MIDDLEFIELD BANC CORP - Quarter Report: 2018 March (Form 10-Q)

 

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		March 31,				December 31,
		2018				2017
ASSETS
Cash and cash equivalents		$	33,258			$	39,886
Equity securities, at fair value			643				-
Investment securities available for sale, at fair value			91,262				95,283
Loans held for sale			937				463
Loans			932,374				923,213
Less allowance for loan and lease losses			7,551				7,190
Net loans			924,823				916,023
Premises and equipment, net			12,225				11,853
Goodwill			15,071				15,071
Core deposit intangibles			2,658				2,749
Bank-owned life insurance			15,764				15,652
Other real estate owned			212				212
Accrued interest receivable and other assets			9,911				9,144
TOTAL ASSETS		$	1,106,764			$	1,106,336
LIABILITIES
Deposits:
Noninterest-bearing demand		$	194,203			$	192,438
Interest-bearing demand			96,659				83,990
Money market			149,359				150,277
Savings			221,851				208,502
Time			282,501				242,987
Total deposits			944,573				878,194
Short-term borrowings			18,671				74,707
Other borrowings			19,028				29,065
Accrued interest payable and other liabilities			4,340				4,507
TOTAL LIABILITIES			986,612				986,473
STOCKHOLDERS' EQUITY
Common stock, no par value; 10,000,000 shares authorized, 3,609,149 and 3,603,881 shares issued; 3,222,984 and 3,217,716 shares outstanding			85,116				84,859
Retained earnings			48,927				47,431
Accumulated other comprehensive (loss) income			(373	)			1,091
Treasury stock, at cost; 386,165 shares			(13,518	)			(13,518	)
TOTAL STOCKHOLDERS' EQUITY			120,152				119,863
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY		$	1,106,764			$	1,106,336

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		Three Months Ended
		March 31,
		2018				2017
INTEREST AND DIVIDEND INCOME
Interest and fees on loans		$	11,054			$	9,180
Interest-bearing deposits in other institutions			119				49
Federal funds sold			14				3
Investment securities:
Taxable interest			169				218
Tax-exempt interest			525				637
Dividends on stock			59				112
Total interest and dividend income			11,940				10,199
INTEREST EXPENSE
Deposits			1,640				1,125
Short-term borrowings			276				177
Other borrowings			122				140
Total interest expense			2,038				1,442
NET INTEREST INCOME			9,902				8,757
Provision for loan losses			210				165
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES			9,692				8,592
NONINTEREST INCOME
Service charges on deposit accounts			453				469
Investment securities gains on sale, net			-				488
Gain on equity securities			18				-
Earnings on bank-owned life insurance			112				109
Gain on sale of loans			4				234
Other income			199				211
Total noninterest income			786				1,511
NONINTEREST EXPENSE
Salaries and employee benefits			3,979				3,696
Occupancy expense			536				488
Equipment expense			233				281
Data processing costs			477				320
Ohio state franchise tax			115				186
Federal deposit insurance expense			150				68
Professional fees			445				373
Advertising expense			228				248
Core deposit intangible amortization			91				72
Merger expense			-				387
Other expense			1,091				1,148
Total noninterest expense			7,345				7,267
Income before income taxes			3,133				2,836
Income taxes			528				736
NET INCOME		$	2,605			$	2,100
EARNINGS PER SHARE
Basic		$	0.81			$	0.78
Diluted			0.80				0.78
DIVIDENDS DECLARED PER SHARE		$	0.33			$	0.27

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		Three Months Ended
		March 31,
		2018				2017
Net income		$	2,605			$	2,100
Other comprehensive loss:
Net unrealized holding (loss) gain on available-for-sale investment securities			(1,912	)			231
Tax effect			402				(78	)
Reclassification adjustment for investment securities gains included in net income			-				(488	)
Tax effect			-				166
Total other comprehensive loss			(1,510	)			(169	)
Comprehensive income		$	1,095			$	1,931

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										Accumulated
										Other								Total
		Common				Retained				Comprehensive				Treasury				Stockholders'
		Stock				Earnings				Income (Loss)				Stock				Equity
Balance, December 31, 2017		$	84,859			$	47,431			$	1,091			$	(13,518	)		$	119,863
Change in accounting principle for adoption of ASU 2016-01							141				(141	)							-
Change in accounting principle for adoption of ASU 2018-02							(187	)			187								-
Net income							2,605												2,605
Other comprehensive loss											(1,510	)							(1,510	)
Dividend reinvestment and purchase plan (3,278 shares)			161																161
Stock-based compensation expense (1,990 shares)			96																96
Cash dividends ($0.33 per share)							(1,063	)											(1,063	)
Balance, March 31, 2018		$	85,116			$	48,927			$	(373	)		$	(13,518	)		$	120,152

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		Three Months Ended
		March 31,
		2018				2017
OPERATING ACTIVITIES
Net income		$	2,605			$	2,100
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Provision for loan losses			210				165
Investment securities gains on sale, net			-				(488	)
Gain on equity securities			(18	)			-
Depreciation and amortization of premises and equipment, net			231				308
Amortization of premium and discount on investment securities, net			104				124
Accretion of deferred loan fees, net			(341	)			(185	)
Amortization of core deposit intangibles			91				72
Stock-based compensation expense			96				-
Origination of loans held for sale			(1,783	)			(2,321	)
Proceeds from sale of loans			1,313				1,921
Gain on sale of loans			(4	)			(100	)
Origination of student loans held for sale			-				(95,679	)
Proceeds from sale of student loans			-				93,438
Gain on sale of student loans			-				(134	)
Earnings on bank-owned life insurance			(112	)			(109	)
Deferred income tax			131				(1,116	)
Net gain loss on other real estate owned			-				(56	)
Decrease (increase) in accrued interest receivable			19				(199	)
Decrease in accrued interest payable			(5	)			(14	)
Other, net			(587	)			547
Net cash provided by (used in) operating activities			1,950				(1,726	)
INVESTING ACTIVITIES
Investment securities available for sale:
Proceeds from repayments and maturities			1,380				3,544
Increase in loans, net			(8,669	)			(34,533	)
Proceeds from the sale of other real estate owned			-				333
Purchase of bank-owned life insurance			-				(4	)
Purchase of premises and equipment			(603	)			(179	)
Purchase of restricted stock			(90	)			(899	)
Redemption of restricted stock			-				795
Acquisition, net of cash paid			-				5,431
Net cash used in investing activities			(7,982	)			(25,512	)
FINANCING ACTIVITIES
Net increase in deposits			66,379				19,873
(Decrease) increase in short-term borrowings, net			(56,036	)			7,854
Repayment of other borrowings			(10,037	)			(49	)
Proceeds from other borrowings			-				30,000
Proceeds from common stock issued			-				53
Proceeds from dividend reinvestment and purchase plan			161				132
Cash dividends			(1,063	)			(756	)
Net cash (used in) provided by financing activities			(596	)			57,107
(Decrease) increase in cash and cash equivalents			(6,628	)			29,869
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD			39,886				32,495
CASH AND CASH EQUIVALENTS AT END OF PERIOD		$	33,258			$	62,364

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		Three Months Ended
		March 31,
		2018				2017
SUPPLEMENTAL INFORMATION
Cash paid during the year for:
Interest on deposits and borrowings		$	2,043			$	1,456
Noncash investing transactions:
Transfers from loans to other real estate owned		$	-			$	977
Common stock issued in business acquisition			-				20,995
Transfer of equity securities from investment securities available for sale, at fair value			(625	)			-
Acquisition of Liberty Bank
Noncash assets acquired
Loans		$	-			$	195,388
Loans held for sale			-				5,953
Premises and equipment, net			-				325
Accrued interest receivable			-				440
Bank-owned life insurance			-				1,681
Core deposit intangible			-				3,087
Other assets			-				997
Goodwill			-				10,740
Total noncash assets acquired			-				218,611
Liabilities assumed
Time deposits			-				(30,744	)
Deposits other than time deposits			-				(167,300	)
Accrued interest payable			-				(47	)
Deferred taxes			-				(1,134	)
Other liabilities			-				(2,754	)
Total liabilities assumed			-				(201,979	)
Liberty stock acquired in business combination			-				(1,068	)
Net noncash assets acquired		$	-			$	15,564
Cash and cash equivalents acquired, net		$	-			$	5,431

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NOTE 1 - BASIS OF PRESENTATION

 

The consolidated financial statements of Middlefield Banc Corp. ("Company") include its bank subsidiary, The Middlefield Banking Company (“MBC” or “Middlefield Bank”), and a nonbank asset resolution subsidiary EMORECO, Inc. All significant inter-company items have been eliminated.

 

The accompanying unaudited financial statements have been prepared in accordance with U.S. generally accepted accounting principles and the instructions for Form 10-Q and Article 10 of Regulation S-X. In management’s opinion, the financial statements include all adjustments, consisting of normal recurring adjustments, that the Company considers necessary to fairly state the Company’s financial position and the results of operations and cash flows. The consolidated balance sheet at December 31, 2017, has been derived from the audited financial statements at that date but does not include all of the necessary informational disclosures and footnotes as required by U.S. generally accepted accounting principles. The accompanying financial statements should be read in conjunction with the financial statements and notes thereto included with the Company’s Form 10-K for the year ended December 31, 2017. The results of the Company’s operations for any interim period are not necessarily indicative for the results of the Company’s operations for any other interim period or for a full fiscal year.

 

Recent Accounting Pronouncements –

 

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The standard requires lessees to recognize the assets and liabilities that arise from leases on the balance sheet.  A lessee should recognize in the statement of financial position a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term.  A short-term lease is defined as one in which (a) the lease term is 12 months or less and (b) there is not an option to purchase the underlying asset that the lessee is reasonably certain to exercise. For short-term leases, lessees may elect to recognize lease payments over the lease term on a straight-line basis. For public business entities, the amendments in this Update are effective for fiscal years beginning after December 15, 2018, and interim periods within those years. For all other entities, the amendments in this Update are effective for fiscal years beginning after December 15, 2019, and for interim periods within fiscal years beginning after December 15, 2020. The amendments should be applied at the beginning of the earliest period presented using a modified retrospective approach with earlier application permitted as of the beginning of an interim or annual reporting period. The Company is currently assessing the practical expedients it may elect at adoption, but does not anticipate the amendments will have a significant impact on the financial statements. Based on the Company’s preliminary analysis of its current portfolio, the impact to the Company’s balance sheet is estimated to result in less than a 1 percent increase in assets and liabilities. The Company also anticipates additional disclosures to be provided at adoption.

 

In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments (“CECL”), which changes the impairment model for most financial assets. This Update is intended to improve financial reporting by requiring timelier recording of credit losses on loans and other financial instruments held by financial institutions and other organizations. The underlying premise of the Update is that financial assets measured at amortized cost should be presented at the net amount expected to be collected, through an allowance for credit losses that is deducted from the amortized cost basis. The allowance for credit losses should reflect management’s current estimate of credit losses that are expected to occur over the remaining life of a financial asset. The income statement will be effected for the measurement of credit losses for newly recognized financial assets, as well as the expected increases or decreases of expected credit losses that have taken place during the period. ASU 2016-13 is effective for annual and interim periods beginning after December 15, 2019, and early adoption is permitted for annual and interim periods beginning after December 15, 2018. With certain exceptions, transition to the new requirements will be through a cumulative effect adjustment to opening retained earnings as of the beginning of the first reporting period in which the guidance is adopted. Management is currently evaluating the impact of the adoption of this guidance on the Company’s consolidated financial statements. Management will oversee the implementation of CECL and is currently in the process of implementing a software solution to assist in the adoption of this ASU. Management plans to run the current incurred loss model and the CECL model concurrently for 12 months prior to the adoption of this guidance on January 1, 2020.

 

 

In February 2018, the FASB issued ASU 2018-03, Technical Corrections and Improvements to Financial Instruments—Overall (Subtopic 825-10), to clarify certain aspects of the guidance issued in ASU 2016-01. (1) An entity measuring an equity security using the measurement alternative may change its measurement approach to a fair value method in accordance with Topic 820, Fair Value Measurement, through an irrevocable election that would apply to that security and all identical or similar investments of the same issuer. Once an entity makes this election, the entity should measure all future purchases of identical or similar investments of the same issuer using a fair value method in accordance with Topic 820. (2) Adjustments made under the measurement alternative are intended to reflect the fair value of the security as of the date that the observable transaction for a similar security took place. (3) Re-measuring the entire value of forward contracts and purchased options is required when observable transactions occur on the underlying equity securities. (4) When the fair value option is elected for a financial liability, the guidance in paragraph 825-10- 45-5 should be applied, regardless of whether the fair value option was elected under either Subtopic 815-15, Derivatives and Hedging—Embedded Derivatives, or 825-10, Financial Instruments—Overall. (5) Financial liabilities for which the fair value option is elected, the amount of change in fair value that relates to the instrument specific credit risk should first be measured in the currency of denomination when presented separately from the total change in fair value of the financial liability. Then, both components of the change in the fair value of the liability should be re-measured into the functional currency of the reporting entity using end-of-period spot rates. (6) The prospective transition approach for equity securities without a readily determinable fair value in the amendments in Update 2016-01 is meant only for instances in which the measurement alternative is applied. An insurance entity subject to the guidance in Topic 944, Financial Services— Insurance, should apply a prospective transition method when applying the amendments related to equity securities without readily determinable fair values. An insurance entity should apply the selected prospective transition method consistently to the entity’s entire population of equity securities for which the measurement alternative is elected. For public business entities, the amendments in this Update are effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years beginning after June 15, 2018. Public business entities with fiscal years beginning between December 15, 2017, and June 15, 2018, are not required to adopt these amendments until the interim period beginning after June 15, 2018, and public business entities with fiscal years beginning between June 15, 2018, and December 15, 2018, are not required to adopt these amendments before adopting the amendments in Update 2016-01. For all other entities, the effective date is the same as the effective date in Update 2016-01. All entities may early adopt these amendments for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years, as long as they have adopted Update 2016-01. The Company is currently evaluating the impact the adoption of the standard will have on the Company’s financial position or results of operations.

 

ASU 2018-04, Investments – Debt Securities (Topic 320) and Regulated Operations (Topic 980) - Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 117 and SEC Release No. 33-9273, ASU 2018-04 supersedes various SEC paragraphs and adds an SEC paragraph pursuant to the issuance of Staff Accounting Bulletin No. 117.

 

NOTE 2 – REVENUE RECOGNITION

 

Effective January 1, 2017, the Company adopted ASU 2014-09 Revenue from Contracts with Customers-Topic 606 and all subsequent ASUs that modified ASC 606. The implementation of the new standard had no material impact to the measurement or recognition of revenue of prior periods and did not require any cumulative effect adjustment for adoption.

 

Management determined that the primary sources of revenue, which emanate from interest income on loans and investments, along with noninterest revenue resulting from investment security gains, gains on the sale of loans, and BOLI income, are not within the scope of ASC 606. As a result, no changes were made during the period related to these sources of revenue, which cumulatively comprise 93.4% of the total revenue of the Company.

 

The main types of noninterest income within the scope of the standard are as follows:

 

Service charges on deposit accounts – The Company has contracts with its deposit customers where fees are charged if the account balance falls below predetermined levels defined as compensating balances. These agreements can be cancelled at any time by either the Company or the deposit customer. Revenue from these transactions is recognized on a monthly basis as the Company has an unconditional right to the fee consideration. The Company also has transaction fees related to specific transactions or activities resulting from a customer request or activity that include overdraft fees, online banking fees, and other transaction fees. All of these fees are attributable to specific performance obligations of the Company where the revenue is recognized at a defined point in time, which is completion of the requested service/transaction.

 

Gains (losses) on sale of other real estate owned – Gains and losses are recognized at the completion of the property sale when the buyer obtains control of the real estate and all of the performance obligations of the Company have been satisfied. Evidence of the buyer obtaining control of the asset include transfer of the property title, physical possession of the asset, and the buyer obtaining control of the risks and rewards related to the asset. In situations where the Company agrees to provide financing to facilitate the sale, additional analysis is performed to ensure that the contract for sale identifies the buyer and seller, the asset to be transferred, payment terms, and that the contract has a true commercial substance and that collection of amounts due from the buyer is reasonable. In situations where financing terms are not reflective of current market terms, the transaction price is discounted impacting the gain/loss and the carrying value of the asset.

 

 

The following table depicts the disaggregation of revenue derived from contracts with customers to depict the nature, amount, timing, and uncertainty of revenue and cash flows for the three months ended March 31:

 

 

 

(a)

Not within scope of ASC 606.

 

NOTE 3 - STOCK-BASED COMPENSATION

 

The Company had no unvested stock options outstanding as of March 31, 2018 and 2017.

 

Stock option activity during the three months ended March 31 is as follows:

 

 

 

The following table presents the activity during the three months ended March 31, 2018 related to awards of restricted stock:

 

 

 

Share-based compensation expense of $55,000 and $48,000 was recognized for the three-month periods ended March 31, 2018 and 2017, respectively.

 

The expected remaining compensation expense that will be recognized on restricted stock totals $199,000, of which $127,000 will be recognized in 2018 and $72,000 will be recognized in 2019.

 

NOTE 4 - EARNINGS PER SHARE

 

The Company provides dual presentation of basic and diluted earnings per share. Basic earnings per share is calculated by dividing net income by the average shares outstanding. Diluted earnings per share adds the dilutive effects of stock options to average shares outstanding.

 

The following table sets forth the composition of the weighted-average common shares (denominator) used in the basic and diluted earnings per share computation.

 

 

 

Options to purchase 18,250 shares of common stock, at prices ranging from $17.55 to $23.00, were outstanding during the three months ended March 31, 2018. Also outstanding were 14,601 shares of restricted stock. None of the outstanding options or restricted stock were anti-dilutive.

 

Options to purchase 27,762 shares of common stock, at prices ranging from $17.55 to $37.48, were outstanding during the three months ended March 31, 2017. Also outstanding were 15,800 shares of restricted stock. None of the outstanding options or restricted stock were anti-dilutive.

 

 

 

NOTE 5 - FAIR VALUE MEASUREMENTS

 

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for an asset or liability in an orderly transaction between market participants at the measurement date. GAAP established a fair value hierarchy that prioritizes the use of inputs used in valuation methodologies into the following levels:

 

Level I:

Quoted prices are available in active markets for identical assets or liabilities as of the reported date.

 

Level II:

Pricing inputs are other than the quoted prices in active markets, which are either directly or indirectly observable as of the reported date. The nature of these assets and liabilities includes items for which quoted prices are available but traded less frequently and items that are fair valued using other financial instruments, the parameters of which can be directly observed.

 

Level III:

Assets and liabilities that have little to no pricing observability as of the reported date. These items do not have two-way markets and are measured using management’s best estimate of fair value, where the inputs into the determination of fair value require significant management judgment or estimation.

 

The following tables present the assets measured on a recurring basis on the Consolidated Balance Sheet at their fair value by level within the fair value hierarchy. Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

 

 

 

Investment Securities Available for Sale - The Company obtains fair values from an independent pricing service which represent quoted prices for similar assets, fair values determined by pricing models using a market approach that considers observable market data, such as interest rate volatilities, LIBOR yield curve, credit spreads and prices from market makers and live trading systems (Level II).

 

Equity Securities - Equity securities that are traded on a national securities exchange are valued at their last reported sales price as of the measurement date. Equity securities traded in the over-the-counter (“OTC”) markets and listed securities for which no sale was reported on that date are generally valued at their last reported “bid” price if held long, and last reported “ask” price if sold short. To the extent equity securities are actively traded and valuation adjustments are not applied, they are categorized in Level I of the fair value hierarchy. Equity securities traded on inactive markets or valued by reference to similar instruments are generally categorized in Level II of the fair value hierarchy. Equity securities are carried at fair value through net income at March 31, 2018.

 

 

Impaired Loans – The Company has measured impairment on collateral-dependent impaired loans generally based on the fair value of the loan’s collateral. Fair value is generally determined based upon independent third-party appraisals of the properties. In some cases, management may adjust the appraised value due to the age of the appraisal, changes in market conditions, or observable deterioration of the property since the appraisal was completed. Additionally, management makes estimates about expected costs to sell the property which are also included in the net realizable value. If the fair value of the collateral-dependent loan is less than the carrying amount of the loan, a specific reserve for the loan is made in the allowance for loan losses or a charge-off is taken to reduce the loan to the fair value of the collateral (less estimated selling costs) and the loan is included in the following table as a Level III measurement. If the fair value of the collateral exceeds the carrying amount of the loan, then the loan is not included in the following table as it is not currently being carried at its fair value. The fair values in the following table exclude estimated selling costs of $573,000 at March 31, 2018.

 

Other Real Estate Owned (OREO) – OREO is carried at the lower of cost or fair value, which is measured at the date of foreclosure. If the fair value of the collateral exceeds the carrying amount of the loan, no charge-off or adjustment is necessary, the loan is not considered to be carried at fair value, and is therefore not included in the following table. If the fair value of the collateral is less than the carrying amount of the loan, management will charge the loan down to its estimated realizable value. The fair value of OREO is based on the appraised value of the property, which is generally unadjusted by management and is based on comparable sales for similar properties in the same geographic region as the subject property, and is included in the following table as a Level II measurement. In some cases, management may adjust the appraised value due to the age of the appraisal, changes in market conditions, or observable deterioration of the property since the appraisal was completed. In these cases, the loans are categorized in the following table as Level III measurement since these adjustments are considered to be unobservable inputs. Income and expenses from operations and further declines in the fair value of the collateral subsequent to foreclosure are included in net expenses from OREO.

 

The following tables present the assets measured on a nonrecurring basis on the Consolidated Balance Sheet at their fair value by level within the fair value hierarchy. Collateral-dependent impaired loans are carried at fair value if they have been charged down to fair value or if a specific valuation allowance has been established. A new cost basis is established at the time a property is initially recorded in OREO. OREO properties are carried at fair value if a devaluation has been taken to the property’s value subsequent to the initial measurement.

 

 

 

The following tables present additional quantitative information about assets measured at fair value on a nonrecurring basis and for which the Company uses Level III inputs to determine fair value:

 

 

 

 

(1)

Fair value is generally determined through independent appraisals of the underlying collateral, which generally include various level III inputs which are not identifiable, less any associated allowance.

 

(2)

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

 

 

The estimated fair value of the Company’s financial instruments not recorded at fair value on a recurring basis is as follows:

 

 

(1) This financial instrument is carried at cost at March 31, 2018, which approximates the fair value of the instrument.

 

 

 

 

NOTE 6 – ACCUMULATED OTHER COMPREHENSIVE INCOME

 

The following tables present the changes in accumulated other comprehensive income by component net of tax for the three months ended March 31, 2018 and 2017, respectively:

 

 

 

(a)

All amounts are net of tax. Amounts in parentheses indicate debits to accumulated other comprehensive income.

(b)

Reclassifications are the result of the adoption of ASUs 2016-01 and 2018-02 effective for the Company beginning January 1, 2018. The reclassifications are presented within the Consolidated Statement of Changes in Stockholders’ Equity for the affected transitional periods.

 

The following tables present significant amounts reclassified from or to each component of accumulated other comprehensive income:

 

 

(a)

For unrealized gains on available-for-sale securities, amounts in parentheses indicate expenses and other amounts indicate income.

 

 

 

NOTE 7 – INVESTMENT AND EQUITY SECURITIES

 

The amortized cost and fair values of investment securities are as follows:

 

 

 

The following table presents the carrying amount of the Company’s equity investments without readily determinable fair values the annual and cumulative amount of impairment, and the annual and cumulative amount of observable price changes for orderly transactions for the identical or a similar investment of the same issuer:

 

 

 

The following table presents the net gains and losses on the Company’s equity investments recognized in earnings during the three months ended March 31, 2018, and the portion of unrealized gains and losses for the period that relates to equity investments held at March 31, 2018.

 

 

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

 

 

Proceeds from the sales of investment securities and the gross realized gains and losses are as follows:

 

 

⁽¹⁾ Prior to the acquisition of Liberty Bank, N.A., the Company had a previously held equity interest in Liberty which was re-measured at fair value on the acquisition date and resulted in a gain of $488,000, which was recorded in Equity Securities, Unrealized Gains on the consolidated Income Statement for the three months ended March 31, 2017.

 

Investment securities with an approximate carrying value of $61.7 million and $57.9 million at March 31, 2018 and December 31, 2017, respectively, were pledged to secure deposits and other purposes as required by law.

 

The following tables show the Company’s gross unrealized losses and fair value, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position.

 

 

 

 

There were 82 securities considered temporarily impaired at March 31, 2018.

 

On a quarterly basis, the Company performs an assessment to determine whether there have been any events or economic circumstances indicating that a security with an unrealized loss has suffered other-than-temporary impairment (“OTTI”). A debt security is considered impaired if the fair value is less than its amortized cost basis at the reporting date. The Company assesses whether the unrealized loss is other than temporary.

 

OTTI losses are recognized in earnings when the Company has the intent to sell the debt security or it is more likely than not that it will be required to sell the debt security before recovery of its amortized cost basis. However, even if the Company does not expect to sell a debt security, it must evaluate expected cash flows to be received and determine if a credit loss has occurred.

 

An unrealized loss is generally deemed to be other than temporary and a credit loss is deemed to exist if the present value of the expected future cash flows is less than the amortized cost basis of the debt security. As a result, the credit loss of an OTTI is recorded as a component of investment securities gains (losses) in the accompanying Consolidated Statement of Income, while the remaining portion of the impairment loss is recognized in other comprehensive income, provided the Company does not intend to sell the underlying debt security and it is “more likely than not” that the Company will not have to sell the debt security prior to recovery.

 

Debt securities issued by U.S. government agencies, U.S. government-sponsored enterprises, and state and political subdivisions accounted for 100% of the total available-for-sale portfolio as of March 31, 2018 and no credit losses are expected, given the explicit and implicit guarantees provided by the U.S. federal government and the lack of prolonged unrealized loss positions within the obligations of state and political subdivisions security portfolio. The Company considers the following factors in determining whether a credit loss exists and the period over which the debt security is expected to recover:

 

	•	The length of time and the extent to which the fair value has been less than the amortized cost basis.
	•	Changes in the near-term prospects of the underlying collateral of a security such as changes in default rates, loss severity given default and significant changes in prepayment assumptions;
	•	The level of cash flows generated from the underlying collateral supporting the principal and interest payments of the debt securities; and,
	•	Any adverse change to the credit conditions and liquidity of the issuer, taking into consideration the latest information available about the overall financial condition of the issuer, credit ratings, recent legislation and government actions affecting the issuer’s industry and actions taken by the issuer to deal with the present economic climate.

 

For the three months ended March 31, 2018 and 2017, there were no available-for-sale debt securities with an unrealized loss that suffered OTTI. Management does not believe any individual unrealized loss as of March 31, 2018 or December 31, 2017 represented an other-than-temporary impairment. The unrealized losses on debt securities are primarily the result of interest rate changes. These conditions will not prohibit the Company from receiving its contractual principal and interest payments on these debt securities. The fair value of these debt securities is expected to recover as payments are received on these securities and they approach maturity. Should the impairment of any of these securities become other than temporary, the cost basis of the investment will be reduced and the resulting loss recognized in net income in the period the other-than-temporary impairment is identified.

 

 

 

NOTE 8 - LOANS AND RELATED ALLOWANCE FOR LOAN AND LEASE LOSSES

 

Major classifications of loans are summarized as follows (in thousands):

 

 

The amounts above include deferred loan origination costs of $1.5 million at both March 31, 2018 and December 31, 2017.

 

The Company’s primary business activity is with customers located within its local Northeastern Ohio trade area, eastern Geauga County, and contiguous counties to the north, east, and south. The Company also serves the central Ohio market with offices in Dublin, Sunbury and Westerville, Ohio. Commercial, residential, consumer, and agricultural loans are granted. Although the Company has a diversified loan portfolio, loans outstanding to individuals and businesses are dependent upon the local economic conditions in the Company’s immediate trade area.

 

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff generally are reported at their outstanding unpaid principal balances net of the allowance for loan and lease losses. Interest income is recognized on the accrual method. The accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions, the borrower’s financial condition is such that collection of interest is doubtful. Interest received on nonaccrual loans is recorded as income or applied against principal according to management’s judgment as to the collectability of such principal.

 

Loan origination fees and certain direct loan origination costs are deferred with the net amount amortized over the contractual life of the loan as an adjustment of the related loan’s yield.

 

The following tables summarize the primary segments of the loan portfolio and allowance for loan and lease losses (in thousands):

 

 

 

 

 

 

 

The Company’s loan portfolio is segmented to a level that allows management to monitor risk and performance. The portfolio is segmented into Commercial and Industrial (“C&I”), Real Estate Construction, Real Estate - Mortgage which is further segmented into Residential and Commercial real estate (“CRE”), and Consumer Installment Loans. The C&I loan segment consists of loans made for the purpose of financing the activities of commercial customers. The residential mortgage loan segment consists of loans made for the purpose of financing the activities of residential homeowners. The commercial mortgage loan segment consists of loans made for the purpose of financing the activities of commercial real estate owners and operators. The consumer loan segment consists primarily of installment loans and overdraft lines of credit connected with customer deposit accounts. The increases in the allowance for loan loss for C&I, Residential, CRE, and Consumer Installment loan portfolios were partially offset by a decrease in the allowance for the Real Estate Construction portfolio.

 

Management evaluates individual loans in all of the commercial segments for possible impairment based on guidance established by the Board of Directors. Loans are considered to be impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement.  Factors considered by management in evaluating impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. The Company does not separately evaluate individual consumer and residential mortgage loans for impairment, unless such loans are part of a larger relationship that is impaired, or the loan was modified in a troubled debt restructuring.

 

Once the determination has been made that a loan is impaired, the determination of whether a specific allocation of the allowance is necessary is measured by comparing the recorded investment in the loan to the fair value of the loan using one of the following methods: (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 collateral less selling costs. The method is selected on a loan-by-loan basis, with management primarily utilizing the fair value of collateral method. The evaluation of the need and amount of a specific allocation of the allowance and whether a loan can be removed from impairment status is made on a quarterly basis. The Company’s policy for recognizing interest income on impaired loans does not differ from its overall policy for interest recognition.

 

 

The following tables present impaired loans by class, segregated by those for which a specific allowance was required and those for which a specific allowance was not necessary (in thousands):

 

 

 

 

The tables above include troubled debt restructuring totaling $9.1 million at March 31, 2018 and $5.4 million as of December 31, 2017.

 

The following tables present the average balance and interest income by class, recognized on impaired loans (in thousands):

 

 

 

Management uses a nine-point internal risk-rating system to monitor the credit quality of the overall loan portfolio. The first five categories are considered not criticized and are aggregated as Pass rated. The criticized rating categories utilized by management generally follow bank regulatory definitions. The Special Mention category includes assets that are currently protected but are potentially weak, resulting in an undue and unwarranted credit risk, but not to the point of justifying a Substandard classification.  Loans in the Substandard category have well-defined weaknesses that jeopardize the liquidation of the debt and have a distinct possibility that some loss will be sustained if the weaknesses are not corrected.  All loans greater than 90 days past due are considered Substandard. Any portion of a loan that has been charged off is placed in the Loss category.  

 

To help ensure that risk ratings are accurate and reflect the present and future capacity of borrowers to repay a loan as agreed, the Company has a structured loan-rating process with several layers of internal and external oversight.  Generally, consumer and residential mortgage loans are included in the Pass categories unless a specific action, such as bankruptcy, repossession, or death, occurs to raise awareness of a possible credit event.  The Company’s Commercial Loan Officers are responsible for the timely and accurate risk rating of the loans in their portfolios at origination and on an ongoing basis with the Chief Credit Officer ultimately responsible for accurate and timely risk ratings.  The Credit Department performs an annual review of all commercial relationships with loan balances of $1,000,000 or greater.  Confirmation of the appropriate risk grade is included in the review on an ongoing basis.  The Company engages an external consultant to conduct loan reviews on a semiannual basis. Generally, the external consultant reviews commercial relationships greater than $250,000 and/or criticized relationships greater than $125,000.  Detailed reviews, including plans for resolution, are performed on loans classified as Substandard on a quarterly basis.  Loans in the Special Mention and Substandard categories that are collectively evaluated for impairment are given separate consideration in the determination of the allowance.

 

The primary risk of commercial and industrial loans is the current economic uncertainties. C&I loans are, by nature, secured by less substantial collateral than real estate-secured loans. The primary risk of real estate construction loans is potential delays and disputes during the completion process. The primary risk of residential real estate loans is current economic uncertainties along with the slow recovery in the housing market. The primary risk of commercial real estate loans is loss of income of the owner or occupier of the property and the inability of the market to sustain rent levels. Consumer installment loans historically have experienced higher delinquency rates. Consumer installments are typically secured by less substantial collateral than other types of credits.

 

The following tables present the classes of the loan portfolio summarized by the aggregate Pass and the criticized categories of Special Mention, Substandard and Doubtful within the internal risk-rating system (in thousands):

 

 

 

 

The increase in the amount classified as special mention for commercial and industrial loans for the three-month period ended March 31, 2018 is due to a large relationship of $5.8 million being reclassified as a troubled debt restructuring (TDR).

 

Management further monitors the performance and credit quality of the loan portfolio by analyzing the age of the portfolio as determined by the length of time a recorded payment is past due.

 

Nonperforming assets include nonaccrual loans, TDRs, loans 90 days or more past due, EMORECO assets, other real estate owned, and repossessed assets. A loan is classified as nonaccrual when, in the opinion of management, there are serious doubts about collectability of interest and principal. Accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions, the borrower’s financial condition is such that collection of principal and interest is doubtful.  Payments received on nonaccrual loans are applied against the principal balance.

 

The following tables present the classes of the loan portfolio summarized by the aging categories of performing loans (in thousands):

 

 

 

 

The following tables present the classes of the loan portfolio summarized by nonaccrual loans (in thousands):

 

 

 

Interest income that would have been recorded had these loans not been placed on nonaccrual status was $369,000 for the three months ended March 31, 2018 and $437,000 for the year ended December 31, 2017.

 

An allowance for loan and lease losses (“ALLL”) is maintained to absorb losses from the loan portfolio.  The ALLL is based on management’s continuing evaluation of the risk characteristics and credit quality of the loan portfolio, assessment of current economic conditions, diversification and size of the portfolio, adequacy of collateral, past and anticipated loss experience, and the amount of nonperforming loans.

 

The Company’s methodology for determining the ALLL is based on the requirements of ASC Section 310-10-35 for loans individually evaluated for impairment (discussed above) and ASC Subtopic 450-20 for loans collectively evaluated for impairment, as well as the Interagency Policy Statements on the Allowance for Loan and Lease Losses and other bank regulatory guidance. The total of the two components represents the Company’s ALLL. Management also performs impairment analyses on TDRs, which may result in specific reserves.

 

Loans that are collectively evaluated for impairment are analyzed with general allowances being made as appropriate.  For general allowances, historical loss trends are used in the estimation of losses in the current portfolio.  These historical loss amounts are modified by other qualitative factors.

 

The classes described above, which are based on the purpose code assigned to each loan, provide the starting point for the ALLL analysis.  Management tracks the historical net charge-off activity at the purpose code level. The historical charge-off factor was calculated using the last twelve consecutive historical quarters.

 

Management has identified a number of additional qualitative factors which it uses to supplement the historical charge-off factor because these factors are likely to cause estimated credit losses associated with the existing loan pools to differ from historical loss experience. The additional factors that are evaluated quarterly and updated using information obtained from internal, regulatory, and governmental sources are: national and local economic trends and conditions; levels of and trends in delinquency rates and nonaccrual loans; trends in volumes and terms of loans; effects of changes in lending policies; experience, ability, and depth of lending staff; value of underlying collateral; and concentrations of credit from a loan type, industry and/or geographic standpoint.

 

 

Management reviews the loan portfolio on a quarterly basis using a defined, consistently applied process in order to make appropriate and timely adjustments to the ALLL. When information confirms all or part of specific loans to be uncollectible, these amounts are promptly charged off against the ALLL.

 

The following tables summarize the primary segments of the loan portfolio (in thousands):

 

 

 

The negative provision allocated to real estate construction loans in the amount of $238,000 for the three-month period ended March 31, 2018 is due to the historical loss rate for the real estate construction pool changing to -0.127% from 0.775% for this time period in the prior year.     

 

The negative provision allocated to residential real estate loans in the amount of $234,000 for the three-month period ended March 31, 2017 is due to the payoff of a large residential credit during that period.

 

The following tables summarize troubled debt restructurings (in thousands):

 

 

 

There were no subsequent defaults of troubled debt restructurings for the three months ended March 31, 2018. One residential real estate contract with a recorded investment of $33,000 had subsequently defaulted for the three-month period ended March 31, 2017.