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SUMMIT FINANCIAL GROUP, INC. - Quarter Report: 2014 September (Form 10-Q)


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
or
[  ]         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 0-16587 

Summit Financial Group, Inc.
(Exact name of registrant as specified in its charter)
West Virginia
55-0672148
(State or other jurisdiction of
(IRS Employer
incorporation or organization)
Identification No.)
300 North Main Street
 
Moorefield, West Virginia
26836
(Address of principal executive offices)
(Zip Code)
(304) 530-1000
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities and Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes þ
No o

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

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

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

Indicate the number of shares outstanding of each of the issuer’s classes of Common Stock as of the latest practicable date.

Common Stock, $2.50 par value
7,460,022 shares outstanding as of November 4, 2014



Table of Contents


 
 
 
Page
PART  I.
FINANCIAL INFORMATION
 
 
 
 
 
 
Item 1.
Financial Statements
 
 
 
 
 
 
 
Consolidated balance sheets
September 30, 2014 (unaudited), December 31, 2013,
and September 30, 2013 (unaudited)
 
 
 
 
 
 
Consolidated statements of income
for the three and nine months ended
September 30, 2014 and 2013 (unaudited)
 
 
 
 
 
 
Consolidated statements of comprehensive
income for the three and nine months ended
September 30, 2014 and 2013 (unaudited)
 
 
 
 
 
 
Consolidated statements of shareholders’ equity
for the nine months ended
September 30, 2014 and 2013 (unaudited)
 
 
 
 
 
 
Consolidated statements of cash flows
for the nine months ended
September 30, 2014 and 2013 (unaudited)
 
 
 
 
 
 
Notes to consolidated financial statements (unaudited)
 
 
 
 
 
Item 2.
Management's Discussion and Analysis of Financial Condition
and Results of Operations
 
 
 
 
 
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
 
 
 
 
 
Item 4.
Controls and Procedures

2


Table of Contents


PART II.
OTHER INFORMATION
 
 
Item 1.
Legal Proceedings
 
 
 
 
 
Item 1A.
Risk Factors
 
 
 
 
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
None
 
 
 
 
 
Item 3.
Defaults upon Senior Securities
None
 
 
 
 
 
Item 4.
Mine Safety Disclosures
None
 
 
 
 
 
Item 5.
Other Information
None
 
 
 
 
 
Item 6.
Exhibits
 
 
 
 
SIGNATURES
 
 
 
 
 
EXHIBIT INDEX
 


3


Consolidated Balance Sheets (unaudited)




 
 
September 30,
2014
 
December 31,
2013
 
September 30,
2013
Dollars in thousands
 
(unaudited)
 
(*)
 
(unaudited)
ASSETS
 
 
 
 

 
 
Cash and due from banks
 
$
3,933

 
$
3,442

 
$
4,571

Interest bearing deposits with other banks
 
9,300

 
8,340

 
11,532

Cash and cash equivalents
 
13,233

 
11,782

 
16,103

Securities available for sale
 
282,401

 
288,780

 
291,258

Other investments
 
7,393

 
7,815

 
8,004

Loans held for sale, net
 
319

 
321

 
602

Loans, net
 
993,347

 
937,070

 
939,169

Property held for sale
 
47,252

 
53,392

 
45,303

Premises and equipment, net
 
20,131

 
20,623

 
20,780

Accrued interest receivable
 
5,467

 
5,669

 
5,364

Intangible assets
 
7,748

 
7,949

 
8,036

Cash surrender value of life insurance policies
 
36,417

 
35,611

 
35,257

Other assets
 
14,961

 
17,215

 
17,911

Total assets
 
$
1,428,669

 
$
1,386,227

 
$
1,387,787

 
 
 
 
 
 
 
LIABILITIES AND SHAREHOLDERS' EQUITY
 
 

 
 

 
 

Liabilities
 
 

 
 

 
 

Deposits
 
 

 
 

 
 

Non interest bearing
 
$
104,442

 
$
92,837

 
$
99,109

Interest bearing
 
950,012

 
910,975

 
917,626

Total deposits
 
1,054,454

 
1,003,812

 
1,016,735

Short-term borrowings
 
127,432

 
62,769

 
54,163

Long-term borrowings
 
78,466

 
163,516

 
163,540

Subordinated debentures
 
16,800

 
16,800

 
16,800

Subordinated debentures owed to unconsolidated subsidiary trusts
 
19,589

 
19,589

 
19,589

Other liabilities
 
10,566

 
8,669

 
8,155

Total liabilities
 
1,307,307

 
1,275,155

 
1,278,982

 
 
 
 
 
 
 
Commitments and Contingencies
 
 

 
 

 
 

 
 
 
 
 
 
 
Shareholders' Equity
 
 

 
 

 
 

Preferred stock and related surplus - authorized 250,000 shares;
 
 

 
 

 
 

Series 2009, 8% Non-cumulative convertible preferred stock,
par value $1.00; issued 3,710 shares
 
3,519

 
3,519

 
3,519

Series 2011, 8% Non-cumulative convertible preferred stock,
par value $1.00; issued 2014 - 11,914 shares, 2013 - 11,938 shares
 
5,764

 
5,776

 
5,776

Common stock and related surplus - authorized 20,000,000 shares;
 
 

 
 

 
 

$2.50 par value; issued and outstanding 2014 - 7,457,222 shares, December 2013 - 7,451,022 shares, and September 2013 - 7,448,222 shares
 
24,691

 
24,664

 
24,632

Retained earnings
 
84,712

 
77,134

 
74,541

Accumulated other comprehensive income
 
2,676

 
(21
)
 
337

Total shareholders' equity
 
121,362

 
111,072

 
108,805

 
 
 
 
 
 
 
Total liabilities and shareholders' equity
 
$
1,428,669

 
$
1,386,227

 
$
1,387,787


(*) - December 31, 2013 financial information has been extracted from audited consolidated financial statements
See Notes to Consolidated Financial Statements

Table of Contents
4


Consolidated Statements of Income (unaudited)


 
 
Three Months Ended
 
Nine months ended
Dollars in thousands, except per share amounts
 
September 30,
2014
 
September 30,
2013
 
September 30,
2014
 
September 30,
2013
Interest income
 
 
 
 
 
 
 
 
Interest and fees on loans
 
 
 
 
 
 
 
 
Taxable
 
$
12,943

 
$
12,469

 
$
37,516

 
$
38,037

Tax-exempt
 
89

 
63

 
248

 
197

Interest and dividends on securities
 
 

 
 

 
 

 
 

Taxable
 
1,084

 
896

 
3,565

 
2,852

Tax-exempt
 
640

 
616

 
1,838

 
1,832

Interest on interest bearing deposits with other banks
 
3

 
1

 
6

 
4

Total interest income
 
14,759

 
14,045

 
43,173

 
42,922

Interest expense
 
 

 
 

 
 

 
 

Interest on deposits
 
2,288

 
2,487

 
6,864

 
8,074

Interest on short-term borrowings
 
98

 
24

 
209

 
50

Interest on long-term borrowings and subordinated debentures
 
1,297

 
1,996

 
4,665

 
5,997

Total interest expense
 
3,683

 
4,507

 
11,738

 
14,121

Net interest income
 
11,076

 
9,538

 
31,435

 
28,801

Provision for loan losses
 
250

 
1,000

 
2,250

 
3,500

Net interest income after provision for loan losses
 
10,826

 
8,538

 
29,185

 
25,301

Other income
 
 

 
 

 
 

 
 

Insurance commissions
 
1,105

 
1,057

 
3,377

 
3,373

Service fees related to deposit accounts
 
1,147

 
1,106

 
3,291

 
3,202

Realized securities gains
 
128

 
132

 
64

 
116

Other
 
533

 
606

 
1,670

 
1,741

Total other-than-temporary impairment loss on securities
 

 
(38
)
 
(1
)
 
(155
)
Portion of loss recognized in other comprehensive income
 

 

 

 
37

Net impairment loss recognized in earnings
 

 
(38
)
 
(1
)
 
(118
)
Total other income
 
2,913

 
2,863

 
8,401

 
8,314

Other expense
 
 

 
 

 
 

 
 

Salaries, commissions, and employee benefits
 
4,026

 
4,050

 
12,052

 
12,155

Net occupancy expense
 
482

 
454

 
1,528

 
1,387

Equipment expense
 
520

 
578

 
1,599

 
1,724

Professional fees
 
380

 
263

 
978

 
885

Amortization of intangibles
 
50

 
88

 
200

 
263

FDIC premiums
 
480

 
503

 
1,477

 
1,558

Foreclosed properties expense
 
298

 
262

 
780

 
836

(Gain) loss on sale of foreclosed properties
 
70

 
(17
)
 
198

 
546

Write-down of foreclosed properties
 
1,580

 
654

 
3,471

 
3,078

Other
 
1,299

 
1,396

 
3,930

 
3,900

Total other expense
 
9,185

 
8,231

 
26,213

 
26,332

Income before income taxes
 
4,554

 
3,170

 
11,373

 
7,283

Income tax expense
 
1,218

 
898

 
3,215

 
2,001

Net Income
 
3,336

 
2,272

 
8,158

 
5,282

Dividends on preferred shares
 
193

 
194

 
580

 
582

Net Income applicable to common shares
 
$
3,143

 
$
2,078

 
$
7,578

 
$
4,700

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic earnings per common share
 
$
0.42

 
$
0.28

 
$
1.02

 
$
0.63

Diluted earnings per common share
 
$
0.35

 
$
0.24

 
$
0.85

 
$
0.55

See Notes to Consolidated Financial Statements 

Table of Contents
5


Consolidated Statement of Comprehensive Income (unaudited)


 
For the Three Months Ended 
 September 30,
Dollars in thousands
2014
 
2013
Net income
$
3,336

 
$
2,272

Other comprehensive income (loss):
 

 
 

Net unrealized gain (loss) on cashflow hedge of:
 
 
 
2014 - $162, net of deferred taxes of $60; 2013 - ($117), net of deferred taxes of ($43)
102

 
(74
)
Net unrealized gain (loss) on available for sale debt securities of:
 
 
 
2014 - $1,017, net of deferred taxes of $376 and reclassification adjustment for net realized gains included in net income of $128; 2013 - ($681), net of deferred taxes of ($252) and reclassification adjustment for net realized gains included in net income of $132
641

 
(429
)
Total comprehensive income
$
4,079

 
$
1,769








 
For the Nine Months Ended 
 September 30,
Dollars in thousands
2014
 
2013
Net income
$
8,158

 
$
5,282

Other comprehensive income (loss):
 

 
 

Net unrealized (loss) on cashflow hedge of:
 
 
 
2014 - ($2,160), net of deferred taxes of ($799); 2013 - ($117), net of deferred taxes of ($43)
(1,361
)
 
(74
)
Non-credit related other-than-temporary impairment on available for sale debt securities:
 
 
 
2014- $0, net of deferred taxes of $0; 2013 - $37, net of deferred taxes of $14

 
(23
)
Net unrealized gain (loss) on available for sale debt securities of:
 

 
 

2014 - $6,441, net of deferred taxes of $2,383 and reclassification adjustment for net realized gains included in net income of $64; 2013 - ($7,038), net of deferred taxes of ($2,604) and reclassification adjustment for net realized gains included in net income of $116
4,058

 
(4,434
)
Total comprehensive income
$
10,855

 
$
751














See Notes to Consolidated Financial Statements

Table of Contents
6


Consolidated Statements of Shareholders’ Equity (unaudited)


Dollars in thousands, except per share amounts
Series 2009
Preferred
Stock and
Related
Surplus
 
Series 2011
Preferred
Stock and
Related
Surplus
 
Common
Stock and
Related
Surplus
 
Retained
Earnings
 
Accumulated
Other
Compre-
hensive
Income
 
Total
Share-
holders'
Equity
 
 
 
 
 
 
 
 
 
 
 
 
Balance, December 31, 2013
$
3,519

 
$
5,776

 
$
24,664

 
$
77,134

 
$
(21
)
 
$
111,072

 
 
 
 
 
 
 
 
 
 
 
 
Nine Months Ended September 30, 2014
 

 
 

 
 

 
 

 
 

 
 

Comprehensive income:
 

 
 

 
 

 
 

 
 

 
 

Net income

 

 

 
8,158

 

 
8,158

Other comprehensive income

 

 

 

 
2,697

 
2,697

Total comprehensive income
 

 
 

 
 

 
 

 
 

 
10,855

Exercise of stock options

 

 
15

 

 

 
15

Stock compensation expense

 

 

 

 

 

Series 2009 Preferred Stock cash dividends declared ($60.00 per share)

 

 

 
(223
)
 

 
(223
)
Series 2011 Preferred Stock cash dividends declared ($30.00 per share)

 

 

 
(357
)
 

 
(357
)
Conversion of Series 2011 Preferred Stock to Common Stock

 
(12
)
 
12

 

 

 

Balance, September 30, 2014
$
3,519

 
$
5,764

 
$
24,691

 
$
84,712

 
$
2,676

 
$
121,362

 
 
 
 
 
 
 
 
 
 
 
 
Balance, December 31, 2012
$
3,519

 
$
5,807

 
$
24,520

 
$
69,841

 
$
4,868

 
$
108,555

 
 
 
 
 
 
 
 
 
 
 
 
Nine Months Ended September 30, 2013
 

 
 

 
 

 
 

 
 

 
 

Comprehensive income:
 

 
 

 
 

 
 

 
 

 
 

Net income

 

 

 
5,282

 

 
5,282

Other comprehensive (loss)

 

 

 

 
(4,531
)
 
(4,531
)
Total comprehensive income
 

 
 

 
 

 
 

 
 

 
751

Exercise of stock options

 

 
80

 

 

 
80

Stock compensation expense

 

 
1

 

 

 
1

Series 2009 Preferred Stock cash dividends declared ($60.00 per share)

 

 

 
(223
)
 

 
(223
)
Series 2011 Preferred Stock cash dividends declared ($30.00 per share)

 

 

 
(359
)
 

 
(359
)
Conversion of Series 2011 Preferred Stock to Common Stock

 
(31
)
 
31

 

 

 

Balance, September 30, 2013
$
3,519

 
$
5,776

 
$
24,632

 
$
74,541

 
$
337

 
$
108,805








See Notes to Consolidated Financial Statements

Table of Contents
7


Consolidated Statements of Cash Flows (unaudited)


 
 
Nine Months Ended
Dollars in thousands
 
September 30,
2014
 
September 30,
2013
Cash Flows from Operating Activities
 
 
 
 
Net income
 
$
8,158

 
$
5,282

Adjustments to reconcile net earnings to net cash
 
 

 
 

provided by operating activities:
 
 

 
 

Depreciation
 
814

 
878

Provision for loan losses
 
2,250

 
3,500

Stock compensation expense
 

 
1

Deferred income tax expense
 
232

 
1,248

Loans originated for sale
 
(1,859
)
 
(7,963
)
Proceeds from loans sold
 
1,861

 
7,587

Securities losses
 
(64
)
 
(116
)
Other-than-temporary impairment of securities
 
1

 
118

Loss on disposal of assets
 
199

 
535

Write down of foreclosed properties
 
3,471

 
3,078

Amortization of securities premiums (accretion of discounts), net
 
3,931

 
4,698

Amortization of goodwill and purchase accounting
 
 

 
 

adjustments, net
 
209

 
272

Decrease in accrued interest receivable
 
201

 
257

Increase in cash surrender value of bank owned life insurance
 
(806
)
 
(704
)
(Increase) decrease in other assets
 
(753
)
 
2,354

Increase (decrease) in other liabilities
 
540

 
(748
)
Net cash provided by operating activities
 
18,385

 
20,277

Cash Flows from Investing Activities
 
 

 
 

Proceeds from maturities and calls of securities available for sale
 
3,601

 
1,258

Proceeds from sales of securities available for sale
 
61,027

 
41,188

Principal payments received on securities available for sale
 
25,890

 
50,650

Purchases of securities available for sale
 
(81,565
)
 
(111,443
)
Purchases of other investments
 
(2,429
)
 
(2,541
)
Proceeds from maturities and calls of other investments
 

 

Redemption of Federal Home Loan Bank Stock
 
2,851

 
5,922

Net principal payments received on loans
 
(61,088
)
 
(8,371
)
Purchases of premises and equipment
 
(321
)
 
(528
)
Proceeds from disposal of premises and equipment
 

 
11

Proceeds from sales of other repossessed assets & property held for sale
 
5,411

 
10,339

Purchase of life insurance contracts
 

 
(5,000
)
Net cash provided by (used in) investing activities
 
(46,623
)
 
(18,515
)
Cash Flows from Financing Activities
 
 

 
 

Net increase in demand deposit, NOW and
 
 

 
 

savings accounts
 
82,643

 
9,759

Net decrease in time deposits
 
(32,002
)
 
(20,149
)
Net increase in short-term borrowings
 
64,663

 
50,205

Proceeds from long-term borrowings
 

 
3,454

Repayment of long-term borrowings
 
(85,050
)
 
(43,228
)
Exercise of stock options
 
15

 
80

Dividends paid on preferred stock
 
(580
)
 
(582
)
Net cash provided by (used in) financing activities
 
29,689

 
(461
)
Increase in cash and cash equivalents
 
1,451

 
1,301

Cash and cash equivalents:
 
 

 
 

Beginning
 
11,782

 
14,802

Ending
 
$
13,233

 
$
16,103

 
 
 
 
 
(Continued)
 
 
 
 
 
See Notes to Consolidated Financial Statements
 
 
 
 

Table of Contents
8


Consolidated Statements of Cash Flows (unaudited)


 
 
Nine Months Ended
Dollars in thousands
 
September 30,
2014
 
September 30,
2013
Supplemental Disclosures of Cash Flow Information
 
 
 
 
Cash payments for:
 
 
 
 
Interest
 
$
12,352

 
$
14,526

Income taxes
 
$
2,445

 
$
1,098

 
 
 
 
 
Supplemental Schedule of Noncash Investing and Financing Activities
 
 
 
 

Other assets acquired in settlement of loans
 
$
2,560

 
$
2,871


























































See Notes to Consolidated Financial Statements


Table of Contents
9



NOTE 1.  BASIS OF PRESENTATION

We, Summit Financial Group, Inc. and subsidiaries, prepare our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America for interim financial information and with instructions to Form 10-Q and Regulation S-X.  Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in the United States of America for annual year end financial statements.  In our opinion, all adjustments considered necessary for a fair presentation have been included and are of a normal recurring nature.

The presentation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ materially from these estimates.

The results of operations for the quarter ended September 30, 2014 are not necessarily indicative of the results to be expected for the full year.  The consolidated financial statements and notes included herein should be read in conjunction with our 2013 audited financial statements and Annual Report on Form 10-K.  Certain accounts in the consolidated financial statements for December 31, 2013 and September 30, 2013, as previously presented, have been reclassified to conform to current year classifications.

NOTE 2.  SIGNIFICANT NEW AUTHORITATIVE ACCOUNTING GUIDANCE

ASU 2013-11, Income Taxes (Topic 740) - Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists requires that an unrecognized tax benefit, or a portion of an unrecognized tax benefit, be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward. However, if a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date under the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position or the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset for such purpose, the unrecognized tax benefit should be presented in the financial statements as a liability and should not be combined with deferred tax assets. The amendments were effective for years, and interim periods within those years, beginning after December 15, 2013. The amendments did not have a material impact on our consolidated financial statements.

ASU 2014-1, Investments (Topic 323) - Accounting for Investments in Affordable Housing Projects revises the necessary criteria that need to be met in order for an entity to account for investments in affordable housing projects net of the provision for income taxes. It also changes the method of recognition from an effective amortization approach to a proportional amortization approach. Additional disclosures were also set forth in this update. The amendments are effective for annual periods, and interim reporting periods within those annual periods, beginning after December 15, 2014. The amendments are required to be applied retrospectively to all periods presented. Early adoption is permitted. Management is currently evaluating the impact of the guidance on our consolidated financial statements.

ASU 2014-4, Receivables (Topic 310) - Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure clarifies that an in substance repossession or foreclosure occurs upon either the creditor obtaining legal title to the residential real estate property or 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. The amendments are effective for annual periods, and interim reporting periods within those annual periods, beginning after December 15, 2014. The amendments may be adopted using either a modified retrospective transition method or a prospective transition method. Early adoption is permitted. Management does not believe the amendments will have a material impact on our consolidated financial statements.

NOTE 3.  FAIR VALUE MEASUREMENTS

ASC Topic 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.  ASC Topic 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  The standard describes three levels of inputs that may be used to measure fair value.


Table of Contents
10


Level 1:Quoted prices (unadjusted) or identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2:Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.

Level 3:Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
        
Accordingly, securities available-for-sale are recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record other assets at fair value on a nonrecurring basis, such as loans held for sale, and impaired loans held for investment.  These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

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

Derivative Financial Instruments:  Derivative financial instruments are recorded at fair value on a recurring basis. Fair value measurement is based on pricing models run by a third-party, utilizing observable market-based inputs.  All future floating cash flows are projected and both floating and fixed cash flows are discounted to the valuation date.  As a result, we classify interest rate swaps as Level 2.

Loans Held for Sale:  Loans held for sale are carried at the lower of cost or market value.  The fair value of loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics.  As such, we classify loans subject to nonrecurring fair value adjustments as Level 2.

Loans:  We do not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan loss is established.  Loans for which it is probable that payment of interest and principal will not be made in accordance with the original contractual terms of the loan agreement are considered impaired.  Once a loan is identified as individually impaired, management measures impairment in accordance with ASC Topic 310, Accounting by Creditors for Impairment of a Loan.  The fair value of impaired loans is estimated using one of several methods, including collateral value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. Prior to January 1, 2014, substantially all impaired loans were valued based upon the fair value of their collateral.  Beginning January 1, 2014, only impaired loans internally graded as substandard, doubtful, or loss are evaluated using the fair value of collateral method.  In accordance with ASC Topic 310, impaired loans where an allowance is established based on the fair value of collateral requires classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the impaired loan as nonrecurring Level 2. When a current appraised value is not available and there is no observable market price, we record the impaired loan as nonrecurring Level 3.  This change in accounting estimate did not have a material impact on our financial condition or results of operations.

When impaired loans are deemed required to be included in the fair value hierarchy, management immediately begins the process of evaluating the estimated fair value of the underlying collateral to determine if a related specific allowance for loan losses or charge-off is necessary.  Current appraisals are ordered once a loan is deemed impaired if the existing appraisal is more than twelve months old, or more frequently if there is known deterioration in value. For recently identified impaired loans, a current appraisal may not be available at the financial statement date. Until the current appraisal is obtained, the original appraised value is discounted, as appropriate, to compensate for the estimated depreciation in the value of the loan’s underlying collateral since the date of the original appraisal.  Such discounts are generally estimated based upon management’s knowledge of sales of similar collateral within the applicable market area and its knowledge of other real estate market-related data as well as general economic trends.  When a new appraisal is received (which generally are received within 3 months of a


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loan being identified as impaired), management then re-evaluates the fair value of the collateral and adjusts any specific allocated allowance for loan losses, as appropriate.  In addition, management also assigns a discount of 7–10% for the estimated costs to sell the collateral.

Other Real Estate Owned (“OREO”):  OREO consists of real estate acquired in foreclosure or other settlement of loans. Such assets are carried on the balance sheet at the lower of the investment in the real estate or its fair value less estimated selling costs.  The fair value of OREO is determined on a nonrecurring basis generally utilizing current appraisals performed by an independent, licensed appraiser applying an income or market value approach using observable market data (Level 2).  Updated appraisals of OREO are generally obtained if the existing appraisal is more than 18 months old or more frequently if there is a known deterioration in value.  However, if a current appraisal is not available, the original appraised value is discounted, as appropriate, to compensate for the estimated depreciation in the value of the real estate since the date of its original appraisal.  Such discounts are generally estimated based upon management’s knowledge of sales of similar property within the applicable market area and its knowledge of other real estate market-related data as well as general economic trends (Level 3).  Upon foreclosure, any fair value adjustment is charged against the allowance for loan losses.  Subsequent fair value adjustments are recorded in the period incurred and included in other noninterest expense in the consolidated statements of income.

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

The table below presents the recorded amount of assets measured at fair value on a recurring basis.
 
Balance at
 
Fair Value Measurements Using:
Dollars in thousands
September 30, 2014
 
Level 1
 
Level 2
 
Level 3
Available for sale securities
 
 
 
 
 
 
 
U.S. Government sponsored agencies
$
23,515

 
$

 
$
23,515

 
$

Mortgage backed securities:
 

 
 

 
 

 
 

Government sponsored agencies
154,884

 

 
154,884

 

Nongovernment sponsored entities
10,168

 

 
10,168

 

State and political subdivisions
10,094

 

 
10,094

 

Corporate debt securities

 

 

 

Other equity securities
7

 

 
7

 

Tax-exempt state and political subdivisions
83,733

 

 
83,733

 

Total available for sale securities
$
282,401

 
$

 
$
282,401

 
$

 
 
 
 
 
 
 
 
Derivative financial instrument
 

 
 

 
 

 
 

Interest rate swaps
$

 
$

 
$

 
$


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12


 
Balance at
 
Fair Value Measurements Using:
Dollars in thousands
December 31, 2013
 
Level 1
 
Level 2
 
Level 3
Available for sale securities
 
 
 
 
 
 
 
U.S. Government sponsored agencies
$
29,657

 
$

 
$
29,657

 
$

Mortgage backed securities:
 

 
 

 
 

 
 

Government sponsored agencies
155,716

 

 
155,716

 

Nongovernment sponsored entities
11,819

 

 
11,819

 

State and political subdivisions
15,870

 

 
15,870

 

Corporate debt securities
3,966

 

 
3,966

 

Other equity securities
77

 

 
77

 

Tax-exempt state and political subdivisions
71,675

 

 
71,675

 

Total available for sale securities
$
288,780

 
$

 
$
288,780

 
$

 
 
 
 
 
 
 
 
Derivative financial instrument
 

 
 

 
 

 
 

Interest rate swaps
$
803

 
$

 
$
803

 
$


There were no assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the period ended September 30, 2014.

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

We may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with U.S. generally accepted accounting principles.  These include assets that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period.  Assets measured at fair value on a nonrecurring basis are included in the table below.
 
Balance at
 
Fair Value Measurements Using:
Dollars in thousands
September 30, 2014
 
Level 1
 
Level 2
 
Level 3
Residential mortgage loans held for sale
$
319

 
$

 
$
319

 
$

 
 
 
 
 
 
 
 
Collateral-dependent impaired loans
 

 
 

 
 

 
 

Commercial
$
44

 
$

 
$

 
$
44

Commercial real estate
1,684

 

 
1,684

 

Construction and development
12,923

 

 
12,923

 

Residential real estate
9,590

 

 
9,477

 
113

Consumer
3

 

 

 
3

Total collateral-dependent impaired loans
$
24,244

 
$

 
$
24,084

 
$
160

 
 
 
 
 
 
 
 
OREO
 

 
 

 
 

 
 

Commercial
$
110

 
$

 
$
110

 
$

Commercial real estate
5,815

 

 
5,815

 

Construction and development
30,609

 

 
28,637

 
1,972

Residential real estate
10,718

 

 
10,104

 
614

Total OREO
$
47,252

 
$

 
$
44,666

 
$
2,586




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13


 
Balance at
 
Fair Value Measurements Using:
Dollars in thousands
December 31, 2013
 
Level 1
 
Level 2
 
Level 3
Residential mortgage loans held for sale
$
321

 
$

 
$
321

 
$

 
 
 
 
 
 
 
 
Collateral-dependent impaired loans
 

 
 

 
 

 
 

Commercial
$
1,616

 

 
$
920

 
$
696

Commercial real estate
17,902

 

 
4,879

 
13,023

Construction and development
22,083

 

 
17,590

 
4,493

Residential real estate
14,747

 

 
8,336

 
6,411

Consumer
34

 

 
3

 
31

Total collateral-dependent impaired loans
$
56,382

 
$

 
$
31,728

 
$
24,654

 
 
 
 
 
 
 
 
OREO
 

 
 

 
 

 
 

Commercial
$

 
$

 
$

 
$

Commercial real estate
9,903

 

 
9,903

 

Construction and development
31,610

 

 
29,993

 
1,617

Residential real estate
11,879

 

 
11,847

 
32

Total OREO
$
53,392

 
$

 
$
51,743

 
$
1,649


ASC Topic 825, Financial Instruments, requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis.  The following summarizes the methods and significant assumptions we used in estimating our fair value disclosures for financial instruments.

Cash and cash equivalents:  The carrying values of cash and cash equivalents approximate their estimated fair value.

Interest bearing deposits with other banks:  The carrying values of interest bearing deposits with other banks approximate their estimated fair values.

Federal funds sold:  The carrying values of Federal funds sold approximate their estimated fair values.

Securities:  Estimated fair values of securities are based on quoted market prices, where available.  If quoted market prices are not available, estimated fair values are based on quoted market prices of comparable securities.
 
Loans held for sale:  The carrying values of loans held for sale approximate their estimated fair values.

Loans:  The estimated fair values for loans are computed based on scheduled future cash flows of principal and interest, discounted at interest rates currently offered for loans with similar terms to borrowers of similar credit quality.  No prepayments of principal are assumed.

Accrued interest receivable and payable:  The carrying values of accrued interest receivable and payable approximate their estimated fair values.

Deposits:  The estimated fair values of demand deposits (i.e. non-interest bearing checking, NOW, money market and savings accounts) and other variable rate deposits approximate their carrying values.  Fair values of fixed maturity deposits are estimated using a discounted cash flow methodology at rates currently offered for deposits with similar remaining maturities.  Any intangible value of long-term relationships with depositors is not considered in estimating the fair values disclosed.

Short-term borrowings:  The carrying values of short-term borrowings approximate their estimated fair values.

Long-term borrowings:  The fair values of long-term borrowings are estimated by discounting scheduled future payments of principal and interest at current rates available on borrowings with similar terms.


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14


Subordinated debentures:  The carrying values of subordinated debentures approximate their estimated fair values.

Subordinated debentures owed to unconsolidated subsidiary trusts:  The carrying values of subordinated debentures owed to unconsolidated subsidiary trusts approximate their estimated fair values.

Derivative financial instruments:  The fair value of the interest rate swaps is valued using independent pricing models.

Off-balance sheet instruments:  The fair values of commitments to extend credit and standby letters of credit are estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present credit standing of the counter parties.  The amounts of fees currently charged on commitments and standby letters of credit are deemed insignificant, and therefore, the estimated fair values and carrying values are not shown below.

The carrying values and estimated fair values of our financial instruments are summarized below:
 
 
September 30, 2014
 
December 31, 2013
Dollars in thousands
 
Carrying
Value
 
Estimated
Fair
Value
 
Carrying
Value
 
Estimated
Fair
Value
Financial assets
 
 
 
 
 
 
 
 
Cash and cash equivalents
 
$
13,233

 
$
13,233

 
$
11,782

 
$
11,782

Securities available for sale
 
282,401

 
282,401

 
288,780

 
288,780

Other investments
 
7,393

 
7,393

 
7,815

 
7,815

Loans held for sale, net
 
319

 
319

 
321

 
321

Loans, net
 
993,347

 
1,003,166

 
937,070

 
952,592

Accrued interest receivable
 
5,467

 
5,467

 
5,669

 
5,669

Derivative financial assets
 

 

 
803

 
803

 
 
$
1,302,160

 
$
1,311,979

 
$
1,252,240

 
$
1,267,762

Financial liabilities
 
 

 
 

 
 

 
 

Deposits
 
$
1,054,454

 
$
1,075,730

 
$
1,003,812

 
$
1,029,606

Short-term borrowings
 
127,432

 
127,432

 
62,769

 
62,769

Long-term borrowings
 
78,466

 
85,998

 
163,516

 
173,863

Subordinated debentures
 
16,800

 
16,800

 
16,800

 
16,800

Subordinated debentures owed to unconsolidated subsidiary trusts
 
19,589

 
19,589

 
19,589

 
19,589

Accrued interest payable
 
821

 
821

 
1,433

 
1,433

Derivative financial liabilities
 
1,357

 
1,357

 

 

 
 
$
1,298,919

 
$
1,327,727

 
$
1,267,919

 
$
1,304,060


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NOTE 4.  EARNINGS PER SHARE

The computations of basic and diluted earnings per share follow:
 
 
For the Three Months Ended September 30,
 
 
2014
 
2013
Dollars in thousands,
except per share amounts
 
Income
(Numerator)
 
Common
Shares
(Denominator)
 
Per
Share
 
Income
(Numerator)
 
Common
Shares
(Denominator)
 
Per
Share
Net income
 
$
3,336

 
 
 
 
 
$
2,272

 
 
 
 
Less preferred stock dividends
 
(193
)
 
 
 
 
 
(194
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic EPS
 
$
3,143

 
7,457,222

 
$
0.42

 
$
2,078

 
7,443,865

 
$
0.28

 
 
 
 
 
 
 
 
 
 
 
 
 
Effect of dilutive securities:
 
 
 
 
 
 

 
 
 
 
 
 

Stock options
 
 
 
9,276

 
 

 
 
 
7,819

 
 

Series 2011 convertible
preferred stock
 
119

 
1,489,250

 
 

 
120

 
1,495,728

 
 

Series 2009 convertible
preferred stock
 
74

 
674,545

 
 
 
74

 
674,545

 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
Diluted EPS
 
$
3,336

 
9,630,293

 
$
0.35

 
$
2,272

 
9,621,957

 
$
0.24


 
 
For the Nine Months Ended September 30,
 
 
2014
 
2013
Dollars in thousands,
except per share amounts
 
Income
(Numerator)
 
Common
Shares
(Denominator)
 
Per
Share
 
Income
(Numerator)
 
Common
Shares
(Denominator)
 
Per
Share
Net income
 
$
8,158

 
 
 
 
 
$
5,282

 
 
 
 
Less preferred stock dividends
 
(580
)
 
 
 
 
 
(582
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic EPS
 
$
7,578

 
7,455,952

 
$
1.02

 
$
4,700

 
7,438,216

 
$
0.63

 
 
 
 
 
 
 
 
 
 
 
 
 
Effect of dilutive securities:
 
 

 
 
 
 

 
 
 
 
 
 

Stock options
 
 
 
9,547

 
 

 
 
 
7,316

 
 

Series 2011 convertible
preferred stock
 
357

 
1,489,898

 
 

 
359

 
1,498,251

 
 

Series 2009 convertible
preferred stock
 
223

 
674,545

 
 

 
223

 
674,545

 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
Diluted EPS
 
$
8,158

 
9,629,942

 
$
0.85

 
$
5,282

 
9,618,328

 
$
0.55


Stock option grants and the convertible preferred shares are disregarded in this computation if they are determined to be anti-dilutive.  Our anti-dilutive stock options at September 30, 2014 and 2013 totaled 143,000 shares and 170,500 shares, respectively.


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16


NOTE 5.  SECURITIES

The amortized cost, unrealized gains, unrealized losses and estimated fair values of securities at September 30, 2014, December 31, 2013, and September 30, 2013 are summarized as follows:
 
September 30, 2014
 
Amortized
 
Unrealized
 
Estimated
Dollars in thousands
Cost
 
Gains
 
Losses
 
Fair Value
Available for Sale
 
 
 
 
 
 
 
Taxable debt securities
 
 
 
 
 
 
 
U.S. Government and agencies and corporations
$
22,643

 
$
919

 
$
47

 
$
23,515

Residential mortgage-backed securities:
 

 
 

 
 

 
 

Government-sponsored agencies
153,095

 
2,680

 
891

 
154,884

Nongovernment-sponsored entities
9,873

 
323

 
28

 
10,168

State and political subdivisions
 

 
 

 
 

 
 

General obligations
3,856

 
16

 
66

 
3,806

Water and sewer revenues
2,375

 
5

 
36

 
2,344

Other revenues
3,927

 
29

 
12

 
3,944

Corporate debt securities

 

 

 

Total taxable debt securities
195,769

 
3,972

 
1,080

 
198,661

Tax-exempt debt securities
 

 
 

 
 

 
 

State and political subdivisions
 

 
 

 
 

 
 

General obligations
46,610

 
2,047

 
62

 
48,595

Water and sewer revenues
12,436

 
224

 
25

 
12,635

Lease revenues
5,060

 
65

 
38

 
5,087

Lottery/casino revenues
4,287

 
115

 

 
4,402

Other revenues
12,624

 
440

 
50

 
13,014

Total tax-exempt debt securities
81,017

 
2,891

 
175

 
83,733

Equity securities
7

 

 

 
7

Total available for sale securities
$
276,793

 
$
6,863

 
$
1,255

 
$
282,401









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17


 
December 31, 2013
 
Amortized
 
Unrealized
 
Estimated
Dollars in thousands
Cost
 
Gains
 
Losses
 
Fair Value
Available for Sale
 
 
 
 
 
 
 
Taxable debt securities
 
 
 
 
 
 
 
U.S. Government and agencies and corporations
$
29,100

 
$
675

 
$
118

 
$
29,657

Residential mortgage-backed securities:
 

 
 

 
 

 
 

Government-sponsored agencies
155,270

 
2,019

 
1,573

 
155,716

Nongovernment-sponsored entities
11,519

 
321

 
21

 
11,819

State and political subdivisions
 

 
 

 
 

 
 

General obligations
9,317

 

 
475

 
8,842

Water and sewer revenues
3,229

 

 
114

 
3,115

Other revenues
4,051

 
4

 
142

 
3,913

Corporate debt securities
3,973

 
24

 
31

 
3,966

Total taxable debt securities
216,459

 
3,043

 
2,474

 
217,028

Tax-exempt debt securities
 

 
 

 
 

 
 

State and political subdivisions
 

 
 

 
 

 
 

General obligations
41,156

 
675

 
1,154

 
40,677

Water and sewer revenues
8,996

 
15

 
306

 
8,705

Lease revenues
7,956

 

 
391

 
7,565

Lottery/casino revenues
4,443

 
63

 
169

 
4,337

Other revenues
10,527

 
55

 
191

 
10,391

Total tax-exempt debt securities
73,078

 
808

 
2,211

 
71,675

Equity securities
77

 

 

 
77

Total available for sale securities
$
289,614

 
$
3,851

 
$
4,685

 
$
288,780





























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18


 
September 30, 2013
 
Amortized
 
Unrealized
 
Estimated
Dollars in thousands
Cost
 
Gains
 
Losses
 
Fair Value
Available for Sale
 
 
 
 
 
 
 
Taxable debt securities:
 
 
 
 
 
 
 
U.S. Government and agencies and corporations
$
27,740

 
$
757

 
$
67

 
$
28,430

Residential mortgage-backed securities:
 

 
 

 
 

 
 

Government-sponsored agencies
149,569

 
2,444

 
1,226

 
150,787

Nongovernment-sponsored agencies
13,134

 
315

 
9

 
13,440

State and political subdivisions:


 


 


 


       General obligations
9,064

 

 
383

 
8,681

       Water and sewer revenues
3,234

 
1

 
91

 
3,144

        Other revenues
3,298

 

 
112

 
3,186

Corporate debt securities
3,970

 
25

 
45

 
3,950

Total taxable debt securities
210,009

 
3,542

 
1,933

 
211,618

Tax-exempt debt securities:
 

 
 

 
 

 
 

State and political subdivisions:


 


 


 


        General obligations
49,569

 
1,048

 
1,112

 
49,505

        Water and sewer revenues
10,132

 
89

 
290

 
9,931

        Lease revenues
8,869

 
1

 
441

 
8,429

        Lottery/casino revenues
4,457

 
68

 
166

 
4,359

        Other revenues
7,490

 
61

 
212

 
7,339

Total tax-exempt debt securities
80,517

 
1,267

 
2,221

 
79,563

Equity securities
77

 

 

 
77

Total available for sale securities
$
290,603

 
$
4,809

 
$
4,154

 
$
291,258


The below information is relative to the five states where issuers with the highest volume of state and political subdivision securities held in our portfolio are located.  We own no such securities of any single issuer which we deem to be a concentration.
 
September 30, 2014
 
Amortized
 
Unrealized
 
Estimated
Dollars in thousands
Cost
 
Gains
 
Losses
 
Fair Value
 
 
 
 
 
 
 
 
California
$
14,959

 
$
572

 
$
3

 
$
15,528

West Virginia
14,048

 
330

 
40

 
14,338

Illinois
8,963

 
255

 
35

 
9,183

Texas
7,391

 
418

 
44

 
7,765

Pennsylvania
7,404

 
148

 
6

 
7,546


Management performs pre-purchase and ongoing analysis to confirm that all investment securities meet applicable credit quality standards.  Prior to July 1, 2013, we principally used credit ratings from Nationally Recognized Statistical Rating Organizations (“NRSROs”) to support analyses of our portfolio of securities issued by state and political subdivisions, as we generally do not purchase securities that are rated below the six highest NRSRO rating categories.  Beginning July 1, 2013, in addition to considering a security’s NRSRO rating, we now also assess or confirm through an internal review of an issuer’s financial information and other applicable information that:  1) the issuer’s risk of default is low; 2) the characteristics of the issuer’s demographics and economic environment are satisfactory; and 3) the issuer’s budgetary position and stability of tax or other revenue sources are sound.


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19


The maturities, amortized cost and estimated fair values of securities at September 30, 2014, are summarized as follows:
Dollars in thousands
 
Amortized
Cost
 
Estimated
Fair Value
Due in one year or less
 
$
60,321

 
$
61,210

Due from one to five years
 
97,348

 
98,597

Due from five to ten years
 
23,114

 
23,764

Due after ten years
 
96,003

 
98,823

Equity securities
 
7

 
7

 
 
$
276,793

 
$
282,401


The proceeds from sales, calls and maturities of available for sale securities, including principal payments received on mortgage-backed obligations, and the related gross gains and losses realized, for the nine months ended September 30, 2014 are as follows:
 
 
Proceeds from
 
Gross realized
Dollars in thousands
 
Sales
 
Calls and
Maturities
 
Principle
Payments
 
Gains
 
Losses
 
 
 
 
 
 
 
 
 
 
 
Securities available for sale
 
$
61,027

 
$
3,601

 
$
25,890

 
$
782

 
$
718


During the three and nine months ended September 30, 2014 and 2013, we recorded other-than-temporary impairment losses on residential mortgage-backed nongovernment sponsored entity securities as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
Dollars in thousands
 
2014
2013
 
2014
2013
 
 
 
 
 
 
 
Total other-than-temporary impairment losses
 
$

$
(38
)
 
$
(1
)
$
(155
)
Portion of loss recognized in other comprehensive income
 


 

37

Net impairment losses recognized in earnings
 
$

$
(38
)
 
$
(1
)
$
(118
)

Activity related to the credit component recognized on debt securities available for sale for which a portion of other-than-temporary impairment was recognized in other comprehensive income for the three and nine months ended September 30, 2014 is as follows:
 
 
Three Months Ended 
 September 30, 2014
 
Nine Months Ended 
 September 30, 2014
In thousands
 
Total
 
Total
Beginning Balance
 
$
(3,021
)
 
$
(3,021
)
Additions for the credit component on debt securities in which other-than-temporary impairment was not previously recognized
 
(1
)
 
(1
)
Securities sold during the period
 
2,816

 
2,816

Ending Balance
 
$
(206
)
 
$
(206
)

We held 67 available for sale securities having an unrealized loss at September 30, 2014.  We do not intend to sell these securities, and it is more likely than not that we will not be required to sell these securities before recovery of their amortized cost bases.  We believe that this decline in value is primarily attributable to the lack of market liquidity and to changes in market interest rates and not due to credit quality.  Accordingly, no additional other-than-temporary impairment charge to earnings is warranted at this time.


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20


Provided below is a summary of securities available for sale which were in an unrealized loss position at September 30, 2014 and December 31, 2013, including debt securities for which a portion of other-than-temporary impairment has been recognized in other comprehensive income.
 
September 30, 2014
 
Less than 12 months
 
12 months or more
 
Total
Dollars in thousands
Estimated
Fair Value
 
Unrealized
Loss
 
Estimated
Fair Value
 
Unrealized
Loss
 
Estimated
Fair Value
 
Unrealized
Loss
Temporarily impaired securities
 
 
 
 
 
 
 
 
 
 
 
Taxable debt securities
 
 
 
 
 
 
 
 
 
 
 
U.S. Government agencies and corporations
$
1,399

 
$
(3
)
 
$
2,682

 
$
(44
)
 
$
4,081

 
$
(47
)
Residential mortgage-backed securities:
 

 
 

 
 

 
 

 
 

 
 

Government-sponsored agencies
38,707

 
(548
)
 
20,979

 
(343
)
 
59,686

 
(891
)
Nongovernment-sponsored entities
4,151

 
(28
)
 
58

 

 
4,209

 
(28
)
State and political subdivisions:
 

 
 

 
 

 
 

 
 

 
 

General obligations
707

 
(2
)
 
2,798

 
(64
)
 
3,505

 
(66
)
Water and sewer revenues

 

 
1,838

 
(36
)
 
1,838

 
(36
)
Other revenues
1,098

 
(12
)
 

 

 
1,098

 
(12
)
Corporate debt securities

 

 

 

 

 

Tax-exempt debt securities
 

 
 

 
 

 
 

 
 

 
 

State and political subdivisions:
 

 
 

 
 

 
 

 
 

 
 

General obligations
4,234

 
(12
)
 
2,613

 
(50
)
 
6,847

 
(62
)
Water and sewer revenues
2,188

 
(25
)
 

 

 
2,188

 
(25
)
Lease revenues

 

 
2,126

 
(38
)
 
2,126

 
(38
)
Lottery/casino revenues

 

 

 


 

 

Other revenues

 

 
1,949

 
(50
)
 
1,949

 
(50
)
Total temporarily impaired securities
52,484

 
(630
)
 
35,043

 
(625
)
 
87,527

 
(1,255
)
Other-than-temporarily impaired securities
 
 

 
 

 
 

 
 

 
 

Taxable debt securities
 

 
 

 
 

 
 

 
 

 
 

Residential mortgage-backed securities:
 

 
 

 
 

 
 

 
 

 
 

Nongovernment-sponsored entities

 

 

 

 

 

Total other-than-temporarily
 

 
 

 
 

 
 

 
 

 
 

impaired securities

 

 

 

 

 

Total
$
52,484

 
$
(630
)
 
$
35,043

 
$
(625
)
 
$
87,527

 
$
(1,255
)














Table of Contents
21


 
December 31, 2013
 
Less than 12 months
 
12 months or more
 
Total
Dollars in thousands
Estimated
Fair Value
 
Unrealized
Loss
 
Estimated
Fair Value
 
Unrealized
Loss
 
Estimated
Fair Value
 
Unrealized
Loss
Temporarily impaired securities
 
 
 
 
 
 
 
 
 
 
 
Taxable debt securities
 
 
 
 
 
 
 
 
 
 
 
U.S. Government agencies and corporations
$
10,868

 
$
(118
)
 
$

 
$

 
$
10,868

 
$
(118
)
Residential mortgage-backed securities:
 

 
 

 
 

 
 

 
 

 
 

Government-sponsored agencies
55,035

 
(1,385
)
 
13,249

 
(188
)
 
68,284

 
(1,573
)
Nongovernment-sponsored entities
2,407

 
(12
)
 
565

 
(7
)
 
2,972

 
(19
)
State and political subdivisions:
 

 
 

 
 

 
 

 
 

 
 

General obligations
4,505

 
(264
)
 
2,337

 
(211
)
 
6,842

 
(475
)
Water and sewer revenues
1,309

 
(31
)
 
1,554

 
(83
)
 
2,863

 
(114
)
Other revenues
3,142

 
(142
)
 

 

 
3,142

 
(142
)
Corporate debt securities
2,968

 
(31
)
 

 

 
2,968

 
(31
)
Tax-exempt debt securities
 

 
 

 
 

 
 

 
 

 
 

State and political subdivisions:
 

 
 

 
 

 
 

 
 

 
 

General obligations
19,603

 
(997
)
 
2,102

 
(157
)
 
21,705

 
(1,154
)
Water and sewer revenues
5,643

 
(224
)
 
983

 
(82
)
 
6,626

 
(306
)
Lease revenues
6,112

 
(349
)
 
958

 
(42
)
 
7,070

 
(391
)
Lottery/casino revenues
2,720

 
(132
)
 
554

 
(37
)
 
3,274

 
(169
)
Other revenues
8,815

 
(191
)
 

 

 
8,815

 
(191
)
Total temporarily impaired securities
123,127

 
(3,876
)
 
22,302

 
(807
)
 
145,429

 
(4,683
)
Other-than-temporarily impaired securities
 
 
 
 

 
 

 
 

 
 

Taxable debt securities
 

 
 

 
 

 
 

 
 

 
 

Residential mortgage-backed securities:
 

 
 

 
 

 
 

 
 

 
 

Nongovernment-sponsored entities

 

 
1

 
(2
)
 
1

 
(2
)
Total other-than-temporarily
 

 
 

 
 

 
 

 
 

 
 

impaired securities

 

 
1

 
(2
)
 
1

 
(2
)
Total
$
123,127

 
$
(3,876
)
 
$
22,303

 
$
(809
)
 
$
145,430

 
$
(4,685
)

NOTE 6.  LOANS

Loans are generally stated at the amount of unpaid principal, reduced by unearned discount and allowance for loan losses. Interest on loans is accrued daily on the outstanding balances.  Loan origination fees and certain direct loan origination costs are deferred and amortized as adjustments of the related loan yield over its contractual life. We categorize residential real estate loans in excess of $600,000 as jumbo loans.

Generally, loans are placed on nonaccrual status when principal or interest is greater than 90 days past due based upon the loan's contractual terms.  Interest is accrued daily on impaired loans unless the loan is placed on nonaccrual status.  Impaired loans are placed on nonaccrual status when the payments of principal and interest are in default for a period of 90 days, unless the loan is both well-secured and in the process of collection.  Interest on nonaccrual loans is recognized primarily using the cost-recovery method.  Loans may be returned to accrual status when repayment is reasonably assured and there has been demonstrated performance under the terms of the loan or, if applicable, the terms of the restructured loans.


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22


Commercial-related loans or portions thereof (which are risk-rated) are charged off to the allowance for loan losses when the loss has been confirmed.  This determination is made on a case by case basis considering many factors, including the prioritization of our claim in bankruptcy, expectations of the workout/restructuring of the loan and valuation of the borrower’s equity.  We deem a loss confirmed when a loan or a portion of a loan is classified “loss” in accordance with bank regulatory classification guidelines, which state, “Assets classified loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted”.
 
Consumer-related loans are generally charged off to the allowance for loan losses upon reaching specified stages of delinquency, in accordance with the Federal Financial Institutions Examination Council policy.  For example, credit card loans are charged off by the end of the month in which the account becomes 180 days past due or within 60 days from receiving notification about a specified event (e.g., bankruptcy of the borrower), which ever is earlier.  Residential mortgage loans are generally charged off to net realizable value no later than when the account becomes 180 days past due.  Other consumer loans, if collateralized, are generally charged off to net realizable value at 120 days past due.

Loans are summarized as follows:
Dollars in thousands
 
September 30,
2014
 
December 31,
2013
 
September 30,
2013
Commercial
 
$
83,762

 
$
88,352

 
$
83,844

Commercial real estate
 
 

 
 

 
 

Owner-occupied
 
156,765

 
149,618

 
151,260

Non-owner occupied
 
314,577

 
280,790

 
279,412

Construction and development
 
 

 
 

 
 

Land and land development
 
61,088

 
71,453

 
73,089

Construction
 
27,239

 
15,155

 
12,323

Residential real estate
 
 

 
 

 
 

Non-jumbo
 
218,125

 
212,946

 
215,058

Jumbo
 
51,917

 
53,406

 
59,701

Home equity
 
64,256

 
54,844

 
53,674

Consumer
 
19,906

 
19,889

 
20,472

Other
 
6,753

 
3,276

 
3,375

Total loans, net of unearned fees
 
1,004,388

 
949,729

 
952,208

Less allowance for loan losses
 
11,041

 
12,659

 
13,039

Loans, net
 
$
993,347

 
$
937,070

 
$
939,169


Table of Contents
23


The following table presents the contractual aging of the recorded investment in past due loans by class as of September 30, 2014 and 2013 and December 31, 2013.
 
At September 30, 2014
 
Past Due
 
 
 
> 90 days and Accruing
Dollars in thousands
30-59 days
 
60-89 days
 
> 90 days
 
Total
 
Current
 
Commercial
$
74

 
$
179

 
$
259

 
$
512

 
$
83,250

 
$

Commercial real estate
 

 
 

 
 

 
 

 
 

 
 

Owner-occupied
365

 
442

 
478

 
1,285

 
155,480

 

Non-owner occupied
288

 

 
120

 
408

 
314,169

 

Construction and development
 

 
 

 
 

 
 

 
 

 
 

Land and land development
388

 
10

 
4,214

 
4,612

 
56,476

 

Construction

 

 

 

 
27,239

 

Residential mortgage
 

 
 

 
 

 
 

 
 

 
 

Non-jumbo
3,381

 
555

 
2,921

 
6,857

 
211,268

 

Jumbo

 
1,181

 
1,435

 
2,616

 
49,301

 

Home equity
190

 
113

 
29

 
332

 
63,924

 

Consumer
350

 
196

 
46

 
592

 
19,314

 

Other

 

 

 

 
6,753

 

Total
$
5,036

 
$
2,676

 
$
9,502

 
$
17,214

 
$
987,174

 
$

 
 
At December 31, 2013
 
Past Due
 
 
 
> 90 days and Accruing
Dollars in thousands
30-59 days
 
60-89 days
 
> 90 days
 
Total
 
Current
 
Commercial
$
74

 
$
34

 
$
1,190

 
$
1,298

 
$
87,054

 
$

Commercial real estate
 

 
 

 
 

 
 

 
 

 
 

Owner-occupied
328

 
459

 
487

 
1,274

 
148,344

 

Non-owner occupied
912

 
115

 
128

 
1,155

 
279,635

 

Construction and development
 
 
 

 
 

 
 

 
 

 
 

Land and land development
1,627

 

 
8,638

 
10,265

 
61,188

 

Construction

 

 

 

 
15,155

 

Residential mortgage
 

 
 

 
 

 
 

 
 

 
 

Non-jumbo
2,708

 
1,673

 
1,321

 
5,702

 
207,244

 

Jumbo

 

 

 

 
53,406

 

Home equity
588

 
87

 

 
675

 
54,169

 

Consumer
224

 
82

 
106

 
412

 
19,477

 

Other

 

 

 

 
3,276

 

Total
$
6,461

 
$
2,450

 
$
11,870

 
$
20,781

 
$
928,948

 
$











Table of Contents
24


 
At September 30, 2013
 
Past Due
 
 
 
> 90 days and Accruing
Dollars in thousands
30-59 days
 
60-89 days
 
> 90 days
 
Total
 
Current
 
Commercial
$
10

 
$
111

 
$
1,583

 
$
1,704

 
$
82,140

 
$

Commercial real estate
 

 
 

 
 

 
 

 
 

 
 

Owner-occupied
846

 
229

 
432

 
1,507

 
149,753

 

Non-owner occupied
587

 
244

 

 
831

 
278,581

 

Construction and development
 

 
 

 
 

 
 

 
 

 
 

Land and land development
154

 

 
8,669

 
8,823

 
64,266

 

Construction

 

 
38

 
38

 
12,285

 

Residential mortgage
 

 
 

 
 

 
 

 
 

 
 

Non-jumbo
3,467

 
2,031

 
2,225

 
7,723

 
207,335

 

Jumbo

 

 
9,000

 
9,000

 
50,701

 

Home equity
214

 
49

 
24

 
287

 
53,387

 

Consumer
197

 
77

 
91

 
365

 
20,107

 

Other
50

 

 

 
50

 
3,325

 

Total
$
5,525

 
$
2,741

 
$
22,062

 
$
30,328

 
$
921,880

 
$


Nonaccrual loans:  The following table presents the nonaccrual loans included in the net balance of loans at September 30, 2014, December 31, 2013 and September 30, 2013.
 
 
September 30,
 
December 31,
Dollars in thousands
 
2014
 
2013
 
2013
Commercial
 
$
309

 
$
2,557

 
$
1,224

Commercial real estate
 
 

 
 

 
 

Owner-occupied
 
593

 
3,795

 
1,953

Non-owner occupied
 
344

 

 
365

Construction and development
 
 

 
 

 
 

Land & land development
 
4,591

 
12,851

 
12,830

Construction
 

 
38

 

Residential mortgage
 
 

 
 

 
 

Non-jumbo
 
3,602

 
3,119

 
2,446

Jumbo
 
1,435

 
9,000

 

Home equity
 
220

 
266

 

Consumer
 
146

 
145

 
128

Total
 
$
11,240

 
$
31,771

 
$
18,946

 
Impaired loans:  Impaired loans include the following:

Loans which we risk-rate (consisting of loan relationships having aggregate balances in excess of $2.0 million, or loans exceeding $500,000 and exhibiting credit weakness) through our normal loan review procedures and which, based on current information and events, it is probable that we will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement.   Risk-rated loans with insignificant delays or insignificant short falls in the amount of payments expected to be collected are not considered to be impaired.

Loans that have been modified in a troubled debt restructuring.

Both commercial and consumer loans are deemed impaired upon being contractually modified in a troubled debt restructuring. Troubled debt restructurings typically result from our loss mitigation activities and occur when we grant a concession to a borrower who is experiencing financial difficulty in order to minimize our economic loss and to avoid foreclosure or

Table of Contents
25


repossession of collateral.  Once restructured in a troubled debt restructuring, a loan is generally considered impaired until its maturity, regardless of whether the borrower performs under the modified terms.  Although such a loan may be returned to accrual status if the criteria set forth in our accounting policy are met, the loan would continue to be evaluated for an asset-specific allowance for loan losses and we would continue to report the loan in the impaired loan table below.

The table below sets forth information about our impaired loans.
Method Used to Measure Impairment of Impaired Loans
 
 
Dollars in thousands
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
September 30,
 
December 31,
 
Method used to measure impairment
Loan Category
2014
 
2013
 
2013
 
Commercial
$
51

 
$
5,997

 
$
1,864

 
Fair value of collateral
 
403

 
160

 
158

 
Discounted cash flow
Commercial real estate
 

 
 

 
 
 
 
Owner-occupied
1,257

 
9,054

 
10,067

 
Fair value of collateral
 
9,181

 
2,497

 
2,483

 
Discounted cash flow
Non-owner occupied
512

 
5,884

 
5,832

 
Fair value of collateral
 
7,358

 

 

 
Discounted cash flow
Construction and development
 
 
 
 
 
 
 
Land & land development
12,934

 
24,870

 
24,625

 
Fair value of collateral
 
1,479

 
649

 
644

 
Discounted cash flow
Residential mortgage
 

 
 
 
 
 
 
Non-jumbo
1,548

 
5,133

 
5,516

 
Fair value of collateral
 
4,980

 
884

 
566

 
Discounted cash flow
Jumbo
7,791

 
17,786

 
8,768

 
Fair value of collateral
 
890

 

 

 
Discounted cash flow
Home equity
285

 
213

 
212

 
Fair value of collateral
 
523

 

 

 
Discounted cash flow
Consumer
3

 
52

 
47

 
Fair value of collateral
 
32

 

 

 
Discounted cash flow
Total
$
49,227

 
$
73,179

 
$
60,782

 
 


Table of Contents
26


The following tables present loans individually evaluated for impairment at September 30, 2014, December 31, 2013 and September 30, 2013.
 
September 30, 2014
Dollars in thousands
Recorded
Investment
 
Unpaid
Principal Balance
 
Related
Allowance
 
Average
Impaired
Balance
 
Interest Income
Recognized
while impaired
 
 
 
 
 
 
 
 
 
 
Without a related allowance
 
 
 
 
 
 
 
 
 
Commercial
$
403

 
$
403

 
$

 
$
409

 
$
26

Commercial real estate
 

 
 

 
 

 
 

 
 

Owner-occupied
5,808

 
5,807

 

 
5,879

 
211

Non-owner occupied
4,989

 
4,991

 

 
5,014

 
248

Construction and development
 

 
 

 
 

 
 

 
 

Land & land development
13,597

 
13,596

 

 
14,099

 
478

Construction

 

 

 

 

Residential real estate
 

 
 

 
 

 
 

 
 

Non-jumbo
4,284

 
4,294

 

 
3,631

 
175

Jumbo
7,786

 
7,791

 

 
7,817

 
310

Home equity
808

 
808

 

 
186

 
11

Consumer
35

 
35

 

 
38

 
2

Total without a related allowance
$
37,710

 
$
37,725

 
$

 
$
37,073

 
$
1,461

 
 
 
 
 
 
 
 
 
 
With a related allowance
 

 
 

 
 

 
 

 
 

Commercial
$
50

 
$
51

 
$
7

 
$
12

 
$
1

Commercial real estate
 

 
 

 
 

 
 

 
 

Owner-occupied
4,631

 
4,631

 
256

 
4,618

 
214

Non-owner occupied
2,879

 
2,879

 
87

 
733

 
28

Construction and development
 

 
 

 
 

 
 

 
 

Land & land development
817

 
817

 
10

 
865

 
38

Construction

 

 

 

 

Residential real estate
 

 
 

 
 

 
 

 
 

Non-jumbo
2,234

 
2,234

 
201

 
2,076

 
99

Jumbo
890

 
890

 
49

 
893

 
45

Home equity

 

 

 

 

Consumer

 

 

 

 

Total with a related allowance
$
11,501

 
$
11,502

 
$
610

 
$
9,197

 
$
425

 
 
 
 
 
 
 
 
 
 
Total
 

 
 

 
 

 
 

 
 

Commercial
$
33,174

 
$
33,175

 
$
360

 
$
31,629

 
$
1,244

Residential real estate
16,002

 
16,017

 
250

 
14,603

 
640

Consumer
35

 
35

 

 
38

 
2

Total
$
49,211

 
$
49,227

 
$
610

 
$
46,270

 
$
1,886







Table of Contents
27


 
December 31, 2013
Dollars in thousands
Recorded
Investment
 
Unpaid
Principal Balance
 
Related
Allowance
 
Average
Impaired
Balance
 
Interest Income
Recognized
while impaired
 
 
 
 
 
 
 
 
 
 
Without a related allowance
 
 
 
 
 
 
 
 
 
Commercial
$
1,161

 
$
1,167

 
$

 
$
1,518

 
$
98

Commercial real estate
 

 
 

 
 

 
 

 
 

Owner-occupied
8,434

 
8,434

 

 
7,675

 
226

Non-owner occupied
5,075

 
5,077

 

 
5,110

 
253

Construction and development
 
 
 

 
 

 
 

 
 

Land & land development
14,732

 
14,737

 

 
11,628

 
325

Construction

 

 

 

 

Residential real estate
 

 
 

 
 

 
 

 
 

Non-jumbo
3,587

 
3,595

 

 
2,858

 
157

Jumbo
7,862

 
7,867

 

 
7,910

 
405

Home equity
186

 
186

 

 
186

 
11

Consumer
26

 
27

 

 
28

 
1

Total without a related allowance
$
41,063

 
$
41,090

 
$

 
$
36,913

 
$
1,476

 
 
 
 
 
 
 
 
 
 
With a related allowance
 

 
 

 
 

 
 

 
 

Commercial
$
855

 
$
855

 
$
406

 
$
1,013

 
$

Commercial real estate
 

 
 

 
 

 
 

 
 

Owner-occupied
4,116

 
4,116

 
305

 
3,945

 
184

Non-owner occupied
747

 
755

 
175

 
515

 
28

Construction and development
 
 
 

 
 

 
 

 
 

Land & land development
10,532

 
10,532

 
3,186

 
11,310

 
147

Construction

 

 

 

 

Residential real estate
 

 
 

 
 

 
 

 
 

Non-jumbo
2,485

 
2,487

 
256

 
2,292

 
107

Jumbo
900

 
901

 
37

 
906

 
45

Home equity
27

 
26

 
22

 
27

 

Consumer
20

 
20

 
13

 
9

 

Total with a related allowance
$
19,682

 
$
19,692

 
$
4,400

 
$
20,017

 
$
511

 
 
 
 
 
 
 
 
 
 
Total
 

 
 

 
 

 
 

 
 

Commercial
$
45,652

 
$
45,673

 
$
4,072

 
$
42,714

 
$
1,261

Residential real estate
15,047

 
15,062

 
315

 
14,179

 
725

Consumer
46

 
47

 
13

 
37

 
1

Total
$
60,745

 
$
60,782

 
$
4,400

 
$
56,930

 
$
1,987





 

Table of Contents
28


 
September 30, 2013
Dollars in thousands
Recorded
Investment
 
Unpaid
Principal Balance
 
Related
Allowance
 
Average
Impaired
Balance
 
Interest Income
Recognized
while impaired
 
 
 
 
 
 
 
 
 
 
Without a related allowance
 
 
 
 
 
 
 
 
 
Commercial
$
4,254

 
$
4,268

 
$

 
$
5,632

 
$
334

Commercial real estate
 

 
 

 
 

 
 

 
 

Owner-occupied
7,609

 
7,613

 

 
8,839

 
293

Non-owner occupied
5,368

 
5,370

 

 
5,800

 
289

Construction and development
 
 
 

 
 

 
 

 
 

Land & land development
20,923

 
20,921

 

 
20,331

 
404

Construction

 

 

 

 

Residential real estate
 

 
 

 
 

 
 

 
 

Non-jumbo
2,888

 
2,895

 

 
2,930

 
171

Jumbo
7,876

 
7,882

 

 
8,168

 
419

Home equity
186

 
186

 

 
186

 
11

Consumer
28

 
28

 

 
32

 
2

Total without a related allowance
$
49,132

 
$
49,163

 
$

 
$
51,918

 
$
1,923

 
 
 
 
 
 
 
 
 
 
With a related allowance
 

 
 

 
 

 
 

 
 

Commercial
$
1,891

 
$
1,889

 
$
702

 
$
2,537

 
$

Commercial real estate
 

 
 

 
 

 
 

 
 

Owner-occupied
3,938

 
3,938

 
216

 
3,956

 
138

Non-owner occupied
514

 
514

 
110

 
516

 
28

Construction and development
 
 
 

 
 

 
 

 
 

Land & land development
4,597

 
4,598

 
1,390

 
3,992

 
121

Construction

 

 

 

 

Residential real estate
 

 
 

 
 

 
 

 
 

Non-jumbo
3,119

 
3,122

 
316

 
2,843

 
130

Jumbo
9,904

 
9,904

 
1,040

 
10,152

 
45

Home equity
27

 
27

 
27

 
27

 

Consumer
24

 
24

 
13

 
25

 
1

Total with a related allowance
$
24,014

 
$
24,016

 
$
3,814

 
$
24,048

 
$
463

 
 
 
 
 
 
 
 
 
 
Total
 

 
 

 
 

 
 

 
 

Commercial
$
49,094

 
$
49,111

 
$
2,418

 
$
51,603

 
$
1,607

Residential real estate
24,000

 
24,016

 
1,383

 
24,306

 
776

Consumer
52

 
52

 
13

 
57

 
3

Total
$
73,146

 
$
73,179

 
$
3,814

 
$
75,966

 
$
2,386


A modification of a loan is considered a troubled debt restructuring (“TDR”) when a borrower is experiencing financial difficulty and the modification constitutes a concession that we would not otherwise consider. This may include a transfer of real estate or other assets from the borrower, a modification of loan terms, or a combination of both.  A loan continues to be classified as a TDR for the life of the loan.  Included in impaired loans are TDRs of $35.9 million, of which $33.9 million were current with respect to restructured contractual payments at September 30, 2014, and $34.5 million, of which $33.6 million were current with respect to restructured contractual payments at December 31, 2013.  There were no commitments to lend additional funds under these restructurings at either balance sheet date.

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29


The following table presents by class the TDRs that were restructured during the three and nine months ended September 30, 2014 and 2013.  Generally, the modifications were extensions of term, modifying the payment terms from principal and interest to interest only for an extended period, or reduction in interest rate.  All TDRs are evaluated individually for allowance for loan loss purposes.
 
For the Three Months Ended 
 September 30, 2014
 
For the Three Months Ended 
 September 30, 2013
Dollars in thousands
Number of
Modifications
 
Pre-modification
Recorded
Investment
 
Post-modification
Recorded
Investment
 
Number of
Modifications
 
Pre-modification
Recorded
Investment
 
Post-modification
Recorded
Investment
Commercial

 
$

 
$

 

 
$

 
$

Commercial real estate
 
 
 
 
 
 
 
 
 
 
 
Owner-occupied

 

 

 

 

 

Non-owner occupied
1

 
2,154

 
2,154

 

 

 

Construction and development
 
 
 
 
 
 
 
 
 
 
 
Land & land development

 

 

 

 

 

Construction

 

 

 

 

 

Residential real estate
 
 
 
 
 
 
 
 
 
 
 
Non-jumbo
3

 
634

 
670

 
2

 
487

 
487

Jumbo

 

 

 

 

 

Home equity
1

 
411

 
523

 

 

 

Consumer

 

 

 

 

 

Total
5

 
$
3,199

 
$
3,347

 
2

 
$
487

 
$
487


 
For the Nine Months Ended 
 September 30, 2014
 
For the Nine Months Ended 
 September 30, 2013
Dollars in thousands
Number of
Modifications
 
Pre-modification
Recorded
Investment
 
Post-modification
Recorded
Investment
 
Number of
Modifications
 
Pre-modification
Recorded
Investment
 
Post-modification
Recorded
Investment
Commercial
3

 
$
82

 
$
86

 
1

 
$
23

 
$
23

Commercial real estate
 
 
 
 
 
 
 
 
 
 
 
Owner-occupied

 

 

 

 

 

Non-owner occupied
1

 
2,154

 
2,154

 

 

 

Construction and development
 
 
 
 
 
 
 
 
 
 
 
Land & land development

 

 

 
1

 
49

 
50

Construction

 

 

 

 

 

Residential real estate
 
 
 
 
 
 
 
 
 
 
 
Non-jumbo
3

 
634

 
670

 
4

 
728

 
514

Jumbo

 

 

 

 

 

Home equity
1

 
411

 
523

 

 

 

Consumer

 

 

 

 

 

Total
8

 
$
3,281

 
$
3,433

 
6

 
$
800

 
$
587



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30


The following table presents defaults during the stated period of TDRs that were restructured during the past twelve months.  For purposes of these tables, a default is considered as either the loan was past due 30 days or more at any time during the period, or the loan was fully or partially charged off during the period. 
 
For the Three Months Ended 
 September 30, 2014
 
For the Nine Months Ended 
 September 30, 2014
Dollars in thousands
Number
of
Defaults
 
Recorded
Investment
at Default Date
 
Number
of
Defaults
 
Recorded
Investment
at Default Date
Commercial
2

 
$
59

 
3

 
$
86

Commercial real estate


 


 


 


Owner-occupied

 

 

 

Non-owner occupied

 

 

 

Construction and development

 


 


 


Land & land development
1

 
699

 
1

 
698

Construction

 

 

 

Residential real estate


 


 


 


Non-jumbo
2

 
278

 
2

 
278

Jumbo

 

 

 

Home equity

 

 

 

Consumer

 

 

 

Total
5

 
$
1,036

 
6

 
$
1,062


The following table details the activity regarding TDRs by loan type for the three months and nine months ended September 30, 2014, and the related allowance on TDRs.
For the Three Months Ended September 30, 2014
 
Construction & Land Development
 
 
 
Commercial Real Estate
 
Residential Real Estate
 
 
 
 
 
 
Dollars in thousands
Land &
Land
Develop-
ment
 
Construc-
tion
 
Commer-
cial
 
Owner
Occupied
 
Non-
Owner
Occupied
 
Non-
jumbo
 
Jumbo
 
Home
Equity
 
Con-
sumer
 
Other
 
Total
Troubled debt restructurings
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance June 30, 2014
$
5,968

 
$

 
$
498

 
$
9,589

 
$
5,465

 
$
5,494

 
$
6,201

 
$

 
$
38

 
$

 
$
33,253

Additions

 

 

 

 
2,154

 
670

 

 
523

 

 

 
3,347

Charge-offs

 

 

 

 

 

 

 

 

 

 

Net (paydowns) advances
(155
)
 

 
(52
)
 
(22
)
 
(37
)
 
(216
)
 
(52
)
 

 
(3
)
 

 
(537
)
Transfer into OREO

 

 

 

 

 
(88
)
 

 

 

 

 
(88
)
Refinance out of TDR status

 

 

 

 

 

 

 

 

 

 

Balance, September 30, 2014
$
5,813

 
$

 
$
446

 
$
9,567

 
$
7,582

 
$
5,860

 
$
6,149

 
$
523

 
$
35

 
$

 
$
35,975

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance related to troubled debt restructurings
$
10

 
$

 
$
7

 
$
183

 
$
87

 
$
201

 
$
49

 
$

 
$

 
$

 
$
537










Table of Contents
31


For the Nine Months Ended September 30, 2014
 
Construction & Land Development
 
 
 
Commercial Real Estate
 
Residential Real Estate
 
 
 
 
 
 
Dollars in thousands
Land &
Land
Develop-
ment
 
Construc-
tion
 
Commer-
cial
 
Owner
Occupied
 
Non-
Owner
Occupied
 
Non-
jumbo
 
Jumbo
 
Home
Equity
 
Con-
sumer
 
Other
 
Total
Troubled debt restructurings
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance January 1, 2014
$
6,163

 
$

 
$
1,243

 
$
9,699

 
$
5,544

 
$
5,541

 
$
6,278

 
$

 
$
47

 
$

 
$
34,515

Additions

 

 
86

 

 
2,154

 
670

 

 
523

 

 

 
3,433

Charge-offs

 

 

 

 

 

 

 

 
(3
)
 

 
(3
)
Net (paydowns) advances
(350
)
 

 
(883
)
 
(132
)
 
(116
)
 
(263
)
 
(129
)
 

 
(9
)
 

 
(1,882
)
Transfer into OREO

 

 

 

 

 
(88
)
 

 

 

 

 
(88
)
Refinance out of TDR status

 

 

 

 

 

 

 

 

 

 

Balance, September 30, 2014
$
5,813

 
$

 
$
446

 
$
9,567

 
$
7,582

 
$
5,860

 
$
6,149

 
$
523

 
$
35

 
$

 
$
35,975

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance related to troubled debt restructurings
$
10

 
$

 
$
7

 
$
183

 
$
87

 
$
201

 
$
49

 
$

 
$

 
$

 
$
537


We categorize loans into risk categories based on relevant information about the ability of borrowers to service their debt such as current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. We analyze loans individually by classifying the loans as to credit risk.  We internally grade all commercial loans at the time of loan origination. In addition, we perform an annual loan review on all non-homogenous commercial loan relationships with an aggregate exposure of $2 million, at which time these loans are re-graded. We use the following definitions for our risk grades:

Pass: Loans graded as Pass are loans to borrowers of acceptable credit quality and risk. They are higher quality loans that do not fit any of the other categories described below.

OLEM (Special Mention):  Commercial loans categorized as OLEM are potentially weak. The credit risk may be relatively minor yet represent a risk given certain specific circumstances. If the potential weaknesses are not monitored or mitigated, the asset may weaken or inadequately protect our position in the future.

Substandard:   Commercial loans categorized as Substandard are inadequately protected by the borrower’s ability to repay, equity, and/or the collateral pledged to secure the loan. These loans have identified weaknesses that could hinder normal repayment or collection of the debt. These loans are characterized by the distinct possibility that we will sustain some loss if the identified weaknesses are not mitigated.

Doubtful:  Commercial loans categorized as Doubtful have all the weaknesses inherent in those loans classified as Substandard, with the added elements that the full collection of the loan is improbable and the possibility of loss is high.

Loss:  Loans classified as loss are considered to be non-collectible and of such little value that their continuance as a bankable asset is not warranted. This does not mean that the loan has absolutely no recovery value, but rather it is neither practical nor desirable to defer writing off the loan, even though partial recovery may be obtained in the future.


Table of Contents
32


The following table presents the recorded investment in construction and development, commercial, and commercial real estate loans which are generally evaluated based upon the internal risk ratings defined above.

Loan Risk Profile by Internal Risk Rating
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction and Development
 
 
 
 
 
Commercial Real Estate
 
Land and Land Development
 
Construction
 
Commercial
 
Owner Occupied
 
Non-Owner Occupied
Dollars in thousands
9/30/2014
 
12/31/2013
 
9/30/2014
 
12/31/2013
 
9/30/2014
 
12/31/2013
 
9/30/2014
 
12/31/2013
 
9/30/2014
 
12/31/2013
Pass
$
47,344

 
$
41,662

 
$
27,239

 
$
15,022

 
$
82,094

 
$
82,323

 
$
154,128

 
$
143,982

 
$
303,848

 
$
268,967

OLEM (Special Mention)
724

 
5,550

 

 
133

 
1,320

 
4,544

 
1,658

 
1,412

 
9,226

 
10,222

Substandard
13,020

 
24,131

 

 

 
348

 
1,485

 
979

 
4,224

 
1,503

 
1,601

Doubtful

 
110

 

 

 

 

 

 

 

 

Loss

 

 

 

 

 

 

 

 

 

Total
$
61,088

 
$
71,453

 
$
27,239

 
$
15,155

 
$
83,762

 
$
88,352

 
$
156,765

 
$
149,618

 
$
314,577

 
$
280,790

 
The following table presents the recorded investment in consumer, residential real estate, and home equity loans, which are generally evaluated based on the aging status of the loans, which was previously presented, and payment activity.
 
Performing
 
Nonperforming
Dollars in thousands
9/30/2014
 
12/31/2013
 
9/30/2013
 
9/30/2014
 
12/31/2013
 
9/30/2013
Residential real estate
 
 
 
 
 
 
 
 
 
 
 
Non-jumbo
$
214,523

 
$
210,500

 
$
211,939

 
$
3,602

 
$
2,446

 
$
3,119

Jumbo
50,482

 
53,406

 
50,701

 
1,435

 

 
9,000

Home Equity
64,037

 
54,844

 
53,408

 
219

 

 
266

Consumer
19,760

 
19,761

 
20,327

 
146

 
128

 
145

Other
6,753

 
3,276

 
3,375

 

 

 

Total
$
355,555

 
$
341,787

 
$
339,750

 
$
5,402

 
$
2,574

 
$
12,530


Loan commitments:  ASC Topic 815, Derivatives and Hedging, requires that commitments to make mortgage loans should be accounted for as derivatives if the loans are to be held for sale, because the commitment represents a written option and accordingly is recorded at the fair value of the option liability.


Table of Contents
33


NOTE 7.  ALLOWANCE FOR LOAN LOSSES

An analysis of the allowance for loan losses for the nine month periods ended September 30, 2014 and 2013, and for the year ended December 31, 2013 is as follows:
 
 
Nine Months Ended 
 September 30,
 
Year Ended 
 December 31,
Dollars in thousands
 
2014
 
2013
 
2013
 
 
 
 
 
 
 
Balance, beginning of year
 
$
12,659

 
$
17,933

 
$
17,933

Losses:
 
 
 
 
 
 
Commercial
 
390

 
205

 
723

Commercial real estate
 
 
 
 
 
 
Owner occupied
 
11

 
1,067

 
1,031

Non-owner occupied
 

 
9

 
9

Construction and development
 
 
 
 
 
 
Land and land development
 
3,535

 
3,560

 
3,596

Construction
 

 

 

Residential real estate
 
 
 
 
 
 
Non-jumbo
 
280

 
494

 
541

Jumbo
 
65

 
3,739

 
4,741

Home equity
 

 
77

 
77

Consumer
 
119

 
55

 
79

Other
 
71

 
84

 
162

Total
 
4,471

 
9,290

 
10,959

Recoveries:
 
 

 
 

 
 

Commercial
 
19

 
7

 
12

Commercial real estate
 
 
 
 
 
 
Owner occupied
 
38

 
2

 
8

Non-owner occupied
 
12

 
633

 
674

Construction and development
 
 
 
 
 
 
Land and land development
 
177

 
13

 
187

Construction
 

 

 

Real estate - mortgage
 
 
 
 
 
 
Non-jumbo
 
71

 
106

 
127

Jumbo
 
163

 
4

 
6

Home equity
 
3

 
4

 
5

Consumer
 
63

 
53

 
79

Other
 
57

 
74

 
87

Total
 
603

 
896

 
1,185

Net losses
 
3,868


8,394


9,774

Provision for loan losses
 
2,250

 
3,500

 
4,500

Balance, end of year
 
$
11,041


$
13,039


$
12,659

 
 

Table of Contents
34


Activity in the allowance for loan losses by loan class during the first nine months of 2014 is as follows:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction & Land Development
 
 
 
Commercial Real Estate
 
Residential Real Estate
 
 
 
 
 
 
Dollars in thousands
Land &
Land
Develop-
ment
 
Construc-
tion
 
Commer-
cial
 
Owner
Occupied
 
Non-
Owner
Occupied
 
Non-
jumbo
 
Jumbo
 
Home
Equity
 
Con-
sumer
 
Other
 
Total
Allowance for loan losses
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
$
5,455

 
$
269

 
$
1,324

 
$
969

 
$
641

 
$
1,842

 
$
1,888

 
$
173

 
$
47

 
$
51

 
$
12,659

Charge-offs
3,535

 

 
390

 
11

 

 
280

 
65

 

 
119

 
71

 
4,471

Recoveries
177

 

 
19

 
38

 
12

 
71

 
163

 
3

 
63

 
57

 
603

Provision
772

 
209

 
(64
)
 
(99
)
 
1,002

 
91

 
170

 
55

 
66

 
48

 
2,250

Ending balance
$
2,869


$
478


$
889


$
897


$
1,655


$
1,724


$
2,156


$
231


$
57


$
85


$
11,041

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance related to:
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Loans individually
evaluated for impairment
$
10

 
$

 
$
7

 
$
256

 
$
87

 
$
201

 
$
49

 
$

 
$

 
$

 
$
610

Loans collectively
evaluated for impairment
2,859

 
478

 
882

 
641

 
1,568

 
1,523

 
2,107

 
231

 
57

 
85

 
10,431

Loans acquired with deteriorated credit quality

 

 

 

 

 

 

 

 

 

 

Total
$
2,869

 
$
478

 
$
889

 
$
897

 
$
1,655

 
$
1,724

 
$
2,156

 
$
231

 
$
57

 
$
85

 
$
11,041

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Loans individually
evaluated for impairment
$
14,413

 
$

 
$
454

 
$
10,438

 
$
7,870

 
$
6,528

 
$
8,681

 
$
808

 
$
35

 
$

 
$
49,227

Loans collectively
evaluated for impairment
46,675

 
27,239

 
83,308

 
146,327

 
306,707

 
211,597

 
43,236

 
63,448

 
19,871

 
6,753

 
$
955,161

Loans acquired with deteriorated credit quality

 

 

 

 

 

 

 

 

 

 

Total
$
61,088

 
$
27,239

 
$
83,762

 
$
156,765

 
$
314,577

 
$
218,125

 
$
51,917

 
$
64,256

 
$
19,906

 
$
6,753

 
$
1,004,388


NOTE 8.  GOODWILL AND OTHER INTANGIBLE ASSETS

The following tables present our goodwill by reporting unit at September 30, 2014 and other intangible assets by reporting unit at September 30, 2014 and December 31, 2013.
 
 
Goodwill Activity
Dollars in thousands
 
Community
Banking
 
Insurance
Services
 
Total
Balance, January 1, 2014
 
$
1,488

 
$
4,710

 
$
6,198

Acquired goodwill, net
 

 

 

Balance, September 30, 2014
 
$
1,488

 
$
4,710

 
$
6,198









Table of Contents
35


 
 
Other Intangible Assets
 
 
September 30, 2014
 
December 31, 2013
Dollars in thousands
 
Community
Banking
 
Insurance
Services
 
Total
 
Community
Banking
 
Insurances
Services
 
Total
Unidentifiable intangible assets
 
 
 
 
 
 
 
 
 
 
 
 
Gross carrying amount
 
$
2,268

 
$

 
$
2,268

 
$
2,267

 
$

 
$
2,267

Less: accumulated amortization
 
2,268

 

 
2,268

 
2,216

 

 
2,216

Net carrying amount
 
$

 
$

 
$

 
$
51

 
$

 
$
51

 
 
 
 
 
 
 
 
 
 
 
 
 
Identifiable intangible assets
 
 

 
 

 
 

 
 

 
 

 
 

Gross carrying amount
 
$

 
$
3,000

 
$
3,000

 
$

 
$
3,000

 
$
3,000

Less: accumulated amortization
 

 
1,450

 
1,450

 

 
1,300

 
1,300

Net carrying amount
 
$

 
$
1,550

 
$
1,550

 
$

 
$
1,700

 
$
1,700


We recorded amortization expense of approximately $200,000 for the nine months ended September 30, 2014 relative to our other intangible assets.  Annual amortization is expected to be approximately $251,000 in 2014, and $200,000 for each of the years ending 2015 through 2018.

NOTE 9.  DEPOSITS

The following is a summary of interest bearing deposits by type as of September 30, 2014 and 2013 and December 31, 2013:
Dollars in thousands
 
September 30,
2014
 
December 31,
2013
 
September 30,
2013
Demand deposits, interest bearing
 
$
195,182

 
$
186,578

 
$
186,702

Savings deposits
 
255,880

 
193,446

 
193,285

Time deposits
 
498,950

 
530,951

 
537,639

Total
 
$
950,012

 
$
910,975

 
$
917,626


Included in time deposits are deposits acquired through a third party (“brokered deposits”) totaling $146.9 million, $160.8 million and $174.5 million at September 30, 2014, December 31, 2013, and September 30, 2013, respectively.

A summary of the scheduled maturities for all time deposits as of September 30, 2014 is as follows:
Dollars in thousands
 
Six month period ending December 31, 2014
$
54,079

Year ending December 31, 2015
159,728

Year ending December 31, 2016
118,360

Year ending December 31, 2017
46,734

Year ending December 31, 2018
45,397

Thereafter
74,652

 
$
498,950


Table of Contents
36


The following is a summary of the maturity distribution of all certificates of deposit in denominations of $100,000 or more as of September 30, 2014:

Dollars in thousands
Amount
 
Percent
Three months or less
$
32,585

 
8.9
%
Three through six months
38,478

 
10.5
%
Six through twelve months
49,374

 
13.5
%
Over twelve months
246,279

 
67.1
%
Total
$
366,716

 
100.00
%

NOTE 10.  BORROWED FUNDS

Short-term borrowings:    A summary of short-term borrowings is presented below:
 
Nine Months Ended September 30,
 
2014
 
2013
Dollars in thousands
Short-term
FHLB
Advances
 
Federal Funds
Purchased
and Lines
of Credit
 
Short-term
FHLB
Advances
 
Federal Funds
Purchased
and Lines
of Credit
Balance at September 30
$
125,000

 
$
2,432

 
$
45,200

 
$
8,963

Average balance outstanding for the period
86,039

 
6,925

 
22,834

 
2,745

Maximum balance outstanding at any month end during period
132,550

 
8,976

 
45,200

 
8,963

Weighted average interest rate for the period
0.26
%
 
0.25
%
 
0.27
%
 
0.25
%
Weighted average interest rate for balances
 

 
 

 
 

 
 

     outstanding at September 30
0.30
%
 
0.25
%
 
0.26
%
 
0.25
%

 
Year Ended December 31, 2013
Dollars in thousands
Short-term
FHLB
Advances
 
Federal Funds
Purchased
and Lines
of Credit
 Balance at December 31
$
53,800

 
$
8,969

Average balance outstanding for the period
29,786

 
4,313

Maximum balance outstanding at any month end during period
55,300

 
8,969

Weighted average interest rate for the period
0.28
%
 
0.25
%
Weighted average interest rate for balances outstanding at December 31
0.26
%
 
0.25
%

Long-term borrowings:  Our long-term borrowings of $78.5 million, $163.5 million and $163.5 million at September 30, 2014, December 31, 2013, and September 30, 2013 respectively, consisted primarily of advances from the Federal Home Loan Bank (“FHLB”) and structured reverse repurchase agreements with two unaffiliated institutions. All FHLB advances are collateralized primarily by similar amounts of residential mortgage loans, certain commercial loans, mortgage backed securities and securities of U. S. Government agencies and corporations.
 
Balance at September 30,
 
Balance at 
 December 31,
Dollars in thousands
2014
 
2013
 
2013
Long-term FHLB advances
$
1,001

 
$
82,624

 
$
82,600

Long-term reverse repurchase agreements
72,000

 
72,000

 
72,000

Term loans
5,465

 
8,916

 
8,916

Total
$
78,466

 
$
163,540

 
$
163,516


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37


 
The term loans are secured by the common stock of our subsidiary bank. $5.0 million bears a variable interest rate of prime minus 50 basis points with a final maturity of 2017, and $0.5 million bears a fixed rate of 8% with a final maturity of 2023.
Our long term FHLB borrowings and reverse repurchase agreements bear both fixed and variable rates and mature in varying amounts through the year 2026.

The average interest rate paid on long-term borrowings for the nine month period ended September 30, 2014 was 4.10% compared to 3.89% for the first nine months of 2013.

Subordinated debentures:  We have subordinated debt totaling $16.8 million at September 30, 2014, December 31, 2013, and September 30, 2013.  The subordinated debt qualifies as Tier 2 capital under Federal Reserve Board guidelines until the debt is within 5 years of its maturity; thereafter the amount qualifying as Tier 2 capital is reduced by 20 percent each year until maturity.  During 2009, we issued $6.8 million in subordinated debt, of which $5 million was issued to an affiliate of a director of Summit.  We also issued $1.0 million and $0.8 million to two unrelated parties.  These three issuances bear an interest rate of 10 percent per annum, a term of 10 years, and are not prepayable by us within the first five years.  During 2008, we issued $10 million of subordinated debt to an unrelated institution, which bears a variable interest rate of 1 month LIBOR plus 275basis points and a term of 7.5 years.

Subordinated debentures owed to unconsolidated subsidiary trusts:  We have three statutory business trusts that were formed for the purpose of issuing mandatorily redeemable securities (the “capital securities”) for which we are obligated to third party investors and investing the proceeds from the sale of the capital securities in our junior subordinated debentures (the “debentures”).  The debentures held by the trusts are their sole assets.  Our subordinated debentures totaled $19.6 million at September 30, 2014, December 31, 2013, and September 30, 2013.

In October 2002, we sponsored SFG Capital Trust I, in March 2004, we sponsored SFG Capital Trust II, and in December 2005, we sponsored SFG Capital Trust III, of which 100% of the common equity of each trust is owned by us.  SFG Capital Trust I issued $3.5 million in capital securities and $109,000 in common securities and invested the proceeds in $3.61 million of debentures. SFG Capital Trust II issued $7.5 million in capital securities and $232,000 in common securities and invested the proceeds in $7.73 million of debentures. SFG Capital Trust III issued $8.0 million in capital securities and $248,000 in common securities and invested the proceeds in $8.25 million of debentures.  Distributions on the capital securities issued by the trusts are payable quarterly at a variable interest rate equal to 3 month LIBOR plus 345basis points for SFG Capital Trust I, 3 month LIBOR plus 280basis points for SFG Capital Trust II, and 3 month LIBOR plus 145basis points for SFG Capital Trust III, and equals the interest rate earned on the debentures held by the trusts, and is recorded as interest expense by us.  The capital securities are subject to mandatory redemption in whole or in part, upon repayment of the debentures.  We have entered into agreements which, taken collectively, fully and unconditionally guarantee the capital securities subject to the terms of the guarantee.  The debentures of each Capital Trust are redeemable by us quarterly.

The capital securities held by SFG Capital Trust I, SFG Capital Trust II, and SFG Capital Trust III qualify as Tier 1 capital under Federal Reserve Board guidelines.  In accordance with these Guidelines, trust preferred securities generally are limited to 25% of Tier 1 capital elements, net of goodwill.  The amount of trust preferred securities and certain other elements in excess of the limit can be included in Tier 2 capital.
 
A summary of the maturities of all long-term borrowings and subordinated debentures for the next five years and thereafter is as follows:
Dollars in thousands
 
 
Long-term
borrowings
 
Subordinated
debentures
 
Subordinated
debentures owed
to unconsolidated
subsidiary trusts
Year Ending December 31,
2014
 
$
476

 
$

 
$

 
2015
 
1,909

 
10,000

 

 
2016
 
28,911

 

 

 
2017
 
960

 

 

 
2018
 
45,100

 

 

 
Thereafter
 
1,110

 
6,800

 
19,589

 
 
 
$
78,466

 
$
16,800

 
$
19,589



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38





NOTE 11.  SHARE BASED COMPENSATION

The 2014 Long-Term Incentive Plan (“2014 LTIP”) was adopted by our shareholders in May 2014 to enhance the ability of the Company to attract and retain exceptionally qualified individuals to serve as key employees. The LTIP provides for the issuance of up to 500,000 shares of common stock, in the form of equity awards including stock options, restricted stock, restricted stock units, stock appreciation rights, performance units, other stock-based awards or any combination thereof,  to our key employees.  No awards have been granted under the 2014 LTIP.

Stock options awarded under the 2009 Officer Stock Option Plan and the 1998 Officer Stock Option Plan (collectively, the “Plans”) were not altered by the 2014 LTIP, and remain subject to the terms of the Plans.  However, under the terms of the 2014 LTIP, all shares of common stock remaining issuable under the Plans at the time the 2014 LTIP was adopted ceased to be available for future issuance.
 
The fair value of our employee stock options granted under the Plans is estimated at the date of grant using the Black-Scholes option-pricing model. This model requires the input of highly subjective assumptions, changes to which can materially affect the fair value estimate. Additionally, there may be other factors that would otherwise have a significant effect on the value of employee stock options granted but are not considered by the model. Because our employee stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options at the time of grant.  There were no options granted during the first nine months of 2014 or 2013.

We recognize compensation expense based on the estimated number of stock awards expected to actually vest, exclusive of the awards expected to be forfeited.  During the first nine months of 2014 and 2013, our stock compensation expense and related deferred taxes were insignificant.

A summary of activity in our Plans during the first nine months of 2014 and 2013 is as follows:
 
For the Nine Months Ended September 30,
 
2014
 
2013
 
Options
 
Weighted-Average
Exercise Price
 
Options
 
Weighted-Average
Exercise Price
Outstanding, January 1
185,410

 
$
19.59

 
249,700

 
$
18.98

Granted

 

 

 

Exercised
(3,200
)
 
4.63

 
(15,200
)
 
5.27

Forfeited

 

 
(1,750
)
 
19.69

Expired
(2,500
)
 
17.43

 
(39,700
)
 
23.41

Outstanding, September 30
179,710

 
$
19.89

 
193,050

 
$
19.14


Other information regarding options outstanding and exercisable at September 30, 2014 is as follows:
 
Options Outstanding
 
Options Exercisable
Range of
exercise price
# of
shares
 
WAEP
 
Wted. Avg.
Remaining
Contractual
Life (yrs)
 
Aggregate
Intrinsic
Value
(in thousands)
 
# of
shares
 
WAEP
 
Aggregate
Intrinsic
Value
(in thousands)
2.54 - $6.00
13,550

 
$
4.69

 
3.95
 
$
76

 
12,550

 
$
4.86

 
$
68

6.01 - 10.00
23,160

 
9.07

 
2.48
 
27

 
23,160

 
9.07

 
27

10.01 - 17.50

 

 
0
 

 

 

 

17.51 - 20.00
38,500

 
17.80

 
2.25
 

 
38,500

 
17.80

 

20.01 - 25.93
104,500

 
25.04

 
1.99
 

 
104,500

 
25.04

 

 
179,710

 
19.89

 
 
 
$
103

 
178,710

 
19.99

 
$
95


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39



NOTE 12.  COMMITMENTS AND CONTINGENCIES

Off-Balance Sheet Arrangements

We are a party to certain financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers.  These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the statement of financial position.  The contract amounts of these instruments reflect the extent of involvement that we have in this class of financial instruments.

Many of our lending relationships contain both funded and unfunded elements.  The funded portion is reflected on our balance sheet.  The unfunded portion of these commitments is not recorded on our balance sheet until a draw is made under the loan facility.  Since many of the commitments to extend credit may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash flow requirements.

A summary of the total unfunded, or off-balance sheet, credit extension commitments follows:
Dollars in thousands
 
September 30,
2014
Commitments to extend credit:
 
 
Revolving home equity and credit card lines
 
$
51,364

Construction loans
 
23,389

Other loans
 
47,710

Standby letters of credit
 
2,791

Total
 
$
125,254


Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  We evaluate each customer's credit worthiness on a case-by-case basis.  The amount of collateral obtained, if we deem necessary upon extension of credit, is based on our credit evaluation.  Collateral held varies but may include accounts receivable, inventory, equipment or real estate.

Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party.  Standby letters of credit generally are contingent upon the failure of the customer to perform according to the terms of the underlying contract with the third party.

Our exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments.  We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments.

Legal Contingencies

On May 13, 2014, the ResCap Liquidating Trust (“ResCap”), as successor to Residential Funding Company, LLC f/k/a Residential Funding Corporation (“RFC”), filed a complaint against Summit Financial Mortgage, LLC (“Summit Mortgage”), a former residential mortgage subsidiary of Summit whose operations were discontinued in 2007, in the United States Bankruptcy Court for the Southern District of New York and subsequently amended its complaint on July 25, 2014. The Amended Complaint asserts the following three causes of action related to Summit Mortgage’s origination and subsequent sale of mortgage loans to Residential Funding Corporation:  1) Summit Mortgage breached its representations and warranties made in the contract governing the sale of the mortgage loans to RFC;  2) an indemnification claim against Summit Mortgage for damages paid by ResCap to settle claims in RFC’s bankruptcy proceeding which allegedly relate to mortgage loans Summit Mortgage sold to RFC; 3) a claim for damages against Summit Community Bank, Inc., former parent of Summit Mortgage, arising out of a guaranty in which the Bank guaranteed Summit Mortgage’s full performance under the contract governing the sale of mortgage loans to RFC. An estimate as to possible loss resulting from the Amended Complaint cannot be provided at this time because such an estimate cannot be made. Summit intends to defend these claims vigorously.
 

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We are not a party to any other litigation except for matters that arise in the normal course of business.  While it is impossible to ascertain the ultimate resolution or range of financial liability with respect to these contingent matters, in the opinion of management, the outcome of these matters will not have a significant adverse effect on the consolidated financial statements.

NOTE 13.  REGULATORY MATTERS

We and our subsidiaries are subject to various regulatory capital requirements administered by the banking regulatory agencies.  Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we and each of our subsidiaries must meet specific capital guidelines that involve quantitative measures of our and our subsidiaries’ assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices.  We and each of our subsidiaries’ capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Quantitative measures established by regulation to ensure capital adequacy require us and each of our subsidiaries to maintain minimum amounts and ratios of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined).  We believe, as of September 30, 2014, that we and each of our subsidiaries met all capital adequacy requirements to which they were subject.

The most recent notifications from the banking regulatory agencies categorized us and each of our subsidiaries as well capitalized under the regulatory framework for prompt corrective action.  To be categorized as well capitalized, we and each of our subsidiaries must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table below.

Our actual capital amounts and ratios as well as our subsidiary, Summit Community Bank’s (“Summit Community”) are presented in the following table.
 
 
 Actual
 
Minimum Required
Regulatory Capital
 
To be Well Capitalized
under Prompt Corrective
Action Provisions
Dollars in thousands
 
Amount
 
Ratio
 
Amount
 
Ratio
 
Amount
 
Ratio
As of September 30, 2014
 
 
 
 
 
 
 
 
 
 
 
 
Total Capital (to risk weighted assets)
 
 
 
 
 
 
 
 
 
 
Summit
 
$
149,309

 
14.3
%
 
$
83,530

 
8.0
%
 
$
104,412

 
10.0
%
Summit Community
 
161,116

 
15.5
%
 
83,157

 
8.0
%
 
103,946

 
10.0
%
Tier I Capital (to risk weighted assets)
 
 

 
 

 
 

 
 

 
 

Summit
 
130,668

 
12.5
%
 
41,814

 
4.0
%
 
62,721

 
6.0
%
Summit Community
 
150,075

 
14.4
%
 
41,688

 
4.0
%
 
62,531

 
6.0
%
Tier I Capital (to average assets)
 
 

 
 

 
 

 
 

 
 

 
 

Summit
 
130,668

 
9.2
%
 
56,812

 
4.0
%
 
71,015

 
5.0
%
Summit Community
 
150,075

 
10.5
%
 
57,171

 
4.0
%
 
71,464

 
5.0
%
As of December 31, 2013
 
 

 
 

 
 

 
 

 
 

 
 

Total Capital (to risk weighted assets)
 
 

 
 

 
 

 
 

 
 

Summit
 
144,202

 
14.5
%
 
79,638

 
8.0
%
 
99,547

 
10.0
%
Summit Community
 
156,473

 
15.7
%
 
79,627

 
8.0
%
 
99,534

 
10.0
%
Tier I Capital (to risk weighted assets)
 
 

 
 

 
 

 
 

 
 

Summit
 
122,918

 
12.4
%
 
39,499

 
4.0
%
 
59,248

 
6.0
%
Summit Community
 
143,989

 
14.5
%
 
39,814

 
4.0
%
 
59,720

 
6.0
%
Tier I Capital (to average assets)
 
 

 
 

 
 

 
 

 
 

 
 

Summit
 
122,918

 
8.9
%
 
55,151

 
4.0
%
 
68,938

 
5.0
%
Summit Community
 
143,989

 
10.4
%
 
55,150

 
4.0
%
 
68,938

 
5.0
%

Summit Financial Group, Inc. (“Summit”) and its bank subsidiary, Summit Community Bank, Inc. (the “Bank”), have entered into informal Memoranda of Understanding (“MOU’s”) with their respective regulatory authorities.  A memorandum of understanding is characterized by the regulatory authorities as an informal action that is not published or publicly available and

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41


that is used when circumstances warrant a milder form of action than a formal supervisory action, such as a formal written agreement or order.

Under the Summit MOU, Summit has agreed among other things to:

Summit suspending all cash dividends on its common stock until further notice.  Dividends on all preferred stock, as well as interest payments on subordinated notes underlying Summit’s trust preferred securities, continue to be permissible; and,

Summit not incurring any additional debt, other than trade payables, without the prior written consent of the principal banking regulators.

Additional information regarding Summit’s MOU is included in Part I. Item 1A – Risk Factors on our Form 10-K for the year ended December 31, 2013.

On October 25, 2012, the Bank entered into a revised MOU (“Bank MOU”) which replaced the Bank MOU effective September 24, 2009 and subsequently amended on February 1, 2011.  In general, the Bank MOU includes provisions substantially similar to those in the prior Bank MOU with the exception that several provisions deemed no longer applicable by the regulatory authorities were removed and a provision relative to reducing the Bank’s levels of classified assets was added.

In summary, we have agreed, among other things, to address the following matters relative to the Bank:

maintaining a Board committee which monitors and promotes compliance with the provisions of the Bank MOU;

providing the Bank’s regulatory authorities with updated reports of criticized assets and/or formal workout plans for all nonperforming borrower relationships with an aggregate outstanding balance exceeding $1 million;

developing and submitting to regulatory authorities a written plan to reduce the Bank’s risk exposure in each adversely classified credit relationship in excess of $1 million and all OREO;

establishing procedures to report all loans with balances exceeding $500,000that have credit weaknesses or that fall outside of the Bank’s policy;

annually reviewing the organizational structure and operations of the Bank’s loan department;

maintaining an adequate allowance for loan and lease losses through charges to current operating income;

reviewing overall liquidity objectives and developing and submitting to regulatory authorities plans and procedures aimed to improve liquidity and reduce reliance on volatile liabilities;

preparing comprehensive budgets and earnings forecasts for the Bank and submitting reports comparing actual performance to the budget plan;

maintaining a minimum Tier 1 Leverage Capital ratio of at least 8% and a Total Risk-based Capital ratio of at least 11%;

not paying any cash dividends without the prior written consent of the banking regulators; and,

providing quarterly progress reports to the Bank’s regulatory authorities detailing steps taken to comply with the Bank MOU.

NOTE  14.  SEGMENT INFORMATION

We operate two business segments:  community banking and insurance & financial services.  These segments are primarily identified by the products or services offered.  The community banking segment consists of our full service banks which offer customers traditional banking products and services through various delivery channels.  The insurance & financial services segment includes three insurance agency offices that sell insurance products.  The accounting policies discussed throughout the notes to the consolidated financial statements apply to each of our business segments.

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42


Inter-segment revenue and expense consists of management fees allocated to the community banking and the insurance & financial services segments for all centralized functions that are performed by the parent, including overall direction in the areas of strategic planning, investment portfolio management, asset/liability management, financial reporting and other financial and administrative services.  Information for each of our segments is included below:
 
 
Nine Months Ended September 30, 2014
Dollars in thousands
 
Community
Banking
 
Insurance &
Financial
Services
 
Parent
 
Eliminations
 
Total
Net interest income
 
$
32,812

 
$

 
$
(1,377
)
 
$

 
$
31,435

Provision for loan losses
 
2,250

 

 

 

 
2,250

Net interest income after provision for loan losses
 
30,562




(1,377
)



29,185

Other income
 
4,574

 
3,786

 
931

 
(890
)
 
8,401

Other expenses
 
22,694

 
3,152

 
1,257

 
(890
)
 
26,213

Income (loss) before income taxes
 
12,442


634


(1,703
)



11,373

Income tax expense (benefit)
 
3,507

 
210

 
(502
)
 

 
3,215

Net income (loss)
 
8,935

 
424

 
(1,201
)
 


8,158

Dividends on preferred shares
 

 

 
580

 

 
580

Net income (loss) applicable to common shares
 
$
8,935

 
$
424

 
$
(1,781
)
 
$

 
$
7,578

Inter-segment revenue (expense)
 
$
(802
)
 
$
(88
)
 
$
890

 
$

 
$

Average assets
 
$
1,462,070

 
$
6,119

 
$
162,904

 
$
(216,335
)
 
$
1,414,758


 
 
Nine Months Ended September 30, 2013
Dollars in thousands
 
Community
Banking
 
Insurance &
Financial
Services
 
Parent
 
Eliminations
 
Total
Net interest income
 
$
30,237

 
$

 
$
(1,436
)
 
$

 
$
28,801

Provision for loan losses
 
3,500

 

 

 

 
3,500

Net interest income after provision for loan losses
 
26,737

 

 
(1,436
)
 


25,301

Other income
 
4,646

 
3,668

 
815

 
(815
)
 
8,314

Other expenses
 
22,530

 
3,459

 
1,158

 
(815
)
 
26,332

Income (loss) before income taxes
 
8,853

 
209

 
(1,779
)
 


7,283

Income tax expense (benefit)
 
2,534

 
79

 
(612
)
 

 
2,001

Net income (loss)
 
6,319

 
130

 
(1,167
)
 


5,282

Dividends on preferred shares
 

 

 
582

 

 
582

Net income (loss) applicable to common shares
 
$
6,319

 
$
130

 
$
(1,749
)
 
$

 
$
4,700

Inter-segment revenue (expense)
 
$
(734
)
 
$
(81
)
 
$
815

 
$

 
$

Average assets
 
$
1,431,835

 
$
6,329

 
$
155,522

 
$
(213,202
)
 
$
1,380,484







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43


 
 
Three Months Ended September 30, 2014
Dollars in thousands
 
Community
Banking
 
Insurance &
Financial
Services
 
Parent
 
Eliminations
 
Total
Net interest income
 
$
11,500

 
$

 
$
(424
)
 
$

 
$
11,076

Provision for loan losses
 
250

 

 

 

 
250

Net interest income after provision for loan losses
 
11,250

 

 
(424
)
 


10,826

Other income
 
1,674

 
1,198

 
341

 
(300
)
 
2,913

Other expenses
 
8,022

 
1,063

 
400

 
(300
)
 
9,185

Income (loss) before income taxes
 
4,902

 
135

 
(483
)
 


4,554

Income tax expense (benefit)
 
1,320

 
38

 
(140
)
 

 
1,218

Net income (loss)
 
3,582

 
97

 
(343
)
 


3,336

Dividends on preferred shares
 

 

 
193

 

 
193

Net income (loss) applicable to common shares
 
$
3,582

 
$
97

 
$
(536
)
 
$


$
3,143

Inter-segment revenue (expense)
 
$
(270
)
 
$
(30
)
 
$
300

 
$

 
$

Average assets
 
$
1,477,127

 
$
6,229

 
$
164,637

 
$
(214,953
)
 
$
1,433,040


 
 
Three Months Ended September 30, 2013
Dollars in thousands
 
Community
Banking
 
Insurance &
Financial
Services
 
Parent
 
Eliminations
 
Total
Net interest income
 
$
10,025

 
$

 
$
(487
)
 
$

 
$
9,538

Provision for loan losses
 
1,000

 

 

 

 
1,000

Net interest income after provision for loan losses
 
9,025

 

 
(487
)
 


8,538

Other income
 
1,705

 
1,158

 
272

 
(272
)
 
2,863

Other expenses
 
7,005

 
1,133

 
365

 
(272
)
 
8,231

Income (loss) before income taxes
 
3,725

 
25

 
(580
)
 


3,170

Income tax expense (benefit)
 
1,087

 
12

 
(201
)
 

 
898

Net income (loss)
 
2,638

 
13

 
(379
)
 


2,272

Dividends on preferred shares
 

 

 
194

 

 
194

Net income (loss) applicable to common shares
 
$
2,638

 
$
13

 
$
(573
)
 
$


$
2,078

Inter-segment revenue (expense)
 
$
(251
)
 
$
(21
)
 
$
272

 
$

 
$

Average assets
 
$
1,409,870

 
$
6,377

 
$
153,596

 
$
(205,332
)
 
$
1,364,511


NOTE  15.  DERIVATIVE FINANCIAL INSTRUMENTS

We use derivative instruments primarily to protect against the risk of adverse interest rate movements on the cash flows of certain liabilities.  Derivative instruments represent contracts between parties that usually require little or no initial net investment and result in one party delivering cash or another type of asset to the other party based upon a notional amount and an underlying as specified in the contract.  A notional amount represents the number of units of a specific item, such as currency units.  An underlying represents a variable, such as an interest rate or price index.  The amount of cash or other asset delivered from one party to the other is determined based upon the interaction of the notional amount of the contract with the underlying.  Derivatives can also be implicit in certain contracts and commitments.


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As with any financial instrument, derivative instruments have inherent risks, primarily market and credit risk.  Market risk associated with changes in interest rates is managed by establishing and monitoring limits as to the degree of risk that may be undertaken as part of our overall market risk monitoring process.  Credit risk occurs when a counterparty to a derivative contract with an unrealized gain fails to perform according to the terms of the agreement.  Credit risk is managed by monitoring the size and maturity structure of the derivative portfolio, and applying uniform credit standards to all activities with credit risk.
 
In accordance with ASC 815, Derivatives and Hedging, all derivative instruments are recorded on the balance sheet at fair value.  Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, depending on the type of hedge transaction.

Fair-value hedges – For transactions in which we are hedging changes in fair value of an asset, liability, or a firm commitment, changes in the fair value of the derivative instrument are generally offset in the income statement by changes in the hedged item’s fair value.

Cash-flow hedges – For transactions in which we are hedging the variability of cash flows related to a variable-rate asset, liability, or a forecasted transaction, changes in the fair value of the derivative instrument are reported in other comprehensive income. The gains and losses on the derivative instrument, which are reported in comprehensive income, are reclassified to    earnings in the periods in which earnings are impacted by the variability of cash flows of the hedged item.

The ineffective portion of all hedges is recognized in current period earnings.

Other derivative instruments – For risk management purposes that do not meet the hedge accounting criteria and, therefore, do not qualify for hedge accounting.  These derivative instruments are accounted for at fair value with changes in fair value recorded in the income statement.
 
We have entered into three forward-starting, pay-fixed/receive LIBOR interest rate swaps.  $40 million notional with an effective date of July 18, 2016, was designated as a cash flow hedge of $40 million of forecasted variable rate Federal Home Loan Bank advances.  Under the terms of this swap we will pay a fixed rate of 2.98% for a 3 year period.  $30 million notional with an effective date of April 18, 2016, was designated as a cash flow hedge of $30 million of forecasted variable rate Federal Home Loan Bank advances.  Under the terms of this swap we will pay a fixed rate of 2.89% for a 4.5 year period.   $40 million notional with an effective date of October 18, 2016,  was designated as a cash flow hedge of $40 million of forecasted variable rate Federal Home Loan Bank advances.  Under the terms of the swap we will pay a fixed rate of 2.84% for a 3 year period.

A summary of our derivative financial instruments as of September 30, 2014 and December 31, 2013 follows:
 
September 30, 2014
 
 
 
Derivative Fair Value
 
Net Ineffective
Dollars in thousands
Notional
Amount
 
Asset
 
Liability
 
Hedge Gains/(Losses)
CASH FLOW HEDGES
 
 
 
 
 
 
 
Pay-fixed/receive-variable interest rate swaps
 
 
 
 
 
 
 
Long term borrowings
$
110,000

 
$

 
$
1,357

 
$

 
$
110,000

 
$

 
$
1,357

 
$

 
December 31, 2013
 
 
 
Derivative Fair Value
 
Net Ineffective
Dollars in thousands
Notional
Amount
 
Asset
 
Liability
 
Hedge Gains/(Losses)
CASH FLOW HEDGES
 
 
 
 
 
 
 
Pay-fixed/receive-variable interest rate swaps
 
 
 
 
 
 
Long term borrowings
$
70,000

 
$
803

 
$

 
$

 
$
70,000

 
$
803

 
$

 
$


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

INTRODUCTION

The following discussion and analysis focuses on significant changes in our financial condition and results of operations of Summit Financial Group, Inc. (“Company” or “Summit”) and our operating segments, Summit Community Bank (“Summit Community”), and Summit Insurance Services, LLC for the periods indicated.  See Note 14 of the accompanying consolidated financial statements for our segment information.  This discussion and analysis should be read in conjunction with our 2013 audited financial statements and Annual Report on Form 10-K.

The Private Securities Litigation Act of 1995 indicates that the disclosure of forward-looking information is desirable for investors and encourages such disclosure by providing a safe harbor for forward-looking statements by us.  Our following discussion and analysis of financial condition and results of operations contains certain forward-looking statements that involve risk and uncertainty.  In order to comply with the terms of the safe harbor, we note that a variety of factors could cause our actual results and experience to differ materially from the anticipated results or other expectations expressed in those forward-looking statements.

OVERVIEW

Our primary source of income is net interest income from loans and deposits.  Business volumes tend to be influenced by the overall economic factors including market interest rates, business spending, and consumer confidence, as well as competitive conditions within the marketplace.

Interest earning assets increased by 2.34% for the first nine months in 2014 compared to the same period of 2013 while our net interest earnings on a tax equivalent basis increased 8.93%.  Our tax equivalent net interest margin increased 20 basis points as our reduced cost of interest bearing funds continues to positively impact our net interest earnings.

BUSINESS SEGMENT RESULTS

We are organized and managed along two major business segments, as described in Note 14 of the accompanying consolidated financial statements.  The results of each business segment are intended to reflect each segment as if it were a stand alone business.  Net income by segment follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
Dollars in thousands
 
2014
 
2013
 
2014
 
2013
Community banking
 
$
3,582

 
$
2,638

 
$
8,935

 
$
6,319

Insurance & financial services
 
97

 
13

 
424

 
130

Parent
 
(536
)
 
(573
)
 
(1,781
)
 
(1,749
)
Consolidated net income
 
$
3,143

 
$
2,078

 
$
7,578

 
$
4,700


CRITICAL ACCOUNTING POLICIES

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and follow general practices within the financial services industry.  Application of these principles requires us to make estimates, assumptions, and judgments that affect the amounts reported in our financial statements and accompanying notes.  These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments.  Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported.

Our most significant accounting policies are presented in the notes to the consolidated financial statements of our 2013 Annual Report on Form 10-K.  These policies, along with the other disclosures presented in the financial statement notes and in this financial review, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined.

Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, we have identified the determination of the allowance for loan losses, the valuation of

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goodwill, fair value measurements and deferred tax assets to be the accounting areas that require the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available.

Allowance for Loan Losses:  The allowance for loan losses represents our estimate of probable credit losses inherent in the loan portfolio.  Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change.  The loan portfolio also represents the largest asset type on our consolidated balance sheet.  To the extent actual outcomes differ from our estimates, additional provisions for loan losses may be required that would negatively impact earnings in future periods.  Note 6 to the consolidated financial statements of our 2013 Annual Report on Form 10-K describes the methodology used to determine the allowance for loan losses and a discussion of the factors driving changes in the amount of the allowance for loan losses is included in the Asset Quality section of the financial review of the 2013 Annual Report on Form 10-K.

Goodwill:  Goodwill is subject to an analysis by reporting unit at least annually to determine whether write-downs of the recorded balances are necessary.  Initially, an assessment of qualitative factors (Step 0) is performed to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount.  If, after assessing the totality of events or circumstances, we determine it is not more likely than not that the fair value of a reporting unit is less than its carrying value, then performing the two-step impairment test is unnecessary.  However, if we conclude otherwise, then we are required to perform the first step (Step 1) of the two-step impairment test by calculating the fair value of the reporting unit and comparing the fair value with the carrying amount of the reporting unit.  If the fair value is less than the carrying value, an expense may be required on our books to write down the goodwill to the proper carrying value.  Step 2 of impairment testing, which is necessary only if the reporting unit does not pass Step 1, compares the implied fair value of the reporting unit goodwill with the carrying amount of the goodwill for the reporting unit.  The implied fair value of goodwill is determined in the same manner as goodwill that is recognized in a business combination.

Community Banking – During third quarter 2014, we performed the Step 0 assessment of our goodwill of our community banking reporting unit and determined that it was not more likely than not that the fair value was less than its carrying value.  In performing the qualitative Step 0 assessments, we considered certain events and circumstances  such as macroeconomic conditions, industry and market considerations, overall financial performance and cost factors when evaluating whether it is more likely than not that the fair value is less than its carrying amount. No indicators of impairment were noted as of September 30, 2014.
 
Insurance Services – During third quarter 2014, we performed the Step 0 assessment of our goodwill of our insurance services reporting unit.  We considered certain events and circumstances specific to the reporting unit, such as macroeconomic conditions, industry and market considerations, overall financial performance and cost factors when evaluating whether it is more likely than not that the fair value of our insurance services reporting unit is less than its carrying value and deemed it necessary to perform the further 2-step impairment test.  We performed an internal valuation utilizing the income approach to determine the fair value of our insurance services reporting unit.  This methodology consisted of discounting the expected future cash flows of this unit based upon a forecast of its operations considering long-term key business drivers such as anticipated commission revenue growth.  The long term growth rate used in determining the terminal value was estimated at 2%, and a discount rate of 10.0% was applied to the insurance services unit’s estimated future cash flows.  We did not fail this Step 1 test as of September 30, 2014, therefore Step 2 testing was not necessary.
 
We cannot assure you that future goodwill impairment tests will not result in a charge to earnings. See Note 9 of the consolidated financial statements of our Annual Report on Form 10-K for further discussion of our intangible assets, which include goodwill.

Fair Value Measurements:  ASC Topic 820 Fair Value Measurements and Disclosures provides a definition of fair value, establishes a framework for measuring fair value, and requires expanded disclosures about fair value measurements. Fair value is the price that could be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Based on the observability of the inputs used in the valuation techniques, we classify our financial assets and liabilities measured and disclosed at fair value in accordance with the three-level hierarchy (e.g., Level 1, Level 2 and Level 3) established under ASC Topic 820. Fair value determination in accordance with this guidance requires that we make a number of significant judgments. In determining the fair value of financial instruments, we use market prices of the same or similar instruments whenever such prices are available. We do not use prices involving distressed sellers in determining fair value. If

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observable market prices are unavailable or impracticable to obtain, then fair value is estimated using modeling techniques such as discounted cash flow analyses. These modeling techniques incorporate our assessments regarding assumptions that market participants would use in pricing the asset or the liability, including assumptions about the risks inherent in a particular valuation technique and the risk of nonperformance.
 
Fair value is used on a recurring basis for certain assets and liabilities in which fair value is the primary basis of accounting. Additionally, fair value is used on a non-recurring basis to evaluate assets or liabilities for impairment or for disclosure purposes in accordance with ASC Topic 825 Financial Instruments.
 
Deferred Income Tax Assets:  At September 30, 2014, we had net deferred tax assets of $10.8 million. Based on our ability to offset the net deferred tax asset against taxable income in carryback years and expected future taxable income in carryforward years, there was no impairment of the deferred tax asset at September 30, 2014.  All available evidence, both positive and negative, was considered to determine whether, based on the weight of that evidence, impairment should be recognized. However, our forecast process includes judgmental and quantitative elements that may be subject to significant change. If our forecast of taxable income within the carryback/carryforward periods available under applicable law is not sufficient to cover the amount of net deferred tax assets, such assets may become impaired.

Earnings Summary

Net income applicable to common shares for the nine months ended September 30, 2014 increased to $7.6 million, or $0.85 per diluted share as compared to $4.7 million or $0.55 per diluted share for the same period of 2013.  Net income applicable to common shares for the quarter ended September 30, 2014 totaled $3.1 million, or $0.35 per diluted share as compared to $2.1 million, or $0.24 per diluted share for the quarter ended September 30, 2013.  Earnings for both the quarter and nine months ended September 30, 2014 were positively impacted by increased net interest income and lower provisions for loan losses.  Included in earnings for the nine months ended September 30, 2014 was $199,000 in losses on the sales of assets, primarily foreclosed properties, and $3.5 million of charges resulting from the write down of a portion of our foreclosed properties to fair value.  Returns on average equity and assets for the first nine months of 2014 were 9.35% and 0.77%, respectively, compared with 6.46% and 0.51% for the same period of 2013.

Net Interest Income

Net interest income is the principal component of our earnings and represents the difference between interest and fee income generated from earning assets and the interest expense paid on deposits and borrowed funds.  Fluctuations in interest rates as well as changes in the volume and mix of earning assets and interest bearing liabilities can materially impact net interest income.

Our net interest income on a fully tax-equivalent basis totaled $32.5 million for the nine months ended September 30, 2014 compared to $29.8 million for the same period of 2013, representing an increase of $2.7 million or 8.9%.  Our tax-equivalent earnings on interest earning assets increased $281,000, while the cost of interest bearing liabilities declined $2.4 million (see Table II).  Average interest earning assets increased 2.3% from $1.26 billion during the first nine months of 2013 to $1.29 billion for the first nine months of 2014.  Average interest bearing liabilities increased 1.55% from $1.170 billion at September 30, 2013 to $1.188 billion at September 30, 2014, at an average cost for the first nine months of 2014 of 1.32% compared to 1.61% for the same period of 2013.

Our consolidated net interest margin increased to 3.37% for the nine months ended September 30, 2014, compared to 3.17% for the same period in 2013. The present continued low interest rate environment has served to positively impact our net interest margin due to our liability sensitive balance sheet.  For the nine months ended September 30, 2014 compared to September 30, 2013, the yields on earning assets decreased 8 basis points, while the cost of our interest bearing funds decreased by 29 basis points.

Assuming no significant change in market interest rates, we anticipate modest growth in our net interest income to continue over the near term due to modest growth in the volume of interest earning assets coupled with expected moderate improvement in net interest margin over the same period.  We continue to monitor the net interest margin through net interest income simulation to minimize the potential for any significant negative impact.  See the “Market Risk Management” section for further discussion of the impact changes in market interest rates could have on us.  Further analysis of our yields on interest earning assets and interest bearing liabilities are presented in Tables I and II below.

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48


Table I - Average Balance Sheet and Net Interest Income Analysis
 
 
 
 
 
 
 
 
For the Nine Months Ended
 
September 30, 2014
 
September 30, 2013
Dollars in thousands
Average
Balance
 
Earnings/
Expense
 
Yield/
Rate
 
Average
Balance
 
Earnings/
Expense
 
Yield/
Rate
Interest earning assets
 
 
 
 
 
 
 
 
 
 
 
Loans, net of unearned income (1)
 
 
 
 
 
 
 
 
 
 
 
Taxable
$
977,336

 
$
37,516

 
5.13
%
 
$
948,870

 
$
38,038

 
5.36
%
Tax-exempt (2)
7,262

 
376

 
6.92
%
 
5,560

 
298

 
7.18
%
Securities
 

 
 

 
 

 
 

 
 

 
 

Taxable
213,089

 
3,565

 
2.24
%
 
220,669

 
2,851

 
1.73
%
Tax-exempt (2)
80,814

 
2,785

 
4.61
%
 
76,021

 
2,776

 
4.88
%
Federal funds sold and interest bearing deposits with other banks
9,737

 
6

 
0.08
%
 
7,706

 
4

 
0.07
%
Total interest earning assets
1,288,238

 
44,248

 
4.59
%
 
1,258,826

 
43,967

 
4.67
%
Noninterest earning assets
 

 
 

 
 

 
 

 
 

 
 

Cash & due from banks
3,790

 
 

 
 

 
4,430

 
 

 
 

Premises and equipment
20,414

 
 

 
 

 
21,006

 
 

 
 

Other assets
114,203

 
 

 
 

 
111,948

 
 

 
 

Allowance for loan losses
(11,887
)
 
 

 
 

 
(15,726
)
 
 

 
 

Total assets
$
1,414,758

 
 

 
 

 
$
1,380,484

 
 

 
 

Interest bearing liabilities
 

 
 

 
 

 
 

 
 

 
 

Interest bearing demand deposits
$
189,581

 
$
162

 
0.11
%
 
$
178,911

 
$
193

 
0.14
%
Savings deposits
232,730

 
1,137

 
0.65
%
 
195,907

 
875

 
0.60
%
Time deposits
520,937

 
5,566

 
1.43
%
 
566,172

 
7,007

 
1.65
%
Short-term borrowings
92,963

 
209

 
0.30
%
 
25,579

 
50

 
0.26
%
Long-term borrowings and capital trust securities
151,541

 
4,665

 
4.12
%
 
203,019

 
5,997

 
3.95
%
Total interest bearing liabilities
1,187,752

 
11,739

 
1.32
%
 
1,169,588

 
14,122

 
1.61
%
Noninterest bearing liabilities
 

 
 

 
 

 
 

 
 

 
 

and shareholders' equity
 

 
 

 
 

 
 

 
 

 
 

Demand deposits
101,006

 
 

 
 

 
94,139

 
 

 
 

Other liabilities
9,609

 
 

 
 

 
7,698

 
 

 
 

Total liabilities
1,298,367

 
 

 
 

 
1,271,425

 
 

 
 

Shareholders' equity - preferred
9,286

 
 

 
 

 
9,319

 
 

 
 

Shareholders' equity - common
107,105

 
 

 
 

 
99,740

 
 

 
 

Total liabilities and
 

 
 

 
 

 
 

 
 

 
 

shareholders' equity
$
1,414,758

 
 

 
 

 
$
1,380,484

 
 

 
 

Net interest earnings
 

 
$
32,509

 
 

 
 

 
$
29,845

 
 

Net yield on interest earning assets
 

 
 

 
3.37
%
 
 

 
 

 
3.17
%
(1)
- For purposes of this table, nonaccrual loans are included in average loan balances.
(2)
- Interest income on tax-exempt securities and loans has been adjusted assuming an effective tax rate of 34% for all periods presented. The tax equivalent adjustment resulted in an increase in interest income of $1,075,000 and $1,045,000 for the periods ended September 30, 2014 and September 30, 2013, respectively.



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49


Table II - Changes in Interest Margin Attributable to Rate and Volume
 
 
For the Nine Months Ended
 
 
September 30, 2014 versus September 30, 2013
 
 
Increase (Decrease) Due to Change in:
Dollars in thousands
 
Volume
 
Rate
 
Net
Interest earned on:
 
 
 
 
 
 
Loans
 
 
 
 
 
 
Taxable
 
$
1,121

 
$
(1,643
)
 
$
(522
)
Tax-exempt
 
88

 
(10
)
 
78

Securities
 
 

 
 

 
 

Taxable
 
(101
)
 
815

 
714

Tax-exempt
 
170

 
(161
)
 
9

Federal funds sold and interest bearing deposits with other banks
 
1

 
1

 
2

Total interest earned on interest earning assets
 
1,279

 
(998
)
 
281

 
 
 
 
 
 
 
Interest paid on:
 
 

 
 

 
 

Interest bearing demand deposits
 
11

 
(42
)
 
(31
)
Savings deposits
 
174

 
88

 
262

Time deposits
 
(532
)
 
(909
)
 
(1,441
)
Short-term borrowings
 
151

 
8

 
159

Long-term borrowings and capital trust securities
 
(1,576
)
 
244

 
(1,332
)
Total interest paid on interest bearing liabilities
 
(1,772
)
 
(611
)
 
(2,383
)
 
 
 
 
 
 
 
Net interest income
 
$
3,051

 
$
(387
)
 
$
2,664


Noninterest Income

Total noninterest income increased to $8.4 million for the first nine months of 2014, compared to $8.3 million for the same period of 2013.  Further detail regarding noninterest income is reflected in the following table.
Table III - Noninterest Income
 
 
 
 
 

 
 

 
For the Quarter Ended September 30,
 
For the Nine Months Ended September 30,
Dollars in thousands
2014
 
2013
 
2014
 
2013
Insurance commissions
$
1,105

 
$
1,057

 
$
3,377

 
$
3,373

Service fees related to deposit accounts
1,147

 
1,106

 
3,291

 
3,202

Realized securities gains (losses)
128

 
132

 
64

 
116

Other-than-temporary impairment of securities

 
(38
)
 
(1
)
 
(118
)
Bank owned life insurance income
266

 
229

 
806

 
703

Other
267

 
377

 
864

 
1,038

Total
$
2,913

 
$
2,863

 
$
8,401

 
$
8,314


Other-than-temporary impairment of securities:  We do not anticipate material charges for other-than-temporary impairment of securities in the near term.






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50


Noninterest Expense

Total noninterest expense decreased 0.5% for the nine months ended September 30, 2014, as compared to the same period in 2013, with lower losses on sales of foreclosed properties having the largest positive impacts.  Table IV below shows the breakdown of the changes.
Table IV - Noninterest Expense
 
For the Quarter Ended September 30,
 
For the Nine Months Ended September 30,
 
 
 
Change
 
 
 
 
 
Change
 
 
Dollars in thousands
2014
 
 $
 
%
 
2013
 
2014
 
 $
 
%
 
2013
Salaries, commissions, and employee benefits
$
4,026

 
$
(24
)
 
(0.6
)%
 
$
4,050

 
$
12,052

 
$
(103
)
 
(0.8
)%
 
$
12,155

Net occupancy expense
482

 
28

 
6.2
 %
 
454

 
1,528

 
141

 
10.2
 %
 
1,387

Equipment expense
520

 
(58
)
 
(10.0
)%
 
578

 
1,599

 
(125
)
 
(7.3
)%
 
1,724

Professional fees
380

 
117

 
44.5
 %
 
263

 
978

 
93

 
10.5
 %
 
885

Amortization of intangibles
50

 
(38
)
 
(43.2
)%
 
88

 
200

 
(63
)
 
(24.0
)%
 
263

FDIC premiums
480

 
(23
)
 
(4.6
)%
 
503

 
1,477

 
(81
)
 
(5.2
)%
 
1,558

Foreclosed properties expense
298

 
36

 
13.7
 %
 
262

 
780

 
(56
)
 
(6.7
)%
 
836

Loss on sales of foreclosed properties
70

 
87

 
(511.8
)%
 
(17
)
 
198

 
(348
)
 
(63.7
)%
 
546

Write-downs of foreclosed properties
1,580

 
926

 
141.6
 %
 
654

 
3,471

 
393

 
12.8
 %
 
3,078

Other
1,299

 
(97
)
 
(6.9
)%
 
1,396

 
3,930

 
30

 
0.8
 %
 
3,900

Total
$
9,185

 
$
954

 
11.6
 %
 
$
8,231

 
$
26,213

 
$
(119
)
 
(0.5
)%
 
$
26,332


Credit Experience

As a result of a historically slow economic recovery, our portfolio of OREO properties remains elevated.   Prior elevated levels of loan delinquencies have returned to acceptable levels.

The provision for loan losses represents charges to earnings necessary to maintain an adequate allowance for probable credit losses inherent in the loan portfolio. Our determination of the appropriate level of the allowance is based on an ongoing analysis of credit quality and loss potential in the loan portfolio, change in the composition and risk characteristics of the loan portfolio, and the anticipated influence of national and local economic conditions.  The adequacy of the allowance for loan losses is reviewed quarterly and adjustments are made as considered necessary.

We recorded $2.3 million and $3.5 million provisions for loan losses for the first nine months of 2014 and 2013, respectively.  This decline is a result of lower levels of specific reserves necessary as a result of lower levels of impaired loans at September 30, 2014 compared to September 30, 2013.


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As illustrated in Table V below, our non-performing assets have decreased since year end 2013.
Table V - Summary of Non-Performing Assets
 
 
 
 
 
 
 
 
September 30,
 
December 31,
Dollars in thousands
 
2014
 
2013
 
2013
Accruing loans past due 90 days or more
 
$

 
$

 
$

Nonaccrual loans
 
 

 
 

 
 

Commercial
 
309

 
2,557

 
1,224

Commercial real estate
 
937

 
3,795

 
2,318

Commercial construction and development
 

 
3,761

 
3,782

Residential construction and development
 
4,591

 
9,128

 
9,048

Residential real estate
 
5,257

 
12,385

 
2,446

Consumer
 
146

 
145

 
128

Total nonaccrual loans
 
11,240

 
31,771

 
18,946

Foreclosed properties
 
 

 
 

 
 

Commercial
 
110

 

 

Commercial real estate
 
5,815

 
9,960

 
9,903

Commercial construction and development
 
10,178

 
11,161

 
11,125

Residential construction and development
 
20,431

 
20,585

 
20,485

Residential real estate
 
10,718

 
3,597

 
11,879

Total foreclosed properties
 
47,252

 
45,303

 
53,392

Repossessed assets
 
34

 

 
8

Total nonperforming assets
 
$
58,526

 
$
77,074

 
$
72,346

Total nonperforming loans as a percentage of total loans
 
1.12
%
 
3.34
%
 
1.99
%
Total nonperforming assets as a percentage of total assets
 
4.10
%
 
5.55
%
 
5.22
%
Allowance for loan losses as a percentage of nonperforming loans
 
98.23
%
 
41.04
%
 
66.82
%
Allowance for loan losses as a percentage of period end loans
 
1.10
%
 
1.37
%
 
1.33
%

The following table details the activity regarding our foreclosed properties for the three months and nine months ended September 30, 2014 and 2013.
Table VI - Foreclosed Property Activity
 
 
 
 
For the Three Months Ended 
 September 30,
 
For the Nine Months Ended 
 September 30,
Dollars in thousands
2014
 
2013
 
2014
 
2013
Beginning balance
$
48,783

 
$
47,258

 
$
53,392

 
$
56,172

Acquisitions
557

 
60

 
2,506

 
2,858

Improvements
26

 
90

 
65

 
197

Disposals
(534
)
 
(1,451
)
 
(5,240
)
 
(10,846
)
Writedowns to fair value
(1,580
)
 
(654
)
 
(3,471
)
 
(3,078
)
Balance September 30
$
47,252

 
$
45,303

 
$
47,252

 
$
45,303

 


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The following table details our most significant nonperforming loan relationships at September 30, 2014
Table VII - Significant Nonperforming Loan Relationships
September 30, 2014
Dollars in thousands
 
 
 
 
 
 
 
 
Location
Underlying Collateral
Loan Origination Date
Loan Nonaccrual Date
Loan Balance
Method Used to Measure Impairment
Most Recent Appraised Value
 
Amount Allocated to Allowance for Loan Losses
Amount Previously Charged-off
Eastern Panhandle WV
Residential development & undeveloped acreage
Mar. 2008 & June 2008
Jun. 2011
$
3,004

Collateral Value
$
6,000

(1)
$

$
5,424

(1)
- Value is based upon recent contract.
 
Refer to Note 6 of the accompanying consolidated financial statements for information regarding our past due loans, impaired loans, nonaccrual loans, and troubled debt restructurings.

We maintain the allowance for loan losses at a level considered adequate to provide for estimated probable credit losses inherent in the loan portfolio.  The allowance is comprised of three distinct reserve components:  (1) specific reserves related to loans individually evaluated, (2) quantitative reserves related to loans collectively evaluated, and (3) qualitative reserves related to loans collectively evaluated.  A summary of the methodology we employ on a quarterly basis with respect to each of these components in order to evaluate the overall adequacy of our allowance for loan losses is as follows:

Specific Reserve for Loans Individually Evaluated

First, we identify loan relationships having aggregate balances in excess of $500,000 and that may also have credit weaknesses.  Such loan relationships are identified primarily through our analysis of internal loan evaluations, past due loan reports, and loans adversely classified by regulatory authorities.  Each loan so identified is then individually evaluated to determine whether it is impaired – that is, based on current information and events, it is probable that we will be unable to collect all amounts due in accordance with the contractual terms of the underlying loan agreement.  Substantially all of our impaired loans historically have been collateral dependent, meaning repayment of the loan is expected to be provided solely from the sale of the loan’s underlying collateral.  For such loans, we measure impairment based on the fair value of the loan’s collateral, which is generally determined utilizing current appraisals.  A specific reserve is established in an amount equal to the excess, if any, of the recorded investment in each impaired loan over the fair value of its underlying collateral, less estimated costs to sell. Our policy is to re-evaluate the fair value of collateral dependent loans at least every twelve months unless there is a known deterioration in the collateral’s value, in which case a new appraisal is obtained.

Quantitative Reserve for Loans Collectively Evaluated

Second, we stratify the loan portfolio into the following ten loan pools:  land and land development, construction, commercial, commercial real estate -- owner-occupied, commercial real estate -- non-owner occupied, conventional residential mortgage, jumbo residential mortgage, home equity, consumer, and other.  Loans within each pool are then further segmented between (1) loans which were individually evaluated for impairment and not deemed to be impaired, (2) larger-balance loan relationships exceeding $2 million which are assigned an internal risk rating in conjunction with our normal ongoing loan review procedures and (3) smaller-balance homogenous loans.
 
Quantitative reserves relative to each loan pool are established as follows:  for all loan segments detailed above, an allocation equaling 100% of the respective pool’s average 12 month historical net loan charge-off rate (determined based upon the most recent twelve quarters) is applied to the aggregate recorded investment in the pool of loans.


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Qualitative Reserve for Loans Collectively Evaluated

Third, we consider the necessity to adjust our average historical net loan charge-off rates relative to each of the above ten loan pools for potential risk factors that could result in actual losses deviating from prior loss experience.  For example, if we observe a significant increase in delinquencies within the conventional mortgage loan pool above historical trends, an additional allocation to the average historical loan charge-off rate is applied.  Such qualitative risk factors considered are:  (1) levels of and trends in delinquencies and impaired loans, (2) levels of and trends in charge-offs and recoveries, (3) trends in volume and term of loans, (4) effects of any changes in risk selection and underwriting standards, and other changes in lending policies, procedures, and practice, (5) experience, ability, and depth of lending management and other relevant staff, (6) national and local economic trends and conditions, (7) industry conditions, and (8) effects of changes in credit concentrations.
 
Relationship between Allowance for Loan Losses, Net Charge-offs and Nonperforming Loans

In analyzing the relationship between the allowance for loan losses, net loan charge-offs and nonperforming loans, it is helpful to understand the process of how loans are treated as they deteriorate over time. Reserves for loans are established at origination through the quantitative and qualitative reserve process discussed above.

Charge-offs, if necessary, are typically recognized in a period after the reserves were established. If the previously established reserves exceed that needed to satisfactorily resolve the problem credit, a reduction in the overall level of the reserve could be recognized. In summary, if loan quality deteriorates, the typical credit sequence is periods of reserve building, followed by periods of higher net charge-offs.

Consumer loans are generally charged off to the allowance for loan losses upon reaching specified stages of delinquency, in accordance with the Federal Financial Institutions Examination Council policy.  For example, credit card loans are charged off by the end of the month in which the account becomes 180 days past due or within 60 days from receiving notification about a specified event (e.g., bankruptcy of the borrower), whichever is earlier.  Residential mortgage loans are generally charged off to net realizable value no later than when the account becomes 180 days past due.  Other consumer loans, if collateralized, are generally charged off to net realizable value at 120 days past due.

Commercial-related loans (which are risk-rated) are charged off to the allowance for loan losses when the loss has been confirmed. This determination includes many factors, including the prioritization of our claim in bankruptcy, expectations of the workout/restructuring of the loan and valuation of the borrower’s equity.
 
Substantially all of our nonperforming loans are secured by real estate. The majority of these loans were underwritten in accordance with our loan-to-value policy guidelines which range from 70-85% at the time of origination. The fair values of the underlying collateral value remains in excess of the recorded investment in many of our nonperforming loans, and therefore, no specific reserve allocation is required; as of September 30, 2014, approximately 77% of our impaired loans required no reserves or have been charged down to their fair value.

At September 30, 2014, December 31, 2013, and September 30, 2013, our allowance for loan losses totaled $11.0 million, or 1.10% of total loans, $12.7 million, or 1.33% of total loans and $13.0 million, or 1.37% of total loans, respectively, and is considered adequate to cover our estimate of probable credit losses inherent in our loan portfolio.

At September 30, 2014, December 31, 2013, and September 30, 2013, we had approximately $47.3 million, $53.4 million and $45.3 million, respectively, in other real estate owned which was obtained as the result of foreclosure proceedings.  Although foreclosed property is recorded at fair value less estimated costs to sell, the prices ultimately realized upon their sale may or may not result in us recognizing loss.


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FINANCIAL CONDITION

Our total assets were $1.429 billion at September 30, 2014, compared to $1.387 billion at December 31, 2013, representing a 3.0% increase.  Table VIII below serves to illustrate significant changes in our financial position between December 31, 2013 and September 30, 2014.
Table VIII - Summary of Significant Changes in Financial Position
 
 
Balance
December 31,
 
Increase (Decrease)
 
Balance
September 30,
Dollars in thousands
 
2013
 
Amount
 
Percentage
 
2014
Assets
 
 
 
 
 
 
 
 
Securities available for sale
 
$
288,780

 
(6,379
)
 
(2.2
)%
 
$
282,401

Loans, net of unearned interest
 
937,070

 
56,277

 
6.0
 %
 
993,347

Liabilities
 
 

 
 

 
 

 
 

Deposits
 
$
1,003,812

 
$
50,642

 
5.0
 %
 
$
1,054,454

Short-term borrowings
 
62,769

 
64,663

 
103.0
 %
 
127,432

Long-term borrowings
 
163,516

 
(85,050
)
 
(52.0
)%
 
78,466


Loan growth of 6.0% during the first nine months of 2014 occurred principally in the commercial real estate and residential real estate portfolios, and was funded primarily with deposits.
 
Deposits increased approximately $50.6 million during the first nine months of 2014; savings deposits increased approximately $62.4 million while time deposits decreased $32.0 million.

The increase in short-term borrowings and the decrease in long term borrowings is primarily attributable to maturities and repayments of long-term FHLB advances during the first nine months of 2014, of which a portion was refinanced with short-term FHLB advances.
 
Refer to Notes 5, 6, 9, and 10 of the notes to the accompanying consolidated financial statements for additional information with regard to changes in the composition of our securities, loans, deposits and borrowings between September 30, 2014 and December 31, 2013.

LIQUIDITY AND CAPITAL RESOURCES

Liquidity reflects our ability to ensure the availability of adequate funds to meet loan commitments and deposit withdrawals, as well as provide for other transactional requirements.  Liquidity is provided primarily by funds invested in cash and due from banks (net of float and reserves), Federal funds sold, non-pledged securities, and available lines of credit with the Federal Home Loan Bank of Pittsburgh (“FHLB”) and Federal Reserve Bank of Richmond, which totaled approximately $610 million or 42.70% of total consolidated assets at September 30, 2014.

Our liquidity strategy is to fund loan growth with deposits and other borrowed funds while maintaining an adequate level of short- and medium-term investments to meet normal daily loan and deposit activity.  As a member of the FHLB, we have access to approximately $494 million.  As of September 30, 2014 and December 31, 2013, these advances totaled approximately $126 million and $136 million, respectively.  At September 30, 2014, we had additional borrowing capacity of $368 million through FHLB programs.  We have established a line with the Federal Reserve Bank to be used as a contingency liquidity vehicle.  The amount available on this line at September 30, 2014 was approximately $85 million, which is secured by a pledge of our consumer and commercial and industrial loan portfolios.  We have a $6 million unsecured line of credit with a correspondent bank.  Also, we classify all of our securities as available for sale to enable us to liquidate them if the need arises.
 
Liquidity risk represents the risk of loss due to the possibility that funds may not be available to satisfy current or future commitments based on external market issues, customer or creditor perception of financial strength, and events unrelated to Summit such as war, terrorism, or financial institution market specific issues.  The Asset/Liability Management Committee (“ALCO”), comprised of members of senior management and certain members of the Board of Directors, oversees our liquidity risk management process.   The ALCO develops and recommends policies and limits governing our liquidity to the Board of



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Directors for approval with the objective of ensuring that we can obtain cost-effective funding to meet current and future obligations, as well as maintain sufficient levels of on-hand liquidity, under both normal and “stressed” circumstances.
 
We continuously monitor our liquidity position to ensure that day-to-day as well as anticipated funding needs are met.  We are not aware of any trends, commitments, events or uncertainties that have resulted in or are reasonably likely to result in a material change to our liquidity.

One of our continuous goals is maintenance of a strong capital position.  Through management of our capital resources, we seek to provide an attractive financial return to our shareholders while retaining sufficient capital to support future growth.  Shareholders’ equity at September 30, 2014 totaled $121.4 million compared to $111.1 million at December 31, 2013.

Summit and Summit Community have entered into informal Memoranda of Understanding (“MOU’s”) with their respective regulatory authorities.  A memorandum of understanding is characterized by the regulatory authorities as an informal action that is not published or publicly available and that is used when circumstances warrant a milder form of action than a formal supervisory action, such as a formal written agreement or order.
 
We have also entered into a Securities Purchase Agreement with Castle Creek Capital Partners V, LP ("Castle Creek"). Castle Creek intends to acquire in a private placement shares of our common stock in an amount expected to approximate 9.9% of our outstanding common stock. We will receive approximately $10.2 million in net proceeds, which will primarily be used to retire higher cost debt at our parent company. See our Form 8K filed with the Securities and Exchange Commission on August 25, 2014 for specific details regarding this transaction.

See Note 13 of the notes to the accompanying consolidated financial statements and Risks Relating to Our Business of the Risk Factors section of the 2013 Annual Report on Form 10K for specific details of the MOUs.

Refer to Note 13 of the notes to the accompanying consolidated financial statements for additional information regarding regulatory restrictions on our capital as well as our subsidiaries’ capital.

CONTRACTUAL CASH OBLIGATIONS

During our normal course of business, we incur contractual cash obligations.  The following table summarizes our contractual cash obligations at September 30, 2014.
Table IX - Contractual Cash Obligations
 
 
 
 
 
 
Dollars in thousands
 
Long
Term
Debt
 
Capital
Trust
Securities
 
Operating
Leases
2014
 
$
476

 
$

 
$
62

2015
 
11,909

 

 
128

2016
 
28,911

 

 
90

2017
 
960

 

 
45

2018
 
45,100

 

 

Thereafter
 
7,910

 
19,589

 

Total
 
$
95,266

 
$
19,589

 
$
325



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OFF-BALANCE SHEET ARRANGEMENTS

We are involved with some off-balance sheet arrangements that have or are reasonably likely to have an effect on our financial condition, liquidity, or capital.  These arrangements at September 30, 2014 are presented in the following table.
Table X - Off-Balance Sheet Arrangements
 
September 30,
Dollars in thousands
 
2014
Commitments to extend credit:
 
 
Revolving home equity and credit card lines
 
$
51,364

Construction loans
 
23,389

Other loans
 
47,710

Standby letters of credit
 
2,791

Total
 
$
125,254



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MARKET RISK MANAGEMENT

Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates, exchange rates and equity prices.  Interest rate risk is our primary market risk and results from timing differences in the repricing of assets, liabilities and off-balance sheet instruments, changes in relationships between rate indices and the potential exercise of imbedded options.  The principal objective of asset/liability management is to minimize interest rate risk and our actions in this regard are taken under the guidance of our Asset/Liability Management Committee (“ALCO”), which is comprised of members of senior management and members of the Board of Directors.  The ALCO actively formulates the economic assumptions that we use in our financial planning and budgeting process and establishes policies which control and monitor our sources, uses and prices of funds.

Some amount of interest rate risk is inherent and appropriate to the banking business.  Our net income is affected by changes in the absolute level of interest rates.  Our interest rate risk position is liability sensitive.  The nature of our lending and funding activities tends to drive our interest rate risk position to being liability sensitive.  That is, absent any changes in the volumes of our interest earning assets or interest bearing liabilities, liabilities are likely to reprice faster than assets, resulting in a decrease in net income in a rising rate environment.  Net income would increase in a falling interest rate environment.  Net income is also subject to changes in the shape of the yield curve.  In general, a flattening yield curve would result in a decline in our earnings due to the compression of earning asset yields and funding rates, while a steepening would result in increased earnings as margins widen.

Several techniques are available to monitor and control the level of interest rate risk.  We primarily use earnings simulations modeling to monitor interest rate risk.  The earnings simulation model forecasts the effects on net interest income under a variety of interest rate scenarios that incorporate changes in the absolute level of interest rates and changes in the shape of the yield curve.  Each increase or decrease in interest rates is assumed to gradually take place over the next 12 months, and then remain stable, except for the up 400 scenario, which assumes a gradual increase in rates over 24 months.  Assumptions used to project yields and rates for new loans and deposits are derived from historical analysis.  Securities portfolio maturities and prepayments are reinvested in like instruments.  Mortgage loan prepayment assumptions are developed from industry estimates of prepayment speeds.  Noncontractual deposit repricings are modeled on historical patterns.

The following table presents the estimated sensitivity of our net interest income to changes in interest rates, as measured by our earnings simulation model as of September 30, 2014.  The sensitivity is measured as a percentage change in net interest income given the stated changes in interest rates (gradual change over 12 months, stable thereafter for the down 100 and the up 200 scenarios, and gradual change over 24 months for the up 400 scenario) compared to net interest income with rates unchanged in the same period.  The estimated changes set forth below are dependent on the assumptions discussed above and are well within our ALCO policy limits shown below relative to reductions in net interest income over the ensuing twelve month period.
 
Estimated % Change in
Net Interest Income over:
Change in
 
 
0 - 12 Months
 
13 - 24 Months
Interest Rates
Policy

 
Actual

 
Actual

Down 100  basis points (1)
(7
)%
 
(0.05
)%
 
(0.50
)%
Up 200 basis points (1)
(10
)%
 
(4.52
)%
 
(6.48
)%
Up 400 basis points (2)
(15
)%
 
(3.53
)%
 
(10.51
)%
(1)
assumes a parallel shift in the yield curve over 12 months
(2)
assumes a parallel shift in the yield curve over 24 months


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CONTROLS AND PROCEDURES

Our management, including the Chief Executive Officer and Chief Financial Officer, has conducted as of September 30, 2014, an evaluation of the effectiveness of disclosure controls and procedures as defined in Exchange Act Rule 13a-15(e).  Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures as of September 30, 2014 were effective.  There were no changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
 

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Part II. Other Information




Item 1.  Legal Proceedings

Refer to Note 12 of the Notes to the Consolidated Financial Statements in Part I, Item 1 for information regarding legal proceedings not reportable under this Item.

Item 1A.  Risk Factors

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2013.

Item 6. Exhibits

Exhibit 3.i
Amended and Restated Articles of Incorporation of Summit Financial Group, Inc.
 
 
Exhibit 3.ii
Articles of Amendment 2009
 
 
Exhibit 3.iii
Articles of Amendment 2011
 
 
Exhibit 3.iv
Amended and Restated By-Laws of Summit Financial Group, Inc.
 
 
Exhibit 11
Statement re: Computation of Earnings per Share – Information contained in Note 4 to the Consolidated Financial Statements on page 15 of this Quarterly Report is incorporated herein by reference.
 
 
Exhibit 31.1
Sarbanes-Oxley Act Section 302 Certification of Chief Executive Officer
 
 
Exhibit 31.2
Sarbanes-Oxley Act Section 302 Certification of Chief Financial Officer
 
 
Exhibit 32.1
Sarbanes-Oxley Act Section 906 Certification of Chief Executive Officer
 
 
Exhibit 32.2
Sarbanes-Oxley Act Section 906 Certification of Chief Financial Officer
 
 
Exhibit 101
Interactive Data File (XBRL)


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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.

 
 
SUMMIT FINANCIAL GROUP, INC.
 
 
(registrant)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
By:
   /s/ H. Charles Maddy, III
 
 
H. Charles Maddy, III,
 
 
President and Chief Executive Officer
 
 
 
 
 
 
 
 
 
 
 
 
 
 
By:
   /s/ Robert S. Tissue
 
 
Robert S. Tissue,
 
 
Senior Vice President and Chief Financial Officer
 
 
 
 
 
 
 
 
 
 
 
 
 
 
By:
  /s/ Julie R. Cook
 
 
Julie R. Cook,
 
 
Vice President and Chief Accounting Officer
 
 
 
 
 
 
 
 
Date:
November 5, 2014
 
 




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EXHIBIT INDEX


Exhibit No.
Description
Page
Number
(3)
Articles of Incorporation and By-laws:
 
 
(i)  Amended and Restated Articles of Incorporation of Summit Financial Group, Inc.
(a)
 
(ii)  Articles of Amendment 2009
(b)
 
(iii)  Articles of Amendment 2011
(c)
 
(iv)  Amended and Restated By-laws of Summit Financial Group, Inc.
(d)
11
Statement re:  Computation of Earnings per Share
15
 
 
 
31.1
Sarbanes-Oxley Act Section 302 Certification of Chief Executive Officer
 
 
 
 
31.2
Sarbanes-Oxley Act Section 302 Certification of Chief Financial Officer
 
 
 
 
32.1*
Sarbanes-Oxley Act Section 906 Certification of Chief Executive Officer
 
 
 
 
32.2*
Sarbanes-Oxley Act Section 906 Certification of Chief Financial Officer
 
101**
Interactive data file (XBRL)
 

*Furnished, not filed.
** As provided in Rule 406T of Regulation S-T, this information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934.

(a)
Incorporated by reference to Exhibit 3.i of Summit Financial Group, Inc.’s filing on Form 10-Q dated March 31, 2006.
(b)
Incorporated by reference to Exhibit 3.1 of Summit Financial Group, Inc.’s filing on Form 8-K dated September 30, 2009.
(c)
Incorporated by reference to Exhibit 3.1 of Summit Financial Group, Inc.’s filing on Form 8-K dated November 3, 2011.
(d)
Incorporated by reference to Exhibit 3.2 of Summit Financial Group, Inc.’s filing on Form 10-Q dated June 30, 2006.


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