for an asset or liability at the measurement date.    GAAP establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

 

    Level 1—inputs to the valuation methodology are quoted prices, unadjusted, for identical assets or liabilities in active markets.

 

    Level 2—inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs that are observable for the asset or liability, either directly or indirectly.

 

    Level 3—inputs to the valuation methodology are unobservable and reflect the Company’s own assumptions about the inputs market participants would use in pricing the asset or liability.

Level changes in fair value measurements

Transfers between levels of the fair value hierarchy are generally recognized at the end of the reporting period. The Company monitors the valuation techniques utilized for each category of financial assets and liabilities to ascertain when transfers between levels have been affected. The nature of the Company’s financial assets and liabilities generally is such that transfers in and out of any level are expected to be infrequent. For the three months ended March 31, 2017, there were no transfers between levels and no changes in valuation techniques for the Company’s financial assets and liabilities.

Assets and liabilities measured at fair value on a recurring basis

Securities available-for-sale

Fair values of securities available for sale were primarily measured using Level 2 inputs. For these securities, the Company obtains pricing from third party pricing services. These third party pricing services consider observable data that may include broker/dealer quotes, market spreads, cash flows, benchmark yields, reported trades for similar securities, market consensus prepayment speeds, credit information, and the securities’ terms and conditions. On a quarterly basis, management reviews the pricing received from the third party pricing services for reasonableness given current market conditions. As part of its review, management may obtain non-binding third party broker quotes to validate the fair value measurements. In addition, management will periodically submit pricing provided by the third party pricing services to another independent valuation firm on a sample basis. This independent valuation firm will compare the price provided by the third party pricing service with its own price and will review the significant assumptions and valuation methodologies used with management.

Interest rate swap agreements

The carrying amount of interest rate swap agreements was included in other assets and accrued expenses and other liabilities on the accompanying consolidated balance sheets. The fair value measurements for our interest rate swap agreements were based on information obtained from a third party bank. This information is periodically tested by the Company and validated against other third party valuations. If needed, other third party market participants may be utilized to corroborate the fair value measurements for our interest rate swap agreements. The Company classified these derivative assets and liabilities within Level 2 of the valuation hierarchy. These swaps qualify as derivatives, but are not designated as hedging instruments.

 

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The following table presents the balances of the assets and liabilities measured at fair value on a recurring basis as of March 31, 2017 and December 31, 2016, respectively, by caption, on the accompanying consolidated balance sheets by ASC 820 valuation hierarchy (as described above).

 

           

Quoted Prices in

 

    

      Significant      

 

        
           

Active Markets

 

    

      Other      

 

    

Significant    

 

 
           

for

 

    

      Observable      

 

    

Unobservable    

 

 
           

Identical Assets

 

    

      Inputs      

 

    

Inputs    

 

 
(Dollars in thousands)    Amount      (Level 1)            (Level 2)            (Level 3)      

 

 

March 31, 2017:

           

Securities available-for-sale:

           

Agency obligations

   $ 55,201               55,201        —    

Agency RMBS

     148,361               148,361        —    

State and political subdivisions

     70,291               70,291        —    

 

 

Total securities available-for-sale

     273,853               273,853        —    

Other assets (1)

     185               185        —    

 

 

Total assets at fair value

   $         274,038               274,038        —    

 

 

Other liabilities(1)

   $ 185               185        —    

 

 

Total liabilities at fair value

   $ 185               185        —    

 

 

December 31, 2016:

           

Securities available-for-sale:

           

Agency obligations

   $ 45,471               45,471        —    

Agency RMBS

     127,787               127,787        —    

State and political subdivisions

     70,314               70,314        —    

 

 

Total securities available-for-sale

     243,572               243,572        —    

Other assets (1)

     241               241        —    

 

 

Total assets at fair value

   $ 243,813               243,813        —    

 

 

Other liabilities(1)

   $ 241               241        —    

 

 

Total liabilities at fair value

   $ 241               241        —    

 

 

(1)Represents the fair value of interest rate swap agreements.

Assets and liabilities measured at fair value on a nonrecurring basis

Loans held for sale

Loans held for sale are carried at the lower of cost or fair value. Fair values of loans held for sale are determined using quoted market secondary market prices for similar loans. Loans held for sale are classified within Level 2 of the fair value hierarchy.

Impaired Loans

Loans considered impaired under ASC 310-10-35, Receivables, are loans for which, based on current information and events, it is probable that the Company will be unable to collect all principal and interest payments due in accordance with the contractual terms of the loan agreement. Impaired loans can be measured based on the present value of expected payments using the loan’s original effective rate as the discount rate, the loan’s observable market price, or the fair value of the collateral less selling costs if the loan is collateral dependent.

 

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The fair value of impaired loans were primarily measured based on the value of the collateral securing these loans. Impaired loans are classified within Level 3 of the fair value hierarchy. Collateral may be real estate and/or business assets including equipment, inventory, and/or accounts receivable. The Company determines the value of the collateral based on independent appraisals performed by qualified licensed appraisers. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Appraised values are discounted for costs to sell and may be discounted further based on management’s historical knowledge, changes in market conditions from the date of the most recent appraisal, and/or management’s expertise and knowledge of the customer and the customer’s business. Such discounts by management are subjective and are typically significant unobservable inputs for determining fair value. Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors discussed above.

Other real estate owned

Other real estate owned, consisting of properties obtained through foreclosure or in satisfaction of loans, are initially recorded at the lower of the loan’s carrying amount or the fair value less costs to sell upon transfer of the loans to other real estate. Subsequently, other real estate is carried at the lower of carrying value or fair value less costs to sell. Fair values are generally based on third party appraisals of the property and are classified within Level 3 of the fair value hierarchy. The appraisals are sometimes further discounted based on management’s historical knowledge, and/or changes in market conditions from the date of the most recent appraisal, and/or management’s expertise and knowledge of the customer and the customer’s business. Such discounts are typically significant unobservable inputs for determining fair value. In cases where the carrying amount exceeds the fair value, less costs to sell, a loss is recognized in noninterest expense.

Mortgage servicing rights, net

Mortgage servicing rights, net, included in other assets on the accompanying consolidated balance sheets, are carried at the lower of cost or estimated fair value. MSRs do not trade in an active market with readily observable prices. To determine the fair value of MSRs, the Company engages an independent third party. The independent third party’s valuation model calculates the present value of estimated future net servicing income using assumptions that market participants would use in estimating future net servicing income, including estimates of prepayment speeds, discount rates, default rates, cost to service, escrow account earnings, contractual servicing fee income, ancillary income, and late fees. Periodically, the Company will review broker surveys and other market research to validate significant assumptions used in the model. The significant unobservable inputs include prepayment speeds or the constant prepayment rate (“CPR”) and the weighted average discount rate. Because the valuation of MSRs requires the use of significant unobservable inputs, all of the Company’s MSRs are classified within Level 3 of the valuation hierarchy.

 

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The following table presents the balances of the assets and liabilities measured at fair value on a nonrecurring basis as of March 31, 2017 and December 31, 2016, respectively, by caption, on the accompanying consolidated balance sheets and by FASB ASC 820 valuation hierarchy (as described above):

 

            Quoted Prices in                
            Active Markets          Other            Significant    
            for          Observable            Unobservable    
     Carrying      Identical Assets          Inputs            Inputs    
(Dollars in thousands)    Amount      (Level 1)          (Level 2)            (Level 3)    

 

 

March 31, 2017:

           

Loans held for sale

   $ 1,026        —          1,026        —     

Loans, net(1)

     2,039        —          —          2,039   

Other real estate owned

     152        —          —          152   

Other assets (2)

     1,862        —          —          1,862   

 

 

Total assets at fair value

   $              5,079        —          1,026        4,053   

 

 

December 31, 2016:

           

Loans held for sale

   $ 1,497        —          1,497        —     

Loans, net(1)

     2,099        —          —          2,099   

Other real estate owned

     152        —          —          152   

Other assets (2)

     1,952        —          —          1,952   

 

 

Total assets at fair value

   $ 5,700        —          1,497        4,203   

 

 

(1)Loans considered impaired under ASC 310-10-35, Receivables. This amount reflects the recorded investment in

impaired loans, net of any related allowance for loan losses.

(2)Represents MSRs, net, carried at lower of cost or estimated fair value.

Quantitative Disclosures for Level 3 Fair Value Measurements

At March 31, 2017, the Company had no Level 3 assets measured at fair value on a recurring basis. For Level 3 assets measured at fair value on a non-recurring basis at March 31, 2017, the significant unobservable inputs used in the fair value measurements are presented below.

 

                            Weighted     
           Carrying                      Average     
(Dollars in thousands)          Amount             Valuation Technique               Significant Unobservable Input              of Input     

 

   

 

  

 

  

 

  

 

Nonrecurring:

            

Impaired loans

  $          2,039    

Appraisal

  

Appraisal discounts (%)

   45.2%   

Other real estate owned

    152    

Appraisal

  

Appraisal discounts (%)

   10.0%   

Mortgage servicing rights, net

    1,862    

Discounted cash flow

  

Prepayment speed or CPR (%)

   10.5%   
         

Discount rate (%)

   10.0%   

 

Fair Value of Financial Instruments

ASC 825, Financial Instruments, requires disclosure of fair value information about financial instruments, whether or not recognized on the face of the balance sheet, for which it is practicable to estimate that value. The assumptions used in the estimation of the fair value of the Company’s financial instruments are explained below. Where quoted market prices are not available, fair values are based on estimates using discounted cash flow analyses. Discounted cash flows can be significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The following fair value estimates cannot be substantiated by comparison to independent markets and should not be considered representative of the liquidation value of the Company’s financial instruments, but rather are a good-faith estimate of the fair value of financial instruments held by the Company. ASC 825 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements.

 

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The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments:

Loans, net

Fair values for loans were calculated using discounted cash flows. The discount rates reflected current rates at which similar loans would be made for the same remaining maturities. This method of estimating fair value does not incorporate the exit-price concept of fair value prescribed by ASC 820 and generally produces a higher value than an exit-price approach. Expected future cash flows were projected based on contractual cash flows, adjusted for estimated prepayments. ASU 2016-01 described under “Current Accounting Policies” requires public company use of exit prices when measuring the fair value of financial instruments for disclosure purposes for fiscal years beginning after December 31, 2017. The effects of ASU 2016-01 on the Company’s consolidated financial statements are being evaluated.

Loans held for sale

Fair values of loans held for sale are determined using quoted secondary market prices for similar loans.

Time Deposits

Fair values for time deposits were estimated using discounted cash flows. The discount rates were based on rates currently offered for deposits with similar remaining maturities.

Long-term debt

The fair value of the Company’s fixed rate long-term debt is estimated using discounted cash flows based on estimated current market rates for similar types of borrowing arrangements. The carrying amount of the Company’s variable rate long-term debt approximates its fair value.

The carrying value, related estimated fair value, and placement in the fair value hierarchy of the Company’s financial instruments at March 31, 2017 and December 31, 2016 are presented below. This table excludes financial instruments for which the carrying amount approximates fair value. Financial assets for which fair value approximates carrying value included cash and cash equivalents. Financial liabilities for which fair value approximates carrying value included noninterest-bearing demand deposits, interest-bearing demand deposits, and savings deposits due to these products having no stated maturity. In addition, financial liabilities for which fair value approximates carrying value included overnight borrowings such as federal funds purchased and securities sold under agreements to repurchase.

 

                       Fair Value Hierarchy  
    

 

Carrying

    

 

Estimated

        

 

Level 1

    

 

Level 2

    

 

Level 3

 
(Dollars in thousands)    amount      fair value          inputs      inputs      Inputs  

 

 

March 31, 2017:

                

Financial Assets:

                

Loans, net (1)

   $        425,965       $         426,253       $                     —         $ —         $          426,253   

Loans held for sale

     1,026         1,036           —           1,036         —     

Financial Liabilities:

                

Time Deposits

   $ 203,696       $ 203,141       $     —         $          203,141       $ —     

Long-term debt

     3,217         3,217           —           3,217         —     

 

 

December 31, 2016:

                

Financial Assets:

                

Loans, net (1)

   $ 426,303       $ 428,446       $     —         $ —         $ 428,446   

Loans held for sale

     1,497         1,507           —           1,507         —     

Financial Liabilities:

                

Time Deposits

   $ 208,137       $ 207,791       $     —         $ 207,791       $ —     

Long-term debt

     3,217         3,217           —           3,217         —     

 

 

(1) Represents loans, net of unearned income and the allowance for loan losses.

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis is designed to provide a better understanding of various factors related to the results of operations and financial condition of the Auburn National Bancorporation, Inc. (the “Company”) and its wholly owned subsidiary, AuburnBank (the “Bank”). This discussion is intended to supplement and highlight information contained in the accompanying unaudited condensed consolidated financial statements and related notes for the quarters ended March 31, 2017 and 2016, as well as the information contained in our Annual Report on Form 10-K for the year ended December 31, 2016.

Special Notice Regarding Forward-Looking Statements

Certain of the statements made in this discussion and analysis and elsewhere, including information incorporated herein by reference to other documents, are “forward-looking statements” within the meaning of, and subject to, the protections of Section 27A of the Securities Act of 1933, as amended, (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).

Forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, expectations, anticipations, assumptions, estimates, intentions and future performance, and involve known and unknown risks, uncertainties and other factors, which may be beyond our control, and which may cause the actual results, performance, achievements, or financial condition of the Company to be materially different from future results, performance, achievements, or financial condition expressed or implied by such forward-looking statements. You should not expect us to update any forward-looking statements.

All statements other than statements of historical fact are statements that could be forward-looking statements. You can identify these forward-looking statements through our use of words such as “may,” “will,” “anticipate,” “assume,” “should,” “indicate,” “would,” “believe,” “contemplate,” “expect,” “estimate,” “continue,” “plan,” “point to,” “project,” “could,” “intend,” “target” and other similar words and expressions of the future. These forward-looking statements may not be realized due to a variety of factors, including, without limitation:

 

    the effects of future economic, business, and market conditions and changes, domestic and foreign, including seasonality;

 

    governmental monetary and fiscal policies;

 

    legislative and regulatory changes, including changes in banking, securities, and tax laws, regulations and rules and their application by our regulators, including capital and liquidity requirements, and changes in the scope and cost of FDIC insurance;

 

    changes in accounting policies, rules, and practices;

 

    the risks of changes in interest rates on the levels, composition, and costs of deposits, loan demand, and the values and liquidity of loan collateral, securities, and interest sensitive assets and liabilities, and the risks and uncertainty of the amounts realizable;

 

    changes in borrower credit risks and payment behaviors;

 

    changes in the availability and cost of credit and capital in the financial markets, and the types of instruments that may be included as capital for regulatory purposes;

 

    changes in the prices, values, and sales volumes of residential and commercial real estate;

 

    the effects of competition from a wide variety of local, regional, national, and other providers of financial, investment, and insurance services;

 

    the failure of assumptions and estimates underlying the establishment of allowances for possible loan and other asset impairments, losses, and other estimates;

 

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    the risks of mergers, acquisitions and divestitures, including, without limitation, the related time and costs of implementing such transactions, integrating operations as part of these transactions and possible failures to achieve expected gains, revenue growth and/or expense savings from such transactions;

 

    changes in technology or products that may be more difficult, costly, or less effective than anticipated;

 

    the effects of war, or other conflicts, acts of terrorism, or other catastrophic events that may affect general economic conditions;

 

    cyber attacks and data breaches that may compromise our systems or customers’ information;

 

    the failure of assumptions and estimates, as well as differences in, and changes to, economic, market, and credit conditions, including changes in borrowers’ credit risks and payment behaviors from those used in our loan portfolio stress tests and other evaluations;

 

    the risk that our deferred tax assets, if any, could be reduced if estimates of future taxable income from our operations and tax planning strategies are less than currently estimated, and sales of our capital stock could trigger a reduction in the amount of net operating loss carry-forwards, if any, that we may be able to utilize for income tax purposes; and

 

    the other factors and information in this report and other filings that we make with the SEC under the Exchange Act, including our Annual Report on Form 10-K for the year ended December 31, 2016 and subsequent quarterly and current reports. See Part II, Item 1A. “RISK FACTORS”.

All written or oral forward-looking statements that are made by or attributable to us are expressly qualified in their entirety by this cautionary notice. We have no obligation and do not undertake to update, revise or correct any of the forward-looking statements after the date of this report, or after the respective dates on which such statements otherwise are made.

Business

The Company was incorporated in 1990 under the laws of the State of Delaware and became a bank holding company after it acquired its Alabama predecessor, which was a bank holding company established in 1984. The Bank, the Company’s principal subsidiary, is an Alabama state-chartered bank that is a member of the Federal Reserve System and has operated continuously since 1907. Both the Company and the Bank are headquartered in Auburn, Alabama. The Bank conducts its business primarily in East Alabama, including Lee County and surrounding areas. The Bank operates full-service branches in Auburn, Opelika, Notasulga, and Valley, Alabama. In-store branches are located in the Kroger and Wal-Mart SuperCenter in Opelika. The Bank also operates a commercial loan production office in Phenix City, Alabama.

Summary of Results of Operations

 

               Quarter ended March 31,      
(Dollars in thousands, except per share data)          2017      2016  

 

 

Net interest income (a)

       $       6,189      $ 6,019   

Less: tax-equivalent adjustment

       300        322   

 

 

  Net interest income (GAAP)

       5,889        5,697   

Noninterest income

       836        834   

 

 

  Total revenue

       6,725        6,531   

Provision for loan losses

       —            (600)  

Noninterest expense

       4,118        4,109   

Income tax expense

       717        831   

 

 

  Net earnings

       $       1,890      $ 2,191   

 

 

Basic and diluted earnings per share

       $       0.52      $ 0.60   

 

 

(a) Tax-equivalent. See “Table 1 - Explanation of Non-GAAP Financial Measures.”

 

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Financial Summary

The Company’s net earnings were $1.9 million for the first quarter of 2017, compared to $2.2 million for the first quarter of 2016. Basic and diluted earnings per share were $0.52 per share for the first quarter of 2017, compared to $0.60 per share for the first quarter of 2016.

Net interest income (tax-equivalent) was $6.2 million for the first quarter of 2017 compared to $6.0 million for the first quarter of 2016. This increase was primarily due to a reduction in interest expense as the Company lowered its deposit costs and repaid higher-cost wholesale funding sources. Average loans were $429.8 million in the first quarter of 2017, compared to $429.5 million in the first quarter of 2016. Average deposits were $742.0 million in the first quarter of 2017, an increase of $15.6 million or 2%, from the first quarter of 2016.

The Company recorded no provision for loan losses for the first quarter of 2017, compared to a negative provision for loan losses of $0.6 million for the first quarter of 2016. Annualized net charge-offs as a percent of average loans were 0.05% for the first quarter of 2017 compared to annualized net recoveries of 1.01% for the first quarter of 2016. The Company recognized a recovery to the allowance for loan losses of $1.2 million from the payoff of one nonperforming construction and land development loan during the first quarter of 2016.

Noninterest income and expense were $0.8 and $4.1 million, respectively, for the first quarter of 2017, unchanged from the first quarter of 2016. The Company had an improved efficiency ratio of 58.62% for the first quarter of 2017, compared to 59.96% in the first quarter of 2016.

Income tax expense and the effective tax rate were $0.7 million and 27.50%, respectively, for the first quarter of 2017, unchanged from the first quarter of 2016.

The Company paid cash dividends of $0.23 per share in the first quarter of 2017, an increase of 2.2% from the same period of 2016. At March 31, 2017, the Bank’s regulatory capital ratios were well above the minimum amounts required to be “well capitalized” under current regulatory standards.

CRITICAL ACCOUNTING POLICIES

The accounting and financial reporting policies of the Company conform with U.S. generally accepted accounting principles and with general practices within the banking industry. In connection with the application of those principles, we have made judgments and estimates which, in the case of the determination of our allowance for loan losses, our assessment of other-than-temporary impairment, recurring and non-recurring fair value measurements, the valuation of other real estate owned, and the valuation of deferred tax assets, were critical to the determination of our financial position and results of operations. Other policies also require subjective judgment and assumptions and may accordingly impact our financial position and results of operations.

Allowance for Loan Losses

The Company assesses the adequacy of its allowance for loan losses prior to the end of each calendar quarter. The level of the allowance is based upon management’s evaluation of the loan portfolio, past loan loss experience, current asset quality trends, known and inherent risks in the portfolio, adverse situations that may affect a borrower’s ability to repay (including the timing of future payment), the estimated value of any underlying collateral, composition of the loan portfolio, economic conditions, industry and peer bank loan loss rates, and other pertinent factors, including regulatory recommendations. This evaluation is inherently subjective as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. Loans are charged off, in whole or in part, when management believes that the full collectability of the loan is unlikely. A loan may be partially charged-off after a “confirming event” has occurred, which serves to validate that full repayment pursuant to the terms of the loan is unlikely.

The Company deems loans impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Collection of all amounts due according to the contractual terms means that both the interest and principal payments of a loan will be collected as scheduled in the loan agreement.

 

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An impairment allowance is recognized if the fair value of the loan is less than the recorded investment in the loan. The impairment is recognized through the allowance. Loans that are impaired are recorded at the present value of expected future cash flows discounted at the loan’s effective interest rate, or if the loan is collateral dependent, the impairment measurement is based on the fair value of the collateral, less estimated disposal costs.

The level of allowance maintained is believed by management to be adequate to absorb probable losses inherent in the portfolio at the balance sheet date. The allowance is increased by provisions charged to expense and decreased by charge-offs, net of recoveries of amounts previously charged-off.

In assessing the adequacy of the allowance, the Company also considers the results of its ongoing internal and independent loan review processes. The Company’s loan review process assists in determining whether there are loans in the portfolio whose credit quality has weakened over time and evaluating the risk characteristics of the entire loan portfolio. The Company’s loan review process includes the judgment of management, the input from our independent loan reviewers, and reviews that may have been conducted by bank regulatory agencies as part of their examination process. The Company incorporates loan review results in the determination of whether or not it is probable that it will be able to collect all amounts due according to the contractual terms of a loan.

As part of the Company’s quarterly assessment of the allowance, management divides the loan portfolio into five segments: commercial and industrial, construction and land development, commercial real estate, residential real estate, and consumer installment. The Company analyzes each segment and estimates an allowance allocation for each loan segment.

The allocation of the allowance for loan losses begins with a process of estimating the probable losses inherent for each loan segment. The estimates for these loans are established by category and based on the Company’s internal system of credit risk ratings and historical loss data. The estimated loan loss allocation rate for the Company’s internal system of credit risk grades is based on its experience with similarly graded loans. For loan segments where the Company believes it does not have sufficient historical loss data, the Company may make adjustments based, in part, on loss rates of peer bank groups. At March 31, 2017 and December 31, 2016, and for the periods then ended, the Company adjusted its historical loss rates for the commercial real estate portfolio segment based, in part, on loss rates of peer bank groups.

The estimated loan loss allocation for all five loan portfolio segments is then adjusted for management’s estimate of probable losses for several “qualitative and environmental” factors. The allocation for qualitative and environmental factors is particularly subjective and does not lend itself to exact mathematical calculation. This amount represents estimated probable inherent credit losses which exist, but have not yet been identified, as of the balance sheet date, and are based upon quarterly trend assessments in delinquent and nonaccrual loans, credit concentration changes, prevailing economic conditions, changes in lending personnel experience, changes in lending policies or procedures, and other influencing factors. These qualitative and environmental factors are considered for each of the five loan segments and the allowance allocation, as determined by the processes noted above, is increased or decreased based on the incremental assessment of these factors.

 

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The Company regularly re-evaluates its practices in determining the allowance for loan losses. Beginning with the quarter ended December 31, 2016, the Company implemented certain refinements to its allowance for loan losses methodology in order to better capture the effects of the most recent economic cycle on the Company’s loan loss experience. First, the Company increased its look-back period for calculating average losses for all loan segments to 31 quarters. Prior to December 31, 2016, the Company calculated average losses for all loan segments using a rolling 20 quarter look-back period. For the quarter ended March 31, 2017, the Company increased its look-back period to 32 quarters to continue to include the losses incurred by the Company beginning with the first quarter of 2009. The Company will likely continue to increase its look-back period to incorporate the effects of at least one economic downturn in its loss history. The Company believes the extension of its look-back period is appropriate due to the risks inherent in the loan portfolio. Absent this extension, the early cycle periods in which the Company experienced significant losses would be excluded from the determination of the allowance for loan losses and its balance would decrease. Second, the Company increased the range of basis point adjustments allowed for qualitative and environmental factors to approximately 200 basis points, an increase of 65 basis points, or 48%, compared to the 135 basis point range used prior to December 31, 2016. After performing sensitivity testing of its calculation of the allowance for loan losses, the Company determined that it should increase the range of basis points allowed for qualitative and environmental factors in order to provide sufficient latitude in determining estimated probable credit losses during periods of economic stress. Third, the Company reduced the percentage allocation for qualitative and environmental factors on a weighted average basis to 21% of total basis points allocable at December 31, 2016, compared to 25% of total basis points allocable at September 30, 2016. The Company believes a decrease in the percentage allocation of qualitative environmental factors on a weighted average basis was appropriate due to the extension of its look-back period described above. If the Company did not make the changes described above, the Company’s calculated allowance for loan loss allocation would have decreased by approximately $0.9 million, or 0.21% of total loans, at December 31, 2016. Other than the changes discussed above, the Company has not made any material changes to its methodology that would impact the calculation of the allowance for loan losses or provision for loan losses for the periods included in the accompanying consolidated balance sheets and statements of earnings.

Assessment for Other-Than-Temporary Impairment of Securities

On a quarterly basis, management makes an assessment to determine whether there have been events or economic circumstances to indicate that a security on which there is an unrealized loss is other-than-temporarily impaired. For equity securities with an unrealized loss, the Company considers many factors including the severity and duration of the impairment; the intent and ability of the Company to hold the security for a period of time sufficient for a recovery in value; and recent events specific to the issuer or industry. Equity securities for which there is an unrealized loss that is deemed to be other-than-temporary are written down to fair value with the write-down recorded as a realized loss in securities gains (losses).

For debt securities with an unrealized loss, an other-than-temporary impairment write-down is triggered when (1) the Company has the intent to sell a debt security, (2) it is more likely than not that the Company will be required to sell the debt security before recovery of its amortized cost basis, or (3) the Company does not expect to recover the entire amortized cost basis of the debt security. If the Company has the intent to sell a debt security or if it is more likely than not that it will be required to sell the debt security before recovery, the other-than-temporary write-down is equal to the entire difference between the debt security’s amortized cost and its fair value. If the Company does not intend to sell the security or it is not more likely than not that it will be required to sell the security before recovery, the other-than-temporary impairment write-down 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. 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 is recognized in other comprehensive income, net of applicable taxes.

Fair Value Determination

U.S. GAAP requires management to value and disclose certain of the Company’s assets and liabilities at fair value, including investments classified as available-for-sale and derivatives. ASC 820, Fair Value Measurements and Disclosures, which defines fair value, establishes a framework for measuring fair value in accordance with U.S. GAAP and expands disclosures about fair value measurements. For more information regarding fair value measurements and disclosures, please refer to Note 8, Fair Value, of the consolidated financial statements that accompany this report.

 

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Fair values are based on active market prices of identical assets or liabilities when available. Comparable assets or liabilities or a composite of comparable assets in active markets are used when identical assets or liabilities do not have readily available active market pricing. However, some of the Company’s assets or liabilities lack an available or comparable trading market characterized by frequent transactions between willing buyers and sellers. In these cases, fair value is estimated using pricing models that use discounted cash flows and other pricing techniques. Pricing models and their underlying assumptions are based upon management’s best estimates for appropriate discount rates, default rates, prepayments, market volatility, and other factors, taking into account current observable market data and experience.

These assumptions may have a significant effect on the reported fair values of assets and liabilities and the related income and expense. As such, the use of different models and assumptions, as well as changes in market conditions, could result in materially different net earnings and retained earnings results.

Other Real Estate Owned

Other real estate owned (“OREO”), consists of properties obtained through foreclosure or in satisfaction of loans and is reported at the lower of cost or fair value, less estimated costs to sell at the date acquired, with any loss recognized as a charge-off through the allowance for loan losses. Additional OREO losses for subsequent valuation adjustments are determined on a specific property basis and are included as a component of other noninterest expense along with holding costs. Any gains or losses on disposal of OREO are also reflected in noninterest expense. Significant judgments and complex estimates are required in estimating the fair value of OREO, and the period of time within which such estimates can be considered current is significantly shortened during periods of market volatility. As a result, the net proceeds realized from sales transactions could differ significantly from appraisals, comparable sales, and other estimates used to determine the fair value of other OREO.

Deferred Tax Asset Valuation

A valuation allowance is recognized for a deferred tax asset if, based on the weight of available evidence, it is more-likely-than-not that some portion or the entire deferred tax asset will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of taxable income over the last three years and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that we will realize the benefits of these deductible differences at March 31, 2017. The amount of the deferred tax assets considered realizable, however, could be reduced if estimates of future taxable income are reduced.

 

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RESULTS OF OPERATIONS

Average Balance Sheet and Interest Rates

 

     Quarter ended March 31,  
     2017      2016  
(Dollars in thousands)   

 

Average

 

Balance

    

 

Yield/      

 

Rate      

    

 

Average

 

Balance

    

 

Yield/      

 

Rate      

 

 

  

 

 

    

 

 

 

Loans and loans held for sale

    $     430,711        4.69%       $     430,545        4.76%  

Securities - taxable

     189,051        2.19%        170,125        2.12%  

Securities - tax-exempt

     68,843        5.19%        66,963        5.69%  

 

  

 

 

    

 

 

 

 Total securities

     257,894        2.99%        237,088        3.13%  

Federal funds sold

     40,977        0.75%        58,415        0.49%  

Interest bearing bank deposits

     58,370        0.87%        49,983        0.44%  

 

  

 

 

    

 

 

 

 Total interest-earning assets

     787,952        3.65%        776,031        3.66%  

 

  

 

 

    

 

 

 

Deposits:

           

NOW

     124,286        0.18%        122,151        0.31%  

Savings and money market

     234,032        0.36%        229,865        0.38%  

Time Deposits

     205,942        1.17%        217,426        1.23%  

 

  

 

 

    

 

 

 

 Total interest-bearing deposits

     564,260        0.62%        569,442        0.69%  

Short-term borrowings

     3,554        0.46%        3,155        0.51%  

Long-term debt

     3,217        3.66%        7,217        3.51%  

 

  

 

 

    

 

 

 

 Total interest-bearing liabilities

     571,031        0.64%        579,814        0.73%  

 

  

 

 

    

 

 

 

Net interest income and margin (tax-equivalent)

    $       6,189        3.19%       $       6,019        3.12%  

 

  

 

 

    

 

 

 

Net Interest Income and Margin

Net interest income (tax-equivalent) was $6.2 million for the first quarter of 2017 compared to $6.0 million for the first quarter of 2016. This increase was primarily due to a reduction in interest expense as the Company lowered its deposit costs and repaid higher-cost wholesale funding sources.

The tax-equivalent yield on total interest-earning assets decreased by 1 basis point in the first quarter of 2017 from the first quarter of 2016. Declining loan yields due to pricing competition for quality loan opportunities in our markets and declining securities yields due to lower reinvestment rates for municipal bonds were largely offset by an increase in yields on short-term assets, such as federal funds sold and interest bearing bank deposits, due to recent increases in the Federal Reserve’s benchmark interest rate.

The cost of total interest-bearing liabilities decreased 9 basis points in the first quarter of 2017 from the first quarter of 2016 to 0.64%. The net decrease was largely a result of the continued shift in our funding mix, as we increased our lower-cost interest bearing demand deposits (NOW accounts) and savings and money market accounts and concurrently reduced balances of higher-cost certificates of deposits and long-term debt.

The Company continues to deploy various asset liability management strategies to manage its risk to interest rate fluctuations. The Company’s net interest margin could experience pressure due to continued pressure on earning asset yields during this extended period of low interest rates, increased competition for quality loan opportunities, and possible increases in our costs of funds and our variable rate assets, if the Federal Reserve continues its gradual increase in interest rates. Despite this challenging environment, we believe our net interest income should increase in 2017 compared to 2016 due to our expected increase in the average volume of total interest earning assets and our belief that interest rates should, depending on competitive pressures, rise faster in our assets than our liabilities.

 

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Provision for Loan Losses

The provision for loan losses represents a charge to earnings necessary to provide an allowance for loan losses that management believes, based on its processes and estimates, should be adequate to provide for the probable losses on outstanding loans. The Company recorded no provision for loan losses for the first quarter of 2017, compared to $0.6 million negative provision for loan losses for the first quarter of 2016 due to the payoff of the nonperforming loan described below. Annualized net charge-offs as a percent of average loans were 0.05% for the first quarter of 2017 compared to annualized net recoveries as a percent of average loans of 1.01% for the first quarter of 2016. The Company recognized a recovery of $1.2 million from the payoff of one nonperforming construction and land development loan during the first quarter of 2016. Provision expense reflects the absolute level of loans, loan growth, the credit quality of the loan portfolio, and the amount of net charge-offs or recoveries.

Based upon its assessment of the loan portfolio, management adjusts the allowance for loan losses to an amount it believes should be appropriate to adequately cover its estimate of probable losses in the loan portfolio. The Company’s allowance for loan losses as a percentage of total loans was 1.07% at March 31, 2017, compared to 1.08% at December 31, 2016. While the policies and procedures used to estimate the allowance for loan losses, as well as the resulting provision for loan losses charged to operations, are considered adequate by management and are reviewed from time to time by our regulators, they are based on estimates and judgments and are therefore approximate and imprecise. Factors beyond our control (such as conditions in the local and national economy, local real estate markets, or industries) may have a material adverse effect on our asset quality and the adequacy of our allowance for loan losses resulting in significant increases in the provision for loan losses.

Noninterest Income

 

                Quarter ended March 31,          
(Dollars in thousands)      

 

2017

    

 

2016

 

 

 

Service charges on deposit accounts

  $     189      $ 198   

Mortgage lending income

      165        179   

Bank-owned life insurance

      107        112   

Securities gains, net

      2        —     

Other

      373        345   

 

 

Total noninterest income

  $             836      $         834   

 

 

Service charges on deposit accounts decreased primarily due to a decline in insufficient funds charges, reflecting changes in customer behavior and spending patterns.

The Company’s income from mortgage lending was primarily attributable to the (1) origination and sale of new mortgage loans and (2) servicing of mortgage loans. Origination income, net, is comprised of gains or losses from the sale of the mortgage loans originated, origination fees, underwriting fees, and other fees associated with the origination of loans, which are netted against the commission expense associated with these originations. The Company’s normal practice is to originate mortgage loans for sale in the secondary market and to either sell or retain the associated mortgage servicing rights (“MSRs”) when the loan is sold.

MSRs are recognized based on the fair value of the servicing right on the date the corresponding mortgage loan is sold. Subsequent to the date of transfer, the Company has elected to measure its MSRs under the amortization method. Servicing fee income is reported net of any related amortization expense.

MSRs are also evaluated for impairment on a quarterly basis. Impairment is determined by grouping MSRs by common predominant characteristics, such as interest rate and loan type. If the aggregate carrying amount of a particular group of MSRs exceeds the group’s aggregate fair value, a valuation allowance for that group is established. The valuation allowance is adjusted as the fair value changes. An increase in mortgage interest rates typically results in an increase in the fair value of the MSRs while a decrease in mortgage interest rates typically results in a decrease in the fair value of MSRs.

 

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The following table presents a breakdown of the Company’s mortgage lending income.

 

                 Quarter ended March 31,          
(Dollars in thousands)       

 

2017

    

 

2016

 

 

 

Origination income, net

  $      99      $ 97   

Servicing fees, net

       65        82   

Decrease in MSR valuation allowance

       1        —     

 

 

Total mortgage lending income

  $            165      $       179   

 

 

Noninterest Expense

                 Quarter ended March 31,          
(Dollars in thousands)       

 

2017

    

 

2016

 

 

 

Salaries and benefits

  $      2,381        $ 2,405   

Net occupancy and equipment

       381        360   

Professional fees

       230        211   

FDIC and other regulatory assessments

       89        122   

Other real estate owned, net

       3        20   

Other

       1,034        991   

 

 

Total noninterest expense

  $          4,118        $     4,109   

 

 

Salaries and benefits decreased in the first quarter of 2017, compared to the first quarter of 2016. A decrease in bonus incentive accruals was partially offset by routine annual increases in salaries and wages.

The decrease in FDIC and other regulatory assessments expense was primarily due to a decrease in the Bank’s initial assessment rate during the third quarter of 2016. In addition to changes in the FDIC assessment rate formula for banks with less than $10 billion in assets, the initial assessment rate for all banks decreased effective July 1, 2016 due to the Deposit Insurance Fund’s reserve ratio exceeding 1.15% at June 30, 2016.

Income Tax Expense

Income tax expense was $0.8 million for the first quarter of 2017 and 2016, respectively. The Company’s income tax expense for the first quarter of 2017 and 2016 reflects an effective income tax rate of 27.50%.

BALANCE SHEET ANALYSIS

Securities

Securities available-for-sale were $273.9 million at March 31, 2017, an increase of $30.3 million, or 12%, compared to $243.6 million at December 31, 2016. This increase reflects an increase in the amortized cost basis of securities available-for-sale of $30.5 million, which was partially offset by a decline in the fair value of securities available-for-sale of $0.2 million. The increase in the amortized cost basis of securities available-for-sale was primarily attributable to management allocating more funding to the investment portfolio as market yields improved in 2017. The decrease in the fair value of securities was primarily due to an increase in long-term interest rates. The average tax-equivalent yields earned on total securities were 2.99% in 2017 and 3.13% in 2016.

 

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Loans

 

          2017      2016  
         

 

First

    

 

Fourth

    

 

Third

    

 

Second

    

 

First

 
(In thousands)        

 

      Quarter      

    

 

      Quarter      

    

 

      Quarter      

    

 

      Quarter      

    

 

      Quarter      

 

 

 

Commercial and industrial

    $       50,228         49,850         50,881         50,190         50,192   

Construction and land development

      45,098         41,650         44,004         49,346         45,953   

Commercial real estate

      218,739         220,439         211,558         208,825         209,320   

Residential real estate

      108,096         110,855         112,303         113,763         117,046   

Consumer installment

      9,032         8,712         8,996         9,125         9,769   

 

 

 Total loans

      431,193         431,506         427,742         431,249         432,280   

Less: unearned income

      (640)        (560)        (539)        (555)        (517)  

 

 

 Loans, net of unearned income

    $       430,553         430,946         427,203         430,694         431,763   

 

 

Total loans, net of unearned income, were $430.6 million at March 31, 2017, compared to $430.9 million at December 31, 2016. Four loan categories represented the majority of the loan portfolio at March 31, 2017: commercial real estate (51%), residential real estate (25%), construction and land development (10%) and commercial and industrial (12%). Approximately 21% of the Company’s commercial real estate loans were classified as owner-occupied at March 31, 2017.

Within the residential real estate portfolio segment, the Company had junior lien mortgages of approximately $12.9 million, or 3% of total loans, at March 31, 2017, compared to $13.7 million, or 3% of total loans, at December 31, 2016. For residential real estate mortgage loans with a consumer purpose, $0.7 million required interest-only payments at March 31, 2017, compared to $1.4 million at December 31, 2016. The Company’s residential real estate mortgage portfolio does not include any option ARM loans, subprime loans, or any material amount of other high-risk consumer mortgage products.

The average yield earned on loans and loans held for sale was 4.69% in the first quarter of 2017 and 4.76% in the first quarter of 2016.

The specific economic and credit risks associated with our loan portfolio include, but are not limited to, the effects of current economic conditions on our borrowers’ cash flows, real estate market sales volumes, valuations, availability and cost of financing properties, real estate industry concentrations, competitive pressures from a wide range of other lenders, deterioration in certain credits, interest rate fluctuations, reduced collateral values or non-existent collateral, title defects, inaccurate appraisals, financial deterioration of borrowers, fraud, and any violation of applicable laws and regulations.

The Company attempts to reduce these economic and credit risks by adhering to loan to value guidelines for collateralized loans, investigating the creditworthiness of borrowers and monitoring borrowers’ financial position. Also, we have established and periodically review, lending policies and procedures. Banking regulations limit a bank’s credit exposure by prohibiting unsecured loan relationships that exceed 10% of its capital; or 20% of capital, if loans in excess of 10% of capital are fully secured. Under these regulations, we are prohibited from having secured loan relationships in excess of approximately $18.1 million. Furthermore, we have an internal limit for aggregate credit exposure (loans outstanding plus unfunded commitments) to a single borrower of $16.3 million. Our loan policy requires that the Loan Committee of the Board of Directors approve any loan relationships that exceed this internal limit. At March 31, 2017, the Bank had no loan relationships exceeding these limits.

We periodically analyze our commercial loan portfolio to determine if a concentration of credit risk exists in any one or more industries. We use classification systems broadly accepted by the financial services industry in order to categorize our commercial borrowers. Loan concentrations to borrowers in the following classes exceeded 25% of the Bank’s total risk-based capital at March 31, 2017 (and related balances at December 31, 2016).

 

         March 31,       December 31,  
(In thousands)   

 

    2017

      2016  

 

 

Multi-family residential properties

   $              47,147      $              46,998  

Lessors of 1 to 4 family residential properties

     44,355        45,290  

Shopping centers

     40,273        40,925  

Office Buildings

     22,276        22,366  

 

 

 

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Table of Contents

Allowance for Loan Losses

The Company maintains the allowance for loan losses at a level that management believes appropriate to adequately cover the Company’s estimate of probable losses inherent in the loan portfolio. The allowance for loan losses was $4.6 million at March 31, 2017 and December 31, 2016, respectively, which management believed to be adequate at each of the respective dates. The judgments and estimates associated with the determination of the allowance for loan losses are described under “Critical Accounting Policies.”

A summary of the changes in the allowance for loan losses and certain asset quality ratios for the first quarter of 2017 and the previous four quarters is presented below.

 

          2017     2016  
         

 

First

   

 

Fourth

    

 

Third

    

 

Second

    

 

    First    

 
(Dollars in thousands)        

 

    Quarter    

   

 

    Quarter    

    

 

    Quarter    

    

 

    Quarter    

    

 

    Quarter    

 

 

 

Balance at beginning of period

   $      4,643        4,578         4,528         4,774         4,289   

Charge-offs:

                

Commercial and industrial

        —          (14)        —          (83)        —     

Commercial real estate

        —          —           —          (194)        —     

Residential real estate

        (78)       (20)        (7)        (37)        (118)  

Consumer installment

        (1)       (38)        (1)        (2)        (26)  

 

 

Total charge-offs

        (79)       (72)        (8)        (316)        (144)  

Recoveries

        24        22         58         70         1,229   

 

 

Net (charge-offs) recoveries

        (55)       (50)        50         (246)        1,085   

Provision for loan losses

        —          115         —           —           (600)  

 

 

Ending balance

   $      4,588        4,643         4,578         4,528         4,774   

 

 

as a % of loans

        1.07      1.08         1.07         1.05         1.11   

as a % of nonperforming loans

        198      196         284         271         246   

Net charge-offs (recoveries) as % of average loans (a)

        0.05      0.05         (0.05)        0.23         (1.01)  

 

 

(a) Net charge-offs (recoveries) are annualized.

As described under “Critical Accounting Policies,” management assesses the adequacy of the allowance prior to the end of each calendar quarter. The level of the allowance is based upon management’s evaluation of the loan portfolios, past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay (including the timing of future payment), the estimated value of any underlying collateral, composition of the loan portfolio, economic conditions, industry and peer bank loan loss rates, and other pertinent factors. This evaluation is inherently subjective as it requires various material estimates and judgments, including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. The ratio of our allowance for loan losses to total loans outstanding was 1.07% at March 31, 2017, compared to 1.08% at December 31, 2016. In the future, the allowance to total loans outstanding ratio will increase or decrease to the extent the factors that influence our quarterly allowance assessment in their entirety either improve or weaken. In addition, our regulators, as an integral part of their examination process, will periodically review the Company’s allowance for loan losses, and may require the Company to make additional provisions to the allowance for loan losses based on their judgment about information available to them at the time of their examinations.

Net charge-offs were $55 thousand, or 0.05% of average loans in the first quarter of 2017, compared to net recoveries of $1.1 million, or 1.01% of average loans in the first quarter of 2016 primarily due to a recovery of $1.2 million from the payoff of one nonperforming construction and land development loan.

At March 31, 2017, the ratio of our allowance for loan losses as a percentage of nonperforming loans was 198%, compared to 196% at December 31, 2016.

The Company’s recorded investment in loans considered impaired was $2.1 million at March 31, 2017 and December 31, 2016, respectively, with corresponding valuation allowances (included in the allowance for loan losses) of $27 thousand and $31 thousand at each respective date.

 

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Table of Contents

Nonperforming Assets

At March 31, 2017 and December 31, 2016, respectively, the Company had $2.5 million in nonperforming assets.

The table below provides information concerning total nonperforming assets and certain asset quality ratios for the first quarter of 2017 and the previous four quarters.

 

        

2017

          

2016

(Dollars in thousands)

      

 

First

 

      Quarter      

          

 

Fourth

 

      Quarter      

  

 

Third

 

      Quarter      

  

 

Second

 

      Quarter      

  

 

First

 

      Quarter      

 

Nonperforming assets:

                    

Nonaccrual loans

  $    2,318            2,370      1,614     1,669     1,938 

Other real estate owned

     152            152      37     300     397 

 

Total nonperforming assets

  $    2,470            2,522      1,651     1,969     2,335 

 

as a % of loans and other real estate owned

     0.57 %        0.59      0.39     0.46     0.54 

as a % of total assets

     0.29 %        0.30      0.19     0.23     0.28 

Nonperforming loans as a % of total loans

     0.54 %        0.55      0.38     0.39     0.45 

Accruing loans 90 days or more past due

  $    —             —        211     —       —   

 

The table below provides information concerning the composition of nonaccrual loans for the first quarter of 2017 and the previous four quarters.

 

        

2017

            

2016

        

 

First

             Fourth    Third      Second    First
(In thousands)       

 

      Quarter      

                   Quarter                Quarter                  Quarter                Quarter      

 

Nonaccrual loans:

                      

Commercial and industrial

 

$

   35              37      38      40    42 

Construction and land development

     22              32      45      55    66 

Commercial real estate

     1,850              2,027      1,521      1,564    1,734 

Residential real estate

     391              252      10      10    96 

Consumer installment

     20              22      —        —      —   

 

Total nonaccrual loans

  $    2,318              2,370      1,614      1,669    1,938 

 

The Company discontinues the accrual of interest income when (1) there is a significant deterioration in the financial condition of the borrower and full repayment of principal and interest is not expected or (2) the principal or interest is 90 days or more past due, unless the loan is both well-secured and in the process of collection. At March 31, 2017 and December 31, 2016, respectively, the Company had $2.3 million and $2.4 million in loans on nonaccrual.

At March 31, 2017 and December 31, 2016, there were no loans 90 days or more past due and still accruing.

The table below provides information concerning the composition of other real estate owned for the first quarter of 2017 and the previous four quarters.

 

         2017      2016  
        

 

First

     Fourth      Third      Second      First  
(In thousands)       

 

    Quarter    

         Quarter              Quarter              Quarter              Quarter      

 

 

Other real estate owned:

                

Commercial:

                

Developed lots

  $      37        37        —          252        252  

Residential

       115        115        37        48        145  

 

 

Total other real estate owned

  $      152        152        37        300        397  

 

 

The Company held $0.2 million in OREO at March 31, 2017 and December 31, 2016, respectively, which we acquired from borrowers.

 

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Table of Contents

Potential Problem Loans

Potential problem loans represent those loans with a well-defined weakness and where information about possible credit problems of a borrower has caused management to have serious doubts about the borrower’s ability to comply with present repayment terms. This definition is believed to be substantially consistent with the standards established by the Federal Reserve, the Company’s primary regulator, for loans classified as substandard, excluding nonaccrual loans. Potential problem loans, which are not included in nonperforming assets, amounted to $5.7 million, or 1.3% of total loans at March 31, 2017, compared to $5.8 million, or 1.4% of total loans at December 31, 2016.

The table below provides information concerning the composition of potential problem loans for the first quarter of 2017 and the previous four quarters.

 

         2017      2016  
        

 

First

    

 

Fourth

    

 

Third

    

 

Second

    

 

First

 
(In thousands)       

 

    Quarter    

    

 

    Quarter    

    

 

    Quarter    

    

 

    Quarter    

    

 

    Quarter    

 

 

 

Potential problem loans:

                

Commercial and industrial

 

$

     210        233        356        285        309   

Construction and land development

       298        340        352        365        477   

Commercial real estate

       795        854        1,184        911        783   

Residential real estate

       4,285        4,326        4,423        3,855        3,938   

Consumer installment

       99        90        89        84        110   

 

 

Total potential problem loans

  $      5,687        5,843        6,404        5,500        5,617   

 

 

At March 31, 2017, approximately $0.8 million, or 14% of total potential problem loans were past due at least 30 days, but less than 90 days.

The following table is a summary of the Company’s performing loans that were past due at least 30 days, but less than 90 days, for the first quarter of 2017 and the previous four quarters.

 

         2017      2016  
        

 

First

     Fourth      Third      Second      First  
(In thousands)       

 

    Quarter    

         Quarter              Quarter              Quarter              Quarter      

 

 

Performing loans past due 30 to 89 days:

                

Commercial and industrial

 

$

     1        66        3        25        14   

Construction and land development

       3        395        —          —          129   

Commercial real estate

       —          242        —          —          —     

Residential real estate

       1,186        1,301        369        645        623   

Consumer installment

       17        38        40        51        28   

 

 

Total

  $      1,207        2,042        412        721        794   

 

 

Deposits

Total deposits were $750.3 million at March 31, 2017, compared to $739.1 million at December 31, 2016. Noninterest bearing deposits were $191.0 million, or 25.5% of total deposits, at March 31, 2017, compared to $181.9 million, or 24.6% of total deposits at December 31, 2016.

The average rate paid on total interest-bearing deposits was 0.62% in the first quarter of 2017 and 0.69% in the first quarter of 2016.

Other Borrowings

Other borrowings consist of short-term borrowings and long-term debt. Short-term borrowings generally consist of federal funds purchased and securities sold under agreements to repurchase with an original maturity less than one year. The Bank had available federal funds lines totaling $41.0 million with none outstanding at March 31, 2017, and at December 31, 2016, respectively. Securities sold under agreements to repurchase totaled $3.6 million and $3.4 million at March 31, 2017 and December 31, 2016, respectively.

 

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Table of Contents

The average rate paid on short-term borrowings was 0.46% in the first quarter of 2017 and 0.54% in the first quarter of 2016.

Long-term debt includes subordinated debentures related to trust preferred securities. The Company had $3.2 million in junior subordinated debentures related to trust preferred securities outstanding at March 31, 2017 compared to $7.2 million at December 31, 2016. The junior subordinated debentures mature on December 31, 2033 and have been redeemable since December 31, 2008.

The average rate paid on long-term debt was 3.66% in the first quarter of 2017 and 3.51% in the first quarter of 2016.

CAPITAL ADEQUACY

The Company’s consolidated stockholders’ equity was $83.4 million and $82.2 million as of March 31, 2017 and December 31, 2016, respectively. The change from December 31, 2016 was primarily driven by net earnings of $1.9 million and other comprehensive income due to the change in unrealized gains (losses) on securities available-for-sale, net-of-tax, of $0.1 million, partially offset by cash dividends paid of $0.8 million.

On January 1, 2015, the Company and Bank became subject to the rules of the Basel III regulatory capital framework and related Dodd-Frank Wall Street Reform and Consumer Protection Act changes. The new rules included the implementation of a new capital conservation buffer that is added to the minimum requirements for capital adequacy purposes. The capital conservation buffer is subject to a three year phase-in period that began on January 1, 2016 and will be fully phased-in on January 1, 2019 at 2.5%. The required phase-in capital conservation buffer during 2017 is 1.25%. A banking organization with a conservation buffer of less than the required amount will be subject to limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers. At March 31, 2017, the ratios for the Company and Bank were sufficient to meet the fully phased-in conservation buffer.

The Company’s tier 1 leverage ratio was 10.40%, common equity tier 1 (“CET1”) risk-based capital ratio was 16.24%, tier 1 risk-based capital ratio was 16.83%, and total risk-based capital ratio was 17.75% at March 31, 2017. These ratios exceed the minimum regulatory capital percentages of 5.0% for tier 1 leverage ratio, 6.5% for CET1 risk-based capital ratio, 8.0% for tier 1 risk-based capital ratio, and 10.00% for total risk-based capital ratio to be considered “well capitalized.” The Company’s capital conservation buffer was 9.75% at March 31, 2017.

MARKET AND LIQUIDITY RISK MANAGEMENT

Management’s objective is to manage assets and liabilities to provide a satisfactory, consistent level of profitability within the framework of established liquidity, loan, investment, borrowing, and capital policies. The Bank’s Asset Liability Management Committee (“ALCO”) is charged with the responsibility of monitoring these policies, which are designed to ensure an acceptable asset/liability composition. Two critical areas of focus for ALCO are interest rate risk and liquidity risk management.

Interest Rate Risk Management

In the normal course of business, the Company is exposed to market risk arising from fluctuations in interest rates. ALCO measures and evaluates interest rate risk so that the Bank can meet customer demands for various types of loans and deposits. Measurements used to help manage interest rate sensitivity include an earnings simulation model and an economic value of equity (“EVE”) model.

 

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Table of Contents

Earnings simulation. Management believes that interest rate risk is best estimated by our earnings simulation modeling. Forecasted levels of earning assets, interest-bearing liabilities, and off-balance sheet financial instruments are combined with ALCO forecasts of market interest rates for the next 12 months and other factors in order to produce various earnings simulations and estimates. To help limit interest rate risk, we have guidelines for earnings at risk which seek to limit the variance of net interest income from gradual changes in interest rates. For changes up or down in rates from management’s flat interest rate forecast over the next 12 months, policy limits for net interest income variances are as follows:

 

    +/- 20% for a gradual change of 400 basis points
    +/- 15% for a gradual change of 300 basis points
    +/- 10% for a gradual change of 200 basis points
    +/- 5% for a gradual change of 100 basis points

At March 31, 2017, our earnings simulation model indicated that we were in compliance with the policy guidelines noted above.

Economic Value of Equity. EVE measures the extent that the estimated economic values of our assets, liabilities, and off-balance sheet items will change as a result of interest rate changes. Economic values are estimated by discounting expected cash flows from assets, liabilities, and off-balance sheet items, which establishes a base case EVE. In contrast with our earnings simulation model, which evaluates interest rate risk over a 12 month timeframe, EVE uses a terminal horizon which allows for the re-pricing of all assets, liabilities, and off-balance sheet items. Further, EVE is measured using values as of a point in time and does not reflect any actions that ALCO might take in responding to or anticipating changes in interest rates, or market and competitive conditions. To help limit interest rate risk, we have stated policy guidelines for an instantaneous basis point change in interest rates, such that our EVE should not decrease from our base case by more than the following:

 

    45% for an instantaneous change of +/- 400 basis points
    35% for an instantaneous change of +/- 300 basis points
    25% for an instantaneous change of +/- 200 basis points
    15% for an instantaneous change of +/- 100 basis points

At March 31, 2017, our EVE model indicated that we were in compliance with the policy guidelines noted above.

Each of the above analyses may not, on its own, be an accurate indicator of how our net interest income will be affected by changes in interest rates. Income associated with interest-earning assets and costs associated with interest-bearing liabilities may not be affected uniformly by changes in interest rates. In addition, the magnitude and duration of changes in interest rates may have a significant impact on net interest income. For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may react in different degrees to changes in market interest rates, and other economic and market factors, including market perceptions. Interest rates on certain types of assets and liabilities fluctuate in advance of changes in general market rates, while interest rates on other types of assets and liabilities may lag behind changes in general market rates. In addition, certain assets, such as adjustable rate mortgage loans, have features (generally referred to as “interest rate caps and floors”) which limit changes in interest rates. Prepayment and early withdrawal levels also could deviate significantly from those assumed in calculating the maturity of certain instruments. The ability of many borrowers to service their debts also may decrease during periods of rising interest rates or economic stress, which may differ across industries and economic sectors. ALCO reviews each of the above interest rate sensitivity analyses along with several different interest rate scenarios in seeking satisfactory, consistent levels of profitability within the framework of the Company’s established liquidity, loan, investment, borrowing, and capital policies.

The Company may also use derivative financial instruments to improve the balance between interest-sensitive assets and interest-sensitive liabilities, and as a tool to manage interest rate sensitivity while continuing to meet the credit and deposit needs of our customers. From time to time, the Company may enter into interest rate swaps (“swaps”) to facilitate customer transactions and meet their financing needs. These swaps qualify as derivatives, but are not designated as hedging instruments. At March 31, 2017 and December 31, 2016, the Company had no derivative contracts designated as part of a hedging relationship to assist in managing its interest rate sensitivity.

 

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Table of Contents

Liquidity Risk Management

Liquidity is the Company’s ability to convert assets into cash equivalents in order to meet daily cash flow requirements, primarily for deposit withdrawals, loan demand and maturing obligations. Without proper management of its liquidity, the Company could experience higher costs of obtaining funds due to insufficient liquidity, while excessive liquidity can lead to a decline in earnings due to the cost of foregoing alternative higher-yielding investment opportunities.

Liquidity is managed at two levels. The first is the liquidity of the Company. The second is the liquidity of the Bank. The management of liquidity at both levels is essential, because the Company and the Bank are separate and distinct legal entities. The Company depends upon dividends from the Bank for liquidity to pay its operating expenses, debt obligations and dividends. The Bank’s payment of dividends depend on its earnings, liquidity, capital and the absence of any regulatory restrictions.

The primary source of funding and the primary source of liquidity for the Company include dividends received from the Bank, and secondarily proceeds from the possible issuance of common stock or other securities. Primary uses of funds by the Company include dividends paid to stockholders, stock repurchases, and interest payments on junior subordinated debentures issued by the Company in connection with trust preferred securities. The junior subordinated debentures are presented as long-term debt in the accompanying consolidated balance sheets and the related trust preferred securities are currently includible in Tier 1 Capital for regulatory capital purposes.

Primary sources of funding for the Bank include customer deposits, other borrowings, repayment and maturity of securities, sales of securities, and the sale and repayment of loans. The Bank has access to federal funds lines from various banks and borrowings from the Federal Reserve discount window. In addition to these sources, the Bank may participate in the FHLB’s advance program to obtain funding for its growth. Advances include both fixed and variable terms and may be taken out with varying maturities. At March 31, 2017, the Bank had a remaining available line of credit with the FHLB of $249.7 million. At March 31, 2017, the Bank also had $41.0 million of available federal funds lines with none outstanding. Primary uses of funds include repayment of maturing obligations and growing the loan portfolio.

Management believes that the Company and the Bank have adequate sources of liquidity to meet all their respective known contractual obligations and unfunded commitments, including loan commitments and reasonable borrower, depositor, and creditor requirements over the next twelve months.

Off-Balance Sheet Arrangements, Commitments and Contingencies

At March 31, 2017, the Bank had outstanding standby letters of credit of $7.2 million and unfunded loan commitments outstanding of $64.5 million. Because these commitments generally have fixed expiration dates and many will expire without being drawn upon, the total commitment level does not necessarily represent future cash requirements. If needed to fund these outstanding commitments, the Bank could liquidate federal funds sold or a portion of securities available-for-sale, or draw on its available credit facilities.

Mortgage lending activities

Since 2009, we have primarily sold residential mortgage loans in the secondary market to Fannie Mae while retaining the servicing of these loans. The sale agreements for these residential mortgage loans with Fannie Mae and other investors include various representations and warranties regarding the origination and characteristics of the residential mortgage loans. Although the representations and warranties vary among investors, they typically cover ownership of the loan, validity of the lien securing the loan, the absence of delinquent taxes or liens against the property securing the loan, compliance with loan criteria set forth in the applicable agreement, compliance with applicable federal, state, and local laws, among other matters.

As of March 31, 2017, the unpaid principal balance of residential mortgage loans, which we have originated and sold, but retained the servicing rights was $330.1 million. Although these loans are generally sold on a non-recourse basis, we may be obligated to repurchase residential mortgage loans or reimburse investors for losses incurred (make whole requests) if a loan review reveals a potential breach of seller representations and warranties. Upon receipt of a repurchase or make whole request, we work with investors to arrive at a mutually agreeable resolution. Repurchase and make whole requests are typically reviewed on an individual loan by loan basis to validate the claims made by the investor and to determine if a contractually required repurchase or make whole event has occurred. We seek to reduce and manage the risks of potential repurchases, make whole requests, or other claims by mortgage loan investors through our underwriting and quality assurance practices and by servicing mortgage loans to meet investor and secondary market standards.

 

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In the first quarter of 2017, as a result of the representation and warranty provisions contained in the Company’s sale agreements with Fannie Mae, the Company was required to repurchase two loans with an aggregage principal balance of $553 thousand which were current as to principal and interest at the time of repurchase. At March 31, 2017, the Company had no pending repurchase or make whole requests.

We service all residential mortgage loans originated and sold by us to Fannie Mae. As servicer, our primary duties are to: (1) collect payments due from borrowers; (2) advance certain delinquent payments of principal and interest; (3) maintain and administer any hazard, title, or primary mortgage insurance policies relating to the mortgage loans; (4) maintain any required escrow accounts for payment of taxes and insurance and administer escrow payments; and (5) foreclose on defaulted mortgage loans or take other actions to mitigate the potential losses to investors consistent with the agreements governing our rights and duties as servicer.

The agreement under which we act as servicer generally specifies a standard of responsibility for actions taken by us in such capacity and provides protection against expenses and liabilities incurred by us when acting in compliance with the respective servicing agreements. However, if we commit a material breach of our obligations as servicer, we may be subject to termination if the breach is not cured within a specified period following notice. The standards governing servicing and the possible remedies for violations of such standards are determined by servicing guides issued by Fannie Mae as well as the contract provisions established between Fannie Mae and the Bank. Remedies could include repurchase of an affected loan.

Although repurchase and make whole requests related to representation and warranty provisions and servicing activities have been limited to date, it is possible that requests to repurchase mortgage loans or reimburse investors for losses incurred (make whole requests) may increase in frequency if investors more aggressively pursue all means of recovering losses on their purchased loans. As of March 31, 2017, we do not believe that this exposure is material due to the historical level of repurchase requests and loss trends, in addition to the fact that 99% of our residential mortgage loans serviced for Fannie Mae were current as of such date. We maintain ongoing communications with our investors and will continue to evaluate this exposure by monitoring the level and number of repurchase requests as well as the delinquency rates in our investor portfolios.

Effects of Inflation and Changing Prices

The Consolidated Financial Statements and related consolidated financial data presented herein have been prepared in accordance with U.S. generally accepted accounting principles and practices within the banking industry which require the measurement of financial position and operating results in terms of historical dollars without considering the changes in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution’s performance than the effects of general levels of inflation.

CURRENT ACCOUNTING DEVELOPMENTS

The following Accounting Standards Updates (“Updates” or “ASUs”) have been issued by the FASB but are not yet effective.

 

    ASU 2014-09, Revenue from Contracts with Customers;

 

    ASU 2015-14, Revenue from Contracts with Customers – Deferral of the Effective Date;

 

    ASU 2016-01, Financial Instruments – Overall: Recognition and Measurement of Financial Assets and Financial Liabilities;

 

    ASU 2016-02, Leases;

 

    ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments; and

 

    ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments.

 

    ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash

 

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Information about these pronouncements is described in more detail below.

ASU 2014-09, Revenue from Contracts with Customers, provides a comprehensive and converged standard on revenue recognition. The new guidance is intended to improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects consideration to which the entity expects to be entitled in exchange for those goods and services. This guidance also requires new qualitative and quantitative disclosures related to revenue from contracts with customers. In August 2015, FASB issued ASU 2015-14, Revenue from Contracts with Customers – Deferral of the Effective Date, which defers the effective date by one year. With the deferral, these changes are effective for the Company in the first quarter of 2018 with retrospective application to each prior reporting period or with the cumulative effect of initially applying this Update at the date of initial application. Early adoption is not permitted. The Company is currently evaluating the impact this ASU will have on its consolidated financial statements.

ASU 2016-01, Financial Instruments – Overall: Recognition and Measurement of Financial Assets and Financial Liabilities, enhances the reporting model for financial instruments to provide users of financial statements with more decision-useful information. The ASU addresses certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. Some of the amendments include the following: 1) Require equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income; 2) Simplify the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; 3) Require public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; 4) Require an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value; among others. For public business entities, the amendments of this ASU are effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company is currently evaluating the impact this ASU will have on its consolidated financial statements.

ASU 2016-02, Leases, requires lessees to recognize the assets and liabilities that arise from leases on the balance sheet. A lessee should recognize in the statement of financial position a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for lease term. The new guidance is effective for annual and interim reporting periods beginning after December 15, 2018. The amendment should be applied at the beginning of the earliest period presented using a modified retrospective approach with earlier application permitted as of the beginning of an interim or annual reporting period. The Company is currently evaluating the impact of the new guidance on its consolidated financial statements.

ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): - Measurement of Credit Losses on Financial Instruments, amends guidance on reporting credit losses for assets held at amortized cost basis and available for sale debt securities. For assets held at amortized cost basis, the new standard eliminates the probable initial recognition threshold in current GAAP and, instead, requires an entity to reflect its current estimate of all expected credit losses using a broader range of information regarding past events, current conditions and forecasts assessing the collectability of cash flows. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial assets to present the net amount expected to be collected. For available for sale debt securities, credit losses should be measured in a manner similar to current GAAP, however the new standard will require that credit losses be presented as an allowance rather than as a write-down. The new guidance affects entities holding financial assets and net investment in leases that are not accounted for at fair value through net income. The amendments affect loans, debt securities, trade receivables, net investments in leases, off balance sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash. For public business entities that are SEC filers, the new guidance is effective for annual and interim periods in fiscal years beginning after December 15, 2019 early adoption is permitted beginning in 2019. The Company is currently evaluating the impact of the new guidance on its consolidated financial statements.

ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, provides guidance on eight specific cash flow issues where current GAAP is either unclear or does not include specific guidance on classification in the statement of cash flows. The new guidance is effective for annual and interim reporting periods in fiscal years beginning after December 15, 2017. The Company is currently evaluating the impact of the new guidance on its consolidated financial statements.

 

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ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted cash, amends guidance on how the statement of cash flows presents the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Therefore, amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. The amendments in this Update do not provide a definition of restricted cash or restricted cash equivalents. The new guidance is effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. The amendments are applied using a retrospective transition method to each period transitioned. The Company is currently evaluating the impact of the new guidance on its consolidated financial statements.

 

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Table 1 – Explanation of Non-GAAP Financial Measures

In addition to results presented in accordance with U.S. generally accepted accounting principles (GAAP), this quarterly report on Form 10-Q includes certain designated net interest income amounts presented on a tax-equivalent basis, a non-GAAP financial measure, including the presentation and calculation of the efficiency ratio.

The Company believes the presentation of net interest income on a tax-equivalent basis provides comparability of net interest income from both taxable and tax-exempt sources and facilitates comparability within the industry. Although the Company believes these non-GAAP financial measures enhance investors’ understanding of its business and performance, these non-GAAP financial measures should not be considered an alternative to GAAP. The reconciliations of these non-GAAP financial measures to their most directly comparable GAAP financial measures are presented below.

 

         2017      2016  
        

 

First

     Fourth      Third      Second      First  
(in thousands)       

 

      Quarter      

           Quarter                  Quarter                  Quarter                  Quarter        

 

 

Net interest income (GAAP)

  $      5,889        5,735        5,608        5,692        5,697  

Tax-equivalent adjustment

       300        316        316        322        322  

 

 

Net interest income (Tax-equivalent)

  $      6,189        6,051        5,924        6,014        6,019  

 

 

 

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Table 2 - Selected Quarterly Financial Data

 

     2017     2016  
     First     Fourth      Third      Second      First  
(Dollars in thousands, except per share amounts)    Quarter     Quarter      Quarter      Quarter      Quarter  

 

 

Results of Operations

             

Net interest income (a)

   $ 6,189       6,051        5,924        6,014        6,019  

Less: tax-equivalent adjustment

     300       316        316        322        322  

 

 

Net interest income (GAAP)

     5,889       5,735        5,608        5,692        5,697  

Noninterest income

     836       493        1,063        993        834  

 

 

Total revenue

     6,725       6,228        6,671        6,685        6,531  

Provision for loan losses

     —         115        —          —          (600)  

Noninterest expense

     4,118       3,238        3,980        4,021        4,109  

Income tax expense

     717       798        740        733        831  

 

 

Net earnings

   $ 1,890       2,077        1,951        1,931        2,191  

 

 

Per share data:

             

Basic and diluted net earnings

   $ 0.52       0.57        0.54        0.53        0.60  

Cash dividends declared

     0.23       0.225        0.225        0.225        0.225  

Weighted average shares outstanding:

             

Basic and diluted

           3,643,541             3,643,523              3,643,506              3,643,503              3,643,484  

Shares outstanding, at period end

     3,643,543       3,643,523        3,643,523        3,643,503        3,643,503  

Book value

   $ 22.88       22.55        23.34        23.28        22.75  

Common stock price

             

High

   $ 33.69       31.31        28.91        29.85        30.49  

Low

     30.75       27.45        27.45        26.81        24.56  

Period end:

     33.00       31.31        27.45        28.49        28.25  

To earnings ratio

     15.28     13.98        12.48        13.07        12.61  

To book value

     144     139        118        122        124  

Performance ratios:

             

Return on average equity

     9.09     9.61        9.06        9.18        10.82  

Return on average assets

     0.90     1.00        0.92        0.93        1.07  

Dividend payout ratio

     44.23     39.47        41.67        42.45        37.50  

Asset Quality:

             

Allowance for loan losses as a % of:

             

Loans

     1.07     1.08        1.07        1.05        1.11  

Nonperforming loans

     198     196        284        271        246  

Nonperforming assets as a % of:

             

Loans and other real estate owned

     0.57     0.59        0.39        0.46        0.54  

Total assets

     0.29     0.30        0.19        0.23        0.28  

Nonperforming loans as a % of total loans

     0.54     0.55        0.38        0.39        0.45  

Annualized net charge-offs (recoveries) as % of average loans

     0.05     0.05        (0.05)        0.23        (1.01)  

Capital Adequacy:

             

CET 1 risk-based capital ratio

     16.24     16.44        15.74        15.54        15.36  

Tier 1 risk-based capital ratio

     16.83     17.00        17.07        16.87        16.69  

Total risk-based capital ratio

     17.75     17.95        17.97        17.77        17.64  

Tier 1 leverage ratio

     10.40     10.27        10.36        10.56        10.47  

Other financial data:

             

Net interest margin (a)

     3.19     3.05        2.94        3.10        3.12  

Effective income tax rate

     27.50     27.76        27.50        27.52        27.50  

Efficiency ratio (b)

     58.62     49.48        56.96        57.39        59.96  

Selected average balances:

             

Securities

   $ 257,894       253,820        227,076        223,414        237,087  

Loans, net of unearned income

     429,784       429,451        429,201        434,934        429,528  

Total assets

     835,679       834,291        851,409        828,106        821,382  

Total deposits

     742,002       735,991        748,229        727,989        726,354  

Long-term debt

     3,217       4,260        7,217        7,217        7,217  

Total stockholders’ equity

     83,191       86,493        86,103        84,124        80,965  

Selected period end balances:

             

Securities

   $ 273,853       243,572        249,556        217,002        234,109  

Loans, net of unearned income

     430,553       430,946        427,203        430,694        431,763  

Allowance for loan losses

     4,588       4,643        4,578        4,528        4,774  

Total assets

     842,781       831,943        851,672        846,056        833,328  

Total deposits

     750,302       739,143        751,915        747,539        737,361  

Long-term debt

     3,217       3,217        7,217        7,217        7,217  

Total stockholders’ equity

     83,366       82,177        85,055        84,808        82,887  

 

 

(a) Tax-equivalent. See “Table 1 - Explanation of Non-GAAP Financial Measures.”

(b) Efficiency ratio is the result of noninterest expense divided by the sum of noninterest income and tax-equivalent net interest income.

 

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Table 3 - Average Balances and Net Interest Income Analysis

 

         Quarter ended March 31,  
        

 

2017

        

 

2016

 
               

 

Interest

                       Interest         
         Average     

 

Income/

     Yield/          Average      Income/      Yield/  
(Dollars in thousands)        Balance     

 

Expense

     Rate          Balance      Expense      Rate  

 

    

 

 

      

 

 

 

Interest-earning assets:

                     

Loans and loans held for sale (1)

  $      430,711       $ 4,981        4.69%     $      430,545       $ 5,096        4.76%  

Securities - taxable

       189,051         1,021        2.19%          170,125         898        2.12%  

Securities - tax-exempt (2)

       68,843         881        5.19%          66,963         947        5.69%  

 

    

 

 

      

 

 

 

Total securities

       257,894         1,902        2.99%          237,088         1,845        3.13%  

Federal funds sold

       40,977         76        0.75%          58,415         71        0.49%  

Interest bearing bank deposits

       58,370         125        0.87%          49,983         55        0.44%  

 

    

 

 

      

 

 

 

Total interest-earning assets

       787,952       $     7,084        3.65%          776,031       $     7,067        3.66%  

Cash and due from banks

       13,459                 13,120         

Other assets

       34,268                 32,231         

 

    

 

 

            

 

 

       

Total assets

  $      835,679            $      821,382         

 

    

 

 

            

 

 

       

Interest-bearing liabilities:

                     

Deposits:

                     

NOW

  $      124,286       $ 56        0.18%     $      122,151       $ 95        0.31%  

Savings and money market

       234,032         210        0.36%          229,865         219        0.38%  

Time Deposits

       205,942         596        1.17%          217,426         667        1.23%  

 

      

 

 

 

Total interest-bearing deposits

       564,260         862        0.62%          569,442         981        0.69%  

Short-term borrowings

       3,554         4        0.46%          3,155         4        0.51%  

Long-term debt

       3,217         29        3.66%          7,217         63        3.51%  

 

    

 

 

      

 

 

 

Total interest-bearing liabilities

       571,031       $ 895        0.64%          579,814       $ 1,048        0.73%  

Noninterest-bearing deposits

       177,741                 156,912         

Other liabilities

       3,716                 3,691         

Stockholders’ equity

       83,191                 80,965         

 

    

 

 

            

 

 

       

Total liabilities and stockholders’ equity

  $      835,679            $      821,382         

 

    

 

 

            

 

 

       

Net interest income and margin (tax-equivalent)

        $ 6,189        3.19%           $ 6,019        3.12%  

 

       

 

 

         

 

 

 

(1) Average loan balances are shown net of unearned income and loans on nonaccrual status have been included in the computation of average balances.

(2) Yields on tax-exempt securities have been computed on a tax-equivalent basis using an income tax rate of 34%.

 

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Table 4 - Loan Portfolio Composition    

 

        2017      2016  
       

 

First

     Fourth      Third      Second      First  
(In thousands)      

 

Quarter

     Quarter      Quarter      Quarter      Quarter  

 

 

Commercial and industrial

 

$

    50,228         49,850         50,881         50,190         50,192   

Construction and land development

      45,098         41,650         44,004         49,346         45,953   

Commercial real estate

      218,739         220,439         211,558         208,825         209,320   

Residential real estate

      108,096         110,855         112,303         113,763         117,046   

Consumer installment

      9,032         8,712         8,996         9,125         9,769   

 

 

Total loans

      431,193         431,506         427,742         431,249         432,280   

Less: unearned income

      (640)        (560)        (539)        (555)        (517)  

 

 

Loans, net of unearned income

      430,553         430,946         427,203         430,694         431,763   

Less: allowance for loan losses

      (4,588)        (4,643)        (4,578)        (4,528)        (4,774)  

 

 

Loans, net

  $           425,965             426,303             422,625             426,166             426,989   

 

 

 

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Table 5 - Allowance for Loan Losses and Nonperforming Assets

 

        2017     2016  
       

 

First

    Fourth      Third          Second     First  
(Dollars in thousands)      

 

Quarter

    Quarter      Quarter          Quarter     Quarter  

 

 

Allowance for loan losses:

               

Balance at beginning of period

  $     4,643        4,578         4,528          4,774       4,289   

Charge-offs:

               

Commercial and industrial

      —         (14)        —            (83     —    

Commercial real estate

      —         —          —            (194     —    

Residential real estate

      (78)       (20)        (7        (37     (118)  

Consumer installment

      (1)       (38)        (1        (2     (26)  

 

 

Total charge-offs

      (79)       (72)        (8        (316     (144)  

Recoveries

      24        22         58          70       1,229   

 

 

Net (charge-offs) recoveries

      (55)       (50)        50          (246     1,085   

Provision for loan losses

      —         115         —            —         (600)  

 

 

Ending balance

  $     4,588                4,643                 4,578                  4,528               4,774   

 

 

as a % of loans

      1.07      1.08         1.07          1.05       1.11   

as a % of nonperforming loans

      198      196         284          271       246   

Net charge-offs (recoveries) as % of avg. loans (a)

      0.05      0.05         (0.05        0.23       (1.01)  

 

 

Nonperforming assets:

               

Nonaccrual loans

 

$

    2,318        2,370         1,614          1,669       1,938   

Other real estate owned

      152        152         37          300       397   

 

 

Total nonperforming assets

 

$

    2,470        2,522         1,651          1,969       2,335   

 

 

as a % of loans and other real estate owned

      0.57      0.59         0.39          0.46       0.54   

as a % of total assets

      0.29      0.30         0.19          0.23       0.28   

Nonperforming loans as a % of total loans

      0.54      0.55         0.38          0.39       0.45   

Accruing loans 90 days or more past due

 

$

    —         —          211          —         —    

 

 

(a) Net charge-offs (recoveries) are annualized.

 

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Table 6 - Allocation of Allowance for Loan Losses

 

        2017         2016  
        First Quarter         Fourth Quarter         Third Quarter         Second Quarter         First Quarter  
(Dollars in thousands)        Amount      %*         Amount      %*         Amount      %*         Amount      %*         Amount      %*  

 

 

Commercial and industrial

  $     524        11.6      $     540        11.6      $     515        11.9      $     506        11.6      $     517        11.6   

Construction and land development

      845        10.5          812        9.7          673        10.3          744        11.4          695        10.6   

Commercial real estate

      2,004        50.7          2,071        51.0          2,232        49.4          2,092        48.5          2,403        48.4   

Residential real estate

      1,064        25.1          1,107        25.7          1,020        26.3          1,061        26.4          1,026        27.1   

Consumer installment

      151        2.1          113        2.0          138        2.1          125        2.1          133        2.3   

 

 

Total allowance for loan losses

  $     4,588        $       4,643        $     4,578        $       4,528        $       4,774     

 

 

* Loan balance in each category expressed as a percentage of total loans.

 

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Table 7 - CDs and Other Time Deposits of $100,000 or More

 

(Dollars in thousands)    March 31, 2017  

 

 

Maturity of:

  

3 months or less

     $            9,555   

Over 3 months through 6 months

     27,110   

Over 6 months through 12 months

     29,540   

Over 12 months

     62,800   

 

 

Total CDs and other time deposits of $100,000 or more

     $        129,005   

 

 

 

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information called for by ITEM 3 is set forth in ITEM 2 under the caption “MARKET AND LIQUIDITY RISK MANAGEMENT” and is incorporated herein by reference.

ITEM 4. CONTROLS AND PROCEDURES

The Company, with the participation of its management, including its Chief Executive Officer and Chief Financial Officer, carried out an evaluation of the effectiveness of the design and operation of its disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this report. Based upon that evaluation and as of the end of the period covered by this report, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective to allow timely decisions regarding disclosure in its reports that the Company files or submits to the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended. There have been no changes in the Company’s internal control over financial reporting that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

In the normal course of its business, the Company and the Bank are, from time to time, involved in legal proceedings. The Company’s and Bank’s management believe there are no pending or threatened legal, governmental, or regulatory proceedings that, upon resolution, are expected to have a material adverse effect upon the Company’s or the Bank’s financial condition or results of operations. See also, Part I, Item 3 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2016.

ITEM 1A. RISK FACTORS

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, Item 1A. “RISK FACTORS” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016, which could materially affect our business, financial condition or future results. The risks described in our annual report on Form 10-K are not the only the risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition, and/or operating results in the future.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Not applicable.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5. OTHER INFORMATION

Not applicable.

 

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ITEM 6. EXHIBITS

 

Exhibit    

Number    

                                            Description
3.1    Certificate of Incorporation of Auburn National Bancorporation, Inc. and all amendments thereto.*
3.2    Amended and Restated Bylaws of Auburn National Bancorporation, Inc., adopted as of November 13, 2007. **
31.1    Certification Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, As Adopted Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002, by E.L. Spencer, Jr., President, Chief Executive Officer and Chairman of the Board.
31.2    Certification Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, As Adopted Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002, by David A. Hedges, Executive Vice President, Chief Financial Officer.
32.1    Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant To Section 906 of the Sarbanes-Oxley Act of 2002, by E.L. Spencer, Jr., President, Chief Executive Officer and Chairman of the Board.***
32.2    Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant To Section 906 of the Sarbanes-Oxley Act of 2002, by David A. Hedges, Executive Vice President, Chief Financial Officer.***
101.INS    XBRL Instance Document
101.SCH    XBRL Taxonomy Extension Schema Document
101.CAL    XBRL Taxonomy Extension Calculation Linkbase Document
101.LAB    XBRL Taxonomy Extension Label Linkbase Document
101.PRE    XBRL Taxonomy Extension Presentation Linkbase Document
101.DEF    XBRL Taxonomy Extension Definition Linkbase Document

 

 

* Incorporated by reference from Registrant’s Form 10-Q dated September 30, 2002.

 

** Incorporated by reference from Registrant’s Form 10-K dated March 31, 2008.

 

*** The certifications attached as exhibits 32.1 and 32.2 to this quarterly report on Form 10-Q are “furnished” to the Securities and Exchange Commission pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not be deemed “filed” by the Company for purposes of Section 18 of the Securities Exchange Act of 1934, as amended.

 

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SIGNATURES

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

 

  AUBURN NATIONAL BANCORPORATION, INC.  
 

(Registrant)

 
Date:            April 28, 2017                                By:          /s/ E. L. Spencer, Jr.                              
  E. L. Spencer, Jr.  
  President, Chief Executive Officer and  
  Chairman of the Board  
Date:            April 28, 2017                               By:          /s/ David A. Hedges                              
  David A. Hedges  
  EVP, Chief Financial Officer