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EX-31.1 - SECTION 302 CEO CERTIFICATION - TOWER BANCORP INCdex311.htm
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EX-31.2 - SECTION 302 CFO CERTIFICATION - TOWER BANCORP INCdex312.htm
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EX-10.10 - DEFERRED COMPENSATION AGREEMENT - TOWER BANCORP INCdex1010.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: June 30, 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: 7,140,227 shares of common stock outstanding at July 31, 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    28

Item 3.

  Quantitative and Qualitative Disclosures About Market Risk    50

Item 4.

  Controls and Procedures    55

PART II

  OTHER INFORMATION   

Item 1.

  Legal Proceedings    56

Item 1A.

  Risk Factors    56

Item 2.

  Unregistered Sales of Equity Securities and Use of Proceeds    59

Item 3.

  Defaults Upon Senior Securities    59

Item 4.

  (Removed and Reserved)    59

Item 5.

  Other Information    59

Item 6.

  Exhibits    60
  Signatures    62
  Exhibit Index    104

 

2


Table of Contents

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Tower Bancorp, Inc. and Subsidiary

Consolidated Balance Sheets

June 30, 2010 and December 31, 2009

(Amounts in thousands, except share data)

 

     June 30,
2010
    December 31,
2009
 
   (unaudited)        

Assets

    

Cash and due from banks

   $ 57,124      $ 33,955   

Federal funds sold

     14,303        16,645   
                

Cash and cash equivalents

     71,427        50,600   

Securities available for sale

     190,895        189,853   

Restricted investments

     6,254        6,254   

Loans held for sale

     14,725        8,034   

Loans, net of allowance for loan losses of $11,619, and $9,695

     1,204,716        1,128,576   

Premises and equipment, net of accumulated depreciation of $4,595 and $3,324

     28,614        29,810   

Premises and equipment held for sale, net of accumulated depreciation of $27

     549        —     

Accrued interest receivable

     5,320        4,974   

Deferred tax asset, net

     1,128        1,742   

Bank owned life insurance

     37,340        24,606   

Goodwill

     11,935        11,935   

Other intangible assets, net

     3,031        3,367   

Other assets

     12,145        10,832   
                

Total Assets

   $ 1,588,079      $ 1,470,583   
                

Liabilities and Stockholders’ Equity

    

Liabilities

    

Deposits:

    

Non-interest bearing

   $ 120,206      $ 119,116   

Interest bearing

     1,202,136        1,097,353   
                

Total deposits

     1,322,342        1,216,469   

Securities sold under agreements to repurchase

     5,055        6,892   

Short-term borrowings

     10,285        5,292   

Long-term debt

     72,476        65,689   

Accrued interest payable

     1,083        1,090   

Other liabilities

     11,495        11,274   
                

Total Liabilities

     1,422,736        1,306,706   
                

Stockholders’ Equity

    

Common stock, no par value; 50,000,000 shares authorized; 7,243,585 issued and 7,140,227 outstanding at June 30, 2010, 7,226,041 shares issued and 7,122,683 outstanding at December 31, 2009

     —          —     

Additional paid-in capital

     172,925        172,409   

Accumulated deficit

     (4,934     (4,025

Accumulated other comprehensive income (loss)

     1,445        (414

Less: cost of treasury stock, 103,358 at June 30, 2010 and December 31, 2009

     (4,093     (4,093
                

Total Stockholders’ Equity

     165,343        163,877   
                

Total Liabilities and Stockholders’ Equity

   $ 1,588,079      $ 1,470,583   
                

See Notes to the Consolidated Financial Statements

 

3


Table of Contents

Tower Bancorp, Inc. and Subsidiary

Consolidated Statements of Operations

For the Three and Six Months Ended June 30 2010 and 2009

(Amounts in thousands, except share data)

 

     Three Months Ended
June 30,
   Six Months Ended
June 30,
 
     2010     2009    2010     2009  
     (unaudited)    (unaudited)  

Interest Income

     

Loans, including fees

   $ 17,274      $ 15,252    $ 33,780      $ 23,540   

Securities

     1,167        387      2,203        516   

Federal funds sold and other

     41        21      74        27   
                               

Total Interest Income

     18,482        15,660      36,057        24,083   

Interest Expense

         

Deposits

     4,544        4,894      9,153        8,657   

Short-term borrowings

     212        170      305        202   

Long-term debt

     823        483      1,647        737   
                               

Total Interest Expense

     5,579        5,547      11,105        9,596   
                               

Net Interest Income

     12,903        10,113      24,952        14,487   

Provision for Loan Losses

     1,900        650      3,350        3,016   
                               

Net Interest Income after Provision for Loan Losses

     11,003        9,463      21,602        11,471   

Non-Interest Income

         

Service charges on deposit accounts

     805        664      1,545        881   

Other service charges, commissions and fees

     682        739      1,208        896   

Gain on sale of mortgage loans originated for sale

     321        581      594        848   

(Loss) gain on sale of other interest earning assets

     (29     311      (5     311   

Income from bank owned life insurance

     470        283      791        442   

Other income

     243        168      363        316   
                               

Total Non-Interest Income

     2,492        2,746      4,496        3,694   

Non-Interest Expenses

         

Salaries and employee benefits

     5,343        4,769      10,442        7,286   

Occupancy and equipment

     1,735        1,470      3,431        2,202   

Amortization of intangible assets

     159        177      336        177   

FDIC insurance premiums

     538        731      936        911   

Advertising and promotion

     374        141      509        218   

Data processing

     643        592      1,154        787   

Professional service fees

     371        284      812        538   

Impairment of long-lived assets

     920        —        920        —     

Other operating expenses

     1,651        1,411      2,917        1,924   

Merger related expenses

     76        106      187        1,412   
                               

Total Non-Interest Expenses

     11,810        9,681      21,644        15,455   
                               

Net Income (Loss) Before Income Tax Benefit

     1,685        2,528      4,454        (290
                               

Income Tax Expense (Benefit)

     508        690      1,372        (243
                               

Net Income (Loss)

   $ 1,177      $ 1,838    $ 3,082      $ (47
                               

Net Income (Loss) Per Common Share

         

Basic

   $ 0.17      $ 0.36    $ 0.43      $ (0.01

Diluted

   $ 0.17      $ 0.36    $ 0.43      $ (0.01

Dividends Declared Per Common Share

   $ 0.28      $ 0.28    $ 0.56      $ 0.28   

Weighted Average Common Shares Outstanding

         

Basic

     7,133,681        5,058,119      7,129,491        3,918,250   

Diluted

     7,137,256        5,065,180      7,133,819        3,918,250   

See Notes to the Consolidated Financial Statements

 

4


Table of Contents

Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income (Loss)

For the Six Months Ended June 30, 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   

Dividends declared

           (1,416         (1,416

Comprehensive Income:

              

Net income

           (47         (47

Unrealized loss on securities available for sale, net of taxes of $86

             (168       (168
                    

Total Comprehensive Loss

                 (215
                                              

Balance—June 30, 2009 (unaudited)

   $ —      $ 120,337    $ (4,372   $ (21   $ (4,093   $ 111,851   
                                              

Balance—December 31, 2009

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

Stock issued as investment in Dellinger, Dolan, McCurdy and Phillips Investment Advisors, LLC (“DDMP”)

        51            51   

Stock option expense

        56            56   

Proceeds from stock purchase plans

        409            409   

Dividends declared

           (3,991         (3,991

Comprehensive Income:

              

Net income

           3,082            3,082   

Unrealized gain on securities available for sale, net of taxes of $991

             1,859          1,859   
                    

Total Comprehensive Income

                 4,941   
                                              

Balance—June 30, 2010 (unaudited)

   $ —      $ 172,925    $ (4,934   $ 1,445      $ (4,093   $ 165,343   
                                              

See Notes to the Consolidated Financial Statements

 

5


Table of Contents

Consolidated Statements of Cash Flows

For the Six Months Ended June 30, 2010 and 2009

(Amounts in thousands, except share data)

 

     2010     2009  
     (unaudited)     (unaudited)  

Cash Flows from Operating Activities

    

Net income (loss)

   $ 3,082      $ (47

Adjustments to reconcile net loss to net cash used in operating activities:

    

Provision for loan losses

     3,350        3,016   

Net accretion on securities and loans

     (79     (177

Depreciation and amortization

     1,308        1,001   

Amortization of intangible assets

     336        177   

Amortization of unearned compensation on restricted stock

     —          295   

Stock option expense

     56        549   

Deferred tax benefit

     (377     (186

(Increase) decrease in accrued interest receivable

     (346     28   

Decrease in accrued interest payable

     (7     (222

Net increase in the cash surrender value of life insurance

     (734     (442

Increase in other assets

     (1,262     (1,628

Increase (decrease) in other liabilities

     221        (1,314

Impairment of premises and equipment

     920        —     

Gain on sale of loans originated for sale and other assets, net

     (621     (1,159

Loans originated for sale

     (51,655     (76,339

Sale of loans

     45,558        73,021   
                

Net Cash Used in Operating Activities

     (250     (3,427
                

Cash Flows from Investing Activities

    

Proceeds from maturities and sales of securities available for sale

     68,955        37,073   

Purchases of securities available for sale

     (66,521     (9,641

Purchases of bank owned life insurance

     (12,000     —     

Net increase in loans

     (80,042     (36,436

Decrease of investment in restricted investments

     —          1,025   

Purchases of premises and equipment

     (1,703     (1,033

Net proceeds from the sale of premises and equipment

     154        —     

Net cash received in Merger

     —          9,017   
                

Net Cash (Used in) Provided by Investing Activities

     (91,157     5   
                

Cash Flows from Financing Activities

    

Proceeds from advances on long-term debt

     6,787        7,627   

Net increase (decrease) in short-term borrowings

     4,993        (37,837

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

     (1,837     132   

Net increase in deposits

     105,873        127,361   

Proceeds from the sale of common stock

     409        —     

Dividends paid

     (3,991     (1,416
                

Net Cash Provided by Financing Activities

     112,234        95,867   
                

Net Increase in Cash and Cash Equivalents

     20,827        92,445   

Cash and Cash Equivalents - Beginning

     50,600        32,022   
                

Cash and Cash Equivalents - Ending

   $ 71,427      $ 124,467   
                

Supplemental disclosure of information:

    

Interest paid

   $ 11,112      $ 9,120   

Income taxes paid

   $ 3,550      $ 125   

Supplemental schedule of noncash investing and financing activities

    

Other real estate (sold) acquired in settlement of loan

   $ (128   $ 927   

Unrealized gain (loss) on investments securities available for sale, net of tax

   $ 1,859      $ (168

Reclassification of long-term debt to short-term borrowings

   $ 5,000      $ —     

See Notes to the Consolidated Financial Statements

 

6


Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

June 30, 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 April 22, 2010, Tower Bancorp, Inc. became a financial holding company pursuant to the Gramm-Leach-Bliley Act of 1999.

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. 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, which would ultimately affect the total value of the acquisition.

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 June 30, 2010, the Bank has loaned $26 million to First Chester. The Bank had also purchased approximately $52 million in performing commercial loans from First National Bank of Chester County during the fourth quarter of 2009.

Following the transaction, based on the 0.453 exchange ratio announced in the FCEC Acquisition Agreement, current Tower shareholders will own approximately 71% and First Chester shareholders will own approximately 29% of the combined company’s common stock. The Company has received all necessary regulatory approvals and pending the approvals of shareholder of both entities, the acquisition is expected to be completed before the end 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, the Company 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. Through June 30, 2010, we have not advanced any funds to First Chester under this facility. As of June 30, 2010, First Chester has not sold the AHB Division.

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 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 and six month periods

 

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Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

June 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

ended June 30, 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, the valuation of long-lived assets, 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 July 2010, the FASB issued Accounting Standard Codification Update No. 2010-20 concerning disclosures about the credit quality of financing receivables and the allowance for credit losses. Update No. 2010-20 is intended to provide additional information to assist financial statement users in assessing an entity’s credit risk exposures and evaluating the adequacy of its allowance for credit losses. Update No. 2010-20 requires companies to (1) provide enhanced disclosures around the nature of credit risk inherent in the entity’s portfolio of financing receivables; (2) explain how that risk is analyzed and assessed in arriving at the allowance for credit losses; and (3) explain the changes and reasons for changes in the allowance for credit losses. The provisions of Update No. 2010-20 concerning disclosures for the end of a period are effective for interim and annual periods ending on or after December 15, 2010, or December 31, 2010 for the Company. The provisions of Update No. 2010-20 concerning disclosures about activity that occurs during a reporting period are applicable to the Company for interim and annual periods beginning on or after December 15, 2010, the interim period ending on March 31, 2011. The adoption of Update No. 2010-20 is expected to provide the reader of the Company’s financial statements with expanded and enhanced disclosure surrounding the allowance for credit losses.

In January 2010, the FASB issued Accounting Standard Codification Update No. 2010-06 for improving disclosures about fair value measurements. Update No. 2010-06 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, Update No. 2010-06 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 Update No. 2010-06 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 Update No. 2010-06 within this Form 10-Q which can be found in Note 12 of the Notes to the Unaudited Consolidated Financial Statements. Update No. 2010-06 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 Update No. 2010-06 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 Update No. 2010-06 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

 

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Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

June 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

January 1, 2010, which did not have a material effect on the consolidated financial statements for the period ended June 30, 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 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 June 30, 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 June 30, 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 June 30, 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 six months 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 six months ended June 30, 2009, assuming that the Merger occurred on January 1, 2009:

 

     Pro-forma
June 30, 2009
 

Net interest income

   $ 19,800   

Pre-tax net income

     (697

Income tax expense

     (457

Net income

     (240

Pro-forma earnings per share:

  

Basic

   $ (0.06

Diluted

   $ (0.06

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

June 30, 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 June 30, 2010 and December 31, 2009 are as follows:

 

     Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
    Fair Value
     June 30, 2010

Equity securities

   $ 356    $ 2    $ —        $ 358

U.S Government sponsored agency securities

     62,632      210      —          62,842

U.S. Government sponsored agency mortgage-backed securities

     6,570      14      —          6,584

Collateralized mortgage obligations

     84,960      1,162      —          86,122

Municipal bonds

     11,134      130      (25     11,239

Municipal bonds – taxable

     12,871      710      —          13,581

SBA Pool Loan Investments

     10,149      23      (3     10,169
                            
   $ 188,672    $ 2,251    $ (28   $ 190,895
                            
     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 $54,248 and $34,999 at June 30, 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 June 30, 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.

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

June 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

     June 30, 2010
     Amortized Cost    Fair Value

Due in one year or less

   $ 335    $ 337

Due after one year through five years

     46,715      47,032

Due after five years through ten years

     27,908      28,353

Due after ten years

     11,679      11,940
             
     86,637      87,662
             

Mortgage-backed securities (1)

     101,679      102,875

Equity securities

     356      358
             
   $ 188,672    $ 190,895
             

 

 

 

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

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

June 30, 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 for the three and six month periods ending June 30, 2010 and 2009.

 

     Three Months Ended June 30,  
     Gross Realized
Gains
   Gross Realized
Losses
    Other-than-
temporary
Impairment
Losses
    Net (Losses)/
Gains
 

2010

         

Equity securities

   $ 14    $ —        $ (68   $ (54

Debt securities

     1      —          —          1   
                               

Total

   $ 15    $ —        $ (68   $ (53
                               

2009

         

Equity securities

   $ 535    $ (237   $ (29   $ 269   

Debt securities

     4      (7     —          (3
                               

Total

   $ 539    $ (244   $ (29   $ 266   
                               
     Six Months Ended June 30,  
     Gross Realized
Gains
   Gross Realized
Losses
    Other-than-
temporary
Impairment
Losses
    Net (Losses)/
Gains
 

2010

         

Equity securities

   $ 38    $ (3   $ (68   $ (33

Debt securities

     4      —          —          4   
                               

Total

   $ 42    $ (3   $ (68   $ (29
                               

2009

         

Equity securities

   $ 541    $ (240   $ (29   $ 272   

Debt securities

     4      (7     —          (3
                               

Total

   $ 545    $ (247   $ (29   $ 269   
                               

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

June 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

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 June 30, 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
     June 30, 2010

Equity securities

   $ —      $ —      $ —      $ —      $ —      $ —  

U.S Government sponsored agency securities

     —        —        —        —        —        —  

U.S. Government sponsored agency mortgage-backed securities

     —        —        —        —        —        —  

Collateralized mortgage obligations

     —        —        —        —        —        —  

Municipal bonds

     4,947      25      —        —        4,947      25

Municipal bonds – taxable

     —        —        —        —        —        —  

SBA Pool Loan Investments

     1,964      3      —        —        1,964      3
                                         
   $ 6,911    $ 28    $ —      $ —      $ 6,911    $ 28
                                         
     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
                                         

The previous table includes 3 investment securities at June 30, 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 quarterly 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. At June 30, 2010, Management identified equity securities with unrealized losses that were deemed to be other-than-temporary in nature and resulting in an impairment charge of $68. Management does not have the intent to sell the investments available for sale carrying an unrealized loss and believes it is more likely than not, that it will not sell these securities prior to the recovery of their cost basis or maturity, with the exception of the securities for which an impairment charge was recognized this quarter. As a result, the Company has determined that, excluding the securities related to the impairment charge, no investments trading below cost had declined on an other-than-temporary basis during the first six months of 2010.

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

June 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

Note 4 – Loans

The following table presents a summary of the loan portfolio at June 30, 2010 and December 31, 2009:

 

     June 30,
2010
    December 31,
2009
 

Commercial

   $ 936,916      $ 861,673   

Consumer & other

     95,023        85,510   

Residential mortgage

     184,474        191,277   
                

Total Loans

     1,216,413        1,138,460   

Deferred costs (fees)

     (78     (189

Allowance for loan losses

     (11,619     (9,695
                

Net Loans

   $ 1,204,716      $ 1,128,576   
                

The Company serviced $107,420 and $111,649 of participation loans for unrelated parties at June 30, 2010 and December 31, 2009, respectively.

The Company sold $45,558 and $73,021 of residential mortgage loans into the secondary market during the six months ended June 30, 2010 and 2009, respectively. A gain of $321 and $581 was recognized on the sale of these loans for the three month periods ended June 30, 2010 and 2009, respectively. A gain of $594 and $848 was recognized on the sale of these loans for the six month periods ended June 30, 2010 and 2009, respectively.

Changes in the allowance for loan losses were as follows for the three months and six months ended June 30, 2010 and 2009:

 

     Three months ended     Six months ended  
     June 30,     June 30,  
     2010     2009     2010     2009  

Balance at beginning of period

   $ 10,892      $ 7,761      $ 9,695      $ 6,017   

Provision for loan losses

     1,900        650        3,350        3,016   

Charge-offs

        

Commercial

     (853     (381     (1,150     (944

Consumer

     (147     (88     (147     (147

Residential mortgage

     (200     —          (200     —     
                                

Total Charge-offs

     (1,200     (469     (1,497     (1,091

Recoveries

        

Commercial

     27        24        71        24   

Consumer

     —          —          —          —     

Residential mortgage

     —          —          —          —     
                                

Total Recoveries

     27        24        71        24   
                                

Net charge-offs

     (1,173     (445     (1,426     (1,067
                                

Balance at end of period

   $ 11,619      $ 7,966      $ 11,619      $ 7,966   
                                

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

June 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

The following table presents non-performing assets as of June 30, 2010 and December 31, 2009:

 

     June 30,    December 31,
     2010    2009

Non-accrual loans

     

Commercial

   $ 8,411    $ 3,408

Consumer

     170      320

Residential mortgage

     1,457      990
             

Total non-accrual loans

     10,038      4,718
             

Accruing loans greater than 90 days past due

     

Commercial

     480      634

Consumer

     —        48

Residential mortgage

     1,908      1,424
             

Total accruing loans greater than 90 days past due

     2,388      2,106
             

Non-performing loans

     12,426      6,824

Other real estate owned

     799      927
             

Non-performing assets

   $ 13,225    $ 7,751
             

The Company had total impaired loans of $14,414 and $10,917 as of June 30, 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. Impaired loans considered to be collateral dependent totaled approximately 99.3% and 99.4% of total impaired loans as of June, 30, 2010 and December 31, 2009, respectively. As of June 30, 2010, the Company has determined that impaired loans with a carrying principal balance of $5,001 require a reserve of $500 with the remaining $9,413 of impaired loans not requiring a specific reserve allocation as the future anticipated cash flow, including the collateral values, will be sufficient to fully recover all amounts due on these loans. As of December 31, 2009 the Company had determined that impaired loans with a carrying principal balance of $1,353 required a reserve of $451 with the remaining $9,564 of impaired loans not requiring a specific reserve allocation as the future anticipated cash flow, including the collateral values, will be sufficient to fully recover all amounts due on these loans. For the six months ended June 30, 2010, the Company charged off $2,292 of loans. These charges have been applied against both the allowance for loans losses as well as against the fair value credit adjustment/discount recorded on performing loans acquired through the Merger.

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 the Company expects to fully collect the new carrying value (i.e. fair value) of the loans.

The following table provides activity for the accretable yield of these purchased impaired loans for the three and six months ended June 30, 2010.

 

     Three Months Ended     Six Months Ended  
     June 30, 2010     June 30, 2010  

Accretable yield, beginning balance

   $ 560      $ 178   

Accretable yield amortized to interest income

     (440     (551

Reclassification from non-accretable difference (1)

     1,039        1,532   
                

Accretable yield, end of period

   $ 1,159      $ 1,159   
                

 

(1) Reclassification from non-accretable difference represents an increase to the estimated cash flows to be collected on the underlying portfolio.

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

June 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

Note 5 – Premises and Equipment

The following table presents premises and equipment as of June 30, 2010 and December 31, 2009:

 

     June 30, 2010     December 31, 2009  

Land

   $ 4,474      $ 5,394   

Building

     13,570        13,684   

Leasehold improvements

     3,889        3,703   

Furniture, fixtures and equipment

     7,904        6,918   

Other

     3,921        3,435   
                
     33,758        33,134   

Accumulated depreciation and amortization

     (4,595     (3,324

Premises and equipment held for sale, net

     (549     —     
                
   $ 28,614      $ 29,810   
                

During the second quarter of 2010, management had explored the potential sale of a parcel of undeveloped land that was acquired as part of the Merger. As a result, management determined that the recorded cost basis of the land may not be recoverable. Accordingly, the Company determined the estimated fair value of the land to be less than its recorded value, resulting in an impairment charge of $920. Management is currently consulting with third party valuation experts to finalize a determination of fair value for the land. Management is of the opinion that the current impairment charge is sufficient and fairly presents the decline in the fair value of the asset; however, upon completion of the third party’s analysis a further impairment charge may be required at that time.

Note 6 – Other Intangibles

Information concerning total amortizable other intangible assets, which consist solely of a core deposit intangible asset, at June 30, 2010 and December 31, 2009 is as follows:

 

     Gross
Carrying
Amount
   Accumulated
Amortization
   Net Carrying
Amount

Balance at December 31, 2009

   $ 3,899    $ 532    $ 3,367

Amortization Expense

     —        336      336
                    

Balance at March 31, 2010

   $ 3,899    $ 868    $ 3,031
                    

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

 

2010 (July – December)

   $ 320

2011

     585

2012

     513

2013

     444

2014

     372

Thereafter

     797
      
   $ 3,031
      

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

June 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

Note 7 – Deposits

The following is a summary of deposits at June 30, 2010 and December 31, 2009:

 

     June 30,
2010
   December 31,
2009

Non-interest bearing transaction accounts

   $ 120,206    $ 119,116

Interest checking accounts

     119,059      110,356

Money market accounts

     591,256      477,292

Savings accounts

     78,904      87,117

Time deposits of $100,000 or greater

     135,337      130,938

Time deposits, other

     277,580      291,650
             

Total

   $ 1,322,342    $ 1,216,469
             

Brokered deposits totaled $127,036 and $61,114 at June 30, 2010 and December 31, 2009, respectively. Brokered deposits, exclusive of in-market reciprocal brokered deposits, totaled $93,103 and $46,018 at June 30, 2010 and December 31, 2009, respectively.

Note 8 – Borrowings

Federal Home Loan Bank

The Bank has a maximum borrowing capacity under an agreement with the Federal Home Loan Bank (“FHLB”) of approximately $544,949 and $482,024 at June 30, 2010 and December 31, 2009, respectively. The available amount of borrowing capacity for June 30, 2010 and December 31, 2009 was approximately $485,609 and $422,679, respectively. The total outstanding borrowings at June 30, 2010 equaled $59,340, of which $10,250 has a maturity of less than one year and is classified as short-term borrowing. The remaining borrowings of $49,090 have a maturity greater than one year and are classified as long-term debt at June 30, 2010. The average interest rate on FHLB borrowings at June 30, 2010 equaled 3.94%. At June 30, 2010, the unamortized fair value adjustment to FHLB borrowings assumed in the Merger totaled $(280). The total outstanding borrowings at December 31, 2009 equaled $59,346, of which, $54,096 have a stated maturity 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 issued to private investors an aggregate of $12,000 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 15, 2015. Interest only payments are due on a quarterly basis with the unpaid principal balance due at maturity.

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 June 30, 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 $2,701 and $2,729 at June 30, 2010 and December 31, 2009, respectively.

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

June 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

Note 9 – 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 the Three Months Ended    For the Six Months Ended
     June 30,
2010
   June 30,
2009
   June 30,
2010
   June 30,
2009

Weighted average shares outstanding (basic)

   7,133,681    5,058,119    7,129,491    3,918,250

Impact of common stock equivalents

   3,575    7,061    4,328    —  
                   

Weighted average shares outstanding (diluted)

   7,137,256    5,065,180    7,133,819    3,918,250
                   

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

           
   79,531    22,831    79,531    60,103
                   

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.

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 Six Months Ended  
     June 30,     June 30,  
     2010     2009  

Gross unrealized holding net gains arising during the year

   $ 2,821      $ 15   

Reclassification adjustment for impairment losses recognized in net income

     68        29   

Reclassification adjustment for net gains realized in net income

     (39     (298
                

Net unrealized holding gains (losses) before taxes

     2,850        (254

Tax effect

     (991     86   
                

Net change

   $ 1,859      $ (168
                

Note 10 – 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.

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

June 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

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 June 30, 2010 and December 31, 2009:

 

     June 30,
2010
   December 31,
2009

Commitments to grant loans

   $ 72,757    $ 12,350

Unfunded commitments under lines of credit

     266,072      267,683

Letters of credit

     27,025      25,524

Commitments to extend credit, which include commitments to grant loans and unfunded commitments under lines of 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 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 June 30, 2010 and December 31, 2009 for guarantees under standby letters of credit issued is not material to the unaudited consolidated financial statements.

Note 11 – Stock-Based Compensation

At June 30, 2010, the Company had five equity compensation plans, the 2010 Stock Incentive Plan (the “2010 Plan”), 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”).

In May 2010, the shareholders of the Company approved the 2010 Stock Incentive Plan (the “2010 Plan”). The 2010 Plan permits grants of stock options, stock appreciation rights, restricted stock, deferred stock and performance awards (collectively, “Awards”) for up to 400,000 shares of the Company’s common stock to key employees and directors. As of June 30, 2010, no Awards have been issued with the 2010 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 six month periods ending June 30, 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

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

June 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

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 June 30, 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 June 30, 2010 and December 31, 2009:

 

Date of Issuance

   Options
Issued
   Exercise
Price
   Expiration
Date
   Options Vested    Unearned Compensation (in
000’s)
            June 30,
2010
   December 31,
2009
   June 30,
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    —      —        284      318

November 24, 2009

   38,000    $ 19.80    November 24, 2019    —      —        164      182
                                  
   174,295          83,895    83,895    $ 448    $ 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 six months of 2010. The aggregate intrinsic value of outstanding unvested stock options at June 30, 2010 and December 31, 2009 was $79 and $116, respectively. Options granted resulted in compensation expense of $26 and $52 for the three and six month periods ended June 30, 2010, respectively. Compensation expense for the three and six months periods ended June 30, 2009 were $0 and $549, respectively. As of June 30, 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 $0. These vested options can be exercised at an average price of $28.24 and have an average remaining life of approximately 7.7 years. The fair values of the options awarded under the Plan are estimated on the date of grant using the Black-Scholes valuation methodology.

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.

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

June 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

At June 30, 2010, there were 5,700 options outstanding under the 1995 Plan and the Company recognized $2 and $4 in compensation expense related to the 1995 Plan during the three and six month period ended June 30, 2010, respectively. There are a total of 27,719 options available to be issued under this plan at June 30, 2010.

The following table summarizes the outstanding non-qualified stock options under the Company’s 1995 Plan at June 30, 2010 and December 31, 2009:

 

Date of Issuance

   Options Issued    Exercise Price    Expiration Date    Options Vested    Unearned Compensation (in 000’s)
            March 31, 2010    December 31, 2009    March 31, 2010    December 31, 2009

September 22, 2009

   5,700    $ 26.77    September 22, 2019    —      —      $ 30    $ 34
                                  
   5,700          —      —      $ 30    $ 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 June 30, 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 5.2 years. The Company recognized $0 in compensation expense related to the Director Plan during the six month period ended June 30, 2010. There are a total of 52,120 options available to be issued under this plan at June 30, 2010.

Note 12 – 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 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 June 30, 2010 are as follows:

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

June 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

     June 30,
2010
   Quoted
Prices

(Level  1)
   Significant
Other
Observable
Inputs
(Level 2)
   Significant
Unobservable
Inputs

(Level 3)

Equity securities

   $ 358    $ 166    $ 38    $ 154

U.S Government sponsored agency securities

     62,842      —        62,842      —  

U.S. Government sponsored agency mortgage-backed securities

     6,584      —        6,584      —  

Collateralized mortgage obligations

     86,122      —        86,122      —  

Municipal bonds

     11,239      —        11,239      —  

Municipal bonds – taxable

     13,581      —        13,581      —  

SBA Pool Loan Investments

     10,169      —        10,169      —  

Commercial servicing rights

     514      —        —        514
                           
   $ 191,409    $ 166    $ 190,575    $ 668
                           

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.

Commercial servicing rights

The fair value of commercial servicing rights (“MSRs”) was estimated using Level 3 inputs. MSRs do not trade in an active, open market with readily observable prices. As such, the Company determines the fair value of our MSRs using a projected cash flow model that considers loan rates and maturities, discount rate assumptions, estimated servicing revenue and expenses, and estimated prepayment speeds.

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

June 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

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 June 30, 2010:

 

     Equity Securities  

Balance, December 31, 2009

   $ 49   

Transfers In from Level 2

     611   

Sale of Securities in Level 3

     (33

Change in fair value

     41   
        

Balance, June 30, 2010

   $ 668   
        

During the Company’s valuation of the investment portfolio performed during the first six 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 and 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.

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 June 30, 2010 and December 31, 2009 are as follows:

 

     June  30,
2010
   Quoted Prices
(Level 1)
   Significant
Other
Observable
Inputs
(Level 2)
   Significant
Unobservable
Inputs

(Level 3)

Loans held for sale

   $ 14,725    $ —      $ —      $ 14,725

Impaired loans

     10,038      —        —        10,038

Other real estate owned

     799      —        —        799

Impaired land

     1,000      —        —        1,000
                           

Total assets

   $ 26,562    $ —      $ —      $ 26,562
                           

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

June 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

     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

     4,718      —        —        4,718

Other real estate owned

     927      —        —        927

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

   $ 458,969    $ —      $ —      $ 458,969
                           

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. Based on this guidance, the Company considers all loans placed in non-accrual status as being impaired and subject to an impairment analysis in accordance with ASC 310-10-35. Loans acquired through the Merger that were deemed impaired were recorded using a discounted cash flow model in accordance with ASC 310-30 at the time of acquisition even though the Company considers these loans to be collateral dependent. The carrying amounts of these loans at June 30, 2010 and December 31, 2009 were $4,375 and $6,199, respectively. These loans are not included in the preceding table.

Impaired loans included in the preceding table are those for which the Company has measured impairment based on the fair value of underlying collateral. The balance of impaired loans consists of loans deemed impaired in accordance with the Company’s accounting policy disclosed within its “Critical Accounting Policies.” Fair value is determined primarily based upon independent third party appraisals of the properties. At June 30, 2010, $9,940 of impaired loans were measured using the fair value of underlying collateral and $98 of impaired loans were measured using a discounted cash flow model. At December 31, 2009, $4,650 of impaired loans were measured using the fair value of underlying collateral and $68 of impaired loans were measured using a discounted cash flow model.

Other real estate owned

Other real estate owned consists of seven properties totaling $799 thousand at June 30, 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.

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

June 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

Impaired Land

During the second quarter of 2010, management had explored the potential sale of a parcel of undeveloped land that was acquired as part of the Merger. Based upon the evaluation performed by an independent third party, the Company determined the estimated fair value of the land to be less than its recorded value, resulting in an impairment charge. The Company is currently consulting with third party valuation experts to finalize a determination of fair value for the land.

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 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.

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

June 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

The estimated fair values of the Company’s financial instruments were as follows as of June 30, 2010 and December 31, 2009:

 

     June 30, 2010    December 31, 2009
     Carrying
Amount
   Fair Value    Carrying
Amount
   Fair Value

Financial assets:

           

Cash, due from banks, and federal funds sold

   71,427    71,427    50,600    50,600

Securities available for sale

   190,895    190,895    189,853    189,853

Restricted investment in bank stock

   6,254    6,254    6,254    6,254

Loans held for sale

   14,725    14,725    8,034    8,034

Loans, net of allowance for loan losses

   1,204,716    1,220,266    1,128,576    1,151,368

Accrued interest receivable

   5,320    5,320    4,974    4,974

Financial liabilities:

           

Deposits

   1,322,342    1,303,593    1,216,469    1,191,126

Securities sold under agreements to repurchase

   5,055    5,055    6,892    6,892

Short-term borrowings

   10,285    10,285    5,292    5,292

Long-term debt

   72,476    73,174    65,689    69,814

Accrued interest payable

   1,083    1,083    1,090    1,090
                   
     Nominal
Amount
   Fair Value    Nominal
Amount
   Fair Value

Off-balance sheet financial instruments:

           

Commitments to grant loans

   72,757    —      12,350    —  

Unfunded commitments under lines of credit

   266,072    —      267,683    —  

Letters of credit

   27,025    —      25,524    —  

The following methods and assumptions were used to estimate the fair values of the Company’s financial instruments at June 30, 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

 

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Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

June 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

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.

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 13 – 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 by the end of the first quarter of 2011. 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 estimated fair market value at June 30, 2010. As of June 30, 2010, the carrying value of the land and buildings for these branches are $549.

 

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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 a 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. 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.

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

 

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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. As described in the FCEC Acquisition Agreement, the exchange ratio is subject to upward or downward adjustment if loan delinquencies at First Chester increase or decrease beyond specified amounts, which would affect the total transaction value disclosed above.

As part of the FCEC Acquisition 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 June 30, 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. As of June 30, 2010, the total balance of the loans purchased from First Chester was $49.4 million.

Following the transaction, based on a 0.453 exchange ratio, which was the ratio at the time of the signing of the FCEC Acquisition Agreement, 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 before the end 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. Through June 30, 2010, we have not advanced any funds to First Chester under this facility. As of June 30, 2010, First Chester has not sold the AHB Division.

Results of Operations

Summary of Financial Results

The three month period ending June 30, 2010 and 2009 represents the first time the Company will show comparable results of operations for the combined entity of Tower Bancorp, Inc. and Graystone Financial Corp. since the Merger on March 30, 2009. For the first six months of 2010 as compared with the first six months of 2009, the Merger has still had a significant impact on our results of operations. The operating results reported herein for the first six months ended June 30, 2010 include the results for the combined entity. However, the results for the six months ended June 30, 2009 include the historical operating results of Graystone for the entire six month period and the operating results of Tower only since March 30, 2009, 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 for the six month ending June, 30 2009 may not be particularly meaningful.

We recognized after-tax net income of approximately $1.2 million or $0.17 per diluted share in the second quarter of 2010, compared to $1.8 million or $0.36 per diluted share in the second quarter of 2009. Net Interest Income before provision for loan loss increased $2.8 million due to a mix of growth in our loan and investment portfolios coupled with a reduction in the average rate paid on interest bearing liabilities from 2009 to 2010. This increase in net interest income was offset by increases in the provision for loan losses and non-interest expenses of $1.3 million and $2.1 million respectively, as well as a decline in non-interest income of $254 thousand. The increase in the provision for loan losses is primarily due to total net loan charge-offs of $1.2 million during the second quarter of 2010, as well as an additional allowance for loan losses needed as a result of the additional risks associated with the loan growth achieved during the quarter. The decrease in non-interest income is due to declines in the gains on sales of mortgage loans originated for sale and gains on the sales of other interest earning assets. The largest increase in non-interest expense related to an impairment charge taken on land held for investment of $920 thousand. Other increases in non-interest expense include salary and benefits expense and occupancy and equipment expense, which increased $574 thousand and $265 thousand, respectively, as compared to the second quarter of

 

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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 in advanced preparation for the acquisition of First Chester.

For the first half of 2010, we recognized an after-tax net income of $3.1 million or $0.43 per diluted share, compared to after-tax net loss of $47 thousand or $(0.01) per diluted share for the same period in 2009. The increase in net income included an increase of net interest income after the provision for loan losses of $10.1 million and non-interest income of $802 thousand offset by the increase in non-interest expense of $6.2 million and income tax expense of $1.6 million. Net interest income before loan loss provision increased $10.5 million during the first six months of 2010 compared to the same period in 2009. In addition to the net interest income contributed by the inclusion of the Tower Bank division’s operations which added $3.6 million, this growth was also driven by organic growth of loans and investments, and the decrease in the average rate paid on interest bearing deposits of 71 basis points. Non-interest income increased by $802 thousand due to increased service charges on deposit accounts, commissions and fees as well as income generated from the bank owned life insurance policies offset by decrease on gains from the sales of mortgage loans originated for sale and gains on the sales of other interest earning assets. Non-interest expense, excluding merger related expenses and an impairment charge related to land held for investment, increased by $6.5 million primarily due to increases in compensation costs, occupancy expenses and other operating expenses incurred in order to support our continued growth of assets and deposits and in preparation for the pending acquisition of First Chester, offset by a FDIC special assessment of $580 thousand incurred during the second quarter of 2009. No such assessment was imposed during the same period in 2010.

Quarter Ended June 30, 2010 compared to the Quarter Ended June 30, 2009

Net Interest Income

Our major source of operating revenues is net interest income, which increased $2.8 million or 27.6% to approximately $12.9 million for the second quarter of 2010, as compared to approximately $10.1 million for the same period in 2009. Net interest income as a percentage of net income plus non interest income was 83.8% for the quarter ended June 30, 2010, compared to 78.7% for the quarter ended June 30, 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 use brokered deposits on a limited basis to fund asset growth as demonstrated by the limited use of brokered deposits, which represents approximately 9.6% of total deposits, on our consolidated balance sheet at June 30, 2010 and approximately 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.

 

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The following table provides a comparative average balance sheet and net interest income analysis for the three-month period ended June 30, 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 statutory Federal tax rate of 35% for 2010 and 34% for 2009. All dollar amounts are in thousands.

 

     For the Three Months Ended June 30,  
     2010     2009  
     Average
Balance (2)
    Interest     Average
Rate
    Average
Balance (2)
    Interest     Average
Rate
 
     (dollars in thousands)  

Interest-earning assets:

            

Federal funds sold and other

   $ 18,738      $ 41      0.88   $ 49,590      $ 21      0.17

Investment securities (1)

     190,417        1,219      2.57     48,396        421      3.49

Loans

     1,183,489        17,274      5.85     1,022,627        15,252      5.98
                                            

Total interest-earning assets

     1,392,644        18,534      5.34     1,120,613        15,694      5.62
                                            

Other assets

     159,519            120,611       
                        

Total assets

   $ 1,552,163          $ 1,241,224       
                        

Interest-bearing liabilities:

            

Interest-bearing non-maturity deposits

   $ 753,088        2,212      1.18   $ 527,468        2,128      1.62

Time deposits

     418,126        2,332      2.24     391,826        2,766      2.83

Borrowings

     88,103        1,035      4.71     73,975        653      3.54
                                            

Total interest-bearing liabilities

     1,259,317        5,579      1.78     993,269        5,547      2.24
                                            

Noninterest-bearing transaction accounts

     114,608            85,803       

Other liabilities

     12,979            50,906       

Stockholders’ equity

     165,259            111,246       
                        

Total liabilities and stockholders’ equity

   $ 1,552,163          $ 1,241,224       
                        

Net interest spread

       3.56       3.38

Net interest income and interest rate margin FTE

     $ 12,955      3.73     $ 10,147      3.63
                    

Tax equivalent adjustment

       (52         (34  
                        

Net interest income

     $ 12,903          $ 10,113     
                        

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

     110.6         112.8    
                        

 

(1) The average yields for investment securities available for sale are reported on a fully taxable-equivalent basis at a rate of 35% for 2010 and 34% for 2009.
(2) Average loan balances include non-accrual loans.

 

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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  
   June 30, 2010 vs. June 30, 2009  
     Increase (Decrease) Due to  
     Volume     Rate     Total  
     (in thousands)  

Interest income:

      

Federal funds sold and other

   $ (363   $ 383      $ 20   

Investment securities

     4,016        (3,218     798   

Loans

     11,012        (8,990     2,022   
                        

Total interest income

   $ 14,665      $ (11,825   $ 2,840   
                        

Interest expense:

      

Interest-bearing non-maturity deposits

   $ 11,434      $ (11,350   $ 84   

Time deposits

     4,422        (4,856     (434

Borrowings

     140        242        382   
                        

Total interest expense

     15,996        (15,964     32   
                        

Net interest income

   $ (1,331   $ 4,139      $ 2,808   
                        

Interest income increased approximately $2.8 million, or 18.1%. This increase was caused by approximately $272.0 million or 24.3% increase in the average balance of interest-earning assets, which resulted in approximately $14.7 million increase to interest income. This increase was partially offset by a 28 basis point reduction in average rates that resulted in a reduction of interest income of approximately $11.8 million.

Interest income on investment securities increased approximately $798 thousand, or 189.5%. The average balance of investments held by the Bank increased from $48.4 million at June 30, 2009 to $190.4 million at June 30, 2010, which resulted in an increase of approximately $4.0 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 debt security investments purchased with excess liquidity. Since March 31, 2009, the Company purchased 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 other than federal funds sold 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 92 basis points on the average rate and a reduction of interest income of $3.2 million.

Average yields on loans decreased 13 basis points or 2.1%, from 5.98% during the second quarter of 2009 to 5.85% during the second quarter of 2010. The Federal Reserve maintained the intended federal funds target rate between 0.09% and 0.25% during both quarters ended June, 30, 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 June 30, 2010, do not reprice when short-term rates decline. 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 88% of our variable rate loans at June 30, 2010 contain interest rate floors. Conversely, 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 $32 thousand, or 0.6% during the second quarter of 2010 compared to the same period in 2009. This relatively small increase was caused by approximately $266.0 million or 26.8% increase in the average balance of interest-bearing liabilities, which resulted in approximately $16.0 million increase to interest expense. This increase, however, was predominately offset by a 46 basis point reduction in the average rate paid on interest-bearing liabilities, which resulted in a reduction of interest expense of approximately $16.0 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 our markets.

 

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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, further migration of assets from federal funds to loans and investments and the continued repricing of a portion of our interest-bearing deposit portfolio into lower rate products. Any significant changes such as 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 risks associated with new loans, evaluate potential charge-offs and recoveries, and assess general economic conditions in the markets we serve.

The following table presents the activity in the allowance for loan losses for the three months ended June 30, 2010 and 2009:

 

     Three months ended  
     June 30,  
     2010     2009  

Balance at beginning of period

   $ 10,892      $ 7,761   

Provision for loan losses

     1,900        650   

Charge-offs

    

Commercial

     (853     (381

Consumer

     (147     (88

Residential mortgage

     (200     —     
                

Total Charge-offs

     (1,200     (469

Recoveries

    

Commercial

     27        24   

Consumer

     —          —     

Residential mortgage

     —          —     
                

Total Recoveries

     27        24   
                

Net charge-offs

     (1,173     (445
                

Balance at end of period

   $ 11,619      $ 7,966   
                

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 June 30, 2010 totaled $1.9 million, an increase of $1.3 million 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 June 30, 2010 consisted of 5 commercial loans, 2 consumer loans and one mortgage loan totaling $1.2 million. Net allowance for loan loss charge-offs were 0.40 % of average loans as of the second quarter 2010 on an annualized basis. Our allowance for loan loss as a percentage of loans was 0.95% at June 30, 2010, compared to 0.85% at December 31, 2009.

 

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The following table presents changes in the credit quality adjustment on loans purchased for the three months ended June 30, 2010 and 2009:

 

     Three months ended  
     March 31,  
     2010     2009  

Balance at beginning of period

   $ 2,519      $ 4,044   

Credit Fair Value Adjustment Mark

     —          271   

Amortization

     (250     —     

Charge-offs

    

Commercial

     (347     —     

Consumer

     (114     (81

Residential mortgage

     (170     (53
                

Total Charge-offs

     (631     (134

Recoveries

    

Commercial

     15        —     

Consumer

     21        —     

Residential mortgage

     2        —     
                

Total Recoveries

     38        —     
                

Net charge-offs

     (593     (134
                

Balance at end of period

   $ 1,676      $ 3,639   
                

The gross loan charge-offs that were applied to the credit quality adjustment on purchased loans for the three months ended June 30, 2010 consisted of 4 commercial loans, 16 consumer loans, and 2 residential mortgage totaling $631 thousand. Net credit mark charge-offs were 0.20% of average loans as of the second quarter 2010 on an annualized basis.

The total gross loan charge-offs during the three months ended June 30, 2010 consisted of 30 loans totaling $1.8 million. Net total loan charge-offs were 0.60% of average loans as of the second quarter of 2010 on an annualized basis. Our adjusted (Non-GAAP) allowance for loan loss, that is the allowance for loan losses adjusted to include the credit quality adjustment on loans purchased, as a percentage of loans was 1.09% at June 30, 2010, compared to 1.11% at December 31, 2009. See an explanation of this Non-GAAP measure later in this filing within management’s discussion and analysis of our loan portfolio performance. Determining the level of the allowance for probable loan loss at any 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 June 30, 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 June 30, 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.

Non-interest income was approximately $2.5 million and $2.7 million for the three months ended June 30, 2010 and 2009, respectively.

 

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

 

     June 30,     June 30,    Increase (Decrease)  
   2010     2009    $     %  

Service charges on deposit accounts

   $ 805      $ 664    $ 141      21.2

Other service charges, commissions and fees

     682        739      (57   (7.7 )% 

Gain on sale of mortgage loans originated for sale

     321        581      (260   (44.8 )% 

(Loss) gain on sale of other interest earning assets

     (29     311      (340   (109.3 )% 

Income from bank owned life insurance

     470        283      187      66.1

Other income

     243        168      75      44.6
                         

Total non-interest income

   $ 2,492      $ 2,746    $ (254   (9.2 )% 
                         

The $254 thousand or 9.2% decrease in total non-interest income is attributable primarily to decreases in the gain on sale of mortgage loans originated for sale and the gain on sale of other interest earning assets, which decreased $260 thousand, and $340 thousand, respectively, offset by increases in service charges and income from bank owned life insurance of $141 thousand and $187 thousand, respectively. The decrease in the gain on sale of mortgage loans originated was primarily due to the decline in volume of mortgage loans originated for sale during 2010 compared to the activity during 2009. The decrease of the gain on sale of other interest earning assets is due in part to the sale of $7.0 million of equity securities during second quarter 2009 compared to the sale of $316 thousand during the second quarter of 2010. Income from bank owned life insurance increased as a result the appreciation in the cash surrender value of life insurance contracts. This increase was positively affected by the purchase of $12.0 million in bank owned life insurance during the second quarter 2010.

Non-Interest Expense

Non-interest expense was approximately $11.8 million and $9.7 million for the three months ended June 30, 2010 and 2009, respectively. The $2.1 million increase is attributable to a $920 thousand impairment charge on land held for investment as well as increases in salary and employee benefits, occupancy and equipment expense, advertising and promotion and other operating expenses, offset by a decrease in FDIC insurance premiums.

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

 

     June  30,
2010
   June  30,
2009
   Increase (Decrease)  
         $     %  

Salaries and employee benefits

   $ 5,343    $ 4,769    $ 574      12.0

Occupancy and equipment

     1,735      1,470      265      18.0

Amortization of intangible assets

     159      177      (18   (10.2 )% 

FDIC insurance premiums

     538      731      (193   (26.4 )% 

Advertising and promotion

     374      141      233      165.2

Data processing

     643      592      51      8.6

Professional service fees

     371      284      87      30.6

Impairment of fixed assets

     920      —        920      n/a   

Other operating expenses

     1,651      1,411      240      17.0

Merger related expenses

     76      106      (30   (28.3 )% 
                        

Total non-interest expenses

   $ 11,810    $ 9,681    $ 2,129      22.0
                        

Salary and employee benefits increased $574 million or 12.0%. Salaries increased by $314 thousand while employee benefits increased by $260 thousand. The increased level of salary expense was driven by personnel costs in connection with our branch expansion during 2009 and the first six months of 2010. Additionally, we continued to add additional personnel to our

 

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operations, finance, credit, and lending departments to support our balance sheet growth and in preparation for the pending acquisition of First Chester. The Company incurred approximately $486 thousand in salary and benefit costs during the second quarter of 2010 as a result of advanced hires in preparation for the First Chester acquisition and $325 thousand related to the adoption of a deferred compensation plan for certain executive officers during the quarter. These increases were partially offset by a reduction in the bank performance incentive bonus accrual compared to second quarter of 2009 based on the level of achievement of the relative performance metrics within the bonus plan. We also incurred general merit increases for all eligible employees between June 30, 2009 and June 30, 2010.

Occupancy and equipment expense increased $265 thousand or 18.0%. The increase in occupancy and equipment expense related to the addition of four 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. At June 30, 2010, the Bank had approximately $978.2 million in FDIC-insured deposits. During the second quarter of 2009, the FDIC imposed a special assessment on all FDIC-insured banks based in the total assets and Tier I capital as of June 30, 2009. At June 30, 2009, the Company recorded an estimated expense for the special assessment of $580 thousand. No special assessment fees were recognized during the second quarter of 2010.

Advertising and Promotion expenses increased $233 thousand or 165.2%. The increase in advertising and promotions relates to the Company’s increased advertising costs due to branch openings since prior year, the Company’s promotion of new loan and deposit products, and increases in costs to maintain our checking account rewards program.

Professional service expenses increased $87 thousand or 30.6% and data processing expense increased $51 thousand or 8.6%. 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 June 30, 2009 and June 30, 2010.

The impairment of fixed asset expense relates to undeveloped land that was acquired as part of the Merger. The impairment charge was based on a decline in the fair value of the land between the time of the Merger, March 31, 2009 and June 30, 2010, identified by the Company as Management explored a possible sale of the subject property.

Other operating expenses increased $240 thousand or 17.0%. The increase was primarily due to increases in share taxes, supplies, and telephone and postage expense of $151 thousand, $92 thousand, and $42 thousand, respectively, offset by decline in other expenses related to the early retirement of debt of $119 thousand during the second quarter 2009.

Income Tax Expense

Income tax expense was $508 thousand and $690 thousand for the three month ended June 30, 2010 and 2009, respectively. Our effective tax rate for the second quarter of 2010 was 30.2%. 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 27.3% for the three months ended June 30, 2009. The statutory tax rates for 2010 and 2009 were 35.0% and 34.0%, respectively.

Six Months Ended June 30, 2010 compared to the Six Months Ended June 30, 2009

Net Interest Income

Net interest income increased $10.5 million or 72.2% to approximately $25.0 million for the first six months of 2010, as compared to approximately $14.5 million for the same period in 2009. The $10.5 million increase in net interest income includes $3.6 million as a result of the net contribution from interest-earning assets and interest-earning liabilities derived from the Tower division acquired in the Merger, which was not included in the first three months of 2009 results of operations. Excluding the effect of the Merger, net interest income, net of corporate interest expense, increased by $6.9 million or 47.6% over the six months ended June 30, 2009. Net interest income as a percentage of net income plus non-interest income was 84.7% for the six months ended June 30, 2010, compared to 79.7% for the same period in 2009.

 

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The following table provides a comparative average balance sheet and net interest income analysis for the six month period ended June 30, 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 Federal tax rate of 35% for 2010 and 34% for 2009. All dollar amounts are in thousands.

 

     For the Six Months Ended June 30,  
     2010     2009  
     Average
Balance (2)
    Interest     Average
Rate
    Average
Balance (2)
    Interest     Average
Rate
 
     (dollars in thousands)  

Interest-earning assets:

            

Federal funds sold and other

   $ 21,641      $ 74      0.69   $ 31,634      $ 27      0.17

Investment securities (1)

     183,806        2,287      2.51     34,108        556      3.29

Loans

     1,167,322        33,780      5.84     804,203        23,540      5.90
                                            

Total interest-earning assets

     1,372,769        36,141      5.31     869,945        24,123      5.59
                                            

Other assets

     156,799            75,188       
                        

Total assets

   $ 1,529,568          $ 945,133       
                        

Interest-bearing liabilities:

            

Interest-bearing non-maturity deposits

   $ 725,658        4,332      1.20   $ 378,935        3,475      1.85

Time deposits

     426,857        4,821      2.28     329,753        5,182      3.17

Borrowings

     85,603        1,952      4.60     60,227        939      3.14
                                            

Total interest-bearing liabilities

     1,238,118        11,105      1.81     768,915        9,596      2.52
                                            

Noninterest-bearing transaction accounts

     113,297            64,926       

Other liabilities

     13,492            32,430       

Stockholders’ equity

     164,661            78,862       
                        

Total liabilities and stockholders’ equity

   $ 1,529,568          $ 945,133       
                        

Net interest spread

       3.50       3.08

Net interest income and interest rate margin FTE

     $ 25,036      3.68     $ 14,527      3.37
                    

Tax equivalent adjustment

       (84         (40  
                        

Net interest income

     $ 24,952          $ 14,487     
                        

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

     110.9         113.1    
                        

 

(1) The average yields for investment securities available for sale are reported on a fully taxable-equivalent basis at a rate of 35% for 2010 and 34% for 2009.
(2) Average loan balances include non-accrual loans.

 

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

 

     Six Months Ended  
   June 30, 2010 vs. June 30, 2009  
     Increase (Decrease) Due to  
     Volume     Rate     Total  
     (in thousands)  

Interest income:

      

Federal funds sold

   $ (59   $ 106      $ 47   

Investment securities

     2,658        (927     1,731   

Loans

     12,114        (1,874     10,240   
                        

Total interest income

   $ 14,713      $ (2,695   $ 12,018   
                        

Interest expense:

      

Interest-bearing non-maturity deposits

   $ 7,761      $ (6,903   $ 857   

Time deposits

     5,878        (6,240     (361

Borrowings

     483        530        1,013   
                        

Total interest expense

     14,122        (12,613     1,509   
                        

Net interest income

   $ 591      $ 9,918      $ 10,509   
                        

Interest income increased approximately $12.0 million, or 49.8%. This increase was caused by approximately $502.8 million or 57.8% increase in the average balance of interest-earning assets, which resulted in approximately $14.7 million increase to interest income. This increase was partially offset by a 28 basis point reduction in average rates that resulted in a reduction of interest income of approximately $2.7 million.

Interest income on investment securities increased approximately $1.7 million, or 311.3%. The average balance of investments held by the Bank increased from $34.1 million at June 30, 2009 to $183.8 million at June 30, 2010, which resulted in an increase of approximately $2.7 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 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 other than federal funds sold 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 78 basis points on the average rate and a reduction of interest income of $927 thousand.

Average yields on loans decreased 6 basis points from 5.90% during the first six months of 2009 to 5.84% during the first six months of 2010. The Federal Reserve maintained the intended federal funds target rate between 0.08% and 0.25% during June, 30, 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 June 30, 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 88% of our variable rate loans at June 30, 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 15.7% during the six months ended June 30, 2010 compared to the same period in 2009. This increase was caused by approximately $469.2 million or 61.0% increase in the average balance of interest-bearing liabilities, which resulted in approximately $14.1 million increase to interest expense. This increase was predominately offset by a 71 basis point reduction in the average rate paid on interest-bearing liabilities, which resulted in a reduction of interest expense of approximately $12.6 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, time deposits, and borrowings.

 

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In future periods, 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, further migration of assets from federal funds to loans and investments, and the continued repricing of our interest-bearing deposit portfolio into lower rate products. Any significant changes such as 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.

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 risks associated with new loans, evaluate potential charge-offs and recoveries, and assess general economic conditions in the markets we serve.

The following table presents the activity in the allowance for loan losses for the six months ended June 30, 2010 and 2009:

 

     Six months ended  
     June 30,  
     2010     2009  

Balance at beginning of period

   $ 9,695      $ 6,017   

Provision for loan losses

     3,350        3,016   

Charge-offs

    

Commercial

     (1,150     (944

Consumer

     (147     (147

Residential mortgage

     (200     —     
                

Total Charge-offs

     (1,497     (1,091

Recoveries

    

Commercial

     71        24   

Consumer

     —          —     

Residential mortgage

     —          —     
                

Total Recoveries

     71        24   
                

Net charge-offs

     (1,426     (1,067
                

Balance at end of period

   $ 11,619      $ 7,966   
                

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 six months ended June 30, 2010 totaled $3.4 million, a increase of approximately $334 thousand compared to the same period in 2009. The gross loan charge-offs that were applied to the allowance for loan loss during the six months ended June 30, 2010 consisted of 15 commercial loans, 2 consumer loans and one mortgage loan totaling $1.5 million. Net allowance for loan loss charge-offs were 0.25% of average loans for the first six months of 2010 on an annualized basis. Our allowance for loan loss as a percentage of loans was 0.95% at June 30, 2010, compared to 0.85% at December 31, 2009.

 

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The following table presents changes in the credit quality adjustment on loans purchased for the six months ended June 30, 2010 and 2009:

 

     Six months ended  
     June 30,  
     2010     2009  

Balance at beginning of period

   $ 2,942      $ —     

Credit Fair Value Adjustment Mark

     —          4,044   

Amortization

     (400     (271

Charge-offs

    

Commercial

     (486     —     

Consumer

     (179     (81

Residential mortgage

     (263     (53
                

Total Charge-offs

     (928     (134

Recoveries

    

Commercial

     18        —     

Consumer

     41        —     

Residential mortgage

     3        —     
                

Total Recoveries

     62        —     
                

Net charge-offs

     (866     (134
                

Balance at end of period

   $ 1,676      $ 3,639   
                

The gross loan charge-offs that were applied to the credit quality adjustment on purchased loans for the six months ended June 30, 2010 consisted of 9 commercial loans, 30 consumer loans, and 5 residential mortgage totaling $928 thousand. Net credit mark charge-offs were 0.15% of average loans for the first six months of 2010 on an annualized basis.

The total gross loan charge-offs during the six months ended June 30, 2010 consisted of 62 loans totaling $2.4 million. Net total charge-offs were 0.40% of average loans for the first six months of 2010 on an annualized basis. Our adjusted (Non-GAAP) allowance for loan losses, that is the allowance for loan losses adjusted to include the credit quality adjustment on loans purchased, as a percentage of loans was 1.09% at June 30, 2010, compared to 1.11% at December 31, 2009. See an explanation of this Non-GAAP measure later in this filing within Management’s discussion and analysis of our loan portfolio performance. Determining the level of the allowance for probable loan loss at any 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 June 30, 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 June 30, 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.

Non-interest income was approximately $4.5 million and $3.7 million for the six months ended June 30, 2010 and 2010, respectively.

 

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

 

     June  30,
2010
    June  30,
2009
   Increase (Decrease)  
        $     %  

Service charges on deposit accounts

   $ 1,545      $ 881    $ 664      75.4

Other service charges, commissions and fees

     1,208        896      312      34.8

Gain on sale of mortgage loans originated for sale

     594        848      (254   (30.0 )% 

Gain on sale of other interest earning assets

     (5     311      (316   (101.6 )% 

Income from bank owned life insurance

     791        442      349      79.0

Other income

     363        316      47      14.9
                         

Total non-interest income

   $ 4,496      $ 3,694    $ 802      21.7
                         

The $802 thousand or 21.7% increase in total non-interest income is mostly attributable 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 $664 thousand, $312 thousand, and $349 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 fees which grew by $322 thousand for the first six months of 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 and purchased during the second quarter 2010, as that income would not have been present in the results of operations for the same period of 2009.

Non-Interest Expense

Non-interest expense was approximately $21.6 million and $15.5 million for the six months ended June 30, 2010 and 2009, respectively. Excluding the effects of merger expenses and a $920 thousand impairment charge taken on land held for investment, non-interest expense for the six months ending June 30, 2010 would have totaled approximately $20.5 million, up approximately $6.5 million or 46.2% from $14.0 million for the same period 2009. The $6.5 million increase is mostly attributable to increases in salary and employee benefits, occupancy and equipment, advertising and promotion, data processing, and other operating expenses.

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

 

     June  30,
2010
   June  30,
2009
   Increase (Decrease)  
         $     %  

Salaries and employee benefits

   $ 10,442    $ 7,286    $ 3,156      43.3

Occupancy and equipment

     3,431      2,202      1,229      55.8

Amortization of intangible assets

     336      177      159      89.8

FDIC insurance premiums

     936      911      25      2.7

Advertising and promotion

     509      218      291      133.5

Data processing

     1,154      787      367      46.6

Professional service fees

     812      538      274      50.9

Impairment on fixed assets

     920      —        920      n/a   

Other operating expenses

     2,917      1,924      993      51.6

Merger related expenses

     187      1,412      (1,225   (86.8 )% 
                        

Total non-interest expenses

   $ 21,644    $ 15,455    $ 6,189      40.0
                        

Salary and employee benefits increased $3.2 million or 43.3%. Salaries increased by $2.3 million while employee benefits increased by $882 thousand. Salaries and employee benefits directly related to the Tower Bank Division branches acquired in the Merger contributed approximately $1.1 million to the increase in salary and benefit expenses for the first six months of 2010. Additionally, we continued to add additional personnel to our operations, finance, credit, and lending departments to

 

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support our balance sheet growth and in preparation for the pending acquisition of First Chester. The Company incurred approximately $486 thousand in salary and benefit costs during the first six months of 2010 as a result of advanced hires in preparation for the First Chester acquisition and $325 thousand related to the adoption of a deferred compensation plan for certain executive officers during the second quarter of 2010. These increases were partially offset by a reduction in the bank performance incentive bonus accrual compared to second quarter of 2009 based on the level of achievement of the relative performance metrics within the bonus plan. We also incurred general merit increases for all eligible employees between June 30, 2009 and June 30, 2010.

Occupancy and equipment expense increased $1.2 million or 55.8%. The increase was partially related to the additional expense attributable to the Tower Bank division’s branches which contributed $579 thousand to occupancy and equipment expense. The remaining building and equipment expense increase related to the addition of four branch offices during 2009 and the first six months of 2010 and the lease of the corporate center office space 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. At June 30, 2010, we had approximately $978.2 million in FDIC-insured deposits. During the second quarter of 2009, the FDIC imposed a special assessment on all FDIC-insured banks based in the total assets and Tier I capital as of June 30, 2009. At June 30, 2009, the Company recorded an estimated expense for the special assessment of $580 thousand. No special assessment fees were recognized during the first six months of 2010.

Advertising and promotion expenses increased $291 thousand or 133.5%. The increase in advertising and promotions relates to the Company’s increased advertising costs due to branch openings since prior year, the Company’s promotion of new loan and deposit products, and increases in costs to maintain our checking account rewards program. Professional service expenses increased $274 thousand or 50.9% and data processing expense increased $367 thousand or 46.6%. 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 June 30, 2009 and June 30, 2010.

The impairment of fixed asset expense relates to undeveloped land that was acquired as part of the Merger. The impairment charge was based on a significant drop in the fair value of the land between the time of the Merger, March 31, 2009 and June 30, 2010.

Other operating expenses increased $993 thousand or 51.6%. The portion of the increase that can be attributed directly to the Tower Bank branches equaled $113 thousand for the six months ended June 30, 2010. The remaining increase was primarily due to increases in share taxes, credit report and appraisal fees, supplies, and telephone and postage expense of $305 thousand, $110 thousand, $193 thousand, and $142 thousand, respectively, offset by decline in other expenses related to the early retirement of debt of $119 thousand during the second quarter 2009.

Income Tax Expense

Income tax expense was $1.3 million for the six months ended June 30, 2010. For the six month ended June 30, 2009, the income tax benefit was $243 thousand. Our effective tax rate for the six months ended June 30, 2010 was 30.8%. The effective tax rate was positively impacted by tax free income generated by the purchase of bank owned life insurance, dividend deductions for dividends paid on ESOP shares and earnings from tax-exempt securities. Our effective tax rate was 83.8% for the six months ended June 30, 2009. The statutory tax rates for 2010 and 2009 were 35.0% and 34.0%, respectively.

Financial Condition

Total Assets

Total assets increased by $117.5 million, or 8.0%, from December 31, 2009 to June 30, 2010. The increase is primarily due to the increase in cash and cash equivalents of $20.8 million and net loans of $76.1 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 bank owned life insurance and payment of dividends.

Loans, net

Our gross loan balance grew by $78.0 million, or 6.8%, to $1.22 billion as of June 30, 2010. During the first six months of 2010, new loan originations totaled $138.7 million. These new loans were offset by a net decrease in existing loan balances of $60.7 million. The net decrease in existing loan balances during the first six months included the net decrease of approximately $7.0 million of mortgages previously held in the Company’s loan portfolio. Management believes that there

 

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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 additional loan growth during the second half of 2010.

See the table below for a detail of the loan balances, net of unearned income and allowance for loan losses at June 30, 2010 and the changes from December 31, 2009:

 

     June  30,
2010
    December 31,
2009
    Increase/(Decrease)  
       $     %  

Commercial

   $ 936,916      $ 861,673      $ 75,243      8.7

Consumer & other

     95,023        85,510        9,513      11.1

Residential mortgage

     184,474        191,277        (6,803   (3.6 )% 
                          

Total Loans

     1,216,413        1,138,460        77,953      6.8

Deferred costs (fees)

     (78     (189     111      (58.7 )% 

Allowance for loan losses

     (11,619     (9,695     (1,924   19.8
                          

Net Loans

   $ 1,204,716      $ 1,128,576      $ 76,140      6.7
                          

The commercial loan portfolio continues to be the largest component of our loan portfolio, representing 77.0% and 75.7% of total loans at June 30, 2010 and December 31, 2009, respectively. In addition, we have $107.4 million in loan participations without recourse sold to unaffiliated banks through June 30, 2010, where we maintain the servicing rights with these relationships. Currently, the bank is participating in 33 loans purchased from unaffiliated banks. The total outstanding balance of these loans is $65.9 million. These participations include 16 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. During the first six months of 2010, one of these purchased loans was fully paid off. Currently, the carrying balance of the remaining purchased loans from First National Bank of Chester County is $49.4 million.

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.

While loan demand in our markets has been suppressed by the current economic conditions, management expects to see loan growth comparable to historic rates as we continue to gain market share from our local competitors.

The following is a summary of our lending activities based on our current loan portfolio:

Lending Activities

Our principal lending activity has been the origination of business and commercial real estate loans, commercial and industrial loans, and personal consumer loans to customers located within our primary market areas. We generally release the servicing rights on residential mortgage loans that we sell which results in additional gains on sale. We also originate and retain in our lending portfolio various types of home equity and consumer loan products.

Commercial Lending

Our commercial loan portfolio includes business term loans and lines of credit issued to small and medium size companies in our market areas, some of which are secured in part by additional owner occupied real estate. Additionally, we make secured and unsecured commercial loans and extend lines of credit for the purpose of financing equipment purchases, inventory, business expansion, working capital, and other general business purposes. The terms of these loans generally range from less than 1 year to 7 years with a maximum term to not exceed 10 years, carrying a fixed interest rate or a variable interest rate indexed to LIBOR or our prime rate. It is our standard practice to issue lines of credit due on demand, accruing interest at a variable interest rate indexed to either LIBOR or our prime rate.

We originate commercial real estate loans secured predominantly by first liens on apartment complexes, office buildings, lodging facilities and industrial and warehouse properties. The maximum term that we offer for commercial real estate loans is generally not more than 10 years, with a payment schedule based on not more than a 25-year amortization schedule and a maximum loan-to-value of 80%. Our current policy with regard to these loans is to minimize our risk by emphasizing diversification of these property types.

Additionally, we offer construction and land development financing secured by the corresponding real estate and other collateral as necessary to meet our underwriting standards. Terms for construction and land development financing vary based on the depth of the project usually requiring a maximum loan-to-value ratio of 65% to 80% and a term typically

 

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ranging from twelve to thirty-six months. The construction/development loan application process includes the same criteria which are required for our permanent commercial mortgage loans, as well as a submission of completed plans, specifications, and cost estimates related to the proposed construction. We use these items as an additional basis to determine the appraised value of the subject property. The appraisal is an important component because construction loans involve additional risks related to advancing loan funds upon the security of the project under construction, which is of uncertain value prior to the completion of construction and subsequent pro-forma lease-up.

Underwriting considerations for all types of commercial lending include, but are not limited to, the borrower’s debt service capacity, an evaluation of the collateral and the strength and capacity of guarantors. Additional considerations for construction and land development financing include, without limitation, market analysis, environmental evaluations and pre-sale activities.

Residential Real Estate Lending

The majority of the residential mortgage loans on our balance sheet have been acquired through the merger of Tower Bancorp, Inc. and Graystone Financial Corp. We originate mortgage loans through our subsidiary, Graystone Mortgage, LLC, to enable our customers to finance residential real estate, both owner occupied and non-owner occupied, in our primary market areas. We generally offer traditional fixed-rate and adjustable-rate mortgage (“ARM”) products, with monthly payment options, that have maturities up to 30 years, and maximum loan amounts generally up to $750 thousand.

We generally sell newly originated conventional 15 to 30 year fixed-rate loans as well as FHA and VA loans in the secondary market to wholesale lenders, receiving a servicing released premium as a result. Our LTV requirements for residential real estate loans vary depending on the secondary market investor. Loans with LTVs in excess of 80% are required to carry private mortgage insurance. We generally originate loans that meet accepted secondary market underwriting standards.

Home Equity Lending

We offer fixed-rate, fixed-term, monthly home equity loans, and prime-based home equity lines of credit (“HELOCs”) in our market areas. We offer both fixed-rate and floating-rate home equity products in amounts up to 85% of the appraised value of the property (including the first mortgage) with a maximum loan amount generally up to $1 million. We offer monthly fixed-rate home equity loans and HELOCs with repayment terms generally up to 15 years. The minimum line of credit is $10 thousand and the maximum generally up to $1 million with exceptions as approved.

Consumer Loans

We offer a variety of fixed-rate installment and variable rate line-of-credit consumer loans, including direct automobile loans as well as personal secured and unsecured loans. Terms of these loans range from 6 months to 72 months and generally do not exceed $50 thousand with exceptions as approved. Secured loans are collateralized by vehicles, savings accounts, or certificates of deposit.

 

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Loan Portfolio Performance

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.

 

     June 31,     December 31,  
     2010     2009  
     (dollars in thousands)  

Total loans outstanding, net of unearned income

   $ 1,231,060      $ 1,146,305   

Daily average balance of loans

     1,167,322        909,476   

Non-accrual loans

   $ 10,038      $ 4,718   

Accruing loans greater than 90 days past due

     2,388        2,106   
                

Total non-performing loans

     12,426        6,824   

Other real estate owned

     799        927   
                

Total non-performing assets

     13,225        7,751   

Allowance for Loan Losses

     11,619        9,695   

Credit fair value adjustment on loans purchased

     1,676        2,942   
                

Adjusted (Non-GAAP) allowance for loan losses

   $ 13,295      $ 12,637   

Non-accrual loans to total loans(1)

     0.82     0.41

Non-performing assets to total assets

     0.83     0.53

Non-performing loans to total loans(1)

     1.01     0.60

Allowance for loan losses to total loans(1)

     0.95     0.85

Impact of Non-GAAP measure

     0.14     0.26

Adjusted (Non-GAAP) allowance for loan losses to total loans(1)

     1.09     1.11

Allowance for loan losses to non-performing loans

     93.51     142.07

Impact of Non-GAAP measure

     13.48     43.11

Adjusted (Non-GAAP) allowance for loan losses to non-performing loans

     106.99     185.18

 

(1) Total loans balance excludes purchased impaired loans accounted for under SOP 03-3 acquired as part of the merger between Tower Bancorp Inc. and Graystone Financial Corp. The total balance of these loans is $6,339 as of June 30, 2010, $6,200 as of December 31, 2009.

GAAP requires that expected credit losses associated with loans obtained in an acquisition be reflected at fair value as of each respective acquisition date and prohibits the carryover of the acquired entity’s allowance for loan losses. Accordingly, the Company’s management believes that presentation of the adjusted (Non-GAAP) allowance for loan losses, consisting of the allowance for loan losses plus the credit fair value adjustment on loans purchased in merger transactions, is useful for investors to understand the complete allowance that is recorded as a representation of future expected losses over the Company’s loan portfolio. These Non-GAAP disclosures should not be viewed as a substitute for financial measures determined in accordance with GAAP, nor are they necessarily comparable to Non-GAAP measures presented by other companies. Reconciliations of these measures are in the table above.

The accounting estimates for loan losses are subject to changing economic conditions. At June 30, 2010, the non-accrual loans totaled $10.0 million compared to $4.7 million at December 31, 2009. Of the $10.0 million of total non-accrual loans at June 30, 2010, $8.4 million or 83.8% related to commercial loans, $170 thousand or 1.7% to consumer loans and $1.5 million or 14.5% 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 principal amount outstanding to this borrower is $5.0 million as of June 30, 2010. The borrower is an in-market financing company that provides interim construction financing, secured by mortgages, for residential manufactured, modular, and site-built homes, which projects are located both within and outside of our primary market area. Our loan was to be secured by the assignment of loans and mortgages securing the loans extended by the borrower to third parties. Although we previously had reason to believe that our security interest in the collateral was perfected, the borrower has identified our interest as an unsecured non-priority claim on the basis that it was not properly perfected. The borrower’s obligations to us are also secured by guarantees given by its two principals. Prior to the bankruptcy filing during the first quarter of 2010, the loan was performing. At March 31, 2010, the loan was 30 days past due and was placed on non-accrual status. We are currently in workout negotiations with the borrower and numerous similarly-situated lenders which, if successful, would result in the borrower emerging from bankruptcy protection and fully secure its outstanding obligations to us. Management has included this credit in our specific reserve analysis as described in the paragraph below and, based upon management’s evaluation of the status of the bankruptcy proceedings and workout negotiations, as well as the support of the guarantors, believes this specific reserve recorded is adequate based on current available information.

As of June 30, 2010, we had total impaired loans of $14.4 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

 

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though the loan is currently performing. The impaired loan balance includes $4.4 million of impaired loans acquired as part of the Merger, which were recorded at their individual fair values at the time of the Merger as determined based on management’s estimate of future cash flows. For the remaining impaired loans, management performed an evaluation of the anticipated cash flow from the sale of collateral to determine that the value of the collateral exceeded the carrying amount of the loan . Based on these evaluations, management has determined that a reserve of $500 thousand is required against the impaired loans at June 30, 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. It is our policy that non-performing loans will remained classified as non-performing until such time that the loan becomes current on all principal and interest payments and remains current for a period of six months. For loans where the original terms have been modified, we would not consider the modified loan to be performing until the borrower demonstrates their performance under the modified terms for a period of at least six months.

During 2009 and the first six months 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 seven properties totaling $799 thousand at June 30, 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.

Securities Available for Sale

The following table presents the amortized cost and fair value of investment securities for the June 30, 2010 and December 31, 2009.

 

     June 30, 2010    December 31, 2009
     Amortized
Cost
   Fair Value    Amortized
Cost
   Fair Value

Equity securities

   $ 356    $ 358    $ 1,156    $ 1,132

U.S Government sponsored agency securities

     62,632      62,842      56,437      56,384

U.S. Government sponsored agency mortgage backed securities

     6,570      6,584      9,109      9,116

Collateralized mortgage obligations

     84,960      86,122      93,058      92,485

Municipal bonds

     11,134      11,239      7,093      7,188

Municipal bonds – taxable

     12,871      13,581      12,917      12,910

SBA Pool Loan Investments

     10,149      10,169      10,710      10,638
                           
   $ 188,672    $ 190,895    $ 190,480    $ 189,853
                           

At June 30, 2010, total available for sale securities were $190.9 million, an increase of $1.0 million from total available for sale securities of $189.9 million at December 31, 2009. During the first six months of 2010, the Bank purchased $66.5 million in securities, offset by the net sales and maturities of $69.0 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 June 30, 2010, the total cash surrender value of the bank-owned life insurance (“BOLI”) was $37.3 million. The Company purchased $12.0 million of BOLI during the second quarter of 2010. The BOLI was 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 were used to fund 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

 

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Total deposits at June 30, 2010 were $1.32 billion, an increase of $105.9 million from total deposits of $1.22 billion at December 31, 2009.

The table below displays the increases in deposits by type at June 30, 2010 as compared to December 31, 2009.

 

     June 30, 2010     December 31, 2009     Increase/Decrease  
     Amount    %     Amount    %     Amount     %  

Noninterest-bearing transaction accounts

   $ 120,206    9.1