MIDDLEFIELD BANC CORP - Quarter Report: 2019 March (Form 10-Q)

 

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		March 31,				December 31,
		2019				2018
ASSETS
Cash and cash equivalents		$	121,045			$	107,933
Equity securities, at fair value			674				616
Investment securities available for sale, at fair value			98,114				98,322
Loans held for sale			1,230				597
Loans			1,004,484				992,109
Less allowance for loan and lease losses			7,206				7,428
Net loans			997,278				984,681
Premises and equipment, net			15,741				13,003
Goodwill			15,071				15,071
Core deposit intangibles			2,312				2,397
Bank-owned life insurance			16,185				16,080
Accrued interest receivable and other assets			13,285				9,698
TOTAL ASSETS		$	1,280,935			$	1,248,398
LIABILITIES
Deposits:
Noninterest-bearing demand		$	194,298			$	203,410
Interest-bearing demand			107,246				92,104
Money market			178,668				196,685
Savings			184,662				222,954
Time			375,357				300,914
Total deposits			1,040,231				1,016,067
Short-term borrowings:
Federal funds purchased			-				398
Federal Home Loan Bank advances			91,000				90,000
Total short-term borrowings			91,000				90,398
Other borrowings			11,518				8,803
Accrued interest payable and other liabilities			6,487				4,840
TOTAL LIABILITIES			1,149,236				1,120,108
STOCKHOLDERS' EQUITY
Common stock, no par value; 10,000,000 shares authorized, 3,642,535 and 3,630,497 shares issued; 3,256,370 and 3,244,332 shares outstanding			86,437				85,925
Retained earnings			58,139				56,037
Accumulated other comprehensive income (loss)			641				(154	)
Treasury stock, at cost; 386,165 shares			(13,518	)			(13,518	)
TOTAL STOCKHOLDERS' EQUITY			131,699				128,290
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY		$	1,280,935			$	1,248,398

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		Three Months Ended
		March 31,
		2019				2018
INTEREST AND DIVIDEND INCOME
Interest and fees on loans		$	12,510			$	11,054
Interest-earning deposits in other institutions			187				119
Federal funds sold			7				14
Investment securities:
Taxable interest			179				169
Tax-exempt interest			565				525
Dividends on stock			58				59
Total interest and dividend income			13,506				11,940
INTEREST EXPENSE
Deposits			2,945				1,640
Short-term borrowings			213				276
Other borrowings			96				122
Total interest expense			3,254				2,038
NET INTEREST INCOME			10,252				9,902
Provision for loan losses			240				210
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES			10,012				9,692
NONINTEREST INCOME
Service charges on deposit accounts			508				453
Gain on equity securities			58				18
Earnings on bank-owned life insurance			105				112
Gain on sale of loans			37				4
Other income			402				199
Total noninterest income			1,110				786
NONINTEREST EXPENSE
Salaries and employee benefits			4,124				3,979
Occupancy expense			553				536
Equipment expense			235				233
Data processing costs			465				477
Ohio state franchise tax			259				115
Federal deposit insurance expense			130				150
Professional fees			431				445
Advertising expense			203				228
Software amortization expense			145				150
Core deposit intangible amortization			85				91
Other expense			870				941
Total noninterest expense			7,500				7,345
Income before income taxes			3,622				3,133
Income taxes			611				528
NET INCOME		$	3,011			$	2,605
EARNINGS PER SHARE
Basic		$	0.93			$	0.81
Diluted		$	0.92			$	0.80

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		Three Months Ended
		March 31,
		2019				2018
Net income		$	3,011			$	2,605
Other comprehensive income (loss):
Net unrealized holding gain (loss) on available-for-sale investment securities			1,006				(1,912	)
Tax effect			(211	)			402
Total other comprehensive income (loss)			795				(1,510	)
Comprehensive income		$	3,806			$	1,095

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														Accumulated
														Other								Total
		Common Stock								Retained				Comprehensive				Treasury				Stockholders'
		Shares				Amount				Earnings				Income (Loss)				Stock				Equity
Balance, December 31, 2018			3,630,497			$	85,925			$	56,037			$	(154	)		$	(13,518	)		$	128,290
Net income											3,011												3,011
Other comprehensive income															795								795
Dividend reinvestment and purchase plan			4,522				196																196
Stock-based compensation, net			7,516				316																316
Cash dividends ($0.28 per share)											(909	)											(909	)
Balance, March 31, 2019			3,642,535			$	86,437			$	58,139			$	641			$	(13,518	)		$	131,699

														Accumulated
														Other								Total
		Common Stock								Retained				Comprehensive				Treasury				Stockholders'
		Shares				Amount				Earnings				Income (Loss)				Stock				Equity
Balance, December 31, 2017			3,603,881			$	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				161																161
Stock-based compensation, net			1,990				96																96
Cash dividends ($0.33 per share)											(1,063	)											(1,063	)
Balance, March 31, 2018			3,609,149			$	85,116			$	48,927			$	(373	)		$	(13,518	)		$	120,152

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		Three Months Ended
		March 31,
		2019				2018
OPERATING ACTIVITIES
Net income		$	3,011			$	2,605
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses			240				210
Gain on equity securities			(58	)			(18	)
Depreciation and amortization of premises and equipment, net			259				231
Software amortization expense			145				150
Financing lease amortization expense			69				-
Amortization of premium and discount on investment securities, net			94				104
Accretion of deferred loan fees, net			(259	)			(341	)
Amortization of core deposit intangibles			85				91
Stock-based compensation expense			186				96
Restricted stock cash portion			(44	)			-
Origination of loans held for sale			(2,556	)			(1,783	)
Proceeds from sale of loans			1,960				1,313
Gain on sale of loans			(37	)			(4	)
Earnings on bank-owned life insurance			(105	)			(112	)
Deferred income tax			295				131
Net gain on other real estate owned			(43	)			-
(Increase) decrease in accrued interest receivable			(200	)			19
Increase (decrease) in accrued interest payable			192				(5	)
Other, net			(2,553	)			(737	)
Net cash provided by operating activities			681				1,950
INVESTING ACTIVITIES
Investment securities available for sale:
Proceeds from repayments and maturities			3,799				1,380
Purchases			(2,679	)			-
Increase in loans, net			(12,616	)			(8,669	)
Proceeds from the sale of other real estate owned			225				-
Purchase of premises and equipment			(295	)			(603	)
Purchase of restricted stock			-				(90	)
Net cash used in investing activities			(11,566	)			(7,982	)
FINANCING ACTIVITIES
Net increase in deposits			24,164				66,379
Increase (decrease) in short-term borrowings, net			602				(56,036	)
Repayment of other borrowings			(56	)			(10,037	)
Proceeds from dividend reinvestment and purchase plan			196				161
Cash dividends			(909	)			(1,063	)
Net cash provided by (used in) financing activities			23,997				(596	)
Increase (decrease) in cash and cash equivalents			13,112				(6,628	)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD			107,933				39,886
CASH AND CASH EQUIVALENTS AT END OF PERIOD		$	121,045			$	33,258

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		Three Months Ended
		March 31,
		2019				2018
SUPPLEMENTAL INFORMATION
Cash paid during the year for:
Interest on deposits and borrowings		$	3,062			$	2,043
Noncash operating transactions:
Operating lease assets added to other, net		$	(2,101	)		$	-
Operating lease liabilities added to other, net			2,101				-
Noncash investing transactions:
Transfers from loans to other real estate owned		$	38			$	-
Transfer of equity securities from investment securities available for sale, at fair value			-				(625	)
Finance lease assets added to premises and equipment			(2,771	)			-
Noncash financing transactions:
Finance lease liabilities added to borrowed funds		$	2,771			$	-

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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.

 

On March 13, 2019, MBC established a wholly owned subsidiary named Middlefield Investments, Inc. (MII), headquartered in Middlefield, Ohio. This operating subsidiary exists to hold and manage a portion of MBC’s investment portfolio. At March 31, 2019, MII’s assets consist of one cash account. MII may only hold and manage investments for MBC, and may not engage in any other activity without prior approval of the Ohio Division of Financial Institutions. All significant inter-company items have been eliminated between MBC and this subsidiary.

 

The unaudited condensed consolidated financial statements have been prepared in conformity with the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles (“GAAP”) for complete financial statements.  The financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Form 10-K for the year ended December 31, 2018.  The interim consolidated financial statements include all adjustments (consisting of only normal recurring items) that, in the opinion of management, are necessary for a fair presentation of the financial position and results of operations for the periods presented.  The results of operations for the interim periods disclosed herein are not necessarily indicative of the results that may be expected for a full year.  

 

Recently Adopted 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.  On January 1, 2019, the Company adopted ASU 2016-02 which resulted in the recording of finance lease assets and liabilities of $2.8 million and operating lease assets and liabilities of $2.1 million on the Consolidated Balance Sheet.  See Note 9 to the financial statements.

 

Recently Issued Accounting Pronouncements –

 

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. The CECL model has been completed by the Company and runs concurrently with the existing incurred loss model each month.  Management continues monitoring model output, with final assumption changes expected to be made in the third quarter.  Management anticipates the model to be validated by a third-party by December 31, 2019.

 

 

 

NOTE 2 – REVENUE RECOGNITION

 

In accordance with ASC Topic 606, 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. These revenue sources cumulatively comprise 92.0% 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 customer requests or activities 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 and the payment terms, that the contract has a true commercial substance and that amounts due from the buyer are 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, 2019 and 2018.

 

Stock option activity during the three months ended March 31, 2019 is as follows:

 

 

 

The following table presents the activity during the three months ended March 31, 2019 related to awards of restricted stock:

 

 

The Company recognizes restricted stock forfeitures in the period they occur.

 

Share-based compensation expense of $90,000 and $55,000 was recognized for the three-month periods ended March 31, 2019 and 2018, respectively. Since the shares of restricted stock are historically paid out at the vesting date in a combination of shares and cash, the Company has recorded a liability related to this plan which totals $236,000 and $426,000 at March 31, 2019 and 2018, respectively.

 

The expected remaining compensation expense that will be recognized on restricted stock totals $351,000, of which $113,000 will be recognized in 2019, $110,000 will be recognized in 2020, $110,000 will be recognized in 2021, and $18,000 will be recognized in 2022.

 

 

 

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 and restricted stock 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 7,450 shares of common stock at $17.55 per share, were outstanding during the three months ended March 31, 2019. Also outstanding were 30,667 shares of restricted stock. None of the outstanding options or restricted stock were anti-dilutive.

 

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.

 

 

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 establishes 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.

 

This hierarchy requires the use of observable market data when available.

 

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.

 

 

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. No such devaluation occurred in the three months ended March 31, 2019.

 

 

 

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 above 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 above table as it is not currently being carried at its fair value. The fair values in the above table exclude estimated selling costs of $1.8 million and $492,000 as of March 31, 2019 and December 31, 2018, respectively.

 

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:

 

 

 

 

All financial instruments included in the above tables, with the exception of net loans, deposits, and other borrowings, are carried at cost, which approximates the fair value of the instrument.

 

 

 

NOTE 6 – ACCUMULATED OTHER COMPREHENSIVE INCOME

 

The following table presents the changes in accumulated other comprehensive income (loss) (“AOCI”) by component net of tax for the three months ended March 31, 2019 and 2018, respectively:

 

 

(a)

All amounts are net of tax. Amounts in parentheses indicate debits to AOCI.

(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.

 

There were no other reclassifications of amounts from accumulated other comprehensive income for the three months ended March 31, 2019 and 2018.

 

NOTE 7 – INVESTMENT AND EQUITY SECURITIES

 

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

 

 

 

 

The Company recognized net gains on equity investments of $58,000 and $18,000 for the three months ended March 31, 2019 and 2018, respectively. No net gains on sold equity securities were realized during this period.

 

The amortized cost and fair value of debt securities at March 31, 2019, 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.

 

 

There were no securities sold during the three months ended March 31, 2019 and 2018, respectively.

 

Investment securities with an approximate carrying value of $59.5 million and $63.5 million at March 31, 2019 and December 31, 2018, respectively, were pledged to secure deposits and for 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 39 securities considered temporarily impaired at March 31, 2019.

 

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, 2019 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 the 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, 2019 and 2018, 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, 2019 or December 31, 2018 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 $1.4 million and $1.6 million at March 31, 2019 and December 31, 2018.

 

The Company’s primary business activity is with customers located within its local Northeastern Ohio trade area, eastern Geauga County, and contiguous counties. The Company also serves the central Ohio market with offices in Dublin, Sunbury, Westerville, and Powell, 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 payments received on nonaccrual loans are applied against the unpaid principal balance until accrual status is restored.

 

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, Real Estate Construction, Residential, and CRE portfolios were partially offset by a decrease in the allowance for the Consumer Installment 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 present value of expected cash flows. 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 $3.8 million as of March 31, 2019 and $4.4 million as of December 31, 2018.

 

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.  The Credit Department performs an annual review of all commercial relationships with loan balances of $500,000 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 related to deterioration in the value of collateral securing the loan should foreclosure become necessary. 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):

 

 

 

 

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 are nonaccrual loans including nonaccrual 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 aging of the recorded investment in past-due loans by class of loans (in thousands):

 

 

 

The following tables present the recorded investment in non-accrual loans and loans past due over 89 days still on accrual by class of loans (in thousands):

 

 

 

 

Interest income that would have been recorded had these loans not been placed on nonaccrual status was $91,000 for the three months ended March 31, 2019 and $456,000 for the year ended December 31, 2018.

 

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 Statement 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 and the activity within those segments (in thousands):

 

 

 

 

The provision fluctuations during the three-month period ended March 31, 2019 allocated to:

●

commercial and industrial loans are due to the charge-off of a large relationship of $336,000 from a previous reserve of $358,000.

●

real estate construction loans are due to the addition of a large loan requiring a reserve of $661,000.

●

commercial real estate loans are due to the payoff of one relationship that had a previous reserve balance of $435,000.

 

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

 

 

There were no troubled debt restructurings during the three months ended March 31, 2019.

 

There were no subsequent defaults of troubled debt restructurings for the three months ended March 31, 2019 and March 31, 2018.