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

f10q063014.htm




UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10 – Q

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

For the quarterly period ended June 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 filero
                    Non-accelerated filer o                  Smaller reporting companyþ

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
7,457,222 shares outstanding as of August 1, 2014

 
 

Summit Financial Group, Inc. and Subsidiaries


     
Page
PART  I.
FINANCIAL INFORMATION
 
       
 
Item 1.
Financial Statements
 
       
   
Consolidated balance sheets
June 30, 2014 (unaudited), December 31, 2013,
 and June 30, 2013 (unaudited)
       
   
Consolidated statements of income
for the three and six months ended
June 30, 2014 and 2013 (unaudited)
       
   
Consolidated statements of comprehensive
income for the three and six months ended
June 30, 2014 and 2013 (unaudited)
       
   
Consolidated statements of shareholders’ equity
for the six months ended
June 30, 2014 and 2013 (unaudited)
       
   
Consolidated statements of cash flows
for the six months ended
June 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

Summit Financial Group, Inc. and Subsidiaries
Table of Contents
 

 
 
PART II.
 
OTHER INFORMATION
 
       
 
 
Item 1.
 
Legal Proceedings
 
       
   
Item 1A.
 
Risk Factors
 
 61
       
 
 
 
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
 
 
 62
       
 
EXHIBIT INDEX
   
 

 


 
3

Summit Financial Group, Inc. and Subsidiaries
Consolidated Balance Sheets (unaudited)


   
June 30,
 
December 31,
 
June 30,
   
2014
 
2013
 
2013
 Dollars in thousands
 
(unaudited)
    (*)  
(unaudited)
 ASSETS
             
 Cash and due from banks
  $ 3,749   $ 3,442   $ 4,336
 Interest bearing deposits with other banks
    9,970     8,340     7,971
       Cash and cash equivalents
    13,719     11,782     12,307
 Securities available for sale
    287,883     288,780     291,180
 Other investments
    7,436     7,815     7,411
 Loans held for sale, net
    413     321     1,080
 Loans, net
    992,816     937,070     925,979
 Property held for sale
    48,783     53,392     47,258
 Premises and equipment, net
    20,301     20,623     20,936
 Accrued interest receivable
    5,683     5,669     5,718
 Intangible assets
    7,798     7,949     8,124
 Cash surrender value of life insurance policies
    36,151     35,611     30,027
 Other assets
    14,975     17,215     19,950
 Total assets
  $ 1,435,958   $ 1,386,227   $ 1,369,970
                   
 LIABILITIES AND SHAREHOLDERS' EQUITY
                 
 Liabilities
                 
     Deposits
                 
         Non interest bearing
  $ 106,134   $ 92,837   $ 92,147
         Interest bearing
    951,661     910,975     946,016
 Total deposits
    1,057,795     1,003,812     1,038,163
     Short-term borrowings
    91,729     62,769     16,762
     Long-term borrowings
    121,942     163,516     163,565
     Subordinated debentures
    16,800     16,800     16,800
     Subordinated debentures owed to unconsolidated subsidiary trusts
    19,589     19,589     19,589
     Other liabilities
    10,638     8,669     7,880
 Total liabilities
    1,318,493     1,275,155     1,262,759
                   
 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, December 2013 - 11,938
    5,764     5,776     5,796
              shares, June 2013 - 11,978 shares
                 
     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 June 2013 - 7,440,222 shares
    24,691     24,664     24,593
     Retained earnings
    81,569     77,134     72,462
     Accumulated other comprehensive income
    1,922     (21)     841
 Total shareholders' equity
    117,465     111,072     107,211
                   
 Total liabilities and shareholders' equity
  $ 1,435,958   $ 1,386,227   $ 1,369,970
                   
                   
(*) - December 31, 2013 financial information has been extracted from audited consolidated financial statements
     
 See Notes to Consolidated Financial Statements
                 
 
 

Summit Financial Group, Inc. and Subsidiaries
Consolidated Statements of Income (unaudited)


   
Three Months Ended
   
Six Months Ended
   
June 30,
 
June 30,
   
June 30,
 
June 30,
 Dollars in thousands, except per share amounts
 
2014
 
2013
   
2014
 
2013
 Interest income
                 
     Interest and fees on loans
                 
         Taxable
  $ 12,428   $ 12,734     $ 24,572   $ 25,568
         Tax-exempt
    87     65       159     135
     Interest and dividends on securities
                         
         Taxable
    1,199     926       2,481     1,956
         Tax-exempt
    628     581       1,198     1,215
     Interest on interest bearing deposits with other banks
    2     2       4     3
 Total interest income
    14,344     14,308       28,414     28,877
 Interest expense
                         
     Interest on deposits
    2,335     2,820       4,576     5,588
     Interest on short-term borrowings
    59     9       112     26
     Interest on long-term borrowings and subordinated debentures
    1,630     1,975       3,368     4,001
 Total interest expense
    4,024     4,804       8,056     9,615
 Net interest income
    10,320     9,504       20,358     19,262
 Provision for loan losses
    1,000     1,000       2,000     2,500
 Net interest income after provision for loan losses
    9,320     8,504       18,358     16,762
 Other income
                         
     Insurance commissions
    1,091     1,132       2,273     2,316
     Service fees related to deposit accounts
    1,101     1,085       2,144     2,096
     Realized securities (losses)
    (43 )   (57 )     (64 )   (16)
     Other
    557     570       1,137     1,134
     Total other-than-temporary impairment loss on securities
    (1 )   (27 )     (1 )   (117)
     Portion of loss recognized in other comprehensive income
    -     -       -     37
     Net impairment loss recognized in earnings
    (1 )   (27 )     (1 )   (80)
 Total other income
    2,705     2,703       5,489     5,450
 Other expense
                         
     Salaries, commissions, and employee benefits
    4,045     3,987       8,026     8,105
     Net occupancy expense
    505     476       1,046     932
     Equipment expense
    513     559       1,079     1,146
     Professional fees
    282     360       598     622
     Amortization of intangibles
    63     88       150     176
     FDIC premiums
    495     515       997     1,055
     Foreclosed properties expense
    229     295       482     575
     Loss on sale of foreclosed properties
    54     523       129     563
     Write-down of foreclosed properties
    962     1,494       1,891     2,423
     Other
    1,382     1,241       2,630     2,503
 Total other expense
    8,530     9,538       17,028     18,100
 Income before income taxes
    3,495     1,669       6,819     4,112
 Income tax expense
    1,063     452       1,997     1,102
 Net Income
    2,432     1,217       4,822     3,010
 Dividends on preferred shares
    193     194       387     388
 Net Income applicable to common shares
  $ 2,239   $ 1,023     $ 4,435   $ 2,622
                           
                           
  Basic earnings per common share
  $ 0.30   $ 0.14     $ 0.59   $ 0.35
  Diluted earnings per common share
  $ 0.25   $ 0.13     $ 0.50   $ 0.31
                           
                           
 See Notes to Consolidated Financial Statements
                         




Summit Financial Group, Inc. and Subsidiaries
Consolidated Statement of Comprehensive Income (unaudited)



 
For the Three Months Ended
 
June 30,
Dollars in thousands
2014
 
2013
 Net income
$ 2,432   $ 1,217
 Other comprehensive income (loss):
         
 Net unrealized (loss) on cashflow hedge of ($1,173), net of deferred
  (739 )   -
       taxes of ($434)
         
 Net unrealized gain (loss) on available for sale debt securities of:
         
           2014 - $2,282 net of deferred taxes of $844 and reclassification adjustment
     
           for net realized (losses) included in net income of ($42); 2013 - ($6,174), net of
     
           deferred taxes of ($2,346) and reclassification adjustment for net realized
     
       (losses) included in net income of ($57)
  1,438     (3,828)
     Total comprehensive income (loss)
$ 3,131   $ (2,611)





 
For the Six Months Ended
 
June 30,
Dollars in thousands
2014
 
2013
 Net income
$ 4,822   $ 3,010
 Other comprehensive income (loss):
         
 Net unrealized (loss) on cashflow hedge of ($2,384), net of deferred
         
      taxes of ($882)
  (1,502 )   -
 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 - $5,468 net of deferred taxes of $2,023 d reclassification adjustment
     
          for net realized (losses) included in net income of ($64); 2013 - ($6,460), net of
     
          deferred taxes of ($2,455) and reclassification adjustment for net realized
     
       (losses) included in net income of ($16)
  3,445     (4,005)
     Total comprehensive income (loss)
$ 6,765   $ (1,018)











                                                            See Notes to Consolidated Financial Statements


Summit Financial Group, Inc. and Subsidiaries
Consolidated Statements of Shareholders’ Equity (unaudited)



 
Series 2009
 
Series 2011
         
Accumulated
   
 
Preferred
 
Preferred
 
Common
     
Other
 
Total
 
Stock and
 
Stock and
 
Stock and
     
Compre-
 
Share-
 
Related
 
Related
 
Related
 
Retained
 
hensive
 
holders'
 Dollars in thousands, except per share amounts
Surplus
 
Surplus
 
Surplus
 
Earnings
 
Income
 
Equity
                       
 Balance, December 31, 2013
$ 3,519   $ 5,776   $ 24,664   $ 77,134   $ (21 ) $ 111,072
                                   
 Six Months Ended June 30, 2014
                                 
     Comprehensive income:
                                 
       Net income
  -     -     -     4,822     -     4,822
       Other comprehensive income (loss)
                          1,943     1,943
     Total comprehensive income (loss)
                                6,765
     Exercise of stock options
  -     -     15     -     -     15
     Stock compensation expense
  -     -     -     -     -     -
     Series 2009 Preferred Stock cash dividends
                                 
 declared ($40.00 per share)
  -     -     -     (149 )   -     (149)
     Series 2011 Preferred Stock cash dividends
                                 
 declared ($20.00 per share)
  -     -     -     (238 )   -     (238)
     Conversion of Series 2011 Preferred Stock to Common Stock
  -     (12 )   12                  
 Balance, June 30, 2014
$ 3,519   $ 5,764   $ 24,691   $ 81,569   $ 1,922   $ 117,465
                                   
                                   
 Balance, December 31, 2012
$ 3,519   $ 5,807   $ 24,520   $ 69,840   $ 4,869   $ 108,555
                                   
 Six Months Ended June 30, 2013
                                 
     Comprehensive income:
                                 
       Net income
  -     -     -     3,010     -     3,010
       Other comprehensive income (loss)
                          (4,028 )   (4,028)
     Total comprehensive income (loss)
                                (1,018)
     Exercise of stock options
  -     -     61     -     -     61
     Stock compensation expense
  -     -     1     -     -     1
     Series 2009 Preferred Stock cash dividends
                                 
 declared ($40.00 per share)
  -     -     -     (148 )   -     (148)
     Series 2011 Preferred Stock cash dividends
                                 
 declared ($20.00 per share)
  -     -     -     (240 )   -     (240)
     Conversion of Series 2011 Preferred Stock to Common Stock
  -     (11 )   11                  
 Balance, June 30, 2013
$ 3,519   $ 5,796   $ 24,593   $ 72,462   $ 841   $ 107,211
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
                                   
 See Notes to Consolidated Financial Statements
                                 


Summit Financial Group, Inc. and Subsidiaries
Consolidated Statements of Cash Flows (unaudited)

   
Six Months Ended
   
June 30,
 
June 30,
 Dollars in thousands
 
2014
 
2013
 Cash Flows from Operating Activities
       
     Net income
  $ 4,822   $ 3,010
     Adjustments to reconcile net earnings to net cash
           
         provided by operating activities:
           
         Depreciation
    547     587
         Provision for loan losses
    2,000     2,500
         Stock compensation expense
    -     1
         Deferred income tax expense
    494     360
         Loans originated for sale
    (960 )   (4,624)
         Proceeds from loans sold
    868     3,770
         Securities losses
    64     16
         Other-than-temporary impairment of securities
    1     80
         Loss on disposal of assets
    129     552
         Write down of foreclosed properties
    1,891     2,423
         Amortization of securities premiums (accretion of discounts), net
    2,517     3,002
         Amortization of goodwill and purchase accounting
           
             adjustments, net
    155     181
         (Increase) in accrued interest receivable
    (15 )   (97)
         (Increase) in cash surrender value of bank owned life insurance
    (539 )   (474)
         (Increase) decrease in other assets
    (492 )   1,009
         Increase (decrease) in other liabilities
    388     (929)
 Net cash provided by operating activities
    11,870     11,367
 Cash Flows from Investing Activities
           
     Proceeds from maturities and calls of securities available for sale
    3,001     1,058
     Proceeds from sales of securities available for sale
    36,230     29,389
     Principal payments received on securities available for sale
    16,664     32,768
     Purchases of securities available for sale
    (52,110 )   (79,177)
     Purchases of other investments
    (1,968 )   -
     Proceeds from maturities and calls of other investments
    -     (643)
     Redemption of Federal Home Loan Bank Stock
    2,347     4,618
     Net principal payments received on loans
    (59,716 )   5,878
     Purchases of premises and equipment
    (224 )   (393)
     Proceeds from disposal of premises and equipment
    -     11
     Proceeds from sales of other repossessed assets & property held for sale
    4,846     8,862
 Net cash provided by (used in) investing activities
    (50,930 )   2,371
 Cash Flows from Financing Activities
           
     Net increase in demand deposit, NOW and
           
         savings accounts
    64,451     6,123
     Net increase (decrease) in time deposits
    (10,468 )   4,915
     Net increase in short-term borrowings
    28,960     12,804
     Proceeds from long-term borrowings
    -     3,454
     Repayment of long-term borrowings
    (41,574 )   (43,202)
     Exercise of stock options
    15     61
     Dividends paid on preferred stock
    (387 )   (388)
 Net cash provided by (used in) financing activities
    40,997     (16,233)
 Increase (decrease) in cash and cash equivalents
    1,937     (2,495)
 Cash and cash equivalents:
           
         Beginning
    11,782     14,802
         Ending
  $ 13,719   $ 12,307
             
             
(Continued)
 See Notes to Consolidated Financial Statements
           



Summit Financial Group, Inc. and Subsidiaries
Consolidated Statements of Cash Flows (unaudited)

         
   
Six Months Ended
   
June 30,
 
June 30,
 Dollars in thousands
 
2014
 
2013
         
 Supplemental Disclosures of Cash Flow Information
       
     Cash payments for:
       
         Interest
  $ 8,294   $ 9,881
         Income taxes
  $ 1,459   $ 1,081
             
Supplemental Schedule of Noncash Investing and Financing Activities
     
     Other assets acquired in settlement of loans
  $ 1,970   $ 2,811
             
             
             
             
             
             
             
             
             
             
             
             
             
             
             
             
             
             
             
             
             
             
             
             
             
             
             
             
             
             
             
             
 See Notes to Consolidated Financial Statements
           

9

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

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 June 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 June 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 2014-01, 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 2014-04, 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.
 
 

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

 
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.

  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.
 
 
11

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

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 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.
 
 
12

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)


 
Balance at
 
Fair Value Measurements Using:
Dollars in thousands
June 30, 2014
 
Level 1
 
Level 2
 
Level 3
Available for sale securities
             
   U.S. Government sponsored agencies
$ 25,830   $ -   $ 25,830   $ -
   Mortgage backed securities:
                     
      Government sponsored agencies
  157,555     -     157,555     -
      Nongovernment sponsored entities
  9,931     -     9,931     -
   State and political subdivisions
  10,035     -     10,035     -
   Corporate debt securities
  -     -     -     -
   Other equity securities
  77     -     77     -
   Tax-exempt state and political subdivisions
  84,455     -     84,455     -
Total available for sale securities
$ 287,883   $ -   $ 287,883   $ -
                       
Derivative financial instrument
                     
   Interest rate swaps
$ -   $ -   $ -      



 
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 June 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.
 
 
13

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)


 
Total at
 
Fair Value Measurements Using:
Dollars in thousands
June 30, 2014
 
Level 1
 
Level 2
 
Level 3
Residential mortgage loans held for sale
$ 413   $ -   $ 413   $ -
                       
Collateral-dependent impaired loans
                     
    Commercial
$ -   $ -   $ -   $ -
    Commercial real estate
  2,119     -     2,119     -
    Construction and development
  13,079     -     9,918     3,161
    Residential real estate
  8,540     -     8,526     14
    Consumer
  4     -     -     4
Total collateral-dependent impaired loans
$ 23,742   $ -   $ 20,563   $ 3,179
                       
OREO
                     
    Commercial
$ 110   $ -   $ 110   $ -
    Commercial real estate
  5,762     -     5,762     -
    Construction and development
  30,920     -     28,810     2,110
    Residential real estate
  11,991     -     11,581     410
Total OREO
$ 48,783   $ -   $ 46,263   $ 2,520




 
Total 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.
 
 
14

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

 
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.

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.
 

 
15

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

The carrying values and estimated fair values of our financial instruments are summarized below:


   
June 30, 2014
   
December 31, 2013
       
Estimated
       
Estimated
   
Carrying
 
Fair
   
Carrying
 
Fair
 Dollars in thousands
 
Value
 
Value
   
Value
 
Value
 Financial assets
                 
     Cash and due from banks
  $ 13,719   $ 13,719     $ 11,782   $ 11,782
     Securities available for sale
    287,883     287,883       288,780     288,780
     Other investments
    7,436     7,436       7,815     7,815
     Loans held for sale, net
    413     413       321     321
     Loans, net
    992,816     1,016,258       937,070     952,592
     Accrued interest receivable
    5,683     5,683       5,669     5,669
     Derivative financial instruments
    -     -       803     803
    $ 1,307,950   $ 1,331,392     $ 1,252,240   $ 1,267,762
 Financial liabilities
                         
     Deposits
  $ 1,057,795   $ 1,082,200     $ 1,003,812   $ 1,029,606
     Short-term borrowings
    91,729     91,729       62,769     62,769
     Long-term borrowings
    121,942     130,627       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
    1,195     1,195       1,433     1,433
     Derivative financial instruments
    1,582     1,582       -     -
    $ 1,310,632   $ 1,343,722     $ 1,267,919   $ 1,304,060


NOTE 4.  EARNINGS PER SHARE

The computations of basic and diluted earnings per share follow:


 
For the Three Months Ended June 30,
 
2014
   
2013
     
Common
           
Common
   
Dollars in thousands,
Income
 
Shares
 
Per
   
Income
 
Shares
 
Per
except per share amounts
(Numerator)
 
(Denominator)
 
Share
   
(Numerator)
 
(Denominator)
 
Share
Net income
$ 2,432             $ 1,217        
 Less preferred stock dividends
  (193 )             (194 )      
                             
 Basic EPS
$ 2,239   7,457,222   $ 0.30     $ 1,023   7,438,401   $ 0.14
                                 
     Effect of dilutive securities:
                               
         Stock options
      9,607                 7,568      
         Series 2011 convertible
                               
              preferred stock
  119   1,489,250             120   1,499,071      
         Series 2009 convertible
                               
              preferred stock
  74   674,545             74   674,545      
                                 
Diluted EPS
$ 2,432   9,630,624   $ 0.25     $ 1,217   9,619,585   $ 0.13

 
16

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

 

 
For the Six Months Ended June 30,
 
2014
   
2013
     
Common
           
Common
   
Dollars in thousands,
Income
 
Shares
 
Per
   
Income
 
Shares
 
Per
except per share amounts
(Numerator)
 
(Denominator)
 
Share
   
(Numerator)
 
(Denominator)
 
Share
Net income
$ 4,822             $ 3,010        
 Less preferred stock dividends
  (387 )             (388 )      
                             
 Basic EPS
$ 4,435   7,455,307   $ 0.59     $ 2,622   7,435,344   $ 0.35
                                 
     Effect of dilutive securities:
                               
         Stock options
      9,675                 7,496      
         Series 2011 convertible
                               
              preferred stock
  238   1,490,228             240   1,499,533      
         Series 2009 convertible
                               
              preferred stock
  149   674,545             148   674,545      
                                 
Diluted EPS
$ 4,822   9,629,755   $ 0.50     $ 3,010   9,616,918   $ 0.31


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 June 30, 2014 and 2013 totaled 143,000 shares and 170,500 shares, respectively.

NOTE 5.  SECURITIES

The amortized cost, unrealized gains, unrealized losses and estimated fair values of securities at June 30, 2014, December 31, 2013, and June 30, 2013 are summarized as follows:


 
June 30, 2014
 
Amortized
 
Unrealized
 
Estimated
 Dollars in thousands
Cost
 
Gains
 
Losses
 
Fair Value
 Available for Sale
             
     Taxable debt securities
             
         U. S. Government agencies
             
             and corporations
$ 24,998   $ 885   $ 53   $ 25,830
         Residential mortgage-backed securities:
                     
             Government-sponsored agencies
  155,631     2,921     997     157,555
             Nongovernment-sponsored entities
  9,555     385     9     9,931
         State and political subdivisions
                     
               General obligations
  4,532     9     144     4,397
               Water and sewer revenues
  2,382     7     44     2,345
               Other revenues
  3,319     7     33     3,293
         Corporate debt securities
  -     -     -     -
 Total taxable debt securities
  200,417     4,214     1,280     203,351
     Tax-exempt debt securities
                     
         State and political subdivisions
                     
               General obligations
  46,859     1,552     204     48,207
               Water and sewer revenues
  11,868     176     58     11,986
               Lease revenues
  7,990     54     68     7,976
               Lottery/casino revenues
  3,832     145     41     3,936
               Other revenues
  12,205     198     53     12,350
 Total tax-exempt debt securities
  82,754     2,125     424     84,455
     Equity securities
  77     -     -     77
 Total available for sale securities
$ 283,248   $ 6,339   $ 1,704   $ 287,883


17

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)


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



 
June 30, 2013
 
Amortized
 
Unrealized
 
Estimated
 Dollars in thousands
Cost
 
Gains
 
Losses
 
Fair Value
 Available for Sale
             
     Taxable debt securities:
             
         U. S. Government agencies
             
             and corporations
$ 35,605   $ 1,186   $ 27   $ 36,764
         Residential mortgage-backed securities:
                     
              Government-sponsored agencies
  147,738     2,313     1,510     148,541
              Nongovernment-sponsored agencies
  12,373     326     42     12,657
         State and political subdivisions
  13,838     2     493     13,347
         Corporate debt securities
  3,966     27     34     3,959
          Total taxable debt securities
  213,520     3,854     2,106     215,268
     Tax-exempt debt securities:
                     
         State and political subdivisions
  76,225     1,647     2,037     75,835
         Residential mortgage-backed securities:
                     
              Government-sponsored agencies
  -     -     -     -
      Total tax-exempt debt securities
  76,225     1,647     2,037     75,835
     Equity securities
  77     -     -     77
      Total available for sale securities
$ 289,822   $ 5,501   $ 4,143   $ 291,180

 

 
18

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

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.

 
June 30, 2014
 
Amortized
 
Unrealized
 
Estimated
 Dollars in thousands
Cost
 
Gains
 
Losses
 
Fair Value
               
 California
$ 17,649   $ 470   $ 41   $ 18,078
 West Virginia
  12,313     242     54     12,501
 Illinois
  8,941     142     77     9,006
 Texas
  7,380     368     74     7,674
 Pennsylvania
  7,298     64     49     7,313


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.

The maturities, amortized cost and estimated fair values of securities at June 30, 2014, are summarized as follows:

   
Available for Sale
   
Amortized
 
Estimated
 Dollars in thousands
 
Cost
 
Fair Value
 Due in one year or less
  $ 59,685   $ 60,630
 Due from one to five years
    100,747     102,143
 Due from five to ten years
    25,962     26,503
 Due after ten years
    96,777     98,530
 Equity securities
    77     77
    $ 283,248   $ 287,883


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 six months ended June 30, 2014 are as follows:


   
Proceeds from
   
Gross realized
       
Calls and
 
Principal
         
Dollars in thousands
 
Sales
 
Maturities
 
Payments
   
Gains
 
Losses
                       
Securities available for sale
  $ 36,230   $ 3,001   $ 16,664     $ 550   $ 614

 

During the three and six months ended June 30, 2014 and 2013, we recorded other-than-temporary impairment losses on residential mortgage-backed nongovernment sponsored entity securities as follows:

 
   
Three Months Ended June 30,
   
Six Months Ended June 30,
 Dollars in thousands
 
2014
 
2013
   
2014
 
2013
                   
 Total other-than-temporary impairment losses
  $ (1 ) $ (27 )   $ (1 ) $ (117)
 Portion of loss recognized in
                         
   other comprehensive income
    -     -       -     37
 Net impairment losses recognized in earnings
  $ (1 ) $ (27 )   $ (1 ) $ (80)
 

 
19

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

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 six months ended June 30, 2014 is as follows:


   
Three Months Ended
 
Six Months Ended
   
June 30, 2014
 
June 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
    2,814     2,814
 Ending Balance
  $ (208 ) $ (208)


We held 86 available for sale securities having an unrealized loss at June 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.

Provided below is a summary of securities available for sale which were in an unrealized loss position at June 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.
 
 
 
 
June 30, 2014
 
Less than 12 months
 
12 months or more
 
Total
 
Estimated
 
Unrealized
 
Estimated
 
Unrealized
 
Estimated
 
Unrealized
Dollars in thousands
Fair Value
 
Loss
 
Fair Value
 
Loss
 
Fair Value
 
Loss
Temporarily impaired securities
                     
   Taxable debt securities
                     
     U. S. Government agencies
                     
       and corporations
$ 2,448   $ (6 ) $ 3,396   $ (47 ) $ 5,844   $ (53)
     Residential mortgage-backed securities:
                                 
        Government-sponsored agencies
  35,211     (550 )   23,421     (447 )   58,632     (997)
        Nongovernment-sponsored entities
  2,598     (9 )   86     -     2,684     (9)
     State and political subdivisions:
                                 
        General obligations
  -     -     4,103     (144 )   4,103     (144)
        Water and sewer revenues
  -     -     1,836     (44 )   1,836     (44)
        Other revenues
  1,104     (16 )   926     (17 )   2,030     (33)
     Corporate debt securities
  -     -     -     -     -     -
   Tax-exempt debt securities
                                 
     State and political subdivisions:
                                 
        General obligations
  4,816     (44 )   7,572     (160 )   12,388     (204)
        Water and sewer revenues
  1,070     (21 )   2,608     (37 )   3,678     (58)
        Lease revenues
  -     -     2,529     (68 )   2,529     (68)
        Lottery/casino revenues
  -     -     1,106     (41 )   1,106     (41)
        Other revenues
  2,771     (18 )   826     (35 )   3,597     (53)
     Total temporarily impaired securities
  50,018     (664 )   48,409     (1,040 )   98,427     (1,704)
Other-than-temporarily impaired securities
                             
   Taxable debt securities
                                 
     Residential mortgage-backed securities:
                                 
        Nongovernment-sponsored entities
  -     -     -     -     -     -
     Total other-than-temporarily
                                 
 impaired securities
  -     -     -     -     -     -
 Total
$ 50,018   $ (664 ) $ 48,409   $ (1,040 ) $ 98,427   $ (1,704)

 

 
20

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

 
 
December 31, 2013
 
Less than 12 months
 
12 months or more
 
Total
 
Estimated
 
Unrealized
 
Estimated
 
Unrealized
 
Estimated
 
Unrealized
Dollars in thousands
Fair Value
 
Loss
 
Fair Value
 
Loss
 
Fair Value
 
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.

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”.
 
 
21

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

 
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:

   
June 30,
 
December 31,
 
June 30,
 Dollars in thousands
 
2014
 
2013
 
2013
 Commercial
  $ 90,096   $ 88,352   $ 78,963
 Commercial real estate
                 
      Owner-occupied
    154,260     149,618     149,660
      Non-owner occupied
    314,439     280,790     277,773
 Construction and development
                 
      Land and land development
    64,246     71,453     73,427
      Construction
    20,902     15,155     7,634
 Residential real estate
                 
      Non-jumbo
    219,569     212,946     216,759
      Jumbo
    52,487     53,406     58,567
      Home equity
    61,248     54,844     53,774
 Consumer
    19,777     19,889     20,147
 Other
    6,798     3,276     3,397
      Total loans, net of unearned fees
    1,003,822     949,729     940,101
 Less allowance for loan losses
    11,006     12,659     14,122
       Loans, net
  $ 992,816   $ 937,070   $ 925,979


The following table presents the contractual aging of the recorded investment in past due loans by class as of June 30, 2014 and 2013 and December 31, 2013.


 
At June 30, 2014
 
Past Due
     
> 90 days
Dollars in thousands
30-59 days
 
60-89 days
 
> 90 days
 
Total
 
Current
 
and Accruing
Commercial
$ 33   $ 363   $ 396   $ 792   $ 89,304   $ -
Commercial real estate
                                 
     Owner-occupied
  642     348     759     1,749     152,511     -
     Non-owner occupied
  237     -     234     471     313,968     -
Construction and development
                                 
     Land and land development
  142     14     4,860     5,016     59,230     -
     Construction
  -     -     -     -     20,902     -
Residential mortgage
                                 
     Non-jumbo
  3,198     1,760     2,060     7,018     212,551     -
     Jumbo
  707     723     -     1,430     51,057     -
     Home equity
  196     36     143     375     60,873     -
Consumer
  452     183     72     707     19,070     -
Other
  -     -     -     -     6,798     -
     Total
$ 5,607   $ 3,427   $ 8,524   $ 17,558   $ 986,264   $ -



22

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 

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



 
At June 30, 2013
 
Past Due
     
> 90 days
Dollars in thousands
30-59 days
 
60-89 days
 
> 90 days
 
Total
 
Current
 
and Accruing
Commercial
$ 144   $ 55   $ 1,669   $ 1,868   $ 77,095   $ -
Commercial real estate
                                 
     Owner-occupied
  85     -     314     399     149,261     -
     Non-owner occupied
  543     -     899     1,442     276,331     -
Construction and development
                                 
     Land and land development
  698     -     9,929     10,627     62,800     -
     Construction
  -     -     60     60     7,574     -
Residential mortgage
                                 
     Non-jumbo
  4,086     1,171     2,494     7,751     209,008     -
     Jumbo
  709     -     9,000     9,709     48,858     -
     Home equity
  101     26     25     152     53,622     -
Consumer
  239     64     63     366     19,781     -
Other
  53     -     -     53     3,344     -
     Total
$ 6,658   $ 1,316   $ 24,453   $ 32,427   $ 907,674   $ -



Nonaccrual loans:  The following table presents the nonaccrual loans included in the net balance of loans at June 30, 2014, December 31, 2013 and June 30, 2013.


Dollars in thousands
 
6/30/2014
 
12/31/2013
 
6/30/2013
Commercial
  $ 416   $ 1,224   $ 3,996
Commercial real estate
                 
   Owner-occupied
    953     1,953     796
   Non-owner occupied
    583     365     899
Construction and development
                 
   Land & land development
    8,849     12,830     11,445
   Construction
    -     -     60
Residential mortgage
                 
   Non-jumbo
    2,950     2,446     4,333
   Jumbo
    -     -     9,000
   Home equity
    339     -     271
Consumer
    129     128     92
     Total
  $ 14,219   $ 18,946   $ 30,892
 

 
23

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 
 
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 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
             
Loan Category
6/30/2014
 
12/31/2013
 
6/30/2013
 
Method used to measure impairment
Commerical
$ 506   $ 1,864   $ 7,825  
Fair value of collateral
    -     158     162  
Discounted cash flow
Commerical real estate
                   
   Owner-occupied
  1,924     10,067     12,074  
Fair value of collateral
    8,969     2,483     2,657  
Discounted cash flow
   Non-owner occupied
  513     5,832     6,814  
Fair value of collateral
    5,236     -     -  
Discounted cash flow
Construction and development
               
   Land & land development
  14,023     24,625     26,710  
Fair value of collateral
    1,446     644     654  
Discounted cash flow
Residential mortgage
                   
   Non-jumbo
  3,440     5,516     5,322  
Fair value of collateral
    2,592     566     891  
Discounted cash flow
   Jumbo
  6,648     8,768     17,824  
Fair value of collateral
    2,073     -     -  
Discounted cash flow
   Home equity
  186     212     213  
Fair value of collateral
Consumer
  37     47     62  
Fair value of collateral
Total
$ 47,593   $ 60,782   $ 81,208    





24

Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)


The following tables present loans individually evaluated for impairment at June 30, 2014, December 31, 2013 and June 30, 2013.


 
June 30, 2014
             
Average
 
Interest Income
 
Recorded
 
Unpaid
 
Related
 
Impaired
 
Recognized
Dollars in thousands
Investment
 
Principal Balance
 
Allowance
 
Balance
 
while impaired
                   
Without a related allowance
                 
  Commercial
$ 506   $ 506   $ -   $ 506   $ 35
  Commercial real estate
                           
     Owner-occupied
  6,287     6,288     -     6,287     248
     Non-owner occupied
  5,012     5,014     -     5,012     249
  Construction and development
                           
     Land & land development
  13,853     13,853     -     13,853     293
     Construction
  -     -     -     -     -
  Residential real estate
                           
     Non-jumbo
  3,390     3,398     -     3,390     161
     Jumbo
  7,823     7,828     -     7,823     401
     Home equity
  186     186     -     186     11
Consumer
  38     37     -     38     3
Total without a related allowance
$ 37,095   $ 37,110   $ -   $ 37,095   $ 1,401
                             
With a related allowance
                           
  Commercial
$ -   $ -   $ -   $ -   $ -
  Commercial real estate
                           
     Owner-occupied
  4,605     4,605     266     4,605     213
     Non-owner occupied
  735     735     79     735     79
  Construction and development
                           
     Land & land development
  1,616     1,616     898     1,616     40
     Construction
  -     -     -     -     -
  Residential real estate
                           
     Non-jumbo
  2,633     2,634     299     2,633     107
     Jumbo
  893     893     53     893     44
     Home equity
  -     -     -     -     -
Consumer
  -     -     -     -     -
Total with a related allowance
$ 10,482   $ 10,483   $ 1,595   $ 10,482   $ 483
                             
Total
                           
   Commercial
$ 32,614   $ 32,617   $ 1,243   $ 32,614   $ 1,157
   Residential real estate
  14,925     14,939     352     14,925     724
   Consumer
  38     37     -     38     3
Total
$ 47,577   $ 47,593   $ 1,595   $ 47,577   $ 1,884

 
 
25

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

 
 
December 31, 2013
             
Average
 
Interest Income
 
Recorded
 
Unpaid
 
Related
 
Impaired
 
Recognized
Dollars in thousands
Investment
 
Principal Balance
 
Allowance
 
Balance
 
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
 
 

 
26

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

 
 
June 30, 2013
             
Average
 
Interest Income
 
Recorded
 
Unpaid
 
Related
 
Impaired
 
Recognized
Dollars in thousands
Investment
 
Principal Balance
 
Allowance
 
Balance
 
while impaired
                   
Without a related allowance
                 
  Commercial
$ 6,942   $ 7,104   $ -   $ 8,133   $ 435
  Commercial real estate
                           
     Owner-occupied
  9,770     9,774     -     10,638     491
     Non-owner occupied
  5,396     5,398     -     3,969     199
Construction and development
                       
     Land & land development
  16,904     16,904     -     16,853     725
     Construction
  -     -     -     -     -
  Residential real estate
                           
     Non-jumbo
  3,250     3,258     -     3,035     120
     Jumbo
  7,911     7,916     -     9,352     503
     Home equity
  186     186     -     186     11
Consumer
  37     38     -     37     2
Total without a related allowance
$ 50,396   $ 50,578   $ -   $ 52,203   $ 2,486
                             
With a related allowance
                           
  Commercial
$ 874   $ 883   $ 387   $ 565   $ 4
  Commercial real estate
                           
     Owner-occupied
  4,957     4,957     741     3,967     186
     Non-owner occupied
  1,415     1,416     165     1,421     28
Construction and development
                       
     Land & land development
  10,460     10,460     1,844     10,483     65
     Construction
  -     -     -     -     -
  Residential real estate
                           
     Non-jumbo
  2,952     2,955     307     2,963     141
     Jumbo
  9,907     9,908     1,044     10,277     45
     Home equity
  28     27     27     28     -
Consumer
  25     24     13     25     2
Total with a related allowance
$ 30,618   $ 30,630   $ 4,528   $ 29,729   $ 471
                             
Total
                           
   Commercial
$ 56,718   $ 56,896   $ 3,137   $ 56,029   $ 2,133
   Residential real estate
  24,234     24,250     1,378     25,841     820
   Consumer
  62     62     13     62     4
Total
$ 81,014   $ 81,208   $ 4,528   $ 81,932   $ 2,957



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 $33.2 million, of which $31.6 million were current with respect to restructured contractual payments at June 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.
 
 
27

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 
The following table presents by class the TDRs that were restructured during the three and six months ended June 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
   
For the Three Months Ended
 
June 30, 2014
   
June 30, 2013
     
Pre-modification
 
Post-modification
       
Pre-modification
 
Post-modification
 
Number of
 
Recorded
 
Recorded
   
Number of
 
Recorded
 
Recorded
dollars in thousands
Modifications
 
Investment
 
Investment
   
Modifications
 
Investment
 
Investment
  Commercial
3   $ 82   $ 86     1   $ 23   $ 23
  Commercial real estate
                               
     Owner-occupied
-     -     -     -     -     -
     Non-owner occupied
-     -     -     -     -     -
Construction and development
                             
     Land & land development
-     -     -     -     -     -
     Construction
-     -     -     -     -     -
  Residential real estate
                               
     Non-jumbo
-     -     -     2     241     241
     Jumbo
-     -     -     -     -     -
     Home equity
-     -     -     -     -     -
  Consumer
-     -     -     -     -     -
Total
3   $ 82   $ 86     3   $ 264   $ 264


 
For the Six Months Ended
   
For the Six Months Ended
 
June 30, 2014
   
June 30, 2013
     
Pre-modification
 
Post-modification
       
Pre-modification
 
Post-modification
 
Number of
 
Recorded
 
Recorded
   
Number of
 
Recorded
 
Recorded
dollars in thousands
Modifications
 
Investment
 
Investment
   
Modifications
 
Investment
 
Investment
  Commercial
3   $ 82   $ 86     1   $ 23   $ 23
  Commercial real estate
                               
     Owner-occupied
-     -     -     -     -     -
     Non-owner occupied
-     -     -     -     -     -
Construction and development
                             
     Land & land development
-     -     -     1     49     50
     Construction
-     -     -     -     -     -
  Residential real estate
                               
     Non-jumbo
-     -     -     2     241     241
     Jumbo
-     -     -     -     -     -
     Home equity
-     -     -     -     -     -
  Consumer
-     -     -     -     -     -
Total
3   $ 82   $ 86     4   $ 313   $ 314

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.


28

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

 
 
For the Three Months Ended
 
For the Six Months Ended
 
June 30, 2014
 
June 30, 2014
 
Number
 
Recorded
 
Number
 
Recorded
 
of
 
Investment
 
of
 
Investment
dollars in thousands
Defaults
 
at Default Date
 
Defaults
 
at Default Date
  Commercial
2   $ 78   2   $ 78
  Commercial real estate
                 
     Owner-occupied
-     -   -     -
     Non-owner occupied
-     -   -     -
Construction and development
               
     Land & land development
1     695   1     698
     Construction
-     -   -     -
  Residential real estate
                 
     Non-jumbo
2     335   2     334
     Jumbo
-     -   -     -
     Home equity
-     -   -     -
  Consumer
-     -   -     -
Total
5   $ 1,108   5   $ 1,110


The following table details the activity regarding TDRs by loan type for the three months and six months ended June 30, 2014, and the related allowance on TDRs.


For the Three Months Ended June 30, 2014
 
Construction & Land Development
                                     
 
Land &
         
Commercial Real Estate
 
Residential Real Estate
             
 
Land
             
Non-
                         
 
Develop-
 
Construc-
 
Commer-
 
Owner
 
Owner
 
Non-
     
Home
 
Con-
         
Dollars in thousands
ment
 
tion
 
cial
 
Occupied
 
Occupied
 
jumbo
 
Jumbo
 
Equity
 
sumer
 
Other
   
Total
Troubled debt restructurings
                                         
Balance June 30, 2013
$ 6,069   $ -   $ 509   $ 9,644   $ 5,492   $ 5,513   $ 6,237   $ -   $ 40   $ -     $ 33,504
   Additions
  -     -     86     -     -     -     -     -     -     -       86
   Charge-offs
  -     -     -     -     -     -     -     -     -     -       -
   Net (paydowns) advances
  (101 )   -     (97 )   (55 )   (27 )   (19 )   (36 )   -     (2 )   -       (337)
   Transfer into OREO
  -     -     -     -     -     -     -     -     -     -       -
   Refinance out of TDR status
  -     -     -     -     -     -     -     -     -     -       -
Balance June 30, 2014
$ 5,968   $ -   $ 498   $ 9,589   $ 5,465   $ 5,494   $ 6,201   $ -   $ 38   $ -     $ 33,253
                                                                   
Allowance related to
                                                                 
   troubled debt restructurings
$ 171   $ -   $ -   $ 188   $ 79   $ 298   $ 52   $ -   $ -   $ -     $ 788



For the Six Months Ended June 30, 2014
 
Construction & Land Development
                                     
 
Land &
         
Commercial Real Estate
 
Residential Real Estate
             
 
Land
             
Non-
                         
 
Develop-
 
Construc-
 
Commer-
 
Owner
 
Owner
 
Non-
     
Home
 
Con-
         
Dollars in thousands
ment
 
tion
 
cial
 
Occupied
 
Occupied
 
jumbo
 
Jumbo
 
Equity
 
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     -     -     -     -     -     -     -       86
   Charge-offs
  -     -     -     -     -     -     -     -     (3 )   -       (3)
   Net (paydowns) advances
  (195 )   -     (831 )   (110 )   (79 )   (47 )   (77 )   -     (6 )   -       (1,345)
   Transfer into OREO
  -     -     -     -     -     -     -     -     -     -       -
   Refinance out of TDR status
  -     -     -     -     -     -     -     -     -     -       -
Balance June 30, 2014
$ 5,968   $ -   $ 498   $ 9,589   $ 5,465   $ 5,494   $ 6,201   $ -   $ 38   $ -     $ 33,253
                                                                   
Allowance related to
                                                                 
   troubled debt restructurings
$ 171   $ -   $ -   $ 188   $ 79   $ 298   $ 52   $ -   $ -   $ -     $ 788
 
 
29

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

 
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.

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
6/30/2014
 
12/31/2013
 
6/30/2014
 
12/31/2013
 
6/30/2014
 
12/31/2013
 
6/30/2014
 
12/31/2013
 
6/30/2014
 
12/31/2013
Pass
$ 45,624   $ 41,662   $ 20,432   $ 15,022   $ 88,446   $ 82,323   $ 150,578   $ 143,982   $ 303,213   $ 268,967
OLEM (Special Mention)
  4,539     5,550     470     133     1,203     4,544     1,903     1,412     9,483     10,222
Substandard
  14,083     24,131     -     -     447     1,485     1,779     4,224     1,743     1,601
Doubtful
  -     110     -     -     -     -     -     -     -     -
Loss
  -     -     -     -     -     -     -     -     -     -
     Total
$ 64,246   $ 71,453   $ 20,902   $ 15,155   $ 90,096   $ 88,352   $ 154,260   $ 149,618   $ 314,439   $ 280,790
 

 
30

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

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
6/30/2014
 
12/31/2013
 
6/30/2013
   
6/30/2014
 
12/31/2013
 
6/30/2013
Residential real estate
                       
   Non-jumbo
$ 216,619   $ 210,500   $ 212,426     $ 2,950   $ 2,446   $ 4,333
   Jumbo
  52,487     53,406     49,567       -     -     9,000
   Home Equity
  60,909     54,844     53,503       339     -     271
Consumer
  19,648     19,761     20,056       129     128     91
Other
  6,798     3,276     3,397       -     -     -
Total
$ 356,461   $ 341,787   $ 338,949     $ 3,418   $ 2,574   $ 13,695


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.

NOTE 7.  ALLOWANCE FOR LOAN LOSSES

An analysis of the allowance for loan losses for the six month periods ended June 30, 2014 and 2013, and for the year ended December 31, 2013 is as follows:


 
Six Months Ended
 
Year Ended
 
June 30,
 
December 31,
Dollars in thousands
2014
 
2013
 
2013
           
  Balance, beginning of year
$ 12,659   $ 17,933   $ 17,933
  Losses:
               
      Commercial
  390     54     723
      Commercial real estate
               
           Owner occupied
  11     66     1,031
           Non-owner occupied
  -     9     9
      Construction and development
               
           Land and land development
  3,533     2,166     3,596
           Construction
  -     -     -
      Residential real estate
               
           Non-jumbo
  46     384     541
           Jumbo
  63     3,625     4,741
           Home equity
  -     76     77
      Consumer
  80     34     79
      Other
  51     51     162
  Total
  4,174     6,465     10,959
  Recoveries:
               
      Commercial
  17     4     12
      Commercial real estate
               
           Owner occupied
  31     2     8
           Non-owner occupied
  4     -     674
      Construction and development
               
           Land and land development
  165     9     187
           Construction
  -     -     -
      Real estate - mortgage
               
           Non-jumbo
  53     43     127
           Jumbo
  163     3     6
           Home equity
  3     1     5
      Consumer
  41     37     79
      Other
  44     55     87
  Total
  521     154     1,185
  Net losses
  3,653     6,311     9,774
  Provision for loan losses
  2,000     2,500     4,500
  Balance, end of year
$ 11,006   $ 14,122   $ 12,659
 
 
31

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

Activity in the allowance for loan losses by loan class during the first six months of 2014 is as follows:

                                           
 
Construction & Land Development
                                   
 
Land &
         
Commercial Real Estate
 
Residential Real Estate
           
 
Land
             
Non-
                       
 
Develop-
 
Construc-
 
Commer-
 
Owner
 
Owner
 
Non-
     
Home
 
Con-
       
Dollars in thousands
ment
 
tion
 
cial
 
Occupied
 
Occupied
 
jumbo
 
Jumbo
 
Equity
 
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
  3,533     -     390     11     -     46     63     -     80     51     4,174
   Recoveries
  165     -     17     31     4     53     163     3     41     44     521
   Provision
  1,722     85     124     8     98     (318 )   93     83     38     67     2,000
Ending balance
$ 3,809   $ 354   $ 1,075   $ 997   $ 743   $ 1,531   $ 2,081   $ 259   $ 46   $ 111   $ 11,006
                                                                 
Allowance related to:
                                                               
Loans individually
                                                               
   evaluated for impairment
$ 898   $ -   $ -   $ 267   $ 79   $ 299   $ 52   $ -   $ -   $ -   $ 1,595
Loans collectively
                                                               
   evaluated for impairment
  2,911     354     1,075     730     664     1,232     2,029     259     46     111     9,411
Loans acquired with
                                                               
   deteriorated credit quality
  -     -     -     -     -     -     -     -     -     -     -
Total
$ 3,809   $ 354   $ 1,075   $ 997   $ 743   $ 1,531   $ 2,081   $ 259   $ 46   $ 111   $ 11,006
                                                                 
Loans
                                                               
Loans individually
                                                               
   evaluated for impairment
$ 15,469   $ -   $ 506   $ 10,893   $ 5,749   $ 6,032   $ 8,721   $ 186   $ 37   $ -   $ 47,593
Loans collectively
                                                               
   evaluated for impairment
  48,777     20,902     89,590     143,367     308,690     213,537     43,766     61,062     19,740     6,798   $ 956,229
Loans acquired with
                                                               
   deteriorated credit quality
  -     -     -     -     -     -     -     -     -     -     -
Total
$ 64,246   $ 20,902   $ 90,096   $ 154,260   $ 314,439   $ 219,569   $ 52,487   $ 61,248   $ 19,777   $ 6,798   $ 1,003,822


NOTE 8.  GOODWILL AND OTHER INTANGIBLE ASSETS

The following tables present our goodwill by reporting unit at June 30, 2014 and other intangible assets by reporting unit at June 30, 2013 and December 31, 2013.


   
Goodwill Activity
   
Community
 
Insurance
   
Dollars in thousands
 
Banking
 
Services
 
Total
Balance, January 1, 2014
  $ 1,488   $ 4,710   $ 6,198
   Acquired goodwill, net
    -     -     -
                   
Balance, June 30, 2014
  $ 1,488   $ 4,710   $ 6,198
 
 
32

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

 
   
Other Intangible Assets
   
June 30, 2014
 
December 31, 2013
   
Community
 
Insurance
     
Community
 
Insurance
   
 Dollars in thousands
 
Banking
 
Services
 
Total
 
Banking
 
Services
 
Total
 Unidentifiable intangible assets
                       
    Gross carrying amount
  $ 2,267   $ -   $ 2,267   $ 2,267   $ -   $ 2,267
    Less:  accumulated amortization
    2,267     -     2,267     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
    -     1,400     1,400     -     1,300     1,300
        Net carrying amount
  $ -   $ 1,600   $ 1,600   $ -   $ 1,700   $ 1,700

We recorded amortization expense of approximately $150,000 for the six months ended June 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 June 30, 2014 and 2013 and December 31, 2013:


   
June 30,
 
December 31,
 
June 30,
 Dollars in thousands
 
2014
 
2013
 
2013
 Demand deposits, interest bearing
  $ 187,855   $ 186,578   $ 187,244
 Savings deposits
    243,323     193,446     196,069
 Time deposits
    520,483     530,951     562,703
 Total
  $ 951,661   $ 910,975   $ 946,016

Included in time deposits are deposits acquired through a third party (“brokered deposits”) totaling $159.0 million, $160.8 million and $192.1 million at June 30, 2014, December 31, 2013, and June 30, 2013, respectively.

A summary of the scheduled maturities for all time deposits as of June 30, 2014 is as follows:



Dollars in thousands
   
 Six month period ending December 31, 2014
  $ 117,062
 Year ending December 31, 2015
    125,062
 Year ending December 31, 2016
    116,389
 Year ending December 31, 2017
    43,842
 Year ending December 31, 2018
    44,658
 Thereafter
    73,470
    $ 520,483

 
33

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

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


Dollars in thousands
Amount
 
Percent
 Three months or less
$ 49,136   12.8%
 Three through six months
  27,033   7.0%
 Six through twelve months
  53,313   13.9%
 Over twelve months
  254,190   66.3%
 Total
$ 383,672   100.0%

NOTE 10.  BORROWED FUNDS

Short-term borrowings:    A summary of short-term borrowings is presented below:


 
Six Months Ended June 30,
 
2014
 
2013
     
Federal Funds
     
Federal Funds
 
Short-term
 
Purchased
 
Short-term
 
Purchased
 
FHLB
 
and Lines
 
FHLB
 
and Lines
 Dollars in thousands
Advances
 
of Credit
 
Advances
 
of Credit
 Balance at June 30
$ 86,050   $ 5,679   $ 15,800   $ 962
 Average balance outstanding for the period
  69,108     8,336     17,938     3,474
 Maximum balance outstanding at
                     
     any month end during period
  87,550     8,976     45,000     5,961
 Weighted average interest rate for the period
  0.31 %   0.25 %   0.25 %   0.25%
 Weighted average interest rate for balances
                     
     outstanding at June 30
  0.29 %   0.25 %   0.25 %   0.25%

 
 
 
Year Ended December 31, 2013
     
Federal Funds
 
Short-term
 
Purchased
 
FHLB
 
and Lines
 Dollars in thousands
Advances
 
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 $121.9 million, $163.5 million and $163.6 million at June 30, 2014, December 31, 2013, and June 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
 
Balance at June 30,
 
December 31,
Dollars in thousands
2014
 
2013
 
2013
Long-term FHLB advances
$ 41,026   $ 82,649   $ 82,600
Long-term reverse repurchase agreements
  72,000     72,000     72,000
Term loans
  8,916     8,916     8,916
Total
$ 121,942   $ 163,565   $ 163,516
 
 
34

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

The term loans are secured by the common stock of our subsidiary bank.  $5.4 million bears a variable interest rate of prime minus 50 basis points with a final maturity of 2017, and $3.5 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 six month period ended June 30, 2014 was 4.01% compared to 3.86% for the first six months of 2013.

Subordinated debentures:  We have subordinated debt totaling $16.8 million at June 30, 2014, December 31, 2013, and June 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 275 basis 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 June 30, 2014, December 31, 2013, and June 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 345 basis points for SFG Capital Trust I, 3 month LIBOR plus 280 basis points for SFG Capital Trust II, and 3 month LIBOR plus 145 basis 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.

 
35

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

 
A summary of the maturities of all long-term borrowings and subordinated debentures for the next five years and thereafter is as follows:

           
Subordinated
           
debentures owed
   
Long-term
 
Subordinated
 
to unconsolidated
Dollars in thousands
 
borrowings
 
debentures
 
subsidiary trusts
Year Ending December 31,
2014
$ 43,952   $ -   $ -
 
2015
  1,909     10,000     -
 
2016
  28,911     -     -
 
2017
  918     -     -
 
2018
  45,017     -     -
 
Thereafter
  1,235     6,800     19,589
    $ 121,942   $ 16,800   $ 19,589


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 six 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 six months of 2014 and 2013, our stock compensation expense and related deferred taxes were insignificant.
 
 
36

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

A summary of activity in our Plans during the first six months of 2014 and 2013 is as follows:


 
For the Six Months Ended June 30,
 
2014
 
2013
     
Weighted-Average
     
Weighted-Average
 
Options
 
Exercise Price
 
Options
 
Exercise Price
 Outstanding, January 1
185,410   $ 19.59   249,700   $ 18.98
     Granted
-     -   -     -
     Exercised
(3,200 )   4.63   (12,000 )   5.09
     Forfeited
-     -   (1,750 )   19.69
     Expired
(2,500 )   17.43   (39,700 )   23.41
 Outstanding, June 30
179,710   $ 19.88   196,250   $ 18.92



Other information regarding options outstanding and exercisable at June 30, 2014 is as follows:

                             
   
Options Outstanding
 
Options Exercisable
           
Wted. Avg.
 
Aggregate
         
Aggregate
           
Remaining
 
Intrinsic
         
Intrinsic
Range of
 
# of
     
Contractual
 
Value
 
# of
     
Value
exercise price
 
shares
 
WAEP
 
Life (yrs)
 
(in thousands)
 
shares
 
WAEP
 
(in thousands)
$ 2.54 - $6.00   13,550   $ 4.69   4.20   $ 81   11,550   $ 5.06   $ 64
  6.01 - 10.00   23,160     9.07   2.73     36   22,560     9.14     34
  10.01 - 17.50   -     -   -     -   -     0     -
  17.51 - 20.00   38,500     17.80   2.50     -   38,500     17.8     -
  20.01 - 25.93   104,500     25.04   2.24     -   104,500     25.04     -
                                       
      179,710     19.88       $ 117   177,110     20.12   $ 98


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.


 
37

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

A summary of the total unfunded, or off-balance sheet, credit extension commitments follows:


   
June 30,
Dollars in thousands
 
2014
Commitments to extend credit:
   
    Revolving home equity and
   
        credit card lines
  $ 51,340
    Construction loans
    22,618
    Other loans
    43,683
Standby letters of credit
    1,668
Total
  $ 119,309


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.
 
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.
 
 
38

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

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 June 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.

                       
To be Well Capitalized
             
Minimum Required
   
under Prompt Corrective
   
Actual
   
Regulatory Capital
   
Action Provisions
 Dollars in thousands
 
Amount
 
Ratio
   
Amount
 
Ratio
   
Amount
 
Ratio
 As of June 30, 2014
                           
Total Capital (to risk weighted assets)
                       
     Summit
  $ 146,096   14.2 %   $ 82,556   8.0 %   $ 103,195   10.0%
     Summit Community
    160,462   15.6 %     82,035   8.0 %     102,543   10.0%
Tier I Capital (to risk weighted assets)
                           
     Summit
    127,490   12.4 %     41,278   4.0 %     61,917   6.0%
     Summit Community
    149,456   14.5 %     41,281   4.0 %     61,922   6.0%
 Tier I Capital (to average assets)
                                 
     Summit
    127,490   9.0 %     56,474   4.0 %     70,592   5.0%
     Summit Community
    149,456   10.6 %     56,452   4.0 %     70,565   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 that is used when circumstances warrant a milder form of action than a formal supervisory action, such as a formal written agreement or order.
 
 
39

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

 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 $500,000 that 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.
 


40

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

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.

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:

   
Six Months Ended June 30, 2014
       
Insurance &
           
   
Community
 
Financial
           
In thousands
 
Banking
 
Services
 
Parent
 
Eliminations
 
Total
Net interest income
  $ 21,311   $ -   $ (953 ) $ -   $ 20,358
Provision for loan losses
    2,000     -     -     -     2,000
Net interest income after provision for loan losses
    19,311     -     (953 )   -     18,358
Other income
    2,901     2,588     590     (590 )   5,489
Other expenses
    14,672     2,089     857     (590 )   17,028
Income (loss) before income taxes
    7,540     499     (1,220 )   -     6,819
Income tax expense (benefit)
    2,187     172     (362 )   -     1,997
Net income (loss)
    5,353     327     (858 )   -     4,822
Dividends on preferred shares
    -     -     387     -     387
Net income (loss) applicable to common shares
  $ 5,353   $ 327   $ (1,245 ) $ -   $ 4,435
Inter-segment revenue (expense)
  $ (532 ) $ (58 ) $ 590   $ -   $ -
Average assets
  $ 1,454,597   $ 6,064   $ 162,023   $ (217,039 ) $ 1,405,645


   
Six Months Ended June 30, 2013
       
Insurance &
           
   
Community
 
Financial
           
In thousands
 
Banking
 
Services
 
Parent
 
Eliminations
 
Total
Net interest income
  $ 20,212   $ -   $ (950 ) $ -   $ 19,262
Provision for loan losses
    2,500     -     -     -     2,500
Net interest income after provision for loan losses
    17,712     -     (950 )   -     16,762
Other income
    2,941     2,509     544     (544 )   5,450
Other expenses
    15,525     2,325     794     (544 )   18,100
Income (loss) before income taxes
    5,128     184     (1,200 )   -     4,112
Income tax expense (benefit)
    1,447     66     (411 )   -     1,102
Net income (loss)
    3,681     118     (789 )   -     3,010
Dividends on preferred shares
    -     -     388     -     388
Net income (loss) applicable to common shares
  $ 3,681   $ 118   $ (1,177 ) $ -   $ 2,622
Intersegment revenue (expense)
  $ (490 ) $ (54 ) $ 544   $ -   $ -
                               
Average assets
  $ 1,442,999   $ 6,304   $ 156,502   $ (217,203 ) $ 1,388,602
 
 
41

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)


   
Three Months Ended June 30, 2014
       
Insurance &
           
   
Community
 
Financial
           
In thousands
 
Banking
 
Services
 
Parent
 
Eliminations
 
Total
Net interest income
  $ 10,800   $ -   $ (480 ) $ -   $ 10,320
Provision for loan losses
    1,000     -     -     -     1,000
Net interest income after provision for loan losses
    9,800     -     (480 )   -     9,320
Other income
    1,491     1,214     297     (297 )   2,705
Other expenses
    7,323     1,061     443     (297 )   8,530
Income (loss) before income taxes
    3,968     153     (626 )   -     3,495
Income tax expense (benefit)
    1,205     50     (192 )   -     1,063
Net income (loss)
    2,763     103     (434 )   -     2,432
Dividends on preferred shares
    -     -     193     -     193
Net income (loss) applicable to common shares
  $ 2,763   $ 103   $ (627 ) $ -   $ 2,239
Inter-segment revenue (expense)
  $ (268 ) $ (29 ) $ 297   $ -   $ -
                               
Average assets
  $ 1,467,261   $ 6,149   $ 163,682   $ (218,027 ) $ 1,419,065


 
Three Months Ended June 30, 2013
     
Insurance &
           
 
Community
 
Financial
           
In thousands
Banking
 
Services
 
Parent
 
Eliminations
 
Total
Net interest income
$ 9,986   $ -   $ (482 ) $ -   $ 9,504
Provision for loan losses
  1,000     -     -     -     1,000
Net interest income after provision for loan losses
  8,986     -     (482 )   -     8,504
Other income
  1,497     1,206     272     (272 )   2,703
Other expenses
  8,332     1,129     349     (272 )   9,538
Income (loss) before income taxes
  2,151     77     (559 )   -     1,669
Income tax expense (benefit)
  622     31     (201 )   -     452
Net income (loss)
  1,529     46     (358 )   -     1,217
Dividends on preferred shares
  -     -     194     -     194
Net income (loss) applicable to common shares
$ 1,529   $ 46   $ (552 ) $ -   $ 1,023
Intersegment revenue (expense)
$ (245 ) $ (27 ) $ 272   $ -   $ -
                             
Average assets
$ 1,439,506   $ 6,344   $ 157,189   $ (217,703 ) $ 1,385,336


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.

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.
 
 
42

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

 
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 2.841% for a 3 year period.

A summary of our derivative financial instruments as of June 30, 2014 and December 31, 2013 follows:


 
June 30, 2014
 
Notional
 
Derivative Fair Value
 
Net Ineffective
Dollars in thousands
Amount
 
Asset
 
Liability
 
Hedge Gains/(Losses)
CASH FLOW HEDGES
             
Pay-fixed/receive-variable interest rate swaps
           
      Long term borrowings
$ 110,000   $ -   $ 1,582   $ -
  $ 110,000   $ -   $ 1,582   $ -




 
December 31, 2013
 
Notional
 
Derivative Fair Value
 
Net Ineffective
Dollars in thousands
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   $ -   $ -

43

Summit Financial Group, Inc. and Subsidiaries
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 0.91% for the first six months in 2014 compared to the same period of 2013 while our net interest earnings on a tax equivalent basis increased 5.51%.  Our tax equivalent net interest margin increased 14 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 June 30,
 
Six Months Ended June 30,
In thousands
 
2014
 
2013
 
2014
 
2013
Community banking
  $ 2,763   $ 1,529   $ 5,353   $ 3,681
Insurance & financial services
    103     46     327     118
Parent
    (627 )   (552 )   (1,245 )   (1,177)
Consolidated net income
  $ 2,239   $ 1,023   $ 4,435   $ 2,622


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.
 
 

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations

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 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 2013, 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, 2013.
 

 
45

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 
Insurance Services – During third quarter 2013, 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, 2013, 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 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 June 30, 2014, we had net deferred tax assets of $11.0 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 June 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.
 

 
46

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations

RESULTS OF OPERATIONS

Earnings Summary

Net income applicable to common shares for the six months ended June 30, 2014 increased to $4.4 million, or $0.50 per diluted share as compared to $2.6 million or $0.31 per diluted share for the same period of 2013.  Net income applicable to common shares for the quarter ended June 30, 2014 totaled $2.2 million, or $0.25 per diluted share as compared to $1.0 million, or $0.13 per diluted share for the quarter ended June 30, 2013.  Earnings for both the quarter and six months ended June 30, 2014 were positively impacted by increased net interest income and lower write-downs of foreclosed properties to their estimated fair values.  Included in earnings for the six months ended June 30, 2013 was $129,000 in losses on the sales of assets, primarily foreclosed properties, and $1.9 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 six months of 2014 were 8.42% and 0.69%, respectively, compared with 5.47% and 0.43% 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 $21.1 million for the six months ended June 30, 2014 compared to $20.0 million for the same period of 2013, representing an increase of $1.1 million or 5.5%.  While our tax-equivalent earnings on interest earning assets decreased $460,000, this decrease was more than offset by a reduction in the cost of interest bearing liabilities (see Table II).  Average interest earning assets increased 0.91% from $1.27 billion during the first six months of 2013 to $1.28 billion for the first six months of 2014.  Average interest bearing liabilities increased 0.59% from $1.176 billion at June 30, 2013 to $1.183 billion at June 30, 2014, at an average cost for the first six months of 2014 of 1.37% compared to 1.65% for the same period of 2013.

Our consolidated net interest margin increased to 3.32% for the six months ended June 30, 2014, compared to 3.18% for the same period in 2013. The margin continues to be affected by elevated levels of nonaccruing loans.  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 six months ended June 30, 2014 compared to June 30, 2013, the yields on earning assets decreased 12 basis points, while the cost of our interest bearing funds decreased by 28 basis points.
 
 
47

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations

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.
 
 
48

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations

 
 
Table I - Average Balance Sheet and Net Interest Income Analysis
                   
Dollars in thousands
               
 
For the Six Months Ended
 
June 30, 2014
     
June 30, 2013
 
Average
 
Earnings/
 
Yield/
     
Average
 
Earnings/
 
Yield/
 
Balance
 
Expense
 
Rate
     
Balance
 
Expense
 
Rate
 Interest earning assets
                         
     Loans, net of unearned income (1)
                         
         Taxable
$ 968,221   $ 24,572   5.12 %     $ 955,425   $ 25,569   5.40%
         Tax-exempt (2)
  6,719     241   7.23 %       5,714     203   7.16%
     Securities
                                 
         Taxable
  215,220     2,480   2.32 %       221,998     1,955   1.78%
         Tax-exempt (2)
  79,218     1,815   4.62 %       75,297     1,842   4.93%
     Federal funds sold and interest
                                 
         bearing deposits with other banks
  8,666     4   0.09 %       8,023     3   0.08%
 Total interest earning assets
  1,278,044     29,112   4.59 %       1,266,457     29,572   4.71%
                                   
 Noninterest earning assets
                                 
     Cash & due from banks
  3,841                   4,384          
     Premises and equipment
  20,506                   21,059          
     Other assets
  115,454                   113,334          
     Allowance for loan losses
  (12,200 )                 (16,632 )        
 Total assets
$ 1,405,645                 $ 1,388,602          
                                   
 Interest bearing liabilities
                                 
     Interest bearing demand deposits
$ 188,573   $ 106   0.11 %     $ 176,811   $ 132   0.15%
     Savings deposits
  223,240     707   0.64 %       196,464     597   0.61%
     Time deposits
  527,097     3,763   1.44 %       577,669     4,859   1.70%
     Short-term borrowings
  77,444     111   0.29 %       20,872     26   0.25%
     Long-term borrowings
                                 
        and capital trust securities
  167,013     3,368   4.07 %       204,584     4,001   3.94%
 Total interest bearing liabilities
  1,183,367     8,055   1.37 %       1,176,400     9,615   1.65%
                                   
 Noninterest bearing liabilities
                                 
     and shareholders' equity
                                 
     Demand deposits
  98,525                   94,501          
     Other liabilities
  9,155                   7,632          
     Total liabilities
  1,291,047                   1,278,533          
                                   
     Shareholders' equity - preferred
  9,287                   9,324          
     Shareholders' equity - common
  105,311                   100,745          
 Total liabilities and
                                 
    shareholders' equity
$ 1,405,645                 $ 1,388,602          
 Net interest earnings
      $ 21,057                 $ 19,957    
 Net yield on interest earning assets
            3.32 %                 3.18%
                                   
(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 $698,000 and $695,000 for the periods ended
        June 30, 2014 and June 30, 2013, respectively.
                             
 

 
49

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 
 
Table II - Changes in Interest Margin Attributable to Rate and Volume
             
   
For the Six Months Ended
   
June 30, 2014 versus June 30, 2013
   
Increase (Decrease) Due to Change in:
In thousands
 
Volume
 
Rate
 
Net
Interest earned on:
           
Loans
           
  Taxable
  $ 338   $ (1,335 ) $ (997)
  Tax-exempt
    36     2     38
Securities
                 
  Taxable
    (62 )   587     525
  Tax-exempt
    93     (120 )   (27)
Federal funds sold and interest
                 
  bearing deposits with other banks
    -     1     1
Total interest earned on
                 
  interest earning assets
    405     (865 )   (460)
                   
Interest paid on:
                 
Interest bearing demand
                 
  deposits
    9     (35 )   (26)
Savings deposits
    84     26     110
Time deposits
    (401 )   (695 )   (1,096)
Short-term borrowings
    80     5     85
Long-term borrowings and capital
                 
   trust securities
    (755 )   122     (633)
  Total interest paid on
                 
    interest bearing liabilities
    (983 )   (577 )   (1,560)
                   
Net interest income
  $ 1,388   $ (288 ) $ 1,100

Noninterest Income

Total noninterest income increased to $5.49 million for the first six months of 2014, compared to $5.45 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 June 30,
   
For the Six Months Ended June 30,
Dollars in thousands
2014
 
2013
   
2014
 
2013
Insurance commissions
$ 1,091   $ 1,132     $ 2,273   $ 2,316
Service fees related to deposit accounts
  1,101     1,085       2,144     2,096
Realized securities gains (losses)
  (43 )   (57 )     (64 )   (16)
Other-than-temporary impairment of securities
  (1 )   (27 )     (1 )   (80)
Bank owned life insurance income
  270     236       539     474
Other
  287     334       598     660
Total
$ 2,705   $ 2,703     $ 5,489   $ 5,450



Other-than-temporary impairment of securities:  We do not anticipate material charges for other-than-temporary impairment of securities in the near term.
 
 
50

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations

Noninterest Expense

Total noninterest expense decreased 10.6% for the six months ended June 30, 2014, as compared to the same period in 2013, with lower losses on sales of foreclosed properties and write-downs 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 June 30,
   
For the Six Months Ended June 30,
     
Change
             
Change
     
Dollars in thousands
2014
   $   %       2013       2014    $   %       2013
    Salaries, commissions, and employee benefits
$ 4,045   $ 58   1.5 %   $ 3,987     $ 8,026   $ (79 ) -1.0 %   $ 8,105
    Net occupancy expense
  505     29   6.1 %     476       1,046     114   12.2 %     932
    Equipment expense
  513     (46 ) -8.2 %     559       1,079     (67 ) -5.8 %     1,146
    Professional fees
  282     (78 ) -21.7 %     360       598     (24 ) -3.9 %     622
    Amortization of intangibles
  63     (25 ) -28.4 %     88       150     (26 ) -14.8 %     176
    FDIC premiums
  495     (20 ) -3.9 %     515       997     (58 ) -5.5 %     1,055
    Foreclosed properties expense
  229     (66 ) -22.4 %     295       482     (93 ) -16.2 %     575
     Loss on sales of foreclosed properties
  54     (469 ) -89.7 %     523       129     (434 ) -77.1 %     563
     Write-downs of foreclosed properties
  962     (532 ) -35.6 %     1,494       1,891     (532 ) -22.0 %     2,423
    Other
  1,382     141   11.4 %     1,241       2,630     126   5.0 %     2,504
Total
$ 8,530   $ (1,008 ) -10.6 %   $ 9,538     $ 17,028   $ (1,073 ) -5.9 %   $ 18,101


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 $2.0 million and $2.5 million provisions for loan losses for the first six 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 June 30, 2014 compared to June 30, 2013.
 
 
51

 
Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations

As illustrated in Table V below, our non-performing assets have decreased since year end 2013.


Table V - Summary of Non-Performing Assets
               
   
June 30,
   
December 31,
 Dollars in thousands
 
2014
   
2013
   
2013
 Accruing loans past due 90 days or more
  $ -     $ -     $ -
 Nonaccrual loans
                     
 Commercial
    415       3,996       1,224
 Commercial real estate
    1,537       1,695       2,318
 Commercial construction and development
    3,601       -       3,782
 Residential construction and development
    5,248       11,505       9,048
 Residential real estate
    3,289       13,605       2,446
 Consumer
    129       91       128
     Total nonaccrual loans
    14,219       30,892       18,946
Foreclosed properties
                     
 Commercial
    110       -       -
 Commercial real estate
    5,762       10,310       9,903
 Commercial construction and development
    10,363       11,492       11,125
 Residential construction and development
    20,557       21,591       20,485
 Residential real estate
    11,991       3,865       11,879
     Total foreclosed properties
    48,783       47,258       53,392
 Repossessed assets
    -       2       8
 Total nonperforming assets
  $ 63,002     $ 78,152     $ 72,346
                       
 Total nonperforming loans as a percentage of total loans
    1.42 %     3.29 %     1.99%
 Total nonperforming assets as a percentage of total assets
    4.39 %     5.70 %     5.22%
Allowance for loan losses as a percentage of nonperforming loans
    77.40 %     55.10 %     66.82%
Allowance for loan losses as a percentage of period end loans
    1.10 %     1.14 %     1.33%


The following table details the activity regarding our foreclosed properties for the three months and six months ended June 30, 2014 and 2013.


Table VI - Foreclosed Property Activity
For the Three Months Ended
   
For the Six Months Ended
 
June 30,
   
June 30,
Dollars in thousands
2014
 
2013
   
2014
 
2013
Beginning balance
$ 52,241   $ 54,625     $ 53,392   $ 56,172
   Acquisitions
  672     1,467       1,949     2,798
   Improvements
  39     34       39     107
   Disposals
  (3,207 )   (7,374 )     (4,706 )   (9,396)
   Writedowns to fair value
  (962 )   (1,494 )     (1,891 )   (2,423)
Balance June 30
$ 48,783   $ 47,258     $ 48,783   $ 47,258
 

The following table details our most significant nonperforming loan relationships at June 30, 2014.

 
Table VII - Significant Nonperforming Loan Relationships
June 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
$ 3,000  
Collateral value
$ 4,617 (1 ) $ -   $ 5,424
Eastern Panhandle WV
Commercial development
Aug. 2006 & Apr. 2007
Aug. 2013
$ 3,601  
Collateral Value
$ 5,979 (1 ) $ -   $ -
                                 
(1) - Values are based upon recent external appraisal.
                         
 
 
52

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 
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.

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.
 
 
53

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations

 
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 June 30, 2014, approximately 78% of our impaired loans required no reserves or have been charged down to their fair value.

At June 30, 2014, December 31, 2013, and June 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 $14.1 million, or 1.50% of total loans, respectively, and is considered adequate to cover our estimate of probable credit losses inherent in our loan portfolio.

At June 30, 2014, December 31, 2013, and June 30, 2013, we had approximately $48.8 million, $53.4 million and $47.3 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.
 
 
54

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations

FINANCIAL CONDITION

Our total assets were $1.436 billion at June 30, 2014, compared to $1.387 billion at December 31, 2013, representing a 3.6% increase.  Table VIII below serves to illustrate significant changes in our financial position between December 31, 2013 and June 30, 2014.


Table VIII - Summary of Significant Changes in Financial Position
                   
   
Balance
           
Balance
   
December 31,
 
Increase (Decrease)
   
June 30,
 Dollars in thousands
 
2013
 
Amount
 
Percentage
   
2014
 Assets
                 
   Securities available for sale
  $ 288,780     (897 ) -0.3 %   $ 287,883
   Loans, net of unearned interest
    937,070     55,746   5.9 %     992,816
                         
 Liabilities
                       
   Deposits
  $ 1,003,812   $ 53,983   5.4 %   $ 1,057,795
   Short-term borrowings
    62,769     28,960   46.1 %     91,729
   Long-term borrowings
    163,516     (41,574 ) -25.4 %     121,942


Loan growth of 5.9% during the first six months of 2014 occurred principally in the commercial real estate and residential real estate portfolios, and was funded primarily with deposits.
 
Deposits increased approximately $54.0 million during the first six months of 2014; savings deposits increased approximately $49.9 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 six 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 June 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 $617 million or 42.97% of total consolidated assets at June 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 $479 million.  As of June 30, 2014 and December 31, 2013, these advances totaled approximately $127 million and $136 million, respectively.  At June 30, 2014, we had additional borrowing capacity of $352 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 June 30, 2014 was approximately $94 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.
 
 
55

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 
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 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 June 30, 2014 totaled $117.5 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.
 
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.
 
 
56

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations

CONTRACTUAL CASH OBLIGATIONS

During our normal course of business, we incur contractual cash obligations.  The following table summarizes our contractual cash obligations at June 30, 2014.



Table IX - Contractual Cash Obligations
 
Long
 
Capital
   
   
Term
 
Trust
 
Operating
Dollars in thousands
 
Debt
 
Securities
 
Leases
2014
  $ 43,952   $ -   $ 125
2015
    11,909     -     128
2016
    28,911     -     90
2017
    918     -     45
2018
    45,017     -     -
Thereafter
    8,035     19,589     -
Total
  $ 138,742   $ 19,589   $ 388



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 June 30, 2014 are presented in the following table.


Table X - Off-Balance Sheet Arrangements
 
June 30,
Dollars in thousands
 
2014
Commitments to extend credit:
   
    Revolving home equity and
   
        credit card lines
  $ 51,340
    Construction loans
    22,618
    Other loans
    43,683
Standby letters of credit
    1,668
Total
  $ 119,309



57

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 
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 June 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.
 

 

Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 

 
 
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 % -0.22 % 1.02%
Up 200 basis points (1)
-10 % -4.51 % -5.70%
Up 400 basis points (2)
-15 % -3.57 % -10.82%
           
(1) assumes a parallel shift in the yield curve over 12 months
   
(2) assumes a parallel shift in the yield curve over 24 months
   







59

 
Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations



CONTROLS AND PROCEDURES

Our management, including the Chief Executive Officer and Chief Financial Officer, has conducted as of June 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 June 30, 2014 were effective.  There were no changes in our internal control over financial reporting that occurred during the quarter ended June 30, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.


Summit Financial Group, Inc. and Subsidiaries
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)
 
 

 


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:  August  8, 2014
     






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.