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COMMUNITY FINANCIAL CORP /MD/ - Quarter Report: 2014 June (Form 10-Q)

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

x    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Quarterly Period Ended June 30, 2014

 

OR

 

¨     TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from ______ to ______

 

Commission File Number 0-18279

 

The Community Financial Corporation

(Exact name of registrant as specified in its charter)

 

  Maryland   52-1652138  
  (State of other jurisdiction of   (I.R.S. Employer  
  incorporation or organization)   Identification No.)  

 

  3035 Leonardtown Road, Waldorf, Maryland 20601  
  (Address of principal executive offices) (Zip Code)  

 

(301) 645-5601

(Registrant's telephone number, including area code)

 

Not applicable

(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 x           No ¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant 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 x           No ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large Accelerated Filer  ¨ Accelerated Filer  ¨
Non-accelerated Filer  ¨ Smaller Reporting Company  x
(Do not check if a smaller reporting company)  

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ¨           No x

 

As of July 31, 2014, the registrant had 4,688,152 shares of common stock outstanding.

 

 
 

 

THE COMMUNITY FINANCIAL CORPORATION

FORM 10-Q

INDEX

 

  Page
PART I - FINANCIAL INFORMATION  
   
Item 1 – Financial Statements (Unaudited)  
   
Consolidated Balance Sheets – June 30, 2014 and December 31, 2013 1
   
Consolidated Statements of Income - Three and Six Months Ended June 30, 2014 and 2013 2
   
Consolidated Statements of  Comprehensive Income - Three and Six Months Ended June 30, 2014 and 2013 3
   
Consolidated Statements of Cash Flows - Three and Six Months Ended June 30, 2014 and 2013 4
   
Notes to Consolidated Financial Statements 6
   
Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations 32
   
Item 3 – Quantitative and Qualitative Disclosures about Market Risk 54
   
Item 4 – Controls and Procedures 54
   
PART II - OTHER INFORMATION  
   
Item 1 –    Legal Proceedings 55
   
Item 1A – Risk Factors 55
   
Item 2 –    Unregistered Sales of Equity Securities and Use of Proceeds 55
   
Item 3 –    Defaults Upon Senior Securities 55
   
Item 4 –    Mine Safety Disclosures 55
   
Item 5 –    Other Information 55
   
Item 6 –    Exhibits 55
   
SIGNATURES 56

 

 
 

 

PART 1 - FINANCIAL INFORMATION

ITEM 1 – FINANCIAL STATEMENTS

 

CONSOLIDATED BALANCE SHEETS

 

   June 30, 2014   December 31, 2013 
(dollars in thousands)  (Unaudited)     
         
Assets          
Cash and due from banks  $10,924   $11,408 
Federal funds sold   60    8,275 
Interest-bearing deposits with banks   434    4,836 
Securities available for sale (AFS), at fair value   41,905    48,247 
Securities held to maturity (HTM), at amortized cost   77,547    86,401 
Federal Home Loan Bank (FHLB) and Federal Reserve Bank (FRB) stock - at cost   6,661    5,593 
Loans held for sale   971    - 
Loans receivable - net of allowance for loan losses of $8,050 and $8,138   837,127    799,130 
Premises and equipment, net   19,745    19,543 
Other real estate owned (OREO)   6,553    6,797 
Accrued interest receivable   2,931    2,974 
Investment in bank owned life insurance   19,653    19,350 
Other assets   10,196    11,270 
Total Assets  $1,034,707   $1,023,824 
           
Liabilities and Stockholders' Equity          
           
Liabilities          
Deposits          
Non-interest-bearing deposits  $112,648   $103,882 
Interest-bearing deposits   705,896    717,413 
Total deposits   818,544    821,295 
Short-term borrowings   7,000    - 
Long-term debt   74,699    70,476 
Guaranteed preferred beneficial interest in junior subordinated debentures (TRUPs)   12,000    12,000 
Accrued expenses and other liabilities   9,238    9,323 
Total Liabilities   921,481    913,094 
           
Stockholders' Equity          
Preferred Stock, Senior Non-Cumulative Perpetual, Series C - par value $1,000; authorized 20,000;  issued 20,000   20,000    20,000 
Common stock - par value $.01; authorized - 15,000,000 shares; issued 4,687,766 and 4,647,407 shares, respectively   47    46 
Additional paid in capital   46,193    45,881 
Retained earnings   48,544    46,523 
Accumulated other comprehensive loss   (895)   (1,057)
Unearned ESOP shares   (663)   (663)
Total Stockholders' Equity   113,226    110,730 
Total Liabilities and Stockholders' Equity  $1,034,707   $1,023,824 

 

See notes to Consolidated Financial Statements

 

1
 

 

CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

 

   Three Months Ended June 30,   Six Months Ended June 30, 
(dollars in thousands, except per share amounts )  2014   2013   2014   2013 
Interest and Dividend Income                    
Loans, including fees  $9,685   $9,117   $19,268   $18,364 
Taxable interest and dividends on investment securities   565    631    1,155    1,221 
Interest on deposits with banks   4    2    6    5 
Total Interest and Dividend Income   10,254    9,750    20,429    19,590 
                     
Interest Expense                    
Deposits   1,159    1,445    2,367    2,996 
Short-term borrowings   1    5    7    9 
Long-term debt   524    568    1,051    1,036 
Total Interest Expense   1,684    2,018    3,425    4,041 
                     
Net Interest Income   8,570    7,732    17,004    15,549 
Provision for loan losses   563    200    766    355 
Net Interest Income After Provision For Loan Losses   8,007    7,532    16,238    15,194 
                     
Noninterest Income                    
Loan appraisal, credit, and miscellaneous charges   92    131    192    319 
Gain on sale of asset   7    11    7    11 
Net gains on sale of OREO   4    -    4    - 
Net gains on sale of investment securities   -    -    24    - 
Income from bank owned life insurance   152    157    303    308 
Service charges   524    632    1,076    1,103 
Gain on sale of loans held for sale   76    138    144    517 
Total Noninterest Income   855    1,069    1,750    2,258 
                     
Noninterest Expense                    
Salary and employee benefits   3,992    3,590    8,021    7,147 
Occupancy expense   654    569    1,219    1,052 
Advertising   201    169    323    273 
Data processing expense   381    366    652    730 
Professional fees   288    265    518    462 
Depreciation of furniture, fixtures, and equipment   182    198    367    390 
Telephone communications   41    54    91    103 
Office supplies   74    46    154    109 
FDIC Insurance   199    273    338    574 
Valuation allowance on OREO   152    19    234    330 
Other   603    557    1,181    1,079 
Total Noninterest Expense   6,767    6,106    13,098    12,249 
                     
Income before income taxes   2,095    2,495    4,890    5,203 
Income tax expense   760    909    1,834    1,899 
Net Income  $1,335   $1,586   $3,056   $3,304 
Preferred stock dividends   50    50    100    100 
Net Income Available to Common Shareholders  $1,285   $1,536   $2,956   $3,204 
                     
Earnings Per Common Share                    
Basic  $0.28   $0.51   $0.64   $1.06 
Diluted  $0.28   $0.51   $0.63   $1.05 
Cash dividends paid per common share  $0.10   $0.10   $0.20   $0.20 

 

See notes to Consolidated Financial Statements

 

2
 

 

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

 

   Three Months Ended June 30,   Six Months Ended June 30, 
(dollars in thousands)  2014   2013   2014   2013 
                 
Net Income  $1,335   $1,586   $3,056   $3,304 
Net unrealized holding gains (losses) arising during period, net of tax expense (benefit) of $126 and $(382); $87 and $(422), respectively   244    (744)   167    (819)
Reclassification adjustment for gains included in net income, net of tax expense (benefit) of $0 and $0; $(3) and $0, respectively   -    -    (5)   - 
Comprehensive Income  $1,579   $842   $3,218   $2,485 

 

See notes to Consolidated Financial Statements

 

3
 

 

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

 

   Six Months Ended June 30, 
(dollars in thousands)  2014   2013 
         
Cash Flows from Operating Activities          
Net income  $3,056   $3,304 
Adjustments to reconcile net income to net cash provided by operating activities          
Provision for loan losses   766    355 
Depreciation and amortization   632    648 
Loans originated for resale   (5,309)   (17,883)
Proceeds from sale of loans originated for sale   4,456    17,963 
Gain on sale of loans held for sale   (144)   (517)
Net gains on the sale of OREO   (4)   - 
Gains on sales of HTM investment securities   (16)   - 
Gains on sales of AFS investment securities   (8)   - 
Gain on sale of asset   (7)   (11)
Net amortization of premium/discount on investment securities   151    327 
Increase in OREO valuation allowance   234    330 
Increase in cash surrender of bank owned life insurance   (303)   (308)
Decrease (Increase) in deferred income tax benefit   600    (97)
Decrease in accrued interest receivable   43    2 
Stock based compensation   146    147 
Increase in deferred loan fees   78    266 
Decrease in accrued expenses and other liabilities   (85)   (988)
Decrease (Increase) in other assets   452    (405)
Net Cash Provided by Operating Activities   4,738    3,133 
           
Cash Flows from Investing Activities          
Purchase of AFS investment securities   (43)   (13,465)
Proceeds from redemption or principal payments of AFS investment securities   4,512    5,234 
Purchase of HTM investment securities   (750)   (10,933)
Proceeds from maturities or principal payments of HTM investment securities   6,360    23,420 
Net increase of FHLB and FRB stock   (1,068)   (1,191)
Loans originated or acquired   (137,242)   (112,182)
Principal collected on loans   97,335    113,696 
Purchase of premises and equipment   (847)   (156)
Proceeds from sale of OREO   1,106    - 
Proceeds from sale of HTM investment securities   3,179    - 
Proceeds from sale of AFS investment securities   2,056    - 
Proceeds from disposal of asset   20    11 
           
Net Cash (Used in) Provided by Investing Activities   (25,382)   4,434 

 

4
 

 

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(continued)

 

   Six Months Ended June 30, 
(dollars in thousands)  2014   2013 
         
Cash Flows from Financing Activities          
Net decrease in deposits  $(2,751)  $(35,549)
Proceeds from long-term borrowings   5,000    10,000 
Payments of long-term borrowings   (777)   (25)
Net increase in short term borrowings   7,000    23,000 
Exercise of stock options   106    75 
Dividends Paid   (1,035)   (709)
Net change in unearned ESOP shares   -    216 
Repurchase of common stock   -    (298)
Net Cash Provided by (Used in) Financing Activities   7,543    (3,290)
(Decrease) Increase in Cash and Cash Equivalents  $(13,101)  $4,277 
Cash and Cash Equivalents - January 1   24,519    11,296 
Cash and Cash Equivalents - June 30  $11,418   $15,573 
           
Supplemental Disclosures of Cash Flow Information          
Cash paid during the period for          
Interest  $3,423   $4,017 
Income taxes  $2,145   $2,600 
           
Supplemental Schedule of Non-Cash Operating Activities          
Issuance of common stock for payment of compensation  $182   $249 
Transfer from loans to OREO  $1,082   $371 

 

See notes to Consolidated Financial Statements

 

5
 

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

NOTE 1 – BASIS OF PRESENTATION

General - The consolidated financial statements of The Community Financial Corporation (the “Company”) and its wholly owned subsidiary, Community Bank of the Chesapeake (the “Bank”), and the Bank’s wholly owned subsidiary, Community Mortgage Corporation of Tri-County, included herein are unaudited. The Bank conducts business through its main office in Waldorf, Maryland, and ten branch offices in Waldorf, Bryans Road, Dunkirk, Leonardtown, La Plata, Charlotte Hall, Prince Frederick, Lusby, California, Maryland; and Dahlgren, Virginia. The Company opened a branch in Fredericksburg, Virginia on July 15, 2014. The Company maintains four loan production offices (“LPOs”) in La Plata, Prince Frederick and Leonardtown, Maryland; and Fredericksburg, Virginia. The Leonardtown and Fredericksburg LPOs are co-located with branches.

 

Effective October 18, 2013, the Company changed its name from Tri-County Financial Corporation and the Bank changed its name from Community Bank of Tri-County. The new names reflect the Bank's recent expansion into the Northern Neck of Virginia. The name of the holding company changed to better align the parent company name with that of the Bank.

 

The consolidated financial statements reflect all adjustments consisting only of normal recurring accruals that, in the opinion of management, are necessary to present fairly the Company’s financial condition, results of operations, and cash flows for the periods presented. Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. The Company believes that the disclosures are adequate to make the information presented not misleading. The balances as of December 31, 2013 have been derived from audited financial statements. There have been no significant changes to the Company’s accounting policies as disclosed in the 2013 Annual Report. The results of operations for the three and six months ended June 30, 2014 are not necessarily indicative of the results of operations to be expected for the remainder of the year or any other period. Certain previously reported amounts have been restated to conform to the 2014 presentation.

 

These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes included in the Company’s 2013 Annual Report.

 

In October 2013, the Company completed a stock offering and issued 1,591,300 shares of common stock at a price of $18.75 per share resulting in net proceeds of $27.4 million after commissions and related offering expenses.

 

NOTE 2 – NATURE OF BUSINESS

The Company provides a variety of financial services to individuals and businesses through its offices in Southern Maryland and King George and Fredericksburg, Virginia. Its primary deposit products are demand, savings and time deposits, and its primary lending products are commercial and residential mortgage loans, commercial loans, construction and land development loans, home equity and second mortgages and commercial equipment loans.

 

NOTE 3 – INCOME TAXES

The Company files a consolidated federal income tax return with its subsidiaries. Deferred tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws and when it is considered more likely than not that deferred tax assets will be realized. It is the Company’s policy to recognize accrued interest and penalties related to unrecognized tax benefits as a component of tax expense. The Company’s income tax returns for the past three years are subject to examinations by tax authorities, and may change upon examination.

 

6
 

 

NOTE 4 - ACCUMULATED OTHER COMPREHENSIVE GAIN (LOSS)

The following tables present the components of comprehensive gain (loss) for the three and six months ended June 30, 2014 and 2013. The Company’s comprehensive gain (loss) was solely related to securities for the three and six months ended June 30, 2014 and 2013. 

 

   Three Months Ended June 30, 2014   Three Months Ended June 30, 2013 
(dollars in thousands)  Before Tax   Tax Effect   Net of Tax   Before Tax   Tax Effect   Net of Tax 
Net unrealized holding gains (losses) arising during period  $370   $126   $244   $(1,126)  $(382)  $(744)
Reclassification adjustments   -    -    -    -    -    - 
Other comprehensive gain (loss)  $370   $126   $244   $(1,126)  $(382)  $(744)

 

   Six Months Ended June 30, 2014   Six Months Ended June 30, 2013 
(dollars in thousands)  Before Tax   Tax Effect   Net of Tax   Before Tax   Tax Effect   Net of Tax 
Net unrealized holding gains (losses) arising during period  $254   $87   $167   $(1,241)  $(422)  $(819)
Reclassification adjustments   (8)   (3)   (5)   -    -    - 
Other comprehensive gain (loss)  $246   $84   $162   $(1,241)  $(422)  $(819)

 

The following table presents the changes in each component of accumulated other comprehensive loss, net of tax, for the three and six months ended June 30, 2014 and 2013.

 

   Three Months
Ended
June 30, 2014
   Three Months
Ended
June, 2013
   Six Months
Ended
June 30, 2014
   Six Months
Ended
June 30, 2013
 
(dollars in thousands)  Net Unrealized
Gains And Losses
   Net Unrealized
Gains And Losses
   Net Unrealized
Gains And Losses
   Net Unrealized
Gains And Losses
 
                 
Beginning of period  $(1,139)  $64   $(1,057)  $139 
Other comprehensive gain (loss) before reclassifications   244    (744)   167    (819)
Amounts reclassified from accumulated other comprehensive income   -    -    (5)   - 
Net other comprehensive gain (loss)   244    (744)   162    (819)
End of period  $(895)  $(680)  $(895)  $(680)

 

NOTE 5 - EARNINGS PER SHARE (“EPS”)

Basic earnings per common share represent income available to common shareholders, divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued. Potential common shares that may be issued by the Company relate to outstanding stock options and are determined using the treasury stock method. As of June 30, 2014 and 2013, there were 87,435 and 101,549 options, respectively, which were excluded from the calculation as their effect would be anti-dilutive, because the exercise price of the options were greater than the average market price of the common shares.

 

7
 

 

Basic and diluted earnings per share have been computed based on weighted-average common and common equivalent shares outstanding as follows:

 

   Three Months Ended   Six Months Ended 
   June 30,   June 30, 
(dollars in thousands)  2014   2013   2014   2013 
Net Income  $1,335   $1,586   $3,056   $3,304 
Less: dividends paid and accrued on preferred stock   (50)   (50)   (100)   (100)
Net income available to common shareholders  $1,285   $1,536   $2,956   $3,204 
                     
Average number of common shares outstanding   4,651,716    3,000,389    4,645,963    3,026,651 
Effect of dilutive options   17,793    23,379    16,632    22,597 
Average number of shares used to calculate diluted EPS   4,669,509    3,023,768    4,662,595    3,049,248 

 

NOTE 6 - STOCK-BASED COMPENSATION

The Company has stock-based incentive arrangements to attract and retain key personnel. In May 2005, the 2005 Equity Compensation Plan (the “Plan”) was approved by shareholders, which authorizes the issuance of restricted stock, stock appreciation rights, stock units and stock options to the Board of Directors and key employees. Compensation expense for service-based awards is recognized over the vesting period. Performance-based awards are recognized based on a vesting schedule, if applicable, and the probability of achieving goals specified at the time of the grant.

 

Stock-based compensation expense totaled $146,000 and $147,000 for the six months ended June 30, 2014 and 2013, respectively, which consisted of the vesting of grants of restricted stock and restricted stock units. Stock-based compensation for the six months ended June 30, 2013 included director compensation of $3,000 for stock granted in lieu of cash compensation. All outstanding options were fully vested and the Company has not granted any stock options since 2007.

 

The fair value of the Company’s outstanding employee stock options is estimated on the date of grant using the Black-Scholes option pricing model. The Company estimates expected market price volatility and expected term of the options based on historical data and other factors.

 

The exercise price for options granted is set at the discretion of the committee administering the Plan, but is not less than the market value of the shares as of the date of grant. An option’s maximum term is 10 years and the options vest at the discretion of the committee.  

 

The following tables below summarize outstanding and exercisable options at June 30, 2014 and December 31, 2013.

 

       Weighted       Weighted-Average 
       Average   Aggregate   Contractual Life 
(dollars in thousands, except per      Exercise   Intrinsic   Remaining In 
share amounts)  Shares   Price   Value   Years 
                 
Outstanding at January 1, 2014   159,517   $20.12   $347      
Exercised   (6,665)   15.89    34      
Outstanding at June 30, 2014   152,852   $20.30   $611    0.7 
                     
Exercisable at June 30, 2014   152,852   $20.30   $611    0.7 

 

8
 

 

       Weighted       Weighted-Average 
       Average   Aggregate   Contractual Life 
(dollars in thousands, except per      Exercise   Intrinsic   Remaining In 
share amounts)  Shares   Price   Value   Years 
                 
Outstanding at January 1, 2013   236,059   $18.49   $164      
Exercised   (55,672)   13.16    310      
Forfeited   (20,870)   20.27           
Outstanding at December 31, 2013   159,517   $20.12   $347    1.0 
                     
Exercisable at December 31, 2013   159,517   $20.12   $347    1.0 

 

Options outstanding are all currently exercisable and are summarized as follows: 

 

Shares Outstanding   Weighted Average  Weighted Average 
June 30, 2014   Remaining Contractual Life  Exercise Price 
 65,417   1 years  $15.89 
 66,224   2 years   22.29 
 21,211   4 years   27.70 
           
 152,852      $20.30 

  

The aggregate intrinsic value of outstanding stock options and exercisable stock options was $611,000 and $347,000 at June 30, 2014 and December 31, 2013, respectively. Aggregate intrinsic value represents the difference between the Company’s closing stock price on the last trading day of the period, which was $23.75 and $20.71 per share at June 30, 2014 and December 31, 2013, respectively, and the exercise price multiplied by the number of in the money options outstanding.

 

The Company has outstanding restricted stock and stock units granted in accordance with the Plan. The vesting period for granted restricted stock is between three and five years. As of June 30, 2014, unrecognized stock compensation expense was $573,000. The following tables summarize the unvested restricted stock awards and units outstanding at June 30, 2014 and December 31, 2013, respectively.

 

   Restricted Stock   Restricted Stock Units 
   Number of
Shares
   Weighted
Average Grant 
Date Fair Value
   Number of Units   Fair Value 
                 
Nonvested at January 1, 2014   16,832   $17.86    4,210   $20.71 
Granted   33,460    21.35    -    - 
Vested   (17,105)   15.39    (2,105)   20.29 
                     
Nonvested at June 30, 2014   33,187   $20.90    2,105   $23.75 

 

9
 

 

   Restricted Stock   Restricted Stock Units 
   Number of
Shares
   Weighted
  Average Grant 
Date Fair Value
   Number of Units   Fair Value 
                     
Nonvested at January 1, 2013   23,569   $15.64    5,211   $15.98 
Granted   13,656    18.00    2,105    20.71 
Vested   (20,393)   18.79    (3,106)   15.98 
                     
Nonvested at December 31, 2013   16,832   $17.86    4,210   $20.71 

 

NOTE 7 - GUARANTEED PREFERRED BENEFICIAL INTEREST IN JUNIOR SUBORDINATED DEBENTURES (“TRUPs”)

On June 15, 2005, Tri-County Capital Trust II (“Capital Trust II”), a Delaware business trust formed, funded and wholly owned by the Company, issued $5.0 million of variable-rate capital securities in a private pooled transaction. The variable rate is based on the 90-day LIBOR rate plus 1.70%. The Trust used the proceeds from this issuance, along with the $155,000 for Capital Trust II’s common securities, to purchase $5.2 million of the Company’s junior subordinated debentures. The interest rate on the debentures and the trust preferred securities is variable and adjusts quarterly. These capital securities qualify as Tier I capital and are presented in the Consolidated Balance Sheets as “Guaranteed Preferred Beneficial Interests in Junior Subordinated Debentures.” Both the capital securities of Capital Trust II and the junior subordinated debentures are scheduled to mature on June 15, 2035, unless called by the Company.

 

On July 22, 2004, Tri-County Capital Trust I (“Capital Trust I”), a Delaware business trust formed, funded and wholly owned by the Company, issued $7.0 million of variable-rate capital securities in a private pooled transaction. The variable rate is based on the 90-day LIBOR rate plus 2.60%. The Trust used the proceeds from this issuance, along with the Company’s $217,000 capital contribution for Capital Trust I’s common securities, to purchase $7.2 million of the Company’s junior subordinated debentures. The interest rate on the debentures and the trust preferred securities is variable and adjusts quarterly. These debentures qualify as Tier I capital and are presented in the Consolidated Balance Sheets as “Guaranteed Preferred Beneficial Interests in Junior Subordinated Debentures.” Both the capital securities of Capital Trust I and the junior subordinated debentures are scheduled to mature on July 22, 2034, unless called by the Company.

 

NOTE 8 - PREFERRED STOCK

Small Business Lending Fund Preferred Stock

On September 22, 2011, the Company issued 20,000 shares of the Company’s Senior Non-Cumulative Perpetual Preferred Stock, Series C (the “Series C Preferred Stock”), having a liquidation amount per share equal to $1,000 to the Department of the Treasury for $20.0 million under the Small Business Lending Fund program.

 

The Series C Preferred Stock receives non-cumulative dividends, payable quarterly. The dividend rate fluctuates quarterly during the first 10 quarters during which the Series C Preferred Stock is outstanding, based upon changes in the level of “Qualified Small Business Lending” or “QSBL” (as defined in the Purchase Agreement) by the Bank. For the second through ninth calendar quarters, the dividend rate may be adjusted to between one percent (1%) and five percent (5%) per annum, to reflect the amount of change in the Bank’s level of QSBL. If the level of the Bank’s qualified small business loans declines so that the percentage increase in QSBL as compared to the baseline level is less than 10%, then the dividend rate payable on the Series C Preferred Stock would increase. For the tenth calendar quarter through four and one half years after issuance, the dividend rate will be fixed at between one percent (1%) and seven percent (7%) based upon the increase in QSBL as compared to the baseline. After four and one half years from issuance, the dividend rate will increase to nine percent (9%). In addition, beginning on January 1, 2014, and on all Series C Preferred Stock dividend payment dates thereafter ending on April 1, 2016, if the Company had not increased its QSBL from the baseline as of the quarter ended September 30, 2013, the Company would have been required to pay to the Department of the Treasury, on each share of Series C Preferred Stock, but only out of assets legally available, a fee equal to 0.5% of the liquidation amount per share of Series C Preferred Stock. At September 30, 2013, the Company had increased its QSBL from the baseline so that the dividend rate should remain at 1% through four and one half years from issuance.

 

10
 

 

The Series C Preferred Stock is non-voting, except in limited circumstances. If the Company misses five dividend payments, whether or not consecutive, the holder of the Series C Preferred Stock will have the right, but not the obligation, to appoint a representative as an observer on the Company’s Board of Directors. The Series C Preferred Stock may be redeemed at any time at the Company’s option, at a redemption price of 100% of the liquidation amount plus accrued but unpaid dividends to the date of redemption for the current period, subject to regulatory approval. The Company is permitted to repay its SBLF funding in increments of 25% or $5.0 million, subject to regulatory approval.

 

NOTE 9 - OTHER REAL ESTATE OWNED (“OREO”)

OREO assets are presented net of valuation allowances. The Company considers OREO as classified assets for regulatory and financial reporting. An analysis of OREO activity follows.

 

   Six Months Ended June 30,   Year Ended
December 31,
 
(dollars in thousands)  2014   2013   2013 
Balance at beginning of year  $6,797   $6,891   $6,891 
Additions of underlying property   1,082    371    1,853 
Disposals of underlying property   (1,092)   -    (1,346)
Valuation allowance   (234)   (330)   (601)
Balance at end of period  $6,553   $6,932   $6,797 

 

During the six months ended June 30, 2014 additions consisted of two residential properties totaling $441,000 and a commercial building of $640,000 compared to $371,000 of additions for a residential property for the six months ended June 30, 2013. Additions were offset by disposals of three residential properties during the six months ended June 30, 2014. There were no disposals of OREO during the six months ended June 30, 2013. Valuation allowances further reduced OREO carrying values $234,000 and $330,000 to current appraised values for the six months ended June 30, 2014 and 2013, respectively. OREO carrying amounts reflect management’s estimate of the realizable value of these properties incorporating current appraised values, local real estate market conditions and related costs.

 

Expenses applicable to OREO assets include the following. 

 

   Three Months Ended June 30,   Six Months Ended June 30, 
(dollars in thousands)  2014   2013   2014   2013 
Valuation allowance  $152   $19   $234   $330 
Operating expenses   13    24    60    64 
   $165   $43   $294   $394 

 

11
 

 

NOTE 10 – SECURITIES 

 

   June 30, 2014 
   Amortized   Gross Unrealized   Gross Unrealized   Estimated 
(dollars in thousands)  Cost   Gains   Losses   Fair Value 
Securities available for sale (AFS)                    
Asset-backed securities issued by GSEs                    
Residential Mortgage Backed Securities ("MBS")  $44   $7   $-   $51 
Residential Collateralized Mortgage Obligations ("CMOs")   38,807    24    1,269    37,562 
Corporate equity securities   37    5    -    42 
Bond mutual funds   4,151    99    -    4,250 
Total securities available for sale  $43,039   $135   $1,269   $41,905 
                     
Securities held to maturity (HTM)                    
Asset-backed securities issued by GSEs:                    
Residential MBS  $21,118   $674   $125   $21,667 
Residential CMOs   53,176    291    788    52,679 
Asset-backed securities issued by Others:                    
Residential CMOs   2,503    138    118    2,523 
Total debt securities held to maturity   76,797    1,103    1,031    76,869 
                     
U.S. government obligations   750    -    -    750 
Total securities held to maturity  $77,547   $1,103   $1,031   $77,619 

  

   December 31, 2013 
   Amortized   Gross Unrealized   Gross Unrealized   Estimated 
(dollars in thousands)  Cost   Gains   Losses   Fair Value 
Securities available for sale (AFS)                    
Asset-backed securities issued by GSEs                    
Residential MBS  $176   $17   $-   $193 
Residential CMOs   45,299    63    1,479    43,883 
Corporate equity securities   37    4    -    41 
Bond mutual funds   4,108    22    -    4,130 
Total securities available for sale  $49,620   $106   $1,479   $48,247 
                     
Securities held to maturity (HTM)                    
Asset-backed securities issued by GSEs:                    
Residential MBS  $22,662   $625   $214   $23,073 
Residential CMOs   59,869    265    943    59,191 
Asset-backed securities issued by Others:                    
Residential CMOs   3,120    114    157    3,077 
Total debt securities held to maturity   85,651    1,004    1,314    85,341 
                     
U.S. government obligations   750    -    -    750 
Total securities held to maturity  $86,401   $1,004   $1,314   $86,091 

 

At June 30, 2014, certain asset-backed securities with an amortized cost of $13.6 million were pledged to secure certain deposits. At June 30, 2014, asset-backed securities with an amortized cost of $2.5 million were pledged as collateral for advances from the Federal Home Loan Bank (“FHLB”) of Atlanta.

  

12
 

 

At June 30, 2014, 98% of the asset-backed securities portfolio was rated AAA by Standard & Poor’s or the equivalent credit rating from another major rating agency. AFS asset-backed securities issued by government sponsored entities (“GSEs”) had an average life of 4.08 years and an average duration of 3.76 years and are guaranteed by their issuer as to credit risk. HTM asset-backed securities issued by GSEs had an average life of 4.11 years and an average duration of 3.86 years and are guaranteed by their issuer as to credit risk.

 

At December 31, 2013, 98% of the asset-backed securities portfolio was rated AAA by Standard & Poor’s or the equivalent credit rating from another major rating agency. AFS asset-backed securities issued by GSEs had an average life of 4.45 years and average duration of 4.45 years and are guaranteed by their issuer as to credit risk. HTM asset-backed securities issued by GSEs had an average life of 4.49 years and average duration of 4.16 years and are guaranteed by their issuer as to credit risk.

 

We believe that AFS securities with unrealized losses will either recover in market value or be paid off as agreed. The Company intends to, and has the ability to, hold these securities until recovery of the market value which may be the maturity. We believe that the losses are the result of general perceptions of safety and creditworthiness of the entire sector and a general disruption of orderly markets in the asset class.

 

Management has the ability and intent to hold the HTM securities with unrealized losses until they mature, at which time the Company will receive full value for the securities. Because our intention is not to sell the investments and it is not more likely than not that we will be required to sell the investments before recovery of their amortized cost basis, which may be maturity, management considers the unrealized losses in the held-to-maturity portfolio to be temporary.

 

No charges related to other-than-temporary impairment were made during the six months ended June 30, 2014 and 2013. During the year ended December 31, 2009, the Company recorded a charge of $148,000 related to other-than-temporary impairment on a single HTM CMO issue. At June 30, 2014, the CMO issue had a par value of $830,000, a market fair value of $598,000 and a carrying value of $460,000 and an average life of 6.85 years and an average duration of 4.39 years.

 

During the three months ended March 31, 2014, the Company recognized net gains on the sale of securities of $24,000. The Company sold five AFS securities with a carrying value of $2.1 million and ten HTM securities with aggregate carrying values of $3.2 million, recognizing gains of $8,000 and $16,000, respectively. The sale of HTM securities was permitted under ASC 320 “Investments - Debt and Equity Securities.” ASC 320 permits the sale of HTM securities for certain changes in circumstances. The Company sold the HTM positions utilizing the safe harbor rule that allows for the sale of HTM securities that have principal payments paid down to less than 15% of original purchased par. ASC 320 10-25-15 indicates that a sale of a debt security after a substantial portion of the principal has been collected is equivalent to holding the security to maturity. There were no sales of AFS and HTM securities during the three months ended June 30, 2014 and the six months ended June 30, 2013.

 

AFS Securities

Gross unrealized losses and estimated fair value by length of time that the individual AFS securities have been in a continuous unrealized loss position at June 30, 2014 were as follows: 

 

June 30, 2014  Less Than 12   More Than 12         
   Months   Months   Total 
(dollars in thousands)  Fair Value   Unrealized
Loss
   Fair Value   Unrealized
Loss
   Fair Value   Unrealized
Losses
 
Asset-backed securities
issued by GSEs
  $4,614   $1   $29,572   $1,268   $34,187   $1,269 

  

At June 30, 2014, the AFS investment portfolio had an estimated fair value of $41.9 million, of which $34.2 million or 82% of the securities had some unrealized losses from their amortized cost. The securities with unrealized losses were CMOs issued by GSEs.

 

AFS securities issued by GSEs are guaranteed by the issuer. Total unrealized losses on the asset-backed securities issued by GSEs were $1.3 million or 3.3% of the portfolio amortized cost of $38.9 million. AFS asset-backed securities issued by GSEs with unrealized losses had an average life of 4.18 years and an average duration of 3.85 years. We believe that the securities will either recover in market value or be paid off as agreed.

 

13
 

 

Gross unrealized losses and estimated fair value by length of time that the individual AFS securities have been in a continuous unrealized loss position at December 31, 2013 were as follows: 

 

December 31, 2013  Less Than 12   More Than 12         
   Months   Months   Total 
(dollars in thousands)  Fair Value   Unrealized
Loss
   Fair Value   Unrealized
Loss
   Fair Value   Unrealized
Losses
 
Asset-backed securities
issued by GSEs
  $28,669   $1,016   $8,352   $463   $37,021   $1,479 

 

At December 31, 2013, the AFS investment portfolio had an estimated fair value of $48.2 million, of which $37.0 million or 77% of the securities had some unrealized losses from their amortized cost. The securities with unrealized losses are predominantly CMOs issued by GSEs.

 

AFS securities issued by GSEs are guaranteed by the issuer. Total unrealized losses on the asset-backed securities issued by GSEs were $1.5 million or 3.3% of the portfolio amortized cost of $45.5 million. AFS asset-backed securities issued by GSEs with unrealized losses had an average life of 4.71 years and an average duration of 4.25 years.

 

HTM Securities

Gross unrealized losses and estimated fair value by length of time that the individual HTM securities have been in a continuous unrealized loss position at June 30, 2014 were as follows: 

 

June 30, 2014  Less Than 12   More Than 12         
   Months   Months   Total 
(dollars in thousands)  Fair Value   Unrealized
Loss
   Fair Value   Unrealized
Loss
   Fair Value   Unrealized
Losses
 
Asset-backed securities
issued by GSEs
  $4,079   $45   $25,716   $868   $29,795   $913 
Asset-backed securities
issued by other
   -    -    1,832    118    1,832    118 
   $4,079   $45   $27,548   $986   $31,627   $1,031 

 

At June 30, 2014, the HTM investment portfolio had an estimated fair value of $77.6 million, of which $31.6 million or 41%, of the securities had some unrealized losses from their amortized cost. Of these securities, $29.8 million or 94%, were asset-backed securities issued by GSEs and the remaining $1.8 million or 6%, were asset-backed securities issued by others.

 

HTM securities issued by GSEs are guaranteed by the issuer. Total unrealized losses on the asset-backed securities issued by GSEs were $913,000 or 1.2% of the portfolio amortized cost of $74.3 million. HTM asset-backed securities issued by GSEs with unrealized losses had an average life of 5.01 years and an average duration of 4.60 years. We believe that the securities will either recover in market value or be paid off as agreed. The Company intends to, and has the ability to, hold these securities to maturity.

 

HTM asset-backed securities issued by others are collateralized mortgage obligation securities. All of the securities have credit support tranches that absorb losses prior to the tranches that the Company owns. The Company reviews credit support positions on its securities regularly. Total unrealized losses on the asset-backed securities issued by others were $118,000 or 4.7% of the portfolio amortized cost of $2.5 million. HTM asset-backed securities issued by others with unrealized losses have an average life of 3.96 years and an average duration of 3.40 years.

 

14
 

 

Gross unrealized losses and estimated fair value by length of time that the individual HTM securities have been in a continuous unrealized loss position at December 31, 2013 were as follows: 

 

December 31, 2013  Less Than 12   More Than 12         
   Months   Months   Total 
(dollars in thousands)  Fair Value   Unrealized
Loss
   Fair Value   Unrealized
Loss
   Fair Value   Unrealized
Losses
 
Asset-backed securities
issued by GSEs
  $36,705   $1,000   $6,832   $157   $43,537   $1,157 
Asset-backed securities
issued by other
   97    -    2,399    157    2,496    157 
   $36,802   $1,000   $9,231   $314   $46,033   $1,314 

 

At December 31, 2013, the HTM investment portfolio had an estimated fair value of $86.1 million, of which $46.0 million, or 53% of the securities, had some unrealized losses from their amortized cost. Of these securities, $43.5 million, or 95%, are mortgage-backed securities issued by GSEs and the remaining $2.5 million, or 5%, were asset-backed securities issued by others.

 

HTM securities issued by GSEs are guaranteed by the issuer. Total unrealized losses on the asset-backed securities issued by GSEs were $1.2 million or 1.4% of the portfolio amortized cost of $82.5 million. HTM asset-backed securities issued by GSEs with unrealized losses had an average life of 5.24 years and an average duration of 4.80 years.

 

HTM asset-backed securities issued by others are collateralized mortgage obligation securities. All of the securities have credit support tranches that absorb losses prior to the tranches that the Company owns. The Company reviews credit support positions on its securities regularly. Total unrealized losses on the asset-backed securities issued by others were $157,000, or 5.0% of the portfolio amortized cost of $3.1 million. HTM asset-backed securities issued by others with unrealized losses had an average life of 5.17 years and an average duration of 4.73 years.

 

Credit Quality of Asset-Backed Securities

The tables below present the Standard & Poor’s or equivalent credit rating from other major rating agencies for AFS and HTM asset-backed securities issued by GSEs and others at June 30, 2014 and December 31, 2013 by carrying value. The Company considers noninvestment grade securities rated BB+ or lower as classified assets for regulatory and financial reporting. GSE asset-backed security downgrades by Standard and Poor’s were treated as AAA based on regulatory guidance.

 

June 30, 2014  December 31, 2013
Credit Rating  Amount   Credit Rating  Amount 
(dollars in thousands)
AAA  $111,908   AAA  $126,607 
BBB   503   BBB   584 
BBB-   -   BBB-   98 
BB   766   BB   813 
B+   -   B+   66 
CCC+   773   CCC+   1,092 
CCC   460   CCC   467 
Total  $114,410   Total  $129,727 

 

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NOTE 11 – LOANS

Loans consist of the following:

 

(dollars in thousands)  June 30, 2014   December 31, 2013 
         
Commercial real estate  $531,919   $476,648 
Residential first mortgages   156,833    159,147 
Construction and land development   32,086    32,001 
Home equity and second mortgages   21,225    21,692 
Commercial loans   77,583    94,176 
Consumer loans   736    838 
Commercial equipment   25,876    23,738 
    846,258    808,240 
Less:          
Deferred loan fees   1,081    972 
Allowance for loan loss   8,050    8,138 
    9,131    9,110 
           
   $837,127   $799,130 

 

At June 30, 2014, the Bank’s allowance for loan losses totaled $8.1 million, or 0.95% of loan balances, as compared to $8.1 million, or 1.01% of loan balances, at December 31, 2013. Management’s determination of the adequacy of the allowance is based on a periodic evaluation of the portfolio with consideration given to the overall loss experience, current economic conditions, size, growth and composition of the loan portfolio, financial condition of the borrowers and other relevant factors that, in management’s judgment, warrant recognition in providing an adequate allowance.

 

Risk Characteristics of Portfolio Segments

The Company manages its credit products and exposure to credit losses (credit risk) by the following specific portfolio segments (classes), which are levels at which the Company develops and documents its allowance for loan loss methodology. These segments are:

 

Commercial Real Estate (“CRE”)

Commercial and other real estate projects include office buildings, retail locations, churches, other special purpose buildings and commercial construction. Commercial construction balances were below 5% of the CRE portfolio at June 30, 2014 and December 31, 2013. The Bank offers both fixed-rate and adjustable-rate loans under these product lines. The primary security on a commercial real estate loan is the real property and the leases that produce income for the real property. Loans secured by commercial real estate are generally limited to 80% of the lower of the appraised value or sales price at origination and have an initial contractual loan payment period ranging from three to 20 years.

 

Loans secured by commercial real estate are larger and involve greater risks than one-to four-family residential mortgage loans. Because payments on loans secured by such properties are often dependent on the successful operation or management of the properties, repayment of such loans may be subject to a greater extent to adverse conditions in the real estate market or the economy.

 

Residential First Mortgages

Residential first mortgage loans made by the Bank are generally long-term loans, amortized on a monthly basis, with principal and interest due each month. The contractual loan payment period for residential loans typically ranges from ten to 30 years. The Bank’s experience indicates that real estate loans remain outstanding for significantly shorter time periods than their contractual terms. Borrowers may refinance or prepay loans at their option, without penalty. The Bank originates both fixed-rate and adjustable-rate residential first mortgages.

  

The annual and lifetime limitations on interest rate adjustments may limit the increases in interest rates on these loans. There are also credit risks resulting from potential increased costs to the borrower as a result of the repricing of adjustable-rate mortgage loans. During periods of rising interest rates, the risk of default on adjustable-rate mortgage loans may increase due to the upward adjustment of interest cost to the borrower. The Bank’s adjustable rate residential first mortgage portfolio was $27.4 million or 3.2% of total gross loans of $846.3 million at June 30, 2014.

 

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Construction and Land Development

The Bank offers loans for the construction of one-to four-family dwellings. Generally, these loans are secured by the real estate under construction as well as by guarantees of the principals involved. In addition, the Bank offers loans to acquire and develop land, as well as loans on undeveloped, subdivided lots for home building by individuals.

 

A decline in demand for new housing might adversely affect the ability of borrowers to repay these loans. Construction and land development loans are inherently riskier than providing financing on owner-occupied real estate. The Bank’s risk of loss is affected by the accuracy of the initial estimate of the market value of the completed project as well as the accuracy of the cost estimates made to complete the project. In addition, the volatility of the real estate market has made it increasingly difficult to ensure that the valuation of land associated with these loans is accurate. During the construction phase, a number of factors could result in delays and cost overruns. If the estimate of construction costs proves to be inaccurate, the Bank may be required to advance funds beyond the amount originally committed to permit completion of the development. If the estimate of value proves to be inaccurate, a project’s value might be insufficient to assure full repayment. As a result of these factors, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, on the success of the project rather than the ability of the borrower or guarantor to repay principal and interest. If the Bank forecloses on a project, there can be no assurance that the Bank will be able to recover all of the unpaid balance of, and accrued interest on, the loan as well as related foreclosure and holding costs.

 

Home Equity and Second Mortgage Loans

The Bank maintains a portfolio of home equity and second mortgage loans. These products contain a higher risk of default than residential first mortgages as in the event of foreclosure, the first mortgage would need to be paid off prior to collection of the second mortgage. This risk has been heightened as the market value of residential property has declined.

 

Commercial Loans

The Bank offers commercial loans to its business customers. The Bank offers a variety of commercial loan products including term loans and lines of credit. Such loans are generally made for terms of five years or less. The Bank offers both fixed-rate and adjustable-rate loans under these product lines. When making commercial business loans, the Bank considers the financial condition of the borrower, the borrower’s payment history of both corporate and personal debt, the projected cash flows of the business, the viability of the industry in which the consumer operates, the value of the collateral, and the borrower’s ability to service the debt from income. These loans are primarily secured by equipment, real property, accounts receivable, or other security as determined by the Bank.

 

Commercial loans are made on the basis of the borrower’s ability to make repayment from the cash flows of the borrower’s business. As a result, the availability of funds for the repayment of commercial loans may depend substantially on the success of the business itself.

 

Consumer Loans

Consumer loans consist of loans secured by automobiles, boats, recreational vehicles and trucks. The Bank also makes home improvement loans and offers both secured and unsecured personal lines of credit. Consumer loans entail greater risk from other loan types due to being secured by rapidly depreciating assets or the reliance on the borrower’s continuing financial stability.

 

Commercial Equipment Loans

These loans consist primarily of fixed-rate, short-term loans collateralized by a commercial customer’s equipment. When making commercial equipment loans, the Bank considers the same factors it considers when underwriting a commercial business loan. Commercial loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flows of the borrower’s business. As a result, the availability of funds for the repayment of commercial loans may depend substantially on the success of the business itself. In the case of business failure, collateral would need to be liquidated to provide repayment for the loan. In many cases, the highly specialized nature of collateral equipment would make full recovery from the sale of collateral problematic.

 

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Non-accrual and Past Due Loans

Non-accrual loans as of June 30, 2014 and December 31, 2013 were as follows: 

 

   June 30, 2014 
(dollars in thousands)  90 or Greater
Days
Delinquent
   Number
of Loans
   Non-accrual
Only Loans
   Number
of Loans
   Total
Non-accrual
Loans
   Total
Number
of Loans
 
                         
Commercial real estate  $5,113    11   $-    -   $5,113    11 
Residential first mortgages   540    2    -    -    540    2 
Construction and land development   3,811    2    -    -    3,811    2 
Home equity and second mortgages   166    2    -    -    166    2 
Commercial loans   2,035    8    -    -    2,035    8 
Consumer loans   -    -    -    -    -    - 
Commercial equipment   221    4    -    -    221    4 
   $11,886    29   $-    -   $11,886    29 

 

   December 31, 2013 
(dollars in thousands)  90 or Greater
Days
Delinquent
   Number
of Loans
   Non-accrual
Only Loans
   Number
of Loans
   Total
Non-accrual
Loans
   Total
Number
of Loans
 
                         
Commercial real estate  $4,235    10   $3,695    2   $7,930    12 
Residential first mortgages   1,683    6    562    3    2,245    9 
Construction and land development   2,968    1    -    -    2,968    1 
Home equity and second mortgages   115    3    -    -    115    3 
Commercial loans   1,935    6    -    -    1,935    6 
Consumer loans   -    -    24    1    24    1 
Commercial equipment   234    2    -    -    234    2 
   $11,170    28   $4,281    6   $15,451    34 

 

Non-accrual loans (90 days or greater delinquent and non-accrual only loans) decreased $3.6 million from $15.5 million or 1.91% of total loans at December 31, 2013 to $11.9 million or 1.40% of total loans at June 30, 2014. Non-accrual only loans are loans classified as non-accrual due to customer operating results or payment history. In accordance with the Company’s policy, interest income is recognized on a cash-basis for these loans if the loans are not impaired or there is no impairment. There were no non-accrual only loans at June 30, 2014. At December 31, 2013 non-accrual only loans were $4.3 million, representing one well-secured commercial relationship with no specific reserves due to the Bank's superior credit position with underlying collateral, which consisted primarily of commercial real estate. As of December 31, 2013, the Bank had received all scheduled interest and principal payments on this relationship.

 

Non-accrual loans at June 30, 2014 included $4.0 million for a stalled residential development project. The Bank has deferred the collection of principal and interest for one year to enable the project to use available funds to build units and complete the project. At June 30, 2014, the stalled development project loans are considered both troubled debt restructured (“TDRs”) loans and non-accrual loans and are reported solely as non-accrual loans for financial reporting purposes. If the loans return to performing status after the forbearance period, they will be reported as TDR loans.

 

18
 

 

Non-accrual loans on which the recognition of interest has been discontinued, which did not have a specific allowance for impairment, amounted to $6.0 million and $9.1 million at June 30, 2014 and December 31, 2013, respectively. Interest due but not recognized on these balances at June 30, 2014 and December 31, 2013 was $427,000 and $304,000, respectively. Non-accrual loans with a specific allowance for impairment on which the recognition of interest has been discontinued amounted to $5.9 million and $6.4 million at June 30, 2014 and December 31, 2013, respectively. Interest due but not recognized on these balances at June 30, 2014 and December 31, 2013 was $331,000 and $295,000, respectively.

 

An analysis of past due loans as of June 30, 2014 and December 31, 2013 was as follows: 

 

   June 30, 2014 
(dollars in thousands)  Current   31-60
Days
   61-89
Days
   90 or Greater
Days
   Total
Past Due
   Total
Loan
Receivables
 
Commercial real estate  $522,327   $-   $4,479   $5,113   $9,592   $531,919 
Residential first mortgages   155,674    6    613    540    1,159    156,833 
Construction and land dev.   28,275    -    -    3,811    3,811    32,086 
Home equity and second mtg.   20,418    360    281    166    807    21,225 
Commercial loans   75,548    -    -    2,035    2,035    77,583 
Consumer loans   733    -    3    -    3    736 
Commercial equipment   25,505    111    39    221    371    25,876 
Total  $828,480   $477   $5,415   $11,886   $17,778   $846,258 

 

   December 31, 2013 
(dollars in thousands)  Current   31-60
Days
   61-89
Days
   90 or Greater
Days
   Total
Past Due
   Total
Loan
Receivables
 
Commercial real estate  $469,182   $58   $3,173   $4,235   $7,466   $476,648 
Residential first mortgages   157,043    8    413    1,683    2,104    159,147 
Construction and land dev.   28,525    -    508    2,968    3,476    32,001 
Home equity and
second mtg.
   21,183    121    273    115    509    21,692 
Commercial loans   88,812    3,111    318    1,935    5,364    94,176 
Consumer loans   830    8    -    -    8    838 
Commercial equipment   23,435    26    43    234    303    23,738 
Total  $789,010   $3,332   $4,728   $11,170   $19,230   $808,240 

 

There were no loans greater than 90 days still accruing interest at June 30, 2014 and at December 31, 2013.

 

19
 

 

Impaired Loans and Troubled Debt Restructures (“TDRs”)

Impaired loans, including TDRs, at June 30, 2014 and 2013 and at December 31, 2013 were as follows: 

 

   June 30, 2014 
(dollars in thousands)  Unpaid
Contractual
Principal
Balance
   Recorded
Investment
With No
Allowance
   Recorded
Investment
With
Allowance
   Total
Recorded
Investment
   Related
Allowance
   Three Month
Average
Recorded
Investment
   Three Month
Interest
Income
Recognized
   Year to Date
Average
Recorded
Investment
   Year to Date
Interest
Income
Recognized
 
                                     
Commercial real estate  $17,500   $13,143   $4,328   $17,471   $311   $17,473   $172   $17,446   $332 
Residential first mortgages   3,078    2,559    519    3,078    75    3,103    35    3,113    70 
Construction and land dev.   6,049    1,799    4,250    6,049    81    6,015    28    5,916    56 
Home equity and second mtg.   403    330    73    403    33    378    2    335    2 
Commercial loans   5,380    4,800    580    5,380    269    5,585    46    5,672    93 
Consumer loans   5    5    -    5    -    8    -    12    1 
Commercial equipment   399    212    168    380    90    381    4    392    8 
Total  $32,814   $22,848   $9,918   $32,766   $859   $32,943   $287   $32,886   $562 

 

   December 31, 2013 
(dollars in thousands)  Unpaid
Contractual
Principal
Balance
   Recorded
Investment
With No
Allowance
   Recorded
Investment
With
Allowance
   Total
Recorded
Investment
   Related
Allowance
   Average
Recorded
Investment
   Interest
Income
Recognized
 
                             
Commercial real estate  $18,342   $14,274   $3,899   $18,173   $372   $18,473   $770 
Residential first mortgages   3,401    2,695    706    3,401    171    3,392    125 
Construction and land dev.   5,666    1,489    4,177    5,666    55    5,386    252 
Home equity and second mtg.   207    207    -    207    -    297    12 
Commercial loans   10,218    9,297    921    10,218    304    10,600    432 
Consumer loans   24    24    -    24    -    39    3 
Commercial equipment   335    234    83    317    83    367    13 
Total  $38,193   $28,220   $9,786   $38,006   $985   $38,554   $1,607 

 

   June 30, 2013 
(dollars in thousands)  Unpaid
Contractual
Principal
Balance
   Recorded
Investment
With No
Allowance
   Recorded
Investment
With
Allowance
   Total
Recorded
Investment
   Related
Allowance
   Three Month
Average
Recorded
Investment
   Three Month
Interest
Income
Recognized
   Year to Date
Average
Recorded
Investment
   Year to Date
Interest
Income
Recognized
 
                                     
Commercial real estate  $20,474   $16,090   $4,384   $20,474   $614   $20,560   $236   $20,625   $435 
Residential first mortgages   5,236    4,328    908    5,236    407    5,278    46    5,283    94 
Construction and land dev.   5,705    4,497    1,208    5,705    170    5,574    71    5,295    147 
Home equity and second mtg.   214    214    -    214    -    233    2    265    5 
Commercial loans   11,388    11,231    157    11,388    40    11,379    149    11,321    227 
Consumer loans   41    41    -    41    -    44    1    47    2 
Commercial equipment   174    152    3    155    3    174    -    174    - 
Total  $43,232   $36,553   $6,660   $43,213   $1,234   $43,242   $505   $43,010   $910 

 

20
 

 

TDRs, included in the impaired loan schedules above, as of June 30, 2014 and December 31, 2013 were as follows: 

 

   June 30, 2014   December 31, 2013 
(dollars in thousands)  Dollars   Number
of Loans
   Dollars   Number
of Loans
 
                 
Commercial real estate  $2,101    3   $3,141    8 
Residential first mortgages   916    3    1,485    4 
Construction and land development   3,811    2    -    - 
Home equity and second mortgage   -    -    -    - 
Commercial loans   227    2    -    - 
Consumer loans   -    -    -    - 
Commercial equipment   157    2    67    1 
Total TDRs  $7,212    12   $4,693    13 
Less: TDRs included in non-accrual loans   (4,037)   (4)   -    - 
Total accrual TDR loans  $3,175    8   $4,693    13 

 

At June 30, 2014, non-accrual loans included $4.0 million for a stalled residential development project. The Bank has deferred the collection of principal and interest for one year to enable the project to use available funds to build units and complete the project. At June 30, 2014, the stalled development project loans are considered both TDR loans and non-accrual loans and are reported solely as non-accrual loans for financial reporting purposes. If the loans return to performing status after the forbearance period, they will be reported as TDR loans.

 

At June 30, 2014, the Bank had eight accruing TDRs totaling $3.2 million compared to 13 TDRs totaling $4.7 million as of December 31, 2013. At June 30, 2014, all TDRs were performing according to the terms of their restructured agreements. At December 31, 2013, one TDR of $329,000 was over 90 days past due. The Bank had specific reserves of $197,000 on four TDRs totaling $2.4 million at June 30, 2014 and $79,000 on two TDRs totaling $1.8 million at December 31, 2013. The Bank added three TDRs totaling $968,000 during the six months ended June 30, 2014. During the same period, there were eight TDRs totaling $2.4 million that were no longer reported as TDRs due to the payment of principal and interest at market rates for greater than six consecutive months. TDR activity for the year ended December 31, 2013 included three additions to the number of TDRs totaling $204,000. There were no other TDR transactions for the year ended December 31, 2013. Interest income in the amount of $124,000 and $214,000 was recognized on TDR loans for the six months ended June 30, 2014 and the year ended December 31, 2013, respectively.

 

21
 

 

Allowance for Loan Losses

The following tables detail activity in the allowance for loan losses at and for the three and six months ended June 30, 2014 and 2013, respectively, and for the year ended December 31, 2013 and loan receivable balances at June 30, 2014 and 2013, respectively, and at December 31, 2013. An allocation of the allowance to one category of loans does not prevent the Company’s ability to utilize the allowance to absorb losses in a different category. The loan receivables are disaggregated on the basis of the Company’s impairment methodology.

 

(dollars in thousands)  Commercial
 Real Estate
   Residential
First
Mortgage
   Construction
and Land
Development
   Home
Equity and
Second Mtg.
   Commercial
Loans
   Consumer
Loans
   Commercial
Equipment
   Total 
At and For the Three Months Ended June 30, 2014                                        
Allowance for loan losses:                                        
Balance at April 1,  $3,610   $1,272   $561   $340   $2,115   $6   $293   $8,197 
Charge-offs   (28)   -    -    -    (720)   -    -    (748)
Recoveries   2    -    -    -    2    10    24    38 
Provisions   393    (182)   12    (57)   338    (12)   71    563 
Balance at June 30,  $3,977   $1,090   $573   $283   $1,735   $4   $388   $8,050 
                                         
At and For the Six Months Ended June 30, 2014                                        
Allowance for loan losses:                                        
Balance at January 1,  $3,525   $1,401   $584   $249   $1,916   $10   $453   $8,138 
Charge-offs   (49)   (94)   -    -    (755)   -    -    (898)
Recoveries   7    -    -    -    3    10    24    44 
Provisions   494    (217)   (11)   34    571    (16)   (89)   766 
Balance at June 30,  $3,977   $1,090   $573   $283   $1,735   $4   $388   $8,050 
Ending balance: individually
evaluated for impairment
  $311   $75   $81   $33   $269   $-   $90   $859 
Ending balance: collectively
evaluated for impairment
  $3,666   $1,015   $492   $250   $1,466   $4   $298   $7,191 
Loan receivables:                                        
Ending balance  $531,919   $156,833   $32,086   $21,225   $77,583   $736   $25,876   $846,258 
Ending balance: individually
evaluated for impairment
  $17,471   $3,078   $6,049   $403   $5,380   $5   $380   $32,766 
Ending balance: collectively
evaluated for impairment
  $514,448   $153,755   $26,037   $20,822   $72,203   $731   $25,496   $813,492 

 

 

(dollars in thousands)  Commercial
Real Estate
   Residential
First
Mortgage
   Construction
and Land
Development
   Home
Equity and
Second Mtg.
   Commercial
Loans
   Consumer
Loans
   Commercial
Equipment
   Total 
                                 
At and For the Year Ended December 31, 2013                                        
Allowance for loan losses:                                        
Balance at January 1,  $4,092   $1,083   $533   $280   $1,948   $19   $292   $8,247 
Charge-offs   (140)   (348)   (36)   (111)   (480)   (12)   (35)   (1,162)
Recoveries   -    11    1    17    23    3    58    113 
Provisions   (427)   655    86    63    425    -    138    940 
Balance at December 31,  $3,525   $1,401   $584   $249   $1,916   $10   $453   $8,138 
Ending balance: individually
evaluated for impairment
  $372   $171   $55   $-   $304   $-   $83   $985 
Ending balance: collectively
evaluated for impairment
  $3,153   $1,230   $529   $249   $1,612   $10   $370   $7,153 
Loan receivables:                                        
Ending balance  $476,648   $159,147   $32,001   $21,692   $94,176   $838   $23,738   $808,240 
Ending balance: individually
evaluated for impairment
  $18,173   $3,401   $5,666   $207   $10,218   $24   $317   $38,006 
Ending balance: collectively
evaluated for impairment
  $458,475   $155,746   $26,335   $21,485   $83,958   $814   $23,421   $770,234 

 

22
 

 

 

(dollars in thousands)  Commercial
Real Estate
   Residential
First
Mortgage
   Construction
and Land
 Development
   Home
Equity and
Second Mtg.
   Commercial
Loans
   Consumer
 Loans
   Commercial
Equipment
   Total 
At and For the Three Months Ended June 30, 2013                                        
Allowance for loan losses:                                        
Balance at April 1,  $3,540   $1,985   $497   $318   $1,824   $17   $169   $8,350 
Charge-offs   -    -    -    (111)   (406)   -    (21)   (538)
Recoveries   -    10    -    -    11    1    -    22 
Provisions   (182)   (34)   104    157    90    (4)   69    200 
Balance at June 30,  $3,358   $1,961   $601   $364   $1,519   $14   $217   $8,034 
At and For the Six Months Ended June 30, 2013                              
Allowance for loan losses:                                        
Balance at January 1,  $4,092   $1,083   $533   $280   $1,948   $19   $292   $8,247 
Charge-offs   -    (59)   (36)   (111)   (406)   (9)   (21)   (642)
Recoveries   -    11    -    -    12    2    49    74 
Provisions   (734)   926    104    195    (35)   2    (103)   355 
Balance at June 30,  $3,358   $1,961   $601   $364   $1,519   $14   $217   $8,034 
Ending balance: individually evaluated for impairment  $614   $407   $170   $-   $40   $-   $3   $1,234 
Ending balance: collectively evaluated for impairment  $2,744   $1,554   $431   $364   $1,479   $14   $214   $6,800 
Loan receivables:                                        
Ending balance  $434,616   $165,434   $29,120   $21,769   $84,993   $937   $17,347   $754,216 
Ending balance: individually evaluated for impairment  $20,474   $5,236   $5,705   $214   $11,388   $41   $155   $43,213 
Ending balance: collectively evaluated for impairment  $414,142   $160,198   $23,415   $21,555   $73,605   $896   $17,192   $711,003 

 

23
 

 

Credit Quality Indicators 

Credit quality indicators as of June 30, 2014 and December 31, 2013 were as follows:

 

Credit Risk Profile by Internally Assigned Grade

 

   Commercial Real Estate   Construction and Land Dev. 
(dollars in thousands)  6/30/2014   12/31/2013   6/30/2014   12/31/2013 
                 
Unrated  $69,610   $66,481   $4,482   $5,782 
Pass   430,956    380,124    18,785    17,628 
Special mention   6,772    7,084    -    - 
Substandard   24,581    22,959    8,819    8,591 
Doubtful   -    -    -    - 
Loss   -    -    -    - 
Total  $531,919   $476,648   $32,086   $32,001 

 

   Commercial Loans   Commercial Equipment 
(dollars in thousands)  6/30/2014   12/31/2013   6/30/2014   12/31/2013 
                 
Unrated  $13,467   $12,873   $7,014   $6,137 
Pass   56,638    67,354    18,694    17,516 
Special mention   -    402    -    2 
Substandard   7,304    13,547    168    83 
Doubtful   174    -    -    - 
Loss   -    -    -    - 
Total  $77,583   $94,176   $25,876   $23,738 

 

24
 

  

Credit Risk Profile Based on Payment Activity

  

   Residential First Mortgages   Home Equity and Second Mtg.   Consumer Loans 
(dollars in thousands)  6/30/2014   12/31/2013   6/30/2014   12/31/2013   6/30/2014   12/31/2013 
                         
Performing  $156,293   $157,464   $21,059   $21,577   $736   $838 
Nonperforming   540    1,683    166    115    -    - 
Total  $156,833   $159,147   $21,225   $21,692   $736   $838 

 

Summary of Total Classified Loans

 

(dollars in thousands)  6/30/2014   12/31/2013 
By Internally Assigned Grade  $41,046   $45,181 
By Payment Activity   2,495    2,464 
Total Classified  $43,541   $47,645 

   

A risk grading scale is used to assign grades to commercial real estate, construction and land development, commercial loans and commercial equipment loans. Loans are graded at inception, annually thereafter when financial statements are received and at other times when there is an indication that a credit may have weakened or improved. Only commercial loan relationships with an aggregate exposure to the Bank of $750,000 or greater are subject to being risk rated.

 

Residential first mortgages, home equity and second mortgages and consumer loans are evaluated for creditworthiness in underwriting and are monitored based on borrower payment history. These loans are classified as unrated unless they are part of a larger commercial relationship that requires grading or are troubled debt restructures or nonperforming loans with an Other Assets Especially Mentioned (“OAEM”) or higher risk rating due to a delinquent payment history.

 

Management regularly reviews credit quality indicators as part of its individual loan reviews and on a monthly and quarterly basis. The overall quality of the Bank’s loan portfolio is assessed using the Bank’s risk grading scale, the level and trends of net charge-offs, nonperforming loans and delinquencies, the performance of troubled debt restructured loans and the general economic conditions in the Company’s geographical market. This review process is assisted by frequent internal reporting of loan production, loan quality, concentrations of credit, loan delinquencies and nonperforming and potential problem loans. Credit quality indicators and allowance factors are adjusted based on management’s judgment during the monthly and quarterly review process.

 

Loans subject to risk ratings are graded on a scale of one to ten. The Company considers loans classified substandard, doubtful and loss as classified assets for regulatory and financial reporting.

 

Ratings 1 thru 6 - Pass

Ratings 1 thru 6 have asset risks ranging from excellent low risk to adequate. The specific rating assigned considers customer history of earnings, cash flows, liquidity, leverage, capitalization, consistency of debt service coverage, the nature and extent of customer relationship and other relevant specific business factors such as the stability of the industry or market area, changes to management, litigation or unexpected events that could have an impact on risks.

 

Rating 7 - OAEM (Other Assets Especially Mentioned) – Special Mention

These credits, while protected by the financial strength of the borrowers, guarantors or collateral, have reduced quality due to economic conditions, less than adequate earnings performance or other factors which require the lending officer to direct more than normal attention to the credit. Financing alternatives may be limited and/or command higher risk interest rates. OAEM loans are the first adversely classified assets on our watch list. These relationships will be reviewed at least quarterly.

 

25
 

  

Rating 8 - Substandard

Substandard assets are assets that are inadequately protected by the sound worth or paying capacity of the borrower or of the collateral pledged. These assets have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the possibility that the Bank will sustain some loss if the deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist in individual assets classified substandard. The loans may have a delinquent history or combination of weak collateral, weak guarantor strength or operating losses. When a loan is assigned to this category the Bank may estimate a specific reserve in the loan loss allowance analysis. These assets listed may include assets with histories of repossessions or some that are non-performing bankruptcies. These relationships will be reviewed at least quarterly.

 

Rating 9 - Doubtful

Doubtful assets have many of the same characteristics of Substandard with the exception that the Bank has determined that loss is not only possible but is probable and the risk is close to certain that loss will occur. When a loan is assigned to this category the Bank will identify the probable loss and the loan will receive a specific reserve in the loan loss allowance analysis. These relationships will be reviewed at least quarterly.

 

Rating 10 - Loss

Once an asset is identified as a definite loss to the Bank, it will receive the classification of “loss”. There may be some future potential recovery; however it is more practical to write off the loan at the time of classification. Losses will be taken in the period in which they are determined to be uncollectable.

 

NOTE 12 - REGULATORY MATTERS

The Company and the Bank are subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

 

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of tangible and core capital (as defined in the regulations) to total adjusted assets (as defined) and of risk-based capital (as defined) to risk-weighted assets (as defined). Management believes, as of June 30, 2014 and December 31, 2013, that the Company and the Bank meet all capital adequacy requirements to which they are subject.

 

As of June 30, 2014 and December 31, 2013, the Bank was well-capitalized under the regulatory framework for prompt corrective action (as defined). To be categorized as well-capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table. There are no conditions or events that management believes have changed the Company’s or the Bank’s category. The Company’s and the Bank’s actual regulatory capital amounts and ratios are presented in the following tables.

 

   At June 30, 2014 
(dollars in thousands)  Actual   Required for Capital
Adequacy Purposes
   To be Considered Well
Capitalized Under
Prompt Corrective Action
 
Total Capital (to risk weighted assets)                              
The Company  $134,217    15.38%  $69,819    8.00%          
The Bank  $133,346    15.31%  $69,694    8.00%  $87,117    10.00%
                               
Tier 1 Capital (to risk weighted assets)                              
The Company  $126,120    14.45%  $34,909    4.00%          
The Bank  $125,249    14.38%  $34,847    4.00%  $52,270    6.00%
                               
Tier 1 Capital (to average assets)                              
The Company  $126,120    12.43%  $40,587    4.00%          
The Bank  $125,249    12.36%  $40,527    4.00%  $50,659    5.00%

 

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   At December 31, 2013 
(dollars in thousands)  Actual   Required for Capital
Adequacy Purposes
   To be Considered Well
Capitalized Under
Prompt Corrective Action
 
Total Capital (to risk weighted assets)                              
The Company  $131,936    15.62%  $67,561    8.00%          
The Bank  $131,216    15.57%  $67,433    8.00%  $84,292    10.00%
                               
Tier 1 Capital (to risk weighted assets)                              
The Company  $123,787    14.66%  $33,781    4.00%          
The Bank  $123,067    14.60%  $33,717    4.00%  $50,575    6.00%
                               
Tier 1 Capital (to average assets)                              
The Company  $123,787    12.50%  $39,597    4.00%          
The Bank  $123,067    12.45%  $39,537    4.00%  $49,422    5.00%

 

In October 2013, the Company added $27.4 million in additional common capital after commissions and related offering expenses and immediately downstreamed $27.2 million of the net proceeds raised to the Bank.

 

NOTE 13 - FAIR VALUE MEASUREMENTS

The Company adopted FASB ASC Topic 820, “Fair Value Measurements” and FASB ASC Topic 825, “The Fair Value Option for Financial Assets and Financial Liabilities”, which provides a framework for measuring and disclosing fair value under generally accepted accounting principles. FASB ASC Topic 820 requires disclosures about the fair value of assets and liabilities recognized in the balance sheet in periods subsequent to initial recognition, whether the measurements are made on a recurring basis (for example, available for sale investment securities) or on a nonrecurring basis (for example, impaired loans).

 

FASB ASC Topic 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. FASB ASC Topic 820 also establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

 

The Company utilizes fair value measurements to record fair value adjustments to certain assets and to determine fair value disclosures. Securities available for sale are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis such as loans held for investment and certain other assets. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

 

Under FASB ASC Topic 820, the Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine the fair value. These hierarchy levels are:

 

Level 1 inputs - Unadjusted quoted prices in active markets for identical assets or liabilities that the entity has the ability to access at the measurement date.

 

Level 2 inputs - Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals.

 

Level 3 inputs - Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

 

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Transfers between levels of the fair value hierarchy are recognized on the actual date of the event or circumstances that caused the transfer, which generally coincides with the Company’s monthly or quarterly valuation process.

 

There were no transfers between levels of the fair value hierarchy and the Company had no Level 3 fair value assets or liabilities for the six months ended June 30, 2014 and the year ended December 31, 2013, respectively.

 

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value:

 

Securities Available for Sale

Investment securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities issued by GSEs, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.

 

Loans Receivable

The Company does not record loans at fair value on a recurring basis, however, from time to time, a loan is considered impaired and an allowance for loan loss is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan are considered impaired. Management estimates the fair value of impaired loans using one of several methods, including the collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Impaired loans not requiring a specific allowance represent loans for which the fair value of expected repayments or collateral exceed the recorded investment in such loans. At June 30, 2014 and December 31, 2013, substantially all of the impaired loans were evaluated based upon the fair value of the collateral. In accordance with FASB ASC 820, impaired loans where an allowance is established based on the fair value of collateral (loans with impairment) require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the loan as nonrecurring Level 3.

 

Other Real Estate Owned

OREO is adjusted for fair value upon transfer of the loans to foreclosed assets. Subsequently, OREO is carried at the lower of carrying value and fair value. Fair value is based upon independent market prices, appraised value of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the foreclosed asset as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the foreclosed asset at nonrecurring Level 3.

 

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

The tables below present the recorded amount of assets as of June 30, 2014 and December 31, 2013 measured at fair value on a recurring basis.

 

(dollars in thousands)  June 30, 2014 
Description of Asset  Fair Value   Level 1   Level 2   Level 3 
Available for sale securities                    
Asset-backed securities issued by GSEs                    
CMOs  $37,562   $-   $37,562   $- 
MBS   51    -    51    - 
Corporate equity securities   42    -    42    - 
Bond mutual funds   4,250    -    4,250    - 
Total available for sale securities  $41,905   $-   $41,905   $- 

 

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(dollars in thousands)  December 31, 2013 
Description of Asset  Fair Value   Level 1   Level 2   Level 3 
Available for sale securities                    
Asset-backed securities issued by GSEs                    
CMOs  $43,883   $-   $43,883   $- 
MBS   193    -    193    - 
Corporate equity securities   41    -    41    - 
Bond mutual funds   4,130    -    4,130    - 
Total available for sale securities  $48,247   $-   $48,247   $- 

 

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

The Company may be required from time to time to measure certain assets at fair value on a nonrecurring basis in accordance with U.S. GAAP. These include assets that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period. Assets measured at fair value on a nonrecurring basis as of June 30, 2014 and December 31, 2013 are included in the tables below.

 

(dollars in thousands)  June 30, 2014 
Description of Asset  Fair Value   Level 1   Level 2   Level 3 
Loans with impairment                    
Commercial real estate  $4,017   $-   $4,017   $- 
Residential first mortgages   444    -    444    - 
Construction and land development   4,169    -    4,169    - 
Home equity and second mtg.   40    -    40    - 
Commercial loans   311    -    311    - 
Commercial equipment   78    -    78    - 
Total loans with impairment  $9,059   $-   $9,059   $- 
                     
Other real estate owned  $6,553   $-   $6,553   $- 

 

(dollars in thousands)  December 31, 2013 
Description of Asset  Fair Value   Level 1   Level 2   Level 3 
Loans with impairment                    
Commercial real estate  $3,527   $-   $3,527   $- 
Residential first mortgage   535    -    535    - 
Construction and land development   4,122    -    4,122    - 
Commercial loans   617    -    617    - 
Total loans with impairment  $8,801   $-   $8,801   $- 
                     
Other real estate owned  $6,797   $-   $6,797   $- 

 

Loans with impairment have unpaid principal balances of $9.9 million and $9.8 million at June 30, 2014 and December 31, 2013, respectively, and include impaired loans with a specific allowance.

 

NOTE 14 - FAIR VALUE OF FINANCIAL INSTRUMENTS

The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. Therefore, any aggregate unrealized gains or losses should not be interpreted as a forecast of future earnings or cash flows. Furthermore, the fair values disclosed should not be interpreted as the aggregate current value of the Company.

 

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Valuation Methodology

Investment securities - Fair values are based on quoted market prices or dealer quotes. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.

 

FHLB and FRB stock - Fair values are at cost, which is the carrying value of the securities.

 

Loans receivable - For conforming residential first-mortgage loans, the market price for loans with similar coupons and maturities was used. For nonconforming loans with maturities similar to conforming loans, the coupon was adjusted for credit risk. Loans that did not have quoted market prices were priced using the discounted cash flow method. The discount rate used was the rate currently offered on similar products. Loans priced using the discounted cash flow method included residential construction loans, commercial real estate loans and consumer loans. The estimated fair value of loans held for sale is based on the terms of the related sale commitments.

 

Loans held for sale - Fair values are derived from secondary market quotations for similar instruments.

 

Deposits - The fair value of checking accounts, saving accounts and money market accounts were the amount payable on demand at the reporting date.

 

Time certificates - The fair value was determined using the discounted cash flow method. The discount rate was equal to the rate currently offered on similar products.

 

Long-term debt and other borrowed funds - These were valued using the discounted cash flow method. The discount rate was equal to the rate currently offered on similar borrowings.

 

Guaranteed preferred beneficial interest in junior subordinated securities (TRUPs) - These were valued using discounted cash flows. The discount rate was equal to the rate currently offered on similar borrowings.

 

Off-balance sheet instruments - The Company charges fees for commitments to extend credit. Interest rates on loans for which these commitments are extended are normally committed for periods of less than one month. Fees charged on standby letters of credit and other financial guarantees are deemed to be immaterial and these guarantees are expected to be settled at face amount or expire unused. It is impractical to assign any fair value to these commitments.

 

The Company’s estimated fair values of financial instruments are presented in the following tables.

  

June 30, 2014          Fair Value Measurements 
Description of Asset (dollars in
thousands)
  Carrying
Amount
   Fair Value   Level 1   Level 2   Level 3 
Assets                         
Investment securities - AFS  $41,905   $41,905   $-   $41,905   $- 
Investment securities - HTM   77,547    77,619    750    76,869    - 
FHLB and FRB Stock   6,661    6,661    -    6,661    - 
Loans   837,127    835,675    -    835,675    - 
Loans held for sale   971    1,009    -    1,009    - 
                          
Liabilities                         
Savings, NOW and money market accounts  $431,422   $431,422   $-   $431,422   $- 
Time deposits   387,122    388,642    -    388,642    - 
Long-term debt   74,699    77,198    -    77,198    - 
Short term borrowings   7,000    7,000    -    7,000    - 
TRUPs   12,000    7,400    -    7,400    - 
                          

 

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December 31, 2013          Fair Value Measurements 
Description of Asset (dollars in
thousands)
  Carrying
Amount
   Fair Value   Level 1   Level 2   Level 3 
Assets                         
Investment securities - AFS  $48,247   $48,247   $-   $48,247   $- 
Investment securities - HTM   86,401    86,091    750    85,341    - 
FHLB and FRB Stock   5,593    5,593    -    5,593    - 
Loans   799,130    793,449    -    793,449    - 
                          
Liabilities                         
Savings, NOW and money market accounts  $433,984   $433,984   $-   $433,984   $- 
Time deposits   387,311    389,705    -    389,705    - 
Long-term debt   70,476    71,960    -    71,960    - 
TRUPs   12,000    2,400    -    2,400    - 

 

At June 30, 2014, the Company had outstanding loan commitments and standby letters of credit of $20.3 million and $28.3 million, respectively. Based on the short-term lives of these instruments, the Company does not believe that the fair value of these instruments differs significantly from their carrying values.

 

The fair value estimates presented herein are based on pertinent information available to management as of June 30, 2014 and December 31, 2013, respectively. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since that date and, therefore, current estimates of fair value may differ significantly from the amount presented herein.

 

NOTE 15 – NEW ACCOUNTING STANDARDS

Financial Accounting Standards Board (“FASB”) Accounting Standards Update (“ASU”) No. 2013-12 - Definition of a Public Business Entity - An Addition to the Master Glossary. ASU 2013-12 amends the Master Glossary of the FASB Accounting Standards Codification to include one definition of public business entity for future use in U.S. GAAP and identifies the types of business entities that are excluded from the scope of the Private Company Decision-Making Framework: A Guide for Evaluating Financial Accounting and Reporting for Private Companies. ASU 2013-12 did not have a material impact on the Company’s consolidated financial statements.

 

ASU No. 2014-04 - Receivables – Troubled Debt Restructurings by Creditors (Subtopic 310-40) - Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure. The amendments clarify that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower conveying all interest in the residential real estate to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. The amendments require interim and annual disclosure of both (1) the amount of foreclosed residential real estate property held by the creditor and (2) the recorded investment in consumer mortgage loans collateralized by residential real estate that are in the process of foreclosure according to local requirements of the applicable jurisdiction. ASU 2014-04 is effective for interim and annual periods beginning after December 15, 2014. Adoption of ASU 2014-04 is not expected to have a material impact on the Company’s consolidated financial statements.

 

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Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations

FORWARD-LOOKING STATEMENTS

This report contains forward-looking statements that are based on assumptions and may describe future plans, strategies and expectations of The Community Financial Corporation (the “Company”) and Community Bank of the Chesapeake (the “Bank”). These forward-looking statements are generally identified by use of the words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project” or similar expressions.

 

The Company and the Bank’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors that could have a material adverse effect on the operations of the Company and its subsidiaries include, but are not limited to, changes in interest rates, national and regional economic conditions, legislative and regulatory changes, monetary and fiscal policies of the U.S. government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality and composition of the loan and investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Company and the Bank’s market area, changes in real estate market values in the Company and the Bank’s market area and changes in relevant accounting principles and guidelines. Additional factors that may affect our results are discussed in Part I of the Company’s Annual Report on Form 10-K for the year ended December 31, 2013 (the “Form 10-K”) that we filed with the Securities and Exchange Commission. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, the Company does not undertake, and specifically disclaims any obligation, to release publicly the result of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of the statements or to reflect the occurrence of anticipated or unanticipated events.

 

Critical Accounting Policies

Critical accounting policies are defined as those that involve significant judgments and uncertainties and could potentially result in materially different results under different assumptions and conditions. The Company considers its determination of the allowance for loan losses, the determination of other-than-temporarily impaired securities, the valuation of foreclosed real estate and the valuation of deferred tax assets to be critical accounting policies.

 

The Company’s Consolidated Financial Statements are prepared in accordance with accounting principles generally accepted in the United States of America and the general practices of the United States banking industry. Application of these principles requires management to make estimates, assumptions and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements. Accordingly, as this information changes, the financial statements could reflect different estimates, assumptions and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported.

 

Estimates, assumptions and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available. When these sources are not available, management makes estimates based upon what it considers to be the best available information.

 

Allowance for Loan Losses

The allowance for loan losses is an estimate of the losses that exist in the loan portfolio. The allowance is based on two principles of accounting: (1) Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 450 “Contingencies,” which requires that losses be accrued when they are probable of occurring and are estimable and (2) FASB ASC 310 “Receivables,” which requires that losses be accrued when it is probable that the Company will not collect all principal and interest payments according to the contractual terms of the loan. The loss, if any, is determined by the difference between the loan balance and the value of collateral, the present value of expected future cash flows and values observable in the secondary markets.

 

The allowance for loan loss balance is an estimate based upon management’s evaluation of the loan portfolio. The allowance is comprised of a specific and a general component. The specific component consists of management’s evaluation of certain classified, impaired and non-accrual loans and their underlying collateral. Management assesses the ability of the borrower to repay the loan based upon all information available. Loans are examined to determine a specific allowance based upon the borrower’s payment history, economic conditions specific to the loan or borrower and other factors that would impact the borrower’s ability to repay the loan on its contractual basis. Depending on the assessment of the borrower’s ability to pay and the type, condition and value of collateral, management will establish an allowance amount specific to the loan.

 

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Management uses a risk scale to assign grades to commercial real estate, construction and land development, commercial loans and commercial equipment loans. Commercial loan relationships with an aggregate exposure to the Bank of $750,000 or greater are risk rated. Residential first mortgages, home equity and second mortgages and consumer loans are monitored on an ongoing basis based on borrower payment history. Consumer loans and residential real estate loans are classified as unrated unless they are part of a larger commercial relationship that requires grading or are troubled debt restructures or nonperforming loans with an Other Assets Especially Mentioned or higher risk rating due to a delinquent payment history.

 

The Company’s commercial loan portfolio is periodically reviewed by regulators and independent consultants engaged by management.

 

In establishing the general component of the allowance, management analyzes non-impaired loans in the portfolio including changes in the amount and type of loans. This analysis reviews trends by portfolio segment in charge-offs, delinquency, classified loans, loan concentrations and the rate of portfolio segment growth. Qualitative factors also include an assessment of the current regulatory environment, the quality of credit administration and loan portfolio management and national and local economic trends. Based upon this analysis a loss factor is applied to each loan category and the Bank adjusts the loan loss allowance by increasing or decreasing the provision for loan losses.

 

Management has significant discretion in making the judgments inherent in the determination of the allowance for loan losses, including the valuation of collateral, assessing a borrower’s prospects of repayment and in establishing loss factors on the general component of the allowance. Changes in loss factors have a direct impact on the amount of the provision and on net income. Errors in management’s assessment of the allowance factors and their impact on the portfolio could result in the allowance not being adequate to cover losses in the portfolio, and may result in additional provisions. An increase or decrease in the allowance could result in a charge or credit to income before income taxes that materially impacts earnings.

 

For additional information regarding the allowance for loan losses, refer to Notes 1 and 6 of the Consolidated Financial Statements as presented in the Company’s Form 10-K for the year ended December 31, 2013 and the discussion under the caption “Provision for Loan Losses” below.

 

Other-Than-Temporary-Impairment (“OTTI”)

Debt securities are evaluated quarterly to determine whether a decline in their value is other-than-temporary. The term “other-than-temporary” is not necessarily intended to indicate a permanent decline in value. It means that the prospects for near-term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the investment. Accounting guidance indicates that the amount of other-than-temporary impairment that is recognized through earnings for debt securities is determined by comparing the present value of the expected cash flows to the amortized cost of the security. The discount rate used to determine the credit loss is the expected book yield on the security.

 

For additional information regarding the evaluation of OTTI, refer to Notes 1 and 5 of the Consolidated Financial Statements as presented in the Company’s Form 10-K for the year ended December 31, 2013.

 

Other Real Estate Owned

The Company maintains a valuation allowance on its other real estate owned. As with the allowance for loan losses, the valuation allowance on OREO is based on FASB ASC 450 “Contingencies,” as well as the accounting guidance on impairment of long-lived assets. These statements require that the Company establish a valuation allowance when it has determined that the carrying amount of a foreclosed asset exceeds its fair value. Fair value of a foreclosed asset is measured by the cash flows expected to be realized from its subsequent disposition. These cash flows are reduced for the costs of selling or otherwise disposing of the asset.

 

In estimating the cash flows from the sale of OREO, management must make significant assumptions regarding the timing and amount of cash flows. For example, in cases where the real estate acquired is undeveloped land, management must gather the best available evidence regarding the market value of the property, including appraisals, cost estimates of development and broker opinions. Due to the highly subjective nature of this evidence, as well as the limited market, long time periods involved and substantial risks, cash flow estimates are highly subjective and subject to change. Errors regarding any aspect of the costs or proceeds of developing, selling or otherwise disposing of foreclosed real estate could result in the allowance being inadequate to reduce carrying costs to fair value and may require an additional provision for valuation allowances.

 

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For additional information regarding OREO, refer to Notes 1 and 8 of the Consolidated Financial Statements as presented in the Company’s Form 10-K for the year ended December 31, 2013.

 

Deferred Tax Assets

The Company accounts for income taxes in accordance with FASB ASC 740, “Income Taxes,” which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. FASB ASC 740 requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or the entire deferred tax asset will not be realized.

 

The Company periodically evaluates the ability of the Company to realize the value of its deferred tax assets.  If the Company were to determine that it was not more likely than not that the Company would realize the full amount of the deferred tax assets, it would establish a valuation allowance to reduce the carrying value of the deferred tax asset to the amount it believes would be realized. The factors used to assess the likelihood of realization are the Company’s forecast of future taxable income and available tax-planning strategies that could be implemented to realize the net deferred tax assets.

 

Failure to achieve forecasted taxable income might affect the ultimate realization of the net deferred tax assets.  Factors that may affect the Company’s ability to achieve sufficient forecasted taxable income include, but are not limited to, the following: increased competition, a decline in net interest margin, a loss of market share, decreased demand for financial services and national and regional economic conditions. 

 

The Company’s provision for income taxes and the determination of the resulting deferred tax assets and liabilities involve a significant amount of management judgment and are based on the best information available at the time. The Company operates within federal and state taxing jurisdictions and is subject to audit in these jurisdictions. 

 

For additional information regarding the deferred tax assets, refer to Note 12 in the Consolidated Financial Statements as presented in the Company’s Form 10-K for the year ended December 31, 2013.

 

OVERVIEW

Community Bank of the Chesapeake (the “Bank”) is headquartered in Southern Maryland with branches located in Maryland and Virginia. The Bank is a wholly owned subsidiary of The Community Financial Corporation. The Bank conducts business through its 12 branch locations including its main office in Waldorf, Maryland, and branch offices in Waldorf, Bryans Road, Dunkirk, Leonardtown, La Plata, Charlotte Hall, Prince Frederick, Lusby, California, Maryland; and Dahlgren and Fredericksburg, Virginia. The Company opened a branch in Fredericksburg, Virginia on July 15, 2014. The Company plans to open a second full-service branch in downtown Fredericksburg in the next 12 to 18 months In addition, the Company maintains four loan production offices (“LPOs”) in La Plata, Prince Frederick and Leonardtown, Maryland; and Fredericksburg, Virginia. The Leonardtown and Fredericksburg LPOs are co-located with branches.

 

In October 2013, the Company issued 1,591,300 shares of common stock at a price of $18.75 per share resulting in net proceeds of $27.4 million after commissions and related offering expenses. In addition, the Company listed its stock on the NASDAQ Stock Exchange and began trading on the exchange September 27, 2013 under the ticker symbol “TCFC.”

 

Effective October 18, 2013, Community Bank of Tri-County changed its name to Community Bank of the Chesapeake. This new name reflects the Bank's recent expansion into the Northern Neck of Virginia and Fredericksburg, Virginia. The name of the holding company changed from Tri-County Financial Corporation to The Community Financial Corporation, to better align the parent company name with that of the Bank.

 

The Bank has sought to increase assets through loan production. The Bank believes that its ability to offer fast, flexible, local decision-making will continue to attract significant new business relationships. The Bank focuses its commercial business generation efforts on targeting small and medium sized businesses with revenues between $5.0 million and $35.0 million. The Bank’s marketing is also directed towards increasing its balances of both consumer and business transaction deposit accounts. The Bank believes that increases in these account types will lessen the Bank’s dependence on higher-cost funding, such as certificates of deposit and borrowings. Although management believes that this strategy will increase financial performance over time, increasing the balances of certain products, such as commercial lending and transaction accounts, may also increase the Bank’s noninterest expense. The Bank recognizes that certain lending and deposit products increase the possibility of losses from credit and other risks.

 

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During the fourth quarter of 2013, the Company began to leverage the $27.4 million in additional capital from the October 2013 capital raise to increase interest-earning assets. The Bank successfully grew its loan portfolio $39.3 million from $768.9 million at September 30, 2013 to $808.2 million at December 31, 2013. The positive loan growth trend continued during the first six months of 2014 as the Bank increased its loan portfolio $38.1 million to $846.3 million by the end of June 2014. Average loan balances increased $45.0 million to $810.4 million for the second quarter of 2014 from $765.4 million for the fourth quarter of 2013.

 

The Bank opened a commercial loan production office (“LPO”) in Fredericksburg, Virginia during August 2013 and a branch in July 2014. The Fredericksburg Virginia area market is comparable in size to our legacy Southern Maryland footprint. During the second quarter of 2014, we continued to execute the Bank’s growth strategy and added seasoned lenders and support staff to expand into the city of Annapolis and surrounding Anne Arundel County. We plan to open a LPO in Annapolis during the third quarter of 2014. We are optimistic that our returns on these investments will continue to increase shareholder value during 2014.

 

Economy

The U.S. economy grew slowly throughout 2013. Locally, real estate values have stabilized and housing prices began to recover during 2012 and 2013. However, uncertainty for small and medium size businesses lessened the demand for lending. The impact of slower economic growth on the Southern Maryland economy has been moderated by the presence of federal government agencies and defense facilities, but the ongoing possibility of large cuts to the defense budget hampered economic expansion. Even through the difficult economic environment, the Bank’s capital levels and asset quality remained strong.

 

For additional information regarding the local economy and its impact on the Company’s business refer to the Business Section in the Company’s Form 10-K for the year ended December 31, 2013 under the caption “Market Area” (Part I. Item 1. Business Section – Market Area).

 

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SELECTED FINANCIAL DATA

 

   Three Months Ended   Six Months Ended 
   June 30,   June 30, 
(dollars in thousands, except per share amounts )  2014   2013   2014   2013 
Condensed Income Statement                    
Interest and Dividend Income  $10,254   $9,750   $20,429   $19,590 
Interest Expense   1,684    2,018    3,425    4,041 
Net Interest Income   8,570    7,732    17,004    15,549 
Provision for Loan Loss   563    200    766    355 
Noninterest Income   855    1,069    1,750    2,258 
Noninterest Expense   6,767    6,106    13,098    12,249 
Income Before Income Taxes   2,095    2,495    4,890    5,203 
Income Tax Expense   760    909    1,834    1,899 
Net Income (NI)   1,335    1,586    3,056    3,304 
Preferred Stock Dividends   50    50    100    100 
NI Available to Common Shareholders  $1,285   $1,536   $2,956   $3,204 
Comprehensive Income  $1,579   $842   $3,218   $2,485 
                     
Per Common Share                    
Basic Earnings  $0.28   $0.51   $0.64   $1.06 
Diluted Earnings  $0.28   $0.51   $0.63   $1.05 
Cash Dividends Paid  $0.10   $0.10   $0.20   $0.20 
Book Value  $19.89   $19.52   $19.89   $19.52 
                     
Return On Average Assets   0.53%   0.66%   0.61%   0.69%
Return On Average Common Equity   5.53%   9.92%   6.38%   10.47%
Return On Average Equity   4.73%   7.74%   5.43%   8.14%
Interest Rate Spread   3.50%   3.35%   3.48%   3.37%
Net Interest Margin   3.63%   3.47%   3.62%   3.50%
Cost of Funds   0.76%   0.93%   0.77%   0.93%
Cost of Deposits   0.58%   0.74%   0.60%   0.76%
Efficiency Ratio   71.80%   69.38%   69.84%   68.79%
Noninterest Expense to Average Assets   2.67%   2.55%   2.60%   2.56%
Net Charge-offs to Average Loans   0.35%   0.28%   0.21%   0.16%

 

COMPARISION OF RESULTS OF OPERATIONS FOR THE SIX MONTHS ENDED JUNE 30, 2014 AND 2013

 

Earnings Summary

Consolidated net income available to common shareholders for the six months ended June 30, 2014 decreased $248,000, or 7.8%, to $3.0 million or $0.63 per common share (diluted) compared to $3.2 million or $1.05 per common share (diluted) for the six months ended June 30, 2013. The decrease in net income available to common was attributable to an increased provision for loan losses of $411,000, decreased noninterest income of $508,000 and increased noninterest expense of $849,000 partially offset by increased net interest income of $1.5 million and decreased income tax expense of $65,000.

 

The Company’s return on average assets was 0.61% for the six months ended June 30, 2014 compared to 0.69% for the six months June 30, 2013. The Company’s return on average common stockholders' equity was 6.38% compared to 10.47% for the same comparative period.

 

In October 2013, the Company issued 1,591,300 shares of common stock at a price of $18.75 per share resulting in net proceeds of $27.4 million after commissions and related offering expenses. The additional shares outstanding impacted year to year comparability of per share and return on equity results beginning with the fourth quarter of 2013.

 

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Net Interest Income

The primary component of the Company’s net income is its net interest income, which is the difference between income earned on assets and interest paid on the deposits and borrowings used to fund them. Net interest income is affected by the difference between the yields earned on the Company’s interest-earning assets and the rates paid on interest-bearing liabilities, as well as the relative amounts of such assets and liabilities. Net interest income, divided by average interest-earning assets, represents the Company’s net interest margin.

 

Net interest income increased $1.5 million to $17.0 million for the six months ended June 30, 2014 compared to $15.5 million for the six months ended June 30, 2013. The net interest margin was 3.62% for the six months ended June 30, 2014, a 12 basis point increase from 3.50% for the six months ended June 30, 2013. The increase was largely the result of a decrease in the cost of funds and an increase in the average balance of loans. These increases were partially offset by a reduction in loan yields.

 

The following table shows the components of net interest income and the dollar and percentage changes for the periods presented.

  

   Six Months Ended June 30,         
(dollars in thousands )  2014   2013   $ Change   % Change 
Interest and Dividend Income                    
Loans, including fees  $19,268   $18,364   $904    4.9%
Taxable interest and dividends on investment securities   1,155    1,221    (66)   (5.4)%
Interest on deposits with banks   6    5    1    20.0%
Total Interest and Dividend Income   20,429    19,590    839    4.3%
                     
Interest Expenses                    
Deposits   2,367    2,996    (629)   (21.0)%
Short-term borrowings   7    9    (2)   (22.2)%
Long-term debt   1,051    1,036    15    1.4%
Total Interest Expenses   3,425    4,041    (616)   (15.2)%
                     
Net Interest Income (NII)  $17,004   $15,549   $1,455    9.4%

 

Interest and dividend income increased by $839,000 to $20.4 million for the six months ended June 30, 2014 compared to $19.6 million for the six months ended June 30, 2013. Interest and dividend income increased due to the growth in the average balance of loans and higher investment yields. These increases were partially offset by decreased interest and dividend income from lower loan yields and lower investment average balances. Interest and dividend income increased $1.8 million due to growth of $75.4 million in the average balance of loans from $727.7 million to $803.1 million and $147,000 due to higher investment yields. This increase was partially offset by a decrease of $904,000 in interest income as a result of a reduction in loan yields. Average loan yields declined 25 basis points from 5.05% for the six months ended June 30, 2013 to 4.80% for the six months ended June 30, 2014. Interest and dividend income was further reduced $212,000 as average interest-earning investment balances decreased $25.0 million from $162.0 million for the six months ended June 30, 2013 to $137.0 million for the six months ended June 30, 2014.

 

The Company’s cost of funds decreased as certificates of deposit re-priced and rates declined on money market accounts. The average cost of total interest-bearing liabilities decreased 17 basis points from 1.03% for the first six months of 2013 to 0.86% for the first six months of 2014. Deposit costs decreased 16 basis points from 0.76% for the first six months of 2013 to 0.60% for the comparable period in 2014. Additionally, the increase of noninterest bearing demand deposits of $10.7 million contributed to the decline in funding costs with average balances increasing from $83.1 million for the six months ended June 30, 2013 to $93.8 million for the six months ended June 30, 2014.

 

Interest expense decreased $616,000 to $3.4 million for the six months ended June 30, 2014 compared to $4.0 million for the six months ended June 30, 2013 due primarily to a reduction in the average cost of funds on interest-bearing liabilities; interest expense decreased $658,000 due to a decrease in rates. This was principally achieved by a decrease in the average rates paid on certificates of deposits and money market accounts, which declined from 1.26% and 0.34%, respectively, for the six months ended June 30, 2013 to 1.01% and 0.28%, respectively, for the six months ended June 30, 2014. The Company has been successful in increasing its core deposits and reducing its cost of funds in the low interest rate environment over the last several years. In addition, the average rate paid on long-term debt and short-term borrowings decreased from 2.46% to 2.30% for the comparable period. Interest expense on interest-bearing deposits was also reduced $45,000 due primarily to a decline in average balances for certificates of deposit. These reductions in interest expense were partially offset by an $87,000 increase in interest expense due to a $7.3 million increase in average debt balances from $84.9 million for the six months ended June 30, 2013 to $92.2 million for the six months ended June 30, 2014.

 

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The following table presents information on average balances and rates for deposits.

  

   For the Six Months Ended June 30,     
   2014   2013 
   Average   Average   Average   Average 
(dollars in thousands)  Balance   Rate   Balance   Rate 
Savings  $39,544    0.10%  $36,859    0.10%
Interest-bearing demand and money market accounts   273,526    0.28%   263,521    0.34%
Certificates of deposit   388,424    1.01%   400,292    1.26%
Total interest-bearing deposits   701,494    0.67%   700,672    0.86%
Noninterest-bearing demand deposits   93,787         83,133      
   $795,281    0.60%  $783,805    0.76%

  

The following table sets forth certain information regarding changes in interest income and interest expense of the Bank for the periods indicated. For each category of interest-earning asset and interest-bearing liability, information is provided on changes attributable to (1) changes in volume (changes in volume multiplied by old rate); and (2) changes in rate (changes in rate multiplied by old volume). Changes in rate-volume (changes in rate multiplied by the change in volume) have been allocated to changes due to volume.

  

   Six Months Ended June 30, 2014 
   compared to Six Months Ended 
   June 30, 2013 
       Due to     
dollars in thousands  Volume   Rate   Total 
             
Interest income:               
Loan portfolio (1)  $1,808   $(904)  $904 
Investment securities, federal funds sold and interest bearing deposits   (212)   147    (65)
Total interest-earning assets  $1,596   $(757)  $839 
                
Interest-bearing liabilities:               
Savings   1    1    2 
Interest-bearing demand and money market accounts   14    (83)   (69)
Certificates of deposit   (60)   (502)   (562)
Long-term debt   87    (75)   12 
Short-term debt   -    (2)   (2)
Guaranteed preferred beneficial interest in junior subordinated debentures   -    3    3 
Total interest-bearing liabilities  $42   $(658)  $(616)
Net change in net interest income  $1,554   $(99)  $1,455 

 

(1) Average balance includes non-accrual loans

 

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The following table presents information on the average balances of the Company’s interest-earning assets and interest-bearing liabilities and interest earned or paid thereon for the six months ended June 30, 2014 and 2013, respectively. There are no tax equivalency adjustments.

 

   For the Six Months Ended June 30, 
       2014           2013     
           Average           Average 
   Average       Yield/   Average       Yield/ 
dollars in thousands  Balance   Interest   Cost   Balance   Interest   Cost 
Assets                              
Interest-earning assets:                              
Loan portfolio (1)  $803,090   $19,268    4.80%  $727,732   $18,364    5.05%
Investment securities, federal funds sold and interest-bearing deposits   136,993    1,161    1.69%   161,980    1,226    1.51%
Total Interest-Earning Assets   940,083    20,429    4.35%   889,712    19,590    4.40%
Cash and cash equivalents   9,618              10,936           
Other assets   58,881              57,073           
Total Assets  $1,008,582             $957,721           
                               
Liabilities and Stockholders' Equity                              
Interest-bearing liabilities:                              
Savings  $39,544   $20    0.10%  $36,859   $18    0.10%
Interest-bearing demand and money market accounts   273,526    379    0.28%   263,521    448    0.34%
Certificates of deposit   388,424    1,968    1.01%   400,292    2,530    1.26%
Long-term debt   74,745    891    2.38%   67,424    879    2.61%
Short-term debt   5,429    7    0.26%   5,459    9    0.33%
Guaranteed preferred beneficial interest in junior subordinated debentures   12,000    160    2.67%   12,000    157    2.62%
                               
Total Interest-Bearing Liabilities   793,668    3,425    0.86%   785,555    4,041    1.03%
                               
Noninterest-bearing demand deposits   93,787              83,133           
Other liabilities   8,503              7,834           
Stockholders' equity   112,624              81,199           
Total Liabilities and Stockholders' Equity  $1,008,582             $957,721           
                               
Net interest income       $17,004             $15,549      
                               
Interest rate spread             3.48%             3.37%
Net yield on interest-earning assets             3.62%             3.50%
Ratio of average interest-earning assets to average interest bearing liabilities             118.45%             113.26%
                               
Cost of funds             0.77%             0.93%
Cost of deposits             0.60%             0.76%

(1) Average balance includes non-accrual loans

 

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Provision for Loan Losses

The following table shows the dollar and percentage changes for the provision for loan losses for the periods presented.

  

   Six Months Ended June 30,         
(dollars in thousands )  2014   2013   $ Change   % Change 
Provision for loan losses  $766   $355   $411    115.8%

 

The provision for loan losses increased $411,000 from the comparable period in 2013 to $766,000 for the six months ended June 30, 2014 and reflected an increase in net-charge-offs offset by a decrease in the specific allowance. The specific allowance is based on management’s estimate of realizable value for particular loans and has decreased as specific credits have been resolved through a return to performance, charge-offs, additions to other real estate owned, or the sale of non-performing and classified loans. Net charge-offs increased $286,000 from $568,000 for the six months ended June 30, 2013 to $854,000 for the six months ended June 30, 2014. During the second quarter of 2014, the Bank charged off $650,000 related to $3.4 million in commercial loans to one customer as a result of a sale of the loans to a third party. The sale of the loans decreased the Bank’s specific allowance and classified loans. See further discussion of the provision under the caption “Asset Quality and the Allowance for Loan Losses” in the Comparison of Financial Condition section of Management’s Discussion and Analysis.

 

Noninterest Income

The following table shows the components of noninterest income and the dollar and percentage changes for the periods presented.

  

   Six Months Ended June 30,         
(dollars in thousands )  2014   2013   $ Change   % Change 
Noninterest Income                    
Loan appraisal, credit, and miscellaneous charges  $192   $319   $(127)   (39.8)%
Gain on sale of asset   7    11    (4)   (36.4)%
Net gains on sale of OREO   4    -    4    n/a 
Net gains on sale of investment securities   24    -    24    n/a 
Income from bank owned life insurance   303    308    (5)   (1.6)%
Service charges   1,076    1,103    (27)   (2.4)%
Gain on sale of loans held for sale   144    517    (373)   (72.1)%
Total Noninterest Income  $1,750   $2,258   $(508)   (22.5)%

  

The decrease in noninterest income was principally due to a reduction in gains on the sale of loans held for sale and a reduction in other fees and miscellaneous charges. Secondary market sales slowed during the third quarter of 2013 due to rising residential mortgage interest rates. In addition, the Company recognized a net gain of $24,000 on the sale of $5.2 million of investment securities during the first quarter of 2014.

 

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Noninterest Expense

The following tables show the components of noninterest expense and the dollar and percentage changes for the periods presented.

  

   Six Months Ended June 30,         
(dollars in thousands )  2014   2013   $ Change   % Change 
Noninterest Expense                    
Salary and employee benefits  $8,021   $7,147   $874    12.2%
Occupancy expense   1,219    1,052    167    15.9%
Advertising   323    273    50    18.3%
Data processing expense   652    730    (78)   (10.7)%
Professional fees   518    462    56    12.1%
Depreciation of furniture, fixtures, and equipment   367    390    (23)   (5.9)%
Telephone communications   91    103    (12)   (11.7)%
Office supplies   154    109    45    41.3%
FDIC Insurance   338    574    (236)   (41.1)%
Valuation allowance on OREO   234    330    (96)   (29.1)%
Other   1,181    1,079    102    9.5%
Total Noninterest Expense  $13,098   $12,249   $849    6.9%

  

   Six Months Ended June 30,         
(dollars in thousands)  2014   2013   $ Change   % Change 
Compensation and Benefits  $8,021   $7,147   $874    12.2%
OREO Valuation Allowance and Expenses   294    394    (100)   (25.4)%
Other Operating Expenses   4,783    4,708    75    1.6%
Total Noninterest Expense  $13,098   $12,249   $849    6.9%

  

For the six months ended June 30, 2014, noninterest expense increased 6.9% or $849,000 to $13.1 million from $12.2 million for the comparable period in 2013. The increase was primarily due to growth in employee compensation of $874,000 to $8.0 million as the Bank added employees in the first six months of 2014 to support its expansion in the Fredericksburg area of Virginia. In addition, during the second quarter of 2014, the Bank hired several loan officers and support employees to expand lending in the city of Annapolis, Maryland and the surrounding Anne Arundel County market. Other operating expenses were higher as a result of the Company’s entrance into new markets during the first six months of the year. The Company’s efficiency ratio and noninterest expense as a percentage of average assets for the six months ended June 30, 2014 were 69.84% and 2.60%, respectively, compared to 68.79% and 2.56%, respectively, for the six months ended June 30, 2013.

 

Income Tax Expense

For the six months ended June 30, 2014, the Company recorded income tax expense of $1.8 million compared to $1.9 million in the prior year. The Company’s effective tax rates for the six months ended June 30, 2014 and 2013 were 37.50% and 36.50%, respectively. The increase in the effective tax rate was the result of tax-exempt income being relatively lower to total income for the six months ended June 30, 2014 compared to the six months ended June 30, 2013.

 

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COMPARISION OF RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED JUNE 30, 2014 AND 2013

 

Earnings Summary

Consolidated net income available to common shareholders for the three months ended June 30, 2014 decreased $251,000 to $1.3 million or $0.28 per common share (diluted) compared to $1.5 million or $0.51 per common share (diluted) for the three months ended June 30, 2013. The decrease in net income was due to an increased provision for loan losses of $363,000, decreased noninterest income of $214,000 and increased noninterest expense of $661,000 due largely to the Bank’s recently announced Fredericksburg branch opening and the hiring of personnel for the planned expansion into Annapolis. This was partially offset by increased net interest income of $838,000 and decreased income tax expense of $149,000.

 

The Company’s return on average assets was 0.53% for the three months ended June 30, 2014 compared to 0.66% for the three months ended June 30, 2013. The Company’s return on average common stockholders' equity was 5.53% compared to 9.92% for the same comparative period.

 

In October 2013, the Company issued 1,591,300 shares of common stock at a price of $18.75 per share resulting in net proceeds of $27.4 million after commissions and related offering expenses. The additional shares outstanding impacted year to year comparability of per share amounts beginning with the fourth quarter of 2013.

 

Net Interest Income

The primary component of the Company’s net income is its net interest income, which is the difference between income earned on assets and interest paid on the deposits and borrowings used to fund them. Net interest income is affected by the difference between the yields earned on the Company’s interest-earning assets and the rates paid on interest-bearing liabilities, as well as the relative amounts of such assets and liabilities. Net interest income, divided by average interest-earning assets, represents the Company’s net interest margin.

 

Net interest income increased $838,000 to $8.6 million for the three months ended June 30, 2014 compared to $7.7 million for the three months ended June 30, 2013. The net interest margin was 3.63% for the three months ended June 30, 2014, a 16 basis point increase from 3.47% for the three months ended June 30, 2013. The increase was largely the result of a decrease in the cost of funds and an increase in the average balance of loans. These increases were partially offset by a reduction in loan yields.

 

The following table shows the components of net interest income and the dollar and percentage changes for the periods presented.

 

   Three Months Ended June 30,         
(dollars in thousands )  2014   2013   $ Change   % Change 
Interest and Dividend Income                    
Loans, including fees  $9,685   $9,117   $568    6.2%
Taxable interest and dividends on investment securities   565    631    (66)   (10.5)%
Interest on deposits with banks   4    2    2    100.0%
Total Interest and Dividend Income   10,254    9,750    504    5.2%
                     
Interest Expenses                    
Deposits   1,159    1,445    (286)   (19.8)%
Short-term borrowings   1    5    (4)   (80.0)%
Long-term debt   524    568    (44)   (7.7)%
Total Interest Expenses   1,684    2,018    (334)   (16.6)%
                     
Net Interest Income (NII)  $8,570   $7,732   $838    10.8%

 

42
 

 

Interest and dividend income increased by $504,000 to $10.3 million for the three months ended June 30, 2014 compared to $9.8 million for the three months ended June 30, 2013. Interest and dividend income increased due to the growth in the average balance of loans and higher investment yields. These increases were partially offset by decreased interest and dividend income from lower loan yields and lower investment average balances. Interest and dividend income increased $996,000 due to growth of $83.3 million in the average balance of loans from $727.1 million to $810.4 million and $68,000 due to better investment yields. This increase was partially offset by a decrease of $427,000 in interest income from a reduction in loan yields. Average loan yields declined 24 basis points from 5.02% for the three months ended June 30, 2013 to 4.78% for the three months ended June 30, 2014. Interest and dividend income was further reduced $133,000 as average interest-earning investment balances decreased $31.1 million from $163.9 million for the three months ended June 30, 2013 to $132.8 million for the three months ended June 30, 2014.

 

Interest expense decreased $334,000 to $1.7 million for the three months ended June 30, 2014 compared to $2.0 million for the three months ended June 30, 2013 due primarily to a reduction in the average cost of funds on interest-bearing liabilities. The average cost of total interest-bearing liabilities decreased 18 basis points from 1.03% for the second quarter of 2013 to 0.85% for the second quarter of 2014. Interest expense decreased $347,000 due to a decrease in rates which was principally achieved by a decrease in the average rates paid on certificates of deposits and money market accounts, which declined from 1.22% and 0.33%, respectively, for the three months ended June 30, 2013 to 1.00% and 0.26%, respectively, for the three months ended June 30, 2014. Deposit costs decreased 16 basis points from 0.74% to 0.58% for the comparable period. Additionally, the increase of noninterest bearing demand deposits of $13.1 million contributed to the decline in funding costs with average balances increasing from $83.8 million for the three months ended June 30, 2013 to $96.9 million for the three months ended June 30, 2014. The average rate paid on long-term debt and short-term borrowings decreased from 2.63% to 2.35% for the comparable period. Interest expense was also reduced $14,000 for interest-bearing deposits due primarily to a decline in average certificate of deposit balances of $9.5 million from $399.2 million for the three months ended June 30, 2013 to $389.7 million for the three months ended June 30, 2014. These reductions in interest expense were partially offset by a $27,000 increase in interest expense due to a $2.3 million increase in average debt balances from $87.0 million for the three months ended June 30, 2013 to $89.3 million for the three months ended June 30, 2014.

 

The following table presents information on average balances and rates for deposits.

 

   For the Three Months Ended June 30,     
   2014   2013 
   Average   Average   Average   Average 
(dollars in thousands)  Balance   Rate   Balance   Rate 
Savings  $40,141    0.10%  $37,535    0.10%
Interest-bearing demand and money market accounts   275,990    0.26%   261,270    0.33%
Certificates of deposit   389,726    1.00%   399,238    1.22%
Total interest-bearing deposits   705,857    0.66%   698,043    0.83%
Noninterest-bearing demand deposits   96,876         83,752      
   $802,733    0.58%  $781,795    0.74%

 

43
 

 

The following table sets forth certain information regarding changes in interest income and interest expense of the Bank for the periods indicated. For each category of interest-earning asset and interest-bearing liability, information is provided on changes attributable to (1) changes in volume (changes in volume multiplied by old rate); and (2) changes in rate (changes in rate multiplied by old volume). Changes in rate-volume (changes in rate multiplied by the change in volume) have been allocated to changes due to volume.

 

   Three Months Ended June 30, 2014 
   compared to Three Months Ended 
   June 30, 2013 
       Due to     
dollars in thousands  Volume   Rate   Total 
             
Interest income:               
Loan portfolio (1)  $996   $(427)  $569 
Investment securities, federal funds sold and interest bearing deposits   (133)   68    (65)
Total interest-earning assets  $863   $(359)  $504 
                
Interest-bearing liabilities:               
Savings   1    -    1 
Interest-bearing demand and money market accounts   9    (47)   (38)
Certificates of deposit   (24)   (226)   (250)
Long-term debt   28    (69)   (41)
Short-term debt   (1)   (2)   (3)
Guaranteed preferred beneficial interest  in junior subordinated debentures   -    (3)   (3)
Total interest-bearing liabilities  $13   $(347)  $(334)
Net change in net interest income  $850   $(12)  $838 

 

(1) Average balance includes non-accrual loans

  

44
 

 

The following table presents information on the average balances of the Company’s interest-earning assets and interest-bearing liabilities and interest earned or paid thereon for the three months ended June 30, 2014 and 2013, respectively. There are no tax equivalency adjustments.

 

   For the Three Months Ended June 30, 
       2014           2013     
           Average           Average 
   Average       Yield/   Average       Yield/ 
dollars in thousands  Balance   Interest   Cost   Balance   Interest   Cost 
Assets                              
Interest-earning assets:                              
Loan portfolio (1)  $810,408   $9,685    4.78%  $727,059   $9,116    5.02%
Investment securities, federal funds sold and interest-bearing deposits   132,771    569    1.71%   163,874    634    1.55%
Total Interest-Earning Assets   943,179    10,254    4.35%   890,933    9,750    4.38%
Cash and cash equivalents   11,060              10,339           
Other assets   59,104              57,179           
Total Assets  $1,013,343             $958,451           
                               
Liabilities and Stockholders' Equity                              
Interest-bearing liabilities:                              
Savings  $40,141   $10    0.10%  $37,535   $9    0.10%
Interest-bearing demand and money market accounts   275,990    178    0.26%   261,270    216    0.33%
Certificates of deposit   389,726    971    1.00%   399,238    1,221    1.22%
Long-term debt   75,272    449    2.39%   70,506    490    2.78%
Short-term debt   1,991    1    0.20%   4,451    4    0.36%
Guaranteed preferred beneficial interest  in junior subordinated debentures   12,000    75    2.50%   12,000    78    2.60%
                               
Total Interest-Bearing Liabilities   795,120    1,684    0.85%   785,000    2,018    1.03%
                               
Noninterest-bearing demand deposits   96,876              83,752           
Other liabilities   8,363              7,786           
Stockholders' equity   112,984              81,913           
Total Liabilities and Stockholders' Equity  $1,013,343             $958,451           
                               
Net interest income       $8,570             $7,732      
                               
Interest rate spread             3.50%             3.35%
Net yield on interest-earning assets             3.63%             3.47%
Ratio of average interest-earning assets to average interest bearing liabilities             118.62%             113.49%
                               
Cost of funds             0.76%             0.93%
Cost of deposits             0.58%             0.74%

(1) Average balance includes non-accrual loans

 

45
 

 

Provision for Loan Losses

The following table shows the dollar and percentage changes for the provision for loan losses for the periods presented.

 

   Three Months Ended June 30,         
(dollars in thousands )  2014   2013   $ Change   % Change 
Provision for loan losses  $563   $200   $363    181.5%

 

The provision for loan losses increased $363,000 from the comparable period in 2013 to $563,000 for the three months ended June 30, 2014 and reflected an increase in net-charge-offs offset by a decrease in the specific allowance. The specific allowance is based on management’s estimate of realizable value for particular loans and has decreased as specific credits have been resolved through a return to performance, charge-offs, additions to other real estate owned, or the sale of non-performing and classified loans. Net charge-offs increased $193,000 from $517,000 for the three months ended June 30, 2013 to $710,000 for the three months ended June 30, 2014. During the second quarter of 2014, the Bank charged off $650,000 related to $3.4 million in commercial loans to one customer as a result of a sale of the loans to a third party. The sale of the loans decreased the Bank’s specific allowance and classified loans. See further discussion of the provision under the caption “Asset Quality and the Allowance for Loan Losses” in the Comparison of Financial Condition section of Management’s Discussion and Analysis.

 

Noninterest Income

The following table shows the components of noninterest income and the dollar and percentage changes for the periods presented.

 

   Three Months Ended June 30,         
(dollars in thousands )  2014   2013   $ Change   % Change 
Noninterest Income                    
Loan appraisal, credit, and miscellaneous charges  $92   $131   $(39)   (29.8)%
Gain on sale of asset   7    11    (4)   (36.4)%
Net gains on sale of OREO   4    -    4    n/a 
Income from bank owned life insurance   152    157    (5)   (3.2)%
Service charges   524    632    (108)   (17.1)%
Gain on sale of loans held for sale   76    138    (62)   (44.9)%
Total Noninterest Income  $855   $1,069   $(214)   (20.0)%

  

Noninterest income totaled $855,000 for the three months ended June 30, 2014 compared to $1.1 million for the three months ended June 30, 2013. The decrease of $214,000 was principally due to a reduction in service charges and gains on loans originated for sale in the secondary market.

 

46
 

 

Noninterest Expense

The following tables show the components of noninterest expense and the dollar and percentage changes for the periods presented.

 

   Three Months Ended June 30,         
(dollars in thousands )  2014   2013   $ Change   % Change 
Noninterest Expense                    
Salary and employee benefits  $3,992   $3,590   $402    11.2%
Occupancy expense   654    569    85    14.9%
Advertising   201    169    32    18.9%
Data processing expense   381    366    15    4.1%
Professional fees   288    265    23    8.7%
Depreciation of furniture, fixtures, and equipment   182    198    (16)   (8.1)%
Telephone communications   41    54    (13)   (24.1)%
Office supplies   74    46    28    60.9%
FDIC Insurance   199    273    (74)   (27.1)%
Valuation allowance on OREO   152    19    133    700.0%
Other   603    557    46    8.3%
Total Noninterest Expense  $6,767   $6,106   $661    10.8%
                     
   Three Months Ended June 30,         
(dollars in thousands)  2014   2013   $ Change   % Change 
Compensation and Benefits  $3,992   $3,590   $402    11.2%
OREO Valuation Allowance and Expenses   165    43    122    283.7%
Other Operating Expenses   2,610    2,473    137    5.5%
Total Noninterest Expense  $6,767   $6,106   $661    10.8%

 

For the three months ended June 30, 2014, noninterest expense increased 10.8% or $661,000 to $6.8 million from $6.1 million for the comparable period in 2013. The increase was primarily due to growth in employee compensation of $402,000 to $4.0 million as the Bank added employees to support its expansion in the Fredericksburg area of Virginia to prepare for the opening of its Central Park Branch in July 2014. In addition, during the second quarter of 2014, the Bank hired several loan officers and support employees to expand lending in the city of Annapolis, Maryland and the surrounding Anne Arundel County market. The Company’s efficiency ratio and noninterest expense as a percentage of average assets for the three months ended June 30, 2014 were 71.80% and 2.67%, respectively, compared to 69.38% and 2.55%, respectively, for the three months ended June 30, 2013. Expenses were higher as a result of the Company’s entrance into new markets and an increase in OREO expenses, of which $152,000 of second quarter 2014 expenses related to an increase in the valuation allowance to adjust OREO properties to current appraised values less the cost to sell.

 

Income Tax Expense

For the three months ended June 30, 2014, the Company recorded income tax expense of $760,000 compared to $909,000 in the prior year. The Company’s effective tax rates for the three months ended June 30, 2014 and 2013 were 36.28% and 36.43%, respectively.

 

47
 

 

COMPARISION OF FINANCIAL CONDITON AT JUNE 30, 2014 AND DECEMBER 31, 2013

Assets

Total assets at June 30, 2014 of $1.03 billion increased $10.9 million compared to total assets of $1.02 billion at December 31, 2013. The increase in total assets was primarily attributable to net loan growth partially offset by declines in cash and securities. The following table shows the Company’s assets and the dollar and percentage changes for the periods presented.

 

   June 30, 2014   December 31, 2013         
(dollars in thousands)  (Unaudited)       $ Change   % Change 
                 
Cash and due from banks  $10,924   $11,408   $(484)   (4.2)%
Federal funds sold   60    8,275    (8,215)   (99.3)%
Interest-bearing deposits with banks   434    4,836    (4,402)   (91.0)%
Securities available for sale (AFS), at fair value   41,905    48,247    (6,342)   (13.1)%
Securities held to maturity (HTM), at amortized cost   77,547    86,401    (8,854)   (10.2)%
FHLB and FRB stock - at cost   6,661    5,593    1,068    19.1%
Loans held for sale   971    -    971    n/a 
Loans receivable - net of ALLL of $8,050 and $8,138   837,127    799,130    37,997    4.8%
Premises and equipment, net   19,745    19,543    202    1.0%
Other real estate owned (OREO)   6,553    6,797    (244)   (3.6)%
Accrued interest receivable   2,931    2,974    (43)   (1.4)%
Investment in bank owned life insurance   19,653    19,350    303    1.6%
Other assets   10,196    11,270    (1,074)   (9.5)%
Total Assets  $1,034,707   $1,023,824   $10,883    1.1%

 

The differences in allocations between the cash and investment categories reflect operational needs. The AFS and HTM securities portfolio decreased $15.2 million during the first six months of 2014 due to principal repayments and the sale of $5.2 million in securities recognizing a gain of $24,000. During the first quarter of 2014, the Company sold five AFS securities with a carrying value of $2.1 million and ten HTM securities with aggregate carrying values of $3.2 million, recognizing gains of $8,000 and $16,000, respectively. The sale of HTM securities was permitted under ASC 320 “Investments - Debt and Equity Securities.” The Company sold the HTM positions utilizing the safe harbor rule that allows for the sale of HTM securities that have principal payments paid down to less than 15% of original purchased par. There were no sales of AFS and HTM securities during the three months ended June 30, 2014 or the six months ended June 30, 2013.

 

Net loans increased $38.0 from $799.1 million at December 31, 2013 to $837.1 million at June 30, 2014, due primarily to increases in loans for commercial real estate partially offset by decreases in commercial loans. The following is a breakdown of the Company’s loan portfolio at June 30, 2014 and December 31, 2013:

 

(dollars in thousands)  June 30, 2014   %   December 31, 2013   % 
                 
Commercial real estate  $531,919    62.86%  $476,648    58.97%
Residential first mortgages   156,833    18.53%   159,147    19.69%
Construction and land development   32,086    3.79%   32,001    3.96%
Home equity and second mortgages   21,225    2.51%   21,692    2.68%
Commercial loans   77,583    9.17%   94,176    11.65%
Consumer loans   736    0.09%   838    0.10%
Commercial equipment   25,876    3.06%   23,738    2.94%
    846,258    100.00%   808,240    100.00%
Less:                    
Deferred loan fees   1,081    0.13%   972    0.12%
Allowance for loan loss   8,050    0.95%   8,138    1.01%
    9,131         9,110      
   $837,127        $799,130      

 

48
 

 

Asset Quality and the Allowance for Loan Losses

 

The Allowance for Loan Losses

The allowance for loan losses decreased from 1.01% of gross loans at December 31, 2013 to 0.95% of gross loans at June 30, 2014 due to changes to general allowance factors that reflect changes in historical loss, delinquency rates, general economic conditions and a reduction in specific reserves on impaired loans. The historical loss experience factor is tracked over various time horizons for each portfolio segment. It is weighted as the most important factor of the general component of the allowance and has decreased as the Bank’s charge-off history has improved. The increase in the general allowance was partially offset by the decrease in specific reserves on impaired loans.

 

Specific reserves at June 30, 2014 were reduced $850,000 to $859,000 from March 31, 2014 specific reserves of $1.4 million due primarily to the sale of $3.4 million of commercial loans to a third party of one customer relationship. The Bank charged-off $650,000 during the second quarter of 2014 for this relationship. The sale of the loans decreased the Bank’s specific allowance and classified loans. The funds provided by the sale were redeployed into interest-earning assets.

 

Management’s determination of the adequacy of the allowance is based on a periodic evaluation of the portfolio with consideration given to: overall loss experience; current economic conditions; size, growth and composition of the loan portfolio; financial condition of the borrowers; current appraised values of underlying collateral; and other relevant factors that, in management’s judgment, warrant recognition in determining an adequate allowance. The specific allowance is based on management’s estimate of realizable value for particular loans. Management believes that the allowance is adequate.

 

The allowance for loan losses decreased $88,000 from December 31, 2013 to June 30, 2014. The decrease in the allowance reflects a decrease in specific reserves of $126,000 partially offset by an increase in the general allowance of $38,000. The following is a breakdown of the Company’s general and specific allowances as a percentage of gross loans at June 30, 2014 and December 31, 2013, respectively.

 

(dollar in thousands)  June 30, 2014   % of Gross
Loans
   December 31, 2013   % of Gross
Loans
 
                 
General Allowance  $7,191    0.85%  $7,153    0.89%
Specific Allowance   859    0.10%   985    0.12%
Total Allowance  $8,050    0.95%  $8,138    1.01%

 

The provision for loan losses increased $411,000 from the comparable period in 2013 to $766,000 for the six months ended June 30, 2014 and reflected an increase in net-charge-offs offset by a decrease in the specific allowance. Net charge-offs increased $286,000 from $568,000 for the six months ended June 30, 2013 to $854,000 for the six months ended June 30, 2014. Although loan balances have grown in 2013 and 2014, the credit quality of our loan portfolio improved, with a slightly better economic climate, low levels of net charge-offs, and a trend of lower levels of classified loans. Non-performing loans have been resolved with workouts, charge-offs, transfers to OREO and sales of nonperforming and classified loans. Net charge-offs have fallen significantly over the last two years and have returned to pre-financial crisis levels.

 

49
 

 

Asset Quality

The following tables show selected asset quality ratios at June 30, 2014 and December 31, 2013.

 

   June 30, 2014   December 31, 2013         
(dollars in thousands)  (Unaudited)       $ Change   % Change 
                 
Total assets  $1,034,707   $1,023,824   $10,883    1.1%
Gross loans   846,258    808,240    38,018    4.7%
Allowance for loan loss (ALLL)   8,050    8,138    (88)   (1.1)%
Foreclosed real estate (OREO)   6,553    6,797    (244)   (3.6)%
Past due loans (PDLs) 31-89 days   5,892    8,060    (2,168)   (26.9)%
Nonperforming loans >= 90 days Delinquent (NPLs)   11,886    11,170    716    6.4%
Non-accrual only loans(A)   -    4,281    (4,281)   (100.0)%
Non-accrual loans (NPLs + Non-accrual only loans)   11,886    15,451    (3,565)   (23.1)%
Troubled debt restructures (TDRs)(C)   3,175    4,693    (1,518)   (32.3)%
Allowance for loan losses (ALLL) to total loans   0.95%   1.01%          
Past due loans to total loans   0.70%   1.00%          
Nonperforming loans to total loans   1.40%   1.38%          
Loan delinquency (PDLs + NPLs) to total loans   2.10%   2.38%          
Non-accrual loans to total loans   1.40%   1.91%          
Non-accrual loans and TDRs to total loans (B)   1.78%   2.45%          
Allowance to nonperforming loans   67.73%   72.86%          
Non-accrual loans and OREO to total assets   1.78%   2.17%          
Non-accrual loans, OREO and TDRs to total assets (B)   2.09%   2.60%          

  

(A) Non-accrual only loans are loans classified as non-accrual loans due to customer operating results or payment history. Non-accrual loans can include loans that are current with all loan payments. Interest and principal are recognized on a cash-basis in accordance with the Bank's policy if the loans are not impaired or there is no impairment.

 

(B) Ratio was adjusted at December 31, 2013 to remove $329,000 for loans that were classified as both nonperforming and troubled debt restructures.

 

(C) The Bank has one TDR customer relationship of $4.03 million dollars with terms that defer the payment of principal and interest for a period of time. These loans are classified as non-accrual loans for financial reporting purposes. If the loans return to performing status after the forbearance period, they will be reported as TDR loans.

 

Non-accrual loans (90 days or greater delinquent and non-accrual only loans) decreased $3.6 million from $15.5 million or 1.91% of total loans at December 31, 2013 to $11.9 million or 1.40% of total loans at June 30, 2014. Non-accrual only loans are loans classified as non-accrual due to customer operating results or payment history. In accordance with the Company’s policy, interest income is recognized on a cash-basis for these loans. There were no non-accrual only loans at June 30, 2014. At December 31, 2013 non-accrual only loans were $4.2 million, representing one well-secured commercial relationship with no specific reserves due to the Bank's superior credit position with underlying collateral, which consists primarily of commercial real estate.

 

Loan delinquency decreased $1.4 million from $19.2 million or 2.38% of loans at December 31, 2013 to $17.8 million or 2.10% of loans at June 30, 2014. Nonperforming loans (loans 90 days or greater delinquent) increased $716,000 from December 31, 2013 to $11.9 million at June 30, 2014. Nonperforming loans as a percentage of total loans increased to 1.40% at June 30, 2014 compared to 1.38% at December 31, 2013. The Bank had 29 nonperforming loans at June 30, 2014 compared to 28 nonperforming loans at December 31, 2013. Nonperforming loans at June 30, 2014 included $9.3 million or 78% of nonperforming loans attributed to 13 loans representing four customer relationships, of which $4.0 million represented a stalled residential development project. The Bank has deferred the collection of principal and interest for one year to enable the project to use available funds to build units and complete the project. At June 30, 2014, the stalled development project loans are considered both TDR loans and non-accrual loans and are reported solely as non-accrual loans for financial reporting purposes. If the loans return to performing status after the forbearance period, they will be reported as TDR loans. Loans 31-89 days delinquent decreased $2.2 million from $8.1 million or 1.00% of total loans at December 31, 2013 to $5.9 million or 0.70% of total loans at June 30, 2014. The Bank had 31 past due loans at December 31, 2013 compared to 27 past due loans at June 30, 2014. Management believes the 31-89 day past due delinquency rate of 0.70% is a leading indicator of the health of the loan portfolio.

 

50
 

 

At June 30, 2014, the Bank had eight accruing TDRs totaling $3.2 million compared to 13 TDRs totaling $4.7 million as of December 31, 2013. At June 30, 2014, all TDRs were performing according to the terms of their agreements. At December 31, 2013, one TDR of $329,000 was over 90 days past due. The Bank had specific reserves of $197,000 on four TDRs totaling $2.4 million at June 30, 2014 and $79,000 on two TDRs totaling $1.8 million at December 31, 2013. The Bank added three TDRs totaling $968,000 during the six months ended June 30, 2014. During the same period, there were eight TDRs totaling $2.4 million that were no longer reported as TDRs due to the payment of principal and interest at market rates for greater than six months.

 

The OREO balance was $6.6 million at June 30, 2014, a decrease of $244,000 compared to $6.8 million at December 31, 2013. This decrease consisted of valuation allowances of $234,000 to adjust properties to current appraised values and $1.1 million in disposals, partially offset by additions of $1.1 million. OREO carrying amounts reflect management’s estimate of the realizable value of these properties incorporating current appraised values, local real estate market conditions and related costs.

 

At June 30, 2014, 98%, or $111.9 million of the asset-backed securities portfolio was rated AAA by Standard & Poor’s or the equivalent credit rating from another major rating agency compared to 98% or $126.6 million at December 31, 2013. Debt securities are evaluated quarterly to determine whether a decline in their value is OTTI. No OTTI charge was recorded for the six months ended June 30, 2014 and the year ended December 31, 2013. Classified securities decreased $439,000 from $2.4 million at December 31, 2013 to $2.0 million at June 30, 2014.

 

Overall asset quality ratios have improved since December 31, 2013 with non-accrual loans and OREO to total assets and non-accrual loans, OREO and TDRs to total assets improving 39 and 51 basis points, respectively, from 2.17% and 2.60%, respectively, at December 31, 2013 to 1.78% and 2.09%, respectively, at June 30, 2014.

 

Management considers classified assets to be an important measure of asset quality. Classified assets have been trending down from a high point of $81.9 million at September 30, 2011. Classified assets have decreased $4.8 million or 8.4% from $56.9 million at December 31, 2013 to $52.1 million at June 30, 2014. The following is a breakdown of the Company’s classified and special mention assets at June 30, 2014 and December 31, 2013, 2012 and 2011, respectively:

 

Classified Assets and Special Mention Assets
(dollars in thousands)  As of
June 30, 2014
   As of
December 31, 2013
   As of
December 31, 2012
   As of
December 31, 2011
 
Classified loans                    
Substandard  $43,367   $47,645   $48,676   $68,515 
Doubtful   174    -    -    - 
Loss   -    -    -    37 
Total classified loans   43,541    47,645    48,676    68,552 
Special mention loans   7,809    9,246    6,092    - 
Total classified and special mention loans  $51,350   $56,891   $54,768   $68,552 
                     
Classified loans   43,541    47,645    48,676    68,552 
Classified securities   2,000    2,438    3,028    6,057 
Other real estate owned   6,553    6,797    6,891    5,029 
Total classified assets  $52,094   $56,880   $58,595   $79,638 

 

Gross unrealized losses on HTM and AFS were $2.3 million and $2.8 million at June 30, 2014 and December 31, 2013, respectively (see Note 10 in Consolidated Financial Statements). Gross unrealized losses at June 30, 2014 for HTM securities were $1.0 million or 3.2% of the book value of $32.7 million. Gross unrealized losses at December 31, 2013 for HTM securities were $1.3 million or 2.8% of the book value of $47.3 million. Gross unrealized losses at June 30, 2014 for AFS securities were $1.3 million or 3.6% of the book value of $35.5 million. Gross unrealized losses at December 31, 2013 for AFS securities were $1.5 million or 3.9% of the book value of $38.5 million. Unrealized losses increased during the second half of 2013 as a result of increases in long-term interest rates and not the result of a deterioration in credit risk. The Bank holds 95% of its AFS and HTM securities as asset-backed securities of GSEs or U.S. government obligations. The Company intends to, and has the ability to, hold both AFS and HTM securities with unrealized losses until they mature, at which time the Company will receive full value for the securities. The Company believes that the AFS and HTM securities with unrealized losses will either recover in market value or be paid off as agreed.

 

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Liabilities

The following table shows the Company’s liabilities and the dollar and percentage changes for the periods presented.

 

   June 30, 2014   December 31, 2013         
(dollars in thousands)  (Unaudited)       $ Change   % Change 
Deposits                    
Non-interest-bearing deposits  $112,648   $103,882   $8,766    8.4%
Interest-bearing deposits   705,896    717,413    (11,517)   (1.6)%
Total deposits   818,544    821,295    (2,751)   (0.3)%
Short-term borrowings   7,000    -    7,000    n/a 
Long-term debt   74,699    70,476    4,223    6.0%
Guaranteed preferred beneficial interest in junior subordinated debentures (TRUPs)   12,000    12,000    -    0.0%
Accrued expenses and other liabilities   9,238    9,323    (85)   (0.9)%
Total Liabilities  $921,481   $913,094   $8,387    0.9%

 

Deposits and Borrowings

Total deposits decreased by 0.3% or $2.8 million, to $818.5 million at June 30, 2014 compared to $821.3 million at December 31, 2013. During 2012 and 2013, the Bank increased transaction deposits, especially noninterest bearing deposits, to lower its overall cost of funds. Transaction deposits have increased from 44.9% of total deposits at December 31, 2011 to 52.7% of total deposits at June 30, 2014. Details of the Company’s deposit portfolio at June 30, 2014 and December 31, 2013 are presented below:

 

   June 30, 2014   December 31, 2013 
(dollars in thousands)  Balance   %   Balance   % 
Noninterest-bearing demand  $113,113    13.82%  $103,882    12.65%
Interest-bearing:                    
Demand   69,700    8.52%   86,954    10.59%
Money market deposits   208,649    25.49%   204,032    24.84%
Savings   39,960    4.88%   39,116    4.76%
Certificates of deposit   387,122    47.29%   387,311    47.16%
Total interest-bearing   705,431    86.18%   717,413    87.35%
                     
Total Deposits  $818,544    100.00%  $821,295    100.00%
                     
Transaction accounts  $431,422    52.71%  $433,984    52.84%

 

The Bank opened its first Fredericksburg, Virginia branch in Central Park on July 15, 2014 and intends to open a second branch in downtown historic Fredericksburg during 2015.

 

The Bank uses both traditional brokered deposits and reciprocal brokered deposits. Traditional brokered deposits at June 30, 2014 and December 31, 2013 were $41.2 million and $27.0 million, respectively. Reciprocal brokered deposits at June 30, 2014 and December 31, 2013 were $28.9 million and $29.4 million, respectively. The reciprocal brokered deposits have many characteristics of core deposits and are used to maximize FDIC insurance available to our customers. The Bank uses the Promontory Network for reciprocal brokered deposits to participate in the Certificate of Deposit Account Registry Service (“CDARS”) and the Insured Cash Sweep product (“ICS”). Long-term debt increased $4.2 million from $70.5 million at December 31, 2013 to $74.7 million at June 30, 2014. During the first quarter of 2014, the Company added $5.0 million in Federal Home Loan Bank advances at 0.52% for two years. The Bank uses brokered deposits and other wholesale funding to supplement funding when loan growth exceeds core deposit growth and for asset-liability management purposes.

 

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Stockholders’ Equity

The following table shows the Company’s equity and the dollar and percentage changes for the periods presented.

 

   June 30, 2014   December 31, 2013         
(dollars in thousands)  (Unaudited)       $ Change   % Change 
                 
Preferred Stock at par of $1,000  $20,000   $20,000   $-    0.0%
Common Stock at par of $0.01   47    46    1    2.2%
Additional paid in capital   46,193    45,881    312    0.7%
Retained earnings   48,544    46,523    2,021    4.3%
Accumulated other comprehensive loss   (895)   (1,057)   162    (15.3)%
Unearned ESOP shares   (663)   (663)   -    0.0%
Total Stockholders' Equity  $113,226   $110,730   $2,496    2.3%

 

During the six months ended June 30, 2014, stockholders’ equity increased $2.5 million to $113.2 million. The increase in stockholders’ equity was due to net income of $3.0 million, net stock related activities related to stock-based compensation and the exercise of options of $312,000 and a current year decrease in accumulated other comprehensive loss of $162,000. These increases to capital were partially offset by quarterly common dividends paid of $935,000 and quarterly preferred stock dividends of $100,000. Increases in common stockholders' equity to $93.2 million at June 30, 2014 have resulted in a book value of $19.89 per common share. The Company remains well-capitalized at June 30, 2014 with a Tier 1 capital to average assets ratio of 12.43%.

 

Accumulated other comprehensive losses increased during the second half of 2013 due to market valuation adjustments of the Company’s AFS asset-backed securities portfolio as a result of increases in long-term interest rates. The Company believes that AFS securities with unrealized losses will either recover in market value or be paid off as agreed. The Company intends to and has the ability to hold these securities to maturity.

 

LIQUIDITY AND CAPITAL RESOURCES

The Company has no business other than holding the stock of the Bank and does not currently have any material funding requirements, except for the payment of dividends on preferred and common stock, and the payment of interest on subordinated debentures.

 

The Company’s principal sources of liquidity are cash on hand and dividends received from the Bank. The Bank is subject to various regulatory restrictions on the payment of dividends.

 

The Bank’s principal sources of funds for investment and operations are net income, deposits, sales of loans, borrowings, principal and interest payments on loans, principal and interest received on investment securities and proceeds from the maturity and sale of investment securities. Its principal funding commitments are for the origination or purchase of loans, the purchase of securities and the payment of maturing deposits. Deposits are considered the primary source of funds supporting the Bank’s lending and investment activities. The Bank also uses borrowings from the FHLB of Atlanta to supplement deposits. The amount of FHLB advances available to the Bank is limited to the lower of 30% of Bank assets or the amount supportable by eligible collateral including FHLB stock, loans and securities. In addition, the Bank has established lines of credit with the Federal Reserve Bank and commercial banks.

 

For additional information on these agreements, including collateral, see Note 11 of the Consolidated Financial Statements as presented in the Company’s Form 10-K for the year ended December 31, 2013.

 

The Bank’s most liquid assets are cash, cash equivalents and federal funds sold. The levels of such assets are dependent on the Bank’s operating, financing and investment activities at any given time. The variations in levels of cash and cash equivalents are influenced by deposit flows and anticipated future deposit flows.

 

Cash and cash equivalents as of June 30, 2014 totaled $11.4 million, a decrease of $13.1 million, or 53.4%, from the December 31, 2013 total of $24.5 million. The decrease in cash was primarily due to an excess of loan originations over principal collected of $39.9 million and a small decrease in deposits of $2.8 million. These decreases to cash were partially offset by increases in total borrowings of $11.2 million, net proceeds from maturing principal and proceeds from the sale of investment securities of $16.1 million, and net income of $3.1 million. Changes to the level of cash and cash equivalents have minimal impact on operational needs as the Bank has substantial sources of funds available from other sources.

 

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During the six months ended June 30, 2014, all financing activities provided $7.5 million in cash compared to $3.3 million in cash used for the same period in 2013. The Bank provided $10.8 million more cash for financing activities in the six months ended June 30, 2014 compared to the six months ended June 30, 2013 primarily due to a reduction in the decrease in deposits from $35.5 million for the six months ended June 30, 2013 to $2.8 million for the six months ended June 30, 2014. The Company did not have any stock repurchases in the first six months of 2014 compared to $298,000 in repurchases in the comparable period of 2013. This increase in the amount of cash provided was partially offset by a reduction in net borrowings of $21.8 million and increased common stock dividends of $326,000 due to more outstanding shares in 2014 compared to 2013.

 

During the six months ended June 30, 2014, all investing activities used $25.4 million in cash compared to $4.4 million in cash provided for the same period in 2013. The primary reason for the reduction in cash of $29.8 million was an increase in loan volume in the first six months of 2014 compared to the first six months of 2013. Cash was used to fund additional loans as loans originated or acquired increased $25.1 million from $112.2 million for the six months ended June 30, 2013 to $137.2 million for the six months ended June 30, 2014. Additionally, a decrease of $16.4 million in cash resulted from a reduction in the amount of principal collected on loans from $113.7 million for the six months ended June 30, 2013 to $97.3 million for the six months ended June 30, 2014. Cash used also increased $691,000 due to premise and equipment purchases. These decreases to cash were partially offset by an increase to cash for securities transactions as the Company used maturing principal and sales proceeds during 2014 to fund loans and operating needs. Net proceeds from securities transactions increased to $14.2 million for the six months ended June 30, 2014 compared to $3.1 million for the six months ended June 30, 2013.

 

Operating activities provided cash of $4.7 million for the six months ended June 30, 2014 compared to $3.1 million of cash provided for the same period of 2013. Cash increased by $1.6 million primarily due to a decrease in deferred tax assets, a reduction in the decrease of accrued expenses and other liabilities, a decrease in other assets and an increase in the provision for loan losses for the six months ended June 30, 2014 compared with the six months ended June 30, 2013. These increases in cash were partially offset by a reduction in net proceeds from the sale of loans held for sale during the first six months of 2014 compared to the same period in 2013.

 

ITEM 3. Quantitative and qualitative Disclosure about Market Risk

Not applicable as the Company is a smaller reporting company.

 

ITEM 4. CONTROLS AND PROCEDURES

As of the end of the period covered by this report, management of the Company carried out an evaluation, under the supervision and with the participation of the Company’s principal executive officer and principal financial officer, of the effectiveness of the Company’s disclosure controls and procedures. Based on this evaluation, the Company’s principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures are effective in ensuring that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934, as amended, (1) is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and (2) is accumulated and communicated to the Company’s management, including its principal executive and financial officers as appropriate to allow timely decisions regarding required disclosure. It should be noted that the design of the Company’s disclosure controls and procedures is based in part upon certain reasonable assumptions about the likelihood of future events, and there can be no reasonable assurance that any design of disclosure controls and procedures will succeed in achieving its stated goals under all potential future conditions, regardless of how remote, but the Company’s principal executive and financial officers have concluded that the Company’s disclosure controls and procedures are, in fact, effective at a reasonable assurance level. There were no changes in the Company’s internal control over financial reporting during the quarter ended June 30, 2014 that have materially affected, or are reasonable likely to materially affect, the Company’s internal control over financial reporting.

 

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PART II - OTHER INFORMATION

Item 1 - Legal Proceedings – The Company is not involved in any pending legal proceedings. The Bank is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business. Such routine legal proceedings, in the aggregate, are believed by management to be immaterial to the financial condition and results of operations of the Company.

 

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 Form 10-K that we filed with the Securities and Exchange Commission, which could materially affect our business, financial condition or future results. The risks described are not the only risks that we face. 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.

 

Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds 

  (a) Not applicable

  (b) Not applicable

  (c) On September 25, 2008, the Company announced a repurchase program under which it would repurchase up to 5% of its outstanding common stock or approximately 147,435 shares. The program will continue until it is completed or terminated by the Company’s Board of Directors. As of June 30,  2014, 66,046 shares were available to be repurchased under the repurchase program. There were no repurchases during the three months ended June 30, 2014.

 

Item 3 - Default Upon Senior Securities - None

 

Item 4 – Mine Safety Disclosures – Not Applicable

 

Item 5 - Other Information - None

 

Item 6 - Exhibits

Exhibit 31 - Rule 13a-14(a) Certifications

Exhibit 32 - Section 1350 Certifications

Exhibit 101.0 - The following materials from the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2014, formatted in XBRL (Extensible Business Reporting Language): (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income and Comprehensive Income, (iii) the Consolidated Statements of Cash Flows; and (iv) the Notes to the Consolidated Financial Statements.

 

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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.

 

  THE COMMUNITY FINANCIAL CORPORATION
     
Date: August 4, 2014   By: /s/ William J. Pasenelli
    William J. Pasenelli
    President and Chief Executive Officer
     
Date: August 4, 2014 By:  /s/ Todd L. Capitani
    Todd L. Capitani
    Chief Financial Officer

 

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