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FIRST KEYSTONE CORP - Quarter Report: 2018 March (Form 10-Q)

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C. 20549

 

FORM 10Q

 

xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended March 31, 2018

 

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: 2-88927

 

FIRST KEYSTONE CORPORATION
(Exact name of registrant as specified in its charter)

 

Pennsylvania   23-2249083
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification No.)

 

111 West Front Street, Berwick, PA   18603
(Address of principal executive offices)   (Zip Code)

 

Registrant’s telephone number, including area code: (570) 752-3671

 

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 (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes  x   No   ¨

 

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

 

Large accelerated filer ¨ Accelerated filer x
Non-accelerated filer ¨ Smaller reporting company ¨
Emerging growth company ¨    

 

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

 

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

Yes  ¨   No   x

 

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

 

Common Stock, $2 Par Value, 5,731,624 shares as of May 4, 2018

 

 

 

   

 

 

PART I - FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

FIRST KEYSTONE CORPORATION AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

(Dollars in thousands, except per share data)

 

   March 31,   December 31, 
   2018   2017 
ASSETS          
Cash and due from banks  $8,973   $7,913 
Interest-bearing deposits in other banks   1,328    826 
Total cash and cash equivalents   10,301    8,739 
Time deposits with other banks   1,482    1,482 
Debt securities available-for-sale                  342,093    348,586 
Marketable equity securities   1,599    1,632 
Restricted investment in bank stocks   5,445    4,058 
Loans   573,244    559,397 
Allowance for loan losses   (7,379)   (7,487)
Net loans   565,865    551,910 
Premises and equipment, net   20,389    20,623 
Accrued interest receivable   3,852    4,237 
Cash surrender value of bank owned life insurance   22,497    22,354 
Investments in low-income housing partnerships   2,371    2,626 
Goodwill   19,133    19,133 
Foreclosed assets held for resale   1,115    1,071 
Deferred income taxes   2,138    936 
Other assets   3,150    2,734 
TOTAL ASSETS  $1,001,430   $990,121 
           
LIABILITIES          
Deposits:          
Non-interest bearing  $131,282   $121,415 
Interest bearing   617,564    656,731 
Total deposits   748,846    778,146 
Short-term borrowings   80,791    26,296 
Long-term borrowings   55,000    65,000 
Accrued interest payable   549    490 
Other liabilities   3,816    3,470 
TOTAL LIABILITIES   889,002    873,402 
           
STOCKHOLDERS’ EQUITY          
Preferred stock, par value $2.00 per share; authorized 1,000,000 shares as of March 31, 2018 and December 31, 2017; issued 0 as of March 31, 2018 and December 31, 2017        
Common stock, par value $2.00 per share; authorized 20,000,000 shares as of March 31, 2018 and December 31, 2017; issued 5,950,951 as of March 31, 2018 and December 31, 2017; outstanding 5,719,339 as of March 31, 2018 and December 31, 2017   11,902    11,902 
Surplus   36,193    36,193 
Retained earnings   73,013    72,507 
Accumulated other comprehensive (loss) income   (2,971)   1,826 
Treasury stock, at cost, 231,612 shares as of March 31, 2018 and December 31, 2017   (5,709)   (5,709)
TOTAL STOCKHOLDERS’ EQUITY   112,428    116,719 
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY  $1,001,430   $990,121 

 

See accompanying notes to consolidated financial statements.

 

 2 

 

 

FIRST KEYSTONE CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

FOR THE THREE MONTHS ENDED MARCH 31, 2018 AND 2017

(Unaudited)

 

(Dollars in thousands, except per share data)

 

   2018   2017 
Interest and fees on loans  $5,945   $5,512 
Interest and dividend income on securities:          
Taxable   1,040    1,142 
Tax-exempt   1,199    1,147 
Dividends   11    11 
Dividend income on restricted investment in bank stocks   68    77 
Interest on interest-bearing deposits in other banks   8    8 
Total interest income   8,271    7,897 
           
INTEREST EXPENSE          
Interest on deposits   1,272    901 
Interest on short-term borrowings   174    136 
Interest on long-term borrowings   335    382 
Total interest expense   1,781    1,419 
Net interest income   6,490    6,478 
Provision for loan losses   50    83 
Net interest income after provision for loan losses   6,440    6,395 
           
NON-INTEREST INCOME          
Trust department   235    238 
Service charges and fees   457    436 
Bank owned life insurance income   143    158 
ATM fees and debit card income   357    327 
Gains on sales of mortgage loans   29    36 
Net securities (losses) gains   (17)   303 
Other   55    40 
Total non-interest income   1,259    1,538 
           
NON-INTEREST EXPENSE          
Salaries and employee benefits   3,036    2,742 
Occupancy, net   472    487 
Furniture and equipment   140    139 
Computer expense   253    246 
Professional services   223    238 
Pennsylvania shares tax   199    206 
FDIC insurance   81    80 
ATM and debit card fees   175    137 
Data processing fees   267    227 
Foreclosed assets held for resale expense   68    26 
Advertising   81    78 
Other   900    657 
Total non-interest expense   5,895    5,263 
Income before income tax expense   1,804    2,670 
Income tax expense   27    384 
NET INCOME  $1,777   $2,286 
           
PER SHARE DATA          
Net income per share:          
Basic  $0.31   $0.40 
Diluted   0.31    0.40 
Dividends per share   0.27    0.27 

 

See accompanying notes to consolidated financial statements.

 

 3 

 

 

FIRST KEYSTONE CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME

THREE MONTHS ENDED MARCH 31, 2018 AND 2017

(Unaudited)

 

(Dollars in thousands)

 

   2018   2017 
Net Income  $1,777   $2,286 
           
Other comprehensive income:          
Unrealized net holding (losses) gains on debt securities available-for-sale arising during the period, net of income taxes of $(1,199) and $534, respectively   (4,510)   1,035 
           
Less reclassification adjustment for net gains included in net income, net of income taxes of $(3) and $(103), respectively (a) (b)   (13)   (200)
           
Total other comprehensive (loss) income   (4,523)   835 
           
Total Comprehensive (Loss) Income  $(2,746)  $3,121 

  

 

(a) Gross amounts are included in net securities (losses) gains on the Consolidated Statements of Income in non-interest income.

(b) Income tax amounts are included in income tax expense on the Consolidated Statements of Income.

 

See accompanying notes to consolidated financial statements.

 

 4 

 

 

FIRST KEYSTONE CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

THREE MONTHS ENDED MARCH 31, 2018 AND 2017

(Unaudited)

 

(Dollars in thousands, except per share data)

 

                   Accumulated         
                   Other       Total 
   Common Stock       Retained   Comprehensive   Treasury   Stockholders’ 
   Shares   Amount   Surplus   Earnings   (Loss) Income   Stock   Equity 
                             
Balance at January 1, 2018   5,950,951   $11,902   $36,193   $72,507   $1,826   $(5,709)  $116,719 
Net Income                  1,777              1,777 
Other comprehensive loss, net of taxes                       (4,523)        (4,523)
Impact of adoption of accounting standards1                  274    (274)          
Dividends - $0.27 per share                (1,545              (1,545
Balance at March 31, 2018   5,950,951   $11,902   $36,193   $73,013   $(2,971)  $(5,709)  $112,428 
                                    
Balance at January 1, 2017   5,904,563   $11,809   $35,047   $70,004   $(1,419)  $(5,756)  $109,685 
Net Income                  2,286              2,286 
Other comprehensive income, net of taxes                       835         835 
Issuance of common stock under  dividend reinvestment plan   11,781    24    277                   301 
Dividends - $0.27 per share              (1,532)             (1,532)
Balance at March 31, 2017   5,916,344   $11,833   $35,324   $70,758   $(584)  $(5,756)  $111,575 

 

 

1Represents the impact of adopting Accounting Standard Update (“ASU”) 2018-02 and ASU 2016-01. See Note 2 to the consolidated financial statements for more information.

 

See accompanying notes to consolidated financial statements.

 

 5 

 

 

FIRST KEYSTONE CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE THREE MONTHS ENDED MARCH 31, 2018 AND 2017

(Unaudited)

 

(Dollars in thousands)

 

   2018   2017 
OPERATING ACTIVITIES          
Net income  $1,777   $2,286 
Adjustments to reconcile net income to net cash provided by operating activities:          
Provision for loan losses   50    83 
Depreciation and amortization   267    283 
Net premium amortization on securities   901    1,186 
Gains on sales of mortgage loans   (29)   (36)
Proceeds from sales of mortgage loans originated for resale   1,794    1,216 
Originations of mortgage loans originated for resale   (1,642)   (1,637)
Net securities losses (gains)   17    (303)
Losses on sales of foreclosed real estate held for resale, including write-downs   31     
Decrease in accrued interest receivable   385    30 
Earnings on investment in bank owned life insurance   (143)   (158)
Increase in other assets   (416)   (469)
Amortization of investment in real estate ventures   255    40 
Increase in accrued interest payable   59    28 
Increase (decrease) increase in other liabilities   36    (502)
NET CASH PROVIDED BY OPERATING ACTIVITIES   3,342    2,047 
INVESTING ACTIVITIES          
Proceeds from sales of debt securities available-for-sale   14,038    24,491 
Proceeds from maturities and redemptions of debt securities available-for-sale   4,999    4,601 
Purchases of debt securities available-for-sale   (19,154)   (38,662)
Proceeds from maturities and redemptions of investment securities held-to-maturity       1 
Net change in restricted investment in bank stocks   (1,387)   (465)
Net increase in loans   (14,197)   (2,123)
Purchases of premises and equipment   (35)   (26)
Purchase of investment in real estate venture       (167)
Proceeds from sales of foreclosed assets held for resale   15    152 
NET CASH USED IN INVESTING ACTIVITIES   (15,721)   (12,198)
FINANCING ACTIVITIES          
Net (decrease) increase in deposits   (29,300)   6,604 
Net increase in short-term borrowings   54,495    5,635 
Repayment of long-term borrowings   (10,000)   (31)
Common stock issued       301 
Dividends paid   (1,254)   (1,532)
NET CASH PROVIDED BY FINANCING ACTIVITIES   13,941    10,977 
INCREASE IN CASH AND CASH EQUIVALENTS   1,562    826 
CASH AND CASH EQUIVALENTS, BEGINNING   8,739    9,128 
CASH AND CASH EQUIVALENTS, ENDING  $10,301   $9,954 
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION          
Interest paid  $1,722   $1,391 
Income taxes paid       650 
SUPPLEMENTAL DISCLOSURE OF NON-CASH ACTIVITIES          
Purchased securities settling after quarter end       4,478 
Loans transferred to foreclosed assets held for resale   90    15 

 

See accompanying notes to consolidated financial statements.

 

 6 

 

 

FIRST KEYSTONE CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

NOTE 1 ― BASIS OF PRESENTATION AND ACCOUNTING POLICIES

 

The consolidated financial statements include the accounts of First Keystone Corporation (the “Corporation”) and its wholly owned subsidiary, First Keystone Community Bank (the “Bank”). All significant intercompany accounts and transactions have been eliminated.

 

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial information. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete consolidated financial statements. In the opinion of management, all adjustments considered necessary for fair presentation have been included. Operating results for the three month period ended March 31, 2018, are not necessarily indicative of the results for the year ending December 31, 2018. For further information, refer to the consolidated financial statements and notes thereto included in First Keystone Corporation’s Annual Report on Form 10-K for the year ended December 31, 2017.

 

For comparative purposes, certain 2017 balances have been reclassified to conform to the 2018 presentation. Such reclassifications had no impact on net income.

 

The Corporation has evaluated events and transactions occurring subsequent to the consolidated balance sheet date of March 31, 2018 for items that should potentially be recognized or disclosed in these consolidated financial statements. The evaluation was conducted through the date these consolidated financial statements were issued.

 

NOTE 2 ― RECENT ACCOUNTING STANDARDS UPDATES (“ASU”)

 

Recently adopted ASUs:

 

On January 1, 2018, the Corporation adopted ASU 2014-09, Revenue from Contracts with Customers, and all subsequent amendments to the ASU (collectively “ASC 606”), which (i) creates a single framework for recognizing revenue from contracts with customers that fall within its scope and (ii) revises when it is appropriate to recognize a gain (loss) from the transfer of nonfinancial assets, such as OREO. The majority of the Corporation’s revenue comes from interest income, including loans and securities, which are outside the scope of ASC 606. The Corporation’s services that fall within the scope of ASC 606 are presented within other income on the consolidated statements of income and are recognized as revenue as the Corporation satisfies its obligation to the customer. Services within the scope of ASC 606 include deposit related fees and service charges, interchange fees and surcharges, and income from wealth management activities. ASC 606 did not result in a change to the accounting for any in-scope revenue streams; as such, no cumulative effect adjustment was recorded.

 

On January 1, 2018, the Corporation adopted ASU 2016-01, Financial Instruments-Overall (Topic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, which amended the guidance on the classification and measurement of financial instruments. Adoption of ASU 2016-01 resulted in: (1) separate classification of marketable equity securities previously included in investment securities available-for-sale on the consolidated balance sheets, (2) changes in the fair value of the equity securities being captured in the consolidated statements of income and (3) an increase in retained earnings and corresponding decrease in accumulated other comprehensive loss of $634,000 at January 1, 2018 for the after-tax impact of the change in accounting for the unrealized gain on the equity securities. Adoption of the standard also resulted in the use of an exit price to determine the fair value of financial instruments not measured at fair value in the consolidated balance sheets. For more information about fair value disclosures, refer to Note 8, “Fair Value Measurements”.

 

 7 

 

 

In August 2016, the Financial Accounting Standards Board (“FASB”) issued ASU 2016-15 – Statement of Cash Flows (topic 230): Classification of Certain Cash Receipts and Cash Payments (a consensus of the Emerging Issues Task Force). ASU No. 2016-15 addresses eight cash flow issues with specific guidance on how certain cash receipts and cash payments should be presented on the statement of cash flows. ASU No. 2016-15 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2017. Early adoption is permitted. The adoption of ASU No. 2016-15 had no material effect on the Corporation’s cash flows.

 

In November 2016, the Financial Accounting Standards Board ("FASB") issued ASU No. 2016-18, Statement of Cash flows-Restricted Cash (Topic 230). The amendments in this Update clarify the inclusion of restricted cash in the cash and cash equivalents beginning-of-period and end-of period reconciliation on the consolidated statement of cash flows. For public business entities that are SEC filers, such as the Corporation, the amendments in this Update are effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The implementation of this ASU in 2018 had no material effect on the Corporation’s consolidated financial position or results of operations.

 

In March 2017, the Financial Accounting Standards Board (“FASB”) issued ASU 2017-07, Compensation - Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. The amendments apply to all entities that offer employees defined benefit pension plans, other postretirement benefit plans, or other types of benefits accounted for under Topic 715, Compensation — Retirement Benefits. The amendments require that an employer report the service cost component in the same line item or items as other compensation costs arising from services rendered by the pertinent employees during the period. The other components of net benefit cost are required to be presented in the income statement separately from the service cost component and outside a subtotal of income from operations, if one is presented. The amendments also allow only the service cost component to be eligible for capitalization when applicable (e.g., as a cost of internally manufactured inventory or a self-constructed asset). The ASU is effective for public business entities for annual periods beginning after December 15, 2017, including interim periods within those annual periods. Early adoption is permitted as of the beginning of an annual period for which financial statements (interim or annual) have not been issued or made available for issuance. The adoption of this update had no material impact on the Corporation’s consolidated financial position or results of operations.

 

In February 2018, the Financial Accounting Standards Board (“FASB”) issued ASU 2018-02, Income Statement – Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income (“AOCI”). This ASU provides financial statement preparers with an option to reclassify stranded tax effects within AOCI to retained earnings in each period in which the effect of the change in the U.S. federal corporate income tax rate in the Tax Cuts and Jobs Act (or portion thereof) are recorded. Effective for all organizations for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted. Organizations should apply the proposed amendments either in the period of adoption or retrospectively to each period (or periods) in which the effect of the change in the U.S. federal corporate income tax rate in the Tax Cuts and Jobs Act is recognized. The Corporation elected to early adopt this standard update, effective January 1, 2018. Adoption resulted in a reclassification between retained earnings and accumulated other comprehensive loss of $360,000 at January 1, 2018, which is included in the consolidated statements of changes in stockholders’ equity.

 

Pending ASUs:

 

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). ASU No. 2016-02 requires lessees to recognize the assets and liabilities that arise from leases on the balance sheet.  A lessee should recognize in the statement of financial position a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term.  For public business entities, ASU No. 2016-02 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2018. Early adoption is permitted. The Corporation is currently assessing the effect that ASU No. 2016-02 will have on its results of operations, financial position and cash flows as it applies to the Corporation’s three leased properties.

 

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. ASU No. 2016-13 requires financial assets measured at amortized cost to be presented at the net amount expected to be collected, through an allowance for credit losses that is deducted from the amortized cost basis. The measurement of expected credit losses is based on relevant information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. ASU No. 2016-13 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2019. Early adoption is permitted for annual and interim periods beginning after December 15, 2018. While the Corporation is currently evaluating the provisions of ASU 2016-13 to determine the potential impact of the new standard will have on the Corporation’s Consolidated Financial Statements, it has taken steps to prepare for the implementation when it becomes effective, such as: forming an internal committee, gathering pertinent data, consulting with outside professionals, and begun evaluating its current IT systems.

  

 8 

 

 

In January 2017, the Financial Accounting Standards Board (“FASB”) issued ASU 2017-04, Intangibles – Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. The ASU simplifies the subsequent measurement of goodwill by eliminating Step 2 from the goodwill impairment test. Instead, under the amendments, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value with its carrying amount. Additionally, an entity should consider income tax effects from any tax deductible goodwill on the carrying amount when measuring the goodwill impairment loss, if applicable. The update also eliminated the requirements for zero or negative carrying amount to perform a qualitative assessment and, if it fails that qualitative test, to perform Step 2 of the goodwill impairment test. The amendments are effective for public business entities for its annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The adoption of this update is not expected to have a material impact on the Corporation’s consolidated financial position or results of operations.

 

In March 2017, the Financial Accounting Standards Board (“FASB”) issued ASU 2017-08, Receivables- Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities. The ASU shortens the amortization period for certain callable debt securities held at a premium. Specifically, the amendments require the premium to be amortized to the earliest call date. The amendments do not require an accounting change for securities held at a discount; the discount continues to be amortized to maturity. The amendments are effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. Early adoption is permitted, including adoption in an interim period. If an entity early adopts in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. The amendments should be applied on a modified retrospective basis, with a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. The Corporation is currently assessing the impact that this guidance will have on its consolidated financial statements and related disclosures.

 

NOTE 3SECURITIES

 

The Corporation classifies its securities as either “Held-to-Maturity” or “Available-for-Sale” at the time of purchase. Securities are accounted for on a trade date basis. Debt securities are classified as Held-to-Maturity when the Corporation has the ability and positive intent to hold the securities to maturity. Securities classified as Held-to-Maturity are carried at cost adjusted for amortization of premium and accretion of discount to maturity.

 

Debt securities not classified as Held-to-Maturity are included in the Available-for-Sale category and are carried at fair value. The amount of any unrealized gain or loss, net of the effect of deferred income taxes, is reported as accumulated other comprehensive income (loss) in the Consolidated Balance Sheets and Consolidated Statements of Changes in Stockholders’ Equity. Management’s decision to sell Available-for-Sale securities is based on changes in economic conditions, controlling the sources and applications of funds, terms, availability of and yield of alternative investments, interest rate risk and the need for liquidity.

 

 9 

 

 

Beginning January 1, 2018, upon adoption of ASU 2016-01, equity securities with readily determinable fair values are stated at fair value with realized and unrealized gains and losses reported in income. For periods prior to January 1, 2018, equity securities were classified as available-for-sale and stated at fair value with unrealized gains and losses reported as a separate component of AOCI, net of tax. Equity securities without readily determinable fair values are recorded at cost less impairment, if any.

 

The cost of debt securities classified as Held-to-Maturity or Available-for-Sale is adjusted for amortization of premiums and accretion of discounts to expected maturity. Such amortization and accretion, as well as interest and dividends, are included in interest and dividend income from investment securities. Realized gains and losses are included in net securities gains and losses. The cost of securities sold, redeemed or matured is based on the specific identification method.

 

The amortized cost, related estimated fair value, and unrealized gains and losses for debt securities classified as “Available-For-Sale” were as follows at March 31, 2018 and December 31, 2017:

 

(Dollars in thousands)

 

   Debt Securities Available-for-Sale 
       Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
   Cost   Gains   Losses   Value 
March 31, 2018:                    
U.S. Treasury securities  $2,823   $   $(4)  $2,819 
Obligations of U.S. Government Corporations and Agencies:                    
Mortgage-backed   83,540    161    (1,715)   81,986 
Other   21,341    80    (488)   20,933 
Obligations of state and political subdivisions   203,561    1,803    (2,436)   202,928 
Asset backed securities   5,025            5,025 
Corporate debt securities   29,564        (1,162)   28,402 
Total  $345,854   $2,044   $(5,805)  $342,093 

 

(Dollars in thousands)

 

   Debt Securities Available-for-Sale 
       Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
   Cost   Gains   Losses   Value 
December 31, 2017:                    
U.S. Treasury securities  $   $   $   $ 
Obligations of U.S. Government Corporations and Agencies:                    
Mortgage-backed   82,825    210    (1,175)   81,860 
Other   22,409    132    (308)   22,233 
Obligations of state and political subdivisions   211,743    4,690    (911)   215,522 
Asset backed securities                
Corporate debt securities   29,645    90    (764)   28,971 
Total  $346,622   $5,122   $(3,158)  $348,586 

 

Securities Available-for-Sale with an aggregate fair value of $251,462,000 at March 31, 2018 and $290,104,000 at December 31, 2017, were pledged to secure public funds, trust funds, securities sold under agreements to repurchase, debtor in possession funds and the Federal Discount Window aggregating $188,312,000 at March 31, 2018 and $224,659,000 at December 31, 2017.

 

 10 

 

 

The amortized cost, estimated fair value and weighted average yield of debt securities, by contractual maturity, are shown below at March 31, 2018. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

(Dollars in thousands)

 

   March 31, 2018  
   Debt Securities Available-For-Sale  
       U.S. Government   Obligations         
       Corporations &   of State   Asset   Corporate 
   U.S. Treasury   Agencies   & Political   Backed   Debt 
   Securities   Obligations1   Subdivisions2   Securities   Securities 
Within 1 Year:                         
Amortized cost  $   $   $2,343   $   $529 
Fair value           2,356        529 
Weighted average yield           3.29%       2.66%
                          
1 - 5 Years:                         
Amortized cost   2,823    16,907    25,009        12,429 
Fair value   2,819    16,389    24,865        12,211 
Weighted average yield   2.21%   2.03%   2.72%       2.77%
                          
5 - 10 Years:                         
Amortized cost       31,064    67,301    5,025    16,606 
Fair value       29,800    66,716    5,025    15,662 
Weighted average yield       2.09%   3.23%   4.32%   2.75%
                          
After 10 Years:                         
Amortized cost       56,910    108,908         
Fair value       56,730    108,991         
Weighted average yield       2.56%   3.75%        
                          
Total:                         
Amortized cost  $2,823   $104,881   $203,561   $5,025   $29,564 
Fair value   2,819    102,919    202,928    5,025    28,402 
Weighted average yield   2.21%   2.34%   3.45%   4.32%   2.76%

 

 

1Mortgage-backed securities are allocated for maturity reporting at their original maturity date.

2Average yields on tax-exempt obligations of state and political subdivisions have been computed on a tax-equivalent basis using a 21% tax rate.

 

There were no aggregate securities with a single issuer (excluding the U.S. Government and U.S. Government Agencies and Corporations) which exceeded ten percent of consolidated stockholders’ equity at March 31, 2018. The quality rating of the obligations of state and political subdivisions are generally investment grade, as rated by Moody’s, Standard and Poor’s or Fitch. The typical exceptions are local issues which are not rated, but are secured by the full faith and credit obligations of the communities that issued these securities.

 

Proceeds from sales of investments in Available-for-Sale debt securities for the first quarter of 2018 and 2017 were $14,038,000 and $24,491,000, respectively. Gross gains realized on these sales were $50,000 and $341,000, respectively. Gross losses realized on these sales were $34,000 and $38,000, respectively. There were no impairment losses realized on Available-for-Sale debt securities during the first quarter of 2018 or 2017.

 

At March 31, 2018 and December 31, 2017, the Corporation had $1,599,000 and $1,632,000, respectively, in equity securities recorded at fair value. Prior to January 1, 2018, equity securities were stated at fair value with unrealized gains and losses reported as a separate component of AOCI, net of tax. At December 31, 2017, net unrealized gains net of tax of $634,000 had been recognized in AOCI. On January 1, 2018, these unrealized gains and losses were reclassified out of AOCI and into retained earnings with subsequent changes in fair value being recognized in net income. The following is a summary of unrealized and realized gains and losses recognized in net income on equity securities during the three months ended March 31, 2018:

 

 11 

 

 

(Dollars in thousands)

 

   Three months ended 
   March 31, 2018 
Net gains and (losses) recognized during the period on equity securities  $(33)
Less: Net gains and (losses) recognized during the period on equity securities sold during the period    
Unrealized gains and (losses) recognized during the reporting period on equity securities still held at the reporting date  $(33)

 

There were no proceeds from sales of investments in Held-to-Maturity debt securities during the first quarter of 2018 or 2017. Therefore, there were no gains or losses realized during these periods.

 

Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. Securities classified as Available-for-Sale or Held-to-Maturity are generally evaluated for OTTI under FASB ASC 320, Investments - Debt and Equity Securities. In determining OTTI under the FASB ASC 320 model, management considers many factors, including (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.

 

When other-than-temporary impairment occurs on debt securities, the amount of the other-than-temporary impairment recognized in earnings depends on whether an entity intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss. If an entity intends to sell or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the other-than-temporary impairment shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis less any current-period loss, the other-than-temporary impairment shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total other-than-temporary impairment related to the credit loss is determined based on the present value of cash flows expected to be collected, and the realized loss is recognized as impairment charges on securities on the Consolidated Statements of Income. The amount of the total other-than-temporary impairment related to the other factors shall be recognized in other comprehensive income (loss), net of applicable taxes. The previous amortized cost basis less the other-than-temporary impairment recognized in earnings becomes the new amortized cost basis of the investment.

 

The Corporation and its investment advisors monitor the entire portfolio monthly with particular attention given to securities in a continuous loss position of at least ten percent for over twelve months. Based on the factors described above, management did not consider any securities to be other-than-temporarily impaired at March 31, 2018 or December 31, 2017.

 

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In accordance with disclosures required by FASB ASC 320-10-50, Investments – Debt and Equity Securities, the summary below shows the gross unrealized losses and fair value of the Corporation’s debt securities. Totals are aggregated by investment category where individual securities have been in a continuous loss position for less than 12 months or 12 months or more as of March 31, 2018 and December 31, 2017:

 

March 31, 2018

 

(Dollars in thousands)

 

   Less Than 12 Months   12 Months or More   Total 
   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
   Value   Loss   Value   Loss   Value   Loss 
Debt Securities Available-for-Sale:                              
U.S. Treasury securities  $2,819   $(4)  $   $   $2,819   $(4)
Obligations of U.S. Government                              
Corporations and Agencies:                              
Mortgage-backed   31,668    (489)   34,194    (1,226)   65,862    (1,715)
Other   2,823    (10)   7,006    (478)   9,829    (488)
Obligations of state and political subdivisions   84,238    (1,142)   26,264    (1,294)   110,502    (2,436)
Corporate debt securities   6,832    (87)   19,570    (1,075)   26,402    (1,162)
   $128,380   $(1,732)  $87,034   $(4,073)  $215,414   $(5,805)

 

December 31, 2017

(Dollars in thousands)

 

   Less Than 12 Months   12 Months or More   Total 
   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
   Value   Loss   Value   Loss   Value   Loss 
Debt Securities Available-for-Sale:                              
U.S. Treasury securities  $   $   $   $   $   $ 
Obligations of U.S. Government                              
Corporations and Agencies:                              
Mortgage-backed   30,555    (300)   33,943    (875)   64,498    (1,175)
Other   2,905    (4)   7,179    (304)   10,084    (308)
Obligations of state and political subdivisions   36,149    (329)   22,566    (582)   58,715    (911)
Corporate debt securities   6,746    (24)   15,174    (740)   21,920    (764)
   $76,355   $(657)  $78,862   $(2,501)  $155,217   $(3,158)

 

The Corporation invests in various forms of agency debt including mortgage-backed securities and callable debt. The mortgage-backed securities are issued by FHLMC (“Federal Home Loan Mortgage Corporation”), FNMA (“Federal National Mortgage Association”) or GNMA (“Government National Mortgage Association”). The municipal securities consist of general obligations and revenue bonds. The fair market value of the above securities is influenced by market interest rates, prepayment speeds on mortgage securities, bid-offer spreads in the market place and credit premiums for various types of agency debt. These factors change continuously and therefore the market value of these securities may be higher or lower than the Corporation’s carrying value at any measurement date. Management does not believe any of their 100 debt securities with a less than one year unrealized loss position, or any of their 58 debt securities with a one year or greater unrealized loss position as of March 31, 2018, represent an other-than-temporary impairment, as the unrealized losses relate principally to changes in interest rates subsequent to the acquisition of the specific securities.

 

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NOTE 4LOANS AND ALLOWANCE FOR LOAN LOSSES

 

Loans

 

Net loans are stated at their outstanding recorded investment, net of deferred fees and costs, unearned income and the allowance for loan losses. Interest on loans is recognized as income over the term of each loan, generally, by the accrual method. Loan origination fees and certain direct loan origination costs have been deferred with the net amount amortized using the straight line method or the interest method over the contractual life of the related loans as an interest yield adjustment.

 

Residential mortgage loans held for sale are carried at the lower of cost or market on an aggregate basis determined by independent pricing from appropriate federal or state agency investors. These loans are sold without recourse. Loans held for sale amounted to $708,000 and $834,000 at March 31, 2018 and December 31, 2017, respectively.

 

The loans receivable portfolio is segmented into commercial, residential and consumer loans. Commercial loans consist of the following classes: Commercial and Industrial and Commercial Real Estate.

 

Commercial and Industrial Lending

 

The Corporation originates commercial and industrial loans primarily to businesses located in its primary market area and surrounding areas. These loans are used for various business purposes, which include short-term loans and lines of credit to finance machinery and equipment, inventory and accounts receivable. Generally, the maximum term for loans extended on machinery and equipment is based on the projected useful life of such machinery and equipment. Most business lines of credit are written on demand and are reviewed annually.

 

Commercial and industrial loans are generally secured with short-term assets; however, in many cases, additional collateral such as real estate is provided as additional security for the loan. Loan-to-value maximum thresholds have been established by the Corporation and are specific to the type of collateral. Collateral values may be determined using invoices, inventory reports, accounts receivable aging reports, business financial statements, collateral appraisals, etc. Commercial and industrial loans are typically secured by personal guarantees of the borrower.

 

In underwriting commercial and industrial loans, an analysis is performed to evaluate the borrower's character and capacity to repay the loan, the adequacy of the borrower's capital and collateral, as well as the conditions affecting the borrower. Evaluation of the borrower's past, present and future cash flows is also an important aspect of the Corporation's analysis of the borrower’s ability to repay.

 

Commercial and industrial loans generally present a higher level of risk than other types of loans due primarily to the effect of general economic conditions. Commercial and industrial loans are typically made on the basis of the borrower’s ability to make repayment from cash flows from the borrower’s primary business activities. As a result, the availability of funds for the repayment of commercial and industrial loans is dependent on the success of the business itself, which in turn, is likely to be dependent upon the general economic environment.

 

Commercial Real Estate Lending

 

The Corporation engages in commercial real estate lending in its primary market area and surrounding areas. The Corporation’s commercial real estate portfolio is secured primarily by commercial retail space, commercial office buildings, residential housing and hotels. Generally, commercial real estate loans have terms that do not exceed twenty years, have loan-to-value ratios of up to eighty percent of the value of the collateral property, and are typically secured by personal guarantees of the borrowers.

 

In underwriting these loans, the Corporation performs a thorough analysis of the financial condition of the borrower, the borrower’s credit history, and the reliability and predictability of the cash flow generated by the property securing the loan. The value of the property is determined by either independent appraisers or internal evaluations by Bank officers.

 

Commercial real estate loans generally present a higher level of risk than residential real estate secured loans. Repayment of loans secured by commercial real estate is typically dependent upon the successful operation of the related real estate project and/or the effect of the general economic conditions on income producing properties.

 

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Residential Real Estate Lending (Including Home Equity)

 

The Corporation’s residential real estate portfolio is comprised of one-to-four family residential mortgage loan originations, home equity term loans and home equity lines of credit. These loans are generated by the Corporation’s marketing efforts, its present customers, walk-in customers and referrals. These loans originate primarily within or with customers from the Corporation’s market area.

 

The Corporation’s one-to-four family residential mortgage originations are secured primarily by properties located in its primary market area and surrounding areas. The Corporation offers fixed-rate mortgage loans with terms up to a maximum of thirty years for both permanent structures and those under construction. Loans with terms of thirty years are normally held for sale and sold without recourse; most of the residential mortgages held in the Corporation’s residential real estate portfolio have maximum terms of twenty years. Generally, the majority of the Corporation’s residential mortgage loans originate with a loan-to-value of eighty percent or less, or those with primary mortgage insurance at ninety-five percent or less. Home equity term loans are secured by the borrower’s primary residence and typically have a maximum loan-to-value of eighty percent and a maximum term of fifteen years. In general, home equity lines of credit are secured by the borrower’s primary residence with a maximum loan-to-value of eighty percent and a maximum term of twenty years.

 

In underwriting one-to-four family residential mortgage loans, the Corporation evaluates the borrower’s ability to make monthly payments, the borrower’s repayment history and the value of the property securing the loan. The ability and willingness to repay is determined by the borrower’s employment history, current financial conditions and credit background. A majority of the properties securing residential real estate loans made by the Corporation are appraised by independent appraisers. The Corporation generally requires mortgage loan borrowers to obtain an attorney’s title opinion or title insurance and fire and property insurance, including flood insurance, if applicable.

 

Residential mortgage loans, home equity term loans and home equity lines of credit generally present a lower level of risk than consumer loans because they are secured by the borrower’s primary residence. Risk is increased when the Corporation is in a subordinate position, especially to another lender, for the loan collateral.

 

Consumer Lending

 

The Corporation offers a variety of secured and unsecured consumer loans, including vehicle loans, stock loans and loans secured by financial institution deposits. These loans originate primarily within or with customers from the market area.

 

Consumer loan terms vary according to the type and value of collateral and creditworthiness of the borrower. In underwriting personal loans, a thorough analysis is performed regarding the borrower’s willingness and financial ability to repay the loan as agreed. The ability to repay is determined by the borrower’s employment history, current financial condition and credit background.

 

Consumer loans may entail greater credit risk than residential real estate loans, particularly in the case of personal loans which are unsecured or are secured by rapidly depreciable assets, such as automobiles or recreational equipment. In such cases, repossessed collateral for a defaulted personal loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. In addition, personal loan collections are dependent on the borrower’s continuing financial stability and therefore, are more likely to be affected by adverse personal circumstances. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.

 

Delinquent Loans

 

Generally, a loan is considered to be past-due when scheduled loan payments are in arrears 10 days or more. Delinquent notices are generated automatically when a loan is 10 or 15 days past-due, depending on loan type. Collection efforts continue on past-due loans that have not been brought current, when it is believed that some chance exists for improvement in the status of the loan. Past-due loans are continually evaluated with the determination for charge-off being made when no reasonable chance remains that the status of the loan can be improved.

 

Commercial and Industrial and Commercial Real Estate loans are charged off in whole or in part when they become sufficiently delinquent based upon the terms of the underlying loan contract and when a collateral deficiency exists. Because all or part of the contractual cash flows are not expected to be collected, the loan is considered to be impaired, and the Bank estimates the impairment based on its analysis of the cash flows or collateral estimated at fair value less cost to sell.

 

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Residential Real Estate and Consumer loans are charged off when they become sufficiently delinquent based upon the terms of the underlying loan contract and when the value of the underlying collateral is not sufficient to support the loan balance and a loss is expected. At that time, the amount of estimated collateral deficiency, if any, is charged off for loans secured by collateral, and all other loans are charged off in full. Loans with collateral are charged down to the estimated fair value of the collateral less cost to sell.

 

Loans in which the borrower is in bankruptcy are considered on a case by case basis and are either charged off or reaffirmed by the borrower.

 

Generally, a loan is classified as non-accrual and the accrual of interest on such a loan is discontinued when the contractual payment of principal or interest has become 90 days past due or management has serious doubts about further collectability of principal or interest, even though the loan may currently be performing. A loan may remain on accrual status if it is well secured (or supported by a strong guarantee) and in the process of collection. When a loan is placed on non-accrual status, unpaid interest credited to income in the current year is reversed and unpaid interest accrued in prior years is charged against interest income. Certain non-accrual loans may continue to perform; that is, payments are still being received. Generally, the payments are applied to principal. These loans remain under constant scrutiny, and if performance continues, interest income may be recorded on a cash basis based on management's judgment as to collectability of principal.

 

Allowance for Loan Losses

 

The allowance for loan losses is established through provisions for loan losses charged against income. Loans deemed to be uncollectible are charged against the allowance for loan losses and subsequent recoveries, if any, are credited to the allowance.

 

The allowance for loan losses is maintained at a level estimated by management to be adequate to absorb potential loan losses. Management’s periodic evaluation of the adequacy of the allowance for loan losses is based on the Corporation’s past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay (including the timing of future payments), the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions, and other relevant factors. This evaluation is inherently subjective as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change.

 

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are individually classified as impaired. Select loans are not aggregated for collective impairment evaluation, as such; all loans are subject to individual impairment evaluation should the facts and circumstances pertinent to a particular loan suggest that such evaluation is necessary. Factors considered by management in determining impairment include payment status and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. If a loan is impaired, a portion of the allowance may be allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from collateral. Troubled debt restructurings are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a troubled debt restructuring is considered to be a collateral dependent loan, the loans may be reported, net, at the fair value of the collateral. For troubled debt restructurings that subsequently default, the Corporation determines the amount of reserve in accordance with the accounting policy for the allowance for loan losses.

 

The general component covers all other loans not identified as impaired and is based on historical losses and qualitative factors. The historical loss component of the allowance is determined by losses recognized by portfolio segment over a time period that management has determined represents the current credit cycle. Qualitative factors impacting each portfolio segment may include: delinquency trends, loan volume trends, Bank policy changes, management processes and oversight, economic trends (including change in consumer and business disposable incomes, unemployment and under-employment levels, and other conditions), concentrations by industry or product, internal and external loan review processes, collateral value and market conditions, and external factors including regulatory issues and competition.

 

 16 

 

 

The unallocated component of the allowance is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

 

A reserve for unfunded lending commitments is provided for possible credit losses on off-balance sheet credit exposures. The reserve for unfunded lending commitments represents management’s estimate of losses inherent in its unfunded loan commitments and, if necessary, is recorded in other liabilities on the Consolidated Balance Sheets. As of March 31, 2018 and December 31, 2017, the amount of the reserve for unfunded lending commitments was $170,000 and $116,000, respectively.

 

The Corporation is subject to periodic examination by its federal and state examiners, and may be required by such regulators to recognize additions to the allowance for loan losses based on their assessment of credit information available to them at the time of their examinations.

 

A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect all amounts due according to the contractual terms of the original loan agreement. Under current accounting standards, the allowance for loan losses related to impaired loans is based on discounted cash flows using the loan’s effective interest rate at inception or the fair value of the collateral for certain collateral dependent loans.

 

The restructuring of a loan is considered a “troubled debt restructuring” if both the following conditions are met: (i) the borrower is experiencing financial difficulties, and (ii) the Bank has granted a concession. The most common concessions granted include one or more modifications to the terms of the debt, such as (a) a reduction in the interest rate for the remaining life of the debt, (b) an extension of the maturity date at an interest rate lower than the current market rate for new debt with similar risk, (c) a temporary period of interest-only payments, and (d) a reduction in the contractual payment amount for either a short period or remaining term of the loan. A less common concession is the forgiveness of a portion of the principal.

 

The determination of whether a borrower is experiencing financial difficulties takes into account not only the current financial condition of the borrower, but also the potential financial condition of the borrower were a concession not granted. Similarly, the determination of whether a concession has been granted is very subjective in nature. For example, simply extending the term of a loan at its original interest rate or even at a higher interest rate could be interpreted as a concession unless the borrower could readily obtain similar credit terms from a different lender.

 

Loans modified in a troubled debt restructuring are considered impaired and may or may not be placed on non-accrual status until the Bank determines the future collection of principal and interest is reasonably assured, which generally requires that the borrower demonstrates a period of performance according to the restructured terms of six months.

 

The Bank utilizes a risk grading matrix as a tool for managing credit risk in the loan portfolio and assigns an asset quality rating (risk grade) to all Commercial and Industrial, Commercial Real Estate, Residential Real Estate and Consumer borrowings. An asset quality rating is assigned using the guidance provided in the Bank’s loan policy. Primary responsibility for assigning the asset quality rating rests with the lender. The asset quality rating is validated periodically by both an internal and external loan review process.

 

The commercial loan grading system focuses on a borrower’s financial strength and performance, experience and depth of management, primary and secondary sources of repayment, the nature of the business and the outlook for the particular industry. Primary emphasis is placed on financial condition and trends. The grade also reflects current economic and industry conditions; as well as other variables such as liquidity, cash flow, revenue/earnings trends, management strengths or weaknesses, quality of financial information, and credit history.

 

The loan grading system for Residential Real Estate and Consumer loans focuses on the borrower’s credit score and credit history, debt-to-income ratio and income sources, collateral position and loan-to-value ratio, as well as other variables such as current economic conditions, and individual strengths and weaknesses.

 

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Risk grade characteristics are as follows:

 

Risk Grade 1 – MINIMAL RISK through Risk Grade 6 – MANAGEMENT ATTENTION (Pass Grade Categories)

 

Risk is evaluated via examination of several attributes including but not limited to financial trends, strengths and weaknesses, likelihood of repayment when considering both cash flow and collateral, sources of repayment, leverage position, management expertise, and repayment history.

 

At the low-risk end of the rating scale, a risk grade of 1 – Minimal Risk is the grade reserved for loans with exceptional credit fundamentals and virtually no risk of default or loss. Loan grades then progress through escalating ratings of 2 through 6 based upon risk. Risk Grade 2 – Modest Risk are loans with sufficient cash flows; Risk Grade 3 – Average Risk are loans with key balance sheet ratios slightly above the borrower’s peers; Risk Grade 4 – Acceptable Risk are loans with key balance sheet ratios usually near the borrower’s peers, but one or more ratios may be higher; and Risk Grade 5 – Marginally Acceptable are loans with strained cash flow, increasing leverage and/or weakening markets. Risk Grade 6 – Management Attention are loans with weaknesses resulting from declining performance trends and the borrower’s cash flows may be temporarily strained. Loans in this category are performing according to terms, but present some type of potential concern.

 

Risk Grade 7 − SPECIAL MENTION (Non-Pass Category)

 

Generally, these loans are currently protected, but are “potentially weak.” They constitute an undue and unwarranted credit risk but not to the point of justifying a classification of substandard.

 

Assets in this category are protected but have potential weakness which may, if not checked or corrected, weaken the asset or inadequately protect the Bank’s credit position at some future date. No loss of principal or interest is envisioned; however, they constitute an undue credit risk that may be minor but is unwarranted in light of the circumstances surrounding a specific asset. Risk is increasing beyond that at which the loan originally would have been granted. Historically, cash flows are inconsistent; financial trends show some deterioration. Liquidity and leverage are above industry averages. Financial information could be incomplete or inadequate. A Special Mention asset has potential weaknesses that deserve management’s close attention.

 

Risk Grade 8 − SUBSTANDARD (Non-Pass Category)

 

Generally, these assets are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified must have “well-defined” weaknesses that jeopardize the full liquidation of the debt.

 

These loans are characterized by the distinct possibility that the Bank will sustain some loss if the aggregate amount of substandard assets is not fully covered by the liquidation of the collateral used as security. Substandard loans have a high probability of payment default and require more intensive supervision by Bank management.

 

Risk Grade 9 − DOUBTFUL (Non-Pass Category)

 

Generally, loans graded doubtful have all the weaknesses inherent in a substandard loan with the added factor that the weaknesses are pronounced to a point whereby the basis of current information, conditions, and values, collection or liquidation in full is deemed to be highly improbable. The possibility of loss is extremely high, but because of certain important and reasonably specific pending factors that may work to strengthen the asset, its classification is deferred until, for example, a proposed merger, acquisition, liquidation procedure, capital injection, perfection of liens on additional collateral and/or refinancing plan is completed. Loans are graded doubtful if they contain weaknesses so serious that collection or liquidation in full is questionable.

 

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The following table presents the classes of the loan portfolio summarized by risk rating as of March 31, 2018 and December 31, 2017:

 

(Dollars in thousands)

 

   Commercial and     
   Industrial   Commercial Real Estate 
   March 31,   December 31,   March 31,   December 31, 
   2018   2017   2018   2017 
Grade:                    
1-6  Pass  $105,794   $97,832   $276,671   $276,682 
7     Special Mention   10    10    9,892    1,514 
8     Substandard   1,221    1,334    11,759    12,210 
9     Doubtful                
Add (deduct):  Unearned discount and                
   Net deferred loan fees and costs   150    161    613    564 
Total loans  $107,175   $99,337   $298,935   $290,970 

 

   Residential Real Estate     
   Including Home Equity   Consumer Loans 
   March 31,   December 31,   March 31,   December 31, 
   2018   2017   2018   2017 
Grade:                    
1-6  Pass  $160,215   $161,405   $5,302   $5,997 
7     Special Mention   123    124    50    52 
8     Substandard   1,385    1,444    23    24 
9     Doubtful                
Add (deduct):  Unearned discount and   (1)   (1)        
   Net deferred loan fees and costs   (49)   (47)   86    92 
Total loans  $161,673   $162,925   $5,461   $6,165 

 

   Total Loans 
   March 31,   December 31, 
   2018   2017 
Grade:          
1-6  Pass  $547,982   $541,916 
7    Special Mention   10,075    1,700 
8    Substandard   14,388    15,012 
9    Doubtful        
Add (deduct):  Unearned discount and   (1)   (1)
   Net deferred loan fees and costs   800    770 
Total loans  $573,244   $559,397 

 

Commercial and Industrial and Commercial Real Estate include loans categorized as tax-free in the amounts of $42,128,000 and $2,278,000 at March 31, 2018 and $40,926,000 and $2,315,000 at December 31, 2017. Loans held for sale amounted to $708,000 at March 31, 2018 and $834,000 at December 31, 2017.

 

 19 

 

 

The activity in the allowance for loan losses, by loan class, is summarized below for the periods indicated.

 

(Dollars in thousands)

 

   Commercial   Commercial   Residential             
   and Industrial   Real Estate   Real Estate   Consumer   Unallocated   Total 
As of and for the three month period ended March 31, 2018:                              
Allowance for Loan Losses:                              
Beginning balance  $949   $4,067   $1,656   $111   $704   $7,487 
Charge-offs       (117)   (29)   (13)       (159)
Recoveries   1                    1 
Provision   67    578    45    (3)   (637)   50 
Ending Balance  $1,017   $4,528   $1,672   $95   $67   $7,379 
Ending balance: individually evaluated for impairment  $   $625   $20   $   $   $645 
Ending balance: collectively evaluated for impairment  $1,017   $3,903   $1,652   $95   $67   $6,734 
                               
Loans Receivable:                              
Ending Balance  $107,175   $298,935   $161,673   $5,461   $   $573,244 
Ending balance: individually evaluated for impairment  $1,188   $11,611   $994   $   $   $13,793 
Ending balance: collectively evaluated for impairment  $105,987   $287,324   $160,679   $5,461   $   $559,451 

 

(Dollars in thousands)

 

   Commercial   Commercial   Residential             
   and Industrial   Real Estate   Real Estate   Consumer   Unallocated   Total 
As of and for the three month period ended March 31, 2017:                              
Allowance for Loan Losses:                              
Beginning balance  $836   $4,421   $1,777   $95   $228   $7,357 
Charge-offs       (9)   (19)   (22)       (50)
Recoveries   67            4        71 
Provision   (28)   45    (9)   18    57    83 
Ending Balance  $875   $4,457   $1,749   $95   $285   $7,461 
Ending balance: individually evaluated for impairment  $   $241   $19   $   $   $260 
Ending balance: collectively evaluated for impairment  $875   $4,216   $1,730   $95   $285   $7,201 
                               
Loans Receivable:                              
Ending Balance  $89,336   $262,651   $166,982   $6,020   $   $524,989 
Ending balance: individually evaluated for impairment  $1,250   $13,062   $1,169   $   $   $15,481 
Ending balance: collectively evaluated for impairment  $88,086   $249,589   $165,813   $6,020   $   $509,508 

 

 20 

 

 

(Dollars in thousands)

 

   Commercial   Commercial   Residential             
   and Industrial   Real Estate   Real Estate   Consumer   Unallocated   Total 
As of and for the year ended December 31, 2017                              
Allowance for Loan Losses:                              
Beginning balance  $836   $4,421   $1,777   $95   $228   $7,357 
Charge-offs       (189)   (62)   (82)       (333)
Recoveries   74    103    9    10        196 
Provision   39    (268)   (68)   88    476    267 
Ending Balance  $949   $4,067   $1,656   $111   $704   $7,487 
Ending balance: individually evaluated for impairment  $   $305   $22   $   $   $327 
Ending balance: collectively evaluated for impairment  $949   $3,762   $1,634   $111   $704   $7,160 
                               
Loans Receivable:                              
Ending Balance  $99,337   $290,970   $162,925   $6,165   $   $559,397 
Ending balance: individually evaluated for impairment  $1,203   $11,673   $1,050   $   $   $13,926 
Ending balance: collectively evaluated for impairment  $98,134   $279,297   $161,875   $6,165   $   $545,471 

 

Of the $1,115,000 in foreclosed assets held for resale at March 31, 2018, $209,000 was represented by residential real estate, $50,000 was represented by land, and $856,000 was represented by commercial real estate. Of the $1,071,000 in foreclosed assets held for resale at December 31, 2017, $15,000 was represented by residential real estate, $50,000 was represented by land, and $1,006,000 was represented by commercial real estate. At March 31, 2018 and December 31, 2017, all foreclosed assets were held as the result of obtaining physical possession. Consumer mortgage loans secured by residential real estate for which the Bank has entered into formal foreclosure proceedings but for which physical possession of the property has yet to be obtained amounted to $516,000 at March 31, 2018 and $485,000 at December 31, 2017. These balances were not included in foreclosed assets held for resale at March 31, 2018 or December 31, 2017.

 

From time to time, the Bank may agree to modify the contractual terms of a borrower’s loan. In cases where the modifications represent a concession to a borrower experiencing financial difficulty, the modification is considered a troubled debt restructuring (“TDR”).

 

The outstanding recorded investment of TDRs as of March 31, 2018 and December 31, 2017 was $9,063,000 and $9,109,000, respectively. The decrease in TDRs at March 31, 2018 as compared to December 31, 2017 is attributable to principal payments, paydowns, and charge-offs made on existing TDRs net against smaller loans modified as TDRs during the three months ended March 31, 2018. There were no unfunded commitments on TDRs at March 31, 2018 and December 31, 2017.

 

During the three months ended March 31, 2018, three loans with a combined post modification balance of $164,000 were modified as TDRs as compared to the same period in 2017, when two loans with a combined post modification balance of $110,000 were classified as TDRs. The loan modifications for the three months ended March 31, 2018 consisted of one term modification and two payment modifications. The loan modifications for the three months ended March 31 2017 consisted of two payment modifications.

 

The following table presents the outstanding recorded investment of TDRs at the dates indicated:

 

(Dollars in thousands)

 

   March 31,   December 31, 
   2018   2017 
Non-accrual TDRs  $160   $273 
Accruing TDRs   8,903    8,836 
Total  $9,063   $9,109 

 

 21 

 

 

At March 31, 2018, eight Commercial Real Estate loans classified as TDRs with a combined recorded investment of $573,000, one Commercial and Industrial loan classified as a TDR with a recorded investment of $10,000 and one Residential Real Estate loan classified as a TDR with a recorded investment of $60,000 were not in compliance with the terms of their restructure, compared to March 31, 2017 when seven Commercial Real Estate loans classified as TDRs with a combined recorded investment of $642,000 and one Commercial and Industrial loan classified as a TDR with a recorded investment of $13,000 were not in compliance with the terms of their restructure.

 

During the three months ended March 31, 2018 and March 31, 2017, no loans that were modified as TDRs within the preceding twelve months had experienced payment defaults

 

The following table presents information regarding the loan modifications categorized as TDRs during the three months ended March 31, 2018 and March 31, 2017.

 

(Dollars in thousands)

 

   Three Months Ended March 31, 2018 
      Pre-Modification   Post-Modification     
   Number   Outstanding Recorded   Outstanding Recorded   Recorded 
   of Contracts   Investment   Investment   Investment 
Commercial and Industrial      $   $   $ 
Commercial Real Estate   3    152    164    160 
Total   3   $152   $164   $160 

 

(Dollars in thousands)

 

   Three Months Ended March 31, 2017 
      Pre-Modification   Post-Modification     
   Number   Outstanding Recorded   Outstanding Recorded   Recorded 
   of Contracts   Investment   Investment   Investment 
Commercial and Industrial   1   $38   $38   $38 
Commercial Real Estate   1    72    72    72 
Total   2   $110   $110   $110 

 

The following table provides detail regarding the types of loan modifications made for loans categorized as TDRs during the three months ended March 31, 2018 and March 31, 2017 with the total number of each type of modification performed.

 

   Three Months Ended March 31, 2018   Three Months Ended March 31, 2017 
   Rate   Term   Payment   Number   Rate   Term   Payment   Number 
   Modification   Modification   Modification   Modified   Modification   Modification   Modification   Modified 
Commercial and Industrial                           1    1 
Commercial Real Estate       1    2    3            1    1 
Total       1    2    3            2    2 

 

 22 

 

 

The recorded investment, unpaid principal balance, and the related allowance of the Corporation’s impaired loans are summarized below for the periods ended March 31, 2018 and December 31, 2017.

 

(Dollars in thousands)

 

   March 31, 2018   December 31, 2017 
       Unpaid           Unpaid     
   Recorded   Principal   Related   Recorded   Principal   Related 
   Investment   Balance   Allowance   Investment   Balance   Allowance 
With no related allowance recorded:                              
Commercial and Industrial  $1,188   $1,188   $   $1,203   $1,203   $ 
Commercial Real Estate   9,284    11,574        9,199    11,383     
Residential Real Estate   866    1,012        878    1,024     
                               
With an allowance recorded:                              
Commercial and Industrial                        
Commercial Real Estate   2,327    3,742    625    2,474    3,889    305 
Residential Real Estate   128    128    20    172    172    22 
Total  $13,793   $17,644   $645   $13,926   $17,671   $327 
                               
Total consists of:                              
Commercial and Industrial  $1,188   $1,188   $   $1,203   $1,203   $ 
Commercial Real Estate  $11,611   $15,316   $625   $11,673   $15,272   $305 
Residential Real Estate  $994   $1,140   $20   $1,050   $1,196   $22 

 

 

At March 31, 2018 and December 31, 2017, $9,063,000 and $9,109,000 of loans classified as TDRs were included in impaired loans with a total allocated allowance of $0 and $2,000, respectively. The recorded investment represents the loan balance reflected on the Consolidated Balance Sheets net of any charge-offs. The unpaid balance is equal to the gross amount due on the loan.

 

The average recorded investment and interest income recognized for the Corporation’s impaired loans are summarized below for the three months ended March 31, 2018 and 2017.

 

(Dollars in thousands)

 

   For the Three Months Ended   For the Three Months Ended 
   March 31, 2018   March 31, 2017 
   Average   Interest   Average   Interest 
   Recorded   Income   Recorded   Income 
   Investment   Recognized   Investment   Recognized 
With no related allowance recorded:                    
Commercial and Industrial  $1,196   $4   $833   $12 
Commercial Real Estate   9,307    101    11,960    127 
Residential Real Estate   873    1    632    1 
                     
With an allowance recorded:                    
Commercial and Industrial                
Commercial Real Estate   2,327        985     
Residential Real Estate   128        424     
Total  $13,831   $106   $14,834   $140 
                     
Total consists of:                    
Commercial and Industrial  $1,196   $4   $833   $12 
Commercial Real Estate  $11,634   $101   $12,945   $127 
Residential Real Estate  $1,001   $1   $1,056   $1 

 

 

Of the $106,000 and $140,000 in interest income recognized on impaired loans for the three months ended March 31, 2018 and 2017, respectively, $0 and $17,000 in interest income was recognized with respect to non-accrual loans.

 

 23 

 

 

Total non-performing assets (which includes loans receivable on non-accrual status, foreclosed assets held for resale and loans past-due 90 days or more and still accruing interest) as of March 31, 2018 and December 31, 2017 were as follows:

 

(Dollars in thousands)

 

   March 31,   December 31, 
   2018   2017 
Commercial and Industrial  $787   $798 
Commercial Real Estate   3,168    3,302 
Residential Real Estate   935    990 
Total non-accrual loans   4,890    5,090 
Foreclosed assets held for resale   1,115    1,071 
Loans past-due 90 days or more and still accruing interest   18    70 
Total non-performing assets  $6,023   $6,231 

 

The following tables present the classes of the loan portfolio summarized by past-due status at March 31, 2018 and December 31, 2017:

 

(Dollars in thousands)

 

                           90 Days 
                           Or Greater 
                           Past Due 
           90 Days               and Still 
   30-59 Days   60-89 Days   or Greater   Total       Total   Accruing 
   Past Due   Past Due   Past Due   Past Due   Current   Loans   Interest 
March 31, 2018:                                   
Commercial and Industrial  $10   $34   $   $44   $107,131   $107,175   $ 
Commercial Real Estate   592    921    2,555    4,068    294,867    298,935     
Residential Real Estate   1,646    635    534    2,815    158,858    161,673    18 
Consumer   1    3        4    5,457    5,461     
Total  $2,249   $1,593   $3,089   $6,931   $566,313   $573,244   $18 

 

(Dollars in thousands)

 

                           90 Days 
                           Or Greater 
                           Past Due 
           90 Days               and Still 
   30-59 Days   60-89 Days   or Greater   Total       Total   Accruing 
   Past Due   Past Due   Past Due   Past Due   Current   Loans   Interest 
December 31, 2017:                                   
Commercial and Industrial  $68   $42   $   $110   $99,227   $99,337   $ 
Commercial Real Estate   603    201    2,606    3,410    287,560    290,970    50 
Residential Real Estate   1,952    484    584    3,020    159,905    162,925    20 
Consumer   21    2        23    6,142    6,165     
Total  $2,644   $729   $3,190   $6,563   $552,834   $559,397   $70 

 

At March 31, 2018, commitments to lend additional funds with respect to impaired loans consisted of one irrevocable letter of credit totaling $1,249,000 that was associated with a loan to a developer of a residential sub-division compared to December 31, 2017 when commitments to lend additional funds with respect to impaired loans consisted of one irrevocable letter of credit in the amount of $1,249,000 associated with a loan to a developer of a residential sub-division and two irrevocable letters of credit totaling $19,000 that were associated with a loan to non-profit community recreation facility.

 

 24 

 

 

NOTE 5BORROWINGS

 

Short-Term Borrowings

 

Short-term borrowings include federal funds purchased, securities sold under agreements to repurchase, the Federal Discount Window, and Federal Home Loan Bank (“FHLB”) advances, which generally represent overnight or less than 30-day borrowings.

 

Securities Sold Under Agreements to Repurchase (“Repurchase Agreements”)

 

The Corporation enters into agreements under which it sells securities subject to an obligation to repurchase the same or similar securities. Under these arrangements, the Corporation may transfer legal control over the assets but still retain effective control through an agreement that both entitles and obligates the Corporation to repurchase the assets.

 

As a result, these repurchase agreements are accounted for as collateralized financing agreements (i.e., secured borrowings) and not as a sale and subsequent repurchase of securities. The obligation to repurchase the securities is reflected as a liability on the Corporation’s Consolidated Balance Sheets, while the securities underlying the repurchase agreements remain in the respective investment securities asset accounts. In other words, there is not offsetting or netting of the investment securities assets with the repurchase agreement liabilities. In addition, as the Corporation does not enter into reverse repurchase agreements, there is no such offsetting to be done with the repurchase agreements.

 

The right of setoff for a repurchase agreement resembles a secured borrowing, whereby the collateral would be used to settle the fair value of the repurchase agreement should the Corporation be in default (e.g., fails to make an interest payment to the counterparty). The collateral is held by a correspondent bank in the counterparty’s custodial account. The counterparty has the right to sell or repledge the investment securities.

 

The following table presents the short-term borrowings subject to an enforceable master netting arrangement or repurchase agreements as of March 31, 2018 and December 31, 2017.

 

(Dollars in thousands)

 

       Gross   Net Amounts             
       Amounts   of Liabilities             
       Offset   Presented             
   Gross   in the   in the             
   Amounts of   Consolidated   Consolidated       Cash     
   Recognized   Balance   Balance   Financial   Collateral   Net 
   Liabilities   Sheet   Sheet   Instruments   Pledge   Amount 
March 31, 2018                              
Repurchase agreements (a)  $14,714   $   $14,714   $(14,714)  $   $ 
                               
December 31, 2017                              
Repurchase agreements (a)  $22,844   $   $22,844   $(22,844)  $   $ 

 

 

(a) As of March 31, 2018 and December 31, 2017, the fair value of securities pledged in connection with repurchase agreements was $24,020,000 and $26,023,000, respectively.

 

The following table presents the remaining contractual maturity of the master netting arrangement or repurchase agreements as of March 31, 2018:

 

(Dollars in thousands)

 

   Remaining Contractual Maturity of the Agreements 
   Overnight           Greater     
   and   Up to   30 -90   than     
   Continuous   30 days   Days   90 Days   Total 
March 31, 2018:                         
Repurchase agreements and repurchase-to-maturity transactions:                         
U.S. Treasury and/or agency securities  $14,714   $   $   $   $14,714 
Total  $14,714   $   $   $   $14,714 
 25 

 

 

Long-Term Borrowings

 

Long-term borrowings are comprised of advances from FHLB. Under terms of a blanket agreement, collateral for the FHLB loans is certain qualifying assets of the Corporation’s banking subsidiary. The principal assets are real estate mortgages and certain investment securities.

 

NOTE 6COMMITMENTS AND CONTINGENCIES

 

In the normal course of business, there are various pending legal actions and proceedings that are not reflected in the consolidated financial statements. Management does not believe the outcome of these actions and proceedings will have a material effect on the consolidated financial position or results of operations of the Corporation.

 

NOTE 7FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND CONCENTRATIONS OF CREDIT RISK

 

Financial Instruments with Off-Balance Sheet Risk

 

The Corporation is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Consolidated Balance Sheets. The contract or notional amounts of those instruments reflect the extent of involvement the Corporation has in particular classes of financial instruments. The Corporation does not engage in trading activities with respect to any of its financial instruments with off-balance sheet risk.

 

The Corporation’s exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments.

 

The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

 

The Corporation may require collateral or other security to support financial instruments with off-balance sheet credit risk.

 

The contract or notional amounts at March 31, 2018 and December 31, 2017, were as follows:

 

(Dollars in thousands)

 

   March 31, 2018   December 31, 2017 
Financial instruments whose contract amounts represent credit risk:          
Commitments to extend credit  $119,274   $90,373 
Financial standby letters of credit  $430   $450 
Performance standby letters of credit  $2,952   $2,901 

 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses that may require payment of a fee. Since some of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Corporation evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation upon extension of credit, is based on management’s credit evaluation of the borrower. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, owner-occupied income-producing commercial properties, and residential real estate.

 

Standby letters of credit are conditional commitments issued by the Corporation to guarantee payment to a third party when a customer either fails to repay an obligation or fails to perform some non-financial obligation. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Corporation may hold collateral (similar to the items held as collateral for commitments to extend credit) to support standby letters of credit for which collateral is deemed necessary.

 

 26 

 

 

Financial Instruments with Concentrations of Credit Risk

 

The Corporation originates primarily commercial and residential real estate loans to customers in northeastern Pennsylvania. The ability of the majority of the Corporation’s customers to honor their contractual loan obligations is dependent on the economy and real estate market in this area. At March 31, 2018, the Corporation had $460,608,000 in loans secured by real estate, which represented 80.4% of total loans. The real estate loan portfolio is largely secured by lessors of residential buildings and dwellings, lessors of non-residential buildings, and lessors of hotels/motels. As of March 31, 2018 and December 31, 2017, management is of the opinion that there were no concentrations exceeding 10% of total loans with regard to loans to borrowers who were engaged in similar activities that were similarly impacted by economic or other conditions.

 

As all financial instruments are subject to some level of credit risk, the Corporation requires collateral and/or guarantees for all loans. Collateral may include, but is not limited to property, plant, and equipment, commercial and/or residential real estate property, land, and pledge of securities. In the event of a borrower’s default, the collateral supporting the loan may be seized in order to recoup losses associated with the loan. The Corporation also establishes an allowance for loan losses that constitutes the amount available to absorb losses within the loan portfolio that may exist due to deficiencies in collateral values.

 

NOTE 8FAIR VALUE MEASUREMENTS

 

Fair value measurement and disclosure guidance defines fair value as the price that would be received to sell the asset or transfer the liability in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. This guidance provides additional information on determining when the volume and level of activity for the asset or liability has significantly decreased. The guidance also includes information on identifying circumstances when a transaction may not be considered orderly.

 

Fair value measurement and disclosure guidance provides a list of factors that a reporting entity should evaluate to determine whether there has been a significant decrease in the volume and level of activity for the asset or liability in relation to normal market activity for the asset or liability. When the reporting entity concludes there has been a significant decrease in the volume and level of activity for the asset or liability, further analysis of the information from that market is needed and significant adjustments to the related prices may be necessary to estimate fair value in accordance with the fair value measurement and disclosure guidance.

 

This guidance clarifies that when there has been a significant decrease in the volume and level of activity for the asset or liability, some transactions may not be orderly. In those situations, the entity must evaluate the weight of the evidence to determine whether the transaction is orderly. The guidance provides a list of circumstances that may indicate that a transaction is not orderly. A transaction price that is not associated with an orderly transaction is given little, if any, weight when estimating fair value.

 

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from independent sources, or unobservable, meaning those that reflect the reporting entity’s own belief about the assumptions market participants would use in pricing the asset or liability based upon the best information available in the circumstances. Fair value measurement and disclosure guidance establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

 

Level 1 Inputs: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;

 

Level 2 Inputs: Quoted prices in markets that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability;

 

Level 3 Inputs: Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity).

 

 27 

 

 

A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth as follows.

 

Financial Assets Measured at Fair Value on a Recurring Basis

 

At March 31, 2018 and December 31, 2017, securities measured at fair value on a recurring basis and the valuation methods used are as follows:

 

(Dollars in thousands)

 

  Level 1   Level 2   Level 3   Total 
March 31, 2018                    
Debt Securities Available-for-Sale:                    
U.S. Treasury securities  $   $2,819   $   $2,819 
Obligations of U.S. Government Corporations and Agencies:                    
Mortgage-backed       81,986        81,986 
Other       20,933        20,933 
Obligations of state and political subdivisions       202,928        202,928 
Asset backed securities       5,025        5,025 
Corporate debt securities       28,402        28,402 
Total debt securities available-for-sale       342,093        342,093 
Marketable equity securities   1,599            1,599 
Total recurring fair value measurements  $1,599   $342,093   $   $343,692 

 

(Dollars in thousands)

 

  Level 1   Level 2   Level 3   Total 
December 31, 2017                    
Debt Securities Available-for-Sale:                    
U.S. Treasury securities  $   $   $   $ 
Obligations of U.S. Government Corporations and Agencies:                    
Mortgaged-backed       81,860        81,860 
Other       22,233        22,233 
Obligations of state and political subdivisions       215,522        215,522 
Asset backed securities                
Corporate debt securities       28,971        28,971 
Total debt securities available-for-sale       348,586        348,586 
Marketable equity securities   1,632            1,632 
Total recurring fair value measurements  $1,632   $348,586   $   $350,218 

 

The estimated fair values of equity securities classified as Level 1 are derived from quoted market prices in active markets; these assets consist mainly of stocks held in other banks. The estimated fair values of all debt securities classified as Level 2 are obtained from nationally-recognized third-party pricing agencies. The estimated fair values are derived primarily from cash flow models, which include assumptions for interest rates, credit losses, and prepayment speeds. The significant inputs utilized in the cash flow models are based on market data obtained from sources independent of the Corporation (observable inputs), and are therefore classified as Level 2 within the fair value hierarchy. The Corporation does not have any Level 3 inputs for securities. There were no transfers between Level 1 and Level 2 during 2018 or 2017.

 

Financial Assets Measured at Fair Value on a Nonrecurring Basis

 

At March 31, 2018 and December 31, 2017, impaired loans measured at fair value on a nonrecurring basis and the valuation methods used are as follows:

 

(Dollars in thousands)

 

   Level 1   Level 2   Level 3   Total 
Assets at March 31, 2018                    
Impaired loans:                    
Commercial Real Estate  $   $   $4,903   $4,903 
Residential Real Estate          212    212 
Total impaired loans  $   $   $5,115   $5,115 

 

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(Dollars in thousands)

 

   Level 1   Level 2   Level 3   Total 
Assets at December 31, 2017                    
Impaired loans:                    
Commercial Real Estate  $   $   $5,498   $5,498 
Residential Real Estate           254    254 
Total impaired loans  $   $   $5,752   $5,752 

 

The Bank’s impaired loan valuation procedure for any loans greater than $250,000 requires an appraisal to be obtained and reviewed annually at year end. A quarterly collateral evaluation is performed which may include a site visit, property pictures and discussions with realtors and other similar business professionals to ascertain current values. For impaired loans less than $250,000 upon classification and annually at year end, the Bank completes a Certificate of Inspection, which includes an onsite inspection, insured values, tax assessed values, recent sales comparisons and a review of the previous evaluations. These assets are included as Level 3 fair values, based upon the lowest level that is significant to the fair value measurements. The fair value consists of the impaired loan balances less the valuation allowance and/or charge-offs. There were no transfers between valuation levels in 2018 and 2017.

 

Nonfinancial Assets Measured at Fair Value on a Nonrecurring Basis

 

At March 31, 2018 and December 31, 2017, foreclosed assets held for resale measured at fair value on a nonrecurring basis and the valuation methods used are as follows:

 

(Dollars in thousands)

 

   Level 1   Level 2   Level 3   Total 
Assets at March 31, 2018                
Foreclosed assets held for resale:                    
Commercial Real Estate  $   $   $856   $856 
Residential Real Estate           209    209 
Total foreclosed assets held for resale  $   $   $1,065   $1,065 

 

(Dollars in thousands)

 

   Level 1   Level 2   Level 3   Total 
Assets at December 31, 2017                
Other foreclosed assets held for resale:                    
Commercial Real Estate  $   $   $81   $81 
Residential Real Estate           13    13 
Total foreclosed assets held for resale  $   $   $94   $94 

 

The Bank’s foreclosed asset valuation procedure requires an appraisal, which considers the sales prices of similar properties in the proximate vicinity, to be completed periodically with the exception of those cases which the Bank has obtained a sales agreement. These assets are included as Level 3 fair values, based upon the lowest level that is significant to the fair value measurements. There were no transfers between valuation levels in 2018 and 2017.

 

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The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis and for which the Bank has utilized Level 3 inputs to determine the fair value:

 

(Dollars in thousands)

 

   Quantitative Information about Level 3 Fair Value Measurements 
   Fair Value             Weighted 
   Estimate   Valuation Technique  Unobservable Input  Range   Average 
March 31, 2018                     
Impaired loans  $2,018   Appraisal of collateral1,3  Appraisal adjustments2   (17%) – (67%)   (21%)
Impaired loans  $3,097   Discounted cash flow  Discount rate   (7%) – (7%)   (7%)
Foreclosed assets held for resale  $1,065   Appraisal of collateral1,3  Appraisal adjustments2   (2%) – (35%)   (7%)
                      
December 31, 2017                     
Impaired loans  $2,495   Appraisal of collateral1,3  Appraisal adjustments2   (7%) – (65%)   (15%)
Impaired loans  $3,257   Discounted cash flow  Discount rate   (7%) –   (8%)   (7%)
Foreclosed assets held for sale  $94   Appraisal of collateral1,3  Appraisal adjustments2   (35%) – (37%)   (36%)

 

 

1Fair value is generally determined through independent appraisals of the underlying collateral, as defined by Bank regulators.

2Appraisals may be adjusted downward by management for qualitative factors such as economic conditions and estimated liquidation expenses. The typical range of appraisal adjustments are presented as a percent of the appraisal value.

3Includes qualitative adjustments by management and estimated liquidation expenses.

 

Fair Value of Financial Instruments

 

(Dollars in thousands)

 

   Carrying   Fair Value Measurements at March 31, 2018 
   Amount   Level 1   Level 2   Level 3   Total 
FINANCIAL ASSETS:                         
Cash and due from banks  $8,973   $8,973   $   $   $8,973 
Interest-bearing deposits in other banks   1,328        1,328        1,328 
Time deposits with other banks   1,482        1,482        1,482 
Debt securities available-for-sale   342,093        342,093        342,093 
Marketable equity securities   1,599    1,599            1,599 
Restricted investment in bank stocks   5,445        5,445        5,445 
Net loans   565,865            560,037    560,037 
Mortgage servicing rights   363            363    363 
Accrued interest receivable   3,852        3,852        3,852 
                          
FINANCIAL LIABILITIES:                         
Core deposits   535,379        535,379        535,379 
Time deposits   213,467        210,647        210,647 
Short-term borrowings   80,791        80,791        80,791 
Long-term borrowings   55,000        54,852        54,852 
Accrued interest payable   549        549        549 
                          
OFF-BALANCE SHEET FINANCIAL INSTRUMENTS                    

 

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(Dollars in thousands)

 

   Carrying   Fair Value Measurements at December 31, 2017 
   Amount   Level 1   Level 2   Level 3   Total 
FINANCIAL ASSETS:                         
Cash and due from banks  $7,913   $7,913   $   $   $7,913 
Interest-bearing deposits in other banks   826        826        826 
Time deposits with other banks   1,482        1,482        1,482 
Debt securities available-for-sale   348,586        348,586        348,586 
Marketable equity securities   1,632    1,632            1,632 
Restricted investment in bank stocks   4,058        4,058        4,058 
Net loans   551,910            550,696    550,696 
Mortgage servicing rights   379            379    379 
Accrued interest receivable   4,237        4,237        4,237 
                          
FINANCIAL LIABILITIES:                         
Core deposits   570,518        570,518        570,518 
Time deposits   207,628        206,299        206,299 
Short-term borrowings   26,296        26,296        26,296 
Long-term borrowings   65,000        65,336        65,336 
Accrued interest payable   490        490        490 
                          
OFF-BALANCE SHEET FINANCIAL  INSTRUMENTS                    

 

NOTE 9REVENUE RECOGNITION

 

As disclosed in Note 2, as of January 1, 2018, the Corporation adopted ASU 2014-09 Revenue from Contracts with Customers - Topic 606 and all subsequent ASUs that modified ASC 606. The Corporation has elected to apply the ASU and all related ASUs using the modified retrospective implementation method. The implementation of the guidance had no material impact on the measurement or recognition of revenue of prior periods, however, additional disclosures have been added in accordance with the ASU.

 

The main types of revenue contracts included in non-interest income within the consolidated statements of income are as follows:

 

Deposits related fees and service charges

 

Service charges and fees on deposits, which are included as liabilities in the consolidated balance sheets, consist of fees related to monthly fees for various retail and business checking accounts, automated teller machine (“ATM”) fees (charged for withdrawals by our deposit customers from other bank ATMs) and insufficient funds fees (“NSF”) (which are charged when customers overdraw their accounts beyond available funds). All deposit liabilities are considered to have one-day terms and therefore related fees are recognized in income at the time when the services are provided to the customers. The Corporation elected to adopt practical expedient related to incremental costs of obtaining deposit contracts. As such, any costs associated with acquiring the deposits, except for certificate of deposits (“CDs”) with maturities in excess of one year, are recognized as an expense within the non-interest expense in the consolidated statements of income when incurred as the amortization period of the deposit liabilities that otherwise would have been recognized is one year or less.

 

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Wealth/Asset/Trust Management Fees

 

Wealth management services are delivered to individuals, corporations and retirement funds located primarily within our geographic markets. The Trust Department of the Corporation conducts the wealth management operations, which provides a broad range of personal and corporate fiduciary services, including the administration of estates.

 

Assets held in a fiduciary capacity by the Trust Department are not assets of the Corporation and, therefore, are not included in our Consolidated Financial Statements. Wealth management fees, which are contractually agreed with each customer, are earned each month and recognized on a cash basis based on average fair value of the trust assets under management. The services provided under such a contract are considered a single performance obligation under ASC 606 because they embody a series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer. Wealth management fees charged by the Trust Department follow a tiered structure based on the type and size of the assets under management. Wealth management fees are included within non-interest income in the consolidated statements of income. As of March 31, 2018 and December 31, 2017, the fair value of trust assets under management was $114,498,000 and $111,130,000 respectively. The costs of acquiring asset management customers are incremental and recognized within the non-interest expense of the consolidated statements of income.

 

Interchange Fees and Surcharges

 

Interchange fees are related to the acceptance and settlement of debit card transactions, both point-of-sale and ATM, to cover operating costs and risks associated with the approval and settlement of the transactions. Interchange fees vary by type of transaction and each merchant sector. Net income recognized from interchange fees is included in non-interest income on the consolidated statements of income. A surcharge is assessed for use of the Corporation’s ATMs by non-customers. All interchange fees and surcharges are recognized as received on a daily basis for the prior business day’s transactions. All expenses related to the settlement of debit card transactions (both point-of-sale and ATM) are recognized on a monthly basis and included in non-interest expense on the consolidated statements of income.

 

NOTE 10EARNINGS PER SHARE

 

Basic earnings per share (“EPS”) is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Corporation. Potential common shares that may be issued by the Corporation relate solely to outstanding stock options and are determined using the treasury stock method. The following table sets forth the computation of basic and diluted earnings per share.

 

(In thousands, except earnings per share)

 

   Three Months Ended 
   March 31, 
   2018   2017 
Net income  $1,777   $2,286 
Weighted-average common shares outstanding   5,719    5,672 
Basic earnings per share  $0.31   $0.40 
           
Weighted-average common shares outstanding   5,719    5,672 
Common stock equivalents due to effect of stock options       2 
Total weighted-average common shares and equivalents   5,719    5,674 
Diluted earnings per share  $0.31   $0.40 

 

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Item 2. First Keystone Corporation Management’s Discussion and Analysis of Financial Condition and Results of Operation

 

This quarterly report contains certain forward-looking statements, which are included pursuant to the “safeharbor” provisions of the Private Securities Litigation Reform Act of 1995, and reflect management’s beliefs and expectations based on information currently available. These forward-looking statements are inherently subject to significant risks and uncertainties, including changes in general economic and financial market conditions, the Corporation’s ability to effectively carry out its business plans and changes in regulatory or legislative requirements. Other factors that could cause or contribute to such differences are changes in competitive conditions, and pending or threatened litigation. Although management believes the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially.

 

CRITICAL ACCOUNTING ESTIMATES

 

The Corporation has chosen accounting policies that it believes are appropriate to accurately and fairly report its operating results and financial position, and the Corporation applies those accounting policies in a consistent manner. The Significant Accounting Policies are summarized in Note 1 to the consolidated financial statements included in the 2017 Annual Report on Form 10-K. There have been no changes to the Critical Accounting Estimates since the Corporation filed its Annual Report on Form 10-K for the year ended December 31, 2017.

 

RESULTS OF OPERATIONS

 

Quarter ended March 31, 2018 compared to quarter ended March 31, 2017

 

First Keystone Corporation realized earnings for the first quarter of 2018 of $1,777,000, a decrease of $509,000, or 22.3% from the first quarter of 2017. The decrease in net income for the three months ended March 31, 2018 was primarily due to increases in salaries and employee benefits and interest expense on deposits and short-term borrowings, as well as a decrease in net investment securities gains.

 

On a per share basis, for the three months ended March 31, 2018, net income was $0.31 versus $0.40 for the same three month period of 2017. Cash dividends amounted to $0.27 per share for the three months ended March 31, 2018 and 2017.

 

NET INTEREST INCOME

 

The major source of operating income for the Corporation is net interest income, defined as interest income less interest expense. In the first quarter of 2018, interest income amounted to $8,271,000, an increase of $374,000 or 4.7% from the first quarter of 2017, while interest expense amounted to $1,781,000 in the first quarter of 2018, an increase of $362,000, or 25.5% from the first quarter of 2017. As a result, net interest income increased $12,000 or 0.2% to $6,490,000 from $6,478,000 for the same period in 2017.

 

The Corporation’s net interest margin for the three months ended March 31, 2018 was 3.12% compared to 3.10% for the three months ended March 31, 2017. The increase in net interest margin was a result of an increase in yield on the investment portfolio.

 

PROVISION FOR LOAN LOSSES

 

The provision for loan losses for the three months ended March 31, 2018 and March 31, 2017 was $50,000 and $83,000, respectively. The decrease in the provision for loan losses resulted from the Corporation’s analysis of the current loan portfolio, including historic losses, past-due trends, current economic conditions and other relevant factors. Charge-off and recovery activity in the allowance for loan losses resulted in net charge-offs of $158,000 and net recoveries of $21,000 for the three months ended March 31, 2018 and 2017, respectively. See Allowance for Loan Losses on page 37 for further discussion.

 

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NON-INTEREST INCOME

 

Total non-interest income was $1,259,000 for the three months ended March 31, 2018, as compared to $1,538,000 for the same period in 2017, a decrease of $279,000, or 18.1%. The decrease was mainly the result of a decrease in net securities gains during the quarter. ATM fees and debit card income increased $30,000 or 9.2% to $357,000 for the three months ended March 31, 2018. Gains on sales of mortgage loans decreased $7,000 or 19.4% due to a decrease in loans originated with the intent to sell. Net gains on sales of securities decreased $320,000 to $(17,000) for the three months ended March 31, 2018 as compared to the three months ended March 31, 2017.

 

NON-INTEREST EXPENSE

 

Total non-interest expense was $5,895,000 for the quarter ended March 31, 2018, as compared to $5,263,000 for the quarter ended March 31, 2017. Non-interest expense increased $632,000 or 12.0%.

 

Expenses associated with employees (salaries and employee benefits) continue to be the largest category of non-interest expense. Salaries and benefits amounted to $3,036,000 or 51.5% of total non-interest expense for the three months ended March 31, 2018, as compared to $2,742,000 or 52.1% for the same three months of 2017. The increase was primarily due to increased costs associated with employee health care, as well as the addition of new sales positions in the commercial and residential mortgage lending areas.

 

Net occupancy, furniture and equipment, and computer expense amounted to $865,000 for the three months ended March 31, 2018, a decrease of $7,000 or 0.8%. Professional services decreased $15,000 or 6.3% to $223,000 as of March 31, 2018. Pennsylvania shares tax expense amounted to $199,000 for the three months ended March 31, 2018, a decrease of $7,000 or 3.4% as compared to the same three months in 2017.

 

FDIC insurance expense increased $1,000 or 1.3% for the three months ended March 31, 2018. FDIC insurance expense varies with changes in net asset size, risk ratings, and FDIC derived assessment rates. ATM and debit card fees expense amounted to $175,000 for the three months ended March 31, 2018, an increase of $38,000 or 27.7% as compared to the same three months of 2017. The increase was due to higher electronic funds transfer fees. Data processing expenses increased $40,000 or 17.6% to $267,000 for the three months ended March 31, 2018 as compared to the same three months of 2017. The increase was a result of pricing increases and new products from our main third party data processor. Foreclosed assets held for resale expense increased $42,000 in the first quarter of 2018 as the result of one OREO property purchased and the write down of two OREO property values during the three months ended March 31, 2018. Advertising expense increased $3,000 or 3.8% during the three months ended March 31, 2018.

 

Other non-interest expense amounted to $900,000 for the three months ended March 31, 2018, an increase of $243,000 or 37.0% as compared to the three months ended March 31, 2017. The increase was due to an increase in amortization costs on one of the Corporation’s low income housing investment properties.

 

INCOME TAXES

 

Income tax expense amounted to $27,000 for the three months ended March 31, 2018, as compared to $384,000 for the three months ended March 31, 2017, a decrease of $357,000. The effective total income tax rate was 1.5% for the first quarter of 2018 as compared to 14.4% for the first quarter of 2017. The decrease in the effective tax rate was due to major tax reform legislation signed into law in December 2017 which reduced the Corporation’s tax rate from 34% to 21%, effective January 1, 2018. The Corporation recognized $101,000 of tax credits from low-income housing partnerships in the first quarter of 2018.

 

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FINANCIAL CONDITION

 

SUMMARY

 

Total assets increased to $1,001,430,000 as of March 31, 2018, an increase of $11,309,000 from year-end 2017. Total assets as of December 31, 2017 amounted to $990,121,000.

 

Total debt securities decreased $6,493,000 or 1.9% to $342,093,000 as of March 31, 2018 from December 31, 2017.

 

Total loans increased $13,847,000 or 2.5% to $573,244,000 as of March 31, 2018 from December 31, 2017. Loan demand grew in the three months ended March 31, 2018 as the Bank has seen an increase in loan originations, primarily in the commercial real estate and commercial and industrial portfolios.

 

Total deposits decreased $29,300,000 or 3.8% to $748,846,000 as of March 31, 2018 from December 31, 2017.

 

The Corporation continues to maintain and manage its asset growth. The Corporation’s strong equity capital position provides an opportunity to further leverage its asset growth. Total borrowings increased in the first three months of 2018 by $44,495,000 to $135,791,000 from $91,296,000 as of December 31, 2017. Borrowings increased mainly due to decreased deposit balances and the need to fund growth in the loan portfolio.

 

Total stockholders’ equity decreased to $112,428,000 at March 31, 2018, a decrease of $4,291,000 or 3.7% from December 31, 2017 due to a decrease in accumulated other comprehensive income.

 

SEGMENT REPORTING

 

Currently, management measures the performance and allocates the resources of the Corporation as a single segment.

 

EARNING ASSETS

 

Earning assets are defined as those assets that produce interest income. By maintaining a healthy asset utilization rate, i.e., the volume of earning assets as a percentage of total assets, the Corporation maximizes income. The earning asset ratio (average interest earning assets divided by average total assets) equaled 92.5% at March 31, 2018 and March 31, 2017. This indicates that the management of earning assets is a priority and non-earning assets, primarily cash and due from banks, fixed assets and other assets, are maintained at minimal levels. The primary earning assets are loans and investment securities.

 

Our primary earning asset, total loans, increased to $573,244,000 as of March 31, 2018, up $13,847,000, or 2.5% since year-end 2017. The loan portfolio continues to be well diversified. Non-performing assets decreased since year-end 2017, and overall asset quality has remained consistent. Total non-performing assets were $6,023,000 as of March 31, 2018, a decrease of $208,000, or 3.3% from $6,231,000 reported in non-performing assets as of December 31, 2017. Total allowance for loan losses to total non-performing assets was 122.5% as of March 31, 2018 and 120.2% at December 31, 2017.

 

In addition to loans, another primary earning asset is our overall investment portfolio, which decreased in size from December 31, 2017 to March 31, 2018. Available-for-sale debt securities amounted to $342,093,000 as of March 31, 2018, a decrease of $6,526,000 from year-end 2017.

 

Interest-bearing deposits in other banks increased as of March 31, 2018, to $1,328,000 from $826,000 at year-end 2017. Time deposits with other banks were $1,482,000 at March 31, 2018 and December 31, 2017.

 

LOANS

 

Total loans increased to $573,244,000 as of March 31, 2018 as compared to $559,397,000 as of December 31, 2017. The table on page 19 provides data relating to the composition of the Corporation’s loan portfolio on the dates indicated. Total loans increased by $13,847,000 or 2.5%.

 

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Steady demand for borrowing by businesses accounted for the 2.5% increase in the loan portfolio from December 31, 2017 to March 31, 2018. The Commercial and Industrial portfolio increased $7,838,000 to $107,175,000 as of March 31, 2018, as compared to $99,337,000 at December 31, 2017. The increase in the Commercial and Industrial portfolio (which includes tax-free Commercial and Industrial loans) was attributed to new loan originations totaling $9,646,000 and a $6,055,000 increase in utilization of existing Commercial and Industrial lines of credit offset by loan payoffs of $3,274,000, as well as regular principal payments and other typical fluctuations and activity in the Commercial and Industrial portfolio. The Commercial Real Estate portfolio (which includes tax-free Commercial Real Estate loans) increased $7,965,000 to $298,935,000 at March 31, 2018, as compared to $290,970,000 at December 31, 2017. The increase was mainly the result of $15,066,000 in new loan originations, offset by $4,725,000 in loan payoffs in addition to regular principal payments and other typical amortizations in the Commercial Real Estate portfolio. Residential Real Estate loans decreased $1,252,000 to $161,673,000 at March 31, 2018, as compared to $162,925,000 at December 31, 2017. The decrease was the result of $3,753,000 in new loan originations offset by loan payoffs of $3,079,000, net loans sold of $478,000, and regular principal payments. Net loans sold in the Residential Real Estate portfolio for the quarter ended March 31, 2018 consisted of total loans sold during the quarter ended March 31, 2018 of $1,764,000, offset with loans opened and sold during the quarter ended March 31, 2018 which amounted to $1,286,000. The Corporation continues to originate and sell certain long-term fixed rate residential mortgage loans which conform to secondary market requirements. The Corporation derives ongoing income from the servicing of mortgages sold in the secondary market. The Corporation continues its efforts to lend to creditworthy borrowers despite the continued slow economic conditions.

 

Management believes that the loan portfolio is well diversified. The total commercial portfolio was $406,110,000 at March 31, 2018. Of total loans, $298,935,000 or 52.1% were secured by commercial real estate, primarily lessors of residential buildings and dwellings and lessors of non-residential buildings. The Corporation continues to monitor these portfolios.

 

The largest relationship is comprised of various real estate entities with a mutual owner who is a related party of the bank and began real estate investment and development activities in 1989. The relationship had outstanding loan balances and unused commitments of $12,682,000 at March 31, 2018. The individual owns a diverse mix of real estate entities which specialize in construction/development projects (which include VA clinics), leasing of commercial office space, and rental of multi-tenant residential units. This relationship is comprised of $11,682,000 in term debt and a line of credit totaling $1,000,000. The relationship is well secured by first lien mortgages on income producing commercial and residential real estate, plus assignment of governmental leases and collateral pledge of cash accounts and marketable securities.

 

The second largest relationship is comprised of multiple first and second lien mortgages relating to the purchase and improvements of several existing hotels. The principal and related owners/guarantors have extensive experience in the hotel industry, owning and operating hotels in various states for over twenty-five years. At March 31, 2018, the relationship had outstanding loan balances and unused commitments of $9,899,000. The debt is comprised of $9,844,000 in term debt and two lines of credit totaling $55,000. The loans are secured by commercial real estate, the assignment of rents and leases, and business assets.

 

The third largest relationship consists of a large, suburban/rural public school district that provides educational services to over 5,000 students and employs approximately 750 individuals as administrative, professional, and support staff. At March 31, 2018, the relationship had outstanding balances totaling $9,640,000 which consisted entirely of tax-free commercial term debt. The relationship is secured by business assets and the full faith, credit, and taxing power of the district.

 

The fourth largest relationship consists of a distributor and marketer of energy products and services including natural gas, propane, butane, and electricity. During 2017, the company undertook to partner with local banks to finance its capital needs while promoting regional economic development. At March 31, 2018, the relationship had outstanding balances of $8,888,000 which consisted entirely of unsecured term debt. The debt will be utilized for general corporate needs, including upgrades to the company’s utility distribution system that will enhance its ability to continue providing safe and reliable natural gas service.

 

The fifth largest relationship consists of a hotel management company that has been in operation since 1987 and successfully owns and operates seven hotels. At March 31, 2018, the relationship had outstanding balances totaling $8,431,000, which consisted entirely of term debt. The relationship is secured by commercial real estate and business assets, as well as the assignment of leases and a life insurance policy. The four loans included in this relationship were downgraded to special mention status during the three month period ended March 31, 2018 as the result of a warning letter that was received from the hotel franchisor regarding unfavorable guest satisfaction survey and brand audit results.

 

Each of the five relationships is headquartered in Corporation’s market area.

 

 36 

 

 

All of the above mentioned loans are performing as agreed. All loans are graded pass with the exception of the loans to the hotel management company. The property securing each of the loans was appraised at the time the loan was originated. Appraisals are ordered independently of the loan approval process from appraisers on an approved list. All appraisals are reviewed internally for conformity with accepted standards of the Bank.

 

Overall, the portfolio risk profile as measured by loan grade is considered low risk, as $547,982,000 or 95.7% of gross loans are graded Pass; $10,075,000 or 1.8% are graded Special Mention; $14,388,000 or 2.5% are graded Substandard; and $0 are graded Doubtful. The rating is intended to represent the best assessment of risk available at a given point in time, based upon a review of the borrower’s financial statements, credit analysis, payment history with the Bank, credit history and lender knowledge of the borrower. See Note 4 — Loans and Allowance for Loan Losses for risk grading tables.

 

Overall, non-pass grades increased to $24,463,000 at March 31, 2018, as compared to $16,712,000 at December 31, 2017. Commercial and Industrial non-pass grades decreased to $1,231,000 as of March 31, 2018 as compared to 1,344,000 as of December 31, 2017. Commercial Real Estate non-pass grades increased to $21,651,000 as of March 31, 2018 as compared to $13,724,000 as of December 31, 2017. The Residential Real Estate and Consumer loan non-pass grades decreased to $1,581,000 as of March 31, 2018 as compared to $1,644,000 as of December 31, 2017.

 

The increase in the Commercial Real Estate non-pass grade portfolio during the three months ended March 31, 2018 was mainly attributable to four loans to a hotel management company in the amount of $8,431,000 that were downgraded to Special Mention due to a warning letter that was issued by the hotel franchisor regarding unfavorable guest satisfaction survey and brand audit results. This large downgrade to non-pass grade status was offset by a $112,000 charge-off of a non-accrual purchased participation loan to a retailer of recreational vehicles that was moved to foreclosed assets held for resale during the three months ended March 31, 2018, $330,000 in regular payments and paydowns made during the three months ended March 31, 2018 on a large Substandard loan to the owner of a recreation facility, and a real estate-secured working capital line of credit to a commercial real estate developer that carried a balance of $148,000 at December 31, 2017 that was upgraded from Special Mention to pass-grade status during the three months ended March 31, 2018 to bring the risk rating of the credit facility into alignment with the risk ratings assigned to loans to a related entity and also as the result of good payment history and an acceptable loan-to-value ratio associated with the specific credit facility.

 

The Corporation continues to internally underwrite each of its loans to comply with prescribed policies and approval levels established by its Board of Directors.

 

Total Loans

 

(Dollars in thousands)  March 31,   December 31, 
   2018   2017 
Commercial and Industrial  $107,175   $99,337 
Commercial Real Estate   298,935    290,970 
Residential Real Estate   161,673    162,925 
Consumer   5,461    6,165 
Total loans  $573,244   $559,397 

 

ALLOWANCE FOR LOAN LOSSES

 

The allowance for loan losses constitutes the amount available to absorb losses within the loan portfolio. As of March 31, 2018, the allowance for loan losses was $7,379,000 as compared to $7,487,000 as of December 31, 2017. The allowance for loan losses is established through a provision for loan losses charged to expenses. Loans are charged against the allowance for possible loan losses when management believes that the collectability of the principal is unlikely. The risk characteristics of the loan portfolio are managed through various control processes, including credit evaluations of individual borrowers, periodic reviews, and diversification by industry. Risk is further mitigated through the application of lending procedures such as the holding of adequate collateral and the establishment of contractual guarantees.

 

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Management performs a quarterly analysis to determine the adequacy of the allowance for loan losses. The methodology in determining adequacy incorporates specific and general allocations together with a risk/loss analysis on various segments of the portfolio according to an internal loan review process. This assessment results in an allocated allowance. Management maintains its loan review and loan classification standards consistent with those of its regulatory supervisory authority.

 

Management considers, based upon its methodology, that the allowance for loan losses is adequate to cover foreseeable future losses. However, there can be no assurance that the allowance for loan losses will be adequate to cover significant losses, if any, that might be incurred in the future.

 

The Analysis of Allowance for Loan Losses table contains an analysis of the allowance for loan losses indicating charge-offs and recoveries for the three month periods ended March 31, 2018 and 2017. For the three month period ended March 31, 2018, net charge-offs as a percentage of average loans was 0.028% as compared to net recoveries of 0.004% of average loans for the three month period ended March 31, 2017. Net charge-offs amounted to $158,000 for the first three months of 2018 as compared to net recoveries of $21,000 for the first three months of 2017.

 

For the first three months of 2018, the provision for loan losses was $50,000 as compared to $83,000 for the first three months of 2017. The provision, net of charge-offs and recoveries, resulted in the quarter end Allowance for Loan Losses of $7,379,000 of which 13.8% was attributed to the Commercial and Industrial component; 61.4% attributed to the Commercial Real Estate component; 22.6% attributed to the Residential Real Estate component (primarily residential mortgages); 1.3% attributed to the Consumer component; and 0.9% being the unallocated component (refer to the activity in Note 4 – Loans and Allowance for Loan Losses on page 14). The Corporation determined that the provision for loan losses made during the current quarter was sufficient to maintain the allowance for loan losses at a level necessary for the probable losses inherent in the loan portfolio as of March 31, 2018.

 

Analysis of Allowance for Loan Losses

 

(Dollars in thousands)  March 31,   March 31, 
   2018   2017 
Balance at beginning of the three month period  $7,487   $7,357 
Charge-offs:          
Commercial and Industrial        
Commercial Real Estate   117    9 
Residential Real Estate   29    19 
Consumer   13    22 
    159    50 
Recoveries:          
Commercial and Industrial   1    67 
Commercial Real Estate        
Residential Real Estate        
Consumer       4 
    1    71 
           
Net charge-offs (recoveries)   158    (21)
Additions charged to operations   50    83 
Balance at end of the three month period  $7,379   $7,461 
           
Ratio of net charge-offs (recoveries) during the period to average loans outstanding during the period   0.028%   (0.004)%
Allowance for loan losses to average loans outstanding during the period   1.300%   1.413%

 

It is the policy of management and the Corporation’s Board of Directors to make a provision for both identified and unidentified losses inherent in its loan portfolio. A provision for loan losses is charged to operations based upon an evaluation of the potential losses in the loan portfolio. This evaluation takes into account such factors as portfolio concentrations, delinquency trends, trends of non-accrual and classified loans, economic conditions, and other relevant factors.

 

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The loan review process, which is conducted quarterly, is an integral part of the Bank’s evaluation of the loan portfolio. A detailed quarterly analysis to determine the adequacy of the Corporation’s allowance for loan losses is reviewed by the Board of Directors.

 

With the Bank’s manageable level of net charge-offs and the additions to the reserve from the provision out of operations, the allowance for loan losses as a percentage of average loans amounted to 1.30% at March 31, 2018 and 1.41% at March 31, 2017.

 

NON-PERFORMING ASSETS

 

The table on page 41 details the Corporation’s non-performing assets and impaired loans as of the dates indicated. Generally, a loan is classified as non-accrual and the accrual of interest on such a loan is discontinued when the contractual payment of principal or interest has become 90 days past due or management has serious doubts about further collectability of principal or interest, even though the loan currently is performing. A loan may remain on accrual status if it is in the process of collection and is either guaranteed or well secured. When a loan is placed on non-accrual status, unpaid interest credited to income in the current year is reversed and unpaid interest accrued in prior years is charged against current period income. A modification of a loan constitutes a troubled debt restructuring (“TDR”) when a borrower is experiencing financial difficulty and the modification constitutes a concession that the Corporation would not otherwise consider. Modifications to loans classified as TDRs generally include reductions in contractual interest rates, principal deferments and extensions of maturity dates at a stated interest rate lower than the current market for a new loan with similar risk characteristics. While unusual, there may be instances of loan principal forgiveness. Foreclosed assets held for resale represent property acquired through foreclosure, or considered to be an in-substance foreclosure.

 

Total non-performing assets amounted to $6,023,000 as of March 31, 2018 as compared to $6,231,000 as of December 31, 2017. The economy, in particular, high unemployment/labor underutilization rate, weak job markets, unsettled fuel prices and energy costs, and the continued slowness in the housing industry in our market areas had a direct effect on the Corporation’s non-performing assets. The Corporation is closely monitoring its Commercial Real Estate portfolio because of the current economic environment. In particular, vacancy rates are rising, while property values in some markets have fallen. Non-accrual loans totaled $4,890,000 as of March 31, 2018 as compared to $5,090,000 as of December 31, 2017. Foreclosed assets held for resale amounted to $1,115,000 at March 31, 2018 as compared to $1,071,000 at December 31, 2017. Loans past-due 90 days or more and still accruing interest amounted to $18,000 as of March 31, 2018 as compared to $70,000 as of December 31, 2017. At March 31, 2018, loans past-due 90 days or more and still accruing interest consisted of one Residential Real Estate loan for which the borrower has filed bankruptcy and loan payments are currently being made through a trustee.

 

Non-performing assets to total loans was 1.1% at March 31, 2018 and December 31, 2017. Non-performing assets to total assets was 0.6% at March 31, 2018 and December 31, 2017. The allowance for loan losses to total non-performing assets was 122.5% as of March 31, 2018 as compared to 120.2% as of December 31, 2017. Additional detail can be found on page 41 in the Non-Performing Assets and Impaired Loans table and page 24 in the Non-Performing Assets table. Asset quality is a priority and the Corporation retains a full-time loan review officer to closely track and monitor overall loan quality, along with a full-time workout specialist to manage collection and liquidation efforts.

 

Potential problem loans are defined as performing substandard loans which are not deemed to be impaired. These loans have characteristics that cause management to have doubts regarding the ability of the borrower to perform under present loan repayment terms and which may result in reporting these loans as non-performing loans in the future. Potential problem loans amounted to $4,580,000 at March 31, 2018, compared to $5,043,000 at December 31, 2017.

 

Impaired loans were $13,793,000 at March 31, 2018 and $13,926,000 at December 31, 2017. The largest impaired loan relationship at March 31, 2018 consisted of one performing loan to a student housing holding company in the amount of $3,097,000, which was secured by commercial real estate. The loan was downgraded to substandard status and modified as a TDR during the first quarter of 2015 due to the borrower’s failure to achieve stabilization and meet projected occupancy rates that was attributed to the overall economic decline in students’ disposable income and an increase in enrollment in online courses. The loan experienced a secondary modification during the third quarter of 2016 to extend the repayment term and modify the interest rate. The discounted cash flow evaluation at March 31, 2018 resulted in a specific allocation of $0. The second largest impaired loan relationship at March 31, 2018 consisted of a non-performing participation loan to a student housing holding company which was secured by commercial real estate. The Corporation’s share of the loan at March 31, 2018 was $2,318,000. The loan was downgraded to substandard and placed on non-accrual status during the third quarter of 2015 due to the borrower’s inability to reach a break-even rental income, related to the borrower’s failure to meet projected occupancy rates. One participant’s share in the amount of $1,350,000 was repurchased during the third quarter of 2017. The collateral evaluation of the total participation at March 31, 2018 carried a value of $3,044,000, after considering estimated appraisal adjustments and cost to sell of 18%, resulted in the Bank’s specific allocation of $624,000. The third largest impaired loan relationship at March 31, 2018 consisted of a substandard performing loan to a developer of a residential sub-division in the amount of $1,664,000, which was secured by commercial real estate. The contract was extended and the loan was modified as a TDR during the fourth quarter of 2015 because the weak real estate market has hindered the process of the development plans and expected sales of building lots have not materialized. The loan experienced a subsequent modification during the fourth quarter of 2017 to extend the maturity date to October 2020, reset the interest rate from a floating rate to a fixed rate, commence regular principal and interest payments, and take additional real estate collateral. The discounted cash flow evaluation at March 31, 2018 resulted in a specific allocation of $0.

 

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The Bank estimates impairment based on its analysis of the cash flows or collateral estimated at fair value less cost to sell. For collateral dependent loans, the estimated appraisal adjustments and cost to sell percentages are determined based on the market area in which the real estate securing the loan is located, among other factors, and therefore, can differ from one loan to another. Of the $13,793,000 in impaired loans at March 31, 2018, none were located outside of the Corporation’s primary market area.

 

The outstanding recorded investment of loans categorized as TDRs was $9,063,000 as of March 31, 2018 as compared to $9,109,000 as of December 31, 2017. The decrease in TDRs at March 31, 2018 as compared to December 31, 2017 is attributable to large principal payments, paydowns, and charge-offs made on existing TDRs net against smaller loans modified as TDRs during the three months ended March 31, 2018. Of the thirty-three restructured loans at March 31, 2018, six loans are classified in the Commercial and Industrial portfolio, twenty-six loans are classified in the Commercial Real Estate portfolio and one loan is classified in the Residential Real Estate portfolio. At March 31, 2018, eight Commercial Real Estate loans classified as TDRs with a combined recorded investment of $573,000, one Commercial and Industrial loan classified as a TDR with a recorded investment of $10,000, and one Residential Real Estate loan classified as a TDR with a recorded investment of $60,000 were not in compliance with the terms of their restructure, compared to March 31, 2017 when seven Commercial Real Estate loans classified as TDRs with a combined recorded investment of $642,000 and one Commercial and Industrial loan classified as a TDR with a recorded investment of $13,000 were not in compliance with the terms of their restructure. Troubled debt restructurings at March 31, 2018 consisted of sixteen term modifications beyond the original stated term, four interest rate modifications, and twelve payment modifications. At March 31, 2018, there was also one troubled debt restructuring that experienced all three types of modifications – payment, rate, and term. TDRs are separately identified for impairment disclosures, and if necessary, a specific allocation is established. As of March 31, 2018 and December 31, 2017, there were $0 and $2,000, respectively in specific allocations attributable to the TDRs. There were no unused commitments attributable to TDRs at March 31, 2018 and December 31, 2017.

 

During the three months ended March 31, 2018 and 2017, no loans that were modified as TDRs within the preceding twelve months had experienced payment defaults.

 

The Corporation’s non-accrual loan valuation procedure for any loans greater than $250,000 requires an appraisal to be obtained and reviewed annually at year end. A quarterly collateral evaluation is performed which may include a site visit, property pictures and discussions with realtors and other similar business professionals to ascertain current values.

 

For non-accrual loans less than $250,000 upon classification and typically at year end, the Corporation completes a Certificate of Inspection, which includes the results of an onsite inspection, insured values, tax assessed values, recent sales comparisons and a review of the previous evaluations.

 

Improving loan quality is a priority. The Corporation actively works with borrowers to resolve credit problems and will continue its close monitoring efforts in 2018. Excluding the assets disclosed in the Non-Performing Assets and Impaired Loans tables below and the Troubled Debt Restructurings section in Note 4 — Loans and Allowance for Loan Losses, management is not aware of any information about borrowers’ possible credit problems which cause serious doubt as to their ability to comply with present loan repayment terms.

 

Should the economic climate no longer continue to be stable or deteriorate further, borrowers may experience difficulty, and the level of impaired loans and non-performing assets, charge-offs and delinquencies could rise and possibly require additional increases in the Corporation’s allowance for loan losses.

 

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In addition, regulatory authorities, as an integral part of their examinations, periodically review the allowance for possible loan losses. They may require additions to allowances based upon their judgments about information available to them at the time of examination.

 

A concentration of credit exists when the total amount of loans to borrowers, who are engaged in similar activities that are similarly impacted by economic or other conditions, exceed 10% of total loans. As of March 31, 2018 and December 31, 2017, management is of the opinion that there were no loan concentrations exceeding 10% of total loans.

 

(Dollars in thousands)  March 31,   December 31, 
   2018   2017 
Non-Performing Assets          
Non-accrual loans  $4,890   $5,090 
Foreclosed assets held for resale   1,115    1,071 
Loans past-due 90 days or more and still accruing interest   18    70 
Total non-performing assets  $6,023   $6,231 
           
Impaired loans          
Non-accrual loans  $4,890   $5,090 
Accruing TDRs   8,903    8,836 
Total impaired loans   13,793    13,926 
Allocated allowance for loan losses   (645)   (327)
Net investment in impaired loans  $13,148   $13,599 
           
Impaired loans with a valuation allowance  $2,455   $2,646 
Impaired loans without a valuation allowance   11,338    11,280 
Total impaired loans  $13,793   $13,926 
           
Allocated valuation allowance as a percent of impaired loans   4.7%   2.3%
Impaired loans to total loans   2.4%   2.5%
Non-performing assets to total loans   1.1%   1.1%
Non-performing assets to total assets   0.6%   0.6%
Allowance for loan losses to impaired loans   53.5%   53.8%
Allowance for loan losses to total non-performing assets   122.5%   120.2%

 

Real estate mortgages comprise 80.4% of the loan portfolio as of March 31, 2018, as compared to 81.1% as of December 31, 2017. Real estate mortgages consist of both residential and commercial real estate loans. The real estate loan portfolio is well diversified in terms of borrowers, collateral, interest rates, and maturities. Also, the residential real estate loan portfolio is largely comprised of fixed rate mortgages. The real estate loans are concentrated primarily in the Corporation’s market area and are subject to risks associated with the local economy. The commercial real estate loans typically reprice approximately every three to five years and are also concentrated in the Corporation’s market area. The Corporation’s loss exposure on its impaired loans continues to be mitigated by collateral positions on these loans. The allocated allowance for loan losses associated with impaired loans is generally computed based upon the related collateral value of the loans. The collateral values are determined by recent appraisals, but are generally discounted by management based on historical dispositions, changes in market conditions since the last valuation and management’s expertise and knowledge of the borrower and the borrower’s business.

 

DEPOSITS AND OTHER BORROWED FUNDS

 

Consumer and commercial retail deposits are attracted primarily by the Bank’s eighteen full service office locations and through its internet banking presence. The Bank offers a broad selection of deposit products and continually evaluates its interest rates and fees on deposit products. The Bank regularly reviews competing financial institutions’ interest rates, especially when establishing interest rates on certificates of deposit.

 

 41 

 

 

Total deposits decreased $29,300,000 to $748,846,000 as of March 31, 2018 as non-interest bearing deposits increased by $9,867,000 and interest bearing deposits decreased by $39,167,000 from year-end 2017. Total deposits decreased due to the withdrawal of funds by municipal depositors through normal, seasonal fluctuations. Demand deposits, savings accounts and certificates of deposit increased from year-end 2017. Total short-term and long-term borrowings increased to $135,791,000 as of March 31, 2018, from $91,296,000 at year-end 2017, an increase of $44,495,000, or 48.7%. Total borrowings increased due to decreased deposit balances and an increase in the balance of the loan portfolio.

 

CAPITAL STRENGTH

 

Normal increases in capital are generated by net income, less dividends paid out. During the first three months of the year, net income less dividends paid increased capital by $232,000. Accumulated other comprehensive income (loss) derived from net unrealized gains on debt securities available-for-sale also impacts capital. At December 31, 2017 accumulated other comprehensive income was $1,826,000. Accumulated other comprehensive loss stood at $(2,971,000) at March 31, 2018, a decrease of $4,797,000. Fluctuations in interest rates have regularly impacted the gain/loss position in the Bank’s investment portfolio, as well as its decision to sell securities at a gain or loss. In order to protect the Bank from market risk in the event of further interest rate increases, the Bank chose to sell a portion of its securities during the first three months of 2018 at an overall net gain of $16,000. These fluctuations from net unrealized gains on debt securities available-for-sale do not affect regulatory capital, as the Bank elected to opt-out of this item with the filing of the March 31, 2015 Call Report.

 

The Corporation held 231,612 shares of common stock as treasury stock at March 31, 2018 and December 31, 2017. This had an effect of reducing our total stockholders’ equity by $5,709,000 as of March 31, 2018 and December 31, 2017.

 

Total stockholders’ equity was $112,428,000 as of March 31, 2018, and $116,719,000 as of December 31, 2017.

 

At March 31, 2018 the Bank met the definition of a “well-capitalized” institution under the regulatory framework for prompt corrective action and the minimum capital requirements under Basel III. The following table presents the Bank’s capital ratios as of March 31, 2018 and December 31, 2017:

 

           To Be Well 
           Capitalized 
           Under Prompt 
   March 31,   December 31,   Corrective Action 
   2018   2017   Regulations 
Tier 1 leverage ratio (to average assets)   8.85%   8.84%   5.00%
Common Equity Tier 1 capital ratio (to risk-weighted assets)   12.84%   13.06%   6.50%
Tier 1 risk-based capital ratio (to risk-weighted assets)   12.84%   13.06%   8.00%
Total risk-based capital ratio   13.96%   14.21%   10.00%

 

Under the final capital rules that became effective on January 1, 2015, there was a requirement for a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets which is in addition to the other minimum risk-based capital standards in the rule. Institutions that do not maintain this required capital buffer will become subject to progressively more stringent limitations on the percentage of earnings that can be paid out in dividends or used for stock repurchases and on the payment of discretionary bonuses to senior executive management. The capital buffer requirement is being phased in over three years beginning in 2016. The capital buffer requirement effectively raises the minimum required common equity Tier 1 capital ratio to 7.0%, the Tier 1 capital ratio to 8.5%, and the total capital ratio to 10.5% on a fully phased-in basis on January 1, 2019. Management believes that, as of March 31, 2018, the Corporation would meet all capital adequacy requirements under the Basel III Capital Rules on a fully phased-in basis as if all such requirements were currently in effect.

 

The Corporation’s capital ratios are not materially different that those of the Bank.

 

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LIQUIDITY

 

The Corporation’s objective is to maintain adequate liquidity to meet funding needs at a reasonable cost and to provide contingency plans to meet unanticipated funding needs or a loss of funding sources, while minimizing interest rate risk. Adequate liquidity is needed to provide the funding requirements of depositors’ withdrawals, loan growth, and other operational needs.

 

Sources of liquidity are as follows:

 

·Growth in the core deposit base;
·Proceeds from sales or maturities of investment securities;
·Payments received on loans and mortgage-backed securities;
·Overnight correspondent bank borrowings on various credit lines;
·Borrowing capacity available from correspondent banks: FHLB, Atlantic Community Bankers Bank (“ACBB”), and Federal Reserve Bank;
·Securities sold under agreements to repurchase; and
·Brokered CDs.

 

At March 31, 2018, the Corporation had $299,115,000 in available borrowing capacity at FHLB (which takes into account FHLB long-term notes and FHLB short-term borrowings); the maximum borrowing capacity at ACBB was $15,000,000 and the maximum borrowing capacity of the Federal Discount Window was $5,142,000.

 

The Corporation enters into “Repurchase Agreements” in which it agrees to sell securities subject to an obligation to repurchase the same or similar securities. Because the agreement both entitles and obligates the Corporation to repurchase the assets, the Corporation may transfer legal control of the securities while still retaining effective control. As a result, the repurchase agreements are accounted for as collateralized financing agreements (secured borrowings) and act as an additional source of liquidity. Securities sold under agreements to repurchase were $14,714,000 at March 31, 2018.

 

Asset liquidity is provided by investment securities maturing in one year or less, other short-term investments, federal funds sold, and cash and due from banks. The liquidity is augmented by repayment of loans and cash flows from mortgage-backed securities. Liability liquidity is accomplished by maintaining a core deposit base, acquired by attracting new deposits and retaining maturing deposits. Also, short-term borrowings provide funds to meet liquidity needs.

 

Net cash flows provided by operating activities were $3,342,000 and $2,047,000 during the three months ended March 31, 2018 and 2017, respectively. Net income amounted to $1,777,000 for the three months ended March 31, 2018 and $2,286,000 for the three months ended March 31, 2017. During the three months ended March 31, 2018 and 2017, net premium amortization on investment securities amounted to $901,000 and $1,186,000, respectively. Cash proceeds (including gains) from sales of mortgage loans originated for resale exceeded net cash utilized for originations of mortgage loans originated for resale by $152,000 for the three months ended March 31, 2018 and net cash utilized for originations of mortgage loans originated for resale exceeded cash proceeds (including gains) from sales of mortgage loans originated for resale by $421,000 for the three months ended March 31, 2017. Other assets decreased $416,000 and $469,000 during the three months ended March 31, 2018 and 2017, respectively. Other liabilities increased $36,000 during the three months ended March 31, 2018 and decreased $502,000 during the three months ended March 31, 2017.

 

Investing activities used $15,721,000 and $12,198,000 during the three months ended March 31, 2018 and 2017, respectively. Net activity in the available-for-sale securities portfolio (including proceeds from sales, maturities, and redemptions net against purchases) used cash of $117,000 and $9,570,000 during the three months ended March 31, 2018 and 2017, respectively. Net cash used to originate loans amounted to $14,197,000 during the three months ended March 31, 2018 and $2,123,000 during the three months ended March 31, 2017.

 

Financing activities provided cash of $13,941,000 and $10,977,000 during the three months ended March 31, 2018 and 2017, respectively. Net deposits used cash of $29,300,000 during the three months ended March 31, 2018 and provided cash of $6,604,000 during the three months ended March 31, 2017. Short-term borrowings increased by $54,495,000 and $5,635,000 during the three months ended March 31, 2018 and 2017, respectively. Repayment of long-term borrowings used cash of $10,000,000 and $31,000 during the three months ended March 31, 2018 and 2017, respectively. Dividends paid amounted to $1,254,000 and $1,532,000 for the three months ended March 31, 2018 and 2017, respectively.

 

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Managing liquidity remains an important segment of asset/liability management. The overall liquidity position of the Corporation is maintained by an active asset/liability management committee. The Corporation believes that its core deposit base is stable even in periods of changing interest rates. Liquidity and funds management are governed by policies and are measured on a monthly basis. These measurements indicate that liquidity generally remains stable and exceeds the Corporation’s minimum defined levels of adequacy. Other than the trends of continued competitive pressures and volatile interest rates, there are no known demands, commitments, events or uncertainties that will result in, or that are reasonably likely to result in, liquidity increasing or decreasing in any material way.

 

MARKET RISK

 

Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates, exchange rates and equity prices. The Corporation’s market risk is composed primarily of interest rate risk. The Corporation’s interest rate risk results from timing differences in the repricing of assets, liabilities, off-balance sheet instruments, and changes in relationships between rate indices and the potential exercise of explicit or embedded options.

 

Increases in the level of interest rates also may adversely affect the fair value of the Corporation’s securities and other earning assets. Generally, the fair value of fixed-rate instruments fluctuates inversely with changes in interest rates. As a result, increases in interest rates could result in decreases in the fair value of the Corporation’s interest-earning assets, which could adversely affect the Corporation’s results of operations if sold, or, in the case of interest-earning assets classified as available-for-sale, the Corporation’s stockholders’ equity, if retained. Under FASB ASC 320-10, Investment Debt and Equity Securities, changes in the unrealized gains and losses, net of taxes, on securities classified as available-for-sale are reflected in the Corporation’s stockholders’ equity. The Corporation does not own any trading assets.

 

Asset/Liability Management

 

The principal objective of asset/liability management is to manage the sensitivity of the net interest margin to potential movements in interest rates and to enhance profitability through returns from managed levels of interest rate risk. The Corporation actively manages the interest rate sensitivity of its assets and liabilities. Several techniques are used for measuring interest rate sensitivity. Interest rate risk arises from the mismatches in the repricing of assets and liabilities within a given time period, referred to as a rate sensitivity gap. If more assets than liabilities mature or reprice within the time frame, the Corporation is asset sensitive. This position would contribute positively to net interest income in a rising rate environment. Conversely, if more liabilities mature or reprice, the Corporation is liability sensitive. This position would contribute positively to net interest income in a falling rate environment. The Corporation’s cumulative gap at one year indicates the Corporation is liability sensitive at March 31, 2018.

 

Earnings at Risk

 

The Bank’s Asset/Liability Committee (“ALCO”) is responsible for reviewing the interest rate sensitivity position and establishing policies to monitor and limit exposure to interest rate risk. The guidelines established by ALCO are reviewed by the Corporation’s Board of Directors. The Corporation recognizes that more sophisticated tools exist for measuring the interest rate risk in the balance sheet beyond interest rate sensitivity gap. Although the Corporation continues to measure its interest rate sensitivity gap, the Corporation utilizes additional modeling for interest rate risk in the overall balance sheet. Earnings at risk and economic values at risk are analyzed.

 

Earnings simulation modeling addresses earnings at risk and net present value estimation addresses economic value at risk. While each of these interest rate risk measurements has limitations, taken together they represent a reasonably comprehensive view of the magnitude of interest rate risk in the Corporation.

 

Earnings Simulation Modeling

 

The Corporation’s net income is affected by changes in the level of interest rates. Net income is also subject to changes in the shape of the yield curve. For example, a flattening of the yield curve would result in a decline in earnings due to the compression of earning asset yields and increased liability rates, while a steepening would result in increased earnings as earning asset yields widen.

 

Earnings simulation modeling is the primary mechanism used in assessing the impact of changes in interest rates on net interest income. The model reflects management’s assumptions related to asset yields and rates paid on liabilities, deposit sensitivity, size and composition of the balance sheet. The assumptions are based on what management believes at that time to be the most likely interest rate environment. Earnings at risk is the change in net interest income from a base case scenario under various scenarios of rate shock increases and decreases in the interest rate earnings simulation model.

 

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The table on this page presents an analysis of the changes in net interest income and net present value of the balance sheet resulting from various increases or decreases in the level of interest rates, such as two percentage points (200 basis points) in the level of interest rates. The calculated estimates of change in net interest income and net present value of the balance sheet are compared to current limits approved by ALCO and the Board of Directors. The earnings simulation model projects net interest income would decrease 9.1%, 17.7% and 24.8% in the 100, 200 and 300 basis point increasing rate scenarios presented. In addition, the earnings simulation model projects net interest income would increase 4.3% and 1.9% in the 100 and 200 basis point decreasing rate scenarios presented. All of these forecasts are within the Corporation’s one year policy guidelines.

 

The analysis and model used to quantify the sensitivity of net interest income becomes less reliable in a decreasing rate scenario given the current unprecedented low interest rate environment with federal funds trading in the 150 – 200 basis point range. Results of the decreasing basis point declining scenarios are affected by the fact that many of the Corporation’s interest-bearing liabilities are at rates below 1% and therefore cannot decline 100 or more basis points. However, the Corporation’s interest-sensitive assets are able to decline by these amounts. For the three months ended March 31, 2018, the cost of interest-bearing liabilities averaged 0.9%, and the yield on interest-earning assets, on a fully taxable equivalent basis, averaged 3.9%.

 

Net Present Value Estimation

 

The net present value measures economic value at risk and is used for helping to determine levels of risk at a point in time present in the balance sheet that might not be taken into account in the earnings simulation model. The net present value of the balance sheet is defined as the discounted present value of asset cash flows minus the discounted present value of liability cash flows. At March 31, 2018, the 100 and 200 basis point immediate decreases in rates are estimated to affect net present value with decreases of 5.7% and 22.2%, respectively. Additionally, net present value is projected to decrease 1.6%, 6.8% and 14.0% in the 100, 200 and 300 basis point immediate increase scenarios, respectively. These scenarios presented are within the Corporation’s policy limits.

 

The computation of the effects of hypothetical interest rate changes are based on many assumptions. They should not be relied upon solely as being indicative of actual results, since the computations do not account for actions management could undertake in response to changes in interest rates.

 

Effect of Change in Interest Rates

 

   Projected Change 
Effect on Net Interest Income     
1-Year Net Income Simulation Projection     
+300 bp Shock vs. Stable Rate   (24.8)%
+200 bp Shock vs. Stable Rate   (17.7)%
+100 bp Shock vs. Stable Rate   (9.1)%
Flat rate     
-100 bp Shock vs. Stable Rate   4.3%
-200 bp Shock vs. Stable Rate   1.9%
      
Effect on Net Present Value of Balance Sheet     
Static Net Present Value Change     
+300 bp Shock vs. Stable Rate   (14.0)%
+200 bp Shock vs. Stable Rate   (6.8)%
+100 bp Shock vs. Stable Rate   (1.6)%
Flat rate     
-100 bp Shock vs. Stable Rate   (5.7)%
-200 bp Shock vs. Stable Rate   (22.2)%

 

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

 

Information with respect to quantitative and qualitative disclosures about market risk is included in the information under Management’s Discussion and Analysis in Item 2.

 

Item 4. Controls and Procedures

 

a)Evaluation of Disclosure Controls and Procedures. First Keystone Corporation maintains disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended) designed to ensure that information required to be disclosed in the reports that the Corporation files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. Based upon their evaluation of those disclosure controls and procedures performed as of the end of the period covered by this report, the Chief Executive Officer and Chief Financial Officer of the Corporation concluded that the Corporation’s disclosure controls and procedures were effective as of March 31, 2018.

 

b)Changes in internal control over financial reporting. There were no other changes in the Corporation’s internal control over financial reporting during the fiscal quarter ended March 31, 2018, that materially affected, or are reasonably likely to materially affect, the Corporation’s internal control over financial reporting.

 

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PART II - OTHER INFORMATION

 

  Item 1. Legal Proceedings

 

Although the Corporation is subject to various claims and legal actions that occur from time to time in the ordinary course of business, the Corporation is not party to any pending legal proceedings that management believes could have a material adverse effect on its business, results of operations, financial condition or cash flows.

 

  Item 1A. Risk Factors

 

There have been no material changes to the risk factors disclosed in Item 1A “Risk Factors” in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2017.

 

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

 

Period  (a)
Total Number of
Shares Purchased
   (b)
Average Price Paid
per Share
   (c)
Total Number of Shares
Purchased as Part of
Publicly Announced
Plans or Programs
   (d)
Maximum Number of
Shares that May Yet Be
Purchased Under the
Plans or Programs
 
Jan. 1 —
Jan. 31, 2018
               120,000 
                     
Feb.1 —
Feb. 28, 2018
               120,000 
                     
March 1 —
March 31, 2018
               120,000 
                     
Total               120,000 

 

  Item 3. Defaults Upon Senior Securities

 

None.

 

  Item 4. Mine Safety Disclosures

 

Not applicable.

 

  Item 5. Other Information

 

None.

 

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  Item 6. Exhibits and Reports on Form 8-K

 

(a) Exhibits required by Item 601 Regulation S-K

 

Exhibit Number   Description of Exhibit
     
3i   Articles of Incorporation, as amended (Incorporated by reference to Exhibit 3(i) to the Registrant’s Report on Form 10-Q for the quarter ended September 30, 2012).
     
3ii   By-Laws, as amended and restated (Incorporated by reference to Exhibit 3(ii) to the Registrant’s Report on Form 8-K dated February 14, 2013).
     
10.1(a)   Supplemental Employee Retirement Plan – J. Gerald Bazewicz (Incorporated by reference to Exhibit 10 to Registrant’s Annual Report on Form 10-K for the year ended December 31, 2013).*
     
10.1(b)   Supplemental Employee Retirement Plan – David R. Saracino (Incorporated by reference to Exhibit 10 to Registrant’s Annual Report on Form 10-K for the year ended December 31, 2013).*
     
10.1(c)   Supplemental Employee Retirement Plan – Matthew P. Prosseda (Incorporated by reference to Exhibit 10 to Registrant’s Annual Report on Form 10-K for the year ended December 31, 2013).*
     
10.1(d)   Supplemental Employee Retirement Plan – Elaine Woodland (Incorporated by reference to Exhibit 10 to Registrant’s Annual Report on Form 10-K for the year ended December 31, 2013).*
     
10.2   Management Incentive Compensation Plan (Incorporated by reference to Exhibit 10 to Registrant’s Annual Report on Form 10-K for the year ended December 31, 2013).*
     
10.4   First Keystone Corporation 1998 Stock Incentive Plan (Incorporated by reference to Exhibit 10 to Registrant’s Report on Form 10-Q for the quarter ended September 30, 2006).*
     
14   First Keystone Corporation Directors and Senior Management Code of Ethics (Incorporated by reference to Exhibit 99.1 to Registrant’s Report on Form 8-K dated August 27, 2013).
     
31.1   Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer.**
     
31.2   Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer.**
     
32.1   Section 1350 Certification of Chief Executive Officer.**
     
32.2   Section 1350 Certification of Chief Financial Officer.**
     
101.INS   XBRL Instance Document.**
     
101.SCH   XBRL Taxonomy Extension Schema Document.**
     
101.CAL   XBRL Taxonomy Extension Calculation Linkbase Document.**
     
101.DEF   XBRL Taxonomy Extension Definition Linkbase Document.**
     
101.LAB   XBRL Taxonomy Extension Label Linkbase Document.**
     
101.PRE   XBRL Taxonomy Extension Presentation Linkbase Document.**

 

*Denotes a compensatory plan.
**Filed herewith.

 

The Corporation will provide a copy of any exhibit upon receipt of a written request for the particular exhibit or exhibits desired. All requests should be addressed to the Corporation’s principal executive offices.

 

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FIRST KEYSTONE CORPORATION

 

SIGNATURES

 

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

 

  FIRST KEYSTONE CORPORATION
  Registrant
   
May 9, 2018 /s/ Elaine A. Woodland
  Elaine A. Woodland
  Interim President and Chief Executive Officer
  (Principal Executive Officer)
   
May 9, 2018 /s/ Diane C.A. Rosler
  Diane C.A. Rosler
  Senior Vice President and Chief Financial Officer
  (Principal Financial Officer)

 

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INDEX TO EXHIBITS

 

Exhibit   Description
     
3i   Articles of Incorporation, as amended (Incorporated by reference to Exhibit 3(i) to the Registrant’s Report on Form 10-Q for the quarter ended September 30, 2012).
     
3ii   By-Laws, as amended and restated (Incorporated by reference to Exhibit 3(ii) to the Registrant’s Report on Form 8-K dated February 14, 2013).
     
10.1(a)   Supplemental Employee Retirement Plan – J. Gerald Bazewicz (Incorporated by reference to Exhibit 10 to Registrant’s Annual Report on Form 10-K for the year ended December 31, 2013).*
     
10.1(b)   Supplemental Employee Retirement Plan – David R. Saracino (Incorporated by reference to Exhibit 10 to Registrant’s Annual Report on Form 10-K for the year ended December 31, 2013).*
     
10.1(c)   Supplemental Employee Retirement Plan – Matthew P. Prosseda (Incorporated by reference to Exhibit 10 to Registrant’s Annual Report on Form 10-K for the year ended December 31, 2013).*
     
10.1(d)   Supplemental Employee Retirement Plan – Elaine Woodland (Incorporated by reference to Exhibit 10 to Registrant’s Annual Report on Form 10-K for the year ended December 31, 2013).*
     
10.2   Management Incentive Compensation Plan (Incorporated by reference to Exhibit 10 to Registrant’s Annual Report on Form 10-K for the year ended December 31, 2013).*
     
10.4   First Keystone Corporation 1998 Stock Incentive Plan (Incorporated by reference to Exhibit 10 to Registrant’s Report on Form 10-Q for the quarter ended September 30, 2006).*
     
14   First Keystone Corporation Directors and Senior Management Code of Ethics (Incorporated by reference to Exhibit 99.1 to Registrant’s Report on Form 8-K dated August 27, 2013).
     
31.1   Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer.**
     
31.2   Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer.**
     
32.1   Section 1350 Certification of Chief Executive Officer.**
     
32.2   Section 1350 Certification of Chief Financial Officer.**
     
101.INS   XBRL Instance Document.**
     
101.SCH   XBRL Taxonomy Extension Schema Document.**
     
101.CAL   XBRL Taxonomy Extension Calculation Linkbase Document.**
     
101.DEF   XBRL Taxonomy Extension Definition Linkbase Document.**
     
101.LAB   XBRL Taxonomy Extension Label Linkbase Document.**
     
101.PRE   XBRL Taxonomy Extension Presentation Linkbase Document.**

 

*Denotes a compensatory plan.
**Filed herewith.

 

The Corporation will provide a copy of any exhibit upon receipt of a written request for the particular exhibit or exhibits desired. All requests should be addressed to the Corporation’s principal executive offices.

 

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