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NATIONAL BANKSHARES INC - Quarter Report: 2014 September (Form 10-Q)

nksh20140930_10q.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

 

FORM 10-Q

 

[x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT   OF 1934

For the quarterly period ended September 30, 2014

[  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from ________ to ________

Commission File Number 0-15204

 

NATIONAL BANKSHARES, INC.

 (Exact name of registrant as specified in its charter)

 

Virginia

(State or other jurisdiction of incorporation or organization)

54-1375874

(I.R.S. Employer Identification No.)

 

101 Hubbard Street

P. O. Box 90002

Blacksburg, VA

 

 

24062-9002

(Address of principal executive offices)

(Zip Code)

 

(540) 951-6300

(Registrant’s telephone number, including area code)

 

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

 

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

 

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

 

 Large accelerated filer  [  ]

 Accelerated filer  [x]

 Non-accelerated filer  [  ]

  Smaller reporting company  [  ]

    (Do not check if a smaller reporting company)

 

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

[ ] Yes   [x] No

 

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

 

Class

Common Stock, $1.25 Par Value

Outstanding at October 31, 2014

6,950,474

 

(This report contains 56 pages)

 

 
 

 

 

NATIONAL BANKSHARES, INC. AND SUBSIDIARIES

Form 10-Q

Index

 

Part I – Financial Information

Page

     

Item 1

Financial Statements

3

     
 

Consolidated Balance Sheets, September 30, 2014 (Unaudited) and December 31, 2013

3

     
 

Consolidated Statements of Income for the Three Months Ended September 30, 2014 and 2013 (Unaudited)

4

     
 

Consolidated Statements of Comprehensive Income (Loss) for the Three Months Ended September 30, 2014 and 2013 (Unaudited)

5

     
 

Consolidated Statements of Income for the Nine Months Ended September 30, 2014 and 2013 (Unaudited)

6

     
 

Consolidated Statements of Comprehensive Income (Loss) for the Nine Months Ended September 30, 2014 and 2013 (Unaudited)

7

     
 

Consolidated Statements of Changes in Stockholders’ Equity for the Nine Months Ended September 30, 2014 and 2013 (Unaudited)

8

 

 

 
 

Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2014 and 2013 (Unaudited)

9

 

 

 
 

Notes to Consolidated Financial Statements (Unaudited) 

10 - 33

     

Item 2

Management’s Discussion and Analysis of Financial Condition and Results of Operations

34 - 46

     

Item 3

Quantitative and Qualitative Disclosures About Market Risk  

46

     

Item 4

Controls and Procedures

47

     

Part II – Other Information

 
     

Item 1

Legal Proceedings

47

     

Item 1A

Risk Factors

47

     

Item 2

Unregistered Sales of Equity Securities and Use of Proceeds 

47

     

Item 3

Defaults Upon Senior Securities

47

 

 

 

Item 4

Mine Safety Disclosures

47

 

 

 

Item 5

Other Information

47 - 48

     

Item 6

Exhibits 

48

     

Signatures

48

     

Index of Exhibits

49 - 50

     

Certifications

51 - 54

 

 
2

 

 

Part I

Item1.  Financial Statements 

Financial Information

 

National Bankshares, Inc. and Subsidiaries

Consolidated Balance Sheets

 

   

(Unaudited)

         
   

September 30,

   

December 31,

 

$ in thousands, except per share data

 

2014

   

2013

 

Assets

               

Cash and due from banks

  $ 12,815     $ 13,283  

Interest-bearing deposits

    87,621       98,066  

Securities available for sale, at fair value

    205,020       181,712  

Securities held to maturity (fair value approximates $167,409 at September 30, 2014 and $159,337 at December 31, 2013)

    162,457       163,983  

Restricted stock, at cost

    1,089       1,414  

Mortgage loans held for sale

    725       1,276  

Loans:

               

Loans, net of unearned income and deferred fees

    595,801       595,690  

Less allowance for loan losses

    (8,031

)

    (8,227

)

Loans, net

    587,770       587,463  

Premises and equipment, net

    9,445       9,951  

Accrued interest receivable

    5,708       5,949  

Other real estate owned, net

    5,145       4,712  

Intangible assets and goodwill

    7,492       8,299  

Bank-owned life insurance

    21,643       21,181  

Other assets

    9,329       13,341  

Total assets

  $ 1,116,259     $ 1,110,630  
                 

Liabilities and Stockholders' Equity

               

Noninterest-bearing demand deposits

  $ 153,118     $ 142,645  

Interest-bearing demand deposits

    492,005       501,541  

Savings deposits

    79,870       74,141  

Time deposits

    223,930       241,709  

Total deposits

    948,923       960,036  

Accrued interest payable

    67       92  

Other liabilities

    4,447       4,610  

Total liabilities

    953,437       964,738  

Commitments and contingencies

    ---       ---  

Stockholders' Equity

               

Preferred stock, no par value, 5,000,000 shares authorized; none issued and outstanding

    ---       ---  

Common stock of $1.25 par value. Authorized 10,000,000 shares; issued and outstanding 6,950,474 shares at September 30, 2014 and 6,947,974 at December 31, 2013

    8,688       8,685  

Retained earnings

    163,181       154,171  

Accumulated other comprehensive loss, net

    (9,047

)

    (16,964

)

Total stockholders' equity

    162,822       145,892  

Total liabilities and stockholders' equity

  $ 1,116,259     $ 1,110,630  

 

See accompanying notes to consolidated financial statements.

 

 
3

 

 

National Bankshares, Inc. and Subsidiaries

Consolidated Statements of Income

Three Months Ended September 30, 2014 and 2013

(Unaudited)

 

   

September 30,

   

September 30,

 

$ in thousands, except per share data

 

2014

   

2013

 

Interest Income

               

Interest and fees on loans

  $ 7,766     $ 8,196  

Interest on interest-bearing deposits

    64       45  

Interest on securities – taxable

    1,718       1,722  

Interest on securities – nontaxable

    1,436       1,581  

Total interest income

    10,984       11,544  
                 

Interest Expense

               

Interest on time deposits of $100 or more

    139       196  

Interest on other deposits

    1,008       1,192  

Total interest expense

    1,147       1,388  

Net interest income

    9,837       10,156  

Provision for loan losses

    356       303  

Net interest income after provision for loan losses

    9,481       9,853  
                 

Noninterest Income

               

Service charges on deposit accounts

    634       709  

Other service charges and fees

    42       37  

Credit card fees

    929       834  

Trust income

    296       267  

BOLI income

    174       182  

Other income

    163       183  

Realized securities gains (losses), net

    4       (62

)

Total noninterest income

    2,242       2,150  
                 

Noninterest Expense

               

Salaries and employee benefits

    2,948       3,031  

Occupancy and furniture and fixtures

    408       394  

Data processing and ATM

    426       477  

FDIC assessment

    147       136  

Credit card processing

    673       656  

Intangible assets amortization

    269       269  

Net costs of other real estate owned

    98       52  

Franchise taxes

    308       280  

Other operating expenses

    859       848  

Total noninterest expense

    6,136       6,143  

Income before income taxes

    5,587       5,860  

Income tax expense

    1,324       1,343  

Net Income

  $ 4,263     $ 4,517  

Basic net income per common share

  $ 0.61     $ 0.65  

Fully diluted net income per common share

  $ 0.61     $ 0.65  

Weighted average number of common shares outstanding – basic

    6,948,681       6,947,974  

Weighted average number of common shares outstanding – diluted

    6,956,777       6,972,769  

Dividends declared per common share

  $ ---     $ ---  

   

See accompanying notes to consolidated financial statements.

 

 
4

 

 

National Bankshares, Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income (Loss)

Three Months Ended September 30, 2014 and 2013

(Unaudited)

 

   

September 30,

   

September 30,

 

$ in thousands

 

2014

   

2013

 

Net Income

  $ 4,263     $ 4,517  
                 

Other Comprehensive Income (Loss), Net of Tax

               

Unrealized holding gains (losses) on available for sale securities net of tax of $919 and ($2,048) for the periods ended September 30, 2014 and 2013, respectively

    1,708       (3,804

)

Reclassification adjustment, net of tax of ($1) and $24 for the periods ended September 30, 2014 and 2013, respectively

    (3

)

    44  

Other comprehensive income (loss), net of tax of $918 and ($2,024) for the periods ended September 30, 2014 and 2013, respectively

    1,705       (3,760

)

Total Comprehensive Income

  $ 5,968     $ 757  

 

See accompanying notes to consolidated financial statements.

 

 
5

 

 

National Bankshares, Inc. and Subsidiaries

Consolidated Statements of Income

Nine Months Ended September 30, 2014 and 2013

(Unaudited)

 

   

September 30,

   

September 30,

 

$ in thousands, except per share data

 

2014

   

2013

 

Interest Income

               

Interest and fees on loans

  $ 23,520     $ 24,707  

Interest on interest-bearing deposits

    193       161  

Interest on securities – taxable

    5,068       4,928  

Interest on securities – nontaxable

    4,410       4,847  

Total interest income

    33,191       34,643  
                 

Interest Expense

               

Interest on time deposits of $100 or more

    437       694  

Interest on other deposits

    3,320       3,921  

Total interest expense

    3,757       4,615  

Net interest income

    29,434       30,028  

Provision for loan losses

    1,160       1,329  

Net interest income after provision for loan losses

    28,274       28,699  
                 

Noninterest Income

               

Service charges on deposit accounts

    1,833       1,922  

Other service charges and fees

    145       139  

Credit card fees

    2,687       2,427  

Trust income

    921       867  

BOLI income

    526       546  

Other income

    669       687  

Realized securities gains (losses), net

    5       (44

)

Total noninterest income

    6,786       6,544  
                 

Noninterest Expense

               

Salaries and employee benefits

    8,954       8,963  

Occupancy and furniture and fixtures

    1,265       1,230  

Data processing and ATM

    1,183       1,288  

FDIC assessment

    411       408  

Credit card processing

    1,887       1,854  

Intangible assets amortization

    807       809  

Net costs of other real estate owned

    259       192  

Franchise taxes

    874       803  

Other operating expenses

    2,738       2,697  

Total noninterest expense

    18,378       18,244  

Income before income taxes

    16,682       16,999  

Income tax expense

    3,906       3,831  

Net Income

  $ 12,776     $ 13,168  

Basic net income per common share

  $ 1.84     $ 1.90  

Fully diluted net income per common share

  $ 1.84     $ 1.89  

Weighted average number of common shares outstanding – basic

    6,948,212       6,947,974  

Weighted average number of common shares outstanding – diluted

    6,960,444       6,970,063  

Dividends declared per common share

  $ 0.55     $ 0.54  

 

See accompanying notes to consolidated financial statements. 

 

 
6

 

 

National Bankshares, Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income (Loss)

Nine Months Ended September 30, 2014 and 2013

(Unaudited)

 

   

September 30,

   

September 30,

 

$ in thousands

 

2014

   

2013

 

Net Income

  $ 12,776     $ 13,168  
                 

Other Comprehensive Income (Loss), Net of Tax

               

Unrealized holding gains (losses) on available for sale securities net of tax of $4,264 and ($7,142) for the periods ended September 30, 2014 and 2013, respectively

    7,920       (13,263

)

Reclassification adjustment, net of tax of ($1) and $18 for the periods ended September 30, 2014 and 2013, respectively

    (3

)

    32  

Other comprehensive income (loss), net of tax of $4,263 and ($7,123) for the periods ended September 30, 2014 and 2013, respectively

    7,917       (13,231

)

Total Comprehensive Income (Loss)

  $ 20,693     $ (63

)

 

See accompanying notes to consolidated financial statements.

 

 
7

 

  

National Bankshares, Inc. and Subsidiaries

Consolidated Statements of Changes in Stockholders’ Equity

Nine Months September 30, 2014 and 2013

(Unaudited)

 

$ in thousands

 

Common Stock

   

Retained Earnings

   

Accumulated Other Comprehensive Loss

   

Total

 

Balances at December 31, 2012

  $ 8,685     $ 144,162     $ (2,738

)

  $ 150,109  

Net income

    ---       13,168       ---       13,168  

Dividends $0.54 per share

    ---       (3,752

)

    ---       (3,752

)

Other comprehensive loss, net of tax( $7,123)

    ---       ---       (13,231

)

    (13,231

)

Balances at September 30, 2013

  $ 8,685     $ 153,578     $ (15,969

)

  $ 146,294  
                                 

Balances at December 31, 2013

  $ 8,685     $ 154,171     $ (16,964

)

  $ 145,892  

Net income

    ---       12,776       ---       12,776  

Dividends $0.55 per share

    ---       (3,821

)

    ---       (3,821

)

Exercise of stock options

    3       55               58  

Other comprehensive income, net of tax $4,263

    ---       ---       7,917       7,917  

Balances at September 30, 2014

  $ 8,688     $ 163,181     $ (9,047

)

  $ 162,822  

 

See accompanying notes to consolidated financial statements.

 

 
8

 

 

National Bankshares, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

Nine Months Ended September 30, 2014 and 2013

(Unaudited)

 

   

September 30,

   

September 30,

 

$ in thousands

 

2014

   

2013

 

Cash Flows from Operating Activities

               

Net income

  $ 12,776     $ 13,168  

Adjustments to reconcile net income to net cash provided by operating activities:

               

Provision for loan losses

    1,160       1,329  

Depreciation of bank premises and equipment

    541       546  

Amortization of intangibles

    807       809  

Amortization of premiums and accretion of discounts, net

    109       130  

Losses on disposal of fixed assets

    94       ---  

(Gains) losses on sales and calls of securities available for sale, net

    (4

)

    50  

Gains on calls of securities held to maturity, net

    (1

)

    (6

)

Losses and write-downs on other real estate owned, net

    76       92  

Increase in cash value of bank-owned life insurance

    (462

)

    (497

)

Net change in:

               

Mortgage loans held for sale

    551       2,179  

Accrued interest receivable

    241       203  

Other assets

    (252

)

    1,089  

Accrued interest payable

    (25

)

    (42

)

Other liabilities

    (163

)

    167  

Net cash provided by operating activities

    15,448       19,217  
                 

Cash Flows from Investing Activities

               

Net change interest-bearing deposits

    10,445       33,809  

Proceeds from calls, principal payments, sales and maturities of securities available for sale

    8,774       60,933  

Proceeds from calls, principal payments and maturities of securities held to maturity

    7,808       9,176  

Purchases of securities available for sale

    (19,906

)

    (83,993

)

Purchases of securities held to maturity

    (6,381

)

    (13,484

)

Net change in restricted stock

    325       275  

Purchases of loan participations

    ---       (900

)

Collections of loan participations

    1,513       127  

Loan originations and principal collections, net

    (4,030

)

    113  

Proceeds from disposal of other real estate owned

    329       848  

Recoveries on loans charged off

    212       92  

Proceeds from sale and purchases of bank premises and equipment, net

    (129

)

    (170

)

Net cash provided by (used in) investing activities

    (1,040

)

    6,826  

Cash Flows from Financing Activities

               

Net change in time deposits

    (17,779

)

    (29,164

)

Net change in other deposits

    6,666       5,896  

Cash dividends paid

    (3,821

)

    (3,752

)

Stock options exercised

    58       ---  

Net cash used in financing activities

    (14,876

)

    (27,020

)

Net change in cash and due from banks

    (468

)

    (977

)

Cash and due from banks at beginning of period

    13,283       14,783  

Cash and due from banks at end of period

  $ 12,815     $ 13,806  
                 

Supplemental Disclosures of Cash Flow Information

               

Interest paid on deposits and borrowed funds

  $ 3,782     $ 4,657  

Income taxes paid

    3,892       3,610  
                 

Supplemental Disclosure of Noncash Activities

               

Loans charged against the allowance for loan losses

  $ 1,568     $ 1,680  

Loans transferred to other real estate owned

    838       478  

Unrealized net gains (losses) on securities available for sale

    12,180       (20,356 )

  

See accompanying notes to consolidated financial statements.

 

 
9

 

 

National Bankshares, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

September 30, 2014

(Unaudited)

 

$ in thousands, except per share data

 

Note 1:   General

 

The consolidated financial statements of National Bankshares, Inc. (“NBI”) and its wholly-owned subsidiaries, The National Bank of Blacksburg (“NBB”) and National Bankshares Financial Services, Inc. (“NBFS”) (collectively, the “Company”), conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. The accompanying interim period consolidated financial statements are unaudited; however, in the opinion of management, all adjustments consisting of normal recurring adjustments, which are necessary for a fair presentation of the consolidated financial statements, have been included.  The results of operations for the nine months ended September 30, 2014 are not necessarily indicative of results of operations for the full year or any other interim period.  The interim period consolidated financial statements and financial information included in this Form 10-Q should be read in conjunction with the notes to consolidated financial statements included in the Company’s 2013 Form 10-K.  The Company posts all reports required to be filed under the Securities and Exchange Act of 1934 on its web site at www.nationalbankshares.com.

Subsequent events have been considered through the date when the Form 10-Q was issued.

 

Note 2:   Stock-Based Compensation

 

The Company’s 1999 Stock Option Plan was terminated on March 9, 2009. Incentive stock options were granted annually to key employees of NBI and its subsidiaries from 1999 to 2005 and none have been granted since 2005. All of the stock options are vested.

 

Options

 

Shares

   

Weighted
Average
Exercise
Price Per Share

   

Weighted
Average
Remaining
Contractual
Term

   


Aggregate
Intrinsic
Value

 

Outstanding at January 1, 2014

    46,000     $ 23.96                  

Exercised

    2,500       23.00                  

Forfeited or expired

    ---       ---                  

Outstanding September 30, 2014

    43,500     $ 24.02       0.58     $ 163  

Exercisable at September 30, 2014

    43,500     $ 24.02       0.58     $ 163  

 

There were 2,500 shares with an intrinsic value of $15 exercised during the first nine months of 2014. There were no shares exercised during the first nine months of 2013. As of September 30, 2014, there was no unrecognized compensation expense related to stock options.

 

 
10

 

 

Note 3:   Loan Portfolio

 

The loan portfolio, excluding loans held for sale, was comprised of the following.

 

   

September 30,

2014

   

December 31,

2013

 

Real estate construction

  $ 42,067     $ 45,925  

Consumer real estate

    144,312       145,499  

Commercial real estate

    312,937       311,266  

Commercial non real estate

    32,224       31,262  

Public sector and IDA

    36,398       34,220  

Consumer non real estate

    28,735       28,423  

Gross loans

    596,673       596,595  

Less unearned income and deferred fees

    (872

)

    (905

)

Loans, net of unearned income and deferred fees

  $ 595,801     $ 595,690  

 

Note 4:    Allowance for Loan Losses, Nonperforming Assets and Impaired Loans

 

The allowance for loan losses methodology incorporates individual evaluation of impaired loans and collective evaluation of groups of non-impaired loans. The Company performs ongoing analysis of the loan portfolio to determine credit quality and to identify impaired loans. Credit quality is rated based on the loan’s payment history, the borrower’s current financial situation and the value of the underlying collateral.

Impaired loans are those loans that have been modified in a troubled debt restructure (“TDR” or “restructure”) and larger, non-homogeneous loans that are in nonaccrual or exhibit payment history or financial status that indicate the probability that collection will not occur according to the loan’s original terms. Generally, impaired loans are given risk ratings that indicate higher risk, such as “classified” or “other assets especially mentioned.” Impaired loans are individually evaluated to determine appropriate reserves and are measured at the lower of the invested amount or the fair market value. Impaired loans that are not troubled debt restructures and for which fair value measurement indicates an impairment loss are designated nonaccrual. A troubled debt restructure with an impairment loss may accrue interest if the loan shows a satisfactory repayment history for at least six months. Please refer to Note 1 of the Company’s 2013 Form 10-K, “Summary of Significant Accounting Policies” for additional information on evaluation of impaired loans and associated specific reserves, and policies regarding nonaccruals, past due status and charge-offs.

Troubled debt restructures impact the estimation of the appropriate level of the allowance for loan losses. If the restructuring included forgiveness of a portion of principal, the charge-off is included in the historical charge-off rates applied to the collective evaluation methodology. Further, restructured loans are individually evaluated for impairment and any amount of book value that exceeds fair value is accrued in the allowance for loan losses. TDRs that experience a payment default are examined to determine whether the default indicates collateral dependency or a decline in estimates of cash flow used in the fair value measurement. TDRs, as well as all impaired loans, that are determined to be collateral dependent are charged down to fair value. Deficiencies indicated by impairment measurements for TDRs that are not collateral dependent may be accrued in the allowance for loan losses or charged off if deemed uncollectible.

The Company evaluated characteristics in the loan portfolio and determined major segments and smaller classes within each segment. These characteristics include collateral type, repayment sources, and (if applicable) the borrower’s business model. The methodology for calculating reserves for collectively-evaluated loans is applied at the class level.

 

 
11

 

 

Portfolio Segments and Classes

The segments and classes used in determining the allowance for loan losses are as follows.

 

Real Estate Construction

Construction, residential

Construction, other

Commercial Non Real Estate

Commercial and Industrial

 

Public Sector and IDA

Consumer Real Estate

Public sector and IDA

Equity lines

Residential closed-end first liens

Residential closed-end junior liens

Investor-owned residential real estate

 

Consumer Non Real Estate

Credit cards

Automobile

Other consumder loans

Commercial Real Estate

 

Multifamily real estate

Commercial real estate, owner-occupied

Commercial real estate, other

 

 

Historical Loss Rates

The Company’s allowance methodology for collectively-evaluated loans applies historical loss rates by class to current class balances as part of the process of determining required reserves. Class loss rates are calculated as the net charge-offs for the class as a percentage of average class balance. The loss rate for the current quarter is averaged with that of prior periods to obtain the historical loss rate. Two loss rates for each class are calculated: total net charge-offs for the class as a percentage of average class loan balance (“class loss rate”), and total net charge-offs for the class as a percentage of average classified loans in the class (“classified loss rate”). Classified loans are those with risk ratings of “substandard” or higher. Net charge-offs in both calculations include charge-offs and recoveries of classified and non-classified loans as well as those associated with impaired loans. Class historical loss rates are applied to non-classified loan balances at the reporting date, and classified historical loss rates are applied to classified balances at the reporting date.

 

Risk Factors

In addition to historical loss rates, risk factors pertinent to credit risk for each class are analyzed to estimate reserves for collectively-evaluated loans. Factors include changes in national and local economic and business conditions, the nature and volume of classes within the portfolio, loan quality, loan officers’ experience, lending policies and the Company’s loan review system.

The analysis of certain factors results in standard allocations to all segments and classes. These factors include loan officers’ average years of experience, the risk from changes in lending policies, and the risk from changes in loan review. Factors analyzed for each class, with resultant allocations based upon the level of risk assessed for each class, include levels of past due loans, nonaccrual loans, current class balance as a percentage of total loans, and the percentage of high risk loans (defined to be junior lien mortgages, high loan-to-value loans, and interest only loans) within the class. Additionally, factors specific to each segment are analyzed and result in allocations to the segment.

Real estate construction loans are subject to general risks from changing commercial building and housing market trends and economic conditions that may impact demand for completed properties and the costs of completion. These risks are measured by market-area unemployment rates, bankruptcy rates, housing and commercial building market trends, and interest rates.

The credit quality of consumer real estate is subject to risks associated with the borrower’s repayment ability and collateral value, measured generally by analyzing local unemployment and bankruptcy trends, local housing market trends, and interest rates.

The commercial real estate segment includes loans secured by multifamily residential real estate, commercial real estate occupied by the owner/borrower, and commercial real estate leased to non-owners. Loans in the commercial real estate segment are impacted by economic risks from changing commercial real estate markets, rental markets for multi-family housing and commercial buildings, business bankruptcy rates, local unemployment and interest rate trends that would impact the businesses housed by the commercial real estate.

Commercial non real estate loans are secured by collateral other than real estate, or are unsecured. Credit risk for commercial non real estate loans is subject to economic conditions, generally monitored by local business bankruptcy trends, and interest rates. Public sector and IDA loans are extended to municipalities and related entities. Credit risk is based upon the entity’s ability to repay and interest rate trends.

Consumer non real estate includes credit cards, automobile and other consumer loans. Credit cards and certain other consumer loans are unsecured, while collateral is obtained for automobile loans and other consumer loans. Credit risk stems primarily from the borrower’s ability to repay, measured by average unemployment, average personal bankruptcy rates and interest rates.

Factor allocations applied to each class are increased for loans rated special mention and classified. The Company allocates additional reserves for “high risk” loans.

 

 
12

 

 

A detailed analysis showing the allowance roll-forward by portfolio segment and related loan balance by segment follows.

 

   

Activity in the Allowance for Loan Losses for the Three Months Ended September 30, 2014

 
   

Real Estate Construction

   

Consumer Real Estate

   

Commercial Real Estate

   

Commercial Non Real Estate

   

Public Sector and IDA

   

Consumer Non Real Estate

   

Unallocated

   

Total

 

Balance, June 30, 2014

  $ 663     $ 1,554     $ 3,790     $ 1,056     $ 278     $ 552     $ 78     $ 7,971  

Charge-offs

    ---       (27

)

    (172

)

    ---       ---       (125

)

    ---       (324

)

Recoveries

    ---       ---       8       1       ---       19       ---       28  

Provision for loan losses

    (79

)

    151       49       7       2       163       63       356  

Balance, September 30, 2014

  $ 584     $ 1,678     $ 3,675     $ 1,064     $ 280     $ 609     $ 141     $ 8,031  

 

   

Activity in the Allowance for Loan Losses for the Nine Months Ended September 30, 2014

 
   

Real Estate Construction

   

Consumer Real Estate

   

Commercial Real Estate

   

Commercial Non Real Estate

   

Public Sector and IDA

   

Consumer Non Real Estate

   

Unallocated

   

Total

 

Balance, December 31, 2013

  $ 863     $ 1,697     $ 3,685     $ 989     $ 132     $ 576     $ 285     $ 8,227  

Charge-offs

    (2

)

    (97

)

    (1,115

)

    (79

)

    ---       (275

)

    ---       (1,568

)

Recoveries

    ---       ---       33       132       ---       47       ---       212  

Provision for loan losses

    (277

)

    78       1,072       22       148       261       (144

)

    1,160  

Balance, September 30, 2014

  $ 584     $ 1,678     $ 3,675     $ 1,064     $ 280     $ 609     $ 141     $ 8,031  

 

   

Activity in the Allowance for Loan Losses for the Three Months Ended September 30, 2013

 
   

Real Estate Construction

   

Consumer Real Estate

   

Commercial Real Estate

   

Commercial Non Real Estate

   

Public Sector and IDA

   

Consumer Non Real Estate

   

Unallocated

   

Total

 

Balance, June 30, 2013

  $ 1,032     $ 1,670     $ 3,029     $ 1,481     $ 111     $ 513     $ 116     $ 7,952  

Charge-offs

    ---       (120

)

    ---       (8

)

    ---       (68

)

    ---       (196

)

Recoveries

    ---       ---       8       2       ---       21       ---       31  

Provision for loan losses

    (11

)

    334       553       (472

)

    (6

)

    (59

)

    (36

)

    303  

Balance, September 30, 2013

  $ 1,021     $ 1,884     $ 3,590     $ 1,003     $ 105     $ 407     $ 80     $ 8,090  

 

   

Activity in the Allowance for Loan Losses for the Nine Months Ended September 30, 2013

 
   

Real Estate Construction

   

Consumer Real Estate

   

Commercial Real Estate

   

Commercial Non Real Estate

   

Public Sector and IDA

   

Consumer Non Real Estate

   

Unallocated

   

Total

 

Balance, December 31, 2012

  $ 1,070     $ 2,263     $ 3,442     $ 959     $ 142     $ 424     $ 49     $ 8,349  

Charge-offs

    (184

)

    (219

)

    (35

)

    (968

)

    ---       (274

)

    ---       (1,680

)

Recoveries

    ---       1       12       18       ---       61       ---       92  

Provision for loan losses

    135       (161

)

    171       994       (37

)

    196       31       1,329  

Balance, September 30, 2013

  $ 1,021     $ 1,884     $ 3,590     $ 1,003     $ 105     $ 407     $ 80     $ 8,090  

 

 
13

 

 

   

Allowance for Loan Losses as of September 30, 2014

 
   

Real Estate Construction

   

Consumer Real Estate

   

Commercial Real Estate

   

Commercial Non Real Estate

   

Public Sector and IDA

   

Consumer Non Real Estate

   

Unallocated

   

Total

 

Individually evaluated for impairment

  $ ---     $ 13     $ 281     $ 2     $ ---     $ ---     $ ---     $ 296  

Collectively evaluated for impairment

    584       1,665       3,394       1,062       280       609       141       7,735  

Total

  $ 584     $ 1,678     $ 3,675     $ 1,064     $ 280     $ 609     $ 141     $ 8,031  

 

   

Allowance for Loan Losses as of December 31, 2013

 
   

Real Estate Construction

   

Consumer Real Estate

   

Commercial Real Estate

   

Commercial Non Real Estate

    Public Sector and IDA    

Consumer Non Real Estate

   

Unallocated

   

Total

 

Individually evaluated for impairment

  $ ---     $ 10     $ 610     $ 4     $ ---     $ ---     $ ---     $ 624  

Collectively evaluated for impairment

    863       1,687       3,075       985       132       576       285       7,603  

Total

  $ 863     $ 1,697     $ 3,685     $ 989     $ 132     $ 576     $ 285     $ 8,227  

 

   

Loans as of September 30, 2014

 
   

Real Estate Construction

   

Consumer Real Estate

    Commercial Real Estate    

Commercial Non Real Estate

    Public Sector and IDA    

Consumer Non Real Estate

   

Unallocated

   

Total

 

Individually evaluated for impairment

  $ ---     $ 686     $ 13,804     $ 697     $ ---     $ ---     $ ---     $ 15,187  

Collectively evaluated for impairment

    42,067       143,626       299,133       31,527       36,398       28,735       ---       581,486  

Total loans

  $ 42,067     $ 144,312     $ 312,937     $ 32,224     $ 36,398     $ 28,735     $ ---     $ 596,673  

 

   

Loans as of December 31, 2013

 
   

Real Estate Construction

   

Consumer Real Estate

   

Commercial Real Estate

   

Commercial Non Real Estate

    Public Sector and IDA    

Consumer Non Real Estate

   

Unallocated

   

Total

 

Individually evaluated for impairment

  $ ---     $ 780     $ 12,079     $ 102     $ ---     $ 24     $ ---     $ 12,985  

Collectively evaluated for impairment

    45,925       144,719       299,187       31,160       34,220       28,399       ---       583,610  

Total

  $ 45,925     $ 145,499     $ 311,266     $ 31,262     $ 34,220     $ 28,423     $ ---     $ 596,595  

 

A summary of ratios for the allowance for loan losses follows.

 

   

Nine Months Ended

September 30,

   

Year Ended

December 31,

 
   

2014

   

2013

   

2013

 

Ratio of allowance for loan losses to the end of period loans, net of unearned income and deferred fees

    1.35

%

    1.37

%

    1.38

%

Ratio of net charge-offs to average loans, net of unearned income and deferred fees(1)

    0.31

%

    0.36

%

    0.28

%

 

(1)

Net charge-offs are on an annualized basis.

 

 
14

 

 

A summary of nonperforming assets follows.

 

   

September 30,

   

December 31,

 
   

2014

   

2013

   

2013

 

Nonperforming assets:

                       

Nonaccrual loans

  $ 5,366     $ 10,194     $ 5,732  

Restructured loans in nonaccrual

    2,360       1,042       852  

Total nonperforming loans

    7,726       11,236       6,584  

Other real estate owned, net

    5,145       973       4,712  

Total nonperforming assets

  $ 12,871     $ 12,209     $ 11,296  

Ratio of nonperforming assets to loans, net of unearned income and deferred fees, plus other real estate owned

    2.14

%

    2.06

%

    1.88

%

Ratio of allowance for loan losses to nonperforming loans(1)

    103.95

%

    72.00

%

    124.95

%

 

(1)     The Company defines nonperforming loans as nonaccrual loans. Loans 90 days or more past due and still accruing and accruing restructured loans are excluded.

 

A summary of loans past due 90 days or more and impaired loans follows.

 

   

September 30,

   

December 31,

 
   

2014

   

2013

   

2013

 

Loans past due 90 days or more and still accruing

  $ 485     $ 149     $ 190  

Ratio of loans past due 90 days or more and still accruing to loans, net of unearned income and deferred fees

    0.08

%

    0.03

%

    0.03

%

Accruing restructured loans

  $ 5,947     $ 6,545     $ 6,191  

Impaired loans:

                       

Impaired loans with no valuation allowance

  $ 9,223     $ 14,874     $ 10,372  

Impaired loans with a valuation allowance

    5,964       2,172       2,613  

Total impaired loans

  $ 15,187     $ 17,046     $ 12,985  

Valuation allowance

    (296

)

    (631

)

    (624

)

Impaired loans, net of allowance

  $ 14,891     $ 16,415     $ 12,361  

Average recorded investment in impaired loans(1)

  $ 15,974     $ 17,357     $ 16,654  

Interest income recognized on impaired loans, after designation as impaired

  $ 384     $ 159     $ 267  

Amount of income recognized on a cash basis

  $ ---     $ ---     $ ---  

 

(1)      Recorded investment is net of charge-offs and interest paid while a loan is in nonaccrual status.

 

Nonaccrual loans that meet the Company’s balance threshold of $250 and TDRs are designated as impaired. No interest income was recognized on nonaccrual loans for the nine months ended September 30, 2014 or September 30, 2013 or for the year ended December 31, 2013.

 

 
15

 

 

A detailed analysis of investment in impaired loans, associated reserves and interest income recognized, segregated by loan class follows.     

 

   

Impaired Loans as of September 30, 2014

 
   

Principal Balance

   

(A)

Total Recorded Investment(1)

   

Recorded Investment(1) in (A) for Which There is No Related Allowance

   

Recorded Investment(1) in (A) for Which There is a Related Allowance

   

Related Allowance

 

Consumer Real Estate(2)

                                       

Residential closed-end first liens

  $ 392     $ 365     $ 168     $ 197     $ 2  

Residential closed-end junior liens

    244       244       ---       244       6  

Investor-owned residential real estate

    77       77       ---       77       5  

Commercial Real Estate(2)

                                       

Multifamily real estate

    2,950       2,794       868       1,926       224  

Commercial real estate, owner-occupied

    5,036       4,942       4,483       459       25  

Commercial real estate, other

    6,068       6,068       3,094       2,974       32  

Commercial Non Real Estate(2)

                                       

Commercial and Industrial

    697       697       610       87       2  

Consumer Non Real Estate(2)

                                       

Automobile

    ---       ---       ---       ---       ---  

Total

  $ 15,464     $ 15,187     $ 9,223     $ 5,964     $ 296  

 

(1)     Recorded investment is net of charge-offs and interest paid while a loan is in nonaccrual status.

(2)     Only classes with impaired loans are shown.

 

   

Impaired Loans as of December 31, 2013

 
   

Principal Balance

   

(A)

Total Recorded Investment(1)

   

Recorded Investment(1) in (A) for Which There is No Related Allowance

   

Recorded Investment(1) in (A) for Which There is a Related Allowance

   

Related Allowance

 

Consumer Real Estate(2)

                                       

Residential closed-end first liens

  $ 440     $ 442     $ 232     $ 210     $ 3  

Residential closed-end junior liens

    259       261       ---       261       7  

Investor-owned residential real estate

    81       82       82       ---       ---  

Commercial Real Estate(2)

                                       

Multifamily real estate

    3,278       3,274       3,274       ---       ---  

Commercial real estate, owner occupied

    5,643       5,645       3,864       1,781       610  

Commercial real estate, other

    3,158       3,158       3,158       ---       ---  

Commercial Non Real Estate(2)

                                       

Commercial and Industrial

    102       103       1       102       4  

Consumer Non Real Estate(2)

                                       

Automobile

    24       24       24       ---       ---  

Total

  $ 12,985     $ 12,989     $ 10,635     $ 2,354     $ 624  

 

(1)     Recorded investment includes principal net of unearned interest and deferred fees and costs, and accrued interest.

(2)    Only classes with impaired loans are shown.

 

 
16

 

 

The following tables show the average investment and interest income recognized for impaired loans.

 

   

For the Nine Months Ended

September 30, 2014

 
   

Average Recorded Investment(1)

   

Interest Income Recognized

 

Consumer Real Estate(2)

               

Residential closed-end first liens

  $ 385     $ 19  

Residential closed-end junior liens

    251       12  

Investor-owned residential real estate

    78       4  

Commercial Real Estate(2)

               

Multifamily real estate

    2,807       ---  

Commercial real estate, owner occupied

    5,606       153  

Commercial real estate, other

    6,134       164  

Commercial Non Real Estate(2)

               

Commercial and Industrial

    713       32  

Consumer Non Real Estate(2)

               

Automobile

    ---       ---  

Total

  $ 15,974     $ 384  

 

(1)     Recorded investment is net of charge-offs and interest paid while a loan is in nonaccrual status.

(2)     Only classes with impaired loans are shown.

 

   

For the Year Ended

December 31, 2013

 
   

Average Recorded Investment(1)

   

Interest Income Recognized

 

Real Estate Construction(2)

               

Construction, residential

  $ 40     $ ---  

Construction, other

    2,885       ---  

Consumer Real Estate(2)

               

Residential closed-end first liens

    364       3  

Residential closed-end junior liens

    280       9  

Investor-owned residential real estate

    131       6  

Commercial Real Estate(2)

               

Multifamily real estate

    4,172       ---  

Commercial real estate, owner occupied

    5,265       136  

Commercial real estate, other

    3,369       110  

Commercial Non Real Estate(2)

               

Commercial and Industrial

    117       3  

Consumer Non Real Estate(2)

               

Automobile

    31       ---  

Total

  $ 16,654     $ 267  

 

(1)     Recorded investment includes principal net of unearned interest and deferred fees and costs, and accrued interest.

(2)     Only classes with impaired loans are shown.

 

 
17

 

 

The Company reviews nonaccrual loans on an individual loan basis to determine whether future payments are reasonably assured. To satisfy this criteria, the Company’s evaluation must determine that the underlying cause of the original delinquency or weakness that indicated nonaccrual status has been resolved, such as receipt of new guarantees, increased cash flows that cover the debt service or other resolution. Nonaccrual loans that demonstrate reasonable assurance of future payments and that have made at least six consecutive payments in accordance with repayment terms and timeframes may be returned to accrual status.

A restructured loan for which impairment measurement does not indicate a loss and that maintains current status for at least six months may be returned to accrual status.

 

An analysis of past due and nonaccrual loans follows.

 

September 30, 2014

                               
   

30 – 89 Days Past Due

   

90 or More Days Past Due

   

90 or More Days Past Due and Still Accruing

   

Nonaccruals (Including Impaired Nonaccruals)

 

Real Estate Construction(1)

                               

Construction, other

  $ 29     $ ---     $ ---     $ ---  

Consumer Real Estate(1)

                               

Equity lines

    46       ---       ---       ---  

Residential closed-end first liens

    1,605       556       457       176  

Residential closed-end junior liens

    67       ---       ---       ---  

Investor-owned residential real estate

    284       ---       ---       15  

Commercial Real Estate(1)

                               

Multifamily real estate

    715       868       ---       2,794  

Commercial real estate, owner-occupied

    350       1,219       ---       1,653  

Commercial real estate, other

    ---       ---       ---       2,974  

Commercial Non Real Estate(1)

                               

Commercial and Industrial

    1,102       ---       ---       114  

Consumer Non Real Estate(1)

                               

Credit cards

    12       6       6       ---  

Automobile

    234       20       20       ---  

Other consumer loans

    64       2       2       ---  

Total

  $ 4,508     $ 2,671     $ 485     $ 7,726  

 

(1)     Only classes with past-due or nonaccrual loans are shown.

 

 
18

 

 

An analysis of past due and nonaccrual loans follows.

 

December 31, 2013

                               
   

30 – 89 Days Past Due

   

90 or More Days Past Due

   

90 or More Days Past Due and Still Accruing

   

Nonaccruals (Including Impaired Nonaccruals)

 

Real Estate Construction(1)

                               

Construction, residential

  $ 45     $ ---     $ ---     $ ---  

Construction, other

    45       ---       ---       ---  

Consumer Real Estate(1)

                               

Residential closed-end first liens

    903       252       128       308  

Residential closed-end junior liens

    10       ---       ---       ---  

Investor-owned residential real estate

    422       91       ---       91  

Commercial Real Estate(1)

                               

Multifamily real estate

    430       3,278       ---       3,278  

Commercial real estate, owner occupied

    604       2,519       ---       2,756  

Commercial real estate, other

    32       ---       ---       ---  

Commercial Non Real Estate(1)

                               

Commercial and Industrial

    196       43       ---       128  

Consumer Non Real Estate(1)

                               

Credit cards

    3       13       13       ---  

Automobile

    217       26       2       23  

Other consumer loans

    49       46       47       ---  

Total

  $ 2,956     $ 6,268     $ 190     $ 6,584  

 

(1)     Only classes with past-due or nonaccrual loans are shown.

 

The estimate of credit risk for non-impaired loans is obtained by applying allocations for internal and external factors. The allocations are increased for loans that exhibit greater credit quality risk.

Credit quality indicators, which the Company terms risk grades, are assigned through the Company’s credit review function for larger loans and selective review of loans that fall below credit review thresholds. Loans that do not indicate heightened risk are graded as “pass.” Loans that appear to have elevated credit risk because of frequent or persistent past due status, which is less than 75 days, or that show weakness in the borrower’s financial condition are risk graded “special mention.” Loans with frequent or persistent delinquency exceeding 75 days or that have a higher level of weakness in the borrower’s financial condition are graded “classified.” Classified loans have regulatory risk ratings of “substandard” and “doubtful.” Allocations are increased by 50% and by 100% for loans with grades of “special mention” and “classified,” respectively.

Determination of risk grades was completed for the portfolio as of September 30, 2014 and 2013 and December 31, 2013.

 

 
19

 

 

The following displays collectively-evaluated loans by credit quality indicator.

 

September 30, 2014

   

Pass

   

Special

Mention

   

Classified (Excluding Impaired)

 

Real Estate Construction

                       

Construction, 1-4 family residential

  $ 18,253     $ ---     $ ---  

Construction, other

    23,786       28       ---  

Consumer Real Estate

                       

Equity lines

    16,432       15       46  

Closed-end first liens

    75,550       926       1,946  

Closed-end junior liens

    4,558       25       97  

Investor-owned residential real estate

    43,604       99       328  

Commercial Real Estate

                       

Multifamily residential real estate

    66,451       ---       715  

Commercial real estate owner-occupied

    138,110       230       936  

Commercial real estate, other

    91,484       1,186       21  

Commercial Non Real Estate

                       

Commercial and Industrial

    30,994       121       412  

Public Sector and IDA

                       

States and political subdivisions

    36,398       ---       ---  

Consumer Non Real Estate

                       

Credit cards

    5,903       ---       ---  

Automobile

    11,677       128       114  

Other consumer

    10,904       2       7  

Total

  $ 574,104     $ 2,760     $ 4,622  

 

 
20

 

 

The following displays collectively-evaluated loans by credit quality indicator.

 

December 31, 2013

   

Pass

   

Special

Mention (Excluding Impaired)

   

Classified (Excluding Impaired)

 

Real Estate Construction

                       

Construction, 1-4 family residential

  $ 17,702     $ 163     $ 45  

Construction, other

    27,971       29       15  

Consumer Real Estate

                       

Equity lines

    16,146       16       ---  

Closed-end first liens

    82,767       1,007       1,275  

Closed-end junior liens

    4,813       109       3  

Investor-owned residential real estate

    38,071       105       407  

Commercial Real Estate

                       

Multifamily residential real estate

    67,573       ---       958  

Commercial real estate owner-occupied

    134,137       2,206       701  

Commercial real estate, other

    89,340       1,209       3,063  

Commercial Non Real Estate

                       

Commercial and Industrial

    29,987       878       295  

Public Sector and IDA

                       

States and political subdivisions

    34,220       ---       ---  

Consumer Non Real Estate

                       

Credit cards

    6,354       ---       ---  

Automobile

    11,428       253       34  

Other consumer

    10,253       17       60  

Total

  $ 570,762     $ 5,992     $ 6,856  

 

Sales, Purchases and Reclassification of Loans

The Company finances mortgages under “best efforts” contracts with mortgage purchasers. The mortgages are designated as held for sale upon initiation. There have been no reclassifications from portfolio loans to held for sale. There have been no loans held for sale transferred to portfolio loans. Occasionally, the Company purchases or sells participations in loans. All participation loans purchased met the Company’s normal underwriting standards at the time the participation was entered. Participation loans are included in the appropriate portfolio balances to which the allowance methodology is applied.

 

 
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Troubled Debt Restructurings

 

The Company modifies loans in troubled debt restructurings. Total troubled debt restructurings amounted to $8,307 at September 30, 2014, $7,043 at December 31, 2013, and $7,587 at September 30, 2013. The Company did not modify any loans in a troubled debt restructuring during the three months ended September 30, 2014. The following tables present restructurings by class that occurred during the nine month period ended September 30, 2014, and the three and nine month periods ended September 30, 2013.

 

Note: Only classes with restructured loans are presented.

 

   

Restructurings That Occurred During the Nine Months

Ended September 30, 2014

 
   

Number of Contracts

   

Pre-Modification Outstanding Principal Balance

   

Post-Modification Outstanding Principal Balance

 

Commercial Real Estate

                       

Multifamily real estate

    1     $ 2,484     $ 2,484  

Commercial real estate, owner occupied

    1       184       209  

Total

    2     $ 2,668     $ 2,693  

 

During the nine-month period ended September 30, 2014, the Company restructured two loans. One multifamily real estate loan was restructured to provide payment relief. The Company reduced the loan’s interest rate and re-amortized payments. One commercial real estate, owner occupied loan was restructured pursuant to bankruptcy court orders. The restructuring provided payment relief by capitalizing interest, reducing the interest rate and re-amortizing payments. The fair value measurements of the restructured loans as of September 30, 2014 resulted in specific allocations to the allowance for loan losses totaling $249. No loans were restructured for the three month period ending September 30, 2014.

 

   

Restructurings That Occurred During the Three Months

Ended September 30, 2013

 
   

Number of Contracts

   

Pre-Modification Outstanding Principal Balance

   

Post-Modification Outstanding Principal Balance

 

Consumer Real Estate

                       

Residential closed-end first liens

    1     $ 241     $ 309  

Commercial Non Real Estate

                       

Commercial and industrial

    1       32       45  

Total

    2     $ 273     $ 354  

 

The loans restructured during the three months ended September 30, 2013 were designated and reported as troubled debt restructures in previous quarters. The loans received additional modifications during the third quarter of 2013, transitioning payments from interest-only to amortizing, and capitalizing accrued interest. The interest rate for the consumer real estate loan remained unchanged, while the interest rate for the commercial non real estate loan decreased.

 

 
22

 

 

   

Restructurings That Occurred During the Nine Months

Ended September 30, 2013

 
   

Number of Contracts

   

Pre-Modification Outstanding Principal Balance

   

Post-Modification Outstanding Principal Balance

 

Consumer Real Estate

                       

Residential closed-end first liens

    2     $ 453     $ 525  

Residential closed-end junior liens

    1       262       267  

Commercial Real Estate

                       

Commercial real estate, owner-occupied

    1       154       239  

Commercial real estate, other

    1       3,500       3,500  

Commercial Non Real Estate

                       

Commercial and industrial

    1       32       45  

Total

    6     $ 4,401     $ 4,576  

 

The modifications that resulted in troubled debt restructurings between January 1, 2013 and September 30, 2013 provided payment relief to the borrowers without forgiveness of principal or accrued interest. The date of conversion from interest-only to amortizing payments for one commercial real estate loan was extended beyond the date specified by the contract, resulting in designation as a troubled debt restructuring. During the third quarter of 2013, the loan was converted to amortizing payments and moved from Real Estate Construction to Commercial Real Estate. The other commercial real estate loan was modified to extend the term, lower the interest rate and provide debt consolidation to allow the borrower increased debt service ability. The modifications of the consumer real estate loans capitalized accrued interest and reduced interest rates. The term for one consumer real estate loan was shortened, resulting in a higher payment, while the term for the other consumer real estate loan was lengthened, resulting in a lower payment.

 

The Company analyzed its TDR portfolio for loans that defaulted during the three- and nine-month periods ended September 30, 2014 and September 30, 2013, and that were modified within 12 months prior to default. The Company defines default as one or more payments that occur more than 90 days past the due date, charge-offs, or foreclosure after the date of restructuring. There were no restructured loans that defaulted and were modified within 12 months prior to default for the three- or nine-month periods ended September 30, 2014.

 

The following table displays restructured loans that defaulted during the three and nine-month periods ended September 30, 2013 and that were modified within twelve months prior to default.

 

   

Restructured Loans That Defaulted

And Were Modified Within 12 Months Prior to Default

 
   

Default During the 3 Month Period Ended September 30, 2013

   

Default During the 9 Month Period Ended September 30, 2013

 
   

Number of Contracts

   

Principal Balance

   

Impairment Accrued

   

Number of Contracts

   

Principal Balance

   

Impairment Accrued

 

Consumer Real Estate

                                               

Residential closed-end first liens

    1     $ 26     $ 1       1     $ 26     $ 1  

Residential closed-end junior liens

    1       47       ---       1       47       ---  

Commercial Real Estate

                                               

Commercial real estate owner-occupied

    2       664       352       3       857       352  

Commercial Non Real Estate

                                               

Commercial and industrial

    1       137       ---       1       137       ---  

Total

    5     $ 874     $ 353       6     $ 1,067     $ 353  

 

Restructured loans are individually evaluated for impairment. The fair value measurements for most of the restructured loans that defaulted during the three-month and nine-month periods ended September 30, 2013 were based upon the fair value of collateral and as such were not significantly affected by the default. One of the commercial real estate restructurings that defaulted during the three months ended September 30, 2013 was measured using the present value of cash flows, resulting in an impairment allocation of $352. In previous quarters, no allocation was recognized. One of the commercial real estate loans that defaulted in the first quarter of 2013 was placed into other real estate owned, and the commercial non real estate loan was partially paid off by the borrower, with the remainder of the principal charged against the allowance for loan losses. All of the restructurings that defaulted during the three-month and nine-month periods ended September 30, 2013 and that remained active loans at September 30, 2013, were in nonaccrual status.

 

 
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Note 5: Securities

 

The amortized costs, gross unrealized gains, gross unrealized losses and fair values for securities available for sale by major security type are as follows.

   

September 30, 2014

 
   

Amortized

Costs

   

Gross

Unrealized

Gains

   

Gross

Unrealized

Losses

   

Fair

Values

 

Available for Sale:

                               

U.S. Government agencies and corporations

  $ 184,737     $ 380     $ 10,673     $ 174,444  

States and political subdivisions

    19,657       894       6       20,545  

Mortgage-backed securities

    2,012       194       ---       2,206  

Corporate debt securities

    7,801       66       175       7,692  

Other securities

    189       ---       56       133  

Total

  $ 214,396     $ 1,534     $ 10,910     $ 205,020  

 

   

December 31, 2013

 
   

Amortized

Costs

   

Gross

Unrealized

Gains

   

Gross

Unrealized

Losses

   

Fair

Values

 

Available for Sale:

                               

U.S. Government agencies and corporations

  $ 169,818     $ 199     $ 22,163     $ 147,854  

States and political subdivisions

    22,830       746       120       23,456  

Mortgage-backed securities

    2,627       213       ---       2,840  

Corporate debt securities

    7,804       97       506       7,395  

Other securities

    189       ---       22       167  

Total securities available for sale

  $ 203,268     $ 1,255     $ 22,811     $ 181,712  

 

The amortized costs, gross unrealized gains, gross unrealized losses and fair values for securities held to maturity by major security type are as follows.

 

   

September 30, 2014

 
   

Amortized
Costs

   

Gross
Unrealized
Gains

   

Gross
Unrealized
Losses

   

Fair
Values

 

Held to Maturity:

                               

U.S. Government agencies and corporations

  $ 18,928     $ 307     $ 666     $ 18,569  

States and political subdivisions

    141,683       6,465       1,206       146,942  

Mortgage-backed securities

    434       52       ---       486  

Corporate debt securities

    1,412       2       2       1,412  

Total

  $ 162,457     $ 6,826     $ 1,874     $ 167,409  

 

 
24

 

 

   

December 31, 2013

 
   

Amortized
Costs

   

Gross
Unrealized
Gains

   

Gross
Unrealized
Losses

   

Fair
Values

 

Held to Maturity:

                               

U.S. Government agencies and corporations

  $ 13,973     $ 280     $ 1,448     $ 12,805  

States and political subdivisions

    149,490       2,971       6,502       145,959  

Mortgage-backed securities

    520       53       ---       573  

Total securities held to maturity

  $ 163,983     $ 3,304     $ 7,950     $ 159,337  

 

Information pertaining to securities with gross unrealized losses aggregated by investment category and length of time that individual securities have been in a continuous loss position, follows.

 

   

September 30, 2014

 
   

Less Than 12 Months

   

12 Months or More

 
   

Fair
Value

   

Unrealized
Loss

   

Fair
Value

   

Unrealized
Loss

 

Temporarily Impaired Securities:

                               

U.S. Government agencies and corporations

  $ 16,798     $ 79     $ 161,479     $ 11,260  

States and political subdivisions

    401       ---       26,841       1,212  

Corporate debt securities

    450       2       3,853       175  

Other securities

    133       56       ---       ---  

Total

  $ 17,782     $ 137     $ 192,173     $ 12,647  

 

   

December 31, 2013

 
   

Less Than 12 Months

   

12 Months or More

 
   

Fair
Value

   

Unrealized
Loss

   

Fair
Value

   

Unrealized
Loss

 

Temporarily Impaired Securities:

                               

U.S. Government agencies and corporations

  $ 138,324     $ 20,400     $ 15,796     $ 3,211  

States and political subdivisions

    58,013       6,131       2,697       491  

Corporate debt securities

    5,511       506       ---       ---  

Other securities

    167       22       ---       ---  

Total

  $ 202,015     $ 27,059     $ 18,493     $ 3,702  

 

The Company had 238 securities with a fair value of $209,955 which were temporarily impaired at September 30, 2014.  The total unrealized loss on these securities was $12,784. Of the temporarily impaired total, 217 securities with a fair value of $192,173 and an unrealized loss of $12,647 have been in a continuous loss position for twelve months or more. The Company has determined that these securities are temporarily impaired at September 30, 2014 for the reasons set out below.

U.S. Government agencies. The unrealized losses in this category of investments were caused by interest rate and market fluctuations. The contractual terms of the investments do not permit the issuer to settle the securities at a price less than the cost basis of each investment. The Company is monitoring bond market trends and developing strategies to address unrealized losses. Because the Company does not intend to sell any of the investments and it is not likely that the Company will be required to sell any of the investments before recovery of its amortized cost basis, which may be at maturity, the Company does not consider these investments to be other-than-temporarily impaired.

States and political subdivisions. This category’s unrealized losses are primarily the result of interest rate and market fluctuations. The contractual terms of the investments do not permit the issuer to settle the securities at a price less than the cost basis of each investment. Because the Company does not intend to sell any of the investments and it is not likely that the Company will be required to sell any of the investments before recovery of its amortized cost basis, which may be at maturity, the Company does not consider these investments to be other-than-temporarily impaired.

 

 
25

 

 

Corporate. The Company’s unrealized losses in corporate debt securities are related to interest rate and market fluctuations. The contractual terms of the investments do not permit the issuer to settle the securities at a price less than the cost basis of each investment. Because the Company does not intend to sell any of the investments before recovery of its amortized cost basis, which may be at maturity, the Company does not consider these investments to be other-than-temporarily impaired.

Other securities. The Company holds a small investment in community bank stock. The value of this investment has been negatively affected by market conditions. Because the Company does not intend to sell this investment before recovery of amortized cost basis, the Company does not consider these investments to be other-than-temporarily impaired.

Restricted stock. Restricted stock is reported separately from available-for-sale securities and held-to-maturity securities. As a member of the Federal Reserve and the Federal Home Loan Bank (“FHLB”) of Atlanta, NBB is required to maintain certain minimum investments in the common stock of those entities. Required levels of investment are based upon NBB’s capital and a percentage of qualifying assets. In addition, NBB is eligible to borrow from the FHLB with borrowings collateralized by qualifying assets, primarily residential mortgage loans and NBB’s capital stock investment in the FHLB. Redemption of FHLB stock is subject to certain limitations and conditions. At its discretion, the FHLB may declare dividends on the stock. Management reviews for impairment based upon the ultimate recoverability of the cost basis of the FHLB stock, and at September 30, 2014, management did not determine any impairment.

Management regularly monitors the credit quality of the investment portfolio. Changes in ratings are noted and follow-up research on the issuer is undertaken when warranted. Management intends to carefully monitor any changes in bond quality.

 

Note 6: Recent Accounting Pronouncements

 

In January 2014, the FASB issued ASU 2014-01, “Investments—Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects (a consensus of the FASB Emerging Issues Task Force).” The amendments in this ASU permit reporting entities to make an accounting policy election to account for their investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance in the income statement as a component of income tax expense (benefit). The amendments in this ASU should be applied retrospectively to all periods presented. A reporting entity that uses the effective yield method to account for its investments in qualified affordable housing projects before the date of adoption may continue to apply the effective yield method for those preexisting investments. The amendments in this ASU are effective for public business entities for annual periods and interim reporting periods within those annual periods, beginning after December 15, 2014. Early adoption is permitted. The Company is currently assessing the impact that ASU 2014-01 will have on its consolidated financial statements.

In January 2014, the FASB issued ASU 2014-04, “Receivables—Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure (a consensus of the FASB Emerging Issues Task Force).” The amendments in this ASU clarify that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additionally, the amendments require interim and annual disclosure of both (1) the amount of foreclosed residential real estate property held by the creditor and (2) the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. The amendments in this ASU are effective for public business entities for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. The Company is currently assessing the impact that ASU 2014-04 will have on its consolidated financial statements.

In April 2014, the FASB issued ASU 2014-08, “Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity.” The amendments in this ASU change the criteria for reporting discontinued operations while enhancing disclosures in this area. Under the new guidance, only disposals representing a strategic shift in operations should be presented as discontinued operations. Those strategic shifts should have a major effect on the organization’s operations and financial results and include disposals of a major geographic area, a major line of business, or a major equity method investment. The new guidance requires expanded disclosures about discontinued operations that will provide financial statement users with more information about the assets, liabilities, income, and expenses of discontinued operations. Additionally, the new guidance requires disclosure of the pre-tax income attributable to a disposal of a significant part of an organization that does not qualify for discontinued operations reporting. The amendments in the ASU are effective for public business entities for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. Early adoption is permitted. The Company does not expect the adoption of ASU 2014-08 to have a material impact on its consolidated financial statements.

 

 
26

 

 

In June 2014, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers: Topic 606”. This ASU applies to any entity using U.S. GAAP that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets unless those contracts are within the scope of other standards. The guidance supersedes the revenue recognition requirements in Topic 605, “Revenue Recognition”, most industry-specific guidance, and some cost guidance included in Subtopic 605-35, “Revenue Recognition—Construction-Type and Production-Type Contracts”. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To be in alignment with the core principle, an entity must apply a five step process including: identification of the contract(s) with a customer, identification of performance obligations in the contract(s), determination of the transaction price, allocation of the transaction price to the performance obligations, and recognition of revenue when (or as) the entity satisfies a performance obligation. Additionally, the existing requirements for the recognition of a gain or loss on the transfer of nonfinancial assets that are not in a contract with a customer have also been amended to be consistent with the guidance on recognition and measurement. The amendments in this ASU are effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Early adoption is not permitted. The Company is currently assessing the impact that ASU 2014-09 will have on its consolidated financial statements.

In June 2014, the FASB issued ASU 2014-10, “Development Stage Entities (Topic 915): Elimination of Certain Financial Reporting Requirements, Including an Amendment to Variable Interest Entities Guidance in Topic 810, Consolidation”. The amendments in this ASU remove all incremental financial reporting requirements from U.S. GAAP for development stage entities, including the removal of Topic 915, “Development Stage Entities”, from the FASB Accounting Standards Codification. In addition, this ASU adds an example disclosure and removes an exception provided to development stage entities in Topic 810, “Consolidation”, for determining whether an entity is a variable interest entity. The presentation and disclosure requirements in Topic 915 will no longer be required for the first annual period beginning after December 15, 2014. The revised consolidation standards are effective for annual periods beginning after December 15, 2015. Early adoption is permitted. The Company does not expect the adoption of ASU 2014-10 to have a material impact on its consolidated financial statements.

In June 2014, the FASB issued ASU No. 2014-11, “Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures”. This ASU aligns the accounting for repurchase-to-maturity transactions and repurchase agreements executed as a repurchase financing with the accounting for other typical repurchase agreements. The new guidance eliminates sale accounting for repurchase-to-maturity transactions and supersedes the guidance under which a transfer of a financial asset and a contemporaneous repurchase financing could be accounted for on a combined basis as a forward agreement. The amendments in the ASU also require a new disclosure for transactions economically similar to repurchase agreements in which the transferor retains substantially all of the exposure to the economic return on the transferred financial assets throughout the term of the transaction. Additional disclosures will be required for the nature of collateral pledged in repurchase agreements and similar transactions accounted for as secured borrowings. The amendments in this ASU are effective for the first interim or annual period beginning after December 15, 2014; however, the disclosure for transactions accounted for as secured borrowings is required to be presented for annual periods beginning after December 15, 2014, and interim periods beginning after March 15, 2015. Early adoption is not permitted. The Company is currently assessing the impact that ASU 2014-11 will have on its consolidated financial statements.

In June 2014, the FASB issued ASU No. 2014-12, “Compensation – Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period”. The new guidance applies to reporting entities that grant employees share-based payments in which the terms of the award allow a performance target to be achieved after the requisite service period. The amendments in the ASU require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. Existing guidance in “Compensation – Stock Compensation (Topic 718)”, should be applied to account for these types of awards. The amendments in this ASU are effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. Early adoption is permitted and reporting entities may choose to apply the amendments in the ASU either on a prospective or retrospective basis. The Company is currently assessing the impact that ASU 2014-12 will have on its consolidated financial statements.

In August 2014, the FASB issued ASU No. 2014-14, “Receivables – Troubled Debt Restructurings by Creditors (Subtopic 310-40): Classification of Certain Government-Guaranteed Mortgage Loans upon Foreclosure”. The amendments in this ASU apply to creditors that hold government-guaranteed mortgage loans and is intended to eliminate the diversity in practice related to the classification of these guaranteed loans upon foreclosure. The new guidance stipulates that a mortgage loan be derecognized and a separate other receivable be recognized upon foreclosure if (1) the loan has a government guarantee that is not separable from the loan prior to foreclosure, (2) at the time of foreclosure, the creditor has the intent to convey the real estate property to the guarantor and make a claim on the guarantee, and the creditor has the ability to recover under that claim, and (3) at the time of foreclosure, any amount of the claim that is determined on the basis of the fair value of the real estate is fixed. Upon foreclosure, the other receivable should be measured on the amount of the loan balance (principal and interest) expected to be recovered from the guarantor. The amendments in this ASU are effective for annual periods and interim periods within those annual periods beginning after December 15, 2014.Entities may adopt the amendments on a prospective basis or modified retrospective basis as of the beginning of the annual period of adoption; however, the entity must apply the same method of transition as elected under ASU 2014-04. Early adoption is permitted provided the entity has already adopted ASU 2014-04. The Company is currently assessing the impact that ASU 2014-14 will have on its consolidated financial statements.

 

 
27

 

 

In August 2014, the FASB issued ASU No. 2014-15, “Presentation of Financial Statements – Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern”. This update is intended to provide guidance about management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern and to provide related footnote disclosures. Management is required under the new guidance to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date the financial statements are issued when preparing financial statements for each interim and annual reporting period. If conditions or events are identified, the ASU specifies the process that must be followed by management and also clarifies the timing and content of going concern footnote disclosures in order to reduce diversity in practice. The amendments in this ASU are effective for annual periods and interim periods within those annual periods beginning after December 15, 2016. Early adoption is permitted. The Company does not expect the adoption of ASU 2014-15 to have a material impact on its consolidated financial statements.

 

Note 7: Defined Benefit Plan

 

Components of Net Periodic Benefit Cost

 

   

Pension Benefits

 
   

Nine Months Ended September 30,

 
   

2014

   

2013

 

Service cost

  $ 393     $ 447  

Interest cost

    498       462  

Expected return on plan assets

    (834

)

    (738

)

Amortization of prior service cost

    (81

)

    (75

)

Recognized net actuarial loss

    195       399  

Net periodic benefit cost

  $ 171     $ 495  

 

2014 Plan Year Employer Contribution

 

Without considering the prefunding balance, the Company’s minimum required contribution to the National Bankshares, Inc. Retirement Income Plan (the “Plan”) is $396. Considering the prefunding balance, the 2014 minimum required contribution is $0. The Company elected to contribute $303 to the Plan during the nine months ended September 30, 2014.

 

Note 8: Fair Value Measurements

 

The Company records fair value adjustments to certain assets and liabilities and determines fair value disclosures utilizing a definition of fair value of assets and liabilities that states that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Additional considerations come into play in determining the fair value of assets in markets that are not active.

The Company uses a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. The three levels of the fair value hierarchy based on these two types of inputs are as follows:

 

Level 1 – 

 

Valuation is based on quoted prices in active markets for identical assets and liabilities.

 

Level 2 –

 

Valuation is based on observable inputs including quoted prices in active markets for similar assets and liabilities, quoted prices for identical or similar assets and liabilities in less active markets, and model-based valuation techniques for which significant assumptions can be derived primarily from or corroborated by observable data in the market.

 

Level 3 – 

 

Valuation is based on model-based techniques that use one or more significant inputs or assumptions that are unobservable in the market.

 

 
28

 

 

The following describes the valuation techniques used by the Company to measure certain assets and liabilities recorded at fair value on a recurring basis in the financial statements.

 

Securities Available for Sale

 

Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2). The carrying value of restricted Federal Reserve Bank and Federal Home Loan Bank stock approximates fair value based upon the redemption provisions of each entity and is therefore excluded from the following table.

 

The following table presents the balances of assets and liabilities measured at fair value on a recurring basis.

           

Fair Value Measurements at September 30, 2014 Using

 

Description

 

Balance as of
September 30, 2014

   

Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)

   

Significant
Other
Observable
Inputs
(Level 2)

   

Significant
Unobservable Inputs
(Level 3)

 

U.S. Government agencies and corporations

  $ 174,444     $ ---     $ 174,444     $ ---  

States and political subdivisions

    20,545       ---       20,545       ---  

Mortgage-backed securities

    2,206       ---       2,206       ---  

Corporate debt securities

    7,692       ---       7,692       ---  

Other securities

    133       ---       133       ---  

Total securities available for sale

  $ 205,020     $ ---     $ 205,020     $ ---  

 

           

Fair Value Measurements at December 31, 2013 Using

 

Description

 

Balance as of
December 31,
2013

   

Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)

   

Significant
Other
Observable
Inputs
(Level 2)

   

Significant
Unobservable Inputs
(Level 3)

 

U.S. Government agencies and corporations

  $ 147,854     $ ---     $ 147,854     $ ---  

States and political subdivisions

    23,456       ---       23,456       ---  

Mortgage-backed securities

    2,840       ---       2,840       ---  

Corporate debt securities

    7,395       ---       7,395       ---  

Other securities

    167       ---       167       ---  

Total securities available for sale

  $ 181,712     $ ---     $ 181,712     $ ---  

 

Certain assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.

 

The following describes the valuation techniques used by the Company to measure certain assets recorded at fair value on a nonrecurring basis in the financial statements.

 

Loans Held for Sale

 

Loans held for sale are carried at the lower of cost or market value. These loans currently consist of one-to-four family residential loans originated for sale in the secondary market. Fair value is based on the price secondary markets offer at the report date for similar loans using observable market data which is not materially different than cost due to the short duration between origination and sale (Level 2). As such, the Company records any fair value adjustments on a nonrecurring basis. No nonrecurring fair value adjustments were recorded on loans held for sale at September 30, 2014 or December 31, 2013. Gains and losses on the sale of loans are recorded within income from mortgage banking on the Consolidated Statements of Income.

  

 
29

 

 

Impaired Loans

 

Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due will not be collected according to the contractual terms of the loan agreement. Troubled debt restructurings are impaired loans. Impaired loans are measured at fair value on a nonrecurring basis. If an individually-evaluated impaired loan’s balance exceeds fair value, the amount is allocated to the allowance for loan losses. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income.

The fair value of an impaired loan and measurement of associated loss is based on one of three methods: the observable market price of the loan, the present value of projected cash flows, or the fair value of the collateral. The observable market price of a loan is categorized as a Level 1 input. The present value of projected cash flows method results in a Level 3 categorization because the calculation relies on the Company’s judgment to determine projected cash flows, which are then discounted at the current rate of the loan, or the rate prior to modification if the loan is a troubled debt restructure.

Loans measured using the fair value of collateral method may be categorized in Level 2 or Level 3. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. Most collateral is real estate. The value of real estate collateral that is determined by a current (less than 12 months of age) appraisal utilizing an income or market valuation approach conducted by an independent, licensed appraiser outside of the Company using observable market data is categorized as Level 2. If a current appraisal cannot be obtained prior to a reporting date and an existing appraisal is discounted to obtain an estimated value, or if declines in value are identified after the date of the appraisal, or if an appraisal is discounted for estimated selling costs, the valuation of real estate collateral is categorized as Level 3. The value of business equipment is based upon an outside appraisal (Level 2) if deemed significant, or the net book value on the applicable business’ financial statements (Level 3) if not considered significant. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3).

Impaired loans are measured quarterly for impairment. The Company employs the most applicable valuation method for each loan based on current information at the time of valuation. Valuations of loans using the collateral method may include a discount for selling costs if collection of the loan is expected to come from sale of the collateral. Fair value measurement using the collateral method for a loan that is dependent on the operation, but not the sale, of collateral for collection is not discounted for selling costs.

 

The following table summarizes the Company’s impaired loans that were measured at fair value on a nonrecurring basis at September 30, 2014 and at December 31, 2013.

 

             

Carrying Value

 

Date

Description  

Balance

   

Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)

   

Significant
Other
Observable
Inputs
(Level 2)

   

Significant
Unobservable Inputs
(Level 3)

 

 

Assets:                                

September 30, 2014

Impaired loans net of valuation allowance   $ 5,668     $ ---     $ ---     $ 5,668  

December 31, 2013

Impaired loans net of valuation allowance     1,989       ---       ---       1,989  

 

The following tables present information about Level 3 Fair Value Measurements for September 30, 2014.

 

 September 30, 2014

 

Valuation Technique

 

Unobservable Input

 

Range

(Weighted Average)

 

Impaired loans

 

Present value of cash flows

 

Market rate for borrower (discount rate)

  5.88%

– 9.50%

( 6.11% )    

Impaired loans

 

Discounted appraised value

 

Selling cost

   

 

      10% (1) 

 

(1)     As of September 30, 2014, the collateral method of fair valuation was applied to one loan.

 

 
30

 

 

Other Real Estate Owned

 

Other real estate owned are real estate assets acquired in full or partial satisfaction of a loan. At acquisition, other real estate owned assets are measured at fair value. If the assets are marketed for sale by an outside party, the acquisition-date fair value is discounted by selling costs; if the assets are marketed for sale by the Company, no reduction to fair value for selling costs is made. Subsequent to acquisition, the assets are measured at the lower of initial measurement or current fair value, discounted for selling costs as appropriate.

The fair value of an other real estate owned asset is determined by an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). If the appraisal is discounted either for age or because management considers the real estate market to be experiencing volatility, then the fair value is considered Level 3. Discounts for selling costs also result in measurement based on Level 3 inputs. Fair value adjustments are measured on a nonrecurring basis and are recorded in the period incurred as valuation allowances to other real estate owned, and expensed through noninterest expense.

 

The following table summarizes the Company’s other real estate owned that was measured at fair value on a nonrecurring basis.

             

Carrying Value

 

Date

 

Description   

Balance

   

Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)

   

Significant
Other
Observable
Inputs
(Level 2)

   

Significant
Unobservable Inputs
(Level 3)

 

 

Assets:                                

September 30, 2014

Other real estate owned net of valuation allowance   $ 5,145     $ ---     $ ---     $ 5,145  

December 31, 2013

Other real estate owned net of valuation allowance     4,712       ---       ---       4,712  

 

The following tables present information about Level 3 Fair Value Measurements for September 30, 2014.

 

September 30, 2014

 

Valuation Technique

 

Unobservable Input

 

Range

(Weighted Average)

 
                       

Other real estate owned

 

Discounted appraised value

 

Selling cost

  0.00% (1) – 10%

(

9.13% )

Other real estate owned

 

Discounted appraised value

 

Discount for lack of marketability and age of appraisal

  3.76%   – 48.33%

(

14.64% )

 

(1)      The Company markets other real estate owned both independently and with local realtors. Properties marketed by realtors are discounted by selling costs. Properties that the Company markets independently are not discounted by selling costs.

 

The following methods and assumptions were used by the Company in estimating fair value disclosures for financial instruments.

 

Cash and Due from Banks and Interest-Bearing Deposits

 

The carrying amounts approximate fair value.

 

Securities

 

The fair value of securities, excluding restricted stock, is determined by quoted market prices or dealer quotes. The fair value of certain state and municipal securities is not readily available through market sources other than dealer quotations, so fair value estimates are based on quoted market prices of similar instruments adjusted for differences between the quoted instruments and the instruments being valued. The carrying value of restricted securities approximates fair value based upon the redemption provisions of the applicable entities.

 

Loans Held for Sale

 

The fair value of loans held for sale is based on commitments on hand from investors or prevailing market prices.

 

 
31

 

 

Loans

 

Fair value for the loan portfolio is estimated on an account-level basis by discounting scheduled cash flows through the projected maturity for each loan. The calculation applies estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The estimate of maturity is based on the Company’s historical experience with repayments for loan classification, modified by an estimate of the effect of economic conditions on lending.

Impaired loans are individually evaluated for fair value. Fair value for the Company’s impaired loans is estimated by using either discounted cash flows or the appraised value of collateral. Any amount of principal balance that exceeds fair value is accrued in the allowance for loan losses. Assumptions regarding credit risk, cash flows and discount rates are determined within management’s judgment, using available market information and specific borrower information. Discount rates for cash flow analysis are based on the loan’s interest rate, and cash flows are estimated based upon the loan’s historical payment performance and the borrower’s current financial condition. Appraisals may be discounted for age, reasonableness, and selling costs.

 

Deposits

 

The fair value of demand and savings deposits is the amount payable on demand. The fair value of fixed maturity term deposits and certificates of deposit is estimated using the rates currently offered for deposits with similar remaining maturities.

 

Accrued Interest

 

The carrying amounts of accrued interest approximate fair value.

 

Bank-Owned Life Insurance

 

Bank owned life insurance represents insurance policies on officers of the Company and certain officers who are no longer employed by the Company.  The cash values of the policies are estimates using information provided by insurance carriers.  These policies are carried at their cash surrender value, which approximates the fair value.

 

Commitments to Extend Credit and Standby Letters of Credit

 

The only amounts recorded for commitments to extend credit, standby letters of credit and financial guarantees written are the deferred fees arising from these unrecognized financial instruments. These deferred fees are not deemed significant at September 30, 2014 and December 31, 2013, and, as such, the related fair values have not been estimated.

 

The estimated fair values and related carrying amounts of the Company’s financial instruments follow.

 

   

September 30, 2014

 
   

Carrying
Amount

   

Quoted Prices in Active Markets for Identical Assets

Level 1

   

Significant Other Observable Inputs

Level 2

   

Significant Unobservable Inputs

Level 3

   

Total Estimated

Fair Value

   

Financial Assets:

                                         

Cash and due from banks

  $ 12,815     $ 12,815     $ ---     $ ---     $ 12,815    

Interest-bearing deposits

    87,621       87,621       ---       ---       87,621    

Securities

    367,477       ---       372,429       ---       372,429    

Restricted securities

    1,089       ---       1,089       ---       1,089    

Mortgage loans held for sale

    725       ---       725       ---       725    

Loans, net

    587,770       ---       ---       649,041       649,041    

Accrued interest receivable

    5,708       5,708       ---       ---       5,708    

Bank-owned life insurance

    21,643       21,643       ---       ---       21,643    

Financial Liabilities:

                                         

Deposits

  $ 948,923     $ 724,993     $ ---     $ 223,261     $ 948,254    

Accrued interest payable

    67       67       ---       ---       67    

 

 
32

 

  

    December 31, 2013  
   

Carrying
Amount

   

Quoted Prices in Active Markets for Identical Assets

Level 1

   

Significant Other Observable Inputs

Level 2

   

Significant Unobservable Inputs

Level 3

   

Total Estimated

Fair Value

 

Financial Assets:

                                       

Cash and due from banks

  $ 13,283     $ 13,283     $ ---     $ ---     $ 13,283  

Interest-bearing deposits

    98,066       98,066       ---       ---       98,066  

Securities

    345,695       ---       341,049       ---       341,049  

Restricted securities

    1,414       ---       1,414       ---       1,414  

Mortgage loans held for sale

    1,276       ---       1,276       ---       1,276  

Loans, net

    587,463       ---       ---       616,755       616,755  

Accrued interest receivable

    5,949       5,949       ---       ---       5,949  

Bank-owned life insurance

    21,181       21,181       ---       ---       21,181  

Financial Liabilities:

                                       

Deposits

  $ 960,036     $ 718,327     $ ---     $ 247,753     $ 966,080  

Accrued interest payable

    92       92       ---       ---       92  

 

Note 9: Components of Accumulated Other Comprehensive Loss

 

   

Net Unrealized Gain (Loss) on Securities

   

Adjustments Related to Pension Benefits

   

Accumulated Other Comprehensive

(Loss)

 

Balance at December 31, 2012

  $ 2,047     $ (4,785

)

  $ (2,738

)

Unrealized holding losses on available for sale securities net of tax of ($7,142)

    (13,263

)

    ---       (13,263

)

Reclassification adjustment, net of tax of $18

    32       ---       32  

Balance at September 30, 2013

  $ (11,184

)

  $ (4,785

)

  $ (15,969

)

                         

Balance at December 31, 2013

  $ (14,011 )   $ (2,953

)

  $ (16,964

)

Unrealized holding gains on available for sale securities net of tax of $4,264

    7,920       ---       7,920  

Reclassification adjustment, net of tax of ($1)

    (3

)

    ---       (3

)

Balance at September 30, 2014

  $ (6,094

)

  $ (2,953

)

  $ (9,047

)

 

The following provides information regarding reclassifications out of accumulated comprehensive income (loss) for the three- and nine-month periods ended September 30, 2014 and September 30, 2013.

 

   

3 Months Ended

   

9 Months Ended

 
   

September 30, 2014

   

September 30, 2013

   

September 30, 2014

   

September 30, 2013

 

Reclassifications out of unrealized gains and losses on available-for-sale securities:

                               

Realized securities gains, net

  $ 4     $ (68

)

  $ 4     $ (50

)

Income tax expense (benefit)

    1       (24

)

    1       (18

)

Realized gains and losses on available-for-sale securities, net of tax, reclassified out of accumulated other comprehensive income

  $ 3     $ (44

)

  $ 3     $ (32

)

 

 
33

 

 

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

$ in thousands, except per share data

 

The purpose of this discussion and analysis is to provide information about the financial condition and results of operations of National Bankshares, Inc. and its wholly-owned subsidiaries (the “Company”), which are not otherwise apparent from the consolidated financial statements and other information included in this report.  Please refer to the financial statements and other information included in this report as well as the 2013 Annual Report on Form 10-K for an understanding of the following discussion and analysis.

 

Cautionary Statement Regarding Forward-Looking Statements

 

We make forward-looking statements in this Form 10-Q that are subject to significant risks and uncertainties.  These forward-looking statements include statements regarding our profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals, and are based upon our management’s views and assumptions as of the date of this report.  The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,”  “forecasts,” “intends,” or other similar words or terms are intended to identify forward-looking statements.

These forward-looking statements are based upon or are affected by factors that could cause our actual results to differ materially from historical results or from any results expressed or implied by such forward-looking statements. These factors include, but are not limited to, changes in:

interest rates,

general economic conditions,

the legislative/regulatory climate,

monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury, the Office of the Comptroller of the Currency, the Federal Reserve Board and the Federal Deposit Insurance Corporation, and the impact of any policies or programs implemented pursuant to the Emergency Economic Stabilization Act of 2008 (“EESA”) the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) and other financial reform legislation,

capital ratio requirements and calculations due to implementation of Basel III regulatory capital rules

unanticipated increases in the level of unemployment in the Company’s trade area,

the quality or composition of the loan and/or investment portfolios,

demand for loan products,

deposit flows,

competition,

demand for financial services in the Company’s trade area,

the real estate market in the Company’s trade area,

the Company’s technology initiatives,

threats from technology-based frauds and scams,

loss or retirement of key executives,

adverse changes in the securities market, and

applicable accounting principles, policies and guidelines.

These risks and uncertainties should be considered in evaluating the forward-looking statements contained in this report. We caution readers not to place undue reliance on those statements, which speak only as of the date of this report. This discussion and analysis should be read in conjunction with the description of our “Risk Factors” in Item 1A. of our 2013 Annual Report on Form 10-K.

The effects of the recession continue to impact the national economy as well as the Company’s market. Signs of economic recovery are mixed with continued high unemployment and continued challenges in the real estate market. The Company’s trade area contains a diverse economy that includes large public colleges and universities, which somewhat insulated the Company’s market from the dramatic declines in real estate values seen in some other areas of the country. Real estate values in the Company’s market area appeared to stabilize in 2012 and 2013 and showed small signs of improving in 2014. If the economic recovery wavers or reverses, it is likely that unemployment will continue at higher-than-normal levels or rise in the Company’s trade area. Because of the importance to the Company’s markets of state-funded universities, any cutbacks in the funding provided by the State could also negatively impact employment. This could lead to an even higher rate of delinquent loans and a greater number of real estate foreclosures. Higher unemployment and the fear of layoffs causes reduced consumer demand for goods and services, which negatively impacts the Company’s business and professional customers. In conclusion, a slow economic recovery could have an adverse effect on all financial institutions, including the Company.

 

 
34

 

 

Critical Accounting Policies

 

General

 

The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained when earning income, recognizing an expense, recovering an asset or relieving a liability. The Company uses historical loss rates as one factor in determining the inherent loss that may be present in the loan portfolio. Actual losses could differ significantly from one previously acceptable method to another method. Although the economics of the Company’s transactions would be the same, the timing of events that would impact the transactions could change.

 

Allowance for Loan Losses

 

The allowance for loan losses is an accrual of estimated losses that have been sustained in our loan portfolio. The allowance is funded by the provision for loan losses, reduced by charge-offs of loans and increased by recoveries of previously charged-off loans. The determination of the allowance is based on two accounting principles, Accounting Standards Codification (“ASC”) Topic 450-20 (Contingencies) which requires that losses be accrued when occurrence is probable and the amount of the loss is reasonably estimable, and ASC Topic 310-10 (Receivables) which requires accrual of losses on impaired loans if the recorded investment exceeds fair value.

Probable losses are accrued through two calculations, individual evaluation of impaired loans and collective evaluation of the remainder of the portfolio. Impaired loans are larger non-homogeneous loans for which there is a probability that collection will not occur according to the loan terms, as well as loans whose terms have been modified in a troubled debt restructuring. Impaired loans with an estimated impairment loss are placed on nonaccrual status.

 

Impaired loans

Impaired loans are identified through the Company’s credit risk rating process. Estimated loss for an impaired loan is the amount of recorded investment that exceeds the loan’s fair value. Fair value of an impaired loan is measured by one of three methods: the fair value of collateral (“collateral method”), the present value of future cash flows (“cash flow method”), or observable market price. The Company applies the collateral method to collateral-dependent loans, loans for which foreclosure is eminent and to loans for which the fair value of collateral is a more reliable estimate of fair value. The cash flow method is applied to loans that are not collateral dependent and for which cash flows may be estimated.

The Company bases collateral method fair valuation upon the “as-is” value of independent appraisals or evaluations. Valuations for impaired loans with outstanding principal balances of $250 or more are based on a current appraisal. Appraisals are also used to value impaired loans with principal balances of $100 or greater and secured by one piece of collateral. Collateral-method impaired loans with principal balances below $100, or if secured by multiple pieces of collateral, below $250, are valued using an internal evaluation.

Appraisals and internal valuations provide an estimate of market value. Appraisals must conform to the Uniform Standards of Professional Appraisal Practice (“USPAP”) and are prepared by an independent third-party appraiser who is certified and licensed and who is approved by the Company. Appraisals incorporate market analysis, comparable sales analysis, cash flow analysis and market data pertinent to the property to determine market value. Internal evaluations are prepared and reviewed by employees of the Company who are independent of the loan origination, operation, management and collection functions. Evaluations provide a property’s market value based on the property’s current physical condition and characteristics and the economic market conditions that affect the collateral’s market value. Evaluations incorporate multiple sources of data to arrive at a property’s market value, including physical inspection, tax values, independent third-party automated tools, comparable sales analysis and local market information.

Updated appraisals or evaluations are ordered when the loan becomes impaired if the appraisal or evaluation on file is more than twelve months old. Appraisals and evaluations are reviewed for propriety and reasonableness and may be discounted if the Company determines that the value exceeds reasonable levels. If an updated appraisal or evaluation has been ordered but has not been received by a reporting date, the fair value may be based on the most recent available appraisal or evaluation, discounted for age.

The appraisal or evaluation value for a collateral-dependent loan for which recovery is expected solely from the sale of collateral is reduced by estimated selling costs. Estimated losses on collateral-dependent loans, as well as any other impairment loss considered uncollectible, are charged against the allowance for loan losses. For loans that are not collateral dependent, the impairment loss is accrued in the allowance. Impaired loans with partial charge-offs are maintained as impaired until the remaining balance is satisfied. Smaller homogeneous impaired loans that are not troubled debt restructurings or part of a larger impaired relationship are collectively evaluated.

Troubled debt restructurings are impaired loans and are measured for impairment under the same valuation methods as other impaired loans. Troubled debt restructurings are maintained in nonaccrual status until the loan has demonstrated reasonable assurance of repayment with at least nine months of consecutive timely payment performance, unless the impairment measurement indicates a loss. Troubled debt restructurings with impairment losses remain in nonaccrual status.

 

 
35

 

 

Collectively-evaluated loans

Non-impaired loans and smaller homogeneous impaired loans that are not troubled debt restructurings and not part of a larger impaired relationship are grouped by portfolio segments that are made up of smaller loan classes. Loans within a segment or class have similar risk characteristics.

Probable loss is determined by applying historical net charge-off rates as well as additional percentages for trends and current levels of quantitative and qualitative factors. Loss rates are calculated for and applied to individual classes. Beginning with the first quarter of 2014, the Company began calculating the applicable loss rates by averaging loss rates over the most recent 8 quarters. Prior to 2014, the Company annualized the current year-to-date loss rate and averaged it with the loss rate of the previous year. The two methods yield similar results, and at the end of the year will yield the same average loss rate. The Company transitioned to using 8 quarters in order to provide ease of calculation on an ongoing basis. The look-back periods of 8 quarters beginning in 2014 and two years for periods ended December 31, 2013 and prior are applied consistently among all classes.

Two loss rates for each class are calculated: total net charge-offs for the class as a percentage of average class loan balance (“class loss rate”), and total net charge-offs for the class as a percentage of average classified loans in the class (“classified loss rate”). Classified loans are those with risk ratings of “substandard” or higher. Net charge-offs in both calculations include charge-offs and recoveries of classified and non-classified loans as well as those associated with impaired loans. Class historical loss rates are applied to non-classified loan balances at the reporting date, and classified historical loss rates are applied to classified balances at the reporting date.

Trends and current levels of qualitative factors are evaluated and allocations are applied to each class. Qualitative factors include delinquency rates, loan quality and concentrations, loan officers’ experience, changes in lending policies and changes in the loan review process. Economic factors such as unemployment rates, bankruptcy rates and others are also evaluated, with standard allocations applied consistently to relevant classes.

The Company accrues additional estimated loss for criticized loans within each class and for loans designated high risk. High risk loans are defined as junior lien mortgages, loans with high loan-to-value ratios and loans with terms that require only interest payments. Both criticized loans and high risk loans are included in the base risk analysis for each class and are allocated additional reserves.

 

Estimation of the allowance for loan losses

The estimation of the allowance involves analysis of internal and external variables, methodologies, assumptions and our judgment and experience. Key judgments used in determining the allowance for loan losses include internal risk rating determinations, market and collateral values, discount rates, loss rates, and our view of current economic conditions. These judgments are inherently subjective and our actual losses could be greater or less than the estimate. Future estimates of the allowance could increase or decrease based on changes in the financial condition of individual borrowers, concentrations of various types of loans, economic conditions or the markets in which collateral may be sold. The estimate of the allowance accrual determines the amount of provision expense and directly affects our financial results.

The estimate of the allowance for September 30, 2014 considered market and portfolio conditions during the first nine months of 2014 as well as the levels of delinquencies and net charge-offs in the seven quarters prior to the quarter ended September 30, 2014. Given the continued economic difficulties, the ultimate amount of loss could vary from that estimate. For additional discussion of the allowance, see Note 4 to the financial statements and “Asset Quality,” and “Provision and Allowance for Loan Losses.”

 

Goodwill and Core Deposit Intangibles

 

Goodwill is subject to at least an annual assessment for impairment by applying a fair value based test. The Company performs impairment testing in the fourth quarter of each year. The Company’s most recent impairment test was performed in the fourth quarter of 2013. Accounting guidance provides the option of performing preliminary assessment of qualitative factors before performing more substantial testing for impairment. The Company opted not to perform the preliminary assessment. The Company’s goodwill impairment analysis considered three valuation techniques appropriate to the measurement. The first technique uses the Company’s market capitalization as an estimate of fair value; the second technique estimates fair value using current market pricing multiples for companies comparable to the Company; while the third technique uses current market pricing multiples for change-of-control transactions involving companies comparable to the Company. Each measure indicated that the Company’s fair value exceeded its book value, validating that goodwill is not impaired.

 

 
36

 

 

Certain key judgments were used in the valuation measurement. Goodwill is held by the Company’s bank subsidiary. The bank subsidiary is 100% owned by the Company, and no market capitalization is available. Because most of the Company’s assets are comprised of the subsidiary bank’s equity, the Company’s market capitalization was used to estimate the Bank’s market capitalization. Other judgments include the assumption that the companies and transactions used as comparables for the second and third technique were appropriate to the estimate of the Company’s fair value, and that the comparable multiples are appropriate indicators of fair value, and compliant with accounting guidance.

Acquired intangible assets (such as core deposit intangibles) are recognized separately from goodwill if the benefit of the asset can be sold, transferred, licensed, rented, or exchanged, and amortized over its useful life. The Company amortizes intangible assets arising from branch transactions over their useful life. Core deposit intangibles are subject to a recoverability test based on undiscounted cash flows, and to the impairment recognition and measurement provisions required for other long-lived assets held and used. The impairment testing showed that the expected cash flows of the intangible assets exceeded the carrying value.

 

Overview

 

National Bankshares, Inc. (“NBI”) is a financial holding company incorporated under the laws of Virginia. Located in southwest Virginia, NBI has two wholly-owned subsidiaries, the National Bank of Blacksburg (“NBB” or “the Bank”) and National Bankshares Financial Services, Inc. (“NBFS”). NBB, which does business as National Bank from twenty-five office locations, is a community bank. NBB is the source of nearly all of the Company’s revenue. NBFS does business as National Bankshares Investment Services and National Bankshares Insurance Services. Income from NBFS is not significant at this time, nor is it expected to be so in the near future.

NBI common stock is listed on the NASDAQ Capital Market and is traded under the symbol “NKSH.” National Bankshares, Inc. has been included in the Russell Investments Russell 3000 and Russell 2000 Indexes since September 29, 2009.

 

Lending

 

NBB is community-oriented and offers a full range of retail and commercial banking services to individuals, small and mid-sized businesses, non-profits and local governments. Loan types include commercial and agricultural, commercial real estate, construction for commercial and residential properties, residential real estate, home equity and various consumer loan products. Of primary consideration in the Bank’s decision to extend credit is the repayment ability of the borrowers and (if secured) the collateral value in relation to the principal balance. Collateral value lowers risk and may be used as a secondary source of repayment. The credit decision is supported by documentation appropriate to the type of loan, including current financial information, income verification or cash flow analysis, tax returns, credit reports, collateral information, guarantor verification, title reports, appraisals (where appropriate), and other documents. A discussion of underwriting policies and procedures specific to the major loan products follows.

Commercial and agricultural loans primarily finance equipment acquisition, expansion, working capital, and other general business purposes. Because these loans have a higher degree of risk, the Bank generally obtains collateral such as inventories, accounts receivable or equipment, and personal guarantees from the borrowing entity’s principal owners. The Bank’s policy limits lending to 60% of the appraised value for inventory and equipment and up to 70% for accounts receivables less than 90 days old. Credit decisions are based upon an assessment of the financial capacity of the applicant, including the primary borrower’s ability to repay within proposed terms, a risk assessment, financial strength of guarantors and adequacy of collateral. Credit agency reports of individual owners’ credit history supplement the analysis.

Commercial mortgages and construction loans are offered to investors, developers and builders, primarily within the Bank’s market area in southwest Virginia. These loans are secured by first mortgages on real estate. The loan amount is generally limited to 80% of the collateral value, and is individually determined based on the property type, quality, location and sponsorship. Commercial properties include retail centers, apartments, and industrial properties.

Underwriting decisions are based upon an analysis of the economic viability of the collateral and creditworthiness of the borrower. The Bank obtains appraisals from qualified certified independent appraisers to establish the value of collateral properties. The property’s projected net cash flows compared to the debt service requirement (the “debt service coverage ratio” or “DSC” ratio) is required to be 110% or greater, and is computed after deduction for a vacancy factor and property expenses, as appropriate. Borrower cash flow may be supplemented by a personal guarantee from the principal(s) of the borrower, and guarantees from other parties. The Bank requires title insurance, fire, and extended coverage casualty insurance, and flood insurance, if appropriate, in order to protect the security interest in the underlying property. In addition, the Bank may employ stress testing techniques on higher balance loans to determine repayment ability in a changing rate environment before granting loan approval.

Construction loans are underwritten against projected cash flows from rental income, business and/or personal income from an owner-occupant or the sale of the property to an end-user. Associated risks may be mitigated by requiring fixed-price construction contracts, performance and payment bonding, controlled disbursements, and pre-sale contracts or pre-lease agreements.

The Bank offers a variety of first mortgage and junior lien loans secured by 1-4 family residences to individuals within our markets. Credit decisions are primarily based on loan-to-value (“LTV”) ratios, debt-to-income (“DTI”) ratios, liquidity, net worth, and DSC ratios. Income and financial information is obtained from personal tax returns, personal financial statements and employment documentation. A maximum LTV ratio of 80% is generally required, although higher levels are permitted with mortgage insurance. The debt-to-income ratio is limited to 43% of gross income.

 

 
37

 

 

Consumer real estate mortgages may have fixed interest rates for the entire term of the loan or variable interest rates subject to change after the first, third, or fifth year. Variable rates are based on the weekly average yield of United States Treasury Securities and are underwritten at fully-indexed rates. We do not offer consumer real estate interest-only loans, sub-prime loans, or any variation on sub-prime lending including hybrid loans and payment option ARMs, or any product with negative amortization. Sub-prime loans involve extending credit to borrowers who exhibit characteristics indicating a significantly higher risk of default than traditional bank lending customers. Hybrid loans are loans that start out as a fixed rate mortgage but after a set number of years automatically adjust to an adjustable rate mortgage. Payment option ARMs usually have adjustable rates, for which borrowers choose their monthly payment of either a full payment, interest only, or a minimum payment which may be lower than the payment required to reduce the balance of the loan in accordance with the originally underwritten amortization.

Home equity loans are secured primarily by second mortgages on residential property. The underwriting policy for home equity loans generally permits aggregate (the total of all liens secured by the collateral property) borrowing availability up to 80% of the appraised value of the collateral. We offer variable rate home equity loans, with variable rate loans underwritten at fully-indexed rates. Decisions are primarily based on LTV ratios, DTI ratios and liquidity. We do not offer home equity loan products with reduced documentation.

Automobile loans include loans secured by new or used automobiles. Automobile loans are originated either on a direct basis or on an indirect basis through selected dealerships. We require borrowers to maintain collision insurance on automobiles securing consumer loans. Our procedures for underwriting automobile loans include an assessment of an applicant’s overall financial capacity, including credit history and the ability to meet existing obligations and payments on the proposed loan. Although an applicant’s creditworthiness is the primary consideration, the underwriting process also includes a comparison of the value of the collateral security to the proposed loan amount.

 

Performance Summary

 

The following table presents the Company’s key performance ratios for the nine months ended September 30, 2014 and the year ended December 31, 2013. The measures for September 30, 2014 are annualized, except for basic earnings per share and fully diluted earnings per share.

 

   

September 30,

2014

   

December 31,
2013

 

Return on average assets

    1.53

%

    1.63

%

Return on average equity

    10.99

%

    11.90

%

Basic earnings per share

  $ 1.84     $ 2.56  

Fully diluted earnings per share

  $ 1.84     $ 2.55  

Net interest margin (1)

    4.05

%

    4.25

%

Noninterest margin (2)

    1.39

%

    1.42

%

 

 

(1)

Net interest margin: Year-to-date tax-equivalent net interest income divided by year-to-date average earning assets.

 

(2)

Noninterest margin: Noninterest expense (excluding the provision for bad debts and income taxes) less noninterest income (excluding securities gains and losses) divided by average year-to-date assets.

 

The annualized return on average assets declined 10 basis points for the nine months ended September 30, 2014 as compared with the year ended December 31, 2013. The annualized return on average equity decreased 91 basis points for the same period.

The annualized net interest margin was 4.05% for the nine months ended September 30, 2014, down 20 basis points from the 4.25% reported for the year ended December 31, 2013. The primary factor driving the decrease in the net interest margin was the declining yield on earning assets offset by a smaller decline in the cost to fund earning assets.

The annualized noninterest margin decreased 3 basis points from the year ended December 31, 2013. Please refer to the discussion under noninterest expense for further information.

 

 
38

 

 

Growth

 

NBI’s key growth indicators are shown in the following table.

 

   

September 30, 2014

   

December 31, 2013

   

Percent Change

 

Interest-bearing deposits

  $ 87,621     $ 98,066       (10.65

)%

Securities

    368,566       347,109       6.18

%

Loans, net

    587,770       587,463       0.05

%

Deposits

    948,923       960,036       (1.16

)%

Total assets

    1,116,259       1,110,630       0.51

%

 

Asset Quality

 

Key indicators of the Company’s asset quality are presented in the following table.

 

   

September 30, 2014

   

September 30, 2013

   

December 31, 2013

 

Nonperforming loans

  $ 7,726     $ 11,236     $ 6,584  

Loans past due 90 days or more, and still accruing

    485       149       190  

Other real estate owned

    5,145       973       4,712  

Allowance for loan losses to loans

    1.35

%

    1.37

%

    1.38

%

Net charge-off ratio

    0.31

%

    0.36

%

    0.28

%

Ratio of nonperforming assets to loans, net of unearned income and deferred fees, plus other real estate owned

    2.14

%

    2.06

%

    1.88

%

Ratio of allowance for loan losses to nonperforming loans

    103.95

%

    72.00

%

    124.95

%

 

The Company monitors asset quality indicators in managing credit risk and in determining the allowance and provision for loan losses. The Company’s risk analysis for collectively-evaluated loans is based on historical charge-off rates, asset quality trends represented by past due and nonaccrual ratios, diversification of loans within the portfolio, the value of underlying collateral if secured, the risk of unsecured loans, and economic trends pertinent to the Company’s loan portfolio.

The Company’s risk analysis determined an allowance for loan losses of $8,031 at September 30, 2014, a decrease from $8,227 at December 31, 2013 and $8,090 at September 30, 2013. The provision for the nine months ended September 30, 2014 was $1,160, a decline from $1,329 for the same period in 2013. The ratio of allowance for loan losses to loans is 1.35% as of September 30, 2014, compared with 1.38% December 31, 2013 and 1.37% at September 30, 2013.

Contributing to the decline in the allowance for loan losses as a percentage of loans and to the decline in the provision for loan losses is an improved charge-off ratio for the nine months ended September 30, 2014 when compared with the nine month period ended September 30, 2013. The annualized net charge-off ratio is 0.31% for the nine months of 2014, compared with 0.36% for the nine months ended September 30, 2013.

Asset quality indicators that improved from September 30, 2013 included levels of nonperforming loans of $7,726 at September 30, 2014, compared with $11,236 at September 30, 2013. The coverage ratio of the allowance for loan losses to nonperforming loans at September 30, 2014 was 103.95%, an improvement from 72.00% at September 30, 2013. When compared with December 31, 2013, asset quality fell slightly.

Economic factors were analyzed to determine their impact on the credit risk of the loan portfolio. Within the Company’s market area, business and personal bankruptcy rates improved slightly, as did the inventory of new and existing homes. Residential vacancy rates and the unemployment rate slightly worsened, while the interest rate, competitive, legal and regulatory environments remained at similar levels to the previous quarter.

Other real estate owned increased $433 from December 31, 2013 and $4,172 from September 30, 2013. As of September 30, 2014, total properties approximating $933 are in various stages of foreclosure and may impact other real estate owned in future quarters. It is not possible to accurately predict the future total of other real estate owned because property sold at foreclosure may be acquired by third parties and NBB’s other real estate owned properties are regularly marketed and sold.

 

 
39

 

 

The recent economic recession and slow recovery have contributed to levels of asset quality measures that are higher than normal for the Company, however risk analyses show signs of improvement. Improvements in charge-off ratios, nonperforming loans, bankruptcy rates and home inventory, partially offset by slightly negative indications in unemployment and residential vacancy rates resulted in an allowance slightly below the level at December 31, 2013 and September 30, 2013. The Company continues to monitor risk levels within the loan portfolio. Please refer to Note 4: Allowance for Loan Losses, Nonperforming Assets and Impaired Loans for further information on collectively-evaluated loans, individually-evaluated impaired loans and the unallocated portion of the allowance for loan losses.

 

Modifications and Troubled Debt Restructurings (“TDRs”)

 

In the ordinary course of business, the Company modifies loan terms on a case-by-case basis, including both consumer and commercial loans, for a variety of reasons. Modifications to consumer loans generally involve short-term deferrals to accommodate specific, temporary circumstances. The Company may grant extensions to borrowers who have demonstrated a willingness and ability to repay their loan but who are dealing with the consequences of a specific unforeseen temporary hardship.

An extension defers monthly payments and requires a balloon payment at the original contractual maturity. Where the temporary event is not expected to impact a borrower’s ability to repay the debt, and where the Company expects to collect all amounts due including interest accrued at the contractual interest rate for the period of delay at contractual maturity, the modification is not designated a TDR.

Modifications to commercial loans may include, but are not limited to, changes in interest rate, maturity, amortization and financial covenants. In the original underwriting, loan terms are established that represent the then-current and projected financial condition of the borrower. If the modified terms are consistent with competitive market conditions and are representative of terms the borrower could otherwise obtain in the open market, the modified loan is not categorized as a TDR.     

The Company began coding modifications on the core processing system during the second quarter of 2013. The Company uses the coding to assist in identifying troubled debt restructurings. The majority of modifications completed since formal coding was implemented were granted for competitive reasons and did not constitute troubled debt restructurings. A description of modifications that did not result in troubled debt restructurings for the first nine months of 2014 follows:

 

Modifications To Borrowers Not Experiencing Financial Difficulty

 

Number of Loans Modified

   

Total Amount Modified

 

Rate reductions for competitive purposes

    35     $ 16,286    

Payment extensions for less than 3 months

    80       1,274    

Maturity date extensions of more than 1 month and up to 6 months

    130       30,175    

Maturity date extensions of more than 6 months and up to 12 months

    197       6,277    

Maturity date extensions of more than 12 months

    11       4,544    

Change in amortization term or method

    21       4,328    

Renewal of expired Home Equity Line of Credit loans for additional 10 years

    22       421    

Renewal of single-payment notes

    151       2,923    

Total modifications that do not constitute TDRs

    647     $ 66,228    

 

Modifications in which the borrower is experiencing financial difficulty and in which the Company makes a concession to the original contractual loan terms are designated troubled debt restructurings.

Modifications of loan terms to borrowers experiencing financial difficulty are made in an attempt to protect as much of the Company’s investment in the loan as possible. The determination of whether a modification should be accounted for as a TDR requires significant judgment after consideration of all facts and circumstances surrounding the transaction.

The Company recognizes that the current economy, elevated levels of unemployment and depressed real estate values have resulted in financial difficulties for some customers. The Company has restructured loan terms for certain qualified financially distressed borrowers who have agreed to work in good faith and have demonstrated the ability to make the restructured payments in order to avoid a foreclosure. All TDR loans are individually evaluated for impairment for purposes of determining the allowance for loan losses. TDR loans with an impairment loss or that do not demonstrate current payments for at least six months are maintained on nonaccrual until the borrower demonstrates sustained repayment history under the restructured terms and continued repayment is not in doubt. Otherwise, interest income is recognized using a cost recovery method.

 

 
40

 

 

The Company’s TDRs were $8,307 at September 30, 2014, an increase from $7,043 at December 31, 2013. Accruing TDR loans amounted to $5,947 at September 30, 2014 and $6,191 at December 31, 2013. TDRs with a current payment history with at least six months may accrue interest.

 

   

TDR Status as of September 30, 2014

 
           

Accruing

         
   

Total TDR Loans

   

Current

   

30-89 Days Past Due

   

90+ Days

Past Due

   

Nonaccrual

 

Consumer real estate

  $ 686     $ 653     $ 33     $ ---     $ ---  

Commercial real estate

    7,584       5,224       ---       ---       2,360  

Commercial non real estate

    37       37       ---       ---       ---  

Total TDR Loans

  $ 8,307     $ 5,914     $ 33     $ ---     $ 2,360  

 

   

TDR Status as of December 31, 2013

 
           

Accruing

         
   

Total TDR Loans

   

Current

   

30-89 Days Past Due

   

90+ Days

Past Due

   

Nonaccrual

 

Consumer real estate

  $ 780     $ 579     $ ---     $ ---     $ 201  

Commercial real estate

    6,203       5,552       ---       ---       651  

Commercial non real estate

    60       60       ---       ---       ---  

Total TDR Loans

  $ 7,043     $ 6,191     $ ---     $ ---     $ 852  

 

Restructuring generally results in loans with either lower payments or an extended maturity beyond that originally required, and are expected to have a lower risk of loss due to nonperformance than loans classified as nonperforming. During the first nine months 2014, the Company modified two loans with post-modification balances totaling $2,693 in troubled debt restructurings, and during the first nine months of 2013, the Company modified six loans with post-modification balances totaling $4,576. Please refer to Note 4 for information on troubled debt restructurings.

 

 
41

 

 

Net Interest Income

 

The net interest income analysis for the nine months ended September 30, 2014 and 2013 follows:

 

   

September 30, 2014

   

September 30, 2013

 
   


Average
Balance

   



Interest

   

Average
Yield/
Rate

   


Average
Balance

   



Interest

   

Average
Yield/
Rate

 

Interest-earning assets:

                                               

Loans, net (1)(2)(3)(4)

  $ 591,995     $ 23,921       5.40

%

  $ 585,230     $ 25,067       5.73

%

Taxable securities (5)

    213,238       5,068       3.18

%

    195,848       4,928       3.36

%

Nontaxable securities (1)(5)(6)

    158,890       6,828       5.75

%

    173,442       7,504       5.78

%

Interest-bearing deposits

    101,908       193       0.25

%

    80,414       161       0.27

%

Total interest-earning assets

  $ 1,066,031     $ 36,010       4.52

%

  $ 1,034,934     $ 37,660       4.87

%

Interest-bearing liabilities:

                                               

Interest-bearing demand deposits

  $ 499,064     $ 2,598       0.70

%

  $ 454,943     $ 2,856       0.84

%

Savings deposits

    78,013       27       0.05

%

    72,226       26       0.05

%

Time deposits

    233,731       1,132       0.65

%

    264,771       1,733       0.88

%

Total interest-bearing liabilities

  $ 810,808     $ 3,757       0.62

%

  $ 791,940     $ 4,615       0.78

%

Net interest income and interest rate spread

          $ 32,253       3.90

%

          $ 33,045       4.09

%

Net yield on average interest-earning assets

                    4.05

%

                    4.27

%

 

 

(1)

Interest on nontaxable loans and securities is computed on a fully taxable equivalent basis using a Federal income tax rate of 35% in the nine-month periods presented.

 

(2)

Included in interest income are loan fees of $447 and $698 for the nine months ended September 30, 2014 and 2013, respectively.

 

(3)

Nonaccrual loans are included in average balances for yield computations.

 

(4)

Includes mortgage loans held for sale.

 

(5)

Daily averages are shown at amortized cost.

 

(6)

Includes restricted stock.

 

The net interest margin for the nine months ended September 30, 2014 decreased 22 basis points from the nine months ended September 30, 2013. The decrease in interest rate spread was driven by a decline in the yield on earning assets of 35 basis points offset by a decline in the cost of interest-bearing liabilities of 16 basis points. Both loans and securities experienced a decline in yields. The 33 basis point decline in the yield on loans stemmed from contractual repricing terms and the renegotiation of loan interest rates in response to competition. The yield on taxable securities was 18 basis points lower for the nine months ended September 30, 2014, when compared with the same period in 2013, while the yield on nontaxable securities declined 3 basis points over the same period. The market yield for securities of a comparable term has declined over the past year, causing matured and called bonds to be replaced with lower yielding investments. The decline in the cost of interest-bearing liabilities came mainly from a 23 basis point reduction in the cost of time deposits and a 14 basis point reduction in interest-bearing demand deposits when the nine month periods ended September 30, 2014 and September 30, 2013 are compared.

The Company’s yield on earning assets and cost of funds are largely dependent on the interest rate environment. In the recent past, historically low interest rates caused funding costs to decline at a faster pace than the yield on earning assets. The decline in deposit pricing has begun to slow while competitive and market forces continue to pressure the yield on earning assets. The Company’s cost of funding is more sensitive to interest rate changes than is the yield on earning assets.

 

 
42

 

 

Provision and Allowance for Loan Losses

 

The provision for loan losses for the nine month period ended September 30, 2014 was $1,160, compared with $1,329 for the nine months of 2013. The provision for loan losses is the result of a detailed analysis to estimate an appropriate and adequate allowance for loan losses. The ratio of the allowance for loan losses to total loans at September 30, 2014 was 1.35%, which compares to 1.38% at December 31, 2013. The net charge-off ratio was 0.31% at September 30, 2014 and 0.28% at December 31, 2013. The change in the provision for loan losses was largely attributable to improvements in credit quality trends, lower net charge-offs when compared with those for the first nine months of 2013 and some positive economic indicators. See “Asset Quality” for additional information.

 

Noninterest Income

 

   

Nine Months Ended

         
   

September 30, 2014

   

September 30, 2013

   

Percent Change

 
                         

Service charges on deposits

  $ 1,833     $ 1,922       (4.63

)%

Other service charges and fees

    145       139       4.32

%

Credit card fees

    2,687       2,427       10.71

%

Trust fees

    921       867       6.23

%

                         

BOLI income

    526       546       (8.15

)%

                         

Other income

    669       687       (2.62

)%

                         

Realized securities gains (losses), net

    5       (44

)

    (111.36

)%

 

Service charges on deposit accounts for the nine months ended September 30, 2014 decreased slightly when compared with the same period in 2013, while other service charges and fees increased slightly. Other service charges and fees includes charges for official checks, income from the sale of checks to customers, safe deposit box rent, fees for letters of credit and the income earned from commissions on the sale of credit life, accident and health insurance.

Credit card fees for the nine months of 2014 increased $260, or 10.71%, when compared with the same period last year. The increase stemmed from a change in vendors that resulted in more favorable fee income, as well as a higher volume of merchant transactions and credit card fees.

Income from trust fees increased 6.23% or $54 from the $867 earned in the same period of 2013. Trust income varies depending on the total assets held in trust accounts, the type of accounts under management and financial market conditions.

BOLI income decreased $20 from September 30, 2013 to September 30, 2014.

Other income includes net gains from the sales of fixed assets, revenue from investment and insurance sales and other smaller miscellaneous components. Other income for the nine months ended September 30, 2014 decreased $18 when compared with the nine months ended September 30, 2013. These areas fluctuate with market conditions and because of competitive factors.

Net realized securities gains for the nine months ended September 30, 2014 were $5, as compared with a loss of $44 for the same period in 2013. Net realized securities gains and losses are market driven and have resulted from calls and sales of securities.

 

Noninterest Expense

 

   

Nine Months Ended

         
   

September 30, 2014

   

September 30, 2013

   

Percent Change

 
                         

Salaries and employee benefits

  $ 8,954     $ 8,963       (0.10

)%

Occupancy, furniture and fixtures

    1,265       1,230       2.85

%

                         

Data processing and ATM

    1,183       1,288       (8.15

)%

FDIC assessment

    411       408       0.74

%

Credit card processing

    1,887       1,854       1.78

%

                         

Intangibles amortization

    807       809       (0.25

)%

Net costs of other real estate owned

    259       192       34.90

%

Franchise taxes

    874       803       8.84

%

Other operating expenses

    2,738       2,697       1.52

%

 

 
43

 

 

Total noninterest expense increased $134 or 0.73% when the nine months ended September 30, 2014 are compared to the same period of 2013. Most of the increase stemmed from an increase of $67 in net cost of other real estate owned, a $71 increase in franchise taxes and a $35 increase in occupancy, furniture and fixtures. Bank franchise tax expense is calculated based on capital levels. The cost of other real estate owned includes maintenance costs as well as valuation write-downs and gains and losses on the sale of properties. The expense varies with the number of properties, the maintenance required and changes in the real estate market.

FDIC assessment expense for the nine months ended September 30, 2014 increased $3 or 0.74% over the same period for 2013. The calculation is based on total assets and incorporates risk-based factors to determine the amount of the assessment.

Credit card processing expense increased by 1.78% from the total for the nine months ended September 30, 2013. This expense is driven by volume and other factors and is subject to a degree of variability.

Other operating expense increased $41 to $2,738 for the nine months ended September 30, 2014 from $2,697 for the nine months ended September 30, 2013. The category of other operating expenses includes noninterest expense items such as professional services, stationery and supplies, telephone costs, postage, charitable donations and other expenses.

Data processing and ATM expense for the nine months ended September 30, 2014 decreased $105 when compared with the expense for the nine months ended September 30, 2013. The decline stemmed from upgrades to ATMs that resulted in lower maintenance expenses, and conversion to a lower-cost vendor for communication infrastructure.

The expense for intangibles amortization is related to acquisitions. There were no acquisitions in the past year, with minimal change in expense between the nine month periods ended September 30, 2014 and September 30, 2013.

 

Balance Sheet

 

Year-to-date daily averages for the major balance sheet categories are as follows:

 

Assets

 

September 30, 2014

   

December 31, 2013

   

Percent Change

 

Interest-bearing deposits

  $ 101,908     $ 80,690       26.30

%

                         

Securities available for sale and restricted stock

    194,736       197,447       (1.37

)%

                         

Securities held to maturity

    163,268       164,888       (0.98

)%

Loans, net

    588,521       577,746       1.87

%

Total assets

    1,115,643       1,090,703       2.29

%

                         

Liabilities and stockholders’ equity

                       

Noninterest-bearing demand deposits

  $ 144,250     $ 141,445       1.98

%

Interest-bearing demand deposits

    499,064       459,340       8.65

%

Savings deposits

    78,013       72,783       7.19

%

                         

Time deposits

    233,731       259,914       (10.07

)%

Stockholders’ equity

    155,447       149,491       3.98

%

 

Securities

 

Management regularly monitors the quality of the securities portfolio, and management closely follows the uncertainty in the economy and the volatility of financial markets.  The value of individual securities will be written down if the decline in fair value is considered to be other than temporary based upon the totality of circumstances. See Note 5 Securities for additional information.

 

 
44

 

 

Loans

 

   

September 30, 2014

   

December 31, 2013

   

Percent Change

 
                         

Real estate construction loans

  $ 42,067     $ 45,925       (8.40

)%

                         

Consumer real estate loans

    144,312       145,499       (0.82

)%

Commercial real estate loans

    312,937       311,266       0.54

%

Commercial non real estate loans

    32,224       31,262       3.08

%

Public sector and IDA

    36,398       34,220       6.36

%

Consumer non real estate

    28,735       28,423       1.10

%

                         

Less: unearned income

    (872)       (905)       (3.65

)%

Loans, net of unearned income

  $ 595,801     $ 595,690       0.02

%

 

The Company’s loans net of unearned income increased by $111 or 0.02%, from $595,690 at December 31, 2013 to $595,801 at September 30, 2014. Growth in commercial real estate loans, commercial non real estate, public sector and IDA, and consumer non real estate was offset by declines in real estate construction and consumer real estate loans. The changes are due to market, economic and competitive forces and are not the result of changes in lending policies. The Company does not now, nor has it ever, offered certain types of higher-risk loans such as subprime loans, option ARM products, reverse mortgages or loans with initial teaser rates.

 

Deposits

 

   

September 30, 2014

   

December 31, 2013

   

Percent Change

 

Noninterest-bearing demand deposits

  $ 153,118     $ 142,645       7.34

%

                         

Interest-bearing demand deposits

    492,005       501,541       (1.90

)%

Saving deposits

    79,870       74,141       7.73

%

                         

Time deposits

    223,930       241,709       (7.36

)%

                         

Total deposits

  $ 948,923     $ 960,036       (1.16

)%

 

Total deposits decreased $11,113, or 1.16% from $960,036 at December 31, 2013 to $948,923 at September 30, 2014. Increases in non-time deposits totaled $6,666. These increases were offset by a decline time deposits of $17,779, or 7.36%, when September 30, 2014 is compared with December 31, 2013. Historically low rates have caused a migration from time deposits to other types of deposits. As longer-term certificates of deposit mature, customers are unwilling to commit their funds for extended periods at low interest rates. Time deposits do not include any brokered deposits.

 

Liquidity

 

Liquidity measures the Company’s ability to meet its financial commitments at a reasonable cost. Demands on the Company’s liquidity include funding additional loan demand and accepting withdrawals of existing deposits. The Company has diverse sources of liquidity, including customer and purchased deposits, customer repayments of loan principal and interest, sales, calls and maturities of securities, Federal Reserve discount window borrowing, short-term borrowing, and Federal Home Loan Bank (“FHLB”) advances. At September 30, 2014, the bank did not have purchased deposits, discount window borrowings, short-term borrowings, or FHLB advances. To assure that short-term borrowing is readily available, the Company tests accessibility annually.

Liquidity from securities is restricted by accounting and business considerations. The securities portfolio is segregated into available-for-sale and held-to-maturity. The Company considers only securities designated available-for-sale for typical liquidity needs. Further, portions of the securities portfolio are pledged to meet state requirements for public funds deposits. Discount window borrowings also require pledged securities. Increased or decreased liquidity from public funds deposits or discount window borrowings results in increased or decreased liquidity from pledging requirements. The Company monitors public funds pledging requirements and the amount of unpledged available-for-sale securities that are accessible for liquidity needs.

Regulatory capital levels determine the Company’s ability to utilize purchased deposits and the Federal Reserve discount window for liquidity needs. At September 30, 2014, the Company is considered well capitalized and does not have any restrictions on purchased deposits or the Federal Reserve discount window.

The Company monitors factors that may increase its liquidity needs. Some of these factors include deposit trends, large depositor activity, maturing deposit promotions, interest rate sensitivity, maturity and repricing timing gaps between assets and liabilities, the level of unfunded loan commitments and loan growth. At September 30, 2014, the Company’s liquidity is sufficient to meet projected trends in these areas.

 

 
45

 

 

To monitor and estimate liquidity levels, the Company performs stress testing under varying assumptions on credit sensitive liabilities. It also tests the sources and amounts of balance sheet and external liquidity available to replace outflows. The Company’s Contingency Funding Plan sets forth avenues for rectifying liquidity shortfalls. At September 30, 2014, the analysis indicated adequate liquidity under the tested scenarios.

The Company utilizes several other strategies to maintain sufficient liquidity. Loan and deposit growth are managed to keep the loan to deposit ratio within the Company’s own policy range of 65% to 75%. At September 30, 2014, the loan to deposit ratio was 62.79%, slightly below the Company’s internal target. The investment strategy takes into consideration the term of the investment, and securities in the available for sale portfolio are laddered to account for projected funding needs.

 

Capital Resources

 

Total stockholders’ equity at September 30, 2014 was $162,822, an increase of $16,930 or 11.60%, from the $145,892 at December 31, 2013. The Tier I and Tier II risk-based capital ratios at September 30, 2014 were 23.85% and 25.02%, respectively. Capital levels remain significantly above the regulatory minimum capital requirements of 4.0% for Tier I and 8.0% for Tier II capital.

In October 2013, the Federal Reserve published final rules to align its market risk capital requirements with the Basel III regulatory capital framework and meet certain provisions of the Dodd-Frank Act. The new capital rules are effective for the Company on January 1, 2015 and will require the Company to comply with the following new minimum capital ratios: (1) a new common equity Tier 1 capital ratio of 4.5% of risk-weighted assets; (2) a Tier 1 capital ratio of 6% of risk-weighted assets (increased from the current requirement of 4%); (3) a total capital ratio of 8% of risk-weighted assets (unchanged from current requirement); and, (4) a leverage ratio of 4% of total assets. Furthermore, beginning January 1, 2016, these rules introduce a capital conservation buffer, which places restrictions on the amount of retained earnings that may be used for distributions or discretionary bonus payments as risk-based capital ratios approach their respective “adequately capitalized” minimums. The Company is currently considered “well capitalized” under the current rules and Management anticipates that the Company will remain “well capitalized” when the new risk-based capital ratio requirements become effective on January 1, 2015.

 

Off-Balance Sheet Arrangements

 

In the normal course of business, NBB extends lines of credit and letters of credit to its customers. Depending on their needs, customers may draw upon lines of credit at any time in any amount up to a pre-approved limit. Standby letters of credit are issued for two purposes. Financial letters of credit guarantee payments to facilitate customer purchases. Performance letters of credit guarantee payment if the customer fails to complete a specific obligation.

Historically, the full approved amount of letters and lines of credit has not been drawn at any one time. The Company has developed plans to meet a sudden and substantial funding demand. These plans include accessing a line of credit with a correspondent bank, borrowing from the FHLB, selling available for sale investments or loans and raising additional deposits.

The Company sells mortgages on the secondary market for which there are recourse agreements should the borrower default. Mortgages must meet strict underwriting and documentation requirements for the sale to be completed. The Company has determined that its risk in this area is not significant because of a low volume of secondary market mortgage loans and high underwriting standards. The Company estimates a potential loss reserve for recourse provisions that is not material as of September 30, 2014. To date, no recourse provisions have been invoked. If funds were needed, the Company would access the same sources as noted above for funding lines and letters of credit.

There were no material changes in off-balance sheet arrangements during the nine months ended September 30, 2014, except for normal seasonal fluctuations in the total of mortgage loan commitments.

 

Contractual Obligations

 

The Company had no capital lease or purchase obligations and no long-term debt at September 30, 2014. Operating lease obligations, which are for buildings used in the Company’s day-to-day operations, were not material at the end of the nine months of 2014 and have not changed materially from those which were disclosed in the Company’s 2013 Form 10-K.

 

Item 3.     Quantitative and Qualitative Disclosures About Market Risk

 

The Company considers interest rate risk to be a significant market risk and has systems in place to measure the exposure of net interest income to adverse movement in interest rates. Interest rate shock analyses provide management with an indication of potential economic loss due to future rate changes. There have not been any changes which would significantly alter the results disclosed as of December 31, 2013 in the Company’s 2013 Form 10-K.

 

 
46

 

 

Item 4. Controls and Procedures

 

The Company’s management evaluated, with the participation of the Company’s principal executive officer and principal financial officer, the effectiveness of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on that evaluation, the Company’s principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures are effective as of September 30, 2014 to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including the Company’s principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure.

There were no changes in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act) during the nine months ended September 30, 2014 that have materially affected, or are reasonably likely to materially affect, the Corporation’s internal control over financial reporting.

Because of the inherent limitations in all control systems, the Company believes that no system of controls, no matter how well designed and operated, can provide absolute assurance that all control issues have been detected.

 

 

Part II

Other Information

 

Item 1.     Legal Proceedings

 

There are no pending or threatened legal proceedings to which the Company or any of its subsidiaries is a party or to which the property of the Company or any of its subsidiaries is subject that, in the opinion of management, may materially impact the financial condition of the Company.

 

Item 1A. Risk Factors

 

Please refer to the “Risk Factors” previously disclosed in Item 1A of our 2013 Annual Report on Form 10-K and the factors discussed under “Cautionary Statement Regarding Forward-Looking Statements” in Part I. Item 2 of this Form 10-Q.

 

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

 

None.

 

Item 3.   Defaults Upon Senior Securities

 

None.

 

Item 4.   Mine Safety Disclosures

 

Not applicable.          

 

Item 5.   Other Information

 

Change in Annual Meeting Date and Deadline for Shareholder Proposals

On July 9, 2014, the Board of Directors of the Company adopted an amendment (the “Amendment”) of the Bylaws of the Company. The Amendment became effective immediately on its adoption and changed the date of the annual meeting of the shareholders from the second Tuesday in April to the second Tuesday in May each year.

A copy of the Company’s Amended and Restated Bylaws was attached to the Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on July 9, 2014.

Because the expected date of the 2015 Annual Meeting represents a change of more than 30 days from the anniversary of the Company’s 2014 annual shareholders’ meeting, the Company has set a new deadline for the receipt of shareholder proposals submitted pursuant to Rule 14a-8 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), for inclusion in the Company’s proxy materials for the 2015 Annual Meeting. In order to be considered for inclusion, such proposals must be received in writing by the Company before the close of business on December 8, 2014 and delivered to the Company’s President at the Company’s principal executive offices located at 101 Hubbard Street, Blacksburg, Virginia 24060, or mailed to P.O. Box 90002, Blacksburg, Virginia, 24062-9002.

 

 
47

 

 

Proposals must also comply with the applicable requirements of Rule 14a-8 of the Exchange Act regarding the inclusion of shareholder proposals in Company-sponsored proxy materials and other applicable laws. The December 8, 2014 deadline will also apply in determining whether notice of a shareholder proposal is timely for purposes of exercising discretionary voting authority with respect to proxies under Rule 14a-4(c)(1) of the Exchange Act.

Additionally, in order for a shareholder to bring business before the 2015 Annual Meeting outside of Rule 14a-8 of the Exchange Act or to nominate a director, it must provide timely notice within the applicable time period set forth in the advance notice provisions of the Company’s Bylaws. The Bylaws provide that the President of the Company must receive written notice at the principal executive offices of the Company no less than 60 days (March 11, 2015) nor more than 90 days (February 10, 2015) prior to the date of the 2015 Annual Meeting. Such notice must be delivered to the Company’s President at the Company’s principal executive offices located at 101 Hubbard Street, Blacksburg, Virginia 24060, or mailed to P.O. Box 90002, Blacksburg, Virginia, 24062-9002.

 

Item 6.     Exhibits

 

See Index of Exhibits.     

 

 

 

Signatures

 

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

 

 

NATIONAL BANKSHARES, INC.

 

 

 

Date: November 3, 2014

/s/ James G. Rakes

 

James G. Rakes
Chairman, President and

Chief Executive Officer

(Principal Executive Officer)

   

Date: November 3, 2014

/s/ David K. Skeens

 

David K. Skeens
Treasurer and

Chief Financial Officer

(Principal Financial Officer)

(Principal Accounting Officer)

 

 
48

 

 

Index of Exhibits

 

Exhibit No.

 

Description

 

Page No. in

Sequential System

3(i)

Amended and Restated Articles of Incorporation of National Bankshares, Inc.

 

(incorporated herein by reference to Exhibit 3.1 of the Form 8K for filed on March 16, 2006)

3(ii)

Amended By-laws of National Bankshares, Inc.

 

(incorporated herein by reference to the Form 8-K filed on July 9, 2014)

4(i)

Specimen copy of certificate for National Bankshares, Inc. common stock 

 

(incorporated herein by reference to Exhibit 4(a) of the Annual Report on Form 10K for fiscal year ended December 31, 1993)

*10(iii)(A)

National Bankshares, Inc. 1999 Stock Option Plan

 

(incorporated herein by reference to Exhibit 4.3 of the Form S-8, filed as Registration No. 333-79979 with the Commission on September 4, 1999)

*10(iii)(A)

Executive Employment Agreement dated December 17, 2008, between National Bankshares, Inc. and James G. Rakes

 

(incorporated herein by reference to Exhibit 10(iii)(A) of the Annual Report on Form 10K for the fiscal year ended December 31, 2008)

*10(iii)(A)

Executive Employment Agreement dated December 17, 2008, between National Bankshares, Inc. and F. Brad Denardo

 

(incorporated herein by reference to Exhibit 10(iii)(A) of the Annual Report on Form 10K for the fiscal year ended December 31, 2008)

*10(iii)(A)

Salary Continuation Agreement dated February 8, 2006, between The National Bank of Blacksburg and James G. Rakes

 

(incorporated herein by reference to Exhibit 10(iii)(A) of the Form 8K filed on February 8, 2006)

*10(iii)(A)

Salary Continuation Agreement dated February 8, 2006, between The National Bank of Blacksburg and F. Brad Denardo

 

(incorporated herein by reference to Exhibit 10(iii)(A) of the Form 8K filed on February 8, 2006)

*10(iii)(A)

Salary Continuation Agreement dated February 8, 2006, between

The National Bank of Blacksburg and David K. Skeens

 

(incorporated herein by reference to Exhibit 10(iii)(A) of the Form 8K filed on January 25, 2012)

*10(iii)(A)

First Amendment, dated December 19, 2007, to The National Bank of Blacksburg Salary Continuation Agreement for James G. Rakes

 

(incorporated herein by reference to Exhibit 10(iii)(A) of the Form 8K filed on December 19, 2007)

*10(iii)(A)

First Amendment, dated December 19, 2007, to The National Bank of Blacksburg Salary Continuation Agreement for F. Brad Denardo

 

(incorporated herein by reference to Exhibit 10(iii)(A) of the Form 8K filed on December 19, 2007)

*10(iii)(A)

First Amendment, dated December 19, 2007, to The National Bank of Blacksburg Salary Continuation Agreement for David K. Skeens

 

(incorporated herein by reference to Exhibit 10(iii)(A) of the Form 8K filed on January 25, 2012)

*10(viii)(A)

Second Amendment, dated September 12, 2008, to The National Bank of Blacksburg Salary Continuation Agreement for F. Brad Denardo

 

(incorporated herein by reference to Exhibit 10(iii)(A) of the Form 8K filed on September 12, 2008)

 

 
49

 

 

 

*10(viii)(A)

Second Amendment, dated December 17, 2008, to The National Bank of Blacksburg Salary Continuation Agreement for James G. Rakes

 

(incorporated herein by reference to Exhibit 10(iii)(A) of the Annual Report on Form 10K for the fiscal year ended December 31, 2008)

*10(iii)(A)

Second Amendment, dated September 12, 2008, to The National Bank of Blacksburg Salary Continuation Agreement for David K. Skeens

 

(incorporated herein by reference to Exhibit 10(iii)(A) of the Form 8K filed on January 25, 2012)

*10(viii)(A)

Third Amendment, dated December 17, 2008, to The National Bank of Blacksburg Salary Continuation Agreement for F. Brad Denardo

 

(incorporated herein by reference to Exhibit 10(iii)(A) of the Annual Report on Form 10K for the fiscal year ended December 31, 2008)

*10(iii)(A)

Third Amendment, dated January 20, 2012, to The National Bank of Blacksburg Salary Continuation Agreement for David K. Skeens

 

(incorporated herein by reference to Exhibit 10(iii)(A) of the Form 8K filed on January 25, 2012)

*10(iii)(A)

Salary Continuation Agreement dated January 20, 2012 between

The National Bank of Blacksburg and Bryson J. Hunter

 

(incorporated herein by reference to Exhibit 10(iii)(A) of the Form 8K filed on January 25, 2012)

31(i)

Section 906 Certification of Chief Executive Officer

 

(included herewith)

31(ii)

Section 906 Certification of Chief Financial Officer

 

(included herewith)

32(i)

18 U.S.C. Section 1350 Certification of Chief Executive Officer

 

(included herewith)

32(ii)

18 U.S.C. Section 1350 Certification of Chief Financial Officer

 

(included herewith)

101

Pursuant to Rule 405 of Regulation S-T, the following financial information from the Company's Quarterly Report on Form 10-Q for the period ended September 30, 2014 is formatted in XBRL interactive data files: (i) Consolidated Statements of Income for the nine months ended September 30, 2014, and 2013; (ii) Consolidated Balance Sheets at September 30, 2014 and December 31, 2013; (iii) Consolidated Statements of Changes in Stockholders’ Equity for the nine months ended September 30, 2014 and 2013; (iv) Consolidated Statements of Cash Flows for the nine months ended September 30, 2014 and 2013; and (v) Notes to Financial Statements

   

 

 

*     Indicates a management contract or compensatory plan.          

 

 

 

 

 

 

 

 

 

50