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FIRST NORTHERN COMMUNITY BANCORP - Quarter Report: 2013 June (Form 10-Q)

form10_q.htm
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
———————————
FORM 10-Q
(Mark one)
x
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 

For the Quarterly Period Ended June 30, 2013

OR

o
 
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 000-30707

First Northern Community Bancorp
(Exact name of registrant as specified in its charter)

California
68-0450397
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification Number)

195 N. First Street, Dixon, California
95620
(Address of principal executive offices)
(Zip Code)


707-678-3041
(Registrant’s telephone number including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or Section 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 website, 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  o

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

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

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

Yes  ¨
No  x

The number of shares of Common Stock outstanding as of August 8, 2013 was 9,478,300.

 
1

 
 
FIRST NORTHERN COMMUNITY BANCORP
 
INDEX
 
   
Page
PART I – Financial Information
   
ITEM I. – Financial Statements (Unaudited)
 
3
Condensed Consolidated Balance Sheets (Unaudited)
 
3
Condensed Consolidated Statements of Income (Unaudited)
 
4
Condensed Consolidated Statements of Comprehensive (Loss) Income (Unaudited)
 
5
Condensed Consolidated Statement of Stockholders’ Equity (Unaudited)
 
6
Condensed Consolidated Statements of Cash Flows (Unaudited)
 
7
Notes to Condensed Consolidated Financial Statements
 
8
ITEM 2. – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
35
ITEM 3. – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
54
ITEM 4. – CONTROLS AND PROCEDURES
 
54
PART II – OTHER INFORMATION
 
54
ITEM 1. – LEGAL PROCEEDINGS
 
54
ITEM 1A. – RISK FACTORS
 
54
ITEM 2. – UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
 
57
ITEM 3. – DEFAULTS UPON SENIOR SECURITIES
 
57
ITEM 4. – MINE SAFETY DISCLOSURES
 
57
ITEM 5. – OTHER INFORMATION
 
57
ITEM 6. – EXHIBITS
 
58
SIGNATURES
 
59

 
2

 



PART I – FINANCIAL INFORMATION
 
FIRST NORTHERN COMMUNITY BANCORP
 
 ITEM I.    – FINANCIAL STATEMENTS (UNAUDITED)
 
CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
 

   
June 30,
   
December 31,
 
(in thousands, except shares and share amounts)
 
2013
   
2012
 
             
Assets
           
             
Cash and cash equivalents
  $ 141,847     $ 161,359  
Investment securities – available-for-sale
    190,769       184,491  
Loans, net of allowance for loan losses of $8,726 at June 30, 2013
               
   and $8,554 at December 31, 2012
    470,046       440,449  
Loans held-for-sale
    1,387       4,559  
Stock in Federal Home Loan Bank and other equity securities, at cost
    3,717       3,607  
Premises and equipment, net
    7,638       7,839  
Other real estate owned
          1,062  
Interest receivable and other assets
    29,260       28,117  
                 
                 Total Assets
  $ 844,664     $ 831,483  
                 
Liabilities and Stockholders’ Equity
               
                 
Liabilities:
               
                 
         Demand deposits
  $ 250,646     $ 230,743  
         Interest-bearing transaction deposits
    196,562       184,900  
         Savings and MMDA's
    217,298       223,078  
         Time, under $100,000
    34,680       35,617  
         Time, $100,000 and over
    55,096       56,473  
                 Total deposits
    754,282       730,811  
                 
         Interest payable and other liabilities
    8,111       8,347  
                 
                 Total Liabilities
    762,393       739,158  
                 
Stockholders' Equity:
               
         Preferred stock, no par value; $1,000 per share liquidation preference,
               
22,847 shares authorized; 12,847 shares issued and 12,847 shares outstanding at June 30, 2013 and 22,847 shares issued and outstanding at December 31, 2012
    12,847       22,847  
        Common stock, no par value; 16,000,000 shares authorized;
               
9,476,800 shares issued and outstanding at June 30, 2013 and 9,272,668 shares issued and outstanding at December 31, 2012
    64,424       63,410  
        Additional paid-in capital
    977       977  
        Retained earnings
    5,299       3,917  
        Accumulated other comprehensive (loss) income, net
    (1,276 )     1,174  
                 Total Stockholders’ Equity
    82,271       92,325  
                 
                 Total Liabilities and Stockholders’ Equity
  $ 844,664     $ 831,483  

See notes to unaudited condensed consolidated financial statements.

 
3

 

 
FIRST NORTHERN COMMUNITY BANCORP
 
 
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
 

   
Three months
   
Three months
   
Six months
   
Six months
 
   
ended
   
ended
   
ended
   
ended
 
(in thousands, except per share amounts)
 
June 30,
2013
   
June 30,
2012
   
June 30, 2013
   
June 30,
2012
 
Interest and dividend income:
                       
     Loans
  $ 6,234     $ 6,044     $ 12,205     $ 12,034  
     Due from banks interest bearing accounts
    107       95       212       174  
     Investment securities
                               
          Taxable
    647       798       1,340       1,578  
          Non-taxable
    99       103       199       207  
     Other earning assets
    60       8       60       12  
               Total interest and dividend income
    7,147       7,048       14,016       14,005  
Interest expense:
                               
     Deposits
    312       438       646       930  
     Other borrowings
          69             141  
               Total interest expense
    312       507       646       1,071  
Net interest income
    6,835       6,541       13,370       12,934  
Provision for  loan losses
    400       676       800       1,226  
 Net interest income after provision
    for loan losses
    6,435       5,865       12,570       11,708  
Other operating income:
                               
     Service charges on deposit accounts
    617       673       1,270       1,326  
     Gains on sales of other real estate owned
    1       17       1       17  
     Gains on sales of loans held-for-sale
    424       505       992       900  
     Investment and brokerage services income
    362       282       663       503  
     Mortgage brokerage income
    6       16       35       46  
     Loan servicing income
    346       142       713       284  
     Fiduciary activities income
    197       121       329       228  
     ATM fees
    68       129       152       258  
     Signature based transaction fees
    337       266       629       514  
     Gains on calls of available-for-sale securities
                4       1  
     Other income
    191       190       382       389  
               Total other operating income
    2,549       2,341       5,170       4,466  
Other operating expenses:
                               
     Salaries and employee benefits
    4,079       3,877       8,208       7,724  
     Occupancy and equipment
    749       748       1,532       1,484  
     Data processing
    424       435       844       820  
     Stationery and supplies
    104       91       189       171  
     Advertising
    106       94       187       204  
     Directors’ fees
    50       55       107       110  
     Other real estate owned expense and impairment
    9       38       21       60  
     Other expense
    1,330       1,188       2,517       2,445  
               Total other operating expenses
    6,851       6,526       13,605       13,018  
               Income before income tax expense
    2,133       1,680       4,135       3,156  
Income tax expense
    691       473       1,330       857  
                                 
               Net  income
  $ 1,442     $ 1,207     $ 2,805     $ 2,299  
                                 
Preferred stock dividends
  $ (160 )   $ (286 )   $ (372 )   $ (571 )
Net  income available to common shareholders
  $ 1,282     $ 921     $ 2,433     $ 1,728  
                                 
Basic income per share 
  $ 0.14     $ 0.10     $ 0.26     $ 0.18  
Diluted income per share
  $ 0.14     $ 0.10     $ 0.26     $ 0.18  

See notes to unaudited condensed consolidated financial statements.

 
4

 

 
FIRST NORTHERN COMMUNITY BANCORP
 
 
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME (UNAUDITED)
 


   
Three months
   
Three months
   
Six months
   
Six months
 
   
ended
   
ended
   
ended
   
ended
 
(in thousands)
 
June 30,
2013
   
June 30,
2012
   
June 30,
2013
   
June 30,
2012
 
Net income
  $ 1,442     $ 1,207     $ 2,805     $ 2,299  
Other comprehensive (loss) income, net of tax:
                               
Unrealized holding gains on securities:
                               
Unrealized holding gains arising during the period, net of tax effect of $(1,526) and $175 for the three-month periods ended June 30, 2013 and June 30, 2012, respectively, and $(1,632) and $566 for the six-month periods ended June 30, 2013 and June 30, 2012, respectively
    (2,287 )     260       (2,448 )     847  
Less: reclassification adjustment due to gains realized on sales of securities, net of tax effect of $0 for the three-month periods ended June 30, 2013 and June 30, 2012, and $(2) and $0 for the six-month periods ended June 30, 2013 and June 30, 2012, respectively
                (2 )     (1 )
Other comprehensive (loss) income
  $ (2,287 )   $ 260     $ (2,450 )   $ 846  
                                 
Comprehensive (loss) income
  $ (845 )   $ 1,467     $ 355     $ 3,145  

See notes to unaudited condensed consolidated financial statements.

 
5

 
 

FIRST NORTHERN COMMUNITY BANCORP
 
 
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY (UNAUDITED)
 

(in thousands, except share data)
 
   
                                       
Accumulated
       
                           
Additional
         
Other
       
   
Preferred Stock
   
Common Stock
   
Paid-in
   
Retained
   
Comprehensive
       
   
Shares
   
Amounts
   
Shares
   
Amounts
   
Capital
   
Earnings
   
(Loss) Income
   
Total
 
                                                 
Balance at December 31, 2012
    22,847     $ 22,847       9,272,668     $ 63,410     $ 977     $ 3,917     $ 1,174     $ 92,325  
                                                                 
Net income
                                            2,805               2,805  
                                                                 
Other comprehensive loss
                                                    (2,450 )     (2,450 )
                                                                 
Redemption of preferred stock
    (10,000 )     (10,000 )                                             (10,000 )
2% stock dividend
                    185,291       1,047               (1,047 )              
Dividend on preferred stock
                                            (372 )             (372 )
Cash in lieu of fractional shares
                    (159 )                     (4 )             (4 )
Stock-based compensation
                            73                               73  
Tax deficiency related to expired, vested non-qualified stock options
                            (106 )                             (106 )
Common shares issued related to restricted stock grants, net
                    19,000            
 
                       
                                                                 
Balance at June 30, 2013
    12,847     $ 12,847       9,476,800     $ 64,424     $ 977     $ 5,299     $ (1,276 )   $ 82,271  

See notes to unaudited condensed consolidated financial statements.

 
6

 
 
FIRST NORTHERN COMMUNITY BANCORP
 
 
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
 
   
(in thousands)
 
   
Six months ended June 30,2013
   
Six months ended June 30, 2012
 
Cash Flows From Operating Activities
           
          Net Income
  $ 2,805     $ 2,299  
          Adjustments to reconcile net income to net cash provided by 
               
       operating activities:
               
 Depreciation
    356       347  
 Accretion and amortization of investment securities premiums and
       discounts, net
    1,821       1,597  
 Valuation adjustment on mortgage servicing rights
    (272 )     59  
 Decrease in deferred loan origination fees and costs, net
    (117 )     (474 )
 Provision for loan losses
    800       1,226  
 Stock plan accruals
    73       59  
 Gains on calls of available-for-sale securities
    (4 )     (1 )
 Gains on sales of other real estate owned
    (1 )     (17 )
 Impairment on other real estate owned
    10       15  
 Gains on sales of loans held-for-sale
    (992 )     (900 )
 Proceeds from sales of loans held-for-sale
    45,465       38,504  
 Originations of loans held-for-sale
    (41,301 )     (37,992 )
          Changes in assets and liabilities:
               
 Decrease in interest receivable and other assets
    657       918  
 (Decrease) increase in interest payable and other liabilities
    (236 )     46  
                    Net cash provided by operating activities
    9,064       5,686  
                 
Cash Flows From Investing Activities
               
          Net increase in investment securities
    (12,179 )     (23,275 )
          Net increase in loans
    (29,740 )     (6,197 )
          Net increase in stock in Federal Home Loan Bank and other equity
       securities, at cost
    (110 )     (532 )
          Proceeds from sale of other real estate owned
    513       1,620  
          Purchases of premises and equipment, net
    (155 )     (322 )
                    Net cash used in investing activities
    (41,671 )     (28,706 )
                 
Cash Flows From Financing Activities
               
          Net increase in deposits
    23,471       8,224  
          Redemption of preferred stock
    (10,000 )      
          Net decrease in FHLB advances and other borrowings
          (7,000 )
          Cash dividends paid in lieu of fractional shares
    (4 )     (3 )
          Cash dividends paid on preferred stock
    (372 )     (571 )
                    Net cash provided by financing activities
    13,095       650  
   
               
Net decrease in Cash and Cash Equivalents
    (19,512 )     (22,370 )
Cash and Cash Equivalents, beginning of period
    161,359       140,172  
Cash and Cash Equivalents, end of period
  $ 141,847       117,802  
                 
Supplemental Disclosures of Cash Flow Information:
               
Cash paid during the period for:
               
Interest
  $ 666     $ 1,098  
Income Taxes
  $ 891     $ 879  
                 
Supplemental disclosures of non-cash investing and financing activities:
               
Stock dividend distributed
  $ 1,047     $ 451  
Tax deficiency related to expired, vested non-qualified stock options
  $ (106 )   $  
   Transfer of loans held-for-investment to other real estate owned
  $     $ 293  
   Financed sale of other real estate owned
  $ (540 )   $  
   Unrealized holding (losses) gains on available for sale securities,
         net of taxes
  $ (2,450 )   $ 846  
See notes to unaudited condensed consolidated financial statements.
 
 
7

 
FIRST NORTHERN COMMUNITY BANCORP
 
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
June 30, 2013 and 2012 and December 31, 2012
 

1.
BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements of First Northern Community Bancorp (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information and with the instructions to Form 10-Q and Articles 9 and 10 of Regulation S-X.  Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.  The results of operations for any interim period are not necessarily indicative of results expected for the full year.  These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012 as filed with the Securities and Exchange Commission.  The preparation of financial statements in conformity with GAAP also requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expense during the reporting period.  Actual results could differ from those estimates.  All material intercompany balances and transactions have been eliminated in consolidation.

Recently Issued Accounting Pronouncements:

In June 2011, FASB issued ASU 2011-05.  This update allows an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements.  In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income.  This update eliminates the option to present the components of other comprehensive income as part of the statement of stockholders’ equity.  The amendments in this ASU are to be applied retrospectively and are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Adoption of the new guidance did not have a significant impact on the Company’s consolidated financial statements.  In December 2011, FASB issued ASU 2011-12.  This update defers the effective date for amendments to the presentation of reclassifications of items out of accumulated other comprehensive income in ASU 2011-05.  In February 2013, FASB issued ASU 2013-02.  This update requires an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component.  In addition, an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under U.S. GAAP to be reclassified to net income in its entirety in the same reporting period.  For other amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures required under U.S. GAAP that provide additional detail about those amounts.  The amendments in ASU 2013-02 are effective prospectively for reporting periods beginning after December 15, 2012.  Adoption of the new guidance did not have a significant impact on the Company’s consolidated financial statements.

In December 2011, FASB issued ASU 2011-11.  The amendments in this ASU require an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position.  The amendments in this ASU are required for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods.  The disclosures required by those amendments should be provided retrospectively for all comparative periods presented.  The Company does not expect the adoption of this update to have a significant impact on its consolidated financial statements.  In January 2013, FASB issued ASU 2013-01.  This update clarifies that ordinary trade receivables and receivables are not in the scope of ASU 2011-11.  ASU 2011-11 applies only to derivatives, repurchase agreements and reverse purchase agreements, and securities borrowing and securities lending transactions that are either offset in accordance with specific criteria contained in the Codification or subject to a master netting arrangement or similar agreement.  This update has the same effective date as ASU 2011-11.

 
8

 
In February 2013, FASB issued ASU 2013-04, Obligations Resulting from Joint and Several Liability Arrangements for Which the Total Amount of the Obligation Is Fixed at the Reporting Date, which provides guidance for the recognition, measurement, and disclosure of obligations resulting from joint and several liability arrangements for which the total amount of the obligation is fixed at the reporting date.  Examples of obligations within the scope of this guidance include debt arrangements, other contractual obligations, and settled litigation and judicial rulings.  This guidance is effective for interim and annual periods beginning on January 1, 2014 and must be retroactively applied to prior periods presented.  Early adoption is permitted.  The Company does not expect the adoption of this update to have a significant impact on its consolidated financial statements.

In July 2013, FASB issued ASU 2013-10, Inclusion of the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) as a Benchmark Interest Rate for Hedge Accounting Purposes.  The amendments in this ASU permit the Fed Funds Effective Swap Rate (OIS) to be used as a U.S. benchmark interest rate for hedge accounting purposes under Topic 815, in addition to UST and LIBOR.  The amendments also remove the restriction on using different benchmark rates for similar hedges.  The amendments are effective prospectively for qualifying new or redesignated hedging relationships entered into on or after July 17, 2013.  The Company does not expect the adoption of this update to have a significant impact on its consolidated financial statements.
 
 

Reclassifications
Certain reclassifications have been made to prior period balances in order to conform to the current year presentation.

 
9

 
 
2.           LOANS

The composition of the Company’s loan portfolio, by loan class, is as follows:
 

 
($ in thousands)
 
June 30,
2013
   
December 31,
2012
 
             
Commercial
  $ 100,540     $ 88,810  
Commercial Real Estate
    212,600       188,426  
Agriculture
    48,058       52,747  
Residential Mortgage
    52,326       51,266  
Residential Construction
    8,583       7,586  
Consumer
    55,773       59,393  
                 
      477,880       448,228  
Allowance for loan losses
    (8,726 )     (8,554 )
Net deferred origination fees and costs
    892       775  
                 
Loans, net
  $ 470,046     $ 440,449  


The Company manages asset quality and credit risk by maintaining diversification in its loan portfolio and through review processes that include analysis of credit requests and ongoing examination of outstanding loans and delinquencies, with particular attention to portfolio dynamics and loan mix.  The Company strives to identify loans experiencing difficulty early enough to correct the problems, to record charge-offs promptly based on realistic assessments of collectability and current collateral values and to maintain an adequate allowance for loan losses at all times.   Asset quality reviews of loans and other non-performing assets are administered using credit risk rating standards and criteria similar to those employed by state and federal banking regulatory agencies.
 
 
Commercial loans, whether secured or unsecured, generally are made to support the short-term operations and other needs of small businesses.  These loans are generally secured by the receivables, equipment, and other real property of the business and are susceptible to the related risks described above.  Problem commercial loans are generally identified by periodic review of financial information that may include financial statements, tax returns, and payment history of the borrower.  Based on this information, the Company may decide to take any of several courses of action including demand for repayment, requiring the borrower to provide a significant principal payment and/or additional collateral or requiring similar support from guarantors. Notwithstanding, when repayment becomes unlikely based on the borrower’s income and cash flow, repossession or foreclosure of the underlying collateral may become necessary.  Collateral values may be determined by appraisals obtained through Bank approved, licensed appraisers, qualified independent third parties, purchase invoices, or other appropriate documentation.

Commercial real estate loans generally fall into two categories, owner-occupied and non-owner occupied.  Loans secured by owner occupied real estate are primarily susceptible to changes in the market conditions of the related business.  This may be driven by, among other things, industry changes, geographic business changes, changes in the individual financial capacity of the business owner, general economic conditions and changes in business cycles. These same risks apply to commercial loans whether secured by equipment, receivables or other personal property or unsecured.  Losses on loans secured by owner occupied real estate, equipment, or other personal property generally are dictated by the value of underlying collateral at the time of default and liquidation of the collateral.  When default is driven by issues related specifically to the business owner, collateral values tend to provide better repayment support and may result in little or no loss. Alternatively, when default is driven by more general economic conditions, underlying collateral generally has devalued more and results in larger losses due to default.  Loans secured by non-owner occupied real estate are primarily susceptible to risks associated with swings in occupancy or vacancy and related shifts in lease rates, rental rates or room rates. Most often, these shifts are a result of changes in general economic or market conditions or overbuilding and resulting over-supply of space.  Losses are dependent on the value of underlying collateral at the time of default.  Values are generally driven by these same factors and influenced by interest rates and required rates of return as well as changes in occupancy costs.  Collateral values may be determined by appraisals obtained through Bank approved, licensed appraisers, qualified independent third parties, sales invoices, or other appropriate means.

 
10

 

Agricultural loans, whether secured or unsecured, generally are made to producers and processors of crops and livestock.  Repayment is primarily from the sale of an agricultural product or service.  Agricultural loans are generally secured by inventory, receivables, equipment, and other real property.  Agricultural loans primarily are susceptible to changes in market demand for specific commodities.  This may be exacerbated by, among other things, industry changes, changes in the individual financial capacity of the business owner, general economic conditions and changes in business cycles, as well as adverse weather conditions.  Problem agricultural loans are generally identified by periodic review of financial information that may include financial statements, tax returns, crop budgets, payment history, and crop inspections.  Based on this information, the Company may decide to take any of several courses of action including demand for repayment, requiring the borrower to provide a significant principal payment and/or additional collateral or requiring similar support from guarantors. Notwithstanding, when repayment becomes unlikely based on the borrower’s income and cash flow, repossession or foreclosure of the underlying collateral may become necessary.

Residential mortgage loans, which are secured by real estate, are primarily susceptible to four risks; non-payment due to diminished or lost income, over-extension of credit, a lack of borrower’s cash flow to sustain payments, and shortfalls in collateral value.  In general, non-payment is usually due to loss of employment and follows general economic trends in the economy, particularly the upward movement in the unemployment rate, loss of collateral value, and demand shifts.

Construction loans, whether owner occupied or non-owner occupied residential development loans, are not only susceptible to the related risks described above but the added risks of construction, including cost over-runs, mismanagement of the project, or lack of demand and market changes experienced at time of completion.  Losses are primarily related to underlying collateral value and changes therein as described above.  Problem construction loans are generally identified by periodic review of financial information that may include financial statements, tax returns and payment history of the borrower.  Based on this information the Company may decide to take any of several courses of action including demand for repayment, requiring the borrower to provide a significant principal payment and/or additional collateral or requiring similar support from guarantors, or repossession or foreclosure of the underlying collateral.  Collateral values may be determined by appraisals obtained through Bank approved, licensed appraisers, qualified independent third parties, purchase invoices, or other appropriate documentation.

Consumer loans, whether unsecured or secured are primarily susceptible to four risks; non-payment due to diminished or lost income, over-extension of credit, a lack of borrower’s cash flow to sustain payments, and shortfall in collateral value.  In general, non-payment is usually due to loss of employment and will follow general economic trends in the economy, particularly the upward movements in the unemployment rate, loss of collateral value, and demand shifts.

Collateral values may be determined by appraisals obtained through Bank approved, licensed appraisers, qualified independent third parties, purchase invoices, or other appropriate documentation.  Collateral valuations are obtained at origination of the credit and periodically thereafter (generally every 3 – 6 months depending on the collateral type), once repayment is questionable, and the loan has been deemed classified.

As of June 30, 2013, approximately 44% in principal amount of the Company’s loans were secured by commercial real estate, which consists primarily of construction and land development loans and loans secured by commercial properties.  Approximately 11% in principal amount of the Company’s loans were residential mortgage loans.  Approximately 2% in principal amount of the Company’s loans were residential construction loans.  Approximately 10% in principal amount of the Company’s loans were for agriculture and 21% in principal amount of the Company’s loans were for general commercial uses including professional, retail and small businesses.  Approximately 12% in principal amount of the Company’s loans were consumer loans.

Once a loan becomes delinquent and repayment becomes questionable, a Company collection officer will address collateral shortfalls with the borrower and attempt to obtain additional collateral or a principal payment.  If this is not forthcoming and payment in full is unlikely, the Company will consider the loan to be collateral dependent and will estimate its probable loss, using a recent valuation as appropriate to the underlying collateral less estimated costs of sale, and charge-off the loan down to the estimated net realizable amount.  Depending on the length of time until final collection, the Company may periodically revalue the underlying collateral and take additional charge-offs as warranted. Revaluations may occur as often as every 3-12 months depending on the underlying collateral and volatility of values.  Final charge-offs or recoveries are taken when collateral is liquidated and actual loss is known.  Unpaid balances on loans after or during collection and liquidation may also be pursued through legal action and attachment of wages or judgment liens on the borrower's other assets.

 
11

 
At June 30, 2013 and December 31, 2012, all loans were pledged under a blanket collateral lien to secure actual and potential borrowings from the Federal Home Loan Bank and Federal Reserve.

Non-accrual and Past Due Loans

The Company’s non-accrual loans by loan class, as of June 30, 2013 and December 31, 2012 were as follows:


 
($ in thousands)
 
June 30,
2013
   
December 31,
2012
 
             
Commercial
  $ 2,612     $ 2,853  
Commercial Real Estate
    2,467       1,879  
Agriculture
           
Residential Mortgage
    2,379       2,095  
Residential Construction
    104        
Consumer
    215       441  
                 
    $ 7,777     $ 7,268  


Non-accrual loans amounted to $7,777,000 at June 30, 2013 and were comprised of eight residential mortgage loans totaling $2,379,000, two residential construction loans totaling $104,000, six commercial real estate loans totaling $2,467,000, eight commercial loans totaling $2,612,000 and four consumer loans totaling $215,000.  Non-accrual loans amounted to $7,268,000 at December 31, 2012 and were comprised of seven residential mortgage loans totaling $2,095,000, five commercial real estate loans totaling $1,879,000, eleven commercial loans totaling $2,853,000 and seven consumer loans totaling $441,000.  It is generally the Company’s policy to charge-off the portion of any non-accrual loan that the Company does not expect to collect by writing the loan down to the estimated net realizable value of the underlying collateral.

 
12

 
 
An age analysis of past due loans, segregated by loan class, as of June 30, 2013 and December 31, 2012 is as follows:
 

 
($ in thousands)
 
30-59 Days Past Due
   
60-89 Days Past Due
   
90 Days or more Past Due
   
Total Past Due
   
Current
   
Total Loans
 
June 30, 2013
                                   
Commercial
  $ 328     $     $ 93     $ 421     $ 100,119     $ 100,540  
Commercial Real Estate
          531       611       1,142       211,458       212,600  
Agriculture
                            48,058       48,058  
Residential Mortgage
          216       226       442       51,884       52,326  
Residential Construction
    51                   51       8,532       8,583  
Consumer
    84       24       42       150       55,623       55,773  
    Total
  $ 463     $ 771     $ 972     $ 2,206     $ 475,674     $ 477,880  
                                                 
December 31, 2012
                                               
Commercial
  $ 2,255     $     $ 170     $ 2,425     $ 86,385     $ 88,810  
Commercial Real Estate
    1,272             566       1,838       186,588       188,426  
Agriculture
                            52,747       52,747  
Residential Mortgage
    570       103       335       1,008       50,258       51,266  
Residential Construction
    53                   53       7,533       7,586  
Consumer
    8       747       126       881       58,512       59,393  
    Total
  $ 4,158     $ 850     $ 1,197     $ 6,205     $ 442,023     $ 448,228  

 
The Company had no loans 90 days or more past due and still accruing at June 30, 2013 and December 31, 2012.
 
 
13

 
 
Impaired Loans
 
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement, including scheduled interest payments.  Loans to be considered for impairment include non-accrual loans, troubled debt restructurings and loans with a risk rating of 6 (substandard) or worse.  Once identified, impaired loans are measured individually for impairment using one of three methods:  present value of expected cash flows discounted at the loan’s effective interest rate; the loan’s observable market price; fair value of collateral if the loan is collateral dependent.  In general, any portion of the recorded investment in a collateral dependent loan in excess of the fair value of the collateral that can be identified as uncollectible, and is, therefore, deemed a confirmed loss, is promptly charged-off against the allowance for loan losses.

Impaired loans, segregated by loan class, as of June 30, 2013 and December 31, 2012 were as follows:
 
($ in thousands)
 
Unpaid Contractual Principal Balance
   
Recorded Investment with no Allowance
   
Recorded Investment with Allowance
   
Total Recorded Investment
   
Related Allowance
 
June 30, 2013
                             
Commercial
  $ 3,573     $ 2,549     $ 710     $ 3,259     $ 84  
Commercial Real Estate
    3,609       2,467       1,139       3,606       18  
Agriculture
                             
Residential Mortgage
    6,893       2,379       3,566       5,945       628  
Residential Construction
    1,142       104       862       966       267  
Consumer
    1,256       275       614       889       76  
    Total
  $ 16,473     $ 7,774     $ 6,891     $ 14,665     $ 1,073  
                                         
December 31, 2012
                                       
Commercial
  $ 3,628     $ 2,769     $ 519     $ 3,288     $ 95  
Commercial Real Estate
    3,629       1,872       1,170       3,042       26  
Agriculture
                             
Residential Mortgage
    5,831       1,860       2,963       4,823       417  
Residential Construction
    1,148             1,097       1,097       433  
Consumer
    1,416       502       629       1,131       101  
    Total
  $ 15,652     $ 7,003     $ 6,378     $ 13,381     $ 1,072  

 
The average recorded investment in impaired loans and the amount of interest income recognized on impaired loans during the three-month periods ended June 30, 2013 and June 30, 2012 was as follows:
 
($ in thousands)
 
Three Months Ended
June 30, 2013
   
Three Months Ended
June 30, 2012
 
   
Average Recorded Investment
   
Interest Income Recognized
   
Average Recorded Investment
   
Interest Income Recognized
 
Commercial
  $ 3,335     $ 10     $ 3,831     $ 10  
Commercial Real Estate
    3,299       22       4,954       23  
Agriculture
                1,475       9  
Residential Mortgage
    5,299       34       3,761       31  
Residential Construction
    1,028       12       1,210       14  
Consumer
    928       8       1,007       9  
    Total
  $ 13,889     $ 86     $ 16,238     $ 96  

 
 
14

 
The average recorded investment in impaired loans and the amount of interest income recognized on impaired loans during the six-month periods ended June 30, 2013 and June 30, 2012 was as follows:
 
($ in thousands)
 
Six Months Ended
June 30, 2013
   
Six Months Ended
June 30, 2012
 
   
Average Recorded Investment
   
Interest Income Recognized
   
Average Recorded Investment
   
Interest Income Recognized
 
Commercial
  $ 3,390     $ 19     $ 3,657     $ 21  
Commercial Real Estate
    3,610       43       5,434       45  
Agriculture
                1,706       35  
Residential Mortgage
    5,082       61       4,438       60  
Residential Construction
    1,075       23       1,251       26  
Consumer
    963       16       815       16  
    Total
  $ 14,120     $ 162     $ 17,301     $ 203  

 
None of the interest on impaired loans was recognized using a cash basis of accounting for the three-month and six-month periods ended June 30, 2013 and June 30, 2012.
 
Troubled Debt Restructurings
 
The Company’s loan portfolio includes certain loans that have been modified in a Troubled Debt Restructuring (“TDR”), which are loans on which concessions in terms have been granted because of the borrowers’ financial difficulties.  These concessions may include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance, or other actions.  Certain TDRs are placed on non-accrual status at the time of restructure and may only be returned to accruing status after considering the borrower’s sustained repayment performance for a reasonable period, generally six months.
 
When a loan is modified, it is measured based upon the present value of future cash flows discounted at the contractual interest rate of the original loan agreement, or the fair value of collateral less selling costs if the loan is collateral dependent.  If the value of the modified loan is less than the recorded investment in the loan, impairment is recognized through a specific allowance or a charge-off of the loan.
 
The Company had $8,119,000 and $6,905,000 in TDR loans as of June 30, 2013 and December 31, 2012, respectively.  Specific reserves for TDR loans totaled $999,000 and $939,000 as of June 30, 2013 and December 31, 2012, respectively.  TDR loans performing in compliance with modified terms totaled $6,815,000 and $6,040,000 as of June 30, 2013 and December 31, 2012, respectively.  There are no commitments to advance more funds on existing TDR loans as of June 30, 2013.
 
 
15

 
Loans modified as troubled debt restructurings during the three-month periods ended June 30, 2013 and June 30, 2012 were as follows:
 
($ in thousands)
 
Three Months Ended June 30, 2013
 
   
Number of Contracts
   
Pre-modification outstanding recorded investment
   
Post-modification outstanding recorded investment
 
Residential Mortgage
    1     $ 568     $ 377  
    Total
    1     $ 568     $ 377  

 
($ in thousands)
 
Three Months Ended June 30, 2012
 
   
Number of Contracts
   
Pre-modification outstanding recorded investment
   
Post-modification outstanding recorded investment
 
Commercial
    2     $ 141     $ 141  
Consumer
    2       279       279  
    Total
    4     $ 420     $ 420  

 
Loans modified as troubled debt restructurings during the six-month periods ended June 30, 2013 and June 30, 2012 were as follows:
 
($ in thousands)
 
Six Months Ended June 30, 2013
 
   
Number of Contracts
   
Pre-modification outstanding recorded investment
   
Post-modification outstanding recorded investment
 
Commercial
    1     $ 244     $ 244  
Residential Mortgage
    1       568       377  
    Total
    2     $ 812     $ 621  

 
($ in thousands)
 
Six Months Ended June 30, 2012
 
   
Number of Contracts
   
Pre-modification outstanding recorded investment
   
Post-modification outstanding recorded investment
 
Commercial
    4     $ 361     $ 361  
Consumer
    4       430       430  
    Total
    8     $ 791     $ 791  

 
The loan modifications generally involved reductions in the interest rate, payment extensions, forgiveness of principal, and forbearance.  There were no loans modified as a troubled debt restructuring within the previous 12 months and for which there was a payment default during the three-month periods ended June 30, 2013 and June 30, 2012.  There were no loans modified as a troubled debt restructuring within the previous 12 months and for which there was a payment default during the six-month periods ended June 30, 2013.  There was one commercial loan with a recorded investment of $136,000 that was modified as a troubled debt restructuring within the previous 12 months and for which there was a payment default during the six-month period ended June 30, 2012.
 
 
16

 
 
Credit Quality Indicators
 
All loans are rated using the credit risk ratings and criteria adopted by the Company.  Risk ratings are adjusted as future circumstances warrant.  All credits risk rated 1, 2, 3 or 4 equate to a Pass as indicated by Federal and State regulatory agencies; a 5 equates to a Special Mention; a 6 equates to Substandard; a 7 equates to Doubtful; and 8 equates to a Loss.  For the definitions of each risk rating, see Note 4 to our condensed consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2012.
 
The following table presents the risk ratings by loan class as of June 30, 2013 and December 31, 2012.
 

 
($ in thousands)
 
Pass
   
Special Mention
   
Substandard
   
Doubtful
   
Loss
   
Total
 
June 30, 2013
                                   
Commercial
  $ 91,932     $ 3,668     $ 4,940     $     $     $ 100,540  
Commercial Real Estate
    195,877       6,739       9,984                   212,600  
Agriculture
    44,834             3,224                   48,058  
Residential Mortgage
    48,592       932       2,802                   52,326  
Residential Construction
    5,470       1,573       1,540                   8,583  
Consumer
    49,475       4,338       1,960                   55,773  
    Total
  $ 436,180     $ 17,250     $ 24,450     $     $     $ 477,880  
                                                 
December 31, 2012
                                               
Commercial
  $ 78,078     $ 4,393     $ 6,339     $     $     $ 88,810  
Commercial Real Estate
    170,676       9,049       8,701                   188,426  
Agriculture
    49,613       172       2,962                   52,747  
Residential Mortgage
    45,962       604       4,700                   51,266  
Residential Construction
    5,512       1,212       862                   7,586  
Consumer
    51,444       4,822       3,054       73             59,393  
    Total
  $ 401,285     $ 20,252     $ 26,618     $ 73     $     $ 448,228  


 
17

 
 
Allowance for Loan Losses

The following table details activity in the allowance for loan losses by loan class for the three-month and six-month periods ended June 30, 2013.

Three-month period ended June 30, 2013
 
($ in thousands)
 
Commercial
   
Commercial Real Estate
   
Agriculture
   
Residential Mortgage
   
Residential Construction
   
Consumer
   
Unallocated
   
Total
 
Balance as of March 31, 2013
  $ 2,888     $ 2,095     $ 813     $ 973     $ 590     $ 1,059     $ 428     $ 8,846  
Provision for loan losses
    (67 )     (105 )     (65 )     324       38       229       46       400  
                                                                 
Charge-offs
    (1 )     (3 )           (255 )     (127 )     (318 )           (704 )
Recoveries
    49       50             12       2       71             184  
Net charge-offs
    (48 )     47             (243 )     (125 )     (247 )           (520 )
Balance as of June 30, 2013
  $ 2,869     $ 2,037     $ 748     $ 1,054     $ 503     $ 1,041     $ 474     $ 8,726  


Six-month period ended June 30, 2013
 
($ in thousands)
 
Commercial
   
Commercial Real Estate
   
Agriculture
   
Residential Mortgage
   
Residential Construction
   
Consumer
   
Unallocated
   
Total
 
Balance as of December 31, 2012
  $ 2,899     $ 1,723     $ 915     $ 1,148     $ 724     $ 1,110     $ 35     $ 8,554  
Provision for loan losses
    (42 )     266       (169 )     227       (137 )     216       439       800  
                                                                 
Charge-offs
    (112 )     (3 )     (1 )     (333 )     (127 )     (376 )           (952 )
Recoveries
    124       51       3       12       43       91             324  
Net charge-offs
    12       48       2       (321 )     (84 )     (285 )           (628 )
Balance as of June 30, 2013
  $ 2,869     $ 2,037     $ 748     $ 1,054     $ 503     $ 1,041     $ 474     $ 8,726  


The following table details the allowance for loan losses allocated to loans individually and collectively evaluated for impairment by loan class as of June 30, 2013.

($ in thousands)
 
Commercial
   
Commercial Real Estate
   
Agriculture
   
Residential Mortgage
   
Residential Construction
   
Consumer
   
Unallocated
   
Total
 
Period-end amount allocated to:
  $       $       $       $       $       $       $       $    
Loans individually evaluated for impairment
    84       18             628       267       76             1,073  
Loans collectively evaluated for impairment
    2,785       2,019       748       426       236       965       474       7,653  
Ending Balance
  $ 2,869     $ 2,037     $ 748     $ 1,054     $ 503     $ 1,041     $ 474     $ 8,726  
 
 
18

 
 
The following table details activity in the allowance for loan losses by loan class for the three-month and six-month periods ended June 30, 2012.

Three-month period ended June 30, 2012
 
($ in thousands)
 
Commercial
   
Commercial Real Estate
   
Agriculture
   
Residential Mortgage
   
Residential Construction
   
Consumer
   
Unallocated
   
Total
 
Balance as of March 31, 2012
  $ 3,582     $ 1,715     $ 1,167     $ 1,194     $ 1,125     $ 1,340     $ 234     $ 10,357  
Provision for loan losses
    (294 )     689       73       422       (253 )     110       (71 )     676  
                                                                 
Charge-offs
    (537 )     (342 )     (115 )           (161 )     (370 )           (1,525 )
Recoveries
    31             1             223       21             276  
Net charge-offs
    (506 )     (342 )     (114 )           62       (349 )           (1,249 )
Balance as of June 30, 2012
  $ 2,782     $ 2,062     $ 1,126     $ 1,616     $ 934     $ 1,101     $ 163     $ 9,784  


Six-month period ended June 30, 2012
 
($ in thousands)
 
Commercial
   
Commercial Real Estate
   
Agriculture
   
Residential Mortgage
   
Residential Construction
   
Consumer
   
Unallocated
   
Total
 
Balance as of December 31, 2011
  $ 3,598     $ 1,747     $ 1,934     $ 1,135     $ 1,198     $ 796     $     $ 10,408  
Provision for loan losses
    26       657       (696 )     512       (327 )     891       163       1,226  
                                                                 
Charge-offs
    (1,079 )     (342 )     (115 )     (31 )     (161 )     (634 )           (2,362 )
Recoveries
    237             3             224       48             512  
Net charge-offs
    (842 )     (342 )     (112 )     (31 )     63       (586 )           (1,850 )
Balance as of June 30, 2012
  $ 2,782     $ 2,062     $ 1,126     $ 1,616     $ 934     $ 1,101     $ 163     $ 9,784  


The following table details the allowance for loan losses allocated to loans individually and collectively evaluated for impairment by loan class as of June 30, 2012.

($ in thousands)
 
Commercial
   
Commercial Real Estate
   
Agriculture
   
Residential Mortgage
   
Residential Construction
   
Consumer
   
Unallocated
   
Total
 
Period-end amount allocated to:
                                               
Loans individually evaluated for impairment
  $ 151     $ 16     $     $ 1,148     $ 573     $ 138     $     $ 2,026  
Loans collectively evaluated for impairment
    2,631       2,046       1,126       468       361       963       163       7,758  
Ending Balance
  $ 2,782     $ 2,062     $ 1,126     $ 1,616     $ 934     $ 1,101     $ 163     $ 9,784  
 
 
19

 
The following table details activity in the allowance for loan losses and the amount allocated to loans individually and collectively evaluated for impairment as of and for the period ended December 31, 2012.


($ in thousands)
 
Commercial
   
Commercial Real Estate
   
Agriculture
   
Residential Mortgage
   
Residential Construction
   
Consumer
   
Unallocated
   
Total
 
Balance as of December 31, 2011
  $ 3,598     $ 1,747     $ 1,934     $ 1,135     $ 1,198     $ 796     $     $ 10,408  
Provision for loan losses
    2,493       351       (907 )     877       (648 )     1,075       35       3,276  
                                                                 
Charge-offs
    (3,498 )     (375 )     (116 )     (864 )     (167 )     (875 )           (5,895 )
Recoveries
    306             4             341       114             765  
Net charge-offs
    (3,192 )     (375 )     (112 )     (864 )     174       (761 )           (5,130 )
Balance as of December 31, 2012
    2,899       1,723       915       1,148       724       1,110       35       8,554  
Period-end amount allocated to:
                                                               
Loans individually evaluated for impairment
    95       26             417       433       101             1,072  
Loans collectively evaluated for impairment
    2,804       1,697       915       731       291       1,009       35       7,482  
Balance as of December 31, 2012
  $ 2,899     $ 1,723     $ 915     $ 1,148     $ 724     $ 1,110     $ 35     $ 8,554  



The Company’s investment in loans as of June 30, 2013, June 30, 2012, and December 31, 2012 related to each balance in the allowance for loan losses by loan class and disaggregated on the basis of the Company’s impairment methodology was as follows:
($ in thousands)
 
Commercial
   
Commercial Real Estate
   
Agriculture
   
Residential Mortgage
   
Residential Construction
   
Consumer
   
Total
 
June 30, 2013
 
Loans individually evaluated for impairment
  $ 3,259     $ 3,606     $     $ 5,945     $ 966     $ 889     $ 14,665  
Loans collectively evaluated for impairment
    97,281       208,994       48,058       46,381       7,617       54,884       463,215  
Ending Balance
  $ 100,540     $ 212,600     $ 48,058     $ 52,326     $ 8,583     $ 55,773     $ 477,880  
                                                         
June 30, 2012
 
Loans individually evaluated for impairment
  $ 3,822     $ 5,238     $ 1,379     $ 3,987     $ 1,127     $ 1,072     $ 16,625  
Loans collectively evaluated for impairment
    91,284       180,942       44,253       46,925       6,604       60,419       430,427  
Ending Balance
  $ 95,106     $ 186,180     $ 45,632     $ 50,912     $ 7,731     $ 61,491     $ 447,052  
                                                         
December 31, 2012
 
Loans individually evaluated for impairment
  $ 3,288     $ 3,042     $     $ 4,823     $ 1,097     $ 1,131     $ 13,381  
Loans collectively evaluated for impairment
    85,522       185,384       52,747       46,443       6,489       58,262       434,847  
Ending Balance
  $ 88,810     $ 188,426     $ 52,747     $ 51,266     $ 7,586     $ 59,393     $ 448,228  


 
20

 
3.           MORTGAGE OPERATIONS

Transfers and servicing of financial assets and extinguishments of liabilities are accounted for and reported based on consistent application of a financial-components approach that focuses on control.  Transfers of financial assets that are sales are distinguished from transfers that are secured borrowings.  Retained interests (mortgage servicing rights) in loans sold are measured by allocating the previous carrying amount of the transferred assets between the loans sold and retained interests, if any, based on their relative fair value at the date of transfer.  Fair values are estimated using discounted cash flows based on a current market interest rate.

The Company recognizes a gain and a related asset for the fair value of the rights to service loans for others when loans are sold.  The Company sold substantially its entire portfolio of conforming long-term residential mortgage loans originated during the six months ended June 30, 2013 for cash proceeds equal to the fair value of the loans.

The recorded value of mortgage servicing rights is included in other assets, and is amortized in proportion to, and over the period of, estimated net servicing revenues.  The Company assesses capitalized mortgage servicing rights for impairment based upon the fair value of those rights at each reporting date. For purposes of measuring impairment, the rights are stratified based upon the product type, term and interest rates.  Fair value is determined by discounting estimated net future cash flows from mortgage servicing activities using discount rates that approximate current market rates and estimated prepayment rates, among other assumptions.  The amount of impairment recognized, if any, is the amount by which the capitalized mortgage servicing rights for a stratum exceeds their fair value.  Impairment, if any, is recognized through a valuation allowance for each individual stratum.  Changes in the carrying amount of mortgage servicing rights are reported in earnings under Other income.

Key assumptions used in measuring the fair value of MSR as of June 30, 2013 were as follows:

   
June, 30, 2013
 
       
Constant prepayment rate
    16.74 %
Discount rate
    11.05 %
Weighted average life (years)
    4.99  

At June 30, 2013, the Company had $1,387,000 of mortgage loans held-for-sale.  At June 30, 2013 and December 31, 2012, the Company serviced real estate mortgage loans for others of $246,155,000 and $235,561,000, respectively.

The following table summarizes the Company’s mortgage servicing rights assets as of June 30, 2013 and December 31, 2012.  Mortgage servicing rights are included in Interest Receivable and Other Assets in the consolidated balance sheets.

   
(in thousands)
 
   
December 31, 2012
   
Additions
   
Reductions
   
June 30, 2013
 
                         
Mortgage servicing rights
  $ 1,760     $ 384     $ 250     $ 1,894  
Valuation allowance
    (536 )           (272 )     (264 )
Mortgage servicing rights, net of valuation allowance
  $ 1,224     $ 384     $ (22 )   $ 1,630  
                                 


The Company received contractually specified servicing fees of $155,000 and $137,000 for the three month periods ended June 30, 2013 and June 30, 2012, respectively.  The Company received contractually specified servicing fees of $307,000 and $272,000 for the six month periods ended June 30, 2013 and June 30, 2012, respectively.  Contractually specified servicing fees are included in Other Income on the consolidated statements of income.

 
21

 
4.           OUTSTANDING SHARES AND EARNINGS PER SHARE

On January 24, 2013, the Board of Directors of the Company declared a 2% stock dividend payable as of March 29, 2013.  All income per share amounts have been adjusted to give retroactive effect to stock dividends.

Earnings Per Share (EPS)

Basic EPS includes no dilution and is computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding for the period.  Diluted EPS includes all common stock equivalents (“in-the-money” stock options, unvested restricted stock, stock units, warrants and rights, convertible bonds and preferred stock), which reflects the potential dilution of securities that could share in the earnings of the Company.


The following table presents a reconciliation of basic and diluted EPS for the three-month and six-month periods ended June 30, 2013 and 2012.

   
Three months ended
   
Six months ended
 
   
June 30,
   
June 30,
 
   
2013
   
2012
   
2013
   
2012
 
Basic earnings per share:
                       
Net income
  $ 1,442     $ 1,207     $ 2,805     $ 2,299  
Preferred stock dividend
  $ (160 )   $ (286 )   $ (372 )   $ (571 )
Net income available to common shareholders
  $ 1,282     $ 921     $ 2,433     $ 1,728  
                                 
Weighted average common shares outstanding
    9,418,518       9,385,824       9,412,185       9,381,645  
Basic EPS
  $ 0.14     $ 0.10     $ 0.26     $ 0.18  
                                 
Diluted earnings per share:
                               
Net income
  $ 1,442     $ 1,207     $ 2,805     $ 2,299  
Preferred stock dividend
  $ (160 )   $ (286 )   $ (372 )   $ (571 )
Net income available to common shareholders
  $ 1,282     $ 921     $ 2,433     $ 1,728  
                                 
Weighted average common shares outstanding
    9,418,518       9,385,824       9,412,185       9,381,645  
                                 
Effect of dilutive shares
    33,118       24,480       31,925       25,717  
                                 
Adjusted weighted average common shares outstanding
    9,451,636       9,410,304       9,444,110       9,407,362  
Diluted EPS
  $ 0.14     $ 0.10     $ 0.26     $ 0.18  


Stock options which were not included in the computation of diluted earnings per share because they would have had an anti-dilutive effect amounted to 317,065 shares and 356,805 shares for the three-month periods ended June 30, 2013 and 2012, respectively.  Stock options which were not included in the computation of diluted earnings per share because they would have had an anti-dilutive effect amounted to 319,516 shares and 353,308 shares for the six-month periods ended June 30, 2013 and 2012, respectively.  There were no non-vested shares of restricted stock not included in the computation of diluted earnings per share because they would have an anti-dilutive effect for the three-month periods ended June 30, 2013 and 2012.  Non-vested shares of restricted stock that were not included in the computation of diluted earnings per share because they would have had an anti-dilutive effect amounted to 4,176 shares and 0 shares for the six-month periods ended June 30, 2013 and 2012, respectively.
 
 
22

 
 
5.    STOCK PLANS

On January 24, 2013, the Board of Directors of the Company declared a 2% stock dividend payable as of March 29, 2013.  All stock options and restricted stock outstanding have been adjusted to give retroactive effect to stock dividends.

 
The following table presents the activity related to stock options for the three months ended June 30, 2013.

   
Number of Shares
   
Weighted Average Exercise Price
   
Aggregate Intrinsic Value
   
Weighted Average Remaining Contractual Term (in years)
 
Options outstanding at Beginning of  Period
    357,493     $ 11.87              
                             
   Granted
                       
                             
   Expired
                       
                             
   Cancelled / Forfeited
                       
                             
   Exercised
                       
                             
Options outstanding at End of Period
    357,493     $ 11.87     $ 78,513       3.23  
                                 
Exercisable (vested) at End of Period
    311,503     $ 12.84     $ 49,489       2.40  

 
The following table presents the activity related to stock options for the six months ended June 30, 2013.

   
Number of Shares
   
Weighted Average Exercise Price
   
Aggregate Intrinsic Value
   
Weighted Average Remaining Contractual Term (in years)
 
Options outstanding at Beginning of  Period
    383,045     $ 11.71              
                             
   Granted
    22,950     $ 5.88              
                             
   Expired
    (48,502 )   $ 7.74              
                             
   Cancelled / Forfeited
                       
                             
   Exercised
                       
                             
Options outstanding at End of Period
    357,493     $ 11.87     $ 78,513       3.23  
                                 
Exercisable (vested) at End of Period
    311,503     $ 12.84     $ 49,489       2.40  


The weighted average grant date fair value per share of options granted during the six-month period ended June 30, 2013 was $2.75 per share.

As of June 30, 2013, there was $100,000 of total unrecognized compensation cost related to non-vested stock options.  This cost is expected to be recognized over a weighted average period of approximately 2.98 years.

There was $19,000 of recognized compensation cost related to stock options granted for the six months ended June 30, 2013.

 
23

 
A summary of the weighted average assumptions used in valuing stock options during the three months and six months ended June 30, 2013 is presented below.

 

   
Three Months Ended
June 30, 2013*
   
Six months Ended
June 30, 2013
 
 Risk Free Interest Rate
          0.86 %
                 
 Expected Dividend Yield
          0.00 %
                 
 Expected Life in Years
          5  
                 
 Expected Price Volatility
          54.36 %
    * There were no stock options or restricted stock granted during the three-month period ended June 30, 2013.
 

The following table presents the activity related to non-vested restricted stock for the three months ended June 30, 2013.
 

   
Number of Shares
   
Weighted Average Grant-Date Fair Value
   
Aggregate Intrinsic Value
   
Weighted Average Remaining Contractual Term (in years)
 
Non-vested restricted stock outstanding at Beginning of  Period
    58,282     $ 5.00              
                             
   Granted
                       
                             
   Cancelled / Forfeited
                       
                             
   Exercised/Released/Vested
                       
                             
Non-vested restricted stock outstanding at End of Period
    58,282     $ 5.00     $ 343,864       8.36  

The following table presents the activity related to non-vested restricted stock for the six months ended June 30, 2013.

   
Number of Shares
   
Weighted Average Grant-Date Fair Value
   
Aggregate Intrinsic Value
   
Weighted Average Remaining Contractual Term (in years)
 
Non-vested restricted stock outstanding at Beginning of Period
    47,707     $ 4.53              
                             
Granted
    19,380     $ 5.88              
                             
Cancelled / Forfeited
                       
                             
Exercised/Released/Vested
    (8,805)     $ 4.37              
                             
Non-vested restricted stock outstanding at End of Period
    58,282     $ 5.00     $ 343,864       8.36  

The weighted average fair value of restricted stock granted during the six month period ended June 30, 2013 was $5.88 per share.

 
24

 
As of June 30, 2013, there was $183,000 of total unrecognized compensation cost related to non-vested restricted stock.  This cost is expected to be recognized over a weighted average period of approximately 2.91 years.

There was $36,000 of recognized compensation cost related to restricted stock awards for the six months ended June 30, 2013.

The Company has an Employee Stock Purchase Plan (“ESPP”).  Under the ESPP, the Company is authorized to issue to eligible employees shares of common stock.  There are 300,958 (adjusted for the 2013 stock dividend) shares authorized under the ESPP.  The ESPP will terminate March 15, 2016.  The ESPP is implemented by participation periods of not more than twenty-seven months each.  The Board of Directors determines the commencement date and duration of each participation period.  The Board of Directors approved the current participation period of November 24, 2012 to November 23, 2013.  An eligible employee is one who has been continually employed for at least 90 days prior to commencement of a participation period. Under the terms of the ESPP, employees can choose to have up to 10 percent of their compensation withheld to purchase the Company’s common stock each participation period.  The purchase price of the stock is 85 percent of the lower of the fair value on the last trading day before the date of participation or the fair value on the last trading day during the participation period.
 
 
As of June 30, 2013, there was $12,000 of unrecognized compensation cost related to ESPP issuances.  This cost is expected to be recognized over a weighted average period of approximately 0.50 years.

There was $18,000 of recognized compensation cost related to ESPP issuances for the six-month period ended June 30, 2013.

The weighted average fair value at issuance date during the six-month period ended June 30, 2013 was $1.04.
 
 
A summary of the weighted average assumptions used in valuing ESPP issuances during the three months and six months ended June 30, 2013 is presented below.
 
 
   
Three Months Ended
June 30, 2013
   
Six Months Ended
June 30, 2013
 
 Risk Free Interest Rate
    0.19 %     0.19 %
                 
 Expected Dividend Yield
    0.00 %     0.00 %
                 
 Expected Life in Years
    1.00       1.00  
                 
 Expected Price Volatility
    20.00 %     20.00 %

 
 
25

 

6.    FAIR VALUE MEASUREMENT
The Company utilizes fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures.  Securities available-for-sale and trading securities are recorded at fair value on a recurring basis.  Additionally, from time to time, the Company may be required to record at fair value other assets on a non-recurring basis, such as loans held-for-sale, loans held-for-investment and certain other assets.  These non-recurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.  Transfers between levels of the fair value hierarchy are recognized on the actual date of the event or circumstances that caused the transfer, which generally corresponds with the Company’s quarterly valuation process.

Fair Value Hierarchy
The Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.  These levels are:

 
Level 1 
 
Valuation is based upon quoted prices for identical instruments traded in active markets.
       
 
Level 2 
 
Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active and model-based valuation techniques for which all significant assumptions are observable or can be corroborated by observable market data.
       
 
Level 3 
 
Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market.  These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability.  Valuation techniques include use of option pricing models, discounted cash flow models, and similar techniques and include management judgment and estimation which may be significant.
          
Following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

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

Loans Held-for-Sale

Loans held-for-sale are carried at the lower of cost or fair value.  The fair value of loans held-for-sale is based on what secondary markets are currently offering for portfolios with similar characteristics.  As such, the Company classifies loans subjected to non-recurring fair value adjustments as Level 2.  At June 30, 2013 there were no loans held-for-sale that required a write-down.

Impaired Loans

The Company does not record loans at fair value on a recurring basis.  However, from time to time, a loan is considered impaired and an allowance for loan losses is established.  Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired.  Once a loan is identified as individually impaired, the Company measures impairment.  The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows.  Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans.

 
26

 
At June 30, 2013, certain impaired loans were considered collateral dependent and were evaluated based on the fair value of the underlying collateral securing the loan.  Impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy.  When a loan is evaluated based on the fair value of the underlying collateral securing the loan, the Company records the impaired loan as non-recurring Level 3.

Other Real Estate Owned

Other real estate assets (“OREO”) acquired through, or in lieu of, foreclosure are held-for-sale and are initially recorded at the lower of cost or fair value, less selling costs.  Any write-downs to fair value at the time of transfer to OREO are charged to the allowance for loan losses.  Appraisals or evaluations are then done periodically thereafter charging any additional write-downs or valuation allowances to the appropriate expense accounts.  Values are derived from appraisals of underlying collateral and discounted cash flow analysis.  OREO is classified within Level 3 of the hierarchy.

Loan Servicing Rights

Loan servicing rights are subject to impairment testing.  The Company utilizes a third party service provider to calculate the fair value of the Company’s loan servicing rights.  Loan servicing rights are measured at fair value as of the date of sale.  The Company uses quoted market prices when available.  Subsequent fair value measurements are determined using a discounted cash flow model.  In order to determine the fair value of the loan servicing rights, the present value of expected future cash flows is estimated.  Assumptions used include market discount rates, anticipated prepayment speeds, delinquency and foreclosure rates, and ancillary fee income.  This model is periodically validated by an independent external model validation group.  The model assumptions and the loan servicing rights fair value estimates are also compared to observable trades of similar portfolios as well as to loan servicing rights broker valuations and industry surveys, as available.  If the valuation model reflects a value less than the carrying value, loan servicing rights are adjusted to fair value through a valuation allowance as determined by the model.  As such, the Company classifies loan servicing rights subjected to non-recurring fair value adjustments as Level 3.

Assets Recorded at Fair Value on a Recurring Basis

The table below presents the recorded amount of assets and liabilities measured at fair value on a recurring basis as of June 30, 2013.
   
(in thousands)
 
June 30, 2013
 
Total
   
Level 1
   
Level 2
   
Level 3
 
U.S. Treasury securities
  $ 1,003     $ 1,003     $     $  
Securities of U.S. government
                               
   agencies and corporations
    52,893             52,893        
Obligations of states and
                               
    political subdivisions
    28,195             28,195        
Collateralized mortgage obligations
    6,447             6,447          
Mortgage-backed securities
    102,231             102,231        
                                 
Total investments at fair value
  $ 190,769     $ 1,003     $ 189,766     $  
                                 
 
 
27

 
 
The table below presents the recorded amount of assets and liabilities measured at fair value on a recurring basis as of December 31, 2012.
   
(in thousands)
 
December 31, 2012
 
Total
   
Level 1
   
Level 2
   
Level 3
 
U.S. Treasury securities
  $ 1,005     $ 1,005     $     $  
Securities of U.S. government
                               
   agencies and corporations
    28,305             28,305        
Obligations of states and
                               
    political subdivisions
    28,786             28,786        
Collateralized mortgage obligations
    8,278             8,278          
Mortgage-backed securities
    118,117             118,117        
                                 
Total investments at fair value
  $ 184,491     $ 1,005     $ 183,486     $  
                                 


Assets Recorded at Fair Value on a Non-Recurring Basis

Assets measured at fair value on a non-recurring basis are included in the table below by level within the fair value hierarchy as of June 30, 2013.

   
(in thousands)
 
 
June 30, 2013
 
Total
   
Level 1
   
Level 2
   
Level 3
 
Impaired loans
  $ 914     $     $     $ 914  
Loan servicing rights
    1,630                   1,630  
                                 
Total assets at fair value
  $ 2,544     $     $     $ 2,544  


Assets measured at fair value on a non-recurring basis are included in the table below by level within the fair value hierarchy as of December 31, 2012.

   
(in thousands)
 
 
December 31, 2012
 
Total
   
Level 1
   
Level 2
   
Level 3
 
Impaired loans
  $ 2,513     $     $     $ 2,513  
Other real estate owned
    1,062                   1,062  
Loan servicing rights
    1,224                   1,224  
                                 
Total assets at fair value
  $ 4,799     $     $     $ 4,799  


There were no liabilities measured at fair value on a recurring or non-recurring basis at June 30, 2013 and December 31, 2012.

 
28

 
 
7.    PREFERRED STOCK

On September 15, 2011, the Company issued to the U.S. Treasury under the United States Department of Treasury Small Business Lending Fund (SBLF) 22,847 shares of the Company’s Non-Cumulative Perpetual Preferred Stock, Series A (SBLF Shares), having a liquidation preference per share equal to $1,000, for an aggregate purchase price of $22,847,000.

On September 15, 2011, the Company redeemed from the U.S. Treasury, using the partial proceeds from the issuance of the SBLF Shares, all 17,390 outstanding shares of its Fixed Rate Cumulative Perpetual Preferred Stock, Series A, liquidation amount $1,000 per share, for a redemption price of $17,390,000, plus accrued but unpaid dividends at the date of redemption.

On February 8, 2013, the Company redeemed $10,000,000 of the $22,847,000 in preferred stock it issued to the U.S. Treasury under the SBLF program.

 
8.    FAIR VALUES OF FINANCIAL INSTRUMENTS
 
The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:

Cash and Cash Equivalents
 
The carrying amounts reported in the balance sheet for cash and short-term instruments are a reasonable estimate of fair value.  The carrying amount is a reasonable estimate of fair value because of the relatively short term between the origination of the instrument and its expected realization.  Therefore, the Company believes the measurement of fair value of cash and cash equivalents is derived from Level 1 inputs.
 
Other Equity Securities
 
The carrying amounts reported in the consolidated balance sheet approximate fair value.  The Company believes the measurement of the fair value of other equity securities is derived from Level 2 inputs.
 
Loans Receivable
 
For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values.  The fair values for other loans (e.g., commercial real estate and rental property mortgage loans, commercial and industrial loans, and agricultural loans) are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.  The allowance for loan losses is considered to be a reasonable estimate of loan discount due to credit risks.  Given that there are loans with specific terms that are not readily available, the Company believes the fair value of loans receivable is derived from Level 3 inputs.
 
Loans Held-for-Sale
 
For loans held for sale, carrying value approximates fair value.  See FN(6), Fair Value Measurement.
 
Interest receivable and payable
 
The carrying amount of interest receivable and payable approximates its fair value.  The Company believes the measurement of the fair value of interest receivable and payable is derived from Level 3 inputs.
 

Deposit Liabilities
 
The Company measures fair value of deposits using Level 2 and Level 3 inputs.  The fair value of deposits were derived by discounting their expected future cash flows back to their present values based on the FHLB yield curve, and their expected decay rates for non maturing deposits.  The Company is able to obtain FHLB yield curve rates as of the measurement date, and believes these inputs fall under Level 2 of the fair value hierarchy.  Decay rates were developed through internal analysis, and are supported by recent years of the Bank’s transaction history.  The inputs used by the Company to derive the decay rate assumptions are unobservable inputs, and therefore fall under Level 3 of the fair value hierarchy.
 
 
29

 
FHLB Advances and Other Borrowings
 
The fair values of borrowed funds were estimated by discounting future cash flows related to these financial instruments using current market rates for financial instruments with similar characteristics.  The Company believes the measurement of the fair value of FHLB advances and other borrowings is derived from Level 2 inputs.
 
Limitations
 
Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision.  Changes in assumptions could significantly affect the estimates.
 
Fair value estimates are based on existing on-and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Other significant assets and liabilities that are not considered financial assets or liabilities include deferred tax liabilities and premises and equipment.  In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in many of the estimates.
 
The estimated fair values of the Company’s financial instruments for the periods ended June 30, 2013 and December 31, 2012 are approximately as follows:
 
         
June 30, 2013
   
December 31, 2012
 
   
Level
   
Carrying amount
   
Fair
value
   
Carrying amount
   
Fair
value
 
                               
Financial assets:
                             
Cash and cash equivalents
    1     $ 141,847     $ 141,847     $ 161,359     $ 161,359  
Other equity securities
    2       3,717       3,717       3,607       3,607  
Loans receivable:
                                       
Net loans
    3       470,046       467,206       440,449       437,818  
Loans held-for-sale
    2       1,387       1,387       4,559       4,704  
Interest receivable
    3       2,608       2,608       2,542       2,542  
Financial liabilities:
                                       
Deposits
    3       754,282       743,722       730,811       720,690  
Interest payable
    3       74       74       94       94  

 
30

 

9.    INVESTMENT SECURITIES
 
The amortized cost, unrealized gains and losses and estimated fair values of investments in debt and other securities at June 30, 2013 are summarized as follows:
 
(in thousands)
 
Amortized cost
   
Unrealized gains
   
Unrealized losses
   
Estimated fair value
 
                         
Investment securities available-for-sale:
                       
U.S. Treasury securities
  $ 999     $ 4     $     $ 1,003  
Securities of U.S. government agencies and corporations
    53,982       24       (1,113 )     52,893  
Obligations of states and political subdivisions
    27,841       722       (368 )     28,195  
Collateralized mortgage obligations
    6,513             (66 )     6,447  
Mortgage-backed securities
    102,461       429       (659 )     102,231  
                                 
Total debt securities
  $ 191,796     $ 1,179     $ (2,206 )   $ 190,769  

The amortized cost, unrealized gains and losses and estimated fair values of investments in debt and other securities at December 31, 2012 are summarized as follows:
 
(in thousands)
 
Amortized cost
   
Unrealized gains
   
Unrealized losses
   
Estimated fair value
 
                         
Investment securities available-for-sale:
                       
U.S. Treasury securities
  $ 997     $ 8     $     $ 1,005  
Securities of U.S. government agencies and corporations
    28,200       105    
—­­­
      28,305  
Obligations of states and political subdivisions
    27,226       1,563       (3 )     28,786  
Collateralized mortgage obligations
    8,156       123       (1 )     8,278  
Mortgage-backed securities
    116,855       1,524       (262 )     118,117  
                                 
Total debt securities
  $ 181,434     $ 3,323     $ (266 )   $ 184,491  

 
There were no proceeds from sales of available-for-sale securities for the six-month and three-month periods ended June 30, 2013 and June 30, 2012.  Gross realized gains from calls of available-for-sale securities were $4 and $0 for the six-month and three-month periods ended June 30, 2013, respectively. Gross realized gains from calls of available-for-sale securities were $1 and $0 for the six-month and three-month periods ended June 30, 2012, respectively.  There were no gross realized losses from sales of available-for-sale securities for the six-month and three-month periods ended June 30, 2013 and June 30, 2012.

The amortized cost and estimated market value of debt and other securities at June 30, 2013, by contractual and expected maturity, are shown in the following table.
 
(in thousands)
 
Amortized
cost
   
Estimated fair value
 
             
Due in one year or less
  $ 11,133     $ 11,151  
Due after one year through five years
    130,359       129,827  
Due after five years through ten years
    42,297       41,692  
Due after ten years
    8,007       8,099  
                 
    $ 191,796     $ 190,769  
 
 
31

 
Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.  Securities due after one year through five years included mortgage-backed securities with expected maturities totaling $100,194,000.  The maturities on these securities were based on the average lives of the securities.
 
An analysis of gross unrealized losses of the available-for-sale investment securities portfolio as of June 30, 2013, follows:
 
   
Less than 12 months
   
12 months or more
   
Total
 
(in thousands)
 
Fair Value
   
Unrealized losses
   
Fair Value
   
Unrealized losses
   
Fair Value
   
Unrealized losses
 
                                     
Securities of U.S. government agencies and corporations
  $ 44,797     $ (1,113 )   $     $     $ 44,797     $ (1,113 )
Obligations of states and political subdivisions
    10,050       (368 )                 10,050       (368 )
                                                 
Collateralized mortgage obligations
    6,447       (66 )                 6,447       (66 )
Mortgaged-backed
     securities
    58,793       (659 )                 58,793       (659 )
                                                 
Total
  $ 120,087     $ (2,206 )   $     $     $ 120,087     $ (2,206 )


No decline in value was considered “other-than-temporary” during 2013.  Eighty-eight securities, all considered investment grade, which had a fair value of $120,087,000 and a total unrealized loss of $2,206,000 have been in an unrealized loss position for less than twelve months as of June 30, 2013. The declines in fair value were primarily attributable to changes in interest rates.  As the Company does not intend to sell these securities and it is not more likely than not that the Company will be required to sell these securities prior to their anticipated recovery, these investments are not considered other-than-temporarily impaired.

An analysis of gross unrealized losses of the available-for-sale investment securities portfolio as of December 31, 2012, follows:
 
   
Less than 12 months
   
12 months or more
   
Total
 
(in thousands)
 
Fair Value
   
Unrealized losses
   
Fair Value
   
Unrealized losses
   
Fair Value
   
Unrealized losses
 
                                     
                                     
Obligations of states and political subdivisions
  $ 1,262     $ (3 )   $     $     $ 1,262     $ (3 )
                                                 
Collateralized mortgage obligations
    1,198       (1 )                 1,198       (1 )
Mortgage-backed securities
    29,779       (262 )                 29,779       (262 )
                                                 
                                                 
Total
  $ 32,239     $ (266 )   $     $     $ 32,239     $ (266 )


Investment securities carried at $28,962,000 and $32,227,000 at June 30, 2013 and December 31, 2012, respectively, were pledged to secure public deposits or for other purposes as required or permitted by law.
 
 
32

 

10.     ACCUMULATED OTHER COMPREHENSIVE INCOME
 
The following table details activity in accumulated other comprehensive (loss) income for the three-month period ended June 30, 2013.
 
($ in thousands)
 
Unrealized Gains on Securities
   
Directors’ and officers’ retirement plans
   
Accumulated Other Comprehensive (Loss) Income
 
Balance as of March 31, 2013
  $ 1,671     $ (660 )   $ 1,011  
Current period other comprehensive loss
    (2,287 )           (2,287 )
     Balance as of June 30, 2013
  $ (616 )   $ (660 )   $ (1,276 )

 
The following table details activity in accumulated other comprehensive income for the six-month period ended June 30, 2013.
 
($ in thousands)
 
Unrealized Gains on Securities
   
Directors’ and officers’ retirement plans
   
Accumulated Other Comprehensive Income
 
Balance as of December 31, 2012
  $ 1,834     $ (660 )   $ 1,174  
Current period other comprehensive loss
    (2,450 )           (2,450 )
     Balance as of June 30, 2013
  $ (616 )   $ (660 )   $ (1,276 )

 
During the three-month and six-month periods ended June 30, 2013, the Company incurred a net increase in unrealized loss of approximately $3,813,000 and $4,084,000, respectively, in the Company’s investment portfolio, resulting in comprehensive loss, net of tax of $2,287,000 and $2,450,000, respectively, recognized in the Consolidated Statements of Comprehensive (Loss) Income.  The net increase in unrealized loss is due to increases in long-term market rates of U.S. Treasury securities.
 
The following table details activity in accumulated other comprehensive income for the three-month period ended June 30, 2012.
 
($ in thousands)
 
Unrealized Gains on Securities
   
Directors’ and officers’ retirement plans
   
Accumulated Other Comprehensive Income
 
Balance as of March 31, 2012
  $ 1,344     $ (495 )   $ 849  
Current period other comprehensive   income
    260             260  
     Balance as of June 30, 2012
  $ 1,604     $ (495 )   $ 1,109  

 
The following table details activity in accumulated other comprehensive income for the six-month period ended June 30, 2012.
 
($ in thousands)
 
Unrealized Gains on Securities
   
Directors’ and officers’ retirement plans
   
Accumulated Other Comprehensive Income
 
Balance as of December 31, 2011
  $ 758     $ (495 )   $ 263  
Current period other comprehensive   income
    846             846  
     Balance as of June 30, 2012
  $ 1,604     $ (495 )   $ 1,109  
 
 
33

 

11.    FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK
 
The Company 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 in the form of loans or through standby letters of credit.  These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the balance sheet.  The contract amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.
 
The Bank’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 Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.
 
Financial instruments, whose contract amounts represent credit risk at the indicated periods, were as follows:
 
(in thousands)
 
June 30,
2013
   
December 31, 2012
 
             
Undisbursed loan commitments
  $ 168,213     $ 159,329  
Standby letters of credit
    1,893       2,376  
Commitments to sell loans
    3,597       7,480  
                 
    $ 173,703     $ 169,185  

 
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 and may require payment of a fee.  Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  The Bank evaluates each customer’s creditworthiness on a case-by-case basis.  The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation.  Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties.
 
Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.  The Bank issues both financial and performance standby letters of credit.  The financial standby letters of credit are primarily to guarantee payment to third parties.  At June 30, 2013, there were no financial standby letters of credit outstanding.  The performance standby letters of credit are typically issued to municipalities as specific performance bonds.  At June 30, 2013, there was $1,893,000 issued in performance standby letters of credit and the Bank carried no liability.  The terms of the guarantees will expire primarily in 2013.  The Bank has experienced no draws on these letters of credit; however, should a triggering event occur, the Bank either has collateral in excess of the letter of credit or imbedded agreements of recourse from the customer.  The Bank has set aside a reserve for unfunded commitments in the amount of $793,000 at June 30, 2013, which is recorded in “interest payable and other liabilities” on the Consolidated Balance Sheets.
 
Commitments to extend credit and standby letters of credit bear similar credit risk characteristics as outstanding loans.  As of June 30, 2013, the Company had no off-balance sheet derivatives requiring additional disclosure.
 
Mortgage loans sold to investors may be sold with servicing rights retained, for which the Company makes only standard legal representations and warranties as to meeting certain underwriting and collateral documentation standards.  In the past two years, the Company has had to repurchase no loans due to deficiencies in underwriting or loan documentation.  Management believes that any liabilities that may result from such recourse provisions are not significant.
 
 
34

 


FIRST NORTHERN COMMUNITY BANCORP
 
ITEM 2. – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 

FORWARD-LOOKING STATEMENTS

This report includes forward-looking statements, which include forecasts of our financial results and condition, expectations for our operations and business, and our assumptions for those forecasts and expectations. Do not rely unduly on forward-looking statements. Actual results might differ significantly compared to our forecasts and expectations. See Part I, Item 1A. “Risk Factors,” and the other risks described in our 2012 Annual Report on Form 10-K for factors to be considered when reading any forward-looking statements in this filing.
This report includes forward-looking statements, which are subject to the “safe harbor” created by section 27A of the Securities Act of 1933, as amended, and section 21E of the Securities Exchange Act of 1934, as amended. We may make forward-looking statements in our Securities and Exchange Commission (SEC) filings, press releases, news articles and when we are speaking on behalf of the Company. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Often, they include the words “believe,” “expect,” “target,” “anticipate,” “intend,” “plan,” “seek,” “strive,” “estimate,” “potential,” “project,” or words of similar meaning, or future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” or “may.” These forward-looking statements are intended to provide investors with additional information with which they may assess our future potential. All of these forward-looking statements are based on assumptions about an uncertain future and are based on information available to us at the date of these statements. We do not undertake to update forward-looking statements to reflect facts, circumstances, assumptions or events that occur after the date the forward-looking statements are made.
In this document and in other SEC filings, for example we make forward-looking statements relating to the following topics:
·  
Our business objectives, strategies and initiatives, our organizational structure, the growth of our business and our competitive position
 
·  
Our assessment of significant factors and developments that have affected or may affect our results
 
·  
Pending and recent legal and regulatory actions, and future legislative and regulatory developments, including the effects of the Dodd-Frank Wall Street Reform and Protection Act (the “Dodd-Frank Act”) and other legislation and governmental measures introduced in response to the financial crises affecting the banking system, financial markets and the U.S. economy
 
·  
Regulatory controls and processes and their impact on our business
 
·  
The costs and effects of legal or regulatory actions
 
·  
We do not expect draws on performance letters of credit
 
·  
Our regulatory capital requirements, including the recently adopted capital rules by the U.S. federal banking agencies
 
·  
We do not anticipate paying a cash dividend in the foreseeable future
 
·  
Credit quality and provision for credit losses
 
·  
Our allowances for credit losses, including the conditions we consider in determining the unallocated allowance and our portfolio credit quality, underwriting standards, and risk grade
 
·  
Our assessment of economic conditions and trends and credit cycles and their impact on our business
 
·  
The seasonal nature of our business
 
 
 
35

 
 
·  
The impact of changes in interest rates and our strategy to manage our interest rate risk profile
 
·  
Loan portfolio composition and risk grade trends, expected charge offs, delinquency rates and our underwriting standards
 
·  
Our deposit base including renewal of time deposits
 
·  
The impact on our net interest income and net interest margin from the current low-interest rate environment
 
·  
The Company does not anticipate any significant increase or decrease in unrecognized tax benefits
 
·  
Our pension and retirement plan costs
 
·  
Our liquidity position
 
·  
Critical accounting policies and estimates, the impact or anticipated impact of recent accounting pronouncements or change in accounting principles
 
·  
Expected rates of return, yields and projected results
 
There are numerous risks and uncertainties that could and will cause actual results to differ materially from those discussed in our forward-looking statements. Many of these factors are beyond our ability to control or predict and could have a material adverse effect on our financial condition and results of operations or prospects. Such risks and uncertainties include, but are not limited to those listed in Item 1A “Risk Factors” of Part II, Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of Part I of this Form 10-Q and “Supervision and Regulation” of our 2012 Annual Report on Form 10-K.

 
36

 
 
INTRODUCTION

This overview of Management’s Discussion and Analysis highlights selected information in this report and may not contain all of the information that is important to you.  For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources and critical accounting estimates, you should carefully read this entire report, together with our Consolidated Financial Statements and the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2012.

Our subsidiary, First Northern Bank of Dixon (the “Bank”), is a California state-chartered bank that derives most of its revenues from lending and deposit taking in the Sacramento Valley region of Northern California.  Interest rates, business conditions and customer confidence all affect our ability to generate revenues.  In addition, the regulatory environment and competition can present challenges to our ability to generate those revenues.


Significant results and developments during the second quarter and year-to-date 2013 include:

· Net income of $2.8 million for the six months ended June 30, 2013, up 21.7% from $2.3 million for the same fiscal period last year.

· Net income available to common shareholders of $2.4 million for the six months ended June 30, 2013, up 41.2% from $1.7 million for the same fiscal period last year.
 
 
· Diluted income per share for the six-month period ended June 30, 2013 was $0.26, up 44.4% from diluted income per share of $0.18 in the same period last year.

· Net interest income increased in the six months ended June 30, 2013 by $436,000, or 3.4%, to $13.37 million from $12.934 million in the same period last year.  The increase in net interest income was primarily attributable to a decrease in interest costs, partially offset by a decrease in interest yields.  The decrease in interest costs is primarily attributable to a decrease in the Company’s average cost of funds, partially offset by an increase in average interest-bearing deposits.  Net interest margin decreased from 3.54% for the six-month period ending June 30, 2012 to 3.41% for the same period ending June 30, 2013.

· Provision for loan losses of $0.8 million for the six-month period ended June 30, 2013 compared to a provision for loan losses of $1.23 million for the same period in 2012.

· Total assets at June 30, 2013 were $844.7 million, an increase of $13.2 million, or 1.6%, compared to total assets at December 31, 2012.
 
 
· Total net loans at June 30, 2013 (including loans held-for-sale) increased $26.4 million, or 5.9%, to $471.4 million compared to December 31, 2012.

· Total investment securities at June 30, 2013 increased $6.3 million, or 3.4%, to $190.8 million compared to December 31, 2012.

· Total deposits of $754.3 million at June 30, 2013, represented an increase of $23.5 million, or 3.2%, compared to December 31, 2012.

· Net income of $1.4 million for the three months ended June 30, 2013, up 16.7% from $1.2 million for the same fiscal period last year.

· Net income available to common shareholders of $1.3 million for the three months ended June 30, 2013, up 44.4% from $0.9 million for the same period last year.
 
 
· Diluted income per share for the three-month period ended June 30, 2013 was $0.14, up 40.0% from a diluted income per share of $0.10 for the same period last year.

· During the three-month and six-month periods ended June 30, 2013, the Company incurred a net increase in unrealized loss of approximately $3,813,000 and $4,084,000, respectively, in the Company’s investment portfolio, resulting in comprehensive loss, net of tax of $2,287,000 and $2,450,000, respectively, recognized in the Consolidated Statements of Comprehensive (Loss) Income.  The net increase in unrealized loss is due to increases in long-term market rates of U.S. Treasury securities.
 
 
37

 
SUMMARY

The Company recorded net income of $2,805,000 for the six-month period ended June 30, 2013, representing an increase of $506,000 from net income of $2,299,000 for the same period in 2012.  The Company recorded net income of $1,442,000 for the three-month period ended June 30, 2013, representing an increase of $235,000 from net income of $1,207,000 for the same period in 2012.


The following tables present a summary of the results for the three-month and six-month periods ended June 30, 2013 and 2012, and a summary of financial condition at June 30, 2013 and December 31, 2012.

   
Three months ended June 30, 2013
   
Three months ended June 30, 2012
   
Six months ended June 30, 2013
   
Six months ended June 30, 2012
 
                         
(in thousands except for per share amounts)
                   
For the Period:
                       
                         
     Net Income
  $ 1,442     $ 1,207     $ 2,805     $ 2,299  
                                 
     Basic Earnings Per Common Share
  $ 0.14     $ 0.10     $ 0.26     $ 0.18  
                                 
     Diluted Earnings Per Common Share
  $ 0.14     $ 0.10     $ 0.26     $ 0.18  
                                 
 
                               


   
June 30,
2013
   
December 31, 2012
 
             
(in thousands except for ratios)
       
At Period End:
           
             
      Total Assets
  $ 844,664     $ 831,483  
                 
      Total Loans, Net (including loans held-for-sale)
  $ 471,433     $ 445,008  
                 
     Total Investment Securities
  $ 190,769     $ 184,491  
                 
     Total Deposits
  $ 754,282     $ 730,811  
                 
      Loan-To-Deposit Ratio
    62.5 %     60.9 %


 
38

 
 
FIRST NORTHERN COMMUNITY BANCORP
 
Distribution of Average Statements of Condition and Analysis of Net Interest Income
(in thousands, except percentage amounts)

   
Three months ended
   
Three months ended
 
   
June 30, 2013
   
June 30, 2012
 
   
Average
         
Yield/
   
Average
         
Yield/
 
   
Balance
   
Interest
   
Rate
   
Balance
   
Interest
   
Rate
 
Assets
                                   
Interest-earning assets:
                                   
Loans (1)
  $ 456,839     $ 6,234       5.47 %   $ 432,772     $ 6,044       5.60 %
Interest bearing due from banks
    135,298       107       0.32 %     109,816       95       0.35 %
Investment securities, taxable
    186,311       647       1.39 %     178,262       798       1.80 %
Investment securities, non-taxable  (2)
    9,971       99       3.98 %     10,482       103       3.94 %
Other interest earning assets
    3,687       60       6.53 %     3,438       8       0.93 %
Total average interest-earning assets
    792,106       7,147       3.62 %     734,770       7,048       3.85 %
Non-interest-earning assets:
                                               
Cash and due from banks
    15,763                       15,207                  
Premises and equipment, net
    7,732                       8,116                  
Other real estate owned
    555                       975                  
Interest receivable and other assets
    29,066                       31,418                  
Total average assets
    845,222                       790,486                  
                                                 
Liabilities and Stockholders’ Equity:
                                               
Interest-bearing liabilities:
                                               
Interest-bearing transaction deposits
    193,374       64       0.13 %     164,820       92       0.22 %
Savings and MMDA’s
    221,019       146       0.26 %     212,556       176       0.33 %
Time, under $100,000
    34,942       34       0.39 %     37,582       52       0.55 %
Time, $100,000 and over
    55,080       68       0.50 %     62,087       118       0.76 %
FHLB advances and other borrowings
    3             %     6,846       69       4.04 %
Total average interest-bearing liabilities
    504,418       312       0.25 %     483,891       507       0.42 %
Non-interest-bearing liabilities:
                                               
Non-interest-bearing demand deposits
    249,259                       209,106                  
Interest payable and other liabilities
    7,541                       6,967                  
Total liabilities
    761,218                       699,964                  
Total average stockholders’ equity
    84,004                       90,522                  
Total average liabilities and stockholders’ equity
  $ 845,222                     $ 790,486                  
Net interest income and net interest margin (3)
          $ 6,835       3.46 %           $ 6,541       3.57 %
                                                 

1.  Average balances for loans include loans held-for-sale and non-accrual loans and are net of the allowance for loan losses, but non-accrued interest thereon is excluded.  Loan interest income includes loan fees of approximately $383 and $256 for the three months ended June 30, 2013 and 2012, respectively.
2.  Interest income and yields on tax-exempt securities are not presented on a taxable equivalent basis.
3.  Net interest margin is computed by dividing net interest income by total average interest-earning assets.
 
 
39

 

FIRST NORTHERN COMMUNITY BANCORP
 
Distribution of Average Statements of Condition and Analysis of Net Interest Income
(in thousands, except percentage amounts)

   
Six months ended
   
Six months ended
 
   
June 30, 2013
   
June 30, 2012
 
   
Average
         
Yield/
   
Average
         
Yield/
 
   
Balance
   
Interest
   
Rate
   
Balance
   
Interest
   
Rate
 
Assets
                                   
Interest-earning assets:
                                   
Loans (1)
  $ 447,399     $ 12,205       5.50 %   $ 427,383     $ 12,034       5.65 %
Interest bearing due from banks
    144,399       212       0.30 %     120,785       174       0.29 %
Investment securities, taxable
    184,650       1,340       1.46 %     171,196       1,578       1.85 %
Investment securities, non-taxable  (2)
    10,075       199       3.98 %     10,500       207       3.95 %
Other interest earning assets
    3,647       60       3.32 %     3,257       12       0.74 %
Total average interest-earning assets
    790,170       14,016       3.58 %     733,121       14,005       3.83 %
Non-interest-earning assets:
                                               
Cash and due from banks
    16,166                       15,446                  
Premises and equipment, net
    7,766                       8,100                  
Other real estate owned
    807                       1,160                  
Interest receivable and other assets
    28,830                       31,731                  
Total average assets
    843,739                       789,558                  
                                                 
Liabilities and Stockholders’ Equity:
                                               
Interest-bearing liabilities:
                                               
Interest-bearing transaction deposits
    191,334       127       0.13 %     162,996       182       0.22 %
Savings and MMDA’s
    223,655       304       0.27 %     215,323       371       0.35 %
Time, under $100,000
    35,132       73       0.42 %     37,769       106       0.56 %
Time, $100,000 and over
    55,466       142       0.52 %     64,934       271       0.84 %
FHLB advances and other borrowings
    2             %     6,923       141       4.08 %
Total average interest-bearing liabilities
    505,589       646       0.26 %     487,945       1,071       0.44 %
Non-interest-bearing liabilities:
                                               
Non-interest-bearing demand deposits
    244,915                       205,122                  
Interest payable and other liabilities
    7,644                       6,948                  
Total liabilities
    758,148                       700,015                  
Total average stockholders’ equity
    85,591                       89,543                  
Total average liabilities and stockholders’ equity
  $ 843,739                     $ 789,558                  
Net interest income and net interest margin (3)
          $ 13,370       3.41 %           $ 12,934       3.54 %
                                                 

1.  Average balances for loans include loans held-for-sale and non-accrual loans and are net of the allowance for loan losses, but non-accrued interest thereon is excluded.  Loan interest income includes loan fees of approximately $661 and $454 for the six months ended June 30, 2013 and 2012, respectively.
2.  Interest income and yields on tax-exempt securities are not presented on a taxable equivalent basis.
3.  Net interest margin is computed by dividing net interest income by total average interest-earning assets.
 
 
40

 
 
CHANGES IN FINANCIAL CONDITION

The assets of the Company set forth in the Unaudited Condensed Consolidated Balance Sheets reflect a $19,512,000 decrease in cash and cash equivalents, a $6,278,000 increase in investment securities available-for-sale, a $29,597,000 increase in net loans held-for-investment, a $3,172,000 decrease in loans held-for-sale, a $1,062,000 decrease in other real estate owned, and a $1,143,000 increase in interest receivable and other assets from December 31, 2012 to June 30, 2013.  The decrease in cash and cash equivalents was due to a decrease in interest bearing due from bank accounts, partially offset by an increase in non-interest bearing due from bank accounts.  The increase in investment securities available-for-sale was primarily the result of purchases of municipal bonds, agency bonds, and mortgage backed securities, partially offset by calls of agency and municipal bonds and amortization on mortgage backed securities.  The increase in loans held-for-investment was due to increases in the following loan categories as a result of increased loan demand:  commercial and industrial; equipment; financed equipment leases; consumer; real estate; real estate commercial and construction.  The increase in loans held-for-investment was partially offset by decreases in the following loan categories:  agricultural; true equipment leases; home equity lines.  The decrease in loans held-for-sale was due to timing of sales of loans held-for-sale.  The decrease in other real estate owned was due to the sale of three other real estate owned properties.  The increase in interest receivable and other assets was mainly due to increases in accrued income on loans, income taxes receivable, cash surrender value of bank owned life insurance, unamortized loan costs, and mortgage servicing asset, which was partially offset by decreases in accrued income on securities, housing tax credits, prepaid expenses, sold loan settlement, and suspense & holdovers.

The liabilities of the Company set forth in the Unaudited Condensed Consolidated Balance Sheets reflect an increase in total deposits of $23,471,000 from December 31, 2012 to June 30, 2013.  The increase in deposits was due to increases in demand deposits, interest-bearing transaction deposits, and savings accounts, which was partially offset by decreases in money market accounts and time deposits.

 
41

 
 
CHANGES IN RESULTS OF OPERATIONS

Interest Income

The Federal Open Market Committee made no changes to the Federal Funds rate during the six-month period ended June 30, 2013.

Interest income on loans for the six-month period ended June 30, 2013 was up 1.4% from the same period in 2012, increasing from $12,034,000 to $12,205,000 and was up 3.1% for the three-month period ended June 30, 2013 over the same period in 2012, increasing from $6,044,000 to $6,234,000.  The increase in interest income on loans for the six-month period ended June 30, 2013 as compared to the same period a year ago was primarily due to an increase in average loans, partially offset by a 15 basis point decrease in loan yields.  The increase in interest income on loans for the three-month period ended June 30, 2013 as compared to the same period a year ago was primarily due to an increase in average loans, partially offset by a 13 basis point decrease in loan yields.  The decrease in loan yields was primarily due to repricing of loans at lower rates.

Interest income on investment securities available-for-sale for the six-month period ended June 30, 2013 was down 13.8% from the same period in 2012, decreasing from $1,785,000 to $1,539,000 and was down 17.2% for the three-month period ended June 30, 2013 over the same period in 2012, decreasing from $901,000 to $746,000.  The decrease in interest income on investment securities for the six-month and three-month periods ended June 30, 2013 as compared to the same periods a year ago was primarily due to a 39 basis point decrease in investment securities yields, partially offset by an increase in average investment securities.  The decrease in investment securities yields was primarily due to reinvestment of cash flows from the securities portfolio at lower rates and purchases of securities at lower rates.

Interest income on interest-bearing due from banks for the six-month period ended June 30, 2013 was up 21.8% from the same period in 2012, increasing from $174,000 to $212,000 and was up 12.6% for the three-month period ended June 30, 2013 over the same period in 2012, increasing from $95,000 to $107,000.  The increase in interest income on interest-bearing due from banks for the six-month period ended June 30, 2013 as compared to the same period a year ago was due to an increase in average interest-bearing due from banks and a 1 basis point increase in interest bearing due from banks yield.  The increase in interest income on interest-bearing due from banks for the three-month period ended June 30, 2013 as compared to the same period a year ago was due to an increase in average interest-bearing due from banks, offset by a 3 basis point decrease in interest bearing due from banks yield.

The Company had no Federal Funds sold balances during the three-month and six-month periods ended June 30, 2013 and June 30, 2012.

 
42

 
 
Interest Expense

The sustained low interest rate environment decreased the Company’s cost of funds in the first six months of 2013 compared to the same period a year ago.

Interest expense on deposits and other borrowings for the six-month period ended June 30, 2013 was down 39.7% from the same period in 2012, decreasing from $1,071,000 to $646,000 and was down 38.5% for the for the three-month period ended June 30, 2013 over the same period in 2012, from $507,000 to $312,000.  The decrease in interest expense during the six-month period ended June 30, 2013 was due to an 18 basis point decrease in the Company’s average cost of funds, which was partially offset by an increase in average interest-bearing liabilities.  The decrease in interest expense during the three-month period ended June 30, 2013 was due to a 17 basis point decrease in the Company’s average cost of funds, which was partially offset by an increase in average interest-bearing liabilities.  The Company had no FHLB advances and related interest expense during the three-month and six-month periods ended June 30, 2013.  Interest expense on FHLB advances, included in interest expense on deposits and other borrowings, for the three-month and six-month periods ended June 30, 2013 was $69,000 and $141,000, respectively.

Provision for Loan Losses

There was a provision for loan losses of $800,000 for the six-month period ended June 30, 2013 compared to a provision for loan losses of $1,226,000 for the same period in 2012.  There was a provision for loan losses of $400,000 for the three-month period ended June 30, 2013 compared to a provision for loan losses of $676,000 for the same period in 2012.  The allowance for loan losses was approximately $8,726,000, or 1.83% of total loans, at June 30, 2013 compared to $8,554,000, or 1.91% of total loans, at December 31, 2012.  The allowance for loan losses is maintained at a level considered adequate by management to provide for probable loan losses inherent in the loan portfolio.

The decrease in the provision for loan losses during the three-month and six-month periods in 2013 was primarily due to decreased net charge-offs, partially offset by increased loan volumes compared to the same periods in 2012.

Provision for Unfunded Lending Commitment Losses

There was no provision for unfunded lending commitment losses for the three-month and six-month periods ended June 30, 2013 and June 30, 2012.

The provision for unfunded lending commitment losses is included in non-interest expense.

 
43

 
 
Other Operating Income
 
 
Other operating income was up 15.8% for the six-month period ended June 30, 2013 from the same period in 2012, increasing from $4,466,000 to $5,170,000.

This increase was primarily due to increases in gains on sales of loans held-for-sale, investment and brokerage services income, loan servicing income, fiduciary activities income, and signature based transaction fees, which was partially offset by decreases in service charges on deposit accounts, gains on sales of other real estate owned, mortgage brokerage income, and ATM fees.  The increase in gains on sales of loans held-for-sale was due to increased sales volume of loans held-for-sale.  The increase in investment and brokerage services income and fiduciary activities income was primarily due to an increase in the demand for those services.  The increase in loan servicing income was primarily due to an increase in mortgage servicing assets booked and the reversal of mortgage servicing impairment expense.  The increase in signature based transaction fees was primarily due to an increase in the volume of transactions.  The decrease in service charges on deposit accounts was primarily due to a decrease in service charges on checking accounts.  The decrease in gains on sales of other real estate owned was primarily due to decreased sales values of other real estate owned.  The decrease in mortgage brokerage income was primarily due to a decrease in the demand for those services.  The decrease in ATM fees was primarily due to a decrease in the volume of transactions.

Other operating income was up 8.9% for the three-month period ended June 30, 2013 from the same period in 2012, increasing from $2,341,000 to $2,549,000.

This increase was primarily due to increases in investment and brokerage services income, loan servicing income, fiduciary activities income, and signature based transaction fees, which was partially offset by decreases in service charges on deposit accounts, gains on sales of other real estate owned, gains on sales of loans held-for-sale, mortgage brokerage income, and ATM fees.  The increase in investment and brokerage services income and fiduciary activities income was primarily due to an increase in the demand for those services.  The increase in loan servicing income was primarily due to an increase in mortgage servicing assets booked and the reversal of mortgage servicing impairment expense.  The increase in signature based transaction fees was primarily due to an increase in the volume of transactions.  The decrease in service charges on deposit accounts was primarily due to a decrease in service charges on checking accounts.  The decrease in gains on sales of other real estate owned was primarily due to decreased sales values of other real estate owned.  The decrease in gains on sales of loans held-for-sale was due to decreased sales volume of loans held-for-sale.  The decrease in mortgage brokerage income was primarily due to a decrease in the demand for those services.  The decrease in ATM fees was primarily due to a decrease in the volume of transactions.

 
44

 
 
Other Operating Expenses

Total other operating expenses were up 4.5% for the six-month period ended June 30, 2013 from the same period in 2012, increasing from $13,018,000 to $13,605,000.

The increase was primarily due to increases in salaries and employee benefits, occupancy and equipment expense, data processing, stationery and supplies, and other expenses, which was partially offset by decreases in advertising and other real estate owned expense and impairment.  The increase in salaries and employee benefits was primarily due to increases in regular salaries, commissions, and profit sharing expense.  The increase in occupancy and equipment expense was primarily due to increases in building maintenance and service contracts, which was partially offset by an increase in solar utility rebates.  The increase in data processing was primarily due to increases in contract pricing.  The increase in other expenses was primarily due to an increase in FDIC assessments, accounting and audit fees, and consulting fees, which was partially offset by decreases in legal fees, loan origination expense, computer software depreciation, sundry losses, and loan collection expense.  The decrease in advertising was due to decreases in printed materials and related costs.  The decrease in other real estate owned expense and impairment was due to a decrease in write-downs and maintenance expense.

Total other operating expenses were up 5.0% for the three-month period ended June 30, 2013 from the same period in 2012, increasing from $6,526,000 to $6,851,000.

The increase was primarily due to increases in salaries and employee benefits, stationery and supplies, advertising, and other expenses, which was partially offset by decreases in data processing and other real estate owned expense and impairment.  The increase in salaries and employee benefits was primarily due to increases in regular salaries and profit sharing expense, which was partially offset by a decrease in contingent compensation.  The increase in advertising was due to increases in printed materials and related costs.  The increase in other expenses was primarily due to an increase in FDIC assessments, legal fees, accounting and audit fees, consulting fees, telephone expense, public relations, and loan origination expense, which was partially offset by decreases in computer software depreciation and loan collection expense.  The decrease in data processing was primarily due to decreases in contract pricing.  The decrease in other real estate owned expense and impairment was due to a decrease in write-downs and maintenance expense.

 
45

 
 
The following table sets forth other miscellaneous operating expenses by category for the three-month and six-month periods ended June 30, 2013 and 2012.

   
(in thousands)
 
       
   
Three
   
Three
   
Six
   
Six
 
   
months
   
months
   
months
   
months
 
   
ended
   
ended
   
ended
   
ended
 
   
June 30,
   
June 30,
   
June 30,
   
June 30,
 
   
2013
   
2012
   
2013
   
2012
 
Other miscellaneous operating expenses
                       
FDIC assessments
  $ 151     $ 93     $ 300     $ 274  
Contributions
    32       32       50       52  
Legal fees
    57       47       82       127  
Accounting and audit fees
    90       81       168       146  
Consulting fees
    155       137       389       225  
Postage expense
    93       99       173       168  
Telephone expense
    65       41       94       98  
Public relations
    58       51       96       94  
Training expense
    25       30       64       55  
Loan origination expense
    148       127       259       288  
Computer software depreciation
    27       37       60       76  
Sundry losses
    26       24       17       41  
Loan collection expense
    16       54       32       111  
Other miscellaneous expense
    387       335       733       690  
                                 
Total other miscellaneous operating expenses
  $ 1,330     $ 1,188     $ 2,517     $ 2,445  
                                 
 
 
46

 
 
Income Taxes

The Company’s tax rate, the Company’s income or loss before taxes and the amount of tax relief provided by non-taxable earnings primarily affect the Company’s provision for income taxes.

In the six months ended June 30, 2013, the Company’s expense for income taxes increased $473,000 from the same period last year, from $857,000 to $1,330,000.

In the three months ended June 30, 2013, the Company’s expense for income taxes increased $218,000 from the same period last year, from $473,000 to $691,000.

The increase in expense for income taxes for the period presented is primarily attributable to the respective level of earnings combined with the interim effective tax rate and the incidence of allowable deductions, in particular non-taxable municipal bond income, tax credits generated from low-income housing investments, solar tax credits, excludable interest income and, for California franchise taxes, higher excludable interest income on loans within designated enterprise zones.

Off-Balance Sheet Commitments

The following table shows the distribution of the Company’s undisbursed loan commitments at the dates indicated.

 
(in thousands)
 
             
   
June 30, 2013
   
December 31, 2012
 
             
Undisbursed loan commitments
  $ 168,213     $ 159,329  
Standby letters of credit
    1,893       2,376  
Commitments to sell loans
    3,597       7,480  
    $ 173,703     $ 169,185  
 
 
 
The reserve for unfunded lending commitments amounted to $793,000 at June 30, 2013 and December 31, 2012, respectively.  The reserve for unfunded lending commitments is included in other liabilities on the Consolidated Balance Sheets.


 
47

 

Asset Quality

The Company manages asset quality and credit risk by maintaining diversification in its loan portfolio and through review processes that include analysis of credit requests and ongoing examination of outstanding loans and delinquencies, with particular attention to portfolio dynamics and loan mix.  The Company strives to identify loans experiencing difficulty early enough to correct the problems, to record charge-offs promptly based on realistic assessments of collectability and current collateral values and to maintain an adequate allowance for loan losses at all times.   Asset quality reviews of loans and other non-performing assets are administered using credit risk rating standards and criteria similar to those employed by state and federal banking regulatory agencies.  The federal bank and thrift regulatory agencies utilize the following definitions for assets adversely classified for supervisory purposes:

·  
Substandard Assets – A substandard asset is 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 a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
·  
Doubtful Assets – An asset classified doubtful has all the weaknesses inherent in one classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Other Real Estate Owned and loans rated Substandard and Doubtful are deemed "classified assets".  This category, which includes both performing and non-performing assets, receives an elevated level of attention regarding collection.

The following tables summarize the Company’s non-accrual loans net of guarantees of the State of California and U.S. Government by loan category at June 30, 2013 and December 31, 2012.

   
At June 30, 2013
   
At March 31, 2013
 
   
Gross
   
Guaranteed
   
Net
   
Gross
   
Guaranteed
   
Net
 
(dollars in thousands)
                                   
                                     
                                     
Residential mortgage
  $ 2,379     $     $ 2,379     $ 1,940     $     $ 1,940  
Residential construction
    104             104                    
Commercial real estate
    2,467       88       2,379       1,840             1,840  
Agriculture
                                   
Commercial
    2,612             2,612       2,747       46       2,701  
Consumer
    215       42       173       282       46       236  
Total non-accrual loans
  $ 7,777     $ 130     $ 7,647     $ 6,809     $ 92     $ 6,717  

   
At December 31, 2012
 
   
Gross
   
Guaranteed
   
Net
 
(dollars in thousands)
                 
                   
                   
Residential mortgage
  $ 2,095     $     $ 2,095  
Residential construction
                 
Commercial real estate
    1,879             1,879  
Agriculture
                 
Commercial
    2,853       73       2,780  
Consumer
    441       50       391  
Total non-accrual loans
  $ 7,268     $ 123     $ 7,145  

It is generally the Company’s policy to discontinue interest accruals once a loan is past due for a period of 90 days as to interest or principal payments.  When a loan is placed on non-accrual, interest accruals cease and uncollected accrued interest is reversed and charged against current income.  Payments received on non-accrual loans are applied against principal.  A loan may only be restored to an accruing basis when it again becomes well secured and in the process of collection or all past due amounts have been collected.

Non-accrual loans amounted to $7,777,000 at June 30, 2013 and were comprised of eight residential mortgage loans totaling $2,379,000, two residential construction loans totaling $104,000, six commercial real estate loans totaling $2,467,000, eight commercial loans totaling $2,612,000 and four consumer loans totaling $215,000.  Non-accrual loans amounted to $7,268,000 at December 31, 2012 and were comprised of seven residential mortgage loans totaling $2,095,000, five commercial real estate loans totaling $1,879,000, eleven commercial loans totaling $2,853,000 and seven consumer loans totaling $441,000.  It is generally the Company’s policy to charge-off the portion of any non-accrual loan that the Company does not expect to collect by writing the loan down to the estimated net realizable value of the underlying collateral.

 
48

 
The five largest non-accrual loans as of June 30, 2013, totaled approximately $4,723,000 or 61% of total non-accrual loans and consisted of two commercial real estate loans totaling $1,663,000, supported by commercial properties located within the Company’s market area, two residential mortgage loans totaling $1,398,000, supported by residential properties located within the Company’s market area and one commercial and industrial loan totaling $1,662,000, supported by the business assets of the borrower.  The collateral securing these loans is generally appraised every six months.

In comparison, the five largest non-accrual loans as of December 31, 2012, totaled approximately $4,889,000 or 67% of total non-accrual loans and consisted of two residential mortgage loan totaling $1,466,000, supported by residential property located within the Company’s market area, two commercial real estate loans totaling $1,665,000, supported by commercial properties located within the Company’s market area and one commercial and industrial loan totaling $1,758,000, supported by the business assets of the borrower.

Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired.  Non-performing impaired loans are non-accrual loans and loans that are 90 days or more past due and still accruing.  Total non-performing impaired loans at June 30, 2013 and December 31, 2012 consisting of loans on non-accrual status totaled $7,777,000 and $7,268,000, respectively.  A restructuring of a loan can constitute a troubled debt restructuring if the Company for economic or legal reasons related to the borrower’s financial difficulties grants a concession to the borrower that it would not otherwise consider.  A loan that is restructured in a troubled debt restructuring is considered an impaired loan.  Performing impaired loans totaled $6,888,000 and $6,113,000 at June 30, 2013 and December 31, 2012, respectively.  Performing impaired loans at June 30, 2013 consist of loans modified as troubled debt restructurings totaling $6,815,000 and other impaired loans totaling $73,000 which the Company expects to collect all principal and interest due and are performing satisfactorily.  Additionally, these loans are not on non-accrual status.  The majority of the non-performing impaired loans were in management's opinion adequately collateralized based on recently obtained appraised property values or guaranteed by a governmental entity.  See “Allowance for Loan Losses” below for additional information.  No assurance can be given that the existing or any additional collateral will be sufficient to secure full recovery of the obligations owed under these loans.

 
49

 
 
As the following table illustrates, total non-performing assets, net of guarantees of the State of California and U.S. Government, including its agencies and its government-sponsored agencies, decreased $560,000, or 6.8% to $7,647,000 during the first six months of 2013.  Non-performing assets, net of guarantees, represent 0.9% of total assets at June 30, 2013.

   
At June 30, 2013
   
At March 31, 2013
 
   
Gross
   
Guaranteed
   
Net
   
Gross
   
Guaranteed
   
Net
 
(dollars in thousands)
                                   
                                     
                                     
Non-accrual loans
  $ 7,777     $ 130     $ 7,647     $ 6,809     $ 92     $ 6,717  
Loans 90 days past due and still accruing
                                   
                                                 
Total non-performing loans
    7,777       130       7,647       6,809       92       6,717  
Other real estate owned
                      1,062             1,062  
Total non-performing assets
    7,777       130       7,647       7,871       92       7,779  
                                                 
Non-performing loans to total loans
                    1.6 %                     1.5 %
Non-performing assets to total assets
                    0.9 %                     0.9 %
Allowance for loan and lease losses to non-performing loans
                    114.1 %                     131.7 %
                                                 

   
At December 31, 2012
 
   
Gross
   
Guaranteed
   
Net
 
(dollars in thousands)
                 
                   
                   
Non-accrual loans
  $ 7,268     $ 123     $ 7,145  
Loans 90 days past due and still accruing
                 
                         
Total non-performing loans
    7,268       123       7,145  
Other real estate owned
    1,062             1,062  
Total non-performing assets
    8,330       123       8,207  
                         
Non-performing loans to total loans
                    1.6 %
Non-performing assets to total assets
                    1.0 %
Allowance for loan and lease losses to non-performing loans
                    119.7 %
                         

The Company had no loans 90 days past due and still accruing at June 30, 2013 and December 31, 2012.

Other real estate owned (OREO) consists of property that the Company has acquired by deed in lieu of foreclosure or through foreclosure proceedings, and property that the Company does not hold title to but is in actual control of, known as in-substance foreclosure.  The estimated fair value of the property is determined prior to transferring the balance to OREO.  The balance transferred to OREO is the estimated fair value of the property less estimated cost to sell.  Impairment may be deemed necessary to bring the book value of the loan equal to the appraised value.  Appraisals or loan officer evaluations are then conducted periodically thereafter charging any additional impairment to the appropriate expense account.
 
OREO amounted to $0 and $1,062,000 as of June 30, 2013 and December 31, 2012, respectively.

 
50

 
 
Allowance for Loan Losses

The Company’s Allowance for Loan Losses is maintained at a level believed by management to be adequate to provide for loan losses that can be reasonably anticipated.  The allowance is increased by provisions charged to operating expense and reduced by net charge-offs.  The Company contracts with vendors for credit reviews of the loan portfolio as well as considers current economic conditions, loan loss experience, and other factors in determining the adequacy of the reserve balance.  The allowance for loan losses is based on estimates, and actual losses may vary from current estimates.

The following table summarizes the Allowance for Loan Losses of the Company during the six-month periods ended June 30, 2013 and 2012, and for the year ended December 31, 2012.

Analysis of the Allowance for Loan Losses
 
(Amounts in thousands, except percentage amounts)
 
             
   
Six months ended
June 30,
   
Year ended
December 31,
 
   
2013
   
2012
   
2012
 
                   
Balance at beginning of period
  $ 8,554     $ 10,408     $ 10,408  
Provision for loan losses
    800       1,226       3,276  
Loans charged-off:
                       
Commercial
    (112 )     (1,079 )     (3,498 )
Commercial Real Estate
    (3 )     (342 )     (375 )
Agriculture
    (1 )     (115 )     (116 )
Residential mortgage
    (333 )     (31 )     (864 )
Residential construction
    (127 )     (161 )     (167 )
Consumer loans to individuals
    (376 )     (634 )     (875 )
                         
Total charged-off
    (952 )     (2,362 )     (5,895 )
                         
Recoveries:
                       
Commercial
    124       237       306  
Commercial Real Estate
    51              
Agriculture
    3       3       4  
Residential mortgage
    12              
Residential construction
    43       224       341  
Consumer loans to individuals
    91       48       114  
                         
Total recoveries
    324       512       765  
                         
Net charge-offs
    (628 )     (1,850 )     (5,130 )
                         
Balance at end of period
  $ 8,726     $ 9,784     $ 8,554  
                         
Ratio of net charge-offs to average loans outstanding
                       
during the period (annualized)
    (0.28 %)     (0.85 %)     (1.18 %)
Allowance for loan losses
                       
To total loans at the end of the period
    1.83 %     2.19 %     1.91 %
To non-performing loans, net of guarantees at the end of the period
    114.1 %     107.5 %     119.7 %
 
 
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Deposits

Deposits are one of the Company’s primary sources of funds.  At June 30, 2013, the Company had the following deposit mix: 28.8% in savings and MMDA deposits, 11.9% in time deposits, 26.1% in interest-bearing transaction deposits and 33.2% in non-interest-bearing transaction deposits.  At December 31, 2012, the Company had the following deposit mix: 30.5% in savings and MMDA deposits, 12.6% in time deposits, 25.3% in interest-bearing transaction deposits and 31.6% in non-interest-bearing transaction deposits.  Non-interest-bearing transaction deposits increase the Company’s net interest income by lowering its cost of funds.

The Company obtains deposits primarily from the communities it serves.  The Company believes that no material portion of its deposits has been obtained from or is dependent on any one person or industry.  The Company accepts deposits in excess of $100,000 from customers.  These deposits are priced to remain competitive.

Maturities of time certificates of deposits of $100,000 or more outstanding at June 30, 2013 and December 31, 2012 are summarized as follows:

   
(in thousands)
 
   
June 30, 2013
   
December 31, 2012
 
Three months or less
  $ 13,930     $ 17,159  
Over three to twelve months
    29,794       30,361  
Over twelve months
    11,372       8,953  
Total
  $ 55,096     $ 56,473  

The decrease in time certificates of deposit (CD's) of $100,000 or more is primarily attributable to the maturities of time deposits.


Liquidity and Capital Resources

In order to serve our market area, the Company must maintain adequate liquidity and adequate capital.  Liquidity is measured by various ratios, in management’s opinion, the most common being the ratio of net loans to deposits (including loans held-for-sale).  This ratio was 62.5% on June 30, 2013.  In addition, on June 30, 2013, the Company had the following short-term investments (based on remaining maturity and/or next repricing date):  $1,955,000 in securities due within one year or less; and $29,193,000 in securities due in one to five years.

To meet unanticipated funding requirements, the Company maintains short-term unsecured lines of credit with other banks totaling $37,000,000 at June 30, 2013.  Additionally, the Company has a line of credit with the Federal Home Loan Bank (the “FHLB”), with a borrowing capacity at June 30, 2013 of $148,088,000; credit availability is subject to certain collateral requirements.

The Company’s primary source of liquidity on a stand-alone basis is dividends from the Bank.  Dividends from the Bank are subject to regulatory restrictions.

As of June 30, 2013, the Bank’s capital ratios exceeded applicable regulatory requirements.  The following table presents the capital ratios for the Bank, compared to the regulatory standards for well-capitalized depository institutions, as of June 30, 2013.

   
(amounts in thousands except percentage amounts)
 
   
Actual
   
Well Capitalized
 
               
Ratio
 
   
Capital
   
Ratio
   
Requirement
 
Leverage
  $ 75,822       9.01 %     5.0 %
Tier 1 Risk-Based
  $ 75,822       14.45 %     6.0 %
Total Risk-Based
  $ 82,416       15.71 %     10.0 %


 
52

 
In July 2013, the Federal Reserve Board and the other U.S. federal banking agencies adopted final rules making significant changes to the U.S. regulatory capital framework for U.S. banking organizations and to conform this framework to the Basel Committee's current international regulatory capital accord (Basel III). These rules, upon their effectiveness, will replace the federal banking agencies' general risk-based capital rules, advanced approaches rule, market-risk rule, and leverage rules, in accordance with certain transition provisions. Banks, such as First Northern Bank, will become subject to the new rules on January 1, 2015. The new rules implement higher minimum capital requirements, include a new common equity Tier 1 capital requirement, and establish criteria that instruments must meet in order to be considered common equity Tier 1 capital, additional Tier 1 capital, or Tier 2 capital. When fully phased in, the final rules will provide for increased minimum capital ratios as follows: (a) a common equity Tier 1 capital ratio of 4.5%; (b) a Tier 1 capital ratio of 6% (which is an increase from 4.0%); (c) a total capital ratio of 8%; and (d) a Tier 1 leverage ratio to average consolidated assets of 4%. Under the new rules, in order to avoid certain limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers, a banking organization must hold a capital conservation buffer composed of common equity Tier 1 capital above its minimum risk based capital requirements (equal to 2.5% of total risk-weighted assets). The phase-in of the capital conservation buffer will begin January 1, 2016, and be completed by January 1, 2019. The new rules also provide for various adjustments and deductions to the definitions of regulatory capital that will phase in from January 1, 2014 to December 31, 2017. We are currently evaluating the impact of these changes on our future regulatory capital position.
 
 
53

 

ITEM 3. – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
The Company believes that there have been no material changes in the quantitative and qualitative disclosures about market risk as of June 30, 2013, from those presented in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012, which are incorporated by reference herein.
 
 
ITEM 4. – CONTROLS AND PROCEDURES
 
(a)  We maintain “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Our disclosure controls and procedures have been designed to meet reasonable assurance standards. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.  Our Chief Executive Officer (principal executive officer) and Chief Financial Officer (principal financial officer) have concluded that the design and operation of our disclosure controls and procedures are effective as of June 30, 2013.  This conclusion is based on an evaluation conducted under the supervision and with the participation of management.

(b)  During the quarter ended June 30, 2013, there were no changes in our internal controls over financial reporting that materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
 

PART II – OTHER INFORMATION

 
ITEM 1. – LEGAL PROCEEDINGS
 
Neither the Company nor the Bank is a party to any material pending legal proceeding, nor is any of their property the subject of any material pending legal proceeding, except ordinary routine litigation arising in the ordinary course of the Bank’s business and incidental to its business, none of which is expected to have a material adverse impact upon the Company’s or the Bank’s business, financial position or results of operations.
 
ITEM 1A. – RISK FACTORS
 
Except as disclosed below, there are no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2012. See Part I, Item 1A in our Annual Report on Form 10-K for the year ended December 31, 2012, entitled “Risk Factors.”

The effects of changes or increases in, or supervisory enforcement of, banking or other laws and regulations or governmental fiscal or monetary policies could adversely affect us.

We are subject to significant federal and state banking regulation and supervision, which is primarily for the benefit and protection of our customers and the Federal Deposit Insurance Fund and not for the benefit of investors in our securities.  In the past, our business has been materially affected by these regulations. This will continue and likely intensify in the future. Laws, regulations or policies, including accounting standards and interpretations, currently affecting us may change at any time. Regulatory authorities may also change their interpretation of and intensify their examination of compliance with these statutes and regulations. Therefore, our business may be adversely affected by changes in laws, regulations, policies or interpretations or regulatory approaches to compliance and enforcement, as well as by supervisory action or criminal proceedings taken as a result of noncompliance, which could result in the imposition of significant civil money penalties or fines. Changes in laws and regulations may also increase our expenses by imposing additional supervision, fees, taxes or restrictions on our operations. Compliance with laws and regulations, especially new laws and regulations, increases our operating expenses and may divert management attention from our business operations.

 
54

 
On July 21, 2010, President Obama signed into law the Dodd-Frank Act. This important legislation has affected U.S. financial institutions in many ways, some of which have increased, or may increase in the future, the cost of doing business and present other challenges to the financial services industry. Many of the law’s provisions are in the process of being implemented by rules and regulations of the federal banking agencies, the scope and impact of which cannot yet be fully determined. While the full effect of these provisions of the Dodd-Frank Act on the Bank cannot be predicted at this time, they have resulted in adjustments to our FDIC deposit insurance premiums, and may result in increased capital and liquidity requirements, increased supervision, increased regulatory and compliance risks and costs and other operational costs and expenses, reduced fee-based revenues and restrictions on some aspects of our operations, and increased interest expense on our demand deposits, some or all of which may be material.

Proposals to reform the housing finance market in the U.S. could also significantly affect our business. These proposals, among other things, consider winding down the government sponsored entities Fannie Mae and Freddie Mac (GSEs) and reducing or eliminating over time the role of the GSEs in guaranteeing mortgages and providing funding for mortgage loans, as well as the implementation of reforms relating to borrowers, lenders, and investors in the mortgage market, including reducing the maximum size of a loan that the GSEs can guarantee, phasing in a minimum down payment requirement for borrowers, improving underwriting standards, and increasing accountability and transparency in the securitization process.

While the specific nature of these reforms and their impact on the financial services industry in general, and on the Bank in particular, is uncertain at this time, such reforms, if enacted, are likely to have a substantial impact on the mortgage market and could potentially reduce our income from mortgage originations by increasing mortgage costs or lowering originations. The GSE reforms could also reduce real estate prices, which could reduce the value of collateral securing outstanding mortgage loans. This reduction of collateral value could negatively impact the value or perceived collectability of these mortgage loans and may increase our allowance for loan losses. Such reforms may also include changes to the Federal Home Loan Bank System, which could adversely affect a significant source of term funding for lending activities by the banking industry, including the Bank. These reforms may also result in higher interest rates on residential mortgage loans, thereby reducing demand, which could have an adverse impact on our residential mortgage lending business.

In July 2013, the Federal Reserve Board and the other U.S. federal banking agencies adopted final rules making significant changes to the U.S. regulatory capital framework for U.S. banking organizations and to conform this framework to the Basel Committee's current international regulatory capital accord (Basel III). These rules, upon their effectiveness, will replace the federal banking agencies' general risk-based capital rules, advanced approaches rule, market-risk rule, and leverage rules, in accordance with certain transition provisions. Banks, such as First Northern Bank, will become subject to the new rules on January 1, 2015. The new rules implement higher minimum capital requirements, include a new common equity Tier 1 capital requirement, and establish criteria that instruments must meet in order to be considered common equity Tier 1 capital, additional Tier 1 capital, or Tier 2 capital. When fully phased in, the final rules will provide for increased minimum capital ratios as follows: (a) a common equity Tier 1 capital ratio of 4.5%; (b) a Tier 1 capital ratio of 6% (which is an increase from 4.0%); (c) a total capital ratio of 8%; and (d) a Tier 1 leverage ratio to average consolidated assets of 4%. Under the new rules, in order to avoid certain limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers, a banking organization must hold a capital conservation buffer composed of common equity Tier 1 capital above its minimum risk based capital requirements (equal to 2.5% of total risk-weighted assets). The phase-in of the capital conservation buffer will begin January 1, 2016, and be completed by January 1, 2019. The new rules also provide for various adjustments and deductions to the definitions of regulatory capital that will phase in from January 1, 2014 to December 31, 2017. We are currently evaluating the impact of these changes on our future regulatory capital position.

We maintain systems and procedures designed to comply with applicable laws and regulations. However, some legal/regulatory frameworks provide for the imposition of criminal or civil penalties (which can be substantial) for noncompliance. In some cases, liability may attach even if the noncompliance was inadvertent or unintentional and even if compliance systems and procedures were in place at the time. There may be other negative consequences from a finding of noncompliance, including restrictions on certain activities and damage to our reputation.
 
Additionally, our business is affected significantly by the fiscal and monetary policies of the U.S. federal government and its agencies. We are particularly affected by the policies of the Federal Reserve Board, which regulates the supply of money and credit in the U.S. Under the Dodd-Frank Act and a long-standing policy of the Federal Reserve Board, a bank holding company is expected to act as a source of financial and managerial strength for its subsidiary banks. As a result of that policy, we may be required to commit financial and other resources to our subsidiary bank in circumstances where we might not otherwise do so. Among the instruments of monetary policy available to the Federal Reserve Board are (a) conducting open market operations in U.S. Government securities, (b) changing the discount rates on borrowings by depository institutions and the federal funds rate, and (c) imposing or changing reserve requirements against certain borrowings by banks and their affiliates. These methods are used in varying degrees and combinations to directly affect the availability of bank loans and deposits, as well as the interest rates charged on loans and paid on deposits. The policies of the Federal Reserve Board may have a material effect on our business, prospects, results of operations and financial condition.

 
55

 
Refer to “Supervision and Regulation” in Item 1 of our Annual Report on Form 10-K for the year-ended December 31, 2012 for discussion of certain existing and proposed laws and regulations that may affect our business.

The Bank is Subject to Interest Rate Risk

The income of the Bank depends to a great extent on “interest rate differentials” and the resulting net interest margins (i.e., the difference between the interest rates earned on the Bank’s interest-earning assets such as loans and investment securities, and the interest rates paid on the Bank’s interest-bearing liabilities such as deposits and borrowings).  These rates are highly sensitive to many factors, which are beyond the Bank’s control, including, but not limited to, general economic conditions and the policies of various governmental and regulatory agencies, in particular, the Federal Reserve Board.  The Bank is generally adversely affected by declining interest rates.  For the past several years, the Federal Reserve Board has pursued a variety of monetary measures aimed at sustaining a very low interest-rate environment in the U.S. in order to stimulate economic growth. In late 2012, the Federal Reserve Board indicated that it expected a very low target range for the federal funds rate as long as the unemployment rate remained above 6.5% and projected near-term and longer term inflation remained modest.  It further indicated that this guidance was consistent with its earlier expectation of exceptionally low levels for the federal funds rate through at least mid-2015.  More recently, the Federal Reserve Board has indicated that, while it expects to continue its highly accommodative monetary policies for the time being, if economic conditions in the U.S., including employment levels, continue to improve, it may be appropriate for the Federal Reserve Board to begin later in 2013 to ease certain aspects of its monetary policies, including reducing its levels of purchases of long-term U.S. Treasury and agency securities.  We cannot predict with any certainty whether or to what extent these developments may occur.  While the historically low interest rate environment has placed negative pressure on the net interest margins of banks in the U.S., including our Bank, increases in interest rates can also have certain negative effects, including a possible reduction in the level of loan refinancing activity, which could impact the amount of prepayment penalty income we receive on loans we hold, possible difficulties for borrowers of variable rate loans to service their loan obligations, and possible negative impacts on the value of our investment securities portfolio.  Also, residential mortgage borrowers with little or no equity in their residences may be encouraged to default on their loans in a rising rate environment.  Changes in the relationship between short-term and long-term market interest rates or between different interest rate indices can also impact our interest rate differential, possibly resulting in a decrease in our interest income relative to interest expense.  In addition, changes in monetary policy, including changes in interest rates, influence the origination of loans, the purchase of investments and the generation of deposits and affect the rates received on loans and investment securities and paid on deposits, which could have a material adverse effect on the Bank’s business, financial condition, and results of operations.

In the future the Company may be required to recognize impairment with respect to investment securities

The Company’s securities portfolio contains mortgage-backed securities and currently includes securities with unrecognized losses.  The Company may continue to observe declines in the fair market value of these securities.  Management evaluates the securities portfolio for any other-than-temporary impairment each reporting period, as required by generally accepted accounting principles.  During the three-month and six-month periods ended June 30, 2013, the Company incurred a net increase in unrealized loss of approximately $3,813,000 and $4,084,000, respectively, in the Company’s investment portfolio, resulting in comprehensive loss, net of tax of $2,287,000 and $2,450,000, respectively, recognized in the Consolidated Statements of Comprehensive (Loss) Income.  The net increase in unrealized loss is due to increases in long-term market rates of U.S. Treasury securities.  There can be no assurance that future evaluations of the securities portfolio will not require us to recognize impairment charges with respect to these and other holdings.
 

 
56

 
 
ITEM 2. – UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
 
None.

ITEM 3. – DEFAULTS UPON SENIOR SECURITIES

None.
 
ITEM 4. – MINE SAFETY DISCLOSURES
 
Not applicable.
 
ITEM 5. – OTHER INFORMATION
 
None.

 
57

 
 
ITEM 6. – EXHIBITS
 
Exhibit
Number
 
Description of Document
     
31.1
 
Rule 13a — 14(a) Certification of Chief Executive Officer
     
31.2
 
Rule 13a — 14(a) Certification of Chief Financial Officer
     
32.1*
 
Statement of the Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350)
     
32.2*
 
Statement of the Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350)
     
101**
 
Pursuant to Rule 405 of Regulation S-T, the following financial information from the Registrant’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2013, is formatted in XBRL interactive data files: (i) Condensed Consolidated Balance Sheets; (ii) Condensed Consolidated Statements of Income; (iii) Condensed Consolidated Statements of Comprehensive (Loss) Income (iv) Condensed Consolidated Statement of Stockholders’ Equity; (v) Condensed Consolidated Statements of Cash Flows; and (vi) Notes to Condensed Consolidated Financial Statements.
 
_____________________
*   In accordance with Item 601(b)(32)(ii) of Regulation S-K and SEC Release No. 34-47986, the certifications furnished in Exhibits 32.1 and 32.2 hereto are deemed to accompany this Form 10-Q and will not be deemed “filed” for purposes of Section 18 of the Exchange Act. Such certifications will not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act.
 
** In accordance with Rule 406T of Regulation S-T, the information furnished in these exhibits will not be deemed “filed” for purposes of Section 18 of the Exchange Act.  Such exhibits will not be deemed to be incorporated by reference into any filing under the Securities Act or Exchange Act.

 
58

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

     
FIRST NORTHERN COMMUNITY BANCORP
       
Date:
August 8, 2013
By:
/s/  Jeremiah Z. Smith
       
     
Jeremiah Z. Smith, Executive Vice President / Chief Financial Officer
     
(Principal Financial Officer and Duly Authorized Officer)


59