FNCB Bancorp, Inc. - Quarter Report: 2013 March (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

 

 

FORM 10-Q

 

(Mark One)

 

 

For the quarterly period ended March 31, 2013

 

OR

 

 

For the transition period from         to         

 

Commission File No. 000-53869

 

FIRST NATIONAL COMMUNITY BANCORP, INC.

(Exact Name of Registrant as Specified in Its Charter)

 

 

Registrant’s telephone number, including area code  (570) 346-7667

 

 

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

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  YES x  NO  ¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  YES x  NO ¨

 

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

 

 

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

 

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

 

Common Stock, $1.25 par value		16,457,169 shares
(Title of Class)		(Outstanding at May 14, 2013)

 

 

Table of Contents

 

Contents

 

PART I. Financial Information	3
Item 1. Financial Statements	3
Consolidated Statements of Financial Condition	3
Consolidated Statements of Operations	4
Consolidated Statements of Comprehensive (Loss) Income	5
Consolidated Statements of Changes in Shareholders’ Equity	6
Consolidated Statements of Cash Flows	7
Notes to Consolidated Financial Statements	8
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	34
Item 3. Quantitative and Qualitative Disclosures about Market Risk	51
Item 4. Controls and Procedures	51
PART II.  Other Information	51
Item 1. Legal Proceedings	51
Item 1A. Risk Factors	52
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	52
Item 3. Defaults upon Senior Securities	52
Item 4. Mine Safety Disclosures	52
Item 5. Other Information	52
Item 6. Exhibits	52

 

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PART I.  Financial Information

Item 1.  Financial Statements

 

FIRST NATIONAL COMMUNITY BANCORP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(unaudited)

 

		March 31,			December 31,
(in thousands, except share data)		2013			2012
Assets
Cash and cash equivalents:
Cash and due from banks		$	11,451		$	21,710
Interest-bearing deposits in other banks		20,892			93,561
Total cash and cash equivalents		32,343			115,271
Securities
Available-for-sale at fair value		216,849			185,361
Held-to-maturity at amortized cost (fair value $2,501 and $2,483)		2,225			2,198
Stock in Federal Home Loan Bank of Pittsburgh, at cost		5,081			5,957
Loans held for sale		847			1,615
Loans, net of allowance for loan and lease losses of $18,473 and $18,536		597,682			579,396
Bank premises and equipment, net		18,658			18,937
Accrued interest receivable		2,618			2,199
Refundable federal income taxes		11,637			11,637
Intangible assets		591			632
Bank-owned life insurance		27,633			27,461
Other real estate owned		3,910			3,983
Other assets		9,453			13,627
Total Assets		$	929,527		$	968,274
Liabilities
Deposits
Demand (non-interest-bearing)		$	121,187		$	131,476
Interest-bearing		702,559			723,137
Total deposits		823,746			854,613
Borrowed funds
FHLB advances		12,388			18,593
Subordinated debentures		25,000			25,000
Junior subordinated debentures		10,310			10,310
Total borrowed funds		47,698			53,903
Accrued interest payable		7,001			6,427
Other liabilities		14,264			16,406
Total liabilities		892,709			931,349
Shareholders’ Equity
Preferred Shares ($1.25 par)
Authorized: 20,000,000 shares at March 31, 2013 and December 31, 2012 Issued and outstanding: 0 shares at March 31, 2013 and December 31, 2012		—			—
Common Shares ($1.25 par)
Authorized: 50,000,000 shares at March 31, 2013 and December 31, 2012 Issued and outstanding: 16,457,169 shares at March 31, 2013 and December 31, 2012		20,571			20,571
Additional paid-in capital		61,584			61,584
Accumulated deficit		(50,197		)	(51,928		)
Accumulated other comprehensive income		4,860			6,698
Total shareholders’ equity		36,818			36,925
Total Liabilities and Shareholders’ Equity		$	929,527		$	968,274

 

The accompanying notes to consolidated financial statements are an integral part of these statements.

 

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FIRST NATIONAL COMMUNITY BANCORP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

 

		Three months ended
		March 31,
(in thousands, except share data)		2013			2012
Interest income
Interest and fees on loans		$	6,607		$	7,789
Interest and dividends on securities:
U.S. government agencies		423			380
State and political subdivisions, tax-free		990			980
State and political subdivisions, taxable		116			130
Other securities		35			409
Total interest and dividends on securities		1,564			1,899
Interest on interest-bearing deposits and federal funds sold		39			56
Total interest income		8,210			9,744
Interest expense
Deposits:
Interest-bearing demand		159			183
Savings		26			46
Time ($100,000 and over)		317			415
Other time		616			888
Total interest on deposits		1,118			1,532
Interest on borrowed funds:
Interest on FHLB advances		126			414
Interest on subordinated debentures		562			569
Interest on junior subordinated debentures		51			58
Total interest on borrowed funds		739			1,041
Total interest expense		1,857			2,573
Net interest income before credit for loan and lease losses		6,353			7,171
Credit for loan and lease losses		(1,224		)	(136		)
Net interest income after credit for loan and lease losses		7,577			7,307
Non-interest income
Deposit service charges		678			737
Net gain on the sale of securities		842			8
Gross other-than-temporary impairment gains		—			175
Portion of gain recognized in other comprehensive income (before taxes)		—			(175		)
Other-than-temporary-impairment losses recognized in earnings		—			—
Net gain on the sale of loans held for sale		110			243
Net gain on the sale of other real estate owned		13			9
Loan related fees		108			124
Income from bank-owned life insurance		172			185
Other		536			144
Total non-interest income		2,459			1,450
Non-interest expense
Salaries and employee benefits		3,320			3,638
Occupancy expense		584			598
Equipment expense		376			420
Advertising expense		77			148
Data processing expense		564			474
FDIC assessment		532			600
Bank shares tax		241			276
Expense of other real estate		218			178
Credit for off-balance sheet commitments		(121		)	(65		)
Legal expense		615			724
Professional fees		551			1,518
Insurance expense		323			232
Loan collection expense		227			229
Other operating expenses		798			952
Total non-interest expense		8,305			9,922
Income (loss) before income taxes		1,731			(1,165		)
Provision for income taxes		—			—
Net income (loss)		$	1,731		$	(1,165	)
Income (loss) Per Share:
Basic		$	0.11		$	(0.07	)
Diluted		$	0.11		$	(0.07	)
Cash dividends declared per common share		—			—
Weighted average number of shares outstanding:
Basic		16,457,169			16,442,119
Diluted		16,457,169			16,442,119

 

The accompanying notes to consolidated financial statements are an integral part of these statements.

 

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FIRST NATIONAL COMMUNITY BANCORP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME

(unaudited)

 

		Three months ended
		March 31,
(in thousands)		2013			2012
Net income (loss)		$	1,731		$	(1,165	)
Other comprehensive (loss) income, net of tax:
Unrealized (losses) gains on securities available-for-sale		(1,943		)	3,494
Taxes		661			(1,188		)
Net of tax amount		(1,282		)	2,306
Non-credit related gains on OTTI securities not expected to be sold		—			175
Taxes		—			(60		)
Net of tax amount		—			115
Reclassification adjustment for gains included in net income (loss)		(842		)	(8		)
Taxes		286			3
Net of tax amount		(556		)	(5		)
Total other comprehensive (loss) income		(1,838		)	2,416
Total comprehensive (loss) income		$	(107	)	$	1,251

 

The accompanying notes to consolidated financial statements are an integral part of these statements.

 

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FIRST NATIONAL COMMUNITY BANCORP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

For the Three Months Ended March 31, 2013 and 2012

(unaudited)

 

													Accumulated
		Number					Additional						Other			Total
		of Common		Common			Paid-in			Accumulated			Comprehensive			Shareholders’
(in thousands, except per share data)		Shares		Stock			Capital			Deficit			Loss			Equity
BALANCES, DECEMBER 31, 2011		16,442,119		$	20,552		$	61,557		$	(38,217	)	$	(3,967	)	$	39,925
Net loss for the period										(1,165		)				(1,165		)
Other comprehensive income, net of tax of $1,245													2,416			2,416
Balances, March 31, 2012		16,442,119		$	20,552		$	61,557		$	(39,382	)	$	(1,551	)	$	41,176
BALANCES, DECEMBER 31, 2012		16,457,169		$	20,571		$	61,584		$	(51,928	)	$	6,698		$	36,925
Net income for the period										1,731						1,731
Other comprehensive loss, net of tax of $947													(1,838		)	(1,838		)
Balances, March 31, 2013		16,457,169		$	20,571		$	61,584		$	(50,197	)	$	4,860		$	36,818

 

The accompanying notes to consolidated financial statements are an integral part of these statements.

 

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FIRST NATIONAL COMMUNITY BANCORP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

 

		Three Months Ended
		March 31,
(in thousands)		2013			2012
Cash flows from operating activities:
Net income (loss)		$	1,731		$	(1,165	)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Investment securities accretion, net		(207		)	(400		)
Equity in trust		(1		)	(1		)
Depreciation and amortization		329			274
Credit for loan and lease losses		(1,224		)	(136		)
Credit for off balance sheet commitments		(121		)	(65		)
Gain on sale of investment securities		(842		)	(8		)
Gain on the sale of loans held for sale		(110		)	(243		)
Gain on the sale of other real estate owned		(13		)	(9		)
Recovery of other real estate owned		—			(26		)
Income from bank-owned life insurance		(172		)	(185		)
Proceeds from the sale of loans held for sale		4,542			8,739
Funds used to originate loans held for sale		(3,664		)	(10,188		)
Increase in interest receivable		(419		)	(109		)
Decrease (increase) in prepaid expenses and other assets		4,108			(240		)
Increase in interest payable		574			591
(Decrease) increase in accrued expenses and other liabilities		(1,074		)	80
Total Adjustments		1,706			(1,926		)
Net cash provided by (used in) operating activities		3,437			(3,091		)
Cash flows from investing activities:
Maturities, calls, and principal payments of investment securities available-for-sale		3,581			8,361
Sales of securities available-for-sale		17,121			—
Purchases of securities available-for-sale		(53,953		)	(19,850		)
Redemption of Federal Home Loan Bank of Pittsburgh stock		876			420
Net increase in loans to customers		(16,950		)	(8,583		)
Proceeds from the sale of other real estate owned		86			1,106
Purchases of property and equipment		(54		)	(712		)
Net cash used in investing activities		(49,293		)	(19,258		)
Cash flows from financing activities:
Net decrease in total deposits		(30,867		)	(66,898		)
Proceeds from FHLB advances		—			5,313
Repayment of FHLB advances		(6,205		)	(8,988		)
Net cash used in financing activities		(37,072		)	(70,573		)
Net decrease in cash and cash equivalents		(82,928		)	(92,922		)
Cash & cash equivalents at beginning of period		115,271			168,646
Cash & cash equivalents at end of period		$	32,343		$	75,724
Supplemental cash flow information
Cash paid during the period for:
Interest		$	1,283		$	1,982
Income taxes		—			25
Other transactions:
Settlement of security recorded on trade date		—			5,120
Principal balance of loans transferred to OREO		—			239
Transfer from loans held for sale to loans, net		—			95

 

The accompanying notes to consolidated financial statements are an integral part of these statements.

 

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FIRST NATIONAL COMMUNITY BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Note 1.         Basis of Presentation

 

The consolidated financial statements are comprised of the accounts of First National Community Bancorp, Inc., and its wholly owned subsidiary, First National Community Bank (the “Bank”), as well as the Bank’s wholly owned subsidiaries (collectively, the “Company”).  The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America (“GAAP”) and general practices within the banking industry.  In the opinion of management, all adjustments necessary for a fair presentation of the results for the quarterly period ended March 31, 2013 have been included in the consolidated financial statements. All intercompany balances and transactions have been eliminated in consolidation. Prior period amounts have been reclassified when necessary to conform to the current period’s presentation. These reclassifications did not have a material effect on the operating results or financial position of the Company. The operating results and financial position of the Company for the three months ended March 31, 2013, may not be indicative of future results of operations and financial position.

 

The preparation of financial statements in accordance with GAAP 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 consolidated financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ significantly from those estimates.  Material estimates that are particularly susceptible to change are the allowance for loan and lease losses (“ALLL”), investment security valuations, the evaluation of investment securities and other real estate owned (“OREO”) for impairment, and the evaluation of deferred income taxes.

 

These financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s audited financial statements, included in our Annual Report filed on Form 10-K as of and for the year ended December 31, 2012.

 

Note 2.         New Authoritative Accounting Guidance

 

Accounting Standards Update (“ASU”) No. 2011-11, Balance Sheet (Topic 210): “Disclosures about Offsetting Assets and Liabilities” requires enhanced disclosures that will enable users of its financial statements to evaluate the effect or potential effect of netting arrangements on an entity’s financial position. This includes the effect or potential effect of rights of setoff associated with an entity’s recognized assets and recognized liabilities within the scope of this update. The amendments require enhanced disclosures by requiring improved information about financial instruments and derivative instruments that are either (1) offset in accordance with either Accounting Standards Codification Topic (“ASC”) 210-20-45 or ASC 815-10-45 or (2) subject to an enforceable master netting arrangement or similar agreement, irrespective of whether they are offset in accordance with either ASC 210-20-45 or ASC 815-10-45. The Company adopted ASU No. 2011-11 on January 1, 2013. The adoption of this new guidance did not have an effect on the operating results or financial position of the Company.

 

ASU No. 2012-02, Intangibles-Goodwill and Other (Topic 350): “Testing Indefinite-Lived Intangible Assets for Impairment” simplifies the guidance for testing the decline in realizable value (impairment) of indefinite-lived intangible assets other than goodwill. ASU No. 2012-02 allows an entity the option to first assess qualitative factors to determine whether it is necessary to perform the quantitative impairment test.  An organization electing to perform a qualitative assessment is no longer required to calculate the fair value of an indefinite-lived intangible asset unless the organization determines, based on a qualitative assessment, that it is “more likely than not” that the asset is impaired. The Company adopted ASU 2012-02 on January 1, 2013. The adoption of this new guidance did not have an effect on the operating results or financial position of the Company.

 

ASU No. 2013-01, Balance Sheet (Topic 210): “Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities” clarifies the scope of transactions that are subject to the disclosures about offsetting, specifically that ordinary trade receivables and receivables are not in the scope of ASU No. 2011-11. This update applies only to derivatives, repurchase agreements and reverse purchase agreements, and securities borrowing and securities lending transactions that are offset in accordance with specific criteria contained in FASB Accounting Standards Codification or subject to a master netting arrangement or similar agreement. The Company adopted ASU 2013-01 on January 1, 2013. The adoption of this new guidance did not have an effect on the operating results or financial position of the Company.

 

ASU No. 2013-02, Comprehensive Income (Topic 220): “Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income” improves the transparency of reporting these reclassifications. The new amendments require an organization to: present either on the face of the statement where income is presented or in the notes to the financial statements the effects on the line items of net income of significant amounts reclassified out of accumulated other comprehensive income; or cross reference to

 

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other disclosures currently required under GAAP for other reclassification items to be reclassified directly to income in their entirety in the same reporting period. The amendments apply to all public and private companies that report other comprehensive income. The Company adopted ASU 2013-02 on January 1, 2013. The adoption of this new guidance did not have an effect on the operating results or financial position of the Company, however see Note 9 for additional disclosures related to the adoption of ASU No. 2013-02.

 

Note 3.         Regulatory Matters

 

The Bank is under a Consent Order (the “Order”) from the Office of the Comptroller of the Currency (“OCC”) dated September 1, 2010. The Company is also subject to a Written Agreement (the “Agreement”) with the Federal Reserve Bank of Philadelphia (the “Reserve Bank”) dated November 24, 2010.

 

OCC Consent Order. The Bank, pursuant to a Stipulation and Consent to the Issuance of a Consent Order dated September 1, 2010, without admitting or denying any wrongdoing, consented and agreed to the issuance of the Order by the OCC, the Bank’s primary regulator. The Order requires the Bank to undertake certain actions within designated timeframes, and to operate in compliance with the provisions thereof during its term. The Order is based on the results of an examination of the Bank as of March 31, 2009. Since the examination, management has engaged in discussions with the OCC and has taken steps to improve the condition, policies and procedures of the Bank. Compliance with the Order is monitored by a committee (the “Committee”) of at least three directors, none of whom is an employee or controlling shareholder of the Bank or its affiliates or a family member of any such person. The Committee is required to submit written progress reports on a monthly basis to the OCC and the Agreement requires the Bank to make periodic reports and filings with the Reserve Bank. The members of the Committee are John P. Moses, Joseph Coccia, Joseph J. Gentile and Thomas J. Melone. The material provisions of the Order are as follows:

 

(i) By October 31, 2010, the Board of Directors of the Bank (the “Board”) was required to adopt and implement a three-year strategic plan which must be submitted to the OCC for review and prior determination of no supervisory objection; the strategic plan must establish objectives for the Bank’s overall risk profile, earnings performance, growth, balance sheet mix, off-balance sheet activities, liability structure, capital adequacy, reduction in the volume of nonperforming assets, product line development, and market segments that the Bank intends to promote or develop, and is to include strategies to achieve those objectives; if the strategic plan involves the sale or merger of the Bank, it must address the timeline and steps to be followed to provide for a definitive agreement within 90 days after the receipt of a determination of no supervisory objection;

 

(ii) by October 31, 2010, the Board was required to adopt and implement a three year capital plan, which must be submitted to the OCC for review and prior determination of no supervisory objection;

 

(iii) by November 30, 2010, the Bank was required to achieve and thereafter maintain a total risk-based capital equal to at least 13% of risk-weighted assets and a Tier 1 capital equal to at least 9% of adjusted total assets;

 

(iv) the Bank may not pay any dividend or capital distribution unless it is in compliance with the higher capital requirements required by the Order, the Capital Plan, applicable legal requirements and, then only after receiving a determination of no supervisory objection from the OCC;

 

(v) by November 15, 2010, the Committee must have reviewed the Board and the Board’s committee structure; by November 30, 2010, the Board was required to prepare or cause to be prepared an assessment of the capabilities of the Bank’s executive officers to perform their past and current duties, including those required to respond to the most recent examination report, and to perform annual performance appraisals of each officer;

 

(vi) by October 31, 2010, the Board was required to adopt, implement and thereafter ensure compliance with a comprehensive conflict of interest policy applicable to the Bank’s and the Company’s directors, executive officers, principal shareholders and their affiliates and such person’s immediate family members and their related interests, employees, and by November 30, 2010, was required to review existing relationships with such persons to identify those, if any, not in compliance with the policy; and review all subsequent proposed transactions with such persons or modifications of transactions;

 

(vii) by October 31, 2010, the Board was required to develop, implement and ensure adherence to policies and procedures for Bank Secrecy Act (“BSA”) compliance; and account opening and monitoring procedures compliance;

 

(viii) by October 31, 2010, the Board was required to ensure the BSA audit function is supported by an adequately staffed department or third party firm; to adopt, implement and ensure compliance with an independent BSA audit; and to assess the capabilities of the BSA officer and supporting staff to perform present and anticipated duties;

 

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(ix) by October 31, 2010, the Board was required to adopt, implement and ensure adherence to a written credit policy, including specified features, to improve the Bank’s loan portfolio management;

 

(x) the Board was required to take certain actions to resolve certain credit and collateral exceptions;

 

(xi) by October 31, 2010, the Board was required to establish an effective, independent and ongoing loan review system to review, at least quarterly, the Bank’s loan and lease portfolios to assure the timely identification and categorization of problem credits; by October 31, 2010, to adopt and adhere to a program for the maintenance of an adequate ALLL, and to review the adequacy of the Bank’s ALLL at least quarterly;

 

(xii) by October 31, 2010, the Board was required to adopt and the Bank implement and adhere to a program to protect the Bank’s interest in criticized assets; and the Bank may only extend additional credit (including renewals) to a borrower whose loans are criticized under specified circumstances;

 

(xiii) by October 31, 2010, the Board was required to adopt and ensure adherence to action plans for each piece of other real estate owned;

 

(xiv) by November 30, 2010, the Board was required to develop, implement and ensure adherence to a policy for effective monitoring and management of concentrations of credit;

 

(xv) by October 31, 2010, the Board was required to revise and implement the Bank’s other than temporary impairment policy;

 

(xvi) by October 31, 2010, the Board was required to take action to maintain adequate sources of stable funding and liquidity and a contingency funding plan; by October 31, 2010, the Board was required to adopt, implement and ensure compliance with an independent, internal audit program; and

 

(xvii) take actions to correct cited violations of law; and adopt procedures to prevent future violations and address compliance management.

 

Federal Reserve Agreement. On November 24, 2010, the Company entered into the Agreement with the Reserve Bank. The Agreement requires the Company to undertake certain actions within designated timeframes, and to operate in compliance with the provisions thereof during its term. The material provisions of the Agreement include the following:

 

(i) the Company’s Board was required to take appropriate steps to fully utilize the Company’s financial and managerial resources to serve as a source of strength to the Bank, including taking steps to ensure that the Bank complies with its Consent Order entered into with the OCC;

 

(ii) the Company may not declare or pay any dividends without the prior written approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation (the “Director”) of the Federal Reserve Board;

 

(iii) the Company may not take dividends or other payments representing a reduction of the Bank’s capital without the prior written approval of the Reserve Bank;

 

(iv) the Company and its nonbank subsidiary may not make any payment of interest, principal or other amounts on the Company’s subordinated debentures or trust preferred securities without the prior written approval of the Reserve Bank and the Director;

 

(v) the Company may not make any payment of interest, principal or other amounts on debt owed to insiders of the Company without the prior written approval of the Reserve Bank and Director;

 

(vi) the Company and its nonbank subsidiary may not incur, increase or guarantee any debt without the prior written approval of the Reserve Bank;

 

(vii) the Company may not purchase or redeem any shares of its stock without the prior written approval of the Reserve Bank;

 

(viii) the Company was required to submit to the Reserve Bank, by January 23, 2011, an acceptable written plan to maintain sufficient capital at the Company on a consolidated basis. Thereafter, the Company must notify the Reserve Bank within 45 days of the end of any quarter in which the Company’s capital ratios fall below the approved capital plan’s minimum ratios, and submit an acceptable written plan to increase the Company’s capital ratios above the capital plan’s minimums;

 

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(ix) the Company was required to immediately take all actions necessary to ensure that: (1) each regulatory report accurately reflects the Company’s condition on the date for which it is filed and all material transactions between the Company and its subsidiaries; (2) each such report is prepared in accordance with its instructions; and (3) all records indicating how the report was prepared are maintained for supervisory review;

 

(x) the Company was required to submit to the Reserve Bank, by January 23, 2011, acceptable written procedures to strengthen and maintain internal controls to ensure all required regulatory reports and notices filed with the Board of Governors are accurate and filed in accordance with the instructions for preparation;

 

(xi) the Company was required to submit to the Reserve Bank, by January 8, 2011, a cash flow projection for 2011, reflecting the Company’s planned sources and uses of cash, and submit a cash flow projection for each subsequent calendar year at least one month prior to the beginning of such year;

 

(xii) the Company must comply with: (1) the notice provisions of Section 32 of the FDI Act and Subpart H of Regulation Y in appointing any new director or senior executive officer or changing the duties of any senior executive officer; and (2) the restrictions on indemnification and severance payments of Section 18(k) of the FDI Act and Part 359 of the FDIC’s regulations; and

 

(xiii) the Board must submit written progress reports within 30 days of the end of each calendar quarter.

 

During the three months ended March 31, 2013, and the year ended December 31, 2012, the Company incurred approximately $45 thousand and $585 thousand, respectively, of expenses related to complying with these regulatory agreements, consisting primarily of professional and consulting fees.  In addition, the Order and the Agreement place restrictions on the Company’s ability to borrow funds and to pay interest and dividends to its security holders.  In the future, the Company may continue to experience increased costs related to compliance with these regulatory agreements and also expects to face certain restrictions on its operations for as long as it continues to operate under the Order and the Agreement.  The Company expects, however, that future compliance expenses will decrease from the 2012 level.

 

The Order and Agreement have not and are not expected to have an impact on the Company’s ability to attract and maintain deposits or the Company’s cost of funds.  In order to meet the increased capital requirements imposed under the Order and the Agreement, however, unless the Company is able to raise additional capital, the Company could be limited in the aggregate amount of loans it can have outstanding, which may constrain loan growth.  While it is not anticipated that the Order and the Agreement will have an impact on the Company’s net interest margin, the overall cost of compliance with the Order and the Agreement will continue to impact profitability at least through the end of 2013.

 

Banking regulations also limit the amount of dividends that may be paid without prior approval of the Bank’s regulatory agency.  As of May 14, 2013, the Company and the Bank are restricted from paying any dividends without regulatory approval.

 

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

 

Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined).

 

In accordance with the Order, the Bank is required to achieve and thereafter maintain total risk-based capital equal to at least 13% of risk-weighted assets and Tier 1 capital equal to at least 9% of adjusted total assets.  At March 31, 2013 and December 31, 2012, the Bank was not in compliance with these requirements.  The minimum capital requirements under the Order take precedence over the standard regulatory capital adequacy definitions described in the tables below. The Company’s and the Bank’s actual capital positions and ratios at March 31, 2013 and December 31, 2012 are presented in the following table:

 

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Capital Analysis

 

		March 31,			December 31,
(in thousands)		2013			2012
Company
Tier I capital:
Total tier I capital		$	41,356		$	39,587
Tier II capital:
Subordinated notes		20,679			19,796
Allowable portion of allowance for loan losses		8,367			8,452
Total tier II capital		29,046			28,248
Total risk-based capital		70,402			67,835
Total risk-weighted assets		$	658,621		$	665,323
Bank
Tier I capital:
Total tier I capital		$	72,343		$	69,963
Tier II capital:
Allowable portion of allowance for loan losses		8,362			8,447
Total tier II capital		8,362			8,447
Total risk-based capital		80,705			78,410
Total risk-weighted assets		$	658,210		$	664,914

 

												To Be Well
												Capitalized
												Under Prompt
							For Capital					Corrective
		Actual					Adequacy Purposes					Action Provision
(dollars in thousands)		Amount			Ratio		Amount			Ratio		Amount			Ratio
March 31, 2013
Total capital
(to risk-weighted assets)
Company		$	70,402		10.69	%	$	>52,690		>8.00	%	N/A			N/A
Bank		$	80,705		12.26	%	$	>52,657		>8.00	%	$	>65,821		>10.00	%
Tier I capital
(to risk-weighted assets)
Company		$	41,356		6.28	%	$	>26,345		>4.00	%	N/A			N/A
Bank		$	72,343		10.99	%	$	>26,328		>4.00	%	$	>39,493		>6.00	%
Tier I capital
(to average assets)
Company		$	41,356		4.42	%	$	>37,449		>4.00	%	N/A			N/A
Bank		$	72,343		7.73	%	$	>37,434		>4.00	%	$	>46,793		>5.00	%

 

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												To Be Well
												Capitalized
												Under Prompt
							For Capital					Corrective
		Actual					Adequacy Purposes					Action Provision
(dollars in thousands)		Amount			Ratio		Amount			Ratio		Amount			Ratio
December 31, 2012
Total capital
(to risk-weighted assets)
Company		$	67,835		10.20	%	$	>53,226		>8.00	%	N/A			N/A
Bank		$	78,410		11.79	%	$	>53,193		>8.00	%	$	>66,491		>10.00	%
Tier I capital
(to risk-weighted assets)
Company		$	39,587		5.95	%	$	>26,613		>4.00	%	N/A			N/A
Bank		$	69,963		10.52	%	$	>26,597		>4.00	%	$	>39,895		>6.00	%
Tier I capital
(to average assets)
Company		$	39,587		4.07	%	$	>38,879		>4.00	%	N/A			N/A
Bank		$	69,963		7.20	%	$	>38,865		>4.00	%	$	>48,581		>5.00	%

 

Note 4.         LOANS

 

The following table presents a summary of loans receivable, net, by category at March 31, 2013 and December 31, 2012:

 

(in thousands)		March 31, 2013			December 31, 2012
Residential real estate		$	98,273		$	90,228
Commercial real estate		248,455			231,835
Construction, land acquisition, and development		22,363			32,502
Commercial and industrial loans		112,176			110,073
Consumer loans		109,378			109,783
State and political subdivisions		25,278			23,354
Total loans, gross		615,923			597,775
Unearned discount		(89		)	(103		)
Net deferred loan fees and costs		321			260
Allowance for loan and lease losses		(18,473		)	(18,536		)
Loans, net		$	597,682		$	579,396

 

The Company has granted loans, letters of credit and lines of credit to certain executive officers and directors of the Company as well as to certain related parties of executive officers and directors.  See Note 10 to these consolidated financial statements for more information about related party transactions.

 

The Company originates one-to-four family mortgage loans primarily for sale in the secondary market.  During the quarter ended March 31, 2013, the Company sold $3.7 million of one-to-four family mortgages.  The Company retains servicing rights on these mortgages.

 

The Company had $847 thousand and $1.6 million in loans held-for-sale at March 31, 2013 and December 31, 2012, respectively.  All loans held for sale are one-to-four family residential mortgage loans.

 

The Company does not have any lending programs commonly referred to as subprime lending.  Subprime lending generally targets borrowers with weakened credit histories typically characterized by payment delinquencies, previous charge-offs, judgments, bankruptcies, or borrowers with questionable repayment capacity as evidenced by low credit scores or high debt-burden ratios.

 

See Note 2 to the Company’s consolidated financial statements included in the 2012 Form 10-K for the risk characteristics related to the Company’s loan segments.

 

The Company provides for loan losses based on the consistent application of its documented ALLL methodology.  Loan losses are charged to the ALLL and recoveries are credited to it.  Additions to the ALLL are provided by charges against income based on various factors which, in management’s judgment, deserve current recognition of estimated probable losses.  Loan losses are charged-

 

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off in the period the loans, or portions thereof, are deemed uncollectible.  Generally, the Company will record a loan charge-off (including a partial charge-off) to reduce a loan to the estimated recoverable amount based on its methodology detailed below.  The Company regularly reviews the loan portfolio and makes adjustments for loan losses in order to maintain the ALLL in accordance with GAAP. The ALLL consists primarily of the following two components:

 

(1)         Specific allowances are established for impaired loans, which are defined by the Company as all loan relationships with an aggregate outstanding balance greater than $100 thousand that are rated substandard and on non-accrual status, rated doubtful or loss, and all troubled debt restructured loans (“TDRs”).  The amount of impairment provided for as an allowance is represented by the deficiency, if any, between the carrying value of the loan and either (a) the present value of expected future cash flows discounted at the loan’s effective interest rate, (b) the loan’s observable market price, or (c) the fair value of the underlying collateral, less estimated costs to sell, for collateral dependent loans.  Impaired loans that have no impairment losses are not considered for general valuation allowances described below.  If the Company determines that collection of the impairment amount is remote, the Company will record a charge-off.

 

(2)         General allowances are established for loan losses on a portfolio basis for loans that do not meet the definition of impaired.  The Company divides its portfolio into loan segments, with loans exhibiting similar characteristics.  Loans rated special mention or substandard and accruing which are embedded in these loan segments are then separated from these loan segments.  These loans are then subject to an analysis placing increased emphasis on the credit risk associated with these specific loans.  The Company applies an estimated loss rate to each loan group.  The loss rates applied are based on the Company’s own historical loss experience based on the loss rate for each segment of loans with similar risk characteristics in its portfolio.  In addition, management evaluates and applies certain qualitative or environmental factors that are likely to cause estimated credit losses associated with the Company’s existing portfolio to differ from historical experience, which are discussed below.  This evaluation is inherently subjective, as it requires material estimates that may be susceptible to significant revisions based upon changes in economic and real estate market conditions.  Actual loan losses may be significantly more than the ALLL that is established, which could have a material negative effect on the Company’s operating results or financial condition.

 

Management makes adjustments for loan losses based on its evaluation of several qualitative and environmental factors, including but not limited to:

 

·                  Changes in national, local, and business economic conditions and developments, including the condition of various market segments;

·                  Changes in the nature and volume of the Company’s loan portfolio;

·                  Changes in the Company’s lending policies and procedures, including underwriting standards, collection, charge-off and recovery practices and results;

·                  Changes in the experience, ability and depth of the Company’s lending management and staff;

·                  Changes in the quality of the Company’s loan review system and the degree of oversight by the Company’s Board of Directors;

·                  Changes in the trend of the volume and severity of past due and classified loans, including trends in the volume of non-accrual loans, troubled debt restructurings and other loan modifications;

·                  The existence and effect of any concentrations of credit and changes in the level of such concentrations;

·                  The effect of external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the Company’s current loan portfolio; and

·                  Analysis of customers’ credit quality, including knowledge of their operating environment and financial condition.

 

Management evaluates the ALLL based on the combined total of the impaired and general components. Generally, when the loan portfolio increases, absent other factors, the ALLL methodology results in a higher dollar amount of estimated probable losses. Conversely, when the loan portfolio decreases, absent other factors, the ALLL methodology results in a lower dollar amount of estimated probable losses.

 

Each quarter, management evaluates the ALLL and adjusts the ALLL as appropriate through a provision for loan losses. While the Company uses the best information available to make evaluations, future adjustments to the ALLL may be necessary if conditions differ substantially from the information used in making the evaluations. In addition, as an integral part of its examination process, the OCC periodically reviews the Company’s ALLL. The OCC may require the Company to adjust the ALLL based on its analysis of information available to it at the time of its examination.

 

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The following table sets forth activity in the ALLL, by loan category, for the three months ended March 31, 2013 and 2012.

 

		Real Estate
(in thousands)		Residential Real Esate			Commercial Real Estate			Construction, Land Acquisition and Development			Commercial and Industrial			Consumer			State and Political Subdivisions			Total
Three months ended March 31, 2013:
Allowance for loan losses:
Beginning balance, January 1, 2013		$	1,764		$	8,062		$	2,162		$	4,167		$	1,708		$	673		$	18,536
Charge-offs		(159		)	(48		)	(110		)	(45		)	(194		)	—			(556		)
Recoveries		8			45			5			1,516			143			—			1,717
Provisions (credits)		271			823			(381		)	(2,033		)	82			14			(1,224		)
Ending balance, March 31, 2013		$	1,884		$	8,882		$	1,676		$	3,605		$	1,739		$	687		$	18,473
Three months ended March 31, 2012:
Allowance for loan losses:
Beginning balance, January 1, 2012		$	1,823		$	11,151		$	2,590		$	3,292		$	1,526		$	452		$	20,834
Charge-offs		(312		)	(154		)	—			(49		)	(79		)	—			(594		)
Recoveries		19			317			21			125			78			—			560
Provisions (credits)		269			(573		)	234			37			(68		)	(35		)	(136		)
Ending balance, March 31, 2012		$	1,799		$	10,741		$	2,845		$	3,405		$	1,457		$	417		$	20,664

 

The following table represents the allocation of the allowance for loan losses and the related loan by loan portfolio segment disaggregated based on the impairment methodology at March 31, 2013 and December 31, 2012:

 

		Real Estate
(in thousands)		Residential Real Esate			Commercial Real Estate			Construction, Land Acquisition and Development			Commercial and Industrial			Consumer			State and Political Subdivisions			Total
March 31, 2013
Allowance for loan losses:
Individually evaluated for impairment		$	26		$	408		$	84		$	—		$	—		$	—		$	518
Collectively evaluated for impairment		1,858			8,474			1,592			3,605			1,739			687			17,955
Total		$	1,884		$	8,882		$	1,676		$	3,605		$	1,739		$	687		$	18,473
Loans receivable:
Individually evaluated for impairment		$	2,158		$	10,857		$	943		$	—		$	—		$	—		$	13,958
Collectively evaluated for impairment		96,115			237,598			21,420			112,176			109,378			25,278			601,965
Total		$	98,273		$	248,455		$	22,363		$	112,176		$	109,378		$	25,278		$	615,923
December 31, 2012
Allowance for loan losses:
Individually evaluated for impairment		$	40		$	268		$	2		$	—		$	—		$	—		$	310
Collectively evaluated for impairment		1,724			7,794			2,160			4,167			1,708			673			18,226
Total		$	1,764		$	8,062		$	2,162		$	4,167		$	1,708		$	673		$	18,536
Loans receivable:
Individually evaluated for impairment		$	2,773		$	11,459		$	993		$	—		$	—		$	—		$	15,225
Collectively evaluated for impairment		87,455			220,376			31,509			110,073			109,783			23,354			582,550
Total		$	90,228		$	231,835		$	32,502		$	110,073		$	109,783		$	23,354		$	597,775

 

Credit Quality Indicators — Commercial Loans

 

The Company continuously monitors the credit quality of its commercial loans.  Credit quality is monitored by reviewing certain credit quality indicators. Management has determined that credit risk ratings are the key credit quality indicator that best help management monitor the credit quality of the Company’s loan receivables.

 

The Bank’s commercial loan classification and credit grading processes are part of the lending, underwriting, and credit administration functions to ensure an ongoing assessment of credit quality. Accurate and timely loan classification or credit grading is a critical component of loan portfolio management. Loan officers are required to review their loan portfolio risk ratings regularly for accuracy. The loan review function uses the same risk rating system in the loan review process. This allows an independent third party to assess the quality of the portfolio and compare the accuracy of ratings with the loan officer’s and management’s assessment.

 

A formal loan classification and credit grading system reflects the risk of default and credit losses.  A written description of the risk ratings is maintained that includes a discussion of the factors used to assign appropriate classifications of credit grades to loans.  The process identifies groups of loans that warrant the special attention of management.  The risk grade groupings provide a mechanism to identify risk within the loan portfolio and provide management and the Board with periodic reports by risk category.  The credit risk ratings play an important role in the establishment and evaluation of the provision for loan and lease losses and the ALLL.  After determining the historical loss factor which is adjusted for qualitative and environmental factors for each portfolio segment, the portfolio segment balances that have been collectively evaluated for impairment are multiplied by the general reserve loss factor for the respective portfolio segments to determine the general reserve.  Loans that have an internal credit rating of special mention or substandard follow the same process; however, the qualitative and environmental factors are further adjusted for the increased risk.

 

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