FARMERS & MERCHANTS BANCORP INC - Quarter Report: 2010 September (Form 10-Q)

 

 

 

 

 

ITEM 2 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS (Continued)

LIQUIDITY AND CAPITAL RESOURCES (Continued)

offered through correspondent banks. Overall, cash and cash equivalents increased over $22.5 million and securities increased an additional $44.5 million. The Company’s increased liquidity came from a decrease of almost $24.1 million in the Bank’s loan portfolio and deposit growth of $36.9 million. During the quarter, $8 million in other borrowed money from the Federal Home Loan Bank was paid off from term deposits that were being held there. This was calculated, as $9 million was borrowed in the first quarter of 2010 to lock in lower rates. Liquidity remains high with the Bank also having access to $27 million of unsecured borrowings through correspondent banks and $70.5 million of unpledged securities which may be sold or used as collateral. The strength of the security portfolio is shown in the tables to follow. With the exception of stock, all of the Bank’s security portfolio is categorized as available for sale and as such is recorded at market value. The charts which follow do not include stock.

Investment securities will at times depreciate to an unrealized loss position. The Bank utilizes the following criteria to assess whether or not an impaired security is other than temporary. No one item by itself will necessarily signal that a security should be recognized as other than temporary impairment.

1. The fair value of the security has significantly declined from book value.

2. A down grade has occurred that lowers the credit rating to below investment grade (below Baa3 by Moody and BBB- by Standard and Poors).

3. Dividends have been reduced or eliminated or scheduled interest payments have not been made.

4. The underwater security has longer than 10 years to maturity and the loss position had existed for more than 3 years.

5. Management does not possess both the intent and ability to hold the security for a period of time sufficient to allow for any anticipated recovery in fair value.

If the impairment is judged to be other than temporary, the cost basis of the individual security shall be written down to fair value, thereby establishing a new cost basis. The amount of the write down shall be included in earnings as a realized loss. The new cost basis shall not be changed for subsequent recoveries in fair value. The recovery in fair value shall be recognized in earnings when the security is sold. The first table is presented by category of security and length of time in a continuous loss position. The Bank currently does not hold any securities with other than temporary impairment.

		Less Than Twelve Months (In Thousands)								Twelve Months & Over ( In Thousands)
		Gross Unrealized				Fair				Gross Unrealized				Fair
September 30, 2010		Losses				Value				Losses				Value
U.S. Treasury		$	—			$	—			$	—			$	—
U.S. Government agency			—				—				—				—
Mortgage-backed securities			—				—				—				—
State and local governments			127				12,752				—				—

The following chart shows the breakdown of the unrealized gain or loss associated within each category of the investment portfolio as of September 30, 2010.

						September 30, 2010				(In Thousands)
						Gross				Gross				Estimated
		Amortized				Unrealized				Unrealized				Market
		Cost				Gains				Losses				Value
Available-for-Sale:
U.S. Treasury		$	27,513			$	162			$	—			$	27,675
U.S. Government agency			129,040				2,081				—				131,121
Mortgage-backed securities			27,029				1,457				—				28,486
State and local governments			62,377				2,209				(127	)			64,459
		$	245,959			$	5,909			$	(127	)		$	251,741

ITEM 2 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS (Continued)
LIQUIDITY AND CAPITAL RESOURCES (Continued)

The following table shows the maturity schedule of the security portfolio with the largest portion due within less than 5 years.

		September 30, 2010				(In Thousands)
		Amortized Cost				Fair Value
One year or less		$	3,771			$	3,793
After one year through five years			118,409				120,328
After five years through ten years			78,148				80,037
After ten years			18,602				19,097
Subtotal		$	218,930			$	223,255
Mortgage Backed Securities			27,029				28,486
Total		$	245,959			$	251,741

Net loans show a decrease of $24.1 million for the nine months ended September 30, 2010. $4.3 million was charged-off during the nine month period. While over $7 million came off the watch list during the third quarter, it was not all due to having been charged-off. A portion of the decrease is positive in that troubled loans were either paid off or were refinanced elsewhere. The purchase of the Hicksville office added approximately $14 million in loans, mainly in the 1-4 family real estate portfolio. Overall, total assets of the Company increased $46.2 million from December 31, 2009 to September 30, 2010.

The following chart shows the breakdown of the loan portfolio as of December 31st for past years and as of the current quarter ended for the current year.

		(In Thousands)
		30-Sep
		2010				2009				2008				2007				2006				2005
Loans:
Commercial Real Estate		$	215,142			$	214,849			$	226,761			$	181,340			$	162,363			$	113,283
Agricultural Real Estate			35,820				41,045				48,607				45,518				49,564				50,777
Consumer Real Estate			88,721				98,599				89,773				102,660				86,688				115,831
Commercial/Industrial			117,625				120,543				112,526				104,188				101,788				81,893
Agricultural			58,057				59,813				56,322				58,809				69,301				61,502
Consumer			29,267				32,581				26,469				27,796				27,388				31,935
Industrial Development Bonds			2,182				2,552				7,572				9,289				7,335				9,237
Total Loans		$	546,814			$	569,982			$	568,030			$	529,600			$	504,427			$	464,458

The following table shows the maturity of loans as of September 30, 2010:

		(In Thousands)
						Maturities
						After One
		Within				Year Within				After
		One Year				Five Years				Five Years				Total
Commercial Real Estate		$	41,073			$	127,430			$	46,639			$	215,142
Agricultural Real Estate			6,626				14,554				14,640				35,820
Consumer Real Estate			6,370				18,963				63,388				88,721
Commercial/Industrial			81,962				27,468				8,195				117,625
Agricultural			42,765				12,378				2,914				58,057
Consumer			5,262				21,427				2,578				29,267
Industrial Development Bonds			580				551				1,051				2,182

The following table presents the total of loans due after one year which has 1) predetermined interest rates as of September 30, 2010. 2) floating or adjustable interest rate as of September 30, 2010.

		(In Thousands)
		Fixed				Variable
		Rate				Rate
Commercial Real Estate		$	62,438			$	111,631
Agricultural Real Estate			16,393				12,801
Consumer Real Estate			72,355				9,996
Commercial/Industrial			28,836				6,827
Agricultural			15,138				154
Consumer			24,005				—
Industrial Development Bonds			1,602				—

ITEM 2 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS (Continued)
LIQUIDITY AND CAPITAL RESOURCES (Continued)

Deposits increased $36.9 million in total from December 31, 2009. The mix of the portfolio continued to transition to a higher level of core deposits as a result primarily of the Bank’s offering of a high interest bearing transaction account along with an increase in health savings accounts. The success of this product is also the reason for the continued movement of deposits out of Certificates of Deposit to interest bearing transaction accounts. In 2010, the Bank strengthened its line of deposit products by adding additional products which added additional options to its already highly successful Reward Checking, which was renamed KASASA Cash. The additional options include KASASA Saver, KASASA Giver and KASASA ITunes. These continue to be the deposit of choice and attract not only new money from existing customers but new customers to the Bank also.

The Certificate of Deposit (COD) portfolio has decreased $1.8 million during the first three quarters of 2010 which is helping to decrease the cost of funds, as demonstrated below in the section of this MD&A captioned “MATERIAL CHANGES IN RESULTS OF OPERATION — Interest Expense”.

Capital increased approximately $3.2 million from year-end during the nine months of 2010. The increase occurred even with the Company’s repurchase of 27,725 shares of common stock costing $533 thousand which took place in the first six months. Positive earnings and an increase in accumulated other comprehensive income offset the stock repurchases. Comprehensive income increased $1.3 million even with the shift of $956 thousand from unrealized gain to realized gain with the sale of securities. Dividends remained stable during the period.

The Company continues to be well-capitalized in accordance with Federal regulatory capital requirements as the capital ratios below show:

Primary Ratio			10.71	%
Tier I Leverage Ratio			9.96	%
Risk Based Capital Tier I			13.59	%
Total Risk Based Capital			14.72	%
Stockholders’ Equity/Total Assets			10.75	%

MATERIAL CHANGES IN RESULTS OF OPERATIONS

Interest Income

Annualized interest income and yield on earning assets is down in 2010 as compared to September 30, 2009. While total assets were higher than year end, the decrease resulted primarily from the transition of the Company’s earning assets from high yield to lower yield assets. As the table that follows confirms, the shift of funds within the interest earning portfolios caused a lower yield thereby causing lower interest income even though assets increased. The largest change in yield came in the additions to the taxable security portfolio as the Bank sought to keep the growth in shorter periods for liquidity.

The Bank worked to minimize the impact of the low rate environment on its loan portfolio with the use of floors to renewed and new loans. Adjustments to the Farmer Mac portfolio, which is a loan participation program, also generated additional interest income. To protect the yield, the Bank is working to add spread to the margin on the variable rate loans so that when prime does adjust up, the Bank’s rate also adjusts up over the floor. Overall, interest income from loans was down $406 thousand in comparing the nine months ended September 30, 2010 to same period for 2009. However, interest income from loans was up $9 thousand in comparing the quarter ended September 30, 2010 to 2009.

Interest income and yield on the securities portfolio was down as agency notes continued to be called due to the low interest rate environment. Period ending balances are deceiving as compared to the interest earnings due to the shift of holdings from the sales, calls and maturity and the replacement securities. The average balances in the table are more useful to see the impact of those activities.

Total interest income was down almost $700 thousand in comparing the first nine month of 2010 to the first nine months of 2009.

ITEM 2 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS (Continued)
MATERIAL CHANGES IN RESULTS OF OPERATIONS (Continued)
Interest Income (Continued)

						(In Thousands)
						September 30, 2010								September 30, 2009
		Average Balance				Interest/Dividends				Yield/Rate				Yield/Rate
Interest Earning Assets:
Loans		$	556,598			$	24,878				5.99	%			6.06	%
Taxable Investment Securities			168,111				3,708				2.94	%			4.09	%
Tax-exempt Investment Securities			58,300				1,558				5.40	%			5.46	%
Fed Funds Sold & Interest Bearing Deposits			40,840				74				0.24	%			0.22	%
Total Interest Earning Assets		$	823,849			$	30,218				5.04	%			5.50	%

     Change in September 30, 2010 Interest Income (In Thousands) Compared to September 30, 2009

		Change				Due to Volume				Due to Rate
Interest Earning Assets:
Loans		$	(406	)		$	(188	)		$	(218	)
Taxable Investment Securities			(696	)			966				(1,662	)
Tax-exempt Investment Securities			364				1,014				(650	)
Fed Funds Sold & Interest Bearing Deposits			40				64				(24	)
Total Interest Earning Assets		$	(698	)		$	1,856			$	(2,554	)

The yields on tax-exempt securities and the portion of tax-exempt IDB loans included in loans have been tax adjusted based on a 34% tax rate in the charts above.

Interest Expense

Interest expense continued to be lower than the comparable three months and nine months periods from 2009. Interest expense related to deposits was down $1.4 million while the deposit balance increased by $70.7 million in comparing the ending balances of each first nine months. Approximately $28 million of the growth came through the purchase of the Hicksville office. Time deposits continue to reprice down and the Bank continues to try and lengthen the duration of the portfolio with specials offered in terms longer than 12 months. However, depositors continue to place more funds in shorter term deposits or move elsewhere.

Interest on borrowed funds was $325 thousand and $66 thousand lower, respectively, for the nine and three month periods ended September 30, 2010, than for the comparable periods of 2009. While additional borrowings from Federal Home Loan Bank in the amount of $9 million were taken in the first quarter of 2010, the rates on those borrowings were lower than those paid off during 2009. Rates paid on the daily repurchase agreements, used by the Bank to offset commercial sweep accounts, were also lower in 2010 than the corresponding rate paid in 2009. Advances from the Federal Home Loan Bank were taken to offset maturities of $13 million scheduled for the remainder of 2010 of which $8 million matured in the third quarter and to lock in a lower rate for a longer length of time.

The decrease in interest expense outpaced the decrease in interest income and remains a bright spot in the performance of 2010 as it was throughout 2009.

						(In Thousands)
						September 30, 2010								September 30, 2009
		Average Balance				Interest/Dividends				Yield/Rate				Yield/Rate
Interest Bearing Liabilities:
Savings Deposits		$	299,312			$	1,617				0.72	%			0.69	%
Other Time Deposits			320,602				5,400				2.25	%			2.99	%
Other Borrowed Money			39,964				1,185				3.95	%			4.49	%
Fed Funds Purchased & Securities Sold under Agreement to Repurch			45,126				204				0.60	%			1.09	%
Total Interest Bearing Liabilities		$	705,004			$	8,406				1.59	%			2.05	%

ITEM 2 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS (Continued)
MATERIAL CHANGES IN RESULTS OF OPERATIONS (Continued)
Interest Expense (Continued)

Change in September 30, 2010 Interest Expense (In Thousands) Compared to September 30, 2009

		Change				Due to Volume				Due to Rate
Interest Bearing Liabilities:
Savings Deposits		$	292			$	414			$	(122	)
Other Time Deposits			(1,682	)			152				(1,834	)
Other Borrowed Money			(160	)			1				(161	)
Fed Funds Purchased & Securities Sold under Agreement to Repurch.			(165	)			1				(166	)
Total Interest Bearing Liabilities		$	(1,715	)		$	568			$	(2,283	)

Net Interest Income

Net interest income is higher in both quarter and first nine months comparisons, which improvement is primarily due to the ability of the Bank to decrease its cost of funds by lowering rates on interest bearing liabilities. This decrease offset the loss of interest income due to lower overall rates on earning assets. The additional revenue helped to offset the loan costs in provision and collection expense.

Net interest income should continue to increase as the Bank continues to work to increase interest income by reducing the amount of nonaccrual loans and attempting to add spread on renewing loans. Interest expense on time deposits should also continue to show a decrease until depositors begin to transition back into longer-term deposits. If and when rates begin to rise, the challenge will be to delay the pricing up of deposits.

Provision Expense

Provision for loan loss was over $1.7 million higher for the nine months ended September 2010 as compared to the same 2009 period. The continuation of a large balance in nonaccrual loans, though decreasing the last two quarters, along with challenging economic conditions warranted the high provision to the loan loss reserve. Non-accruals decreased $2.1 million during the first nine months of 2010 and past dues over 30 days decreased to 2.17% of total loans as of September 30, 2010 from 2.26% at December 31, 2009. The Bank continues to work on these accounts, with its focus primarily on the commercial and com- mercial real estate portfolios. For the nine months ended September 30, 2010, the ALLL stood at $7.0 million compared to $7.4 million as of September 30, 2009 and $6.0 million as of December 31, 2009. The provision of $4.9 million as of September 30, 2010 consisted of $1.7 million for the first quarter 2010, another $2.0 million in the second quarter and another $1.2 million for the third quarter. One million of the provision was allocated for two specific commercial loans whose collateral values had deteriorated upon receipt of new valuations. As charts below will show, a part of the provision was also to replace the reserve balance depleted from net charge-offs during the period. The longer the economy struggles, the more likely additional credits may encounter cash flow problems and the Bank remains diligent in providing funds to offset future losses.

The Bank uses the following guidelines as stated in policy to determine when to realize a charge-off, whether a partial or full loan balance. A charge down in whole or in part is realized when unsecured consumer loans, credit card credits and overdraft lines of credit reach 90 days delinquency. At 120 days delinquent, secured consumer loans are charged down to the value of the collateral, if repossession of the collateral is assured and/or in the process of repossession. Consumer mortgage loan deficiencies are charged down upon the sale of the collateral or sooner upon the recognition of collateral deficiency. Commercial and agricultural credits are charged down at 120 days delinquency, unless an established

ITEM 2 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS (Continued)
MATERIAL CHANGES IN RESULTS OF OPERATIONS (Continued)
Provision Expense (Continued)

and approved work-out plan is in place or litigation of the credit will likely result in recovery of the loan balance. Upon notification of bankruptcy, unsecured debt is charged off. Additional charge-off may be realized as further unsecured positions are recognized.

Looking at the balance in impaired loans, it shows the Bank has finally had some movement of loans out of this classification, $3.3 million. The decrease was due mainly to the collection of principal from the sale of collateral from one borrower and the remainder from charge-off activity within this classification of loans.

The make-up of loans in the impaired classification has also changed during the nine month period with over one third of the relationships considered impaired as of December 31, 2009 are no longer included in the balances in September 2010. The following table tracks the change in impaired loans and their valuation allowance along with nonaccrual balances as of year end 2009 and the quarter ending September 30, 2010.

		(In Thousands)
		9/30/2010				12/31/2009
Impaired loans without a valuation allowance		$	5,213			$	10,804
Impaired loans with a valuation allowance			3,698				1,385
Total impaired loans		$	8,911			$	12,189
Valuation allowance related to impaired loans		$	1,545			$	353
Total non-accrual loans		$	11,981			$	14,054
Total loans past-due ninety days or more and still accruing		$	22			$	69
Average investment in impaired loans		$	11,730			$	13,643

The Bank did classify almost $4 million of its impaired loans as troubled debt restructured during the third quarter of 2010.

In determining the allocation for impaired loans the Bank applies the observable market price of the collateral securing the asset, reduced by applying a discount for estimated costs of collateral liquidation. In some instances where the discounted market value is less than the loan amount, a specific impairment allocation is assigned, which may be reduced or eliminated by the write down of the credit’s active principal outstanding balance.

For the majority of the Bank’s impaired loans, the Bank will apply the observable market price methodology. However, the Bank may also utilize a measurement incorporating the present value of expected future cash flows discounted at the loan’s effective rate of interest. To determine observable market price, collateral asset values securing an impaired loan are periodically evaluated. Maximum time of re-evaluation is every 12 months for chattels and titled vehicles and every two years for real estate. In this process, third party evaluations are obtained and heavily relied upon. Until such time that updated appraisals are received, the Bank may discount the collateral value used.

The ALLL has a direct impact on the provision expense. The increase in the ALLL is funded through recoveries and provision expense. The following tables both deal with the allowance for credit losses. The first table breaks down the activity within ALLL for each loan portfolio segment and shows the contribution provided by both the recoveries and the provision along with the reduction of the allowance caused by charge-offs. The second table discloses how much of ALLL is attributed to each segment of the loan portfolio, as well as the percent that each particular segment of the loan portfolio represents to the entire loan portfolio in the aggregate. As was mentioned in previous discussion, the commercial and commercial real estate portfolios are having a major impact on the ALLL and the provision expense.

ITEM 2 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS (Continued)

MATERIAL CHANGES IN RESULTS OF OPERATIONS (Continued)

Provision Expense (Continued)

		(In Thousands)
		Year-to-date				Year-to-date
		September 30, 2010				September 30, 2009
Loans		$	546,814			$	560,823
Daily average of outstanding loans		$	557,001			$	558,951
Allowance for Loan Losses-Jan 1		$	6,008			$	5,497
Loans Charged off:
Commercial Real Estate			205				—
Ag Real Estate			—				—
Consumer Real Estate			423				284
Commercial and Industrial			3,413				620
Agricultural			100				198
Consumer & other loans			320				262
			4,461				1,364
Loan Recoveries:
Commercial Real Estate			51				—
Ag Real Estate			—				—
Consumer Real Estate			54				6
Commercial and Industrial			363				17
Agricultural			6				2
Consumer & other loans			109				119
			583				144
Net Charge Offs			3,878				1,220
Provision for loan loss			4,875				3,170
Acquisition provision for loan loss			—				—
Allowance for Loan & Lease Losses			7,005				7,447
Allowance for Unfunded Loan Commitments & Letters of Credit — Sept 30			189				286
Total Allowance for Credit Losses		$	7,194			$	7,734
Ratio of net charge-offs to average Loans Outstanding			0.70	%			0.22	%
Ratio of ALLL to Nonperforming Loans*			58.46	%			42.59	%

*     Nonperforming loans are defined as all loans on nonaccrual, plus any loans past 90 days not on nonaccrual.

		September 30,2010								September 30, 2009
		Amount				%				Amount				%
		(000’s)				of Portfolio				(000’s)				of Portfolio
Balance at End of Period Applicable To:
Commercial Real Estate		$	2,953				39.34			$	1,803				37.69
Ag Real Estate			140				6.55				79				7.79
Consumer Real Estate			298				16.23				524				17.57
Commercial and Industrial			2,908				21.57				3,806				19.95
Agricultural			288				10.55				742				10.40
Consumer, Overdrafts and other loans			418				5.75				494				6.60
Unallocated			—								—
Allowance for Loan & Lease Losses			7,005				100				7,448				100
Off Balance Sheet Commitments			189								286
Total Allowance for Credit Losses		$	7,194							$	7,734

The percentage of delinquent loans has trended downward since the beginning of 2010 from a high of 2.85% of total loans in January to a low of 1.97% as of the end of June 2010. These percentages do not include nonaccrual loans which are not past due. This level of delinquency is due in part to an adherence to sound underwriting practices over the course of time, an improvement in the financial status of companies to which the Bank extends credit, continued financial stability in the agricultural loan portfolio, and the writing down of uncollectable credits in a timely manner.

ITEM 2 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS (Continued)

MATERIAL CHANGES IN RESULTS OF OPERATIONS (Continued)

Non-interest Income

Non-interest income was higher for the three and nine months ended September 30, 2010 as compared to same periods in September 30, 2009. It is surprising; because it is a reversal of the same comparison of the first quarter 2010 to the first quarter of 2009. First quarter 2009 performance was exceptional with the addition of revenue coming from the mortgage financing activity and sale of consumer real estate loans into the secondary market. Mortgage financing in 2010 has been minimal at best; however, the activity picked-up again in the third quarter of 2010. Offsetting the impact of the loss of mortgage financing revenue was the gain on sale of securities which was $809 thousand higher than the nine month period ended September 30, 2009 of which $438 thousand was the increase for just the quarter ended September 30, 2010. Service Charge income was also higher in both quarters with a difference of $210 thousand in year-to-date comparison of 2010 and 2009. The majority of the increase was associated with overdraft and return check fees. The increase in the checking and savings portfolios in terms of number of accounts has been the main factor behind the additional collection of fees. Overall, non-interest income improved and ended $955 thousand higher for the first nine months of operations in 2010 as compared to 2009.

The impact of mortgage servicing rights, both to income and expense, is shown in the following table which reconciles the value of mortgage servicing rights which is reported as an “other asset” on the balance sheet. The capitalization runs through non-interest income while the amortization thereof is included in non-interest expense.

(In Thousands)		September 30, 2010				September 30, 2009
Beginning Balance, January 1		$	2,177			$	1,962
Capitalized Additions			421				1,056
Amortizations			(410	)			(828	)
Valuation Allowance			0				0
Ending Balance, September 30		$	2,188			$	2,190

Of concern for the remainder of the year is the impact of recently amended Federal Reserve Regulation E on overdraft revenue and the cost of compliance. Regulation E requires confirmation to be received from the depositor to allow overdrafts to occur on point of sale (debit) card and ATM transactions. Customers must notify us of their decision to either “Opt In” or “Opt Out” of the Bank’s overdraft protection program. Opting in allows the overdraft and also allows the Bank to charge accordingly. At this point in time, the Bank has been very pleased with the response of 85% of our target depositors “opting in”. Target depositors are those who have had overdraft since January 1, 2009. “Opting in” enables the customer to access funds available through the Bank’s overdraft protection program. Industry projections had been for a possible loss of income from 30 to 50% for Banks; however the Bank is optimistic that with the positive response received thus far, the loss of revenue will be lower. Since its implementation in the middle of August, for the two months ended, the decrease has only been 11%.

As long as the opportunity exists for gains to be recognized from the sale of securities without impacting yield and extending the maturity duration too long, the Bank will continue to take advantage of it. This provides an opportunity for the Bank to offset the loss of both noninterest income from the mortgage financing of 2009 and possible future overdraft revenue. The gain booked in 2010 was based on security sales of $55.7 million while 2009’s nine months gain was based on security sales of $4.2 million. There were not any securities sold at a loss in the nine month periods ending September 30, 2009 and 2010.

The movement of income from comprehensive income to realized gain on sale of securities is disclosed in the table to follow. Since the Bank classifies its entire investment portfolio, with the exception of stock, as available for sale, the majority of any gain/loss on the sale is a direct shift of funds from unrealized gain to realized gain. Since the purchase of additional or replacement securities occurs at the same time, those new securities immediately impact the other comprehensive income. Also impacting the comprehensive income is the movement of the market rates in general and its impact on the overall portfolio.

ITEM 2 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS (Continued)

MATERIAL CHANGES IN RESULTS OF OPERATIONS (Continued)

Non-Interest Income (Continued)

		(In Thousands)
		Nine Months Ended				Three Months Ended
		September 30, 2010				September 30, 2010
Net Unrealized gain on available-for-sale securities			2,930				2,072
Reclassification adjustment for gain on sale of available-for-sale securities			(956	)			(438	)
Net unrealized gains			1,974				1,634
Tax Effect			671				556
Other comprehensive income			1,303				1,078

Non-Interest Expense

Non-interest expenses for the quarter ended September 30, 2010 was $92 thousand higher than for the same period of 2009. For the nine months ended September 30, 2010, it was at $87 thousand lower than for the same period of 2009. Salaries and wages was higher by $87 thousand during the quarter which was expected with the addition of the Hicksville office. The larger increase was in other operating expenses, driven primarily by loan collection expenses. One of the benefits of the mortgage financing in 2009 was the addition of mortgage servicing rights income and its large increase over the amortization expense of those rights. Mortgage servicing expense therefore was a large piece of the non-interest expense in 2009 and since the mortgage financing has slowed considerably in 2010, that expense is $417 thousand lower year to date than what it was in 2009 as of September 30th, though somewhat lower than the difference of $484 thousand as of the end of June 30th, 2010.

With respect to FDIC assessments, in the second quarter of 2009 the FDIC levied a special assessment on all banks, in addition to the regular assessments and while the expense is still high in 2010, it does not include an additional assessment. As a result, FDIC expense was approximately $315 thousand lower year to date than 2009. Continuing on the positive side, a smaller decrease of $99 thousand in comparing September 30, 2010 to September 30, 2009 was derived from a change in service bureaus for the Bank’s core operating system. This change occurred in late first quarter so the Bank would expect this lower cost to carry forward throughout 2010. The improvement continued even with the addition of the new branch office in Hicksville, Ohio in July 2010, though it did lessen the savings in terms of actual dollars spent but not in prorata costs.

The higher expense for salary and wages was also related to the reduction of the contra account that serves as an offset for loan origination costs. With loan production lower, deferred loan costs established were $410 thousand lower and accounted for a larger portion of the line item increase in salaries and wages.

Occupancy expense was lower by $194 thousand in the nine months comparison of 2010 to 2009 and lower by $82 thousand in the three months ended September 30th comparing 2010 and 2009. The reduction is partly attributed to the increase in building rent of $89 thousand which serves as an offset to this line item. The Bank collects building rent from the F&M Investment division which offers a brokerage service through a partnership with Raymond James Financial. F&M Investment is not a separate company but a department within the Bank. The Bank also collects rental income on some of its other real estate owned.

The increase in troubled loans impacts more than just the interest income of the Bank. It also tends to increase the cost of collection and legal fees, all of which added together accounted for an increase of $218 thousand for 2010 over the first nine months 2009 in non-interest expense.

Net Income

Overall, net income was up $389 thousand for the nine months ended September 30, 2010, and $921 thousand for the three compared months ended September 30, 2010 as to the same periods 2009. For the first time in 2010, the Company showed an improvement year to date over the comparable period in 2009. This is important to note in that it highlights the Company has made improvements that significantly impact the bottom line when the loan provision entries for each of the three quarters of 2010 is reviewed. The gain on sale of investments obviously plays a large role in the improvement and the Company

ITEM 2 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS (Continued)

MATERIAL CHANGES IN RESULTS OF OPERATIONS (Continued)

Net Income (Continued)

is fortunate that the opportunity existed to capture income that has been used to offset the large provision expense. However, the gain on sale is not the only bright spot that occurred in the third quarter. The improvement in net interest income for the quarter and also in the net non-interest position of the Company bodes well for continued improvement in profitability through the last quarter of 2010.

The Company remains positioned for continued improvement in the net interest margin while rates remain low. It will be a challenge to maintain the margin once short term rates begin to rise. However, the Bank remains focused on improving the asset yield through improved asset quality and added spread to prime on variable loans. As long as the economy remains slow, the Company’s goals may be hampered by increasing troubled loans even though the Bank has been working diligently to limit its exposure. As an industry, the Company is also limited from achieving higher profitability by the cost of FDIC assessments and increased regulatory requirements such as Regulation E, the newly passed Dodd-Frank Wall Street Reform and Consumer Protection Act and any other additional regulations that may be enacted during 2010 and their corresponding cost of compliance.

FORWARD LOOKING STATEMENTS

Statements contained in this portion of the Company’s report may be forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements may be identified by the use of words such as “intend,” “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” and “potential.” Such forward-looking statements are based on current expectations, but may differ materially from those currently anticipated due to a number of factors, which include, but are not limited to, factors discussed in documents filed by the Company with the Securities and Exchange Commission from time to time. Other factors which could have a material adverse effect on the operations of the company and its subsidiaries which include, but are not limited to, changes in interest rates, general 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 or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Bank’s market area, changes in relevant accounting principles and guidelines and other factors over which management has no control. The forward-looking statements are made as of the date of this report, and the Company assumes no obligation to update the forward-looking statements or to update the reasons why actual results differ from those projected in the forward-looking statements.

ITEM 3 QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk is the exposure to loss resulting from changes in interest rates and equity prices. The primary market risk to which the Company is subject to is interest rate risk. The majority of the Company’s interest rate risk arises from the instruments, positions and transactions entered into for purposes, other than trading, such as lending, investing and securing sources of funds. Interest rate risk occurs when interest bearing assets and liabilities reprice at different times as market interest rates change. For example, if fixed rate assets are funded with variable rate debt, the spread between asset and liability rates will decline or turn negative if rates increase.

Interest rate risk is managed within an overall asset/liability framework for the Company. The principal objectives of asset/liability management are to manage sensitivity of net interest spreads and net income to potential changes in interest rates. Funding positions are kept within predetermined limits designed to ensure that risk-taking is not excessive and that liquidity is properly managed.

ITEM 3 QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK (Continued)

Market Risk (Continued)

The Company employs a sensitivity analysis in the form of a net interest rate shock as shown in the following table.

Interest Rate Shock on Net Interest Margin						Interest Rate Shock on Net Interest Income
		% Change								% Change
Net Interest		to		Rate		Rate		Cumulative		to
Margin (Ratio)		Flat Rate		Direction		Changes by		Total ($000)		Flat Rate
3.05%		-8.52%		Rising		3.000%		25,844		-7.79%
3.15%		-5.73%		Rising		2.000%		26,553		-5.26%
3.24%		-2.98%		Rising		1.000%		27,258		-2.75%
3.34%		0.00%		Flat		0.000%		28,028		0.00%
3.39%		1.42%		Falling		-1.000%		28,643		2.19%
3.33%		-0.12%		Falling		-2.000%		28,640		2.18%
3.22%		-3.57%		Falling		-3.000%		28,266		0.85%

The net interest margin represents the forecasted twelve month margin. It also shows what effect rate changes will have on both the margin and the net interest income. The shock report has consistently shown an improvement in a falling rate environment at the 100 basis point drop. It is hard to imagine that the Company could actually experience a 200 basis point or higher drop in the low rate environment of today. The goal of the Company is to lengthen some of the liabilities or sources of funds to decrease the exposure to a rising rate environment. The Bank has offered higher rates on certificates of deposits for longer periods during 2009 and so far in 2010. Of course, customer desires also drive the ability to capture longer term deposits. Currently, the customer looks for terms twelve months and under while the Bank would prefer 24 months and longer. It is often a meeting in the middle that satisfies both.

The Bank continues to remain focused on gaining more relationships per customer as a way to help control the cost of funds also. In the flat and rising rate environment scenario, the model cannot take into account the addition of floors and increased spread on the loan accounts. These are added as the note is renewed and cannot be captured until then. To the extent the Bank is successful in this endeavor, the flat and rising rate scenario will be more profitable than forecasted here.

ITEM 4 CONTROLS AND PROCEDURES

As of September 30, 2010, an evaluation was performed under the supervision and with the participation of the Company’s management including the CEO and CFO, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on that evaluation, the Company’s management, including the CEO and CFO, concluded that the Company’s disclosure controls and procedures were effective as of September 30, 2010. There have been no significant changes in the Company’s internal control over financial reporting that occurred during the quarter ended September 30, 2010.

PART II

ITEM 1 LEGAL PROCEEDINGS

None

ITEM 1A RISK FACTORS

There have been no material changes in the risk factors disclosed by Registrant in its Report on Form 10-K for the fiscal year ended December 31, 2009.