Attached files

file filename
EX-31.2 - SECTION 302 CFO CERTIFICATION - TOWER BANCORP INCdex312.htm
EX-10.2 - LIMITED WAIVER DATED MAY 5, 2010 - TOWER BANCORP INCdex102.htm
EX-31.1 - SECTION 302 CEO CERTIFICATION - TOWER BANCORP INCdex311.htm
EX-32.2 - SECTION 906 CFO CERTIFICATION - TOWER BANCORP INCdex322.htm
EX-32.1 - SECTION 906 CEO CERTIFICATION - TOWER BANCORP INCdex321.htm
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 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: March 31, 2010

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: 001-34277

 

 

LOGO

(Exact name of registrant as specified in its charter)

 

 

 

Pennsylvania   25-1445946

(State or other jurisdiction

of incorporation)

 

(IRS Employer

Identification Number)

 

112 Market Street, Harrisburg, Pennsylvania   17101
(Address of principal executive office)   (Zip Code)

(717) 231-2700

(Registrant’s telephone number, including area code)

 

 

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

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

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

 

Large accelerated filer   ¨    Accelerated filer   x
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)    Smaller reporting company   ¨

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

 

 

 


Table of Contents

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 7,130,734 shares of common stock outstanding at April 28, 2010

TABLE OF CONTENTS

 

    Description    Page
PART I  

FINANCIAL INFORMATION

  
Item 1.  

Financial Statement

   3
 

Consolidated Balance Sheets

   3
 

Consolidated Statements of Operations

   4
 

Consolidated Statements of Shareholders’ Equity and Comprehensive Income (Loss)

   5
 

Consolidated Statements of Cash Flows

   6
Item 2.  

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

   27
Item 3.  

Quantitative and Qualitative Disclosures About Market Risk

   40
Item 4.  

Controls and Procedures

   45
PART II  

OTHER INFORMATION

  
Item 1.  

Legal Proceedings

   46
Item 1A.  

Risk Factors

   46
Item 2.  

Unregistered Sales of Equity Securities and Use of Proceeds

   48
Item 3.  

Defaults Upon Senior Securities

   48
Item 4.  

(Removed and Reserved)

   48
Item 5.  

Other Information

   48
Item 6.  

Exhibits

   49
 

Signatures

   50
 

Exhibit Index

   51

 

2


Table of Contents

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements

Tower Bancorp, Inc. and Subsidiary

Consolidated Balance Sheets

March 31, 2010 and December 31, 2009

(Amounts in thousands, except share data)

 

     March 31,     December 31,  
     2010     2009  
     (unaudited)        

Assets

    

Cash and due from banks

   $ 85,545      $ 33,955   

Federal funds sold

     10,621        16,645   
                

Cash and cash equivalents

     96,166        50,600   

Securities available for sale

     195,305        189,853   

Restricted investments

     6,254        6,254   

Loans held for sale

     6,103        8,034   

Loans, net of allowance for loan losses of $10,892, and $9,695

     1,151,320        1,128,576   

Premises and equipment, net

     29,133        29,810   

Premises and equipment held for sale, net

     549        —     

Accrued interest receivable

     5,052        4,974   

Deferred tax asset, net

     1,577        1,742   

Bank owned life insurance

     24,898        24,606   

Goodwill

     11,935        11,935   

Other intangible assets, net

     3,190        3,367   

Other assets

     10,690        10,832   
                

Total Assets

   $ 1,542,172      $ 1,470,583   
                

Liabilities and Stockholders’ Equity

    

Liabilities

    

Deposits:

    

Non-interest bearing

   $ 121,868      $ 119,116   

Interest bearing

     1,154,633        1,097,353   
                

Total deposits

     1,276,501        1,216,469   

Securities sold under agreements to repurchase

     5,119        6,892   

Short-term borrowings

     5,284        5,292   

Long-term debt

     77,581        65,689   

Accrued interest payable

     1,184        1,090   

Other liabilities

     12,116        11,274   
                

Total Liabilities

     1,377,785        1,306,706   
                

Stockholders’ Equity

    

Common stock, no par value; 50,000,000 shares authorized; 7,234,092 issued and 7,130,734 outstanding at March 31, 2010, 7,226,041 shares issued and 7,122,683 outstanding at December 31, 2009

     —          —     

Additional paid-in capital

     172,686        172,409   

Accumulated deficit

     (4,114     (4,025

Accumulated other comprehensive loss

     (92     (414

Less: cost of treasury stock, 103,358 at March 31, 2010 and December 31, 2009

     (4,093     (4,093
                

Total Stockholders’ Equity

     164,387        163,877   
                

Total Liabilities and Stockholders’ Equity

   $ 1,542,172      $ 1,470,583   
                

See Notes to the Consolidated Financial Statements

 

3


Table of Contents

Tower Bancorp, Inc. and Subsidiary

Consolidated Statements of Operations

Three Months Ended March 31, 2010 and 2009

(Amounts in thousands, except share data)

 

     Three Months Ended March 31,  
     2010    2009  
     (unaudited)    (unaudited)  

Interest Income

     

Loans, including fees

   $ 16,506    $ 8,288   

Securities

     1,036      129   

Federal funds sold and other

     33      6   
               

Total Interest Income

     17,575      8,423   

Interest Expense

     

Deposits

     4,609      3,763   

Short-term borrowings

     93      32   

Long-term debt

     824      254   
               

Total Interest Expense

     5,526      4,049   
               

Net Interest Income

     12,049      4,374   

Provision for Loan Losses

     1,450      2,366   
               

Net Interest Income after Provision for Loan Losses

     10,599      2,008   

Non-Interest Income

     

Service charges on deposit accounts

     740      217   

Other service charges, commissions and fees

     526      234   

Gain on sale of mortgage loans originated for sale

     273      267   

Gain on sale of other interest earnings assets

     24      —     

Income from bank owned life insurance

     321      164   

Other income

     120      66   
               

Total Non-Interest Income

     2,004      948   

Non-Interest Expenses

     

Salaries and employee benefits

     5,099      2,517   

Occupancy and equipment

     1,696      732   

Amortization of intangible assets

     177      —     

FDIC insurance premiums

     398      180   

Advertising and promotion

     135      77   

Data processing

     511      195   

Professional service fees

     441      254   

Other operating expenses

     1,266      513   

Merger related expenses

     111      1,306   
               

Total Non-Interest Expenses

     9,834      5,774   
               

Net Income (Loss) Before Income Tax Expense (Benefit)

     2,769      (2,818
               

Income Tax Expense (Benefit)

     864      (933
               

Net Income (Loss)

   $ 1,905    $ (1,885
               

Net Income (Loss) Per Common Share

     

Basic

   $ 0.27    $ (0.68

Diluted

   $ 0.27    $ (0.68

Dividends declared

   $ 0.28    $ —     

Weighted Average Common Shares Outstanding

     

Basic

     7,125,253      2,765,717   

Diluted

     7,130,335      2,765,717   

See Notes to the Consolidated Financial Statements

 

4


Table of Contents

Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income

Three months ended March 31, 2010 and 2009

(Amounts in thousands, except share data)

 

     Common
Stock
   Additional
Paid-in
Capital
   Accumulated
Deficit
    Accumulated
Other
Comprehensive
Income (Loss)
    Treasury
Stock
    Total  

Balance—December 31, 2008

   $ —      $ 57,547    $ (2,909   $ 147      $ —        $ 54,785   

Restricted common stock awards earned

        295            295   

Stock Option Expense

        549            549   

Fair Value of Consideration Exchanged in Merger

        61,946          (4,093     57,853   

Comprehensive Income:

              

Net Income

           (1,885         (1,885

Unrealized loss on securities available for sale, net of taxes of $21

             (41       (41
                    

Total Comprehensive Income

                 (1,926
                                              

Balance—March 31, 2009 (unaudited)

   $ —      $ 120,337    $ (4,794   $ 106      $ (4,093   $ 111,556   
                                              

Balance—December 31, 2009

   $ —      $ 172,409    $ (4,025   $ (414   $ (4,093   $ 163,877   

Stock issued as investment in DDMP

        51            51   

Stock Option Expense

        28            28   

Proceeds from stock purchase plans

        198            198   

Dividends declared

           (1,994         (1,994

Comprehensive Income:

              

Net Income

           1,905            1,905   

Unrealized gain on securities available for sale, net of taxes of $166

             322          322   
                    

Total Comprehensive Income

                 2,227   
                                              

Balance—March 31, 2010 (unaudited)

   $ —      $ 172,686    $ (4,114   $ (92   $ (4,093   $ 164,387   
                                              

See Notes to the Consolidated Financial Statements

 

5


Table of Contents

Consolidated Statements of Cash Flows

Three Months ended March 31, 2010 and 2009

(Amounts in thousands, except share data)

 

     2010     2009  

Cash Flows from Operating Activities

    

Net income (loss)

   $ 1,905      $ (1,885

Adjustments to reconcile net loss to net cash (used in) provided by operating activities:

    

Provision for loan losses

     1,450        2,366   

Net accretion on securities and loans

     (169     (45

Depreciation and amortization

     646        209   

Amortization of intangible assets

     177        —     

Amortization of unearned compensation on restricted stock

     —          295   

Stock option expense

     28        549   

Deferred tax benefit

     —          (844

(Increase) decrease in accrued interest receivable

     (78     114   

Increase (decrease) in accrued interest payable

     94        (278

Net increase in the cash surrender value of life insurance

     (292     (164

Decrease (increase) in other assets

     193        (434

Increase (decrease) in other liabilities

     842        (3,767

Gain on sale of loans originated for sale and other interest earning assets

     (297     (267

Loans originated for sale

     (21,198     (26,169

Sale of loans

     23,402        24,532   
                

Net Cash Provided by (Used in) Operating Activities

     6,703        (5,788
                

Cash Flows from Investing Activities

    

Proceeds from maturities and sales of securities available for sale

     39,809        6,496   

Purchases of securities available for sale

     (44,431     —     

Net increase in loans

     (24,344     (24,296

Purchases of premises and equipment

     (518     (558

Net cash received in Merger

     —          9,017   
                

Net Cash Used in Investing Activities

     (29,484     (9,341
                

Cash Flows from Financing Activities

    

Net proceeds from advances on long-term debt

     11,892        100   

Net decrease in short-term borrowings

     (8     (33,936

Net (decrease) increase in securities sold under agreements to repurchase

     (1,773     1,314   

Net increase in deposits

     60,032        72,365   

Proceeds from the sale of common stock

     198        —     

Dividends paid

     (1,994     —     
                

Net Cash Provided by Financing Activities

     68,347        39,843   
                

Net Increase in Cash and Cash Equivalents

     45,566        24,714   

Cash and Cash Equivalents - Beginning

     50,600        32,022   
                

Cash and Cash Equivalents - Ending

   $ 96,166      $ 56,736   
                

 

6


Table of Contents

Supplemental disclosure of information:

     

Interest paid

   $ 5,432    $ 4,327   

Income taxes paid

   $ 750    $ —     

Supplemental schedule of noncash investing and financing activities

     

Other real estate acquired in settlement of loan

   $ 266    $ 674   

Unrealized gain (loss) on investments securities available for sale

   $ 488    $ (63

See Notes to the Consolidated Financial Statements

 

7


Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

March 31, 2010 (Unaudited)

(Amounts in thousands, except share data)

Note 1 - Summary of Significant Accounting Policies

Organization and Nature of Operations

Tower Bancorp, Inc. (the “Company”) is a registered bank holding company that was incorporated in 1983 under the Bank Holding Company Act of 1956, as amended. On March 31, 2009, the Company merged with Graystone Financial Corp. (“Graystone”), a privately held, non-reporting corporation and a registered bank holding company under the Bank Holding Company Act of 1956, as amended (the “Merger”). Pursuant to an Agreement and Plan of Merger between the Company and Graystone (the “Merger Agreement”), the Company remains the surviving bank holding company and the First National Bank of Greencastle has merged with and into Graystone Bank, the wholly-owned subsidiary of Graystone, with Graystone Bank as the surviving institution under the name “Graystone Tower Bank” (the “Bank Merger”). Graystone Tower Bank (the “Bank”) operates as the sole subsidiary of the Company through two divisions – “Graystone Bank, a division of Graystone Tower Bank”, consisting of the former Graystone Bank branches, and “Tower Bank, a division of Graystone Tower Bank,” consisting of the former branches of The First National Bank of Greencastle.

On December 27, 2009, Tower Bancorp, Inc. and First Chester County Corporation (“First Chester”) entered into an Agreement and Plan of Merger (the “FCEC Acquisition Agreement”) pursuant to which Tower will acquire First Chester in an all-stock transaction valued at approximately $65 million or $10.22 per share based on the closing price of Tower common stock at the announcement of this acquisition. In the acquisition, First Chester shareholders will receive 0.453 shares of Tower common stock for each share of First Chester common stock they hold on the effective date of the acquisition. As described in the definitive agreement, the exchange ratio is subject to upward or downward adjustment if loan delinquencies at First Chester increase or decrease beyond specified amounts.

As part of the definitive agreement, Tower’s subsidiary bank, Graystone Tower Bank, agreed to increase its lending facility with First Chester to up to $26 million as well as to purchase up to $100 million of residential mortgage and commercial loans from First National Bank of Chester County (“FNB”) in order for the bank to satisfy the regulatory capital requirements of the Office of the Comptroller of the Currency (the “OCC”). As of March 31, 2010, the Bank has loaned $26 million to First Chester. The Bank has also purchased approximately $52 million in performing commercial loans from First National Bank of Chester County during the fourth quarter of 2009.

On March 4, 2010, the FCEC Acquisition Agreement was amended between Tower and First Chester. As part of the amended agreement, First Chester shall use its best efforts to sell at or prior to the effective date of the acquisition, the American Home Bank Division of FNB (“AHB Division”) to one or more purchasers on terms and conditions acceptable to both First Chester and Tower. The AHB Division engages in mortgage-banking activities on a nation-wide basis. Additionally, we extended a $2 million non-revolving line of credit to First Chester, which permits draws from time to time for the sole purpose of contributing additional capital to FNB in the event that, as a result of the attempt to sell the AHB Division, the actual sale thereof, or the effects on FNB of such sale, FNB’s regulatory capital ratios, as reported in FNB’s quarterly call report, fall below the minimum regulatory capital ratios applicable to FNB.

Following the transaction, based on the 0.453 exchange ratio, current Tower shareholders will own approximately 71% and First Chester shareholders will own approximately 29% of the combined company’s common stock. Pending regulatory approvals and approvals of shareholder of both entities, the acquisition is expected to be completed during the middle of 2010.

Basis of Presentation

The merger between the Company and Graystone was considered a “merger of equals” and was accounted for as a reverse merger using the acquisition method of accounting with Graystone as the accounting acquirer. As a result, the historical financial information included in the Company’s financial statements and related footnotes as reported in this Form 10-Q is that of Graystone.

The accompanying unaudited consolidated financial statements of the Company have been prepared in conformity with U.S. generally accepted accounting principles (U.S. GAAP), the instructions for Form 10-Q, and Article 10 of Regulation S-X. Accordingly, they do not include all information and footnotes required by U.S. GAAP for a complete presentation of

 

8


Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements—(Continued)

March 31, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

consolidated financial statements. In the opinion of management, all adjustments, consisting of normal recurring adjustments, considered necessary for fair presentation are included. The operating results for the three month periods ended March 31, 2010 are not necessarily indicative of results that may be expected for any other period or for the full year ending December 31, 2010. The accounting policies discussed within the notes to the unaudited consolidated financial statements are followed consistently by the Company. These policies are in accordance with U.S. GAAP and conform to common practices in the banking industry.

The accompanying unaudited consolidated financial statements include the accounts of Tower Bancorp, Inc. and its wholly-owned subsidiary, Graystone Tower Bank and the Bank’s 90% owned mortgage subsidiary, Graystone Mortgage, LLC. All intercompany accounts and transactions are eliminated from the unaudited consolidated financial statements.

Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management 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 from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the potential other-than-temporary impairment of investments, and the valuation of deferred tax assets.

Significant Group Concentrations of Credit Risk

Most of the Company’s activities are with customers located within central Pennsylvania and Washington County, Maryland. Note 3 discusses the types of securities in which the Company invests. Note 4 discusses the types of lending in which the Company engages. The Company does not have any significant concentrations to any one industry or customer.

Recent Accounting Pronouncements

In January 2010, the FASB issued an Accounting Standard Codification Update for improving disclosures about fair value measurements. This update requires companies to disclose, and provide the reasons for, all transfers of assets and liabilities between the Level 1 and 2 fair value categories. It also clarifies that companies should provide fair value measurement disclosures for classes of assets and liabilities which are subsets of line items within the balance sheet, if necessary. In addition, the update clarifies that companies provide disclosures about the fair value techniques and inputs for assets and liabilities classified within Level 2 or 3 categories. The disclosure requirements prescribed by this update are effective for fiscal years beginning after December 15, 2009, and for interim periods within those fiscal years, or March 31, 2010 for the Company. The Company has implemented the disclosure requirements of this update within this Form 10-Q which can be found in Note 11 of the Notes to the Unaudited Consolidated Financial Statements. This update also requires companies to reconcile changes in Level 3 assets and liabilities by separately providing information about Level 3 purchases, sales, issuances and settlements on a gross basis. This provision of this update is effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years, or March 31, 2011 for the Company. The adoption of this update is not expected to materially impact the Company’s fair value measurement disclosures.

In June 2009, the FASB issued a pronouncement that amends the derecognition guidance in U.S. GAAP and eliminates the concept of qualifying special-purpose entities (“QSPE”s). This pronouncement is effective for fiscal years and interim periods beginning after November 15, 2009 and early adoption is prohibited. We have adopted this pronouncement on January 1, 2010, which did not have a material effect on the consolidated financial statements for the period ended March 31, 2010.

In June 2009, the FASB issued a pronouncement, which amends the consolidation guidance applicable to variable interest entities (“VIE”s). An entity would consolidate a VIE, as the primary beneficiary, when the entity has both of the following characteristics: (a) the power to direct the activities of a VIE that most significantly impact the entity’s economic performance and (b) the obligation to absorb losses of the entity that could potentially be significant to the VIE or the right to receive benefits from the entity that could potentially be significant to the VIE. Ongoing reassessment of whether an enterprise is the primary beneficiary of a VIE is required. This pronouncement eliminates the quantitative approach previously required for determining the primary beneficiary of a VIE. The pronouncement is effective for fiscal years and

 

9


Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements—(Continued)

March 31, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

interim periods beginning after November 15, 2009. We have adopted this pronouncement on January 1, 2010, which did not have a material effect on the consolidated financial statements for the period ended March 31, 2010.

In December 2007, the FASB issued a pronouncement that establishes accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. The guidance became effective as of January 1, 2009. The adoption of this pronouncement did not have a material impact to our consolidated financial statements. In January 2010, the FASB issued updated guidance relating to the decrease in ownership of a subsidiary. The updated guidance is effective at the beginning of the first interim or annual reporting period ending on or after December 15, 2009 and should be applied retrospectively. We have adopted this pronouncement on January 1, 2010, which did not have a material effect on the consolidated financial statements for the period ended March 31, 2010.

Note 2 – Merger Accounting

On November 13, 2008, Graystone and the Company announced the execution of an agreement of merger, providing for the merger of Graystone with and into the Company. The Merger became effective prior to the start of business on March 31, 2009. The Merger has been accounted for as a reverse merger using the acquisition method of accounting. For accounting purposes, Graystone is considered to be acquiring Tower in this transaction with the surviving legal entity operating under Tower Bancorp, Inc.’s articles of incorporation. Immediately following the holding company merger, the Company’s wholly-owned subsidiary, The First National Bank of Greencastle, merged with and into Graystone Bank, the wholly-owned subsidiary of Graystone, under the name “Graystone Tower Bank.” Graystone Tower Bank is, therefore, the wholly owned subsidiary of Tower Bancorp, Inc. and operates under the prior Graystone Bank charter.

The Merger generated goodwill of $11,935, consisting of synergies and increased economies of scale such as the ability to offer more diverse and more profitable products, added diversity to the branch system to achieve lower cost deposits, an increased legal lending limit, etc. Management expects that no goodwill recognized as a result of the Merger will be deductible for income tax purposes. Goodwill totaled $11,935 as of both March 31, 2010 and December 31, 2009. The Company tests goodwill for impairment annually as of October 31 and intermittently as events occur that would indicate that a potential impairment of goodwill had occurred. The Company experienced no events during the first quarter of 2010 that required the completion of a goodwill impairment test.

The following table shows the pro forma financial results for the Company and Graystone for the three months ended March 31, 2009, assuming that the Merger occurred on January 1, 2009:

 

     Pro-forma  
     March 31, 2009  

Net interest income

   $ 9,687   

Pre-tax net income

     (1,919

Income tax expense

     (1,147

Net income

     (772

Pro-forma earnings per share:

  

Basic

   $ (0.11

Diluted

   $ (0.11

 

10


Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements—(Continued)

March 31, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

Note 3 - Securities Available for Sale

The amortized cost of securities and their approximate fair values at March 31, 2010 and December 31, 2009 are as follows:

 

     Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
    Fair Value
     March 31, 2010

Equity securities

   $ 740    $ 5    $ (66   $ 679

U.S Government sponsored agency securities

     62,650      96      (104     62,642

U.S. Government sponsored agency mortgage-backed securities

     8,046      21      (28     8,039

Collateralized mortgage obligations

     89,170      35      (382     88,823

Municipal bonds

     11,502      115      (43     11,574

Municipal bonds – taxable

     12,893      288      (35     13,146

SBA Pool Loan Investments

     10,443      —        (41     10,402
                            
   $ 195,444    $ 560    $ (699   $ 195,305
                            
     December 31, 2009

Equity securities

   $ 1,156    $ 20    $ (44   $ 1,132

U.S Government sponsored agency securities

     56,437      12      (65     56,384

U.S. Government sponsored agency mortgage-backed securities

     9,109      37      (30     9,116

Collateralized mortgage obligations

     93,058      81      (654     92,485

Municipal bonds

     7,093      95      —          7,188

Municipal bonds – taxable

     12,917      64      (71     12,910

SBA Pool Loan Investments

     10,710      —        (72     10,638
                            
   $ 190,480    $ 309    $ (936   $ 189,853
                            

Included with the Company’s securities available for sale are pledged securities with a fair market value of $54,488 and $34,999 at March 31, 2010 and December 31, 2009, respectively. The securities were pledged to secure public deposits and securities sold under agreements to repurchase.

The amortized cost and fair value of available for sale securities as of March 31, 2010 by contractual maturity are shown below. Expected maturities may differ from contractual maturities due to the issuer’s rights to call or prepay the obligation without penalty.

 

     March 31, 2010
     Amortized Cost    Fair Value

Due in one year or less

   $ 435    $ 439

Due after one year through five years

     38,940      39,144

Due after five years through ten years

     35,982      36,052

Due after ten years

     11,688      11,727
             
     87,045      87,362
             

Mortgage-backed securities (1)

     107,659      107,264

Equity securities

     740      679
             
   $ 195,444    $ 195,305
             

 

(1) Mortgage-backed securities include agency mortgage-backed securities, Government National Mortgage Association collateralized mortgage and Small Business Agency Loan Pools obligations.

 

11


Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements—(Continued)

March 31, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

The following table presents information related to the Company’s gains and losses on the sales of equity and debt securities, and losses recognized for other-than-temporary impairment of investments.

 

     Year Ended March 31,
     Gross
Realized
Gains
   Gross
Realized
Losses
    Other-than-
temporary
Impairment
Losses
   Net (Losses)
Gains

2010

          

Equity securities

   $ 24    $ (3   $ —      $ 21

Debt securities

     3      —          —        3
                            

Total

   $ 27    $ (3   $ —      $ 24
                            

2009

          

Equity securities

   $ —      $ —        $ —      $ —  

Debt securities

     —        —          —        —  
                            

Total

   $ —      $ —        $ —      $ —  
                            

The following table shows gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at March 31, 2010 and December 31, 2009:

 

     Less Than 12 Months    12 Months or More    Total
     Fair Value    Unrealized
Losses
   Fair Value    Unrealized
Losses
   Fair Value    Unrealized
Losses
     March 31, 2010

Equity securities

   $ 491    $ 66    $ —      $ —      $ 491    $ 66

U.S Government sponsored agency securities

     14,891      104      —        —        14,891      104

U.S. Government sponsored agency mortgage-backed securities

     6,570      28      —        —        6,570      28

Collateralized mortgage obligations

     53,770      382      —        —        53,770      382

Municipal bonds

     2,938      43      —        —        2,938      43

Municipal bonds – taxable

     1,977      35      —        —        1,977      35

SBA Pool Loan Investments

     10,402      41      —        —        10,402      41
                                         
   $ 91,039    $ 699    $ —      $ —      $ 91,039    $ 699
                                         
     December 31, 2009

Equity securities

   $ 417    $ 44    $ —      $ —      $ 417    $ 44

U.S Government sponsored agency securities

     47,101      65      —        —        47,101      65

U.S. Government sponsored agency mortgage-backed securities

     7,275      30      —        —        7,275      30

Collateralized mortgage obligations

     70,991      654      —        —        70,991      654

Municipal bonds

     —        —        —        —        —        —  

Municipal bonds – taxable

     6,955      71      —        —        6,955      71

SBA Pool Loan Investments

     10,710      72      —        —        10,710      72
                                         
   $ 143,449    $ 936    $ —      $ —      $ 143,449    $ 936
                                         

 

12


Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements—(Continued)

March 31, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

The previous table represents 26 investment securities at March 31, 2010 where the current fair value is less than the related amortized cost. There were 36 investment securities at December 31, 2009 that had a current fair value less than the related amortized cost. Management evaluates all securities for other-than-temporary impairment at least on a monthly basis. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Management does not have the intent is to sell these investments and believes it is more likely than not, that it will not sell the securities prior to the recovery of their cost basis or maturity unless market, economic or specific investment concerns warrant a sale of securities. Management believes these impairments to be temporary in nature for all cases.

Note 4 – Loans

The following table presents a summary of the loan portfolio at March 31, 2010 and December 31, 2009:

 

     March 31,     December 31,  
     2010     2009  

Commercial

   $ 892,534      $ 861,673   

Consumer & other

     84,786        85,510   

Residential mortgage

     185,040        191,277   
                

Total Loans

     1,162,360        1,138,460   

Deferred costs (fees)

     (148     (189

Allowance for loan losses

     (10,892     (9,695
                

Net Loans

   $ 1,151,320      $ 1,128,576   
                

The Company serviced $111,843 and $111,649 of participation loans for unrelated parties at March 31, 2010 and December 31, 2009, respectively.

The Company sold $23,402 and $24,532 of residential mortgage loans into the secondary market during the three months ended March 31, 2010 and 2009, respectively. A gain of $273 and $267 was recognized on the sale of these loans for the three month periods ended March 31, 2010 and 2009, respectively.

The following table presents the components of the allowance for credit losses as of March 31, 2010 and December 31, 2009:

 

     March 31,    December 31,
     2010    2009

Allowance for loan losses

   $ 10,892    $ 9,695

Credit quality adjustment on loans purchased

     2,519      2,942
             

Allowance for credit losses

   $ 13,411    $ 12,637
             

 

13


Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements—(Continued)

March 31, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

Changes in the allowance for loan losses were as follows for the three months ended March 31, 2010 and 2009:

 

     March 31,  
     2010     2009  

Balance at beginning of period

   $ 9,695      $ 6,017   

Provision for loan losses

     1,450        2,366   

Charge-offs

    

Commercial

     (297     (563

Consumer

     —          (59

Residential mortgage

     —          —     
                

Total Charge-offs

     (297     (622

Recoveries

    

Commercial

     44        —     

Consumer

     —          —     

Residential mortgage

     —          —     
                

Total Recoveries

     44        —     
                

Net charge-offs

     (253     (622
                

Balance at end of period

   $ 10,892      $ 7,761   
                

Changes in the credit quality adjustment on loans purchased were as follows for the three months ended March 31, 2010 and 2009:

 

     March 31,
     2010     2009

Balance at beginning of period

   $ 2,942      $ —  

Credit fair value adjustment mark

     —          4,044

Amortization

     (150     —  

Charge-offs

    

Commercial

     (139     —  

Consumer

     (65     —  

Residential mortgage

     (93     —  
              

Total Charge-offs

     (297     —  

Recoveries

    

Commercial

     3        —  

Consumer

     20        —  

Residential mortgage

     1        —  
              

Total Recoveries

     24        —  
              

Net charge-offs

     (273     —  
              

Balance at end of period

   $ 2,519      $ 4,044
              

 

14


Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements—(Continued)

March 31, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

Acquired loans deemed to be impaired at the time of purchase in accordance with Accounting Standard Codification 310-30-30, previously known as Statement of Position (SOP) 03-3, “Accounting for Certain Loans Acquired in a Transfer” are included in the balance of impaired loans. However, these purchased impaired loans have been recorded at their fair value based on anticipated future cash flows at the time of acquisition and are considered to be performing loans as we expect to fully collect the new carrying value (i.e. fair value) of the loans.

The following table presents non-performing assets as of March 31, 2010 and December 31, 2009:

 

     March 31,    December 31,
     2010    2009

Non-accrual loans

     

Commercial

   $ 9,072    $ 3,408

Consumer

     356      320

Residential mortgage

     1,300      990
             

Total non-accrual loans

     10,728      4,718
             

Accruing loans greater than 90 days past due

     

Commercial

     443      634

Consumer

     —        48

Residential mortgage

     1,214      1,424
             

Total accruing loans greater than 90 days past due

     1,657      2,106
             

Non-performing loans

     12,385      6,824

Other real estate owned

     661      927
             

Non-performing assets

   $ 13,046    $ 7,751
             

The Company had total impaired loans of $16,940 and $10,917 as of March 31, 2010 and December 31, 2009, respectively. Management performed an evaluation of expected future cash flows, including the anticipated cash flow from the sale of collateral, and compared that to the carrying amount of the impaired loans. Based on these evaluations, the Company has determined that a reserve of $2,010 and $451 was required against the impaired loans at March 31, 2010 and December 31, 2009, respectively.

 

15


Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements—(Continued)

March 31, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

Note 5 – Other Intangibles

Information concerning total amortizable other intangible assets at March 31, 2010 and December 31, 2009 is as follows:

 

     Gross Carrying
Amount
   Accumulated
Amortization

Balance at December 31, 2009

   $ 3,899    $ 532

2010 Activity:

     

Core deposit intangibles

     —        177
             

Balance at March 31, 2010

   $ 3,899    $ 709
             

The estimated amortization for the next five years and thereafter is as follows:

 

2010 (April – December)

   $ 479

2011

     585

2012

     513

2013

     444

2014

     372

Thereafter

     797
      
   $ 3,190
      

Note 6 - Deposits

The following is a summary of deposits at March 31, 2010 and December 31, 2009:

 

     March 31,
2010
   December 31,
2009

Non-interest bearing transaction accounts

   $ 121,868    $ 119,116

Interest checking accounts

     118,204      110,356

Money market accounts

     508,708      477,292

Savings accounts

     91,732      87,117

Time deposits of $100,000 or greater

     149,884      130,938

Time deposits, other

     286,105      291,650
             

Total

   $ 1,276,501    $ 1,216,469
             

Brokered deposits totaled $87,441 and $61,114 at March 31, 2010 and December 31, 2009, respectively. Brokered deposits, exclusive of in-market reciprocal brokered deposits, totaled $55,436 and $46,018 at March 31, 2010 and December 31, 2009, respectively.

Note 7 – Borrowings

Federal Home Loan Bank

The Bank has a maximum borrowing capacity under an agreement with the Federal Home Loan Bank (“FHLB”) of approximately $551,896 and $482,024 at March 31, 2010 and December 31, 2009, respectively. The available amount of borrowing capacity for March 31, 2010 and December 31, 2009 was approximately $492,553 and $422,679, respectively. The total outstanding borrowings at March 31, 2010 equaled $59,343, of which $5,250 has a maturity of less than one year and is classified as short-term borrowing. The remaining borrowings of $54,093 have a maturity greater than one year and are classified as long-term debt at March 31, 2010. The average interest rate on FHLB borrowings at March 31, 2010 equaled 3.94%. At March 31, 2010, the unamortized fair value adjustment to FHLB borrowings assumed in the Merger totaled $(187). The total outstanding borrowings at December 31, 2009 equaled $59,346, of which, $54,096 have a stated maturity

 

16


Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements—(Continued)

March 31, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

greater than one year and are classified as long-term debt at December 31, 2009. The remaining $5,250 in FHLB borrowings are classified as short-term borrowings at December 31, 2009.

Other Borrowings

On June 12, 2009, the Company issued, to private investors, $9,000 of subordinated notes bearing an annual interest rate of 9.00%. Each note may be redeemed at the Company’s discretion and contains a maturity date of July 1, 2014. Interest only payments are due on a quarterly basis with the unpaid principal balance due at maturity.

On February 5, 2010, the Company accepted subscriptions for and sold, at 100% of their principal amount, an aggregate of $12,000 of subordinated notes, on a private placement basis, to accredited investors. The investors included a director of the Company and his spouse, who purchased an aggregate of $1,000 in principal amount of the subordinated notes. The notes bear interest, payable on the 15th of January, April, July and October of each year, at a fixed interest rate of 9.00% per year. The notes have a maturity date of July 1, 2015. The notes may be redeemed at the option of the Company, in whole or in part, at any time, without penalty or premium, subject to any required regulatory approvals.

Federal funds are reported on a gross basis. Federal funds sold are stated as assets and federal funds purchased are stated as liabilities. Federal funds purchased are considered short-term borrowings and are subject to restrictions limiting the frequency and terms of advances. Generally, federal funds are purchased or sold for one day periods and bear interest based upon the daily federal funds rate. The Company did not have any federal funds purchased at March 31, 2010 or December 31, 2009.

Capital Lease Obligations

Included in short-term borrowings and long-term debt are two capital lease agreements, which relate to the Lebanon and York branches. Total capital lease obligations related to these leases were $2,709 and $2,729 at March 31, 2010 and December 31, 2009, respectively.

Note 8 - Net Income Per Share and Comprehensive Income

The Company’s basic net income per share is calculated as net income divided by the weighted average number of shares outstanding. For diluted net income per share, net income is divided by the weighted average number of shares outstanding plus the incremental number of shares added as a result of converting common stock equivalents, calculated using the treasury stock method. The Company’s common stock equivalents consist solely of outstanding stock options and restricted stock. The effects of options to issue common stock are excluded from the computation of diluted earnings per share in periods in which the effect would be anti-dilutive.

A reconciliation of the weighted average shares outstanding used to calculate basic net income per share and diluted net income per share follows:

 

     For Three Months Ended
     March 31, 2010    March 31, 2009

Weighted average shares outstanding (basic)

   7,125,253    2,765,717

Impact of common stock equivalents

   5,082    —  
         

Weighted average shares outstanding (diluted)

   7,130,335    2,765,717
         

Common stock equivalents excluded from earnings per share as their effect would have been anti-dilutive

   79,531    117,103
         

Comprehensive income is defined as the change in equity from transactions and other events from non-owner sources. It includes all changes in equity except those resulting from investments by stockholders and distributions to stockholders. Comprehensive income includes net income and accounting for certain investments in debt and equity securities.

 

17


Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements—(Continued)

March 31, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

The Company has elected to report its comprehensive income in the statement of changes in stockholders’ equity. The only element of “other comprehensive income” that the Company has is the unrealized gains or losses on available for sale securities.

The components of the change in net unrealized gains (losses) on securities are as follows:

 

     For Three Months Ended  
     March 31,     March 31,  
     2010     2009  

Gross unrealized holding gains (losses) arising during the year

   $ 512      $ (62

Reclassification adjustment for losses (gains) realized in net income

     (24     —     
                

Net unrealized holding gains (losses) before taxes

     488        (62

Tax effect

     (166     21   
                

Net change

   $ 322      $ (41
                

Note 9 - Financial Instruments with Off-Balance Sheet Risk

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet.

The Company’s 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. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

The outstanding financial instruments represent credit risk in the following amounts at March 31, 2010 and December 31, 2009:

 

     March 31,
2010
   December 31,
2009

Commitments to grant loans

   $ 71,842    $ 12,350

Unfunded commitments under lines of credit

     248,734      267,683

Letters of credit

     24,785      25,524

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. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The Company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation. Collateral held varies but may include personal or commercial real estate, accounts receivable, inventory and equipment.

Outstanding letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank typically requires collateral supporting these letters of credit. Management believes that the

 

18


Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements—(Continued)

March 31, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

proceeds obtained through a liquidation of such collateral would be sufficient to cover the maximum potential amount of future payments required under the corresponding guarantees. The amount of the liability as of March 31, 2010 and December 31, 2009 for guarantees under standby letters of credit issued is not material to the unaudited consolidated financial statements.

Note 10 - Stock-Based Compensation

At March 31, 2010, the Company had four equity compensation plans, the 2006 Restricted Stock Plan (the “2006 Plan”), the 2007 Stock Incentive Plan (the “2007 Plan”), the 1995 Non-Qualified Stock Option Plan (the “1995 Plan”) and the Stock Option Plan for Outside Directors (the “Director Plan”).

During 2006, the shareholders of Graystone approved the 2006 Restricted Stock Plan (the “2006 Plan”), as amended, that provides for the issuance of up to 375,000 shares of restricted stock awards subject to a three year vesting period to key employees and directors. The recipient shall receive all dividends or other distributions and shall have the right to vote with respect to issued but unvested shares. On March 31, 2009, as a result of the Merger, the Company had adopted the provisions of this plan. As of March 31, 2009, the Company had issued all of the available awards under the plan and all of the awards are completely vested as a result of the vesting acceleration in association with the Merger. The Company recognized $0 and $295 of compensation expense during the three month periods ending March 31, 2010 and 2009, respectively, related to the vesting of the restricted stock awards.

In May 2007, the shareholders of Graystone approved the 2007 Stock Incentive Plan (the “2007 Plan”). Under the Plan, Graystone may grant incentive stock options, nonqualified stock options, stock appreciation rights, restricted stock, and deferred stock for up to 600,000 shares (shares reflect the 3-for-2 stock split paid September 30, 2007) of Graystone’s common stock to key employees and directors. On March 31, 2009, as a result of the Merger, the Company had adopted the provisions of this plan. Subsequent to the Merger and as a result of the conversion factor, the total options authorized to be issued under the 2007 Plan equaled 252,000. At March 31, 2010, the Company had 77,705 options available for issuance.

The following table summarizes the outstanding stock options under the Company’s 2007 Plan at March 31, 2010 and December 31, 2009:

 

               Expiration Date    Options Vested    Unearned Compensation (in 000’s)

Date of Issuance

   Options
Issued
   Exercise
Price
      March 31,
2010
   December 31,
2009
   March 31,
2010
   December 31,
2009

June 26, 2007

   26,145    $ 22.22    June 26, 2017    26,145    26,145    $ —      $ —  

January 22, 2008

   1,050    $ 30.96    January 22, 2018    1,050    1,050      —        —  

July 17, 2008

   56,700    $ 30.96    July 17, 2018    56,700    56,700      —        —  

September 22, 2009

   52,400    $ 26.77    September 22, 2019    —      —        302      318

November 24, 2009

   38,000    $ 19.80    November 24, 2019    —      —        173      182
                                  
   174,295          83,895    83,895    $ 475    $ 500
                                  

The stock options normally vest over a three to five year vesting period and will be expensed over the vesting period. As a result of the Merger, all of the outstanding options at March 30, 2009 became fully vested and exercisable. No options issued under this plan have been exercised during the first three months of 2010. The aggregate intrinsic value of outstanding unvested stock options at March 31, 2010 and December 31, 2009 was $265 and $116, respectively. Options granted resulted in compensation expense of $26 and $549 for the three month periods ended March 31, 2010 and 2009, respectively. As of March 31, 2010 and in conjunction with the vesting acceleration due to the Merger, a total of 83,895 options have vested with an intrinsic value of $119. These vested options can be exercised at an average price of $28.24 and have an average remaining life of approximately 8 years. The fair values of the options awarded under the Plan are estimated on the date of grant using the Black-Scholes valuation methodology.

 

19


Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements—(Continued)

March 31, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

Upon the closing of the Merger, all of the issued and outstanding stock options originally issued by Graystone converted to options exercisable for Tower common stock. Additionally, all options became fully vested at the time of conversion. As a result and in accordance with U.S. GAAP, the Company revalued the converted options as of the conversion date. The re-valuation of the converted options did not result in any incremental costs to the Company. The table below shows the assumptions utilized by Management to value all stock options:

 

Date of Issuance

   Dividend
Yield
  Expected
Volatility
  Risk Free
Interest Rate
  Estimated
Forfeitures
  Expected
Life
  Issue-Date
Fair Value

June 26, 2007

   4.49%   32.17%   2.31%   0.00%   6 years   $ 5.75

January 22, 2008

   4.49%   32.17%   2.31%   0.00%   6 years   $ 3.70

July 17, 2008

   4.49%   32.17%   2.31%   1% – 3%   6.5 years   $ 3.80

September 22, 2009

   4.00%   31.84%   3.50%   (1)   (2)   $ 6.63

November 24, 2009

   4.00%   32.63%   3.39%   2.00%   9 years   $ 5.00

 

(1) Estimated forfeitures for stock options issued to executives are 2.00% while the estimated forfeiture for stock options issued to employees is 5.00%.
(2) Expected life for stock options issued to executives is 9 years while estimated expected life for stock options issued to employees is 7 years.

The dividend yield assumption is based on dividend history and the expectation of future dividend yields. The expected volatility is based on historical volatility using the Company’s own stock price. The risk-free rate is the U.S. Treasury zero-coupon rate commensurate with the expected life of the options on the date of the grant.

At March 31, 2010, there were 5,700 options outstanding under the 1995 Plan and the Company recognized $2 in compensation expense related to the 1995 Plan during the three month period ended March 31, 2010. There are a total of 27,719 options available to be issued under this plan at March 31, 2010.

The following table summarizes the outstanding non-qualified stock options under the Company’s 1995 Plan at March 31, 2010 and December 31, 2009:

 

               Expiration Date    Options Vested    Unearned Compensation (in 000’s)

Date of Issuance

   Options
Issued
   Exercise
Price
      March 31,
2010
   December 31,
2009
   March 31,
2010
   December 31,
2009

September 22, 2009

   5,700    $ 26.77    September 22, 2019    —      —      $ 32    $ 34
                                  
   5,700          —      —      $ 32    $ 34
                                  

The assumptions utilized by management to calculate the issue date fair value of $6.63 are the same as the assumptions used for shares issued under the 2007 Plan.

At March 31, 2010, there were a total of 30,958 options outstanding under the Director Plan. The options outstanding are all fully vested, have a weighted average exercise price of $35.80 per share, and have a weighted average life to maturity of 5.4 years. The Company recognized $0 in compensation expense related to the Director Plan during the three month period ended March 31, 2010. There are a total of 50,170 options available to be issued under this plan at March 31, 2010.

Note 11 - Fair Value Measurements

Fair value is the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants on the measurement date. The Company determines the fair value of its financial instruments based on the fair value hierarchy. The Company maximizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value. Observable inputs are inputs that market participants would use in pricing

 

20


Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements—(Continued)

March 31, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

the asset or liability developed based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions that the market participants would use in pricing the asset or liability based on the best information available in the circumstances. Three levels of inputs are used to measure fair value. A financial instrument’s level within the fair value hierarchy is based on the lowest level of input significant to the fair value measurement.

 

  Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

 

  Level 2: Quoted prices in markets that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability.

 

  Level 3: Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported with little or no market activity).

An asset’s or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

For financial assets measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy used at March 31, 2010 are as follows:

 

     March 31,
2010
   Quoted
Prices
(Level 1)
   Significant
Other
Observable
Inputs
(Level 2)
   Significant
Unobservable
Inputs

(Level 3)

Equity securities

   $ 679    $ 190    $ 302    $ 187

U.S Government sponsored agency securities

     62,642      —        62,642      —  

U.S. Government sponsored agency mortgage-backed securities

     8,039      —        8,039      —  

Collateralized mortgage obligations

     88,823      —        88,823      —  

Municipal bonds

     11,574      —        11,574      —  

Municipal bonds – taxable

     13,146      —        13,146      —  

SBA Pool Loan Investments

     10,402      —        10,402      —  

Commercial servicing rights

     528      —        528      —  
                           
   $ 195,833    $ 190    $ 195,456    $ 187
                           

 

21


Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements—(Continued)

March 31, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

For financial assets measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy used at December 31, 2009 are as follows:

 

     December 31,
2009
   Quoted
Prices
(Level 1)
   Significant
Other
Observable
Inputs
(Level 2)
   Significant
Unobservable
Inputs

(Level 3)

Equity securities

   $ 1,132    $ 300    $ 783    $ 49

U.S Government sponsored agency securities

     56,384      —        56,384      —  

U.S. Government sponsored agency mortgage-backed securities

     9,116      —        9,116      —  

Collateralized mortgage obligations

     92,485      —        92,485      —  

Municipal bonds

     7,188      —        7,188      —  

Municipal bonds – taxable

     12,910      —        12,910      —  

SBA Pool Loan Investments

     10,638      —        10,638      —  

Commercial servicing rights

     473      —        473      —  
                           
   $ 190,326    $ 300    $ 189,977    $ 49
                           

Securities available for sale (carried at fair value)

As quoted market prices for the investments in securities available for sale held at the Bank, such as government agency bonds, corporate bonds, municipal bonds, etc, are not readily available, a matrix pricing model is used to value these investments. The matrix pricing model takes into consideration yields/prices of securities with similar characteristics, including credit quality, industry, and maturity to determine a fair value measure.

For equity securities held by the Company, management has determined which securities are traded in active markets versus inactive markets. For those securities traded in active markets, management has recorded the securities at quoted market prices. In cases where the securities are deemed to trade in inactive markets, management has adjusted quoted market prices for factors such as indicative bids received from brokers.

The following table presents reconciliations of the Company’s assets measured at fair value on a recurring basis using unobservable inputs (Level 3) for the year ended March 31, 2010:

 

     Equity Securities

Balance, December 31, 2009

   $ 49

Transfers In from Level 2

     138
      

Balance, March 31, 2010

   $ 187
      

During the Company’s valuation of the investment portfolio performed during the first three months of 2010, the Company determined one equity security was no longer actively traded on the open market. In the prior year, the fair value of the equity security was determined based on an estimate from limited activity in the open market, determined as Level 2 pricing. As there has been no activity in the current year to determine the fair value price, the Company evaluated the entity’s current financial reports for any going concern or other issues that would affect the entity’s current or future position. Based upon this review, the Company determined the entity does not have any significant issues that would affect the current or future position of the entity. The technique used to determine the price of the equity security required estimates and judgments of management resulting in the classification of the security as a Level 3 security.

 

22


Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements—(Continued)

March 31, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

For financial assets and liabilities measured at fair value on a nonrecurring basis, the fair value measurements by level within the fair value hierarchy used at March 31, 2010 and December 31, 2009 are as follows:

 

     March 31,
2010
   Quoted Prices
(Level 1)
   Significant
Other
Observable
Inputs
(Level 2)
   Significant
Unobservable
Inputs

(Level 3)

Loans held for sale

   $ 6,103    $ —      $ —      $ 6,103

Impaired loans

     16,940      —        —        16,940
                           

Total assets

   $ 23,043    $ —      $ —      $ 23,043
                           
     December 31,
2009
   Quoted Prices
(Level 1)
   Significant
Other
Observable
Inputs
(Level 2)
   Significant
Unobservable
Inputs

(Level 3)

Loans held for sale

   $ 8,034    $ —      $ —      $ 8,034

Impaired loans

     10,917      —        —        10,917

Loans purchased (1)

     418,747      —        —        418,747

Core deposit intangible asset (1)

     3,899      —        —        3,899

Premises and equipment (1)

     22,644      —        —        22,644
                           

Total assets

   $ 464,241    $ —      $ —      $ 464,241
                           

Time deposits (1)

   $ 160,806    $ —      $ 160,806    $ —  

Borrowings (1)

     69,601      —        69,601      —  
                           

Total Liabilities

   $ 230,407    $ —      $ 230,407    $ —  
                           

 

(1) – Assets and liabilities are presented at fair value as of the date of the Merger.

Loans held for sale

Loan held for sale include residential mortgage loans which are measured at the lower of aggregate cost or fair value. The fair value is measured as the price that secondary market investors were offering for loans with similar characteristics.

Impaired loans

Under U.S GAAP, a loan is classified as impaired when it is possible that the bank will be unable to collect all or part of the loan balance due based on the contractual agreement, including the interest as well as the principal. Impaired loans included in the preceding table are those for which the Company has measured impairment generally based on the fair value of the loan’s collateral as well as impaired loan purchased as part of the Merger. Fair value is generally determined based upon independent third party appraisals of the properties. The fair value consists of loan balances less valuation allowances. The Company has 106 impaired loans valued at $16,940 at March 31, 2010. As of March 31, 2010, the Company charged off $594 of loans.

Loans purchased

In conjunction with the Merger, the loans purchased were recorded at their acquisition date fair value. In order to record the loans at fair value, management made three different types of fair value adjustments. A market rate adjustment was made to adjust for the movement in market interest rates, irrespective of credit adjustments, compared to the stated rates of the acquired loans. A credit adjustment was made on pools of homogeneous loans representing the changes in credit quality of the underlying borrowers from the loan inception to the acquisition date. The credit adjustment on distressed loans represents the portion of the loan balance that has been deemed uncollectible based on management’s expectations of future cash flows for each respective loan.

Core deposit intangible assets

The fair value assigned to the core deposit intangible asset represents the future economic benefit of the potential cost savings from acquiring core deposits in the Merger compared to the cost of obtaining alternative funding such as

 

23


Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements—(Continued)

March 31, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

brokered deposits from market sources. Management utilized an income valuation approach to present value the estimated future cash savings in order to determine the fair value of the intangible asset.

Premises and equipment

Premises and equipment acquired through the Merger has been assigned an acquisition date fair value through the use of independent appraisals and internal discounted cash flow models. Both approaches utilized an income based valuation approach to determine the fair value for the premises and equipment based on the highest and best use concept.

Time deposits

Time deposits acquired through the Merger have been recorded at their acquisition date fair value. In order to derive the fair value, management adjusted the amortized cost basis of the deposits to reflect the current interest rates paid on time deposits at the time of acquisition. The fair value adjustment reflects the movement in interest rates from inception of the deposit to the acquisition date.

Borrowings

Borrowings assumed through the Merger have been recorded at their acquisition date fair value. The fair value adjustment to the carrying value of the borrowings represents the movement in interest rates from the inception of the individual borrowings to the acquisition date.

The following information should not be interpreted as an estimate of the fair value of the entire Company since a fair value calculation is only provided for a limited portion of the Company’s assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between the Company’s disclosures and those of other companies may not be meaningful.

 

24


Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements—(Continued)

March 31, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

The estimated fair values of the Company’s financial instruments were as follows as of March 31, 2010 and December 31, 2009:

 

     March 31, 2010    December 31, 2009
     Carrying
Amount
   Fair Value    Carrying
Amount
   Fair Value

Financial assets:

           

Cash, due from banks, and federal funds sold

   96,166    96,166    50,600    50,600

Securities available for sale

   195,305    195,305    189,853    189,853

Restricted investment in bank stock

   6,254    6,254    6,254    6,254

Loans held for sale

   6,103    6,103    8,034    8,034

Loans, net of allowance for loan losses

   1,151,320    1,177,691    1,128,576    1,151,368

Accrued interest receivable

   5,052    5,052    4,974    4,974

Financial liabilities:

           

Deposits

   1,276,501    1,242,268    1,216,469    1,191,126

Securities sold under agreements to repurchase

   5,119    5,119    6,892    6,892

Short-term borrowings

   5,284    5,284    5,292    5,292

Long-term debt

   77,581    73,747    65,689    69,814

Accrued interest payable

   1,184    1,184    1,090    1,090
     Nominal
Amount
   Fair Value    Nominal
Amount
   Fair Value

Off-balance sheet financial instruments:

           

Commitments to grant loans

   71,842    —      12,350    —  

Unfunded commitments under lines of credit

   248,734    —      267,683    —  

Letters of credit

   24,785    —      25,524    —  

The following methods and assumptions were used to estimate the fair values of the Company’s financial instruments at March 31, 2010 and December 31, 2009.

Cash and cash equivalents (carried at cost)

The carrying amounts reported in the balance sheet for cash and short-term instruments approximate those assets’ fair values.

Restricted investment in bank stock (carried at cost)

The carrying amount of restricted investment in bank stock approximates fair value, and considers the limited marketability of such securities.

Loans held for sale (carried at lower of cost or fair value)

The carrying amounts of loans held for sale approximate their fair value.

Loans (carried at cost)

The fair values of loans are estimated using discounted cash flow analyses, using market rates at the balance sheet date that reflect the credit and interest rate-risk inherent in the loans. Projected future cash flows are calculated based upon contractual maturity or call dates, projected repayments and prepayments of principal. Generally, for variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. This method of estimating fair value does not incorporate the exit price concept of fair value but is a permitted methodology for purposes of this disclosure.

Accrued interest receivable and payable (carried at cost)

The carrying amount of accrued interest receivable and accrued interest payable approximates its fair value.

 

25


Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements—(Continued)

March 31, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

Deposits (carried at cost)

The fair values disclosed for demand deposits (e.g., interest and noninterest checking, passbook savings and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market on certificates to a schedule of aggregated expected monthly maturities on time deposits.

Short-term borrowings (carried at cost)

The carrying amounts of short-term borrowings approximate their fair values.

Long-term debt (carried at cost)

Fair values of FHLB advances are estimated using discounted cash flow analysis, based on quoted prices for new FHLB advances with similar credit risk characteristics, terms and remaining maturity. These prices obtained from this active market represent a market value that is deemed to represent the transfer price if the liability were assumed by a third party.

Off-balance sheet financial instruments (disclosed at cost)

Fair values for the Bank’s off-balance sheet financial instruments (lending commitments and letters of credit) are based on fees currently charged in the market to enter into similar agreements, taking into account, the remaining terms of the agreements and the counterparties’ credit standing.

Note 12 – Premise and Equipment Held for Sale

During the first quarter of 2010, the Company closed two Tower Bank branches to consolidate banking operations in selected areas. All loans and deposit accounts related to these branches were transferred to existing Tower Bank branches. The Company is currently in the process of selling the land and buildings related to two branches and anticipates the sale of the land and buildings within the next year. The carrying value of the branches is based on the net value of the land and building prior to being reclassified as held for sale. This value is currently less than the fair market value at March 31, 2010. As of March 31, 2010, the carrying value of the land and buildings for these branches are $549.

 

26


Table of Contents
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s discussion and analysis of the changes in the consolidated results of operations, financial condition, and cash flows of Tower Bancorp, Inc. and its subsidiary is set forth below for the periods indicated. Unless the context requires otherwise, the terms “Tower,” “we,” “us,” and “our” refer to Tower Bancorp, Inc. and its wholly-owned subsidiary, Graystone Tower Bank. Through Graystone Tower Bank, we provide banking and banking related services to our customers within our principal market areas consisting of Centre, Cumberland, Dauphin, Franklin, Fulton, Lancaster, Lebanon, and York Counties of Pennsylvania and Washington County, Maryland. The following discussion and analysis, the purpose of which is to provide investors and others with information that we believe to be necessary for an understanding of Tower’s financial condition, changes in financial condition, and results of operations, should be read in conjunction with the consolidated financial statements, notes, and other information contained in this report.

FORWARD-LOOKING STATEMENTS

We have made, and may continue to make, certain forward-looking statements in this Report, including information incorporated by reference in this Report. These forward-looking statements are intended to be covered by the safe harbor for forward-looking statements provided by the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not statements of historical fact, and can be identified by the use of forward-looking terminology such as “believe,” “expect,” “may,” “will,” “should,” “project,” “plan,” “seek,” “target,” “intend” or “anticipate” or the negative thereof or comparable terminology. Forward-looking statements include discussions of strategy, financial projections and estimates and their underlying assumptions, statements regarding plans, objectives, expectations or consequences of various transactions, and statements about the future performance, operations, products and services of Tower and our subsidiaries. These forward-looking statements are subject to various assumptions, risks, uncertainties and other factors including, but not limited to, market risk; changes or adverse developments in economic, political, or regulatory conditions; a continuation or worsening of the current disruption in credit and other markets; the effect of competition and interest rates on net interest margin and net interest income; investment strategy and income growth; investment securities gains; declines in the value of securities which may result in charges to earnings; changes in rates of deposit and loan growth; asset quality and the impact on assets from adverse changes in the economy and in credit or other markets and resulting effects on credit risk and asset values; balances of risk-sensitive assets to risk-sensitive liabilities; salaries and employee benefits and other expenses; amortization of intangible assets; capital and liquidity strategies and other financial and business matters for future periods.

Because of the possibility of changes in these assumptions, actual results could differ materially from those contained in any forward-looking statements. We encourage readers of this Report to understand forward-looking statements to be strategic objectives rather than absolute targets of future performance. Forward-looking statements are qualified in their entirety by the risk factors and cautionary statements contained in this Report and speak only as of the date they are made. We do not undertake any obligation to update publicly any forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events except as required by law.

Availability of Information

Our web-site address is www.towerbancorp.com. We make available free of charge, through the Investor Relations section of our web site, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission. We include our web-site address in this Quarterly Report on Form 10-Q as an inactive textual reference only.

Merger and Acquisitions

On March 31, 2009, Tower Bancorp, Inc. completed the merger with Graystone Financial Corp., (“Graystone”) in an all stock transaction valued at approximately $57.9 million (“the Merger”). The Merger, while considered a merger of equals, was accounted for as a reverse acquisition by Graystone Financial Corp. of Tower Bancorp, Inc. using the acquisition method of accounting and, accordingly, the assets and liabilities of Tower Bancorp, Inc. have been recorded at their respective fair values on the date the Merger was completed. Furthermore, the historical financial information for periods prior to March 31, 2009 included in Tower’s consolidated financial statements and related footnotes as reported in this Form 10-Q is that of Graystone Financial Corp. The Merger was effected by the issuance of shares of Tower Bancorp, Inc. common stock to Graystone shareholders. Each share of Graystone common stock was exchanged for 0.42 shares of Tower common stock, with any fractional shares as a result of the exchange, paid to Graystone shareholders in cash based on $19.78 per share of Tower common stock.

 

27


Table of Contents

Pursuant to the Agreement and Plan of Merger, Tower Bancorp, Inc. is the surviving bank holding company and its wholly-owned subsidiary, The First National Bank of Greencastle, merged with and into Graystone’s wholly owned subsidiary, Graystone Bank, with Graystone Bank as the surviving institution, under the name “Graystone Tower Bank” (the “Bank”). The Bank operates as the sole subsidiary of Tower Bancorp, Inc. through two divisions – “Graystone Bank, a division of Graystone Tower Bank”, consisting of the former Graystone Bank branches, and “Tower Bank, a division of Graystone Tower Bank,” consisting of the former branches of The First National Bank of Greencastle.

On December 27, 2009, Tower Bancorp, Inc. and First Chester County Corporation (“First Chester”) entered into an Agreement and Plan of Merger pursuant to which Tower will acquire First Chester in an all-stock transaction valued at approximately $65 million or $10.22 per share based on the closing price of Tower common stock at the announcement of this acquisition. In the acquisition, First Chester shareholders will receive 0.453 shares of Tower common stock for each share of First Chester common stock they hold on the effective date of the acquisition. As described in the definitive agreement, the exchange ratio is subject to upward or downward adjustment if loan delinquencies at First Chester increase or decrease beyond specified amounts.

As part of the definitive agreement, Tower’s subsidiary bank, Graystone Tower Bank, agreed to increase its lending facility with First Chester to up to $26 million as well as to purchase up to $100 million of residential mortgage and commercial loans from First National Bank of Chester County (“FNB”) in order for FNB to satisfy the regulatory capital requirements of the Office of the Comptroller of the Currency (the “OCC”). As of March 31, 2010, the Bank loaned $26 million to First Chester, the proceeds of which First Chester contributed to FNB as Tier 1 capital. First Chester pledged 100% of in the capital stock of FNB to Graystone Tower Bank to secure repayment of the loan. The Bank has also purchased approximately $52 million in performing commercial loans from FNB during December of 2009.

Following the transaction, based on the 0.453 exchange ratio, current Tower shareholders will own approximately 71% and First Chester shareholders will own approximately 29% of the combined company’s common stock. The shareholders of both entities must approve the combination. Pending final regulatory and shareholder approvals, the acquisition is expected to be completed during the middle of 2010.

On March 4, 2010, the FCEC Acquisition Agreement was amended between Tower and First Chester. As part of the amended agreement, First Chester shall use its best efforts to sell at or prior to the effective date of the acquisition, the American Home Bank Division of FNB (“AHB Division”) to one or more purchasers on terms and conditions acceptable to both First Chester and Tower. The AHB Division engages in mortgage-banking activities on a nation-wide basis. Additionally, we extended a $2 million non-revolving line of credit to First Chester, which permits draws from time to time for the sole purpose of contributing additional capital to FNB in the event that, as a result of the attempt to sell the AHB Division, the actual sale thereof, or the effects on FNB of such sale, FNB’s regulatory capital ratios, as reported in FNB’s quarterly call report, fall below the minimum regulatory capital ratios applicable to FNB.

Results of Operations

Summary of Financial Results

The merger of Tower Bancorp, Inc. and Graystone Financial Corp. on March 31, 2009 has had a significant impact on our results of operations for the first quarter of 2010 as compared with the first quarter 2009. The operating results reported herein for the three months ended March 31, 2010 include the results for the combined entity. However, the results for the three months ended March 31, 2009 include the operating results of the historic Graystone for the entire three month period and only the operating results since March 30, 2009 for the historical Tower, representing the period after consummation of the Merger which was effective before the opening of business on March 31, 2009. Consequently, comparisons of our results of operation to the same period in 2009 may not be particularly meaningful.

We recognized after-tax net income of approximately $1.9 million or $0.27 per diluted share in the first quarter of 2010, compared to an after-tax net loss of $1.9 million or $(0.68) per diluted share in the first quarter of 2009. The increase in net income of $3.8 million was driven by increases in net interest income of $7.7 million and non-interest income of $1.1 million and a decrease in the provision for loan loss of $916 thousand, which were partially offset by increases in non-interest expense of $4.1 million and income tax expense of $1.8 million. For the quarter, our growth in net interest income was the result of core organic growth, net of corporate interest expense, of $4.1 million or 94.0% over the first quarter 2009 coupled with the addition of the Tower Bank division’s net interest earning assets that contributed $3.6 million to net interest income. The increase in non-interest income was partially the result of the Merger, which directly contributed $519 thousand to the growth of service charges on deposit accounts. Additionally we recognized combined growth of other service charges and fees of $292 thousand primarily due to the addition of income from the trust services department and increased card

 

28


Table of Contents

interchange fees. The largest increases in non-interest expense related to salary and benefits expense and occupancy and equipment expense, which increased $2.6 million and $964 thousand, respectively, as compared to the first quarter of 2009. Both of these increases can be attributed to the rapid growth experienced by the Company since the Merger, which resulted in the opening of new branch locations and the addition of personnel within the finance, operations, credit and lending departments.

We experienced continued asset growth during the first three months of 2010. At March 31, 2010, our assets totaled approximately $1.54 billion compared to $1.47 billion at December 31, 2009.

Net Interest Income

Our major source of operating revenues is net interest income, which increased $7.7 million or 175.5% to approximately $12.1 million for the first quarter of 2010, as compared to approximately $4.4 million for the same period in 2009. The $7.7 million increase in net interest income includes $3.6 million related to the net contribution from interest-earning assets and interest-earning liabilities derived from of the Tower division, which is excluded from the first quarter 2009 results of operations. Excluding the effect of the Merger, net interest income, net of corporate interest expense, increased by $4.1 million or 94.0% over first quarter of 2009.

Net interest income is the income that remains after deducting, from total income generated by earning assets, the interest expense attributable to the acquisition of the funds required to support earning assets. Income from earning assets includes income from loans, investment securities, and short-term investments. The amount of interest income is dependent upon many factors, including the volume of earning assets, the general level of interest rates, the dynamics of the change in interest rates, and the levels of non-performing loans. The cost of funds varies with the amount of funds necessary to support earning assets, the rates paid to attract and hold deposits, the rates paid on borrowed funds, and the levels of noninterest-bearing demand deposits and equity capital.

We principally utilize in-market deposits to fund loans and investments, while strategically obtaining additional funding from short-term and long-term borrowings when advantageous rates and maturities can be obtained. We do not rely on brokered deposits to fund asset growth as demonstrated by the limited use of brokered deposits, which represent less than 7.0% of total deposits, on our consolidated balance sheet at March 31, 2010 and less than 5.0% at December 31, 2009. In connection with our growth plans and ongoing focus to improve our net interest spread, we may continue to supplement in-market deposits with brokered deposits and additional short-term and long-term borrowings, including additional borrowings from the Federal Home Loan Bank and federal funds lines with correspondent banks, based upon prevailing economic conditions, deposit availability and pricing, interest rates and other factors at such time.

 

29


Table of Contents

The following table provides a comparative average balance sheet and net interest income analysis for the three-month period ended March 31, 2010 as compared to the same period in 2009. Interest income and average rates are presented on a fully taxable-equivalent (FTE) basis, using a 34% Federal tax rate. All dollar amounts are in thousands.

 

     For the Three Months Ended March 31,  
     2010     2009  
     Average
Balance (2)
    Interest     Average
Rate
    Average
Balance (2)
    Interest     Average
Rate
 
     (in thousands)  

Interest-earning assets:

            

Federal funds sold and other

   $ 24,576      $ 33      0.54   $ 13,918      $ 6      0.17

Investment securities (1)

     177,121        1,057      2.42     19,287        135      2.84

Loans

     1,150,976        16,506      5.82     585,807        8,288      5.74
                                            

Total interest-earning assets

     1,352,673        17,596      5.28     619,012        8,429      5.52
                                            

Other assets

     153,173            30,349       
                        

Total assets

   $ 1,505,846          $ 649,361       
                        

Interest-bearing liabilities:

            

Interest-bearing non-maturity deposits

   $ 697,925        2,120      1.23   $ 230,749        1,347      2.37

Time deposits

     435,686        2,489      2.32     267,702        2,416      3.66

Borrowings

     83,077        917      4.48     46,219        286      2.51
                                            

Total interest-bearing liabilities

     1,216,688        5,526      1.84     544,670        4,049      3.01
                                            

Demand deposits

     110,886            44,113       

Other liabilities

     14,036            6,056       

Stockholders’ equity

     164,236            54,522       
                        

Total liabilities and stockholders’ equity

   $ 1,505,846          $ 649,361       
                        

Net interest spread

       3.43       2.51

Net interest income and interest rate margin FTE

     $ 12,070      3.62     $ 4,380      2.87
                    

Tax equivalent adjustment

       (21         (6  
                        

Net interest income

     $ 12,049          $ 4,374     
                        

Ratio of average interest-earning assets to average interest-bearing liabilities

     111.2         113.6    
                        

 

(1) The average yields for investment securities available for sale are reported on a fully taxable-equivalent basis at a rate of 34%
(2) Average loan balances include non-accrual loans.

The following table summarizes the changes in FTE interest income and expense due to changes in average balances (volume) and changes in rates:

 

     Three Months Ended
   March 31, 2010 vs. March 31, 2009
     Increase (Decrease) Due to
     Volume     Rate     Total
     (in thousands)

Interest income:

      

Federal funds sold

   $ 7      $ 20      $ 27

Investment securities

     1,550        (628     922

Loans

     8,104        114        8,218
                      

Total interest income

   $ 9,660      $ (494   $ 9,167
                      

Interest expense:

      

Interest-bearing non-maturity deposits

   $ 17,807      $ (17,034   $ 773

Time deposits

     18,449        (18,376     73

Borrowings

     318        313        631
                      

Total interest expense

     36,574        (35,097     1,477
                      

Net interest income

   $ (26,914   $ 34,603      $ 7,690
                      

Interest income increased approximately $9.2 million, or 108.8%. This increase was caused by approximately $733.7 million or 118.5% increase in the average balance of interest-earning assets, which resulted in approximately $9.7 million increase to interest income. This increase was partially offset by a 24 basis point reduction in average rates that resulted in a reduction of interest income of approximately $494 thousand.

Interest income on investment securities increased approximately $922 thousand, or 682.8%. The average balance of investments held by the Bank increased from $19.3 million at March 31, 2009 to $177.1 million at March 31, 2010, which resulted in an increase of approximately $1.6 million in interest income. The increase in the average balance of investment securities relates primarily to the addition of securities acquired through the Merger as well as additional investments purchased with excess liquidity. Since March 31, 2009, the Company purchased higher-yielding collateralized mortgage obligation securities, government agency step-up securities, and SBA pooled loan securitizations as well as other lower risk debt securities. These investments served as an initial way for management to deploy funds received through deposit growth and capital offerings into interest earning assets until the proceeds could be used to fund loan growth. This increase is offset by the reduction in the interest rates earned on securities as compared to prior year resulting in a reduction of 42 basis points on the average rate and a reduction of interest income of $628 thousand.

 

30


Table of Contents

Average yields on loans increased 8 basis points or 1.4%, from 5.74% during the first quarter of 2009 to 5.82% during the first quarter of 2010. The Federal Reserve maintained the intended federal funds target rate between 0.08% and 0.25% during both quarters ended March, 31, 2010 and 2009. This rate continues to place downward pressure on the prime rate and all other lending rates, further prolonging the reduced interest rate environment. Average yields during 2009 and 2010 have not decreased as severely compared to the interest rate environment as fixed rate loans, which represent approximately 24% of total loans held at March 31, 2010, and do not reprice when short-term rates declined. Additionally, the total effect of downward loan repricing on variable rate loans will not coincide with the decrease in the aforementioned rates due to the fact that approximately 90% of our variable rate loans at March 31, 2010 contain interest rate floors. Any benefit associated with an increase in interest rates in the future might not be immediately realized due to the use of interest rate floors. Presumably, an increase in future interest rates would cause repricing in all assets and liabilities linked to variable rate indices; however, as deposit products would experience any increase on a relatively immediate basis, loan products with floors in place would require a rate increase such that the resulting rate earned on the loan would exceed the floor. Refer to Item 3 Quantitative and Qualitative Disclosures About Market Risk for a more detailed discussion of interest rate risk.

Interest expense increased $1.5 million, or 36.5% during the first quarter of 2010 compared to the same period in 2009. This increase was caused by approximately $672.0 million or 123.4% increase in the average balance of interest-bearing liabilities, which resulted in approximately $36.6 million increase to interest expense. This increase was predominately offset by a 117 basis point reduction in the average rate paid on interest-bearing liabilities, which resulted in a reduction of interest expense of approximately $35.1 million. This reduction in average rates paid on interest-bearing liabilities was the result of lower rates paid on interest-bearing non-maturity deposit accounts and time deposits, which can be attributed to both the low cost deposits acquired through the Merger and management’s efforts to reduce rates paid on deposits while still remaining competitive in the markets we serve.

In future periods, assuming a prolonged flat or declining interest rate environment, we expect an increase in the total amount of net interest income driven by continued growth in average interest-earning assets, the continued use of floors in our variable rate commercial loan portfolio, and the continued repricing of a portion of our interest-bearing deposit portfolio into lower rate products. Any significant changes such as rapid movement in interest rates set by the Federal Reserve, changes in the performance of our interest earning assets, the continued repricing of assets, and the inability to move deposit rates in similar increments as earning asset rates may mitigate this benefit in the future. Also, our strategy to extend the duration of our time deposit portfolio during this low interest rate environment may also offset benefits to the margin.

We manage our risk associated with changes in interest rates through the techniques described in this Report under Item 3. Quantitative and Qualitative Disclosures About Market Risk.

Provision for Loan Losses and Allowance for Loan Losses

The provision for loan losses is the expense necessary to maintain the allowance for loan losses at a level adequate to absorb management’s estimate of probable losses in the loan portfolio. Our provision for loan loss is based upon management’s continuous review of the loan portfolio. The purpose of the review is to assess loan quality, identify impaired loans, analyze delinquencies, ascertain loan growth, evaluate potential charge-offs and recoveries, and assess general economic conditions in the markets we serve.

 

31


Table of Contents

The following table presents the activity in the allowance for loan losses:

 

     Three months ended  
     March 31,  
     2010     2009  

Balance at beginning of period

   $ 9,695      $ 6,017   

Provision for loan losses

     1,450        2,366   

Charge-offs

    

Commercial

     (297     (563

Consumer

     —          (59

Residential mortgage

     —          —     
                

Total Charge-offs

     (297     (622

Recoveries

    

Commercial

     44        —     

Consumer

     —          —     

Residential mortgage

     —          —     
                

Total Recoveries

     44        —     
                

Net charge-offs

     (253     (622
                

Balance at end of period

   $ 10,892      $ 7,761   
                

We continue to operate in a challenging economic environment. Given the economic pressures that impact some of our borrowers, we have increased our allowance for loan loss in accordance with our assessment process, which took into consideration the growth of our loan portfolio, the status of the current economic environment and the results of management’s risk assessment process over loans. The provision for loan losses for the three months ended March 31, 2010 totaled $1.5 million, a decrease of approximately $916 thousand compared to the same period in 2009. The gross loan charge-offs that were applied to the allowance for loan loss during the three months ended March 31, 2010 consisted of 10 commercial loans totaling $297 thousand or 0.10% of average loans on an annualized basis for the first quarter of 2010. Our allowance for loan loss as a percentage of loans was 0.94% at March 31, 2010, compared to 0.85% at December 31, 2009.

The following table presents changes in the credit quality adjustment on loans purchased for the three months ended March 31, 2010:

 

     Three months ended
     March 31,
     2010     2009

Balance at beginning of period

   $ 2,942      $ —  

Credit Fair Value Adjustment Mark

     —          4,044

Amortization

     (150     —  

Charge-offs

    

Commercial

     (139     —  

Consumer

     (65     —  

Residential mortgage

     (93     —  
              

Total Charge-offs

     (297     —  

Recoveries

    

Commercial

     3        —  

Consumer

     20        —  

Residential mortgage

     1        —  
              

Total Recoveries

     24        —  
              

Net charge-offs

     (273     —  
              

Balance at end of period

   $ 2,519      $ 4,044
              

The gross loan charge-offs that were applied to the credit quality adjustment on purchased loans for the three months ended March 31, 2010 consisted of 5 commercial loans, 14 consumer loans, and 3 residential mortgage totaling $297 thousand or 0.11% of average loans on an annualized basis.

The total gross loan charge-offs during the three months ended March 31, 2010 consisted of 32 loans totaling $594 thousand or 0.21% of average loans on an annualized basis. Our allowance for credit loss as a percentage of loans was 1.15% at March 31, 2010, compared to 1.11% at December 31, 2009. Determining the level of the allowance for probable loan loss at any

 

32


Table of Contents

given point in time is difficult, particularly during uncertain economic periods. We must make estimates using assumptions and information that is often subjective and changing rapidly. The review of the loan portfolio is a continuing process in light of a changing economy and the dynamics of the banking and regulatory environment. In our opinion, the allowance for loan loss is adequate to meet probable incurred loan losses at March 31, 2010. There can be no assurance, however, that we will not sustain loan losses in future periods that could be greater than the size of the allowance at March 31, 2010. Management believes that the allowance for loan loss is appropriate based on applicable accounting standards.

Non-Interest Income

In addition to our focus on increasing net interest income through growth of interest-earning assets and expansion in our net interest spread, we remain committed to increasing non-interest income as a way to improve profitability and diversify our sources of revenue. Net interest income as a percentage of net interest income plus non-interest income was 85.7% for the quarter ended March 31, 2010, compared to 82.2% for the quarter ended March 31, 2009.

Non-interest income was approximately $2.0 million and $948 thousand for the three-months ended March 31, 2010 and 2009, respectively.

The following table presents the components of non-interest income:

 

     March  31,
2010
   March  31,
2009
   Increase (Decrease)  
         $    %  

Service charges on deposit accounts

   $ 740    $ 217    $ 523    241.0

Other service charges, commissions and fees

     526      234      292    124.8

Gain on sale of mortgage loans originated for sale

     273      267      6    2.2

Gain on sale of other interest earnings assets

     24      —        24    n/a

Income from bank owned life insurance

     321      164      157    95.7

Other income

     120      66      54    81.8
                       

Total non-interest income

   $ 2,004    $ 948    $ 1,056    111.4
                       

The $1.1 million or 111.4% increase in total non-interest income is attributable primarily to increases in service charges on deposit accounts, other service charges and fees, and income recognized on the cash surrender value of bank owned life insurance, which increased $523 thousand, $292 thousand, and $157 thousand, respectively. As a result of the Merger, service charges on deposit accounts directly related to the Tower Bank division’s branches contributed $519 thousand to the overall change in service charges on deposit accounts. The majority of the increase in the other service charges and fees relates to debit card interchange fees and trust services income which grew by $246 thousand and $28 thousand for the first quarter 2010 when compared to the same period in 2009. Income from bank owned life insurance increased as a result of appreciation in the cash surrender value of life insurance contracts acquired through the Merger, as that income would not have been present in the results of operations for the first quarter of 2009.

Non-Interest Expense

Non-interest expense was approximately $9.8 million and $5.8 million for the three-months ended March 31, 2010 and 2009, respectively. Excluding the effects of Merger expenses, non-interest expense for the first quarter 2010 would have totaled approximately $9.7 million, up approximately $5.2 million or 117.6% from $4.5 million for the same period in 2009. The $5.2 million increase is mostly attributable to increases in salary and employee benefits, occupancy and equipment expense, amortization of intangible assets, FDIC insurance premiums, data processing expenses, and other operating expenses.

 

33


Table of Contents

The following table presents the components of non-interest expenses:

 

     March  31,
2010
   March  31,
2009
   Increase (Decrease)  
           $     %  

Salaries and employee benefits

   $ 5,099    $ 2,517    $ 2,582      102.6

Occupancy and equipment

     1,696      732      964      131.7

Amortization of intangible assets

     177      —        177      n/a

FDIC insurance premiums

     398      180      218      121.1

Advertising and promotion

     135      77      58      75.3

Data processing

     511      195      316      162.1

Professional service fees

     441      254      187      73.6

Other operating expenses

     1,266      513      753      146.8

Merger related expenses

     111      1,306      (1,195   -91.5
                        

Total non-interest expenses

   $ 9,834    $ 5,774    $ 4,060      70.3
                        

Salary and employee benefits increased $2.6 million or 102.6%. Salaries increased by $2.0 million while employee benefits increased by $656 thousand. As a result of the Merger, salaries and employee benefits directly related to Tower Bank branches contributed approximately $1.1 million to the increase in salary and benefit expenses for the quarter ended March 31, 2010. The remaining increased level of salary expense was driven by personnel costs in connection with our branch expansion during 2009 and the first quarter of 2010. We continued to add additional personnel to our operations, finance, credit, and lending departments to support our balance sheet growth. We also incurred general merit increases for all eligible employees between March 31, 2009 and March 31, 2010.

Occupancy and equipment expense increased $964 thousand or 131.7%. The increase related partially to the additional expense attributable to the Tower Bank division’s branches which contributed $579 thousand in occupancy and equipment expense while the remaining occupancy and equipment expense increase related to the addition of three branch offices during 2009 and 2010 and the lease of the corporate center office space entered into during the third quarter of 2009.

On February 27, 2009, the FDIC announced that it was increasing federal deposit insurance premiums, beginning the second quarter of 2009, for all well managed, well capitalized banks to a range between 12 and 16 cents per $100 of insured deposits on an annual basis resulting in an increase in such premiums from the first quarter of 2009 to the same period in 2010. At March 31, 2010, the Bank had approximately $1.00 billion in FDIC-insured deposits.

Professional service expenses increased $187 thousand or 73.6% and data processing expense increased $316 thousand or 162.1%. These increases are directly related to increased audit, consulting and legal services, along with increased data processing costs given the rapid growth in the Bank, between March 31, 2009 and March 31, 2010.

Other operating expenses increased $753 thousand or 146.8%. The portion of the increase that can be attributed directly to the Tower Bank branches equaled $113 thousand for the quarter ended March 31, 2010. The remaining increase was primarily due to increases in share taxes, supplies, telephone and postage expense, and travel and entertainment, of $152 thousand, $101 thousand, $100 thousand, and $41 thousand, respectively.

Income Tax Expense

Income tax expense was $864 thousand for the three month ended March 31, 2010. For the three months ended March 31, 2009, the income tax benefit was $933 thousand. Our effective tax rate for the first quarter of 2010 was 31.2%. The effective tax rate was positively impacted by tax free income generated by the purchase of bank owned life insurance, dividends deductions for dividends paid on ESOP shares, and earnings from tax-exempt securities. Our effective tax rate was 33.1% for the three months ended March 31, 2009. The statutory tax rate for both periods was 34.0%.

Financial Condition

Total Assets

Total assets increased by $71.6 million, or 4.9%, from December 31, 2009 to March 31, 2010. The increase is primarily due to the increase in cash and cash equivalents of $45.6 million and net loans of $22.7 million. The increase to cash and cash equivalents is directly related to cash received as a result of deposit growth, net income adjusted for non-cash income and expenses, the proceeds from the sale of mortgage loans held for sale, and proceeds from the issuance of debt all of which were partially offset by cash distributed to fund loan growth, purchases of investment securities, repayment of borrowings, purchases of fixed assets and payment of dividends.

 

34


Table of Contents

Loans, net

Our gross loan balance grew by $23.9 million, or 2.1%, to $1.16 billion as of March 31, 2010. During the first quarter of 2010, new loan originations totaled $45.6 million, which were offset by a net decrease in existing loan balances of $21.7 million. The net decrease in existing loan balances during the first quarter included the net reduction of approximately $6.2 million of mortgages previously held in the Company’s loan portfolio. Management believes that there continues to be opportunities to bring quality existing credits into our bank from our competitors, coupled with demand for commercial and consumer loans to credit qualified businesses and individuals within the Company’s market areas, which management anticipates will result in increased loan growth during the 2010.

See the table below for a detail of the loan balances, net of unearned income and allowance for loan losses at March 31, 2010 and the changes from December 31, 2009:

 

     March  31,
2010
    December 31,
2009
    Increase (Decrease)  
         $     %  

Commercial

   $ 892,534      $ 861,673      $ 30,861      3.6

Consumer & other

     84,786        85,510        (724   -0.8

Residential mortgage

     185,040        191,277        (6,237   -3.3
                          

Total Loans

     1,162,360        1,138,460        23,900      2.1

Deferred costs (fees)

     (148     (189     41      21.7

Allowance for loan losses

     (10,892     (9,695     (1,197   12.3
                          

Net Loans

   $ 1,151,320      $ 1,128,576      $ 22,744      2.0
                          

The commercial loan portfolio continues to be the largest component of our loan portfolio, representing 76.8% and 75.7% of total loans at March 31, 2010 and December 31, 2009, respectively. In addition, we have $112.0 million in loan participations without recourse sold to unaffiliated banks through March 31, 2010, where we maintain the servicing rights with these relationships. Currently, the bank is participating in 27 loans purchased from unaffiliated banks. The total outstanding balance of these loans is $59.0 million. These participations include16 loans purchased from First National Bank of Chester County at 98.5% of par. The net purchase price of these loans was $51.7 million. The borrowers on all these loans are in-market customers and the Company has not experienced any losses due to nonperformance.

Additionally, we have not participated in any shared national credit programs and we do not have any shared national credits in our loan portfolio. We expect continued loan growth during the remainder of 2010, as we focus on serving the credit needs of our market areas, while exercising prudent underwriting standards considering the economic uncertainties that are expected to continue. However, due to current uncertain economic conditions resulting in lower levels of loan demand, we expect that loan growth may be slower than historically experienced.

 

35


Table of Contents

The table below sets forth, for the periods indicated, information with respect to our non-accrual loans, accruing loans greater than 90 days past due, total nonperforming loans, other real estate owned, total nonperforming assets, and selected asset quality ratios.

 

     March 31,
2010
    December 31,
2009
 
     (in thousands)  

Total loans outstanding, net of unearned income

   $ 1,168,315      $ 1,146,305   

Daily average balance of loans

     1,150,976        1,034,631   

Non-accrual loans

   $ 10,728      $ 4,718   

Accruing loans greater than 90 days past due

     1,657        2,106   
                

Total non-performing loans

     12,385        6,824   

Other real estate owned

     661        927   
                

Total non-performing assets

     13,046        7,751   

Allowance for Loan Losses

     10,892        9,695   

Credit fair value adjustment on loans purchased

     2,519        2,942   
                

Allowance for credit losses

   $ 13,411      $ 12,637   

Non-accrual loans to total loans

     0.92     0.41

Non-performing assets to total assets

     0.85     0.53

Non-performing loans to total loans

     1.07     0.60

Allowance for loan losses to total loans

     0.94     0.85

Allowance for credit losses to total loans

     1.15     1.11

Allowance for loan losses to non-performing loans

     87.95     142.07

Allowance for credit losses to non-performing loans

     108.28     185.18

The accounting estimates for loan losses are subject to changing economic conditions. At March 31, 2010, the non-accrual loans totaled $10.7 million compared to $4.7 million at December 31, 2009. Of the $10.7 million of total non-accrual loans at March 31, 2010, $9.7 million or 84.6% related to commercial loans, $356 thousand or 3.3% to consumer loans and $1.3 million or 12.1% to residential mortgage loans. When analyzing the non-accrual loans on an individual basis, the increase was primarily due to one commercial relationship filing for Chapter 11 bankruptcy protection during the first quarter of 2010. The total loan relationship to this customer is $5.0 million as of March 31, 2010. The loan was to be secured by pledges of loans and mortgages securing the loans extended by the customer to third parties; however, the customer is taking the position that the loan is unsecured because the security interest was not perfected. Management has included this credit in our specific reserve analysis as described in the paragraph below and believes specific reserve recorded is adequate based on current available information.

As of March 31, 2010, we had total impaired loans of $16.9 million. Included in impaired loans are loans on which management has stopped accruing interest in accordance with our loan accounting policy and impaired loans purchased as a result of the Merger. Management discontinues the accrual of interest on a loan when the contractual payment of principal or interest has become 90 days past due or management has serious doubts about further collectability of principal or interest, even though the loan is currently performing. The impaired loan balance includes $6.2 million of impaired loans acquired as part of the Merger, which were recorded at their individual fair values as determined based on management’s estimate of future cash flows. In order to reflect these purchased loans at fair value, we reduced their carrying value by $3.4 million at the time of the Merger. For the remaining impaired loans, management performed an evaluation of expected future cash flows, including the anticipated cash flow from the sale of collateral. Based on these evaluations, management has determined that a reserve of $2.0 million is required against the impaired loans at March 31, 2010.

Management has performed a detailed review of the non-performing loans and of their related collateral and believes the allowance for loan losses remains adequate for the level of risk inherent in the loan portfolio. During 2009 and the first quarter of 2010, the banking industry experienced increasing defaults in mortgage loans coupled with decreasing values of real estate values as a result of an economic downturn. In addition, the prolonged economic downturn present throughout 2009 and continuing into 2010 has resulted in increased delinquencies in our loan portfolio. Through our loan approval process and diligent loan monitoring, we have experienced a relatively low percentage of non-performing loans when compared to the total amount of loans.

Other real estate owned consists of four properties totaling $661 thousand at March 31, 2010. These properties have been through the foreclosure process and are currently in the process of being sold. These properties are recorded at their lower of cost or fair value less costs to sell.

 

36


Table of Contents

Securities Available for Sale

The following table presents the amortized cost and fair value of investment securities for the March 31, 2010 and December 31, 2009.

 

     March 31, 2010    December 31, 2009
     Amortized
Cost
   Fair Value    Amortized
Cost
   Fair Value

Equity securities

   $ 740    $ 679    $ 1,156    $ 1,132

U.S Government sponsored agency securities

     62,650      62,642      56,437      56,384

U.S. Government sponsored agency mortgage backed securities

     8,046      8,039      9,109      9,116

Collateralized mortgage obligations

     89,170      88,823      93,058      92,485

Municipal bonds

     11,502      11,574      7,093      7,188

Municipal bonds – taxable

     12,893      13,146      12,917      12,910

SBA Pool Loan Investments

     10,443      10,402      10,710      10,638
                           
   $ 195,444    $ 195,305    $ 190,480    $ 189,853
                           

At March 31, 2010, total available for sale securities were $195.3 million, an increase of $5.4 million from total available for sale securities of $189.9 million at December 31, 2009. During the first three months of 2010, the Bank purchased $44.4 million in securities, offset by the net sales and maturities of $39.8 million. Since March 31, 2009, we have purchased debt securities and sold various debt and equity securities to realign the holdings within the investment portfolio to our overall investment strategy.

Bank-owned Life Insurance

At March 31, 2010, the total cash surrender value of the bank-owned life insurance (“BOLI”) was $24.9 million. The BOLI were purchased as a means to offset a portion of current and future employee benefit costs. The Bank’s deposits and proceeds from the sale of investment securities funded the BOLI. Earnings from the BOLI are recognized as other income and are treated as tax-free earnings. The BOLI is profitable from the appreciation of the cash surrender value of the pool of insurance, and its tax advantage to the Company.

Deposits

Total deposits at March 31, 2010 were $1.28 billion, an increase of $60.0 million from total deposits of $1.22 billion at December 31, 2009.

The table below displays the increases in deposits by type at March 31, 2010 as compared to December 31, 2009.

 

     March 31, 2010     December 31, 2009     Increase/Decrease  
     Amount    %     Amount    %     Amount     %  

Non-interest bearing transaction accounts

   $ 121,868    9.5   $ 119,116    9.8   $ 2,751      2.31

Interest checking accounts

     118,204    9.3     110,356    9.1     7,849      7.11

Money market accounts

     508,708    39.9     477,292    39.2     31,416      6.58

Savings accounts

     91,732    7.2     87,117    7.2     4,615      5.30

Time deposits of $100,000 or greater

     149,884    11.7     130,938    10.7     18,946      14.47

Time deposits, other

     286,105    22.4     291,650    24.0     (5,545   (1.90 )% 
                                    

Total deposits

   $ 1,276,501    100   $ 1,216,469    100   $ 60,032      4.93
                                    

There has been no significant change in the deposit types between March 31, 2010 and December 31, 2009. Management continues to make efforts to grow core deposits having a lower cost than higher-cost time deposits. The money market accounts include $32.4 million and $23.1 million of brokered money market deposits at March 31, 2010 and December 31, 2009, respectively. Time deposits represent 34.1% of total deposits at March 31, 2010 compared to 34.8% of total deposits at December 31, 2009. The time deposits include $55.0 and $38.0 million of brokered certificates of deposit at March 31, 2010 and December 31, 2009, respectively. Overall, total brokered deposits increased to $87.4 million or approximately 6.9 % of our total deposits at March 31, 2010 as compared to $61.1 million or 5.0% of total deposits at December 31, 2009. Money market deposits at March 31, 2010 have increased by $31.4 million or 6.6% from December 31, 2009 as a result of an increase in brokered money market deposits of $9.3 million and new account growth of $34.8 million due to our competitive

 

37


Table of Contents

rates of return offered in our money market products, offset by deposit run-off. Time deposits increased by $13.4 million or 3.17% resulting from an increase in brokered time deposits of $17.0 million offset by time deposit run-off.

The average balances and weighted average rates paid on deposits for the first three months of 2010 and 2009 are presented in the table below:

 

     March 31, 2010     March 31, 2009     Increase/(Decrease) in
average balance
 
     Average
Balance
   Average
Rate
    Average
Balance
   Average
Rate
    $    %  

Non-interest bearing transaction accounts

   $ 110,886    N/A      $ 44,113    N/A      $ 66,773    151.37

Interest checking accounts

     112,210    0.42     21,706    0.74     90,504    416.95

Money market accounts

     494,416    1.50     155,244    2.40     339,172    218.48

Savings accounts

     91,299    0.80     53,799    2.90     37,500    69.70

Time deposits

     435,686    2.32     267,702    3.66     167,984    62.75
                           

Total

   $ 1,244,497    1.50   $ 542,564    3.06   $ 701,933    129.37
                           

As reflected above, we have decreased the average rate on our total deposits by 156 basis points between the first three months of 2010 and the first three months of 2009. Although we operate in a very competitive environment for deposits, we have been able to grow our deposits from an average of $701.9 million to $1.24 billion between the three months ended March 31, 2009 and the three months ended March 31, 2010 as a result of acquisition-related growth and organic growth.

Short-Term Borrowings and Long-Term Debt

Short-term borrowings had no significant change in balance from December 31, 2009 to March 31, 2010. At December 31, 2009 and March 31, 2010, short-term borrowings consisted advances from the Federal Home Loan Bank of Pittsburgh and current obligations under capital leases. Advances from Federal Home Loan Bank of Pittsburgh totaled $5.3 million as of March 31, 2010 and December 31, 2009. The current obligation under capital leases was $34 thousand and $42 thousand as of March 31, 2010 and December 31, 2009, respectively.

Long-term debt increased by $11.9 million to $77.6 million at March 31, 2010 compared to $65.7 million at December 31, 2009. The increase in long-term debt was caused by the issuance of $12.0 million in subordinated debt during February of 2010 bearing interest at a 9.0% annual interest rate with a term of 65 months. At March 31, 2010, long-term debt consisted of $54.1 million in advances from the FHLB that had a maturity of greater than one year, $21.0 million of subordinated debt and $2.7 million in obligations under capital leases. The total average rate incurred on borrowings and securities sold under agreement to repurchase during the first quarter of 2010 was 4.48% compared to an average rate of 2.51% during the first quarter of 2009.

Stockholders’ Equity and Capital Adequacy

Total stockholders’ equity increased $510 thousand or 0.31%, from $163.9 million at December 31, 2009 to $164.4 million at March 31, 2010. The increase of $510 thousand was due to equity proceeds received from the Dividend Reinvestment and Stock Purchase Plans and a decrease in accumulated other comprehensive loss offset by the increase in accumulated deficit. The decrease in accumulated comprehensive loss is attributed to the unrealized gains on available for sale securities. The increase in our accumulated deficit is due to the declaration of dividends of $2.0 million to our stockholders offset by the net income of $1.9 million.

The Company is subject to various regulatory capital requirements administered by banking regulators. Failure to meet minimum capital requirements can initiate certain actions by regulators that could have a material effect on our consolidated financial statements. The regulations require that banks maintain minimum amounts and ratios of total and Tier I capital (as defined in the regulations) to risk weighted assets (as defined), and Tier I capital to average assets (as defined). As of March 31, 2010, the Company and the Bank met the minimum requirements. In addition, capital ratios of the Company and the Bank exceeded the amounts required to be considered “well capitalized” as defined in the regulations.

On June 12, 2009, the Company issued, to private investors, $9.0 million of subordinated notes bearing an annual interest rate of 9.00%. On February 5, 2010, the Company issued an additional $12.0 million in subordinated notes bearing annual interest of 9.00%. Each note may be redeemed at the Company’s discretion and contains a maturity date of July 1, 2014 for

 

38


Table of Contents

notes issued in June 2009 and July 1, 2015 for notes issued in February 2010. The Company has contributed $17.0 million of the net proceeds of $21.0 million from the sale of the notes to the Graystone Tower Bank, the Company’s wholly-owned subsidiary, as Tier 1 capital to support the Bank’s continued growth, including ongoing lending activities in its local markets. The notes are intended to qualify as Tier 2 capital at Tower Bancorp, Inc, for regulatory purposes, to the extent permitted. In accordance with applicable regulatory treatment one-fifth of the original principal amount of the notes will be excluded each year from Tier 2 capital during the last five years prior to maturity. The following table summarizes Graystone Tower Bank and Tower Bancorp, Inc.’s regulatory capital ratios in comparison to regulatory requirements:

 

      March 31,
2010
    December 31,
2009
    Minimum Capital
Adequacy
 

Graystone Tower Bank

      

Total Capital (to Risk Weighted Assets)

   14.98   14.43   8.00

Tier I Capital (to Risk Weighted Assets)

   14.05   13.58   4.00

Tier I Capital (to Average Assets)

   10.98   11.13   4.00
      March 31,
2010
    December 31,
2009
    Minimum Capital
Adequacy
 

Tower Bancorp, Inc.

      

Total Capital (to Risk Weighted Assets)

   15.41   14.53   8.00

Tier I Capital (to Risk Weighted Assets)

   12.82   13.05   4.00

Tier I Capital (to Average Assets)

   10.02   10.70   4.00

Management believes, as of March 31, 2010, that the Company and the Bank met all capital adequacy requirements to which it is subject.

The Bank is subject to certain restrictions on the amount of dividends that it may declare due to regulatory considerations. The Pennsylvania Banking Code provides that cash dividends may be declared and paid only out of accumulated net earnings. As a result of the Merger, $24.4 million of accumulated earnings related to the pre-merger retained earnings of the Company, were transferred and reclassified into additional paid-in capital. Based on the approval from the Pennsylvania Department of Banking, this amount is available for cash dividends and may be declared and paid in future periods. The remaining balance of retained earnings available for payment of dividends equals $25.1 million at March 31, 2010. During the first quarter of 2010, the Company declared a dividend of $0.28 per share which totaled $2.0 million.

During the second quarter of 2009, the Board of Directors approved a Dividend Reinvestment and Stock Purchase Plan (“Plan”) to provide our shareholders with the opportunity to use cash dividends, as well as optional cash payments up to $50,000 per quarter, to purchase additional shares of Company common stock. The Company has reserved 1,000,000 shares of common stock, no par value, for issuance under the Plan. At the discretion of the Company, shares may be purchased under the Plan directly from the Company or in open market purchases from others by the plan agent. The purchase price for shares purchased from the Company with reinvested dividends is 95% of the fair market value of the Company’s common stock on the investment date. The purchase price for shares purchased with voluntary cash payments or any open market purchases is 100% of the fair market value of the Company’s common stock on the investment date. During the first quarter of 2010, approximately $171 thousand in capital has been raised under the Plan. As of March 31, 2010, the Plan has raised approximately $575 thousand since plan inception.

Also during the second quarter of 2009, the Company’s Board of Directors and shareholders approved an Employee Stock Purchase Plan (“Employee Plan”) to provide our employees with the opportunity to purchase shares of Company common stock directly from the Company. The purchase price for shares purchased under the Employee Plan is 95% of the fair market value of the Company’s common stock on the purchase date. During the first quarter of 2010, approximately $27 thousand in capital has been raised under the Employee Plan. As of March 31, 2010, the Employee Plan has raised approximately $92 thousand since plan inception.

 

39


Table of Contents

In connection with the Emergency Economic Stabilization Act of 2009 and the Troubled Asset Recovery Program (TARP), the U.S. Department of the Treasury (UST) has initiated a Capital Purchase Program. Through this program, qualifying financial institutions are eligible to participate in the sale of senior preferred stock to the UST in an amount not less than 1% of total risk-weighted assets and not more than 3% of total risk-weighted assets. The senior preferred stock will pay cumulative dividends at a rate of 5% per year for the first five years and 9% thereafter. The UST would also receive warrants to purchase a number of shares of common stock of the financial institution having an aggregate market value equal to 15% of the senior preferred stock on the date of the investment, subject to certain reductions.

In January 2009, Graystone received preliminary approval from the U.S. Treasury Department for the placement of up to $17.3 million in senior preferred stock. In March 2009, Graystone announced that it would not be participating in the U.S. Treasury Department’s Troubled Asset Relief Program Capital Purchase Program. The Company did not apply to participate in the Capital Purchase Program.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Our exposure to market risk principally includes liquidity risk, interest rate risk, and market price risk which are discussed below.

Liquidity Risk

We manage our liquidity position on a daily basis as part of the daily settlement function and continuously as part of the formal asset liability management process. Our liquidity is maintained by managing several variables including, but not limited to:

 

   

Pricing and dollar amount of core deposit products;

 

   

Pricing and dollar amount of in-market time deposits;

 

   

Growth rate of the loan portfolio (including the sale of loans on a participation basis);

 

   

Purchase and sale of federal funds;

 

   

Purchase and sale of investment securities;

 

   

Use of wholesale funding such as brokered deposits; and

 

   

Use of borrowing capacity at the FHLB.

Management maintains a detailed liquidity contingency plan designed to respond to an overall decline in the condition of the banking industry or a problem specific to the Company. On a quarterly basis, the Asset Liability Committee (“ALCO”) of the board of directors reviews a comprehensive liquidity analysis along with any changes to the liquidity contingency plan.

As of March 31, 2010, we had a maximum borrowing capacity at the Federal Home Loan Bank of Pittsburgh (“FHLB”) of $551.9 million of which $59.3 million was used in the form of borrowings. Accordingly, we had unused borrowing capacity of $492.6 million at the FHLB. Based on the FHLB capital stock owned by the Bank as of March 31, 2010, we can access approximately $8.5 million of funding without the need to purchase additional FHLB stock. As of March 31, 2010, we had federal funds lines availability at three correspondent banks totaling $27.5 million. There were no funds drawn upon these facilities as of March 31, 2010.

We participate in obtaining wholesale funding sources in addition to core demand deposits as described above. As of March 31, 2010 and December 31, 2009, total brokered deposits, excluding CDARS, represented 4.3% and 3.8%, respectively, of total deposits. Brokered deposits, exclusive of CDARS, are generally comprised of money market accounts that are indexed to one-month LIBOR and time deposits. We have issued brokered time deposits, exclusive of CDARS, in maturities beyond four years as a means of extending the composite maturity structure of the time deposit portfolio.

At March 31, 2010, liquid assets (defined as cash and cash equivalents, loans held for sale, and securities available for sale exclusive of securities pledged as collateral or used in connection with customer repurchase agreements) totaled approximately $237.0 million or 18.6% of total deposits. This compares to $204.3 million, or 16.8%, of total deposits, at December 31, 2009.

Management is of the opinion that its liquidity position at March 31, 2010, is adequate to respond to fluctuations “on” and “off” balance sheet. In addition, management knows of no trends, demands, commitments, events or uncertainties that may result in, or that are reasonably likely to result in our inability to meet anticipated or unexpected liquidity needs.

 

40


Table of Contents

Interest Rate Risk

We actively manage our interest rate sensitivity position. Interest rate sensitivity is the matching or mismatching of the repricing and rate structure of the interest-bearing assets and liabilities. Our primary objectives of interest rate risk management are to neutralize adverse impacts to net interest income arising from interest rate movements and to attain sustainable growth in net interest income. The Management Asset Liability Committee (“MALCO”) is primarily responsible for developing and implementing asset liability management strategies in accordance with the Asset and Liability Management Policy and Procedures (the “ALCO Policy”) approved by the board of directors. The MALCO generally meets on a monthly basis and is comprised of members of our senior management team. The ALCO of the board of directors meets on a quarterly basis to review the guidelines established by MALCO and the results of our interest rate risk analysis.

We manage interest rate sensitivity by changing the volume, mix, pricing and repricing characteristics of our assets and liabilities. We have not entered into separate derivative contracts such as interest rate swaps, caps, and floors.

The interest rate characteristics and interest repricing characteristics of the loan portfolio at March 31, 2010 are set forth in the tables below. Adjustable-rate loans represent loans that are currently in a fixed-rate, but are subject to repricing to either a fixed or variable rate at the related next repricing date.

 

Interest Rate Characteristic

   Percentage
of Portfolio
 

Fixed-rate loans

   24.2

Adjustable-rate loans

   37.1

Variable-rate loans

   38.7
      

Total

   100.0

Repricing Structure

   Percentage
of Portfolio
 

One month or less

   34.6

Two to six months

   4.7

Six to twelve months

   10.9

One to two years

   7.5

Two to three years

   7.2

Three to five years

   22.6

Greater than five years

   12.5
      
   100.0

As of March 31, 2010, the loan portfolio contained $451.7 million of loans in the variable-rate interest mode. Of these loans, 89.8% had interest rate floors. The majority of these loans are indexed to prime, 1-Month LIBOR, and 3-Month LIBOR (i.e. the index plus a spread). While the interest rate floors provide the Company with interest rate protection given that the prime rate and LIBOR rates, plus the applicable spread, are substantially below these floors, these loans will not generate incremental income in an upward rising environment until the floors have been pierced. The compression on net interest margin related to these relationships will be influenced by a number of variables including, but not limited to, the volatility of the respective indices, the speed at which rates rise, and the interest rate sensitivity of deposit costs. To date, we have elected to manage this risk without the use of separate derivative contracts.

As of March 31, 2010, the mortgage loan portfolio contained $185.0 million of mortgages of which $62.6 million will reprice over the next twelve months. The mortgage loans that will reprice over the next twelve months have a current weighted average interest rate of approximately 4.44%. The majority of these mortgage loans are indexed to the one-year Treasury rate. In the current rate environment, these loans will reprice to new rates that are below the current contractual rates thereby putting pressure on net interest margin. In the event that the one-year Treasury rate rises, the loss of interest income from repricing will be lessened. We have been actively encouraging customers to refinance these loans into fixed-rate loans through our mortgage company subsidiary as a means of locking in historically low interest rates. Since December 31, 2009, the mortgage loan portfolio has been reduced by $6.2 million. We expect to continue this strategy and other initiatives to manage this interest rate risk. Furthermore, we expect that newly originated mortgage loan volume will principally be underwritten and sold into the secondary market through our mortgage subsidiary. To date, we have elected to manage this risk without the use of separate derivative contracts.

 

41


Table of Contents

As of March 31, 2010, we reported deposit liabilities of approximately $1.28 billion and securities sold under agreements to repurchase of approximately $5.1 million. Comparatively, we reported deposit liabilities of approximately $1.22 billion and securities sold under repurchase agreements of approximately $6.9 million at December 31, 2009. We increased brokered deposits, exclusive of reciprocal in-market deposits, by $9.4 million between March 31, 2010 and December 31, 2009. The remaining $50.6 million of growth was attributed to deposit origination within markets we serve.

The maturity structure of the time deposit portfolio as of March 31, 2010, is summarized below.

 

Certificates of Deposit Maturity Structure

   Dollars
(millions)
   Percentage  

One months or less

   $ 47.4    10.9

Over one month through one year

     150.6    34.5

Over one year through two years

     41.5    9.5

Over two years

     196.5    45.1
             

Total

   $ 436.0    100.0
         

As noted above, approximately $198.0 million of time deposits will mature over the next year. Given existing market conditions, we expect to retain a significant portion of the maturing time deposit portfolio in the form of new time deposits or money market accounts at interest rates that are generally comparable to the current rates of the time deposits maturing over the next year except for that portion of the time deposit portfolio that we target for longer maturities. During the first quarter of 2010, we increased the dollar amount of time deposits maturing beyond two years by $31.8 million, as we seek to extend the maturity structure of the time deposit portfolio considering the current low interest rate environment. The majority of this growth was from in-market deposit gathering efforts. We are actively seeking to extend the weighted average life of the time deposit portfolio which may result in renewing a portion of the time deposit portfolio at rates that are higher than the rates of time deposits maturing over the next year.

We use several tools to assess and measure its interest rate risk including interest rate simulation analysis that is prepared on a quarterly basis. Each analysis is largely dependent on many assumptions and variables with past behaviors that may not prove to be effective predictors of future outcomes. These assumptions are reviewed on at least a quarterly basis.

Gap Analysis. We use gap analysis to compare the relationship of assets that are expected to reprice during a specific time frame (“Rate Sensitive Assets” or “RSA”) as compared to liabilities that are scheduled to reprice during an identical time period (“Rate Sensitive Liabilities” or “RSL”). When the ratio is greater than one, RSA exceed RSL and potentially exposes the bank to a risk of a decline in interest rates by virtue of a larger amount of assets repricing at lower interest rates than rate sensitive liabilities. The converse would be true of a RSA/RSL ratio less than 1.0. While gap analysis can be useful in evaluating the relationship of RSA to RSL, it does not capture other critical interest rate risk variables such as the extent of change that will take place when a RSA or RSL reprices, prepayment considerations, and other factors. Under the ALCO Policy, the interest rate simulation report measures the ratio of rate sensitive assets to rate sensitive liabilities at a one-year time frame. The ALCO Policy has established an acceptable relationship of RSA to RSL to a range of 80% to 120%.

We use the following methodology in computing repricing gap. This methodology is noteworthy given the current interest rate environment. First, we classify variable-rate loans with current interest rates below loan floors as rate sensitive assets. As of March 31, 2010, we have $403.3 million of loans that are currently in the variable rate mode with interest rates indexed to the prime rate, the one-month LIBOR, and the three-month that are subject to contractual floors. The majority of these loans have current interest rates determined by the contractual floors. To the extent that these loans will not reprice until the floor have been pierced (approximately 175 basis points), these loans are technically not rate sensitive. However, for purposes of computing repricing gap, we have treated these loans as rate-sensitive to capture their behavior in more traditional interest rate environments. Second, we have classified all interest-bearing non-maturity deposits as repricing immediately. We believe that this methodology is more conservative in comparison to other methodologies that assume non-maturity deposits reprice across time. We recognize that this methodology has the potential to highlight the inherent weaknesses of repricing gap analysis. For this reason, we emphasize the metrics of net interest income at risk and economic value of equity at risk when evaluating interest rate risk.

At March 31, 2010, our balance sheet was liability sensitive with a gap ratio of approximately 86.0%. The gap ratio is within policy guidelines. In large part, the liability sensitive position of the balance sheet is due to the increase in transaction,

 

42


Table of Contents

money market, and savings accounts in the deposit portfolio. This is an intentional strategy designed to strengthen on-balance sheet liquidity, acquire lower cost in-market deposits, and address consumer demand for FDIC-insured liquid deposits. Management believes the interest rate sensitivity of the Company’s non-maturity deposit portfolio is less than that of the general market. Accordingly, the lower level of interest rate sensitivity will partially mitigate the general effects of liability sensitivity. As of March 31, 2010, 96.0% of deposits were originated within markets we serve. The table below summarizes the repricing gap of the Company as of March 31, 2010.

 

Repricing Gap Report as of December 31, 2009 (in thousands)

 
     1 to 3
Months
    3 to 6
Months
    6 to 12
Months
    12 -24
Months
    24 to 36
Months
    36 to 60
Months
    Greater
than 60
Months /
non-rate
sensitive
    Total  

Assets

                

Cash, due from banks, and Federal funds sold

   $ 10,621      —        —        —        —        —        85,545      $ 96,166   

Securities available for sale (1)

     25,688      17,642      26,303      25,746      17,892      37,349      50,939        201,559   

Loans

     481,882      78,989      155,982      145,922      104,858      162,842      26,948        1,157,423   

Other Assets

     —        —        —        —        —        —        87,024        87,024   
                                                    

Total Assets

   $ 518,191      96,631      182,285      171,668      122,750      200,191      250,456      $ 1,542,172   
                                                    

Liabilities

                

Non-interest bearing deposits

     —        —        —        —        —        —        121,868      $ 121,868   

Interest-bearing transaction and savings deposits

     718,644      —        —        —        —        —        —          718,644   

Time deposits

     89,869      44,359      63,248      41,657      63,344      133,479      33        435,989   
                                                    

Total deposits

     808,513      44,359      63,248      41,657      63,344      133,479      121,901        1,276,501   

Borrowings, including repurchase agreements

     5,142      5,273      47      5,101      34,101      21,252      17,059        87,984   

Other Liabilities

     —        —        —        —        —        —        13,300        13,300   
                                                    

Total Liabilities

   $ 813,655      49,632      63,295      46,758      97,454      154,731      152,260      $ 1,377,785   
                                                    

Equity

     —        —        —        —        —        —        164,387        164,387   

Total Liabilities and Equity

   $ 813,655      49,632      63,295      46,758      97,454      154,731      316,647      $ 1,542,172   
                                                    

Repricing Assets

   $ 518,191      96,631      182,285      171,668      122,750      200,191      250,456      $ 1,542,172   

Repricing Liabilities

     813,655      49,632      63,295      46,758      97,454      154,731      316,647      $ 1542,172   

Period Repricing Gap

     (295,464   46,999      118,990      124,910      25,296      45,460      (66,192     0   

Period Repricing Gap Percentage

     63.7   194.7   288.0   367.1   126.0   129.4   79.1     100.0

Cumulative Repricing Gap Percentage

     63.7   71.2   86.0   99.5   101.9   105.4   100.0     100.0

 

Net Interest Income at Risk. We assess the percentage change in net interest income assuming interest rate shocks (upward and downward) of 100, 200, and 300 basis points. Given the current rate environment, we limited the downward shock to 100 basis points, but included an upward shock of 400 basis points. This analysis captures the timing of the repricing of RSA and RSL as well as the degree of change (“beta”) in the interest rates of particular asset and liability products that occurs as interest rates move upward or downward. Under the Asset and Liability Management Policy and Procedures, the interest rate simulation report measures the percentage change in net interest income for one year assuming interest rate shocks of 100, 200, and 300 basis points. The ALCO Policy has established an acceptable negative percentage change in net interest income under 100, 200, and 300 basis point shocks of 20%.

 

43


Table of Contents

The table below summarizes the Net Interest Income at Risk modeling results as of March 31, 2010.

 

     

Actual

    Policy  

Net Interest Income: Up 100 Bps (%)

   -2.45   20.0

Net Interest Income: Up 200 Bps (%)

   -1.84   20.0

Net Interest Income: Up 300 Bps (%)

   0.74   20.0

Net Interest Income: Up 400 Bps (%)

   3.56   N/A   

Net Interest Income: Down 100 Bps (%)

   0.63   20.0

Economic Value of Equity at Risk. We assess the present value of cash inflows of cash, investments, loans, bank-owned life insurance policies, when applicable, netted against the present value of cash outflows from deposits, repurchase agreements, borrowings, and other interest-bearing liabilities, all discounted to a measurement date. This measure is expressed as the percentage change in the present value of such cash flows when interest rates are shocked (upward and downward) at 100, 200, and 300 basis points. Under the Asset and Liability Management Policy and Procedures, the interest rate simulation reports measures the percentage change in economic value of equity at risk assuming interest rate shocks of 100, 200, and 300 basis points. Given the current rate environment, we limited the downward shock to 100 basis points, but included an upward shock of 400 basis points. The ALCO Policy has established an acceptable negative percentage change in economic value of equity at risk under 100, 200, and 300 basis point shocks of 20%.

The table below summarizes the Economic Value of Equity at Risk as of March 31, 2010.

 

     Actual     Policy  

Economic Value of Equity: Up 100 Bps (%)

   -4.60   20.0

Economic Value of Equity: Up 200 Bps (%)

   -6.77   20.0

Economic Value of Equity: Up 300 Bps (%)

   -6.85   20.0

Economic Value of Equity: Up 400 Bps (%)

   -6.03   N/A   

Economic Value of Equity: Down 100 Bps (%)

   7.95   20.0

Market Price Risk

As of March 31, 2010, our investment portfolio had a market value of approximately $201.6 million. The investment portfolio is comprised of two separate components each of which is managed pursuant to a board approved investment policy. At the holding company level, we have a portfolio of equity securities of financial institutions (the “Equity Portfolio”) with a market value of approximately $679 thousand. At the bank level, the Bank has a portfolio with a market value of approximately $200.9 million comprised of debt securities summarized below and certain restricted investments related to business relationships with the Federal Home Loan Bank of Pittsburgh and a correspondent bank. As of December 31, 2009, we had an investment portfolio with a market value of approximately $196.1 million of which $195.0 million was that was held at the bank level and $1.1 million was held at the holding company level.

The investment portfolio held by the Bank increased $5.9 million during the first quarter of 2010. The increase was largely related to replacing assets that matured or called and an increase of $4.6 million in municipal securities. The maturities and cash flows from these investments have been structured to coincide with the lending activities of the bank. For example, the weighted average life of the bank investment portfolio is 2.98 years. We believe that the off balance sheet liquidity sources of the bank and the ability to raise in-market deposits at reasonable prices adequately mitigates the cash flow variability of the investment portfolio.

The securities available for sale in the bank portfolio at March 31, 2010 consisted of U.S. Government agency securities, U.S. Government agency mortgage-backed securities; Government National Mortgage Association collateralized mortgage obligations, Small Business Administration loan pools, and municipal bonds. The Government National Mortgage Association collateralized mortgage obligations and Small Business Administration loan pool securities are secured by the full, faith, credit and taxing power of the United States of America and carry a zero risk weighting for regulatory capital purposes.

 

44


Table of Contents

Debt security market price risk is the risk that changes in the values of debt security investments could have a material impact on our financial position or results of operations. The table below summarizes the maturity structure of the portfolio as of March 31, 2010.

 

     Within 1 year     After 1 year but
within 5 years
    After 5 years but
within 10 years
    After 10 years     Total  
     (dollars in thousands)  
     Fair
Value
   W/A
yield
    Fair
Value
   W/A
yield
    Fair
Value
   W/A
yield
    Fair
Value
   W/A
yield
    Fair Value    W/A
yield
 

U.S Government agency obligations

        $ 34,379    1.67   $ 28,263    2.54        $ 62,642    2.06

State and municipal obligations

     439    4.04     4,765    3.17     7,789    4.16     11,727    4.23     24,720    4.00

Asset-backed securities (1)

                         107,264    2.61

Other securities (2)

                         6,254    —     
                                             

Graystone Tower Bank Portfolio

   $ 439      $ 39,144      $ 36,052      $ 11,727      $ 200,880    2.61
                                             

Holding company equity investments

  

                   679   
                             

Total investment securities

                       $ 201,559   
                             

 

(1): Mortgage-backed securities include agency mortgage-backed securities; Government National Mortgage Association collateralized mortgage obligations, and Small Business Administration loan pools.
(2): Equity investments in business relationship banks such as the Federal Home Loan Bank and correspondent banks.

Equity market price risk is the risk that changes in the values of equity investments could have a material impact on our financial position or results of operations. The Equity Portfolio was acquired as a result of the Merger. As of March 31, 2010, the equity portfolio was comprised of nine different equity securities of financial institutions. The investment portfolio at the holding company level decreased by $453 thousand as a result of selling nine equity positions. The total asset sizes of the financial institutions ranged from less than $100 million to financial institutions with assets of approximately $700 million. The financial institutions are geographically diverse with concentrations in the mid-Atlantic and south-eastern states.

 

Item 4. Controls and Procedures.

We maintain a system of controls and procedures designed to ensure that information required to be disclosed by us in reports that we file with the Securities and Exchange Commission (the “Commission”) is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms. Tower’s Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of our disclosure controls and procedures as of March 31, 2010. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting management to information required to be included in our periodic Securities and Exchange Commission filings.

As disclosed in management’s report on internal control over financial reporting, filed in Tower’s Form 10-K for the year ended December 31, 2009, in connection with Tower’s reverse merger with Graystone Financial Corp., Tower’s internal control structure was converted to the former control structure of Graystone Financial Corp. during 2009; however, because of the timing of the new internal control implementation, it was not practical for management to evaluate the effectiveness of internal control over financial reporting in a manner that would prove meaningful. Tower is continuing to execute its internal audit program under the direction of the Audit Committee of the Board of Directors and will be in a position to report on the effectiveness of internal control over financial reporting within the annual report for 2010.

During the quarter ended March 31, 2010, in connection with the continuing integration of Tower into the former control structure of Graystone Financial Corp., as well as the execution of the internal audit program with the support of a third-party service provider, Tower continued implementing or changing key procedures, systems, and personnel throughout the organization. The merger with Graystone Financial Corp. also provided for the enhancement of certain management and administrative personnel and staffing, as well as the implementation of certain credit administration, loan review, lending and other control policies and procedures throughout the entire Tower organization. Management believes that these changes will significantly remediate the material weaknesses related to credit administration and documentation identified in

 

45


Table of Contents

Management’s Report on Internal Control over Financial Reporting, as filed with Tower’s annual report on Form 10-K for the year ended December 31, 2008.

Other than the foregoing, there were no changes in Tower’s internal control over financial reporting during the first quarter of 2010 that materially affected, or are reasonably likely to materially affect, Tower’s internal control over financial reporting.

PART II – OTHER INFORMATION

 

Item 1. Legal Proceedings.

Tower is an occasional party to legal actions arising in the ordinary course of its business. In the opinion of Tower’s management, Tower has adequate legal defenses and/or insurance coverage respecting any and each of these actions and does not believe that they will materially affect Tower’s operations or financial position.

 

Item 1A. Risk Factors.

There have been no material changes from the risk factors as disclosed in Tower’s Annual Report on Form 10-K for the year ended December 31, 2009, except for the following risk factors, which have been amended or added since December 31, 2009.

Risks Related to the Proposed Acquisition of First Chester County Corporation

Regulatory approvals for Tower’s acquisition of First Chester County Corporation (“First Chester”) may not be received, may take longer than expected, or may impose conditions that are not presently anticipated or cannot be met.

Before the transactions contemplated in the acquisition agreement with First Chester County Corporation, including the acquisition, may be completed, various approvals or consents must be obtained from the Federal Reserve and various bank regulatory and other authorities. These governmental entities may impose conditions on the completion of the acquisition or require changes to the terms of the acquisition agreement. Although we do not currently expect that any such conditions or changes would be imposed, there can be no assurance that they will not be, and such conditions or changes could have the effect of delaying completion of the transactions contemplated in the acquisition agreement or imposing additional costs on or limiting our revenues, any of which might have a material adverse effect on us following the merger. There can be no assurance as to whether the regulatory approvals will be received, the timing of those approvals, or whether any conditions will be imposed.

First Chester’s banking subsidiary, the First National Bank of Chester County (“FNB”) is currently subject to a Memorandum of Understanding between its board of directors and the Office of the Comptroller of the Currency (OCC), the failure to comply with which could result in additional enforcement action.

On October 16, 2009, the Board of Directors of FNB entered into a Memorandum of Understanding, or MOU, with the OCC, which focused, among other things, on FNB’s need to: (i) develop a comprehensive three-year capital plan; (ii) take action to protect criticized assets and adopt and implement a program to eliminate the basis of criticism of such assets; (iii) establish an effective program that provides for early problem loan identification and a formal plan to proactively manage those assets; (iv) review the adequacy of the bank’s information technology activities and Bank Secrecy Act compliance and approve written programs of policies and procedures to provide for compliance; and (v) establish a Compliance Committee of the board of directors to monitor and coordinate the bank’s adherence to the provisions of the MOU.

Additionally, in early November 2009, the OCC notified FNB that it had established individual minimum capital ratios, or IMCRs, requiring FNB to achieve, by December 31, 2009, a Tier 1 leverage capital ratio of at least 8% of adjusted total assets, a Tier 1 risk-based capital ratio of at least 10% and a total risk-based capital ratio of at least 12%, each of which exceeded the well-capitalized ratios generally applicable to banks under then-current regulations. Tower, individually and through our subsidiary Graystone Tower Bank, has taken certain actions to assist FNB in achieving and maintaining capital ratios consistent with the IMCRs, including: (i) extending a $26 million loan to First Chester, the proceeds of which were contributed to FNB as Tier 1 capital, and which loan is secured by the stock of FNB; and (ii) purchasing from FNB $52.5 million in participations in performing commercial loans at a 1.5% discount. There can be no assurance that any of these actions will result in achieving the desired results. If the condition of FNB continues to deteriorate, we may lose all or a

 

46


Table of Contents

portion of the funds we invested in First Chester and/or FNB in order to assist it in achieving and maintaining “well-capitalized” status.

If the acquisition agreement is terminated, the loans between First Chester and us, which were designed to alleviate regulatory pressure on FNB, may not have their intended result.

In early November 2009, the OCC imposed IMCRs on FNB requiring it to increase its regulatory capital ratios. To enable FNB to achieve and maintain capital ratios consistent with the IMCRs, we, through Graystone Tower Bank, loaned $26 million to First Chester, the proceeds of which were contributed to FNB as Tier 1 capital. Additionally, we extended a $2 million non-revolving line of credit to First Chester, which permits draws from time to time for the sole purpose of contributing additional capital to FNB in the event that, as a result of the attempt to sell the AHB Division, the actual sale thereof, or the effects on FNB of such sale, FNB’s regulatory capital ratios, as reported in FNB’s quarterly call report, fall below the minimum regulatory capital ratios applicable to FNB as established by the IMCRs. Both loans are secured by a pledge of all of the stock of FNB. If the acquisition agreement is terminated, constituting an event of default under the loan agreements, First Chester will have to immediately repay the full amount of the loans to us. If First Chester cannot repay the loans, we could, with prior regulatory approval, foreclose on the stock of FNB under the pledge security agreement. There can be no assurance that First Chester will be able to raise funds sufficient to repay the loans from us if the acquisition agreement is terminated or that we would receive the requisite regulatory approval in order to foreclose on the FNB stock. If the acquisition agreement is terminated, we could lose all or a portion of the funds loaned to First Chester

There are numerous conditions to the acquisition and the acquisition may not be completed.

The acquisition agreement is subject to a number of conditions which must be fulfilled or, to the extent permissible, waived in order to close. Those conditions include: receipt of approval from both First Chester’s and our shareholders, receipt of regulatory approval, the continued accuracy of certain representations and warranties by both parties and the performance by both parties of certain covenants and agreements. In particular, it is a condition to our obligation to close the acquisition that: (i) First Chester delinquent loans, as defined in the acquisition agreement, not exceed $90 million as of the last day of the month prior to the closing date; and (ii) FNB shall have received written confirmation from the OCC of the termination of the MOU, such termination to be effective as of or prior to the effective time of the acquisition. The failure of any of the foregoing conditions would allow us to refuse to consummate the merger.

Additionally, either party may terminate the acquisition agreement if the acquisition has not been completed on or before September 30, 2010.

There can be no assurance that the conditions to closing the acquisition will be fulfilled or waived or that the acquisition will be completed.

First Chester’s asset quality may continue to deteriorate prior to completion of the acquisition.

Should the asset quality at First Chester deteriorate further, such deterioration may have an adverse effect on First Chester’s financial and capital positions.

First Chester may be unsuccessful in selling its AHB Division prior to completion of the acquisition, which could result in additional costs to Tower associated with winding down the AHB Division’s mortgage-banking activities.

First Chester, through the American Home Bank Division of FNB (the “AHB Division”), engages in mortgage-banking activities on a nation-wide basis. The acquisition agreement requires that First Chester use its best efforts, and shall cause FNB to use its best efforts, to sell, at or prior to the effective time of the acquisition, the AHB Division to one or more purchasers on terms and conditions acceptable to First Chester and Tower. There can be no assurance that First Chester will be successful in selling the AHB Division prior to the acquisition. If unsuccessful, Tower intends to discontinue the mortgage-banking activities associated with the AHB Division in an orderly fashion upon completing the acquisition. Discontinuing such activities may result in additional costs to Tower that may not have been fully accounted for in Tower’s acquisition analyses.

 

47


Table of Contents

First Chester holds certain intangible assets that could be classified as impaired in the future. If these assets are considered to be either partially or fully impaired in the future, First Chester’s earnings and the book value of these assets, which would be acquired by us if the acquisition is consummated, would decrease.

Pursuant to FASB ASC Topic 350, “Intangibles-Goodwill and Other,” First Chester is required to test its goodwill and core deposit intangible assets for impairment on a periodic basis. The impairment testing process considers a variety of factors, including the current market price of its common shares, the estimated net present value of its assets and liabilities, and information concerning the terminal valuation of similarly situated depository institutions. The market price of First Chester common shares was below their book value as of December 31, 2009. If the duration of this decline in the market value of First Chester common shares and the decline in the market prices of the common shares of similarly situated insured depository institutions persists during future reporting periods, or if the severity of the decline increases, it is possible that future impairment testing could result in a partial or full impairment of the value of First Chester’s goodwill or core deposit intangibles, or both. If an impairment determination is made in a future reporting period, First Chester’s earnings and the book value of these intangible assets, which would be acquired by us if the acquisition is consummated, will be reduced by the amount of the impairment.

The pending acquisition of First Chester may distract our management from their other responsibilities.

The pending acquisition of First Chester could cause our management to focus their time and energies on matters related to the acquisition that otherwise would be directed to our business and operations. Any such distraction on the part of management, if significant, could affect management’s ability to service existing business and develop new business and otherwise adversely affect us following the acquisition.

 

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

None.

 

Item 3. Defaults Upon Senior Securities.

None.

 

Item 4. (Removed and Reserved).

None

 

Item 5. Other Information.

On May 5, 2010, Graystone Tower Bank (the “Bank”), Tower’s bank subsidiary, entered into a Limited Waiver with respect to certain loan covenants under that certain Loan Agreement (the “Loan Agreement”) between the Bank and First Chester County Corporation (“First Chester”) dated November 20, 2009, as amended. Pursuant to the Limited Waiver, the Bank agreed to waive the requirement under the Loan Agreement that provides First Chester’s subsidiary bank, First National Bank of Chester County (“FNB”), must maintain a Tier 1 leverage capital ratio of at least 8%, provided that FNB maintains a Tier 1 leverage capital ratio of at least 7.75%. The waiver shall automatically terminate upon the earlier of the submission of FNB’s Report of Condition and Income to the Federal Deposit Insurance Corporation for the quarter ended June 30, 2010, and July 30, 2010. A copy of the Limited Waiver is filed herewith as Exhibit 10.2 and incorporated herein by reference.

 

48


Table of Contents
Item 6. Exhibits.

 

Exhibit

No.

  

Description

  2.1    Agreement and Plan of Merger by and between First Chester County Corporation and Tower Bancorp, Inc., dated as of December 27, 2009 (Incorporated by reference to Exhibit 2.1 to Registrant’s Current Report on Form 8-K filed December 28, 2009)
  2.2    First Amendment to Agreement and Plan of Merger by and between Tower Bancorp, Inc. and First Chester County Corporation, dated March 4, 2010. (Incorporated by reference to Exhibit 10.1 to Registrant’s Current Report on Form 8-K filed on March 9, 2010)
  2.3    Form of Bank Plan of Merger by and between Graystone Tower Bank and First National Bank of Chester County (included as Exhibit F to the First Amendment to Agreement and Plan of Merger filed herewith as Exhibit 2.2)
  3.1    Amended and Restated Articles of Incorporation (Incorporated by reference to Exhibit 3.1 to Registrant’s Current Report on Form 8-K filed on September 24, 2009)
  3.2    Bylaws of Tower Bancorp, Inc. (Incorporated by reference to Exhibit 3.1 to Registrant’s Current Report on Form 8-K filed on March 31, 2009)
  4.1    Form of Subordinated Note due July 1, 2014 (Incorporated by reference to Exhibit 4.1 to Registrant’s Current Report on Form 8-K filed on June 12, 2009)
  4.2    Form of Form of Subordinated Note Due July 1, 2015 (Incorporated by reference to Exhibit 4.1 to Registrant’s Current Report on Form 8-K filed on February 8, 2010)
10.1    Form of Loan Agreement by and between Tower Bancorp, Inc. and First Chester County Corporation (included as Exhibit G to the First Amendment to Agreement and Plan of Merger filed herewith as Exhibit 2.2)
10.2    Limited Waiver dated May 5, 2010 relating to Loan Agreement between First Chester County Corporation and Graystone Tower Bank dated November 20, 2010, as amended
31.1    Certification of President and Chief Executive Officer of Tower Bancorp, Inc. Pursuant to Securities and Exchange Commission Rule 13a-14(a) / 15d-14(a)
31.2    Certification of Chief Financial Officer of Tower Bancorp, Inc. Pursuant to Securities and Exchange Commission Rule 13a-14(a) / 15d-14(a)
32.1    Certification of President and Chief Executive Officer of Tower Bancorp, Inc. Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Furnished, not filed)
32.2    Certification of Chief Financial Officer of Tower Bancorp, Inc. Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Furnished, not filed)

 

49


Table of Contents

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.

 

      TOWER BANCORP, INC.
      (Registrant)
Date:  

May 6, 2010

    By:  

/S/    ANDREW S. SAMUEL        

        Andrew S. Samuel
        President and Chief Executive Officer
       
Date:  

May 6, 2010

    By:  

/S/    MARK S. MERRILL        

        Mark S. Merrill
        Executive Vice President and Chief Financial Officer

 

50


Table of Contents

Exhibit

No.

  

Description

  2.1    Agreement and Plan of Merger by and between First Chester County Corporation and Tower Bancorp, Inc., dated as of December 27, 2009 (Incorporated by reference to Exhibit 2.1 to Registrant’s Current Report on Form 8-K filed December 28, 2009)
  2.2    First Amendment to Agreement and Plan of Merger by and between Tower Bancorp, Inc. and First Chester County Corporation, dated March 4, 2010. (Incorporated by reference to Exhibit 10.1 to Registrant’s Current Report on Form 8-K filed on March 9, 2010)
  2.3    Form of Bank Plan of Merger by and between Graystone Tower Bank and First National Bank of Chester County (included as Exhibit F to the First Amendment to Agreement and Plan of Merger filed herewith as Exhibit 2.2)
  3.1    Amended and Restated Articles of Incorporation (Incorporated by reference to Exhibit 3.1 to Registrant’s Current Report on Form 8-K filed on September 24, 2009)
  3.2    Bylaws of Tower Bancorp, Inc. (Incorporated by reference to Exhibit 3.1 to Registrant’s Current Report on Form 8-K filed on March 31, 2009)
  4.1    Form of Subordinated Note due July 1, 2014 (Incorporated by reference to Exhibit 4.1 to Registrant’s Current Report on Form 8-K filed on June 12, 2009)
  4.2    Form of Form of Subordinated Note Due July 1, 2015 (Incorporated by reference to Exhibit 4.1 to Registrant’s Current Report on Form 8-K filed on February 8, 2010)
10.1    Form of Loan Agreement by and between Tower Bancorp, Inc. and First Chester County Corporation (included as Exhibit G to the First Amendment to Agreement and Plan of Merger filed herewith as Exhibit 2.2)
10.2    Limited Waiver dated May 5, 2010 relating to Loan Agreement between First Chester County Corporation and Graystone Tower Bank dated November 20, 2010, as amended
31.1    Certification of President and Chief Executive Officer of Tower Bancorp, Inc. Pursuant to Securities and Exchange Commission Rule 13a-14(a) / 15d-14(a)
31.2    Certification of Chief Financial Officer of Tower Bancorp, Inc. Pursuant to Securities and Exchange Commission Rule 13a-14(a) / 15d-14(a)
32.1    Certification of President and Chief Executive Officer of Tower Bancorp, Inc. Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Furnished, not filed)
32.2    Certification of Chief Financial Officer of Tower Bancorp, Inc. Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Furnished, not filed)

 

51