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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

x Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended March 31, 2011

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 000-52947

 

 

United Financial Bancorp, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

Maryland   74-3242562
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification Number)

95 Elm Street, West Springfield, Massachusetts 01089

(Address of principal executive offices)

Registrant’s telephone number, including area code: (413) 787-1700

 

 

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 definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer   ¨    Accelerated filer   x
Non-accelerated filer   ¨  (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.

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

Common stock, $0.01 par value

16,103,831 shares outstanding as of May 3, 2011

 

 

 


Table of Contents

United Financial Bancorp, Inc.

INDEX

 

     Page  
PART I. FINANCIAL INFORMATION   

Item 1.

   Financial Statements   
   Consolidated Statements of Condition
March 31, 2011 (unaudited) and December 31, 2010
     1   
   Consolidated Statements of Earnings
Three Months Ended March 31, 2011 and 2010 (unaudited)
     2   
   Consolidated Statements of Stockholders’ Equity and Comprehensive Income
Three Months Ended March 31, 2011 and 2010 (unaudited)
     3   
   Consolidated Statements of Cash Flows
Three Months Ended March 31, 2011 and 2010 (unaudited)
     4   
   Notes to Unaudited Consolidated Financial Statements      6   

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations      23   

Item 3.

   Quantitative and Qualitative Disclosures About Market Risk      33   

Item 4.

   Controls and Procedures      33   
PART II. OTHER INFORMATION   

Item 1.

   Legal Proceedings      34   

Item 1A.

   Risk Factors      34   

Item 2.

   Unregistered Sales of Equity Securities and Use of Proceeds      34   

Item 3.

   Defaults Upon Senior Securities      35   

Item 4.

   [Removed and Reserved]      35   

Item 5.

   Other Information      35   

Item 6.

   Exhibits      35   
SIGNATURES      36   


Table of Contents
PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements

UNITED FINANCIAL BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CONDITION

(Dollars in thousands, except per share amounts)

 

 

     March 31,
2011
    December 31,
2010
 
     (unaudited)     (audited)  

ASSETS

    

Cash and due from banks

   $ 15,281      $ 10,157   

Interest-bearing deposits

     57,258        72,912   
                

Total cash and cash equivalents

     72,539        83,069   

Securities available for sale, at fair value

     214,430        205,852   

Securities held to maturity, at amortized cost (fair value of $124,814 at March 31, 2011 and $132,026 at December 31, 2010)

     125,179        132,475   

Loans held for sale

     583        —     

Loans, net of allowance for loan losses of $10,468 at March 31, 2011 and $9,987 at December 31, 2010

     1,088,576        1,066,197   

Other real estate owned

     1,480        1,536   

Accrued interest receivable

     4,976        4,905   

Deferred tax asset, net

     10,821        11,029   

Stock in the Federal Home Loan Bank of Boston

     15,365        15,365   

Banking premises and equipment, net

     15,746        15,565   

Bank-owned life insurance

     29,474        29,180   

Goodwill

     8,192        8,192   

Other assets

     12,364        11,512   
                

TOTAL ASSETS

   $ 1,599,725      $ 1,584,877   
                

LIABILITIES AND STOCKHOLDERS’ EQUITY

    

Liabilities:

    

Deposits:

    

Interest-bearing

   $ 992,703      $ 967,305   

Non-interest-bearing

     181,208        175,996   
                

Total deposits

     1,173,911        1,143,301   

Short-term borrowings

     18,900        21,029   

Long-term debt

     161,461        173,307   

Subordinated debentures

     5,471        5,448   

Escrow funds held for borrowers

     2,194        1,899   

Due to broker

     —          3,002   

Capitalized lease obligations

     4,978        5,011   

Accrued expenses and other liabilities

     8,758        9,304   
                

Total liabilities

     1,375,673        1,362,301   
                

Stockholders’ equity:

    

Preferred stock, par value $0.01 per share, authorized 50,000,000 shares; none issued

     —          —     

Common stock, par value $0.01 per share, authorized 100,000,000 shares; 18,706,933 shares issued at March 31, 2011 and December 31, 2010

     187        187   

Paid-in capital

     180,926        180,322   

Retained earnings

     84,128        82,899   

Unearned compensation

     (10,578     (10,750

Treasury stock, at cost (2,610,898 shares at March 31, 2011 and 2,597,827 shares at December 31, 2010)

     (35,123     (34,940

Accumulated other comprehensive income, net of taxes

     4,512        4,858   
                

Total stockholders’ equity

     224,052        222,576   
                

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

   $ 1,599,725      $ 1,584,877   
                

See notes to unaudited consolidated financial statements

 

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Table of Contents

UNITED FINANCIAL BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF EARNINGS (unaudited)

(Dollars in thousands, except per share amounts)

 

 

     Three Months Ended March 31,  
     2011      2010  

Interest and dividend income:

     

Loans

   $ 14,487       $ 15,457   

Investments

     3,191         3,292   

Other interest-earning assets

     40         8   
                 

Total interest and dividend income

     17,718         18,757   

Interest expense:

     

Deposits

     3,297         3,375   

Short-term borrowings

     37         105   

Long-term debt

     1,593         1,781   
                 

Total interest expense

     4,927         5,261   

Net interest income before provision for loan losses

     12,791         13,496   

Provision for loan losses

     808         733   
                 

Net interest income after provision for loan losses

     11,983         12,763   

Non-interest income:

     

Fee income on depositors’ accounts

     1,292         1,371   

Net gain on sale of loans

     23         88   

Net gain on sale of securities

     1         —     

Impairment charge on security

     —           (145

Wealth management income

     240         138   

Income from bank-owned life insurance

     331         346   

Other income

     262         239   
                 

Total non-interest income

     2,149         2,037   

Non-interest expense:

     

Salaries and benefits

     6,269         6,078   

Occupancy expenses

     844         927   

Marketing expenses

     447         560   

Data processing expenses

     988         1,067   

Professional fees

     661         541   

Merger related expenses

     —           979   

FDIC insurance assessments

     330         415   

Other expenses

     1,401         1,451   
                 

Total non-interest expense

     10,940         12,018   

Income before income taxes

     3,192         2,782   

Income tax expense

     763         1,031   
                 

Net income

   $ 2,429       $ 1,751   
                 

Earnings per share:

     

Basic

   $ 0.16       $ 0.11   

Diluted

   $ 0.16       $ 0.11   

Weighted average shares outstanding:

     

Basic

     15,014,143         15,618,540   

Diluted

     15,258,574         15,662,592   

Dividends paid per share

   $ 0.08       $ 0.07   

See notes to unaudited consolidated financial statements.

 

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UNITED FINANCIAL BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND

COMPREHENSIVE INCOME (unaudited)

FOR THE THREE MONTHS ENDED MARCH 31, 2011 and 2010

(Dollars in thousands, except per share amounts)

 

 

     Common
Shares
Outstanding
    Common
Stock
     Paid-In
Capital
    Retained
Earnings
    Unearned
Compensation
    Treasury
Stock
    Accumulated
Other
Comprehensive
Income (Loss)
    Total  

Balances at December 31, 2009

     16,838,598      $ 187       $ 178,666      $ 77,456      $ (11,441   $ (24,980   $ 5,358      $ 225,246   

Prior service costs on pension and other post retirement benefit plans

     —          —           —          —          —          —          (472     (472

Net income

     —          —           —          1,751        —          —          —          1,751   

Other comprehensive income

     —          —           —          —          —          —          91        91   
                       

Total comprehensive income

                    1,842   
                       

Cash dividends paid ($0.07 per share)

     —          —           —          (1,090     —          —          —          (1,090

Treasury stock purchases

     (164,338     —           —          —          —          (2,124     —          (2,124

Reissuance of treasury shares in connection with restricted stock grants

     69,702        —           (901     —          —          901        —          —     

Stock-based compensation

     —          —           591        —          —          —          —          591   

ESOP shares committed to be released

     —          —           66        —          173        —          —          239   
                                                                 

Balances at March 31, 2010

     16,743,962      $ 187       $ 178,422      $ 78,117      $ (11,268   $ (26,203   $ 4,977      $ 224,232   
                                                                 

Balances at December 31, 2010

     16,109,106      $ 187       $ 180,322      $ 82,899      $ (10,750   $ (34,940   $ 4,858      $ 222,576   

Net income

     —          —           —          2,429        —          —          —          2,429   

Other comprehensive loss

     —          —           —          —          —          —          (346     (346
                       

Total comprehensive income

                    2,083   
                       

Cash dividends paid ($0.08 per share)

     —          —           —          (1,200     —          —          —          (1,200

Treasury stock purchases

     (13,896     —           —          —          —          (195     —          (195

Tax withheld on options exercised

     —          —           (7     —          —          —          —          (7

Reissuance of treasury shares in connection with restricted stock grants

     825        —           (12     —          —          12        —          —     

Stock-based compensation

     —          —           526        —          —          —          —          526   

ESOP shares committed to be released

     —          —           97        —          172        —          —          269   
                                                                 

Balances at March 31, 2011

     16,096,035      $ 187       $ 180,926      $ 84,128      $ (10,578   $ (35,123   $ 4,512      $ 224,052   
                                                                 

The components of other comprehensive (loss) income and related tax effects are as follows:

 

     Three Months Ended March 31,  
     2011     2010  

Change in unrealized holding gains on available-for-sale securities

   $ (553   $ 27   

Reclassification adjustment for (gains) losses realized in income

     (1     145   
                

Net change in unrealized gains

     (554     172   

Tax effect

     208        (81
                

Other comprehensive (loss) income

   $ (346   $ 91   
                

See notes to unaudited consolidated financial statements.

 

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UNITED FINANCIAL BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)

FOR THE THREE MONTHS ENDED MARCH 31, 2011 and 2010

(Dollars in thousands)

 

 

     2011     2010  

Cash flows from operating activities:

    

Net income

   $ 2,429      $ 1,751   

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

    

Provision for loan losses

     808        733   

ESOP expense

     269        239   

Stock-based compensation

     526        591   

Amortization of premiums and discounts

     392        273   

Depreciation and amortization

     135        360   

Amortization of intangible assets

     26        28   

Net loss (gain) on sale of other real estate owned

     11        (23

Impairment charges on securities

     —          145   

Net gain on sale of securities

     (1     —     

Originations of loans held for sale

     (583     —     

Loans originated for sale and sold

     (1,671     —     

Proceeds from sales of loans held for sale

     1,694        —     

Net gain on sale of loans

     (23     (88

Net increase in cash surrender value of bank-owned life insurance

     (294     (317

Increase in accrued interest receivable

     (71     (72

Increase in other assets

     (462     (2,792

Decrease in accrued expenses and other liabilities

     (480     (892
                

Net cash provided by (used in) operating activities

     2,705        (64

Cash flows from investing activities:

    

Purchases of securities available for sale

     (34,204     —     

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

     21,986        18,303   

Purchases of securities held to maturity

     —          (11,601

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

     6,989        3,134   

Increase in investment in short term time deposits

     —          (4

Proceeds from sales of other real estate owned

     210        271   

Net loan (originations), (purchases) and principal repayments

     (23,352     10,396   

Proceeds from sales of loans

     —          9,725   

Purchases of property and equipment

     (313     (230
                

Net cash (used in) provided by investing activities

     (28,684     29,994   

(Continued)

 

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Table of Contents

UNITED FINANCIAL BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)

FOR THE THREE MONTHS ENDED MARCH 31, 2011 and 2010 (Concluded)

(Dollars in thousands)

 

 

     2011     2010  

Cash flows from financing activities:

    

Net increase in deposits

   $ 30,610      $ 26,265   

Net change in short-term borrowings

     (2,129     (35,393

Repayment of long-term debt

     (11,823     (17,862

Net increase in escrow funds held for borrowers

     295        166   

Payments on capitalized lease obligations

     (102     (102

Tax withheld on options exercised

     (7     —     

Treasury stock purchases

     (195     (2,124

Cash dividends paid

     (1,200     (1,090
                

Net cash provided by (used in) financing activities

     15,449        (30,140
                

Decrease in cash and cash equivalents

     (10,530     (210

Cash and cash equivalents at beginning of period

     83,069        21,877   
                

Cash and cash equivalents at end of period

   $ 72,539      $ 21,667   
                

Supplemental Disclosure of Cash Flow Information:

    

Cash paid during the period:

    

Interest on deposits, borrowings and other interest bearing liabilities

   $ 5,111      $ 5,983   

Income taxes – net

     232        41   

Non-cash items:

    

Transfer of loans to other real estate owned

     165        677   

Trade date accounting for securities purchased

     (3,002     —     

See notes to unaudited consolidated financial statements.

 

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UNITED FINANCIAL BANCORP, INC. AND SUBSIDIARY

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2011

Dollars in Thousands (except per share amounts)

 

 

NOTE A – BASIS OF PRESENTATION

The consolidated financial statements include the accounts of United Financial Bancorp, Inc. (“United Financial”) and its wholly-owned subsidiary, United Bank (the “Bank”). UCB Securities, Inc. and UCB Securities, Inc. II are subsidiaries of the Bank and are engaged in buying, selling and holding investment securities. UB Properties, LLC is a subsidiary of the Bank formed to hold real estate assets acquired through foreclosure. All significant intercompany accounts and transactions have been eliminated in consolidation. These entities are collectively referred to herein as the “Company”.

The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and with general practices within the banking industry. In the opinion of management, the accompanying unaudited interim consolidated financial statements reflect all adjustments, consisting of normal recurring adjustments, which are necessary for the fair presentation of the Company’s financial condition as of March 31, 2011 and the results of operations for the three months ended March 31, 2011 and 2010. The interim results of operations presented herein are not necessarily indicative of the results to be expected for the entire year or any other period. These financial statements should be read in conjunction with the consolidated financial statements and the notes thereto for the year ended December 31, 2010 included in the Company’s Annual Report on Form 10-K, which was filed with the Securities and Exchange Commission on March 14, 2011.

NOTE B – RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In April 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-02, Receivables (Topic 310), “A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring”. This ASU provides additional guidance and clarification to help creditors in determining whether a creditor has granted a concession and whether a debtor is experiencing financial difficulties for purposes of determining whether a restructuring constitutes a troubled debt restructuring (“TDR”). This ASU is effective for the first interim or annual period beginning on or after June 15, 2011, with retrospective application to the beginning of the annual period of adoption. The measurement of impairment should be done prospectively in the period of adoption for loans that are newly identified as TDRs upon adoption of this ASU. In addition, the TDR disclosures required by ASU 2010-20, Receivables (Topic 310), “Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses” should be provided beginning in the period of adoption of this ASU. The Company will adopt this ASU on July 1, 2011 and is currently evaluating the impact of adoption on its consolidated financial statements.

NOTE C – CRITICAL ACCOUNTING POLICIES

The Securities and Exchange Commission (the “SEC”) defines “critical accounting policies” as those that require application of management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in future periods. Management believes that the following policies would be considered critical under the SEC’s definition:

Allowance for Loan Losses. The allowance for loan losses is the amount estimated by management as necessary to cover credit losses inherent in the loan portfolio at the balance sheet date. The allowance is established through the provision for loan losses which is charged against income. The methodology for determining the allowance for loan losses is considered a critical accounting policy by management due to the high degree of judgment involved, the subjectivity of the assumptions utilized and the potential for changes in the economic environment that could result in adjustments to the amount of the recorded allowance for loan losses.

 

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Management performs a quarterly evaluation of the adequacy of the allowance for loan losses. We consider a variety of factors in establishing this estimate including, but not limited to, prior loss experience, current economic conditions, trends in non-performing loans and delinquency rates, the adequacy of the underlying collateral, the financial strength of the borrower, results of internal loan reviews and other relevant factors. This evaluation is inherently subjective as it requires material estimates by management that may be susceptible to significant change based on changes in economic and real estate market conditions. The allowance consists of a specific and a general component, as further described below.

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired.

The Company periodically may agree to modify the contractual terms of loans. A loan is classified as a troubled debt restructuring (“TDR”) if the Company, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. This usually includes a modification of loan terms, such as a reduction of the interest rate to below market terms, capitalizing past due interest or extending the maturity date or a partial forgiveness of debt. Interest income on restructured loans is returned to accrual status after the borrower demonstrates the ability to pay under the restructured terms through a sustained period of repayment performance, which is generally six months. All TDRs are initially classified as impaired.

The allowance consists of a specific and a general component, as further described below.

Specific component. The specific component relates to loans that are classified as impaired. Impairment is measured on a loan by loan basis for the commercial segment (commercial and industrial, commercial real estate and construction) by either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral if the loan is collateral dependent. A specific allowance is established when the discounted cash flows (or collateral value) of the impaired loan is lower than the carrying value of the loan. Groups of smaller balance homogenous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual loans in the consumer segment (residential real estate, home equity and consumer loans) for impairment disclosures, unless such loans are subject to a troubled debt restructuring agreement.

General component. The general component is based on historical loss experience adjusted for qualitative factors stratified by each of the loan classes: commercial and industrial, commercial real estate, construction, residential real estate, home equity and consumer. Management uses an average of historical losses based on a time frame appropriate to capture relevant loss data for each loan class. This historical loss factor for each loan class is adjusted for the following qualitative factors: the levels/trends in delinquencies and non-accruals; levels and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of changes in risk selection and underwriting standards and other changes in lending policies, procedures and practices; experience, ability and depth of lending management and staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations. This analysis establishes factors that are applied to each loan class to determine the amount of the general component of the allowance for loan losses.

 

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Evaluation of the Investment Portfolio for Other-Than-Temporary Impairment. The evaluation of the investment portfolio for other-than-temporary impairment is also a critical accounting estimate. On a quarterly basis, we review securities with a decline in fair value below the amortized cost of the investment to determine whether the decline in fair value is temporary or other than temporary. Declines in the fair value of securities below their cost that are deemed to be other than temporary based on the severity and duration of the impairment are reflected in earnings as realized losses. In estimating other than temporary impairment losses for held to maturity and available for sale debt securities, impairment is required to be recognized: (1) if we intend to sell the security; (2) if it is “more likely than not” that we will be required to sell the security before recovery of its amortized cost basis; or (3) the present value of expected cash flows is not sufficient to recover the entire amortized cost basis. For all impaired held to maturity and available for sale securities that we intend to sell, or more likely than not will be required to sell, the full amount of the other than temporary impairment is recognized through earnings. For all other impaired held to maturity or available for sale securities, credit-related other than temporary impairment is recognized through earnings, while non-credit related other than temporary impairment is recognized in other comprehensive income, net of applicable taxes.

Income Taxes. The Company uses the asset and liability method of accounting for income taxes in which deferred tax assets and liabilities are established for the temporary differences between the financial reporting basis and the tax basis of the Company’s asset and liabilities. The realization of the net deferred tax asset generally depends upon future levels of taxable income and the existence of prior years’ taxable income, to which “carry back” refund claims could be made. A valuation allowance is maintained for deferred tax assets that management estimates are more likely than not to be unrealizable based on available evidence at the time the estimate is made. Significant management judgment is required in determining income tax expense and deferred tax assets and liabilities. In determining the valuation allowance, the Company uses historical and forecasted future operating results, based upon approved business plans, including a review of the eligible carryforward periods, tax planning opportunities and other relevant considerations. These underlying assumptions can change from period to period. For example, tax law changes or variances in future projected operating performance could result in a change in the valuation allowance. Should actual factors and conditions differ materially from those considered by management, the actual realization of the net deferred tax asset could differ materially from the amounts recorded in the financial statements. If the Company is not able to realize all or part of its net deferred tax asset in the future, an adjustment to the deferred tax asset valuation allowance would be charged to income tax expense in the period such determination was made.

Goodwill and Identifiable Intangible Assets. Goodwill and identifiable intangible assets are recorded as a result of business acquisitions and combinations. These assets are evaluated for impairment annually or whenever events or changes in circumstances indicate the carrying value of these assets may not be recoverable. If the carrying amount exceeds fair value, an impairment charge is recorded to income. The fair value is based on observable market prices, when practicable. Other valuation techniques may be used when market prices are unavailable, including estimated discounted cash flows and market multiples analyses. These types of analyses contain uncertainties because they require management to make assumptions and to apply judgment to estimate industry economic factors and the profitability of future business strategies. In the event of future changes in fair value, the Company may be exposed to an impairment charge that could be material.

Fair Valuation of Financial Instruments. The Company uses fair value measurements to record fair value adjustments to certain financial instruments and to determine fair value disclosures. Trading assets, securities available for sale, and derivative instruments are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a non-recurring basis, or to establish a loss allowance or write-down based on the fair value of impaired assets. Further, the notes to financial statements include information about the extent to which fair value is used to measure assets and liabilities, the valuation methodologies used and its impact to earnings. Additionally, for financial instruments not recorded at fair value, the notes to financial statements disclose the estimate of their fair value. Due to the judgments and uncertainties involved in the estimation process, the estimates could result in materially different results under different assumptions and conditions.

 

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NOTE D – EARNINGS PER SHARE

Earnings per share (“EPS”) have been computed by dividing net income by weighted average shares outstanding before any dilution and are adjusted to exclude the weighted average number of unallocated shares held by the Bank’s employee stock ownership plan (the “ESOP”). Diluted earnings per share have been calculated by dividing net income by weighted average shares outstanding after giving effect to the potential dilution that could occur if potential common shares were converted into common stock using the treasury stock method because there is no difference under the two-class method.

The calculation of basic and diluted earnings per common share for the periods indicated is presented below.

 

     Three Months Ended
March 31,
 
     2011      2010  

Net income

   $ 2,429       $ 1,751   
                 

Weighted average common shares applicable to basic EPS

     15,014,143         15,618,540   

Effect of dilutive potential common shares (1) (2)

     244,431         44,052   
                 

Weighted average common shares applicable to diluted EPS

     15,258,574         15,662,592   
                 

Earnings per share:

     

Basic

   $ 0.16       $ 0.11   

Diluted

   $ 0.16       $ 0.11   

 

(1) Options to purchase 308,615 and 339,109 shares for three months ended March 31, 2011 and 2010, respectively, were outstanding but not included in the computation of earnings per share because they were anti-dilutive.
(2) Includes incremental shares related to dilutive stock options.

 

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NOTE E – INVESTMENT SECURITIES

The amortized cost and fair value of securities classified as available for sale and held to maturity are as follows:

 

     Amortized      Unrealized        
     Cost      Gains      Losses     Fair Value  

Securities Available for Sale

          

March 31, 2011:

          

Debt Securities:

          

Government-sponsored enterprises

   $ 5,227       $ 8       $ (238   $ 4,997   

Government-sponsored and government-guaranteed mortgage-backed securities

     188,983         8,255         (286     196,952   

Private label mortgage-backed securities

     2,747         95         (14     2,828   

Municipal bonds

     7,760         184         (38     7,906   

Corporate bonds

     1,451         484         (188     1,747   
                                  

Total

   $ 206,168       $ 9,026       $ (764   $ 214,430   
                                  

December 31, 2010:

          

Debt Securities:

          

Government-sponsored enterprises

   $ 12,747       $ 36       $ (281   $ 12,502   

Government-sponsored and government-guaranteed mortgage-backed securities

     172,003         8,892         (129     180,766   

Private label mortgage-backed securities

     3,076         110         (16     3,170   

Municipal bonds

     7,760         105         (70     7,795   

Corporate bonds

     1,450         357         (188     1,619   
                                  

Total

   $ 197,036       $ 9,500       $ (684   $ 205,852   
                                  
     Amortized      Unrealized        
     Cost      Gains      Losses     Fair Value  

Securities Held to Maturity

          

March 31, 2011:

          

Government-sponsored and government-guaranteed mortgage-backed securities

   $ 98,158       $ 840       $ (1,168   $ 97,830   

Private label mortgage-backed securities

     247         —           (1     246   

Industrial revenue bonds

     19,050         —           —          19,050   

State of Israel bonds

     150         —           —          150   

Municipal bonds

     7,574         74         (110     7,538   
                                  

Total

   $ 125,179       $ 914       $ (1,279   $ 124,814   
                                  

December 31, 2010:

          

Government-sponsored and government- guaranteed mortgage-backed securities

   $ 105,312       $ 936       $ (1,203   $ 105,045   

Private label mortgage-backed securities

     388         1         —          389   

Industrial revenue bonds

     19,050         —           —          19,050   

State of Israel bonds

     150         —           —          150   

Municipal bonds

     7,575         65         (248     7,392   
                                  

Total

   $ 132,475       $ 1,002       $ (1,451   $ 132,026   
                                  

The scheduled maturities of debt securities available for sale and held to maturity at March 31, 2011 are shown below. Actual maturities will differ from contractual maturities because issuers generally have the right to call or prepay obligations with or without call or prepayment penalties.

 

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     At March 31, 2011  
     Securities
Available for Sale
     Securities
Held to Maturity
 
     Amortized             Amortized         
     Cost      Fair Value      Cost      Fair Value  

Due in one year or less

   $ 88       $ 88       $ 130       $ 132   

Due from one year to five years

     4,254         4,390         1,267         1,305   

Due from five years to ten years

     25,860         26,648         19,567         19,772   

Due after ten years

     175,966         183,304         104,215         103,605   
                                   
   $ 206,168       $ 214,430       $ 125,179       $ 124,814   
                                   

The Company’s portfolio of mortgage-backed securities, which represent interests in pools of residential mortgage loans, consists primarily of securities issued by the Federal Home Loan Mortgage Corporation (Freddie Mac), the Federal National Mortgage Association (Fannie Mae), and the Government National Mortgage Association (Ginnie Mae), all of which are federal government owned or sponsored enterprises. The Company also owns $3.1 million of private label residential mortgage-backed securities as a result of its acquisition of CNB Financial Corp. (“CNB”) on November 30, 2009.

 

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Gross unrealized losses and fair values at March 31, 2011 and December 31, 2010 aggregated by investment category and the length of time that individual securities have been in a continuous unrealized loss position follow:

 

     Less than 12 months     12 months or longer     Total  
     Fair
Value
     Unrealized
Losses
    Fair
Value
     Unrealized
Losses
    Number of
Securities
     Fair
Value
     Unrealized
Losses
 

At March 31, 2011:

                  

Securities Available for Sale

                  

Debt Securities:

                  

Government-sponsored enterprises

   $ 4,762       $ (238   $ —         $ —          1       $ 4,762       $ (238

Government-sponsored and government-guaranteed mortgage-backed securities

     29,484         (286     —           —          10         29,484         (286

Private label mortgage-backed securities

     —           —          814         (14     1         814         (14

Municipal bonds

     544         (14     265         (24     3         809         (38

Corporate bonds

     137         (188     —           —          1         137         (188
                                                            

Total

   $ 34,927       $ (726   $ 1,079       $ (38     16       $ 36,006       $ (764
                                                            

Securities Held to Maturity

                  

Government-sponsored and government-guaranteed mortgage-backed securities

   $ 47,789       $ (1,168   $ —         $ —          13       $ 47,789       $ (1,168

Private label mortgage-backed securities

     246         (1     —           —          1         246         (1

Municipal bonds

     3,442         (110     —           —          17         3,442         (110
                                                            

Total

   $ 51,477       $ (1,279   $ —         $ —          31       $ 51,477       $ (1,279
                                                            
     Less than 12 months     12 months or longer     Total  
     Fair
Value
     Unrealized
Losses
    Fair
Value
     Unrealized
Losses
    Number of
Securities
     Fair
Value
     Unrealized
Losses
 

At December 31, 2010:

                  

Securities Available for Sale

                  

Debt Securities:

                  

Government-sponsored enterprises

   $ 4,718       $ (281   $ —         $ —          1       $ 4,718       $ (281

Government-sponsored and government-guaranteed mortgage-backed securities

     15,343         (129     —           —          6         15,343         (129

Private label mortgage-backed securities

     —           —          907         (16     1         907         (16

Municipal bonds

     2,713         (37     256         (33     9         2,969         (70

Corporate bonds

     137         (188     —           —          1         137         (188
                                                            

Total

   $ 22,911       $ (635   $ 1,163       $ (49     18       $ 24,074       $ (684
                                                            

Securities Held to Maturity

                  

Government-sponsored and government-guaranteed mortgage-backed securities

   $ 51,839       $ (1,203   $ —         $ —          14       $ 51,839       $ (1,203

Municipal bonds

     4,960         (248     —           —          23         4,960         (248
                                                            

Total

   $ 56,799       $ (1,451   $ —         $ —          37       $ 56,799       $ (1,451
                                                            

Management has determined that no declines in the fair value of the Company’s securities portfolio are deemed to represent an other-than temporary impairment as of March 31, 2011. In its evaluation, management considered the types of securities, including if the securities were U.S. Government issued, the credit rating on the securities, credit outlook, payment status and financial condition, the length of time the security has been in a loss position, the size of the loss position, our intent and ability to hold the securities to expected recovery of value and other meaningful information. The Company does not intend to sell any debt securities and is unlikely to be required to sell any security before its maturity or market price recovery.

 

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NOTE F – LOANS

The components of the loan portfolio were as follows at March 31, 2011 and December 31, 2010:

 

     March 31,
2011
    December 31,
2010
 

Residential mortgages

   $ 317,307      $ 295,721   

Commercial mortgages

     429,949        427,994   

Construction

     30,512        27,553   

Home equity

     135,625        138,290   

Commercial and industrial

     165,607        165,335   

Automobile

     10,059        11,051   

Consumer

     7,942        8,167   
                

Total loans

     1,097,001        1,074,111   

Net deferred loan costs and fees

     2,043        2,073   

Allowance for loan losses

     (10,468     (9,987
                

Loans, net

   $ 1,088,576      $ 1,066,197   
                

The Company has transferred a portion of its originated commercial real estate and commercial and industrial loans to participating lenders. The amounts transferred have been accounted for as sales and are therefore not included in the Company’s accompanying consolidated balance sheets. The Company and participating lenders share ratably in any gains or losses that may result from a borrower’s lack of compliance with contractual terms of the loan. The Company continues to service the loans on behalf of the participating lenders and, as such, collects cash payments from the borrowers, remits payments (net of servicing fees) to participating lenders and disburses required escrow funds to relevant parties. At March 31, 2011 and December 31, 2010, the Company was servicing loans for participants aggregating $45.5 million and $44.4 million, respectively.

A summary of the activity pertaining to the allowance for loan losses at March 31, 2011 is as follows:

 

     Commercial
and
Industrial
    Commercial
Real Estate
    Commercial
& Residential
Construction
    Residential     Home
Equity
    Consumer     Total  

At March 31, 2011:

              

Allowance for Credit Losses:

              

Beginning balance

   $ 2,801      $ 5,000      $ 668      $ 740      $ 623      $ 155      $ 9,987   

Charge-offs

     (325     (112     (28     —          —          —          (465

Recoveries

     136        —          —          —          —          2        138   

Provision

     500        390        227        (119     (146     (44     808   
                                                        

Ending balance

   $ 3,112      $ 5,278      $ 867      $ 621      $ 477      $ 113      $ 10,468   
                                                        

Amount of allowance for loan losses for loans deemed to be impaired

   $ 247      $ —        $ 80      $ —        $ —        $ —        $ 327   
                                                        

Amount of allowance for loan losses for loans not deemed to be impaired

   $ 2,820      $ 4,988      $ 661      $ 621      $ 477      $ 113      $ 9,680   
                                                        

Amount of allowance for loan losses for loans acquired with deteriorated credit quality

   $ 45      $ 290      $ 126      $ —        $ —        $ —        $ 461   
                                                        

Financing Receivables:

              

Total loans

   $ 165,607      $ 429,949      $ 30,512      $ 317,307      $ 135,625      $ 18,001      $ 1,097,001   
                                                        

Loans deemed to be impaired

   $ 2,422      $ 1,944      $ 1,112      $ 336      $ 74      $ 101      $ 5,989   
                                                        

Loans not deemed to be impaired

   $ 162,891      $ 426,053      $ 29,274      $ 316,971      $ 135,551      $ 17,900      $ 1,088,640   
                                                        

Loans acquired with deteriorated credit quality

   $ 294      $ 1,952      $ 126      $ —        $ —        $ —        $ 2,372   
                                                        

 

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The following is a summary of past due and non-accrual loans at March 31, 2011 and December 31, 2010:

 

     30-59 Days
Past Due
     60-89 Days
Past Due
     90 Days
and Over
Past Due
     Total
Past Due
     Current      Total
Financing
Receivables
     Recorded
Investments
> 90 Days
and Accruing
 

At March 31, 2011:

                    

Commercial:

                    

Commercial and industrial

   $ 342       $ 23       $ 2,716       $ 3,081       $ 162,526       $ 165,607       $ —     

Commercial real estate

     2,160         806         3,633         6,599         423,350         429,949         —     

Construction

     536         —           366         902         29,610         30,512         —     

Consumer:

                    

Residential real estate

     9,648         953         336         10,937         306,370         317,307         —     

Home equity

     349         116         74         539         135,086         135,625         —     

Consumer

     144         2         101         247         17,754         18,001         —     
                                                              

Total

   $ 13,179       $ 1,900       $ 7,226       $ 22,305       $ 1,074,696       $ 1,097,001       $ —     
                                                              

At December 31, 2010:

                    

Commercial:

                    

Commercial and industrial

   $ 131       $ 122       $ 3,135       $ 3,388       $ 161,947       $ 165,335       $ —     

Commercial real estate

     3,291         1,088         2,864         7,243         420,751         427,994         —     

Construction

     —           —           552         552         27,001         27,553         —     

Consumer:

                    

Residential real estate

     7,657         1,001         1,036         9,694         286,027         295,721         —     

Home equity

     730         223         60         1,013         137,277         138,290         —     

Consumer

     145         8         55         208         19,010         19,218         —     
                                                              

Total

   $ 11,954       $ 2,442       $ 7,702       $ 22,098       $ 1,052,013       $ 1,074,111       $ —     
                                                              

The following is a summary of impaired loans at March 31, 2011 and December 31, 2010:

 

     At March 31, 2011      At December 31, 2010  
     Recorded
Investment
     Unpaid
Principal
Balance
     Related
Allowance
     Recorded
Investment
     Unpaid
Principal
Balance
     Related
Allowance
 

With no related allowance recorded:

                 

Commercial and industrial

   $ 364       $ 364       $ —         $ 112       $ 112       $ —     

Commercial real estate

     2,271         2,271         —           6,246         6,246         —     

Construction

     872         872         —           1,282         1,282         —     

Residential real estate

     336         336         —           1,036         1,036         —     

Home Equity

     74         74         —           60         60         —     

Consumer

     101         101         —           55         55         —     

With an allowance recorded:

                 

Commercial and industrial

     2,060         2,352         292         2,324         2,773         449   

Commercial real estate

     1,335         1,625         290         1,125         1,343         218   

Construction

     160         366         206         —           —           —     

Residential real estate

     —           —           —           —           —           —     

Home Equity

     —           —           —           —           —           —     

Consumer

     —           —           —           —           —           —     
                                                     

Total:

                 

Commercial portfolio segment

   $ 7,062       $ 7,850       $ 788       $ 11,089       $ 11,756       $ 667   

Consumer portfolio segment

     511         511         —           1,151         1,151         —     
                                                     

Total impaired loans

   $ 7,573       $ 8,361       $ 788       $ 12,240       $ 12,907       $ 667   
                                                     

Loans acquired from CNB Financial that are impaired at March 31, 2011, are included in the above table.

 

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The following is a summary of information pertaining to impaired and non-accrual loans:

 

     Three Months Ended
March 31, 2011
 

Average investment in impaired loans

   $ 8,550   
        

Interest income recognized on impaired loans

  

Commercial:

  

Commercial and industrial

   $ 4   

Commercial real estate

     92   

Commercial and residential construction

     9   

Consumer:

  

Residential real estate

     5   

Home equity

     —     

Consumer

     2   
        

Total

   $ 112   
        

Interest income recognized on a cash basis on impaired loans

  

Commercial:

  

Commercial and industrial

   $ 4   

Commercial real estate

     37   

Commercial and residential construction

     9   

Consumer:

  

Residential real estate

     5   

Home equity

     —     

Consumer

     2   
        

Total

   $ 57   
        

The following is a summary of non-accrual loans, which includes impaired loans, at March 31, 2011 and December 31, 2010:

 

     March 31,
2011
     December 31,
2010
 

Commercial:

     

Commercial and industrial

   $ 2,716       $ 2,885   

Commercial real estate

     3,896         4,116   

Commercial and residential construction

     1,238         1,282   

Consumer:

     

Residential real estate

     336         1,036   

Home equity

     74         60   

Consumer

     101         55   
                 

Total

   $ 8,361       $ 9,434   
                 

CREDIT QUALITY INFORMATION

The Company utilizes a nine grade risk rating system for commercial and industrial, commercial real estate and construction loans as follows:

Pass: Loans within these five categories are considered low to average risk.

 

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Special Mention: Loans in this category portray one or more weaknesses that may be tolerated in the short run. Assets in this category are currently protected but are potentially weak and are being closely monitored by management.

Substandard: Loans in this category are considered inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged. There is a distinct possibility that the Company will sustain some loss if the weakness is not corrected.

Doubtful: Loans in this category have all the weaknesses inherent in those classified substandard with the added characteristic that the weaknesses make the collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. The possibility of loss is extremely high, however, its classification as an estimated loss is deferred until a more exact determination of the extent of the loss is ascertained.

Loss: Loans in this category are considered uncollectible and of such little value that their continuance as loans is not warranted.

The Company does not assign risk ratings to residential real estate, home equity and mobile home consumer loans unless they are contractually past due 90 days or more or where legal action has commenced against the borrower. All other consumer loans are charged off when they become contractually past due 120 days. Those loans not assigned a rating are considered “pass”.

On an annual basis, or more often if needed, the Company formally reviews the ratings on all commercial and industrial, commercial real estate and construction loans. Semi-annually, the Company engages an independent third-party to review loans within these segments. Management uses the results of these reviews as part of its annual review process.

The following table presents the Company’s loan segment by internally assigned grades:

 

     At March 31, 2011      At December 31, 2010  
     Commercial
& Industrial
     Commercial
Real Estate
     Construction      Commercial
& Industrial
     Commercial
Real Estate
     Construction  

Commercial Portfolio:

                 

Grade:

                 

Pass

   $ 144,790       $ 393,211       $ 23,147       $ 141,101       $ 391,336       $ 18,315   

Special Mention

     8,756         11,946         1,193         11,503         13,447         2,678   

Substandard

     11,969         24,792         6,172         12,419         23,211         6,560   

Doubtful

     92         —           —           312         —           —     
                                                     

Total

   $ 165,607       $ 429,949       $ 30,512       $ 165,335       $ 427,994       $ 27,553   
                                                     
     Residential      Home Equity      Consumer      Residential      Home Equity      Consumer  

Consumer Portfolio:

                 

Grade:

                 

Pass

   $ 314,856       $ 135,384       $ 17,856       $ 293,999       $ 138,093       $ 19,155   

Special Mention

     57         —           —           59         —           —     

Substandard

     2,394         241         145         1,663         197         63   

Doubtful

     —           —           —           —           —           —     
                                                     

Total

   $ 317,307       $ 135,625       $ 18,001       $ 295,721       $ 138,290       $ 19,218   
                                                     

 

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The following is a summary of acquired loan information for CNB Financial as of March 31, 2011:

 

     Contractual
Required Payments
Receivable
    Cash Expected
To Be
Collected (1)
    Non-
Accretable
Difference
    Accretable
Yield
    Loans
Receivable
 

Balance at acquisition date of November 30, 2009

   $ 5,178      $ 3,079      $ 2,099      $ 13      $ 3,066   

Recognition of additional non-accretable yield

     —          (250 )(2)      250        —          —     
                                        

Balance as of December 31, 2009

     5,178        2,829        2,349        13        2,816   

2010 Collections

     (3,645     (2,264     (1,381     (13     (2,251

Transfer to OREO

     (393     (393 )(3)      —          —          (393

Accretable yield recognized in earnings

     —          —          —          (348 )(4)      —     
                                        

Balance as of December 31, 2010

     1,140        172        968        —          172   

2011 Collections

     (37     (37     —          —          (37

Impairment

     —          (135 )(5)      —          —          (135
                                        

Balance as of March 31, 2011

   $ 1,103      $ —        $ 968      $ —        $ —     
                                        

 

(1) The Company has not factored any prepayments into the expected cash flows.
(2) During the third quarter of 2010, the Company increased its non-accretable difference, with a corresponding increase to goodwill, by $250,000, based upon information obtained in the third quarter about conditions existing at the acquisition date.
(3) The reduction in the carrying amount and the cash expected to be collected was due to one loan that was foreclosed upon and tranfered to OREO. Prior to acquisition of CNB, a portion of this loan was charged off in order to adjust the loan to its fair value; therefore, there was no non-accretable difference recorded against this loan on the aquisition date.
(4) The transfer from non-accretable yield was due to repayment received in excess of cash expected to be collected, net of selling costs.
(5) Amount represents a full reserve against the remaining net book value of the loan due to uncollectibility.

The excess of cash flows expected at acquisition over the estimated fair value is referred to as the accretable yield and is recognized in interest income over the remaining life of the loans. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the non-accretable difference. Changes in the expected cash flows from the date of acquisition will either impact the accretable yield or result in a charge to the provision for credit losses. Subsequent decreases to expected principal cash flows will result in a charge to the provision for credit losses and a corresponding increase to the allowance for loan losses. Subsequent increases in expected principal cash flows will result in recovery of any previously recorded allowance for loan losses, to the extent applicable, and a reclassification from non-accretable difference to accretable yield for any remaining increase. All changes in expected interest cash flows will result in reclassifications to/from non-accretable differences.

Acquired loans that are modified subsequent to acquisition are reviewed to compare modified contractual cash flows to the carrying value. If modified cash flows are lower than the carrying value, the loan is removed from the acquired loans pool at its carrying value, as well as the related allowance for loan losses, and is classified as a troubled debt restructure. At March 31, 2011, the Company had one acquired loan that was a troubled debt restructure.

NOTE G – COMMITMENTS

Financial instruments with off-balance sheet risk at March 31, 2011 and December 31, 2010 were as follows:

 

     March 31,
2011
     December 31,
2010
 

Unused lines of credit

   $ 236,631       $ 233,403   

Amounts due mortgagors

     22,998         26,500   

Standby letters of credit

     4,402         4,382   

Commitments to originate loans

     14,630         27,068   

 

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The Company has a commitment to invest up to $1.0 million in a venture capital fund. As of March 31, 2011, the Company has contributed $500,000 to the fund.

The Company has also committed to invest up to $10.0 million, representing 25% of the Class A or senior investor balance, in a low income housing tax credits fund by the end of 2014. At March 31, 2011, the Company has invested $3.1 million in the fund, which is included in other assets on the consolidated statement of condition. As a Class A investor, the Company has the right to transfer its investment to the fund’s Class B investor at the end of 10 years at which time the Company would have no compliance requirements or interest in the fund. The fund structure contemplates that the Class A investors will receive 95% of the tax credits and tax benefits from net operating losses for a period of eight years or until the minimum investment return has been met.

NOTE H – DEPOSITS

Deposit accounts, by type, are summarized as follows at March 31, 2011 and December 31, 2010:

 

     March 31,
2010
     December 31,
2010
 

Demand

   $ 181,208       $ 175,996   

NOW

     42,117         40,922   

Savings

     227,069         203,165   

Money market

     273,536         260,573   

Certificates of deposit

     449,981         462,645   
                 
   $ 1,173,911       $ 1,143,301   
                 

NOTE I – CONTINGENCIES

The Bank, as successor in interest to Commonwealth National Bank, is involved in litigation relating to its foreclosure on a certain loan property. The litigants claim that Commonwealth National Bank acted in bad faith and in violation of applicable law and that its actions resulted in a sale of the underlying property for less than it should have thereby causing damage to the parties. The Bank believes these claims are without merit and is vigorously defending the litigation. The parties are scheduled to go to trial in the third quarter of 2011. No estimate of any reasonably possible loss or range of loss to the Bank can be made at this time.

In addition, the Company is a defendant in other claims and legal action arising in the ordinary course of business. In the opinion of management, after consultation with legal counsel, the ultimate disposition of these matters is not expected to have a material adverse effect on the Company’s financial condition, results of operations or cash flows.

NOTE J – FAIR VALUES OF ASSETS AND LIABILITIES

In accordance with and as required by the Fair Value Measurements and Disclosures Topic of FASB ASC, the Company groups its financial assets and financial liabilities measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value, as follows:

Level 1 – Valuations for assets and liabilities traded in active exchange markets, such as the New York Stock Exchange. Level 1 also includes U.S. Treasury, other U.S. government and government-sponsored enterprises and agency mortgage-backed securities that are traded by dealers or brokers in active markets. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities.

 

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Level 2 – Valuations for assets and liabilities traded in less active dealer or broker markets. Valuations are obtained from third party pricing services for identical or comparable assets or liabilities.

Level 3 – Valuations for assets and liabilities that are derived from other valuation methodologies, including option pricing models, discounted cash flow models and similar techniques, and not based on market exchange, dealer, or broker-traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets and liabilities.

Assets measured at fair value on a recurring basis, are summarized below:

 

     Level 1      Level 2      Level 3      Total
Fair Value
 

At March 31, 2011

           

Securities available for sale:

           

Government-sponsored enterprises

   $ —         $ 4,997       $ —         $ 4,997   

Government-sponsored and government-guaranteed mortgage-backed securities

     —           196,952         —           196,952   

Private label mortgage-backed securities

     —           2,828         —           2,828   

Municipal bonds

     —           7,906         —           7,906   

Corporate bonds

     —           —           1,747         1,747   
                                   

Total

   $ —         $ 212,683       $ 1,747       $ 214,430   
                                   

At December 31, 2010

           

Securities available for sale

           

Government-sponsored enterprises

   $ —         $ 12,502       $ —         $ 12,502   

Government-sponsored and government-guaranteed mortgage-backed securities

     —           180,766         —           180,766   

Private label mortgage-backed securities

     —           3,170         —           3,170   

Municipal bonds

     —           7,795         —           7,795   

Corporate bonds

     —           —           1,619         1,619   
                                   

Total

   $ —         $ 204,233       $ 1,619       $ 205,852   
                                   

The Company had no liabilities measured at fair value on a recurring basis at March 31, 2011 or December 31, 2010.

The table below presents the changes in Level 3 assets measured at fair value on a recurring basis for the three months ended March 31, 2011.

 

Balance at December 31, 2010

   $  1,619   

Total realized/unrealized losses included in net income

     —     

Change in unrealized gain

     128   

Purchases

     —     

Sales

     —     

Issuances

     —     

Settlements

     —     

Transfers

     —     
        

Balance at March 31, 2011

   $ 1,747   
        

There were no transfers in or out of levels 1 and 2.

 

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The Company may be required, from time to time, to measure at fair value certain other financial and non-financial assets on a nonrecurring basis in accordance with GAAP. These adjustments to fair value usually result from application of lower-of-cost-or-fair value accounting or write-downs of individual assets. The following table summarizes the fair value hierarchy used to determine the adjustment and the carrying value of the related individual assets for the three months ended March 31, 2011.

 

                          Three Months Ended
March 31, 2011
 
     At March 31, 2011      Total  
     Level 1      Level 2      Level 3      Gains/(Losses)  

Assets:

           

Loans

   $ —         $ 4,343       $ —         $ (140
                                   

Total assets

   $ —         $ 4,343       $ —         $ (140
                                   
                          Three Months Ended
March 31, 2010
 
     At March 31, 2010      Total  
     Level 1      Level 2      Level 3      Gains/(Losses)  

Assets:

           

Loans

   $ —         $ 16,460       $ —         $ (607

Other real estate owned

     —           1,976         —           —     

Other assets

     —           —           545         (145
                                   

Total assets

   $ —         $ 18,436       $ 545       $ (752
                                   

The amount of loans represents the carrying value of impaired loans net of related write-downs and valuation allowances for which adjustments are based on the estimated fair value of the underlying collateral. The other real estate owned amount represents the carrying value for which adjustments are also based on the estimated fair value of the property. Included in other assets is private company stock which is carried at cost. Management determined that several impairment indicators existed and that the investment was impaired at March 31, 2010. In its evaluation, management considered the investee’s earnings performance, credit rating, asset quality, regulatory, economic, or technological environment operating environment, and the investee’s ability to continue as a going concern. The cost basis of the individual security was written down to fair value as a new cost basis and the amount of the write-down was accounted for as a realized loss and was included in earnings. As a result, management recorded an impairment charge of $145,000 in the first quarter of 2010. There were no additional indicators of impairment in the first quarter of 2011.

Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because a market may not readily exist for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

The following methods and assumptions were used by the Company in estimating fair values of its financial instruments:

Cash and Cash Equivalents and Short-term Investments. The carrying amounts of cash and short-term instruments approximate fair values based on the short-term nature of the assets.

 

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Investment Securities and FHLBB Stock. The fair value of securities to be held to maturity and securities available for sale is estimated based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. Ownership of Federal Home Loan Bank of Boston (“FHLBB”) stock is restricted to member banks; therefore, the stock is not traded. The estimated fair value of FHLBB stock is equal to its carrying value, which represents the price at which the FHLBB is obligated to redeem its stock.

Loans. For valuation purposes, the loan portfolio was segregated into its significant categories, which are residential mortgage, commercial real estate, commercial and consumer loans. These categories were further segregated, where appropriate, into components based on significant financial characteristics such as type of interest rate (fixed or adjustable). Fair values were estimated for each component using assumptions developed by management and a valuation model provided by a third party specialist.

The fair values of residential mortgage, commercial real estate, commercial and consumer loans were estimated by discounting the anticipated cash flows from the respective portfolios. Estimates of the timing and amount of these cash flows considered factors such as future loan prepayments. The discount rates reflected current market rates for loans with similar terms to borrowers of similar credit quality. The fair value of home equity lines of credit was based on the outstanding loan balances. Fair values for non-performing loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable.

Deposits. The fair value of deposits with no stated maturity, such as demand deposits, NOW, regular savings, and money market deposit accounts, is equal to the amount payable on demand. The fair value estimates do not include the benefit that results from the generally lower cost of funding provided by the deposit liabilities compared to the cost of borrowing funds in the market. The fair value estimate of time deposits is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits having similar remaining maturities.

Short-term Borrowings. For short-term borrowings maturing within one year, carrying values approximate fair values. Fair values of other short-term borrowings are estimated using discounted cash flow analyses based on the current incremental borrowing rates in the market for similar types of borrowing arrangements.

Long-term Debt. The fair values of the Company’s long-term debt are estimated using discounted cash flow analyses based on the current incremental borrowing rates in the market for similar types of borrowing arrangements.

Repurchase Agreements. The Company enters into overnight repurchase agreements with its customers. Since these agreements are short-term instruments, the fair value of these agreements approximates their recorded balance. The Company also secures term repurchase agreements through other financial institutions. The fair value of these agreements are determined by discounting the anticipated future cash payments using rates currently available to the Bank for debt with similar terms and remaining maturities.

Subordinated Debentures. The Company has outstanding subordinated debt in the form of trust preferred securities issued through a private placement offering. The fair value estimate is determined by discounting the anticipated future cash payments by using the rates currently available to the Company for debt with similar terms and remaining maturities.

Off-Balance Sheet Instruments. The fair value of off-balance-sheet mortgage lending commitments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. In the case of the commitments discussed in Note G, the fair value equals the carrying amounts which are not significant.

 

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Table of Contents

Summary of Fair Values of Financial Instruments. The estimated fair values, and related carrying or notional amounts, of the Company’s financial instruments are as follows. Certain financial instruments and all nonfinancial instruments are exempt from disclosure requirements. Accordingly, the aggregate fair value amounts presented herein do not represent the underlying fair value of the Company.

The fair value of the Company’s financial instruments is as follows at dates indicated:

 

     At March 31, 2011      At December 31, 2010  
     Carrying
Value
     Estimated
Fair Value
     Carrying
Value
     Estimated
Fair Value
 

Financial Assets:

           

Cash and cash equivalents

   $ 72,539       $ 72,539       $ 83,069       $ 83,069   

Securities available for sale

     214,430         214,430         205,852         205,852   

Securities held to maturity

     125,179         124,814         132,475         132,026   

Stock in Federal Home Loan Bank of Boston

     15,365         15,365         15,365         15,365   

Net loans

     1,088,576         1,108,796         1,066,197         1,091,165   

Financial Liabilities:

           

Deposits (with no stated maturity)

     723,930         723,930         680,656         680,656   

Time deposits

     449,981         457,703         462,645         469,717   

Federal Home Loan Bank of Boston advances

     141,461         146,085         153,307         155,945   

Repurchase agreements

     38,900         37,645         41,029         40,403   

Subordinated debentures

     5,471         5,471         5,448         5,448   

NOTE K – PENSION AND POSTRETIREMENT BENEFIT PLANS

The Company maintains a Senior Executive Retirement Plan (SERP) and a Director Retirement Plan. These plans had no assets at March 31, 2011 and 2010. The following table presents the components of the net periodic benefit cost for the indicated periods:

 

     For the Three Months Ended March 31,  
     2011      2010  
     SERP      Director
Retirement
Plan
     SERP      Director
Retirement
Plan
 

Periodic benefit cost:

           

Service cost

   $ 84       $ 23       $ 80       $ 17   

Interest cost

     46         14         44         11   
                                   

Total pension cost

     130         37         124         28   

Prior service cost amortization

     35         9         29         9   

Net loss amortization

     —           3         —           —     
                                   

Net periodic benefit cost

   $ 165       $ 49       $ 153       $ 37   
                                   

Benefits expected to be paid over the next five years as presented in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 have not changed. These plans are funded on a pay-as-you-go-basis and the Company does not expect to make any contributions to these plans in 2011.

 

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

Forward-Looking Statements

This report may contain, and from time to time, the Company may disclose, forward-looking statements relating to such matters as anticipated financial performance, business prospects, technological developments, new products, and similar matters. Forward-looking statements are generally preceded by terms such as “expects,” “believes,” “anticipates,” “intends” or similar expressions. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements provided that the Company notes that a variety of factors could cause the Company’s actual results to differ materially from the anticipated results expressed in the Company’s forward-looking statements. Factors that may cause actual results to differ materially from those projected in the forward-looking statements include, but are not limited to, general economic conditions, changes in market interest rates, changes in size, composition or risks in the loan portfolio, loan or deposit demand, changes in asset quality, including levels of delinquent, classified and charged-off loans, legislative, accounting or regulatory changes, and significant increases in competitive pressures. Additional factors are discussed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 under “Item 1A. Risk Factors”. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Forward-looking statements speak only as of the date they are made and the Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date of the forward-looking statements or to reflect the occurrence of unanticipated events. Accordingly, past results and trends should not be used by investors to anticipate future results or trends.

Comparison of Financial Condition at March 31, 2011 and December 31, 2010

Total assets increased $14.8 million, or 0.9%, to $1.60 billion at March 31, 2011 from $1.58 billion at December 31, 2010 reflecting loan growth partially offset by a decrease in interest-bearing deposits and held to maturity investment securities. Net loans increased $22.4 million, or 2.1%, to $1.09 billion at March 31, 2011 from $1.07 billion at December 31, 2010 primarily due to increased residential mortgage origination activity. Residential mortgages increased $21.6 million, or 7.3%, to $317.3 million at March 31, 2011 from $295.7 million at December 31, 2010 due to increased originations of 10- and 15-year loans as a result of promotional efforts and continued lower market interest rates. Securities available for sale increased $8.6 million, or 4.2%, to $214.4 million at March 31, 2011 due to purchases of fixed-rate mortgage-backed securities totaling $31.2 million, partially offset by calls and repayments of government-sponsored agency debt and mortgage-backed securities of $21.8 million. Interest-bearing deposits decreased $15.7 million, or 21.5%, reflecting the use of excess cash to paydown maturing FHLB advances. Securities held to maturity decreased $7.3 million, or 5.5%, as a result of repayments.

Total deposits increased $30.6 million, or 2.7%, to $1.17 billion at March 31, 2011 compared to $1.14 billion at December 31, 2010 primarily due to growth in core deposits accounts of $43.3 million, or 6.4%, to $723.9 million at March 31, 2011 from $680.7 million at December 31, 2010. The strong growth in core deposit account balances was driven by the success of sales and marketing initiatives in our new Worcester market, competitive products and pricing, attention to excellence in customer service and targeted promotional activities. The increase in core deposits was partially offset by a decrease in certificates of deposit of $12.7 million, or 2.7%, to $450.0 million at March 31, 2011 compared to $462.6 million at December 31, 2010. Long-term debt decreased $11.8 million, or 6.8%, to $161.5 million at March 31, 2011 compared to $173.3 million at December 31, 2010 mainly due to the use of excess cash balances to pay down FHLB advances. At March 31, 2011, the Company continued to have considerable liquidity including significant unused borrowing capacity at the FHLBB and the Federal Reserve Bank and access to funding through the repurchase agreement and brokered deposit markets.

 

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Table of Contents

Total stockholders’ equity increased $1.5 million, or 0.7%, to $224.1 million at March 31, 2011 from $222.6 million at December 31, 2010 as a result of net income of $2.4 million, stock-based compensation totaling $526,000 and employee stock ownership plan (“ESOP”) compensation of $269,000 for the three months ended March 31, 2011. These increases were partially offset by a cash dividend payment amounting to $1.2 million, a decrease of $346,000 in other comprehensive income and repurchases of common stock totaling $195,000.

Credit Quality

The Company actively manages credit risk through its underwriting practices and collection operations and it does not offer nor has it historically offered residential mortgage and other consumer loans to subprime or Alt-A borrowers. Non-accrual loans totaled $8.4 million, or 0.76% of total loans, at March 31, 2011 compared to $9.4 million, or 0.88% of total loans, at December 31, 2010. The non-accrual loan total for March 31, 2011 includes an $860,000 commercial real estate loan which was impaired at March 31, 2011 and was restructured during the second quarter of 2010 as well as a $263,000 commercial real estate loan which was impaired at March 31, 2011 and was restructured during the first quarter of 2011. The non-accrual loan total for March 31, 2011 also includes an $872,000 commercial construction loan which was impaired at March 31, 2011 and was restructured during the fourth quarter of 2010. The total amount of classified loans at March 31, 2011 totaled $67.8 million and includes sixteen relationships which represent 58% of the total. Construction loans for one- to four-family home or condominium development represent 12% of total classified assets, a slight decrease from 13% at December 31, 2010. Of the $1.5 million in other real estate owned, $940,000 is under a sales contract with a closing expected in the second quarter of 2011. See also “Note F – Loans” in the Notes to the Unaudited Consolidated Financial Statements in this report for disclosures about the credit quality.

Comparison of Operating Results for the Three Months Ended March 31, 2011 and 2010

Overview

Our results of operations depend primarily on our net interest income. Net interest income is the difference between the interest income earned on interest-earning assets, consisting primarily of loans, investment securities and other interest-earning assets, and the interest paid on interest-bearing liabilities, consisting primarily of deposits, FHLBB advances and repurchase agreements.

Our results of operations also are affected by provisions for loan losses, non-interest income and non-interest expense. Non-interest income consists primarily of deposit account fees, gain (loss) on sale of loans and securities, wealth management fees, increases in the cash surrender value of bank-owned life insurance and miscellaneous other income. Non-interest expense consists primarily of salaries and benefits, data processing, occupancy, marketing, professional fees, FDIC insurance assessments and other operating expenses. Our results of operations also may be affected significantly by general and local economic and competitive conditions, changes in market interest rates, governmental policies and actions of regulatory authorities.

Net Income. Net income was $2.4 million, or $0.16 per diluted share, for the first quarter of 2011 compared to net income of $1.8 million, or $0.11 per diluted share, for the same period in 2010. Excluding expenses totaling $979,000 ($808,000 net of tax benefit) related to the acquisition of Commonwealth National Bank, net income would have been $2.6 million, or $0.16 per diluted share, for the first quarter of 2010.

 

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Average Balances and Yields. The following table sets forth average balances, average yields and costs, and certain other information for the periods indicated. No tax-equivalent yield adjustments were made, as the effect thereof was not material. All average balances are daily average balances. Non-accrual loans were included in the computation of average balances, but have been reflected in the table as loans carrying a zero yield.

 

     Three Months Ended March 31,  
     2011     2010  
     Average
Balance
     Interest
and
Dividends
     Yield/
Cost
    Average
Balance
     Interest
and
Dividends
     Yield/
Cost
 
            (Dollars in thousands)         

Interest-earning assets:

                

Loans:

                

Residential real estate(1)

   $ 313,619       $ 3,927         5.01   $ 341,337       $ 4,632         5.43

Commercial real estate

     455,123         6,765         5.95     455,852         7,069         6.20

Home equity

     137,805         1,307         3.79     138,530         1,443         4.17

Commercial and industrial

     165,028         2,221         5.38     152,627         1,977         5.18

Consumer and other

     19,221         267         5.56     23,983         336         5.60
                                        

Total loans(2)

     1,090,796         14,487         5.31     1,112,329         15,457         5.56

Investment securities

     341,804         3,191         3.73     302,916         3,292         4.35

Other interest-earning assets

     61,346         40         0.26     19,011         8         0.17
                                        

Total interest-earning assets

     1,493,946         17,718         4.74     1,434,256         18,757         5.23

Noninterest-earning assets(3)

     85,102              94,953         
                            

Total assets

   $ 1,579,048            $ 1,529,209         
                            

Interest-bearing liabilities:

                

Savings accounts

   $ 211,758         406         0.77   $ 170,489         397         0.93

Money market accounts

     262,220         494         0.75     206,325         449         0.87

NOW accounts

     39,589         43         0.43     38,650         50         0.52

Certificates of deposit

     456,692         2,354         2.06     467,551         2,479         2.12
                                        

Total interest-bearing deposits

     970,259         3,297         1.36     883,015         3,375         1.53

FHLB advances

     147,880         1,303         3.52     202,644         1,552         3.06

Other interest-bearing liabilities

     52,152         327         2.51     53,981         334         2.47
                                        

Total interest-bearing liabilities

     1,170,291         4,927         1.68     1,139,640         5,261         1.85

Demand deposits

     175,037              155,358         

Other noninterest-bearing liabilities

     10,653              9,425         
                            

Total liabilities

     1,355,981              1,304,423         

Stockholders’ equity

     223,067              224,786         
                            

Total liabilities and stockholders’ equity

   $ 1,579,048            $ 1,529,209         
                            

Net interest income

      $ 12,791            $ 13,496      
                            

Interest rate spread(4)

           3.06           3.39

Net interest-earning assets(5)

   $ 323,655            $ 294,616         
                            

Net interest margin(6)

           3.42           3.76

Average interest-earning assets to average interest-bearing liabilities

           127.66           125.85

 

(1) Includes loans held for sale.
(2) Loans, including non-accrual loans, are net of deferred loan origination costs and advanced funds.
(3) Includes bank-owned life insurance, the income on which is classified as non-interest income.
(4) Net interest rate spread represents the difference between the yield on average interest-earning assets and the cost of average interest-bearing liabilities.
(5) Net interest-earning assets represent total interest-earning assets less total interest-bearing liabilities.
(6) Net interest margin represents annualized net interest income divided by average total interest-earning assets.

 

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Rate/Volume Analysis. The following table presents the effects of changing rates and volumes on our net interest income for the periods indicated. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate). The net column represents the sum of the prior columns. For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately, based on the changes due to rate and the changes due to volume.

 

     Three Months Ended March 31,
2011 vs. 2010
 
     Increase (Decrease) Due to        
     Volume     Rate     Net  
     (In thousands)  

Interest-earning assets:

      

Loans:

      

Residential real estate(1)

   $ (361   $ (344   $ (705

Commercial real estate

     (11     (293     (304

Home equity

     (8     (128     (136

Commercial and industrial

     165        79        244   

Consumer and other

     (66     (3     (69
                        

Total loans

     (281     (689     (970

Investment securities

     394        (495     (101

Other interest-earning assets

     26        6        32   
                        

Total interest-earning assets

     139        (1,178     (1,039

Interest-bearing liabilities:

      

Savings accounts

     86        (77     9   

Money market accounts

     111        (66     45   

NOW accounts

     1        (8     (7

Certificates of deposit

     (57     (68     (125
                        

Total interest-bearing deposits

     141        (219     (78

FHLB advances

     (459     210        (249

Other interest-bearing liabilities

     (11     4        (7
                        

Total interest-bearing liabilities

     (329     (5     (334
                        

Change in net interest income

   $ 468      $ (1,173   $ (705
                        

 

(1) Includes loans held for sale.

Net Interest Income Before Provision for Loan Losses. Net interest income before provision for loan losses decreased $705,000, or 5.2%, to $12.8 million for the first quarter of 2011 from $13.5 million for the same period in 2010 as a result of net interest margin compression, partially offset by an increase in average interest earning assets. The net interest margin decreased 34 basis points to 3.42% for the three months ended March 31, 2011 from 3.76% for the same period in 2010 due to a decrease of $330,000 in amortization of certain acquisition accounting adjustments to $402,000 for the first quarter of 2011 from $732,000 for the same period in 2010, the downward repricing of certain fixed rate loans and investments as a result of the lower interest rate environment and an increase in funds held in lower-yielding cash equivalents. These items were partially offset by lower funding costs. Total average interest-earning assets increased $59.7 million, or 4.2%, to $1.49 billion for the three months ended March 31, 2011, mainly due to growth in investment securities and excess cash balances held at the Federal Reserve Bank.

 

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Interest Income. Interest income decreased $1.0 million, or 5.5%, to $17.7 million for the three months ended March 31, 2011 from $18.8 million for the prior year period due to a lower yield on average interest-earning assets, partially offset by growth in average interest-earning assets. The yield on average interest-earning assets decreased by 49 basis points to 4.74% for the first quarter of 2011 in connection with the lower interest rate environment and a reduction of $57,000 in the accretion of certain loan fair value accounting adjustments to $245,000 in the first quarter of 2011 from $302,000 for the same period in 2010. The decrease in market rates contributed to the downward repricing of a portion of the Company’s existing assets and to lower rates for new assets. Total average interest-earning assets increased $59.7 million, or 4.2%, to $1.49 billion for the three months ended March 31, 2011, mainly due to growth in investment securities and excess cash balances held at the Federal Reserve Bank.

Interest Expense. Interest expense decreased $334,000, or 6.3%, to $4.9 million for the three months ended March 31, 2011 from $5.3 million for the prior year period reflecting a decrease in the average rate paid on interest-bearing liabilities, partially offset by an increase in average interest-bearing liabilities. The average rate paid on interest-bearing liabilities declined 17 basis points to 1.68% for the three months ended March 31, 2011 reflecting the repricing of savings, money market, NOW accounts and certificate of deposit balances in response to the lower interest rate environment, partially offset by a $273,000 reduction in interest expense associated with the amortization of certain fair value deposits and borrowings accounting adjustments to $157,000 in the first quarter of 2011 from $430,000 for the same period in 2010. Average interest-bearing liabilities increased $30.7 million, or 2.7%, to $1.17 billion for the three months ended March 31, 2011 from $1.14 billion for the prior year period reflecting growth in interest-bearing deposits attributable to attractive products, competitive pricing and excellent customer service.

Provision for Loan Losses. The provision for loan losses increased $75,000, or 10.2%, to $808,000 for the three months ended March 31, 2011 compared to $733,000 for the same period in 2010. The allowance for loan losses is based on management’s estimate of the probable losses inherent in the portfolio, considering the impact of certain factors. Among the factors management considers are prior loss experience, current economic conditions and their effect on borrowers, the composition and size of the portfolio, trends in non-performing loans and delinquency rates and the performance of individual loans in relation to contractual terms. The provision for loan losses reflects adjustments to the allowance based on management’s review of the loan portfolio in light of those conditions. The allowance for loan losses was $10.5 million, or 0.95% of loans outstanding at March 31, 2011. Excluding the impact of loans acquired from CNB Financial Corp. and other financial institutions, the ratio of the allowance for loan losses to total loans would have been 1.17%.

Non-interest Income. Non-interest income increased $112,000, or 5.5%, to $2.1 million for the three months ended March 31, 2011, reflecting growth of $102,000, or 73.9%, in wealth management income as a result of increases in commissions from annuity sales and fees from assets under management. The results were also impacted by lower gains from sales of loans of $23,000 for the first quarter of 2011 from $88,000 for the same period in 2010, a decrease of $79,000, or 5.8% in fee income on depositors’ accounts and an other-than-temporary impairment charge on an equity security of $145,000 for the first quarter of 2010.

Non-interest Expense. Non-interest expense decreased $1.1 million, or 9.0%, to $10.9 million for the first quarter of 2011 from $12.0 million in the same period last year. Excluding acquisition-related expenses totaling $979,000 in the first quarter of 2010, non-interest expense would have decreased $99,000, or 0.9%. Marketing expenses decreased $113,000, or 20.2%, reflecting the cost of promotional activities in 2010 to support the Company’s entry into the Worcester market. FDIC premium expense decreased $85,000, or 20.5%, driven by a one-time adjustment in the first quarter of 2010 related to the CNB acquisition. Occupancy expenses decreased $83,000, or 9.0%, mainly due to the closing of the Company’s Worcester operations center in 2010. Data processing expenses decreased $79,000, or 7.4%, largely attributable to one-time software setup expenses incurred during the first quarter of 2010. Other expenses decreased $50,000, or 3.4%, reflecting lower costs to operate the Worcester franchise as a result of integration efforts during the first quarter of 2010 and a one-time depreciation expense adjustment related to the CNB fixed assets conversion in 2010, partially offset by an operating loss from an investment in a low income housing tax credit fund. These favorable variances were partially offset by increases in salaries and benefits and professional services. Salaries and

 

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benefits expense increased $191,000, or 3.1%, mainly reflecting annual wage adjustments and new employees hired to support and facilitate the growth of the Company. Professional services expenses increased $120,000, or 22.2%, in connection with expanded consulting and legal costs primarily driven by the timing of loan review and annual meeting activities.

Income Tax Expense. Income tax expense decreased $268,000, or 26.0%, to $763,000 for the first quarter of 2011 from $1.0 million in the same period last year primarily due to a lower effective tax rate. The effective tax rate decreased from 37.1% in the first quarter of 2010 to 23.9% for the first quarter of 2011 largely as a result of tax credits from an investment in a low income housing tax credit fund and an increase in tax exempt municipal investment income in 2011.

Market Risk, Liquidity and Capital Resources

Market Risk

The majority of our assets and liabilities are monetary in nature. Consequently, our most significant form of market risk is interest rate risk (“IRR”). Our assets, the largest portion of which are mortgage loans, have longer maturities than our liabilities, consisting primarily of deposits. As a result, a principal part of our business strategy is to manage IRR and reduce the exposure of our net interest income (“NII”) to changes in market interest rates. Accordingly, our Board of Directors has established an Asset/Liability Management Committee which is responsible for evaluating the IRR inherent in our assets and liabilities, for determining the level of risk that is appropriate given our business strategy, operating environment, capital, liquidity and performance objectives, and for managing this risk consistent with the guidelines approved by the Board of Directors. With the assistance of an IRR management consultant, the committee monitors the level of IRR on a regular basis and meets at least on a quarterly basis to review our asset/liability policies and IRR position.

We have sought to manage our IRR in order to minimize the exposure of our earnings and capital to changes in interest rates. As part of our ongoing asset-liability management, we currently use the following strategies to manage our IRR: (i) using alternative funding sources, such as advances from the FHLBB, to “match fund” certain longer-term loans; (ii) continued emphasis on increasing core deposits; (iii) offering adjustable rate and shorter-term home equity loans, commercial real estate loans, construction loans and commercial and industrial loans; (iv) offering a variety of consumer loans, which typically have shorter-terms and (v) investing in mortgage-backed securities with variable rates or fixed rates with shorter durations. Reducing the average maturity of our interest-earning assets by increasing our investments in shorter-term loans and securities, as well as loans and securities with variable rates of interest, helps to better match the maturities and interest rates of our assets and liabilities, thereby reducing the exposure of our NII to changes in market interest rates.

Net interest income at-risk measures the risk of a decline in earnings due to potential short-term and long term changes in interest rates. The table below represents an analysis of our IRR as measured by the estimated changes in NII for the following twelve months, resulting from an instantaneous and sustained parallel shift in the yield curve of +200 and -100 basis points at March 31, 2011 and December 31, 2010.

 

Net Interest Income At-Risk

 
Change in Interest Rates    Estimated Increase (Decrease)
in NII
    Estimated Increase (Decrease)
in NII
 

(Basis Points)

   (March 31, 2011)     (December 31, 2010)  

-100

     (1.7 )%      (1.1 )% 

Stable

     0.0     0.0

+200

     0.3     0.5

 

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The preceding income simulation analysis is for the Bank and its subsidiaries only and does not represent a forecast of NII and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions, which are subject to change, including: the nature and timing of interest rate levels including the yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment/replacement of asset and liability cash flows, and others. Also, market conditions, prepayment/refinancing levels, the varying impact of interest rate changes on caps and floors embedded in adjustable rate loans, early withdrawal of deposits, changes in product preferences, and other internal/external variables and other factors may vary significantly from assumptions used.

Net Portfolio Value Simulation Analysis. The Office of Thrift Supervision requires the computation of amounts by which the net present value of an institution’s cash flow from assets, liabilities and off balance sheet items (the institution’s net portfolio value or “NPV”) would change in the event of a range of assumed changes in market interest rates. The Office of Thrift Supervision provides all institutions that file a Consolidated Maturity/Rate Schedule as a part of their quarterly Thrift Financial Report an interest rate sensitivity report of net portfolio value. The Office of Thrift Supervision simulation model uses a discounted cash flow analysis and an option-based pricing approach to measuring the interest rate sensitivity of net portfolio value. Historically, the Office of Thrift Supervision model estimated the economic value of each type of asset, liability and off-balance sheet contract under the assumption that the United States Treasury yield curve increases or decreases instantaneously by 100 to 300 basis points in 100 basis point increments. However, given the low level of market interest rates, a net portfolio value calculation for an interest rate decrease of greater than 100 basis points was not prepared. A basis point equals one-hundredth of one percent, and 200 basis points equals two percent. An increase in interest rates from 3% to 5% would mean, for example, a 200 basis point increase in the “Change in Interest Rates” column below. The Office of Thrift Supervision provides us the results of the interest rate sensitivity model, which is based on information we provide to the Office of Thrift Supervision to estimate the sensitivity of our net portfolio value.

The tables below set forth, at the dates indicated, the estimated changes in our net portfolio value that would result from the designated instantaneous changes in the United States Treasury yield curve. Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, loan prepayments and deposit decay, and should not be relied upon as indicative of actual results. This data is for the Bank and its subsidiary only and does not include any yield curve changes in the assets of United Financial.

 

     March 31, 2011  
                        NPV as a Percentage of Present  
                        Value of Assets (3)  
            Estimated Increase (Decrease) in              
Change in           NPV           Increase  
Interest Rates    Estimated                        (Decrease)  

(basis points) (1)

   NPV (2)      Amount     Percent     NPV Ratio (4)     (basis points)  
            (Dollars in thousands)                    
+300    $ 154,977       $ (65,654     (30 )%      10.48     (326
+200      180,031         (40,600     (18     11.83        (191
+100      203,383         (17,248     (8     12.99        (75
      0      220,631             13.74     
-100      237,961         17,330        8        14.51        78   

 

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Table of Contents
     December 31, 2010  
                        NPV as a Percentage of Present  
                        Value of Assets (3)  
            Estimated Increase (Decrease) in              
Change in           NPV           Increase  
Interest Rates    Estimated                        (Decrease)  

(basis points) (1)

   NPV (2)      Amount     Percent     NPV Ratio (4)     (basis points)  
            (Dollars in thousands)                    
+300    $ 146,150       $ (64,887     (31 )%      9.99     (334
+200      170,561         (40,475     (19     11.34        (198
+100      193,589         (17,448     (8     12.53        (80
      0      211,036             13.32     
-100      227,944         16,908        8        14.11        78   

 

(1) Assumes an instantaneous uniform change in interest rates at all maturities.
(2) NPV is the discounted present value of expected cash flows from assets, liabilities and off-balance sheet contracts.
(3) Present value of assets represents the discounted present value of incoming cash flows on interest-earning assets.
(4) NPV ratio represents NPV divided by the present value of assets.

The tables above indicate that at March 31, 2011 and December 31, 2010, in the event of a 300 basis point increase in interest rates, we would experience a 30% and 31%, respectively, decrease in net portfolio value. In the event of a 100 basis point decrease in interest rates at March 31, 2011 and December 31, 2010, we would experience a 8% increase in net portfolio value.

Certain shortcomings are inherent in the methodology used in the above interest rate risk measurement. Modeling changes in net portfolio value require making certain assumptions that may or may not reflect the manner in which actual yields and costs respond to changes in market interest rates. In this regard, the net portfolio value table presented assumes that the composition of our interest-sensitive assets and liabilities existing at the beginning of a period remains constant over the period being measured and assumes that a particular change in interest rates is reflected uniformly across the yield curve regardless of the duration or repricing of specific assets and liabilities. Accordingly, although the net portfolio value table provides an indication of our interest rate risk exposure at a particular point in time, such measurements are not intended to and do not provide a precise forecast of the effect of changes in market interest rates on our net interest income and will differ from actual results.

Liquidity

Liquidity is the ability to meet current and future financial obligations of a short-term nature. Our primary sources of funds consist of deposit inflows, advances from the FHLBB, loan and mortgage-backed security repayments and maturities and sales of loans and investment securities. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by market interest rates, economic conditions and competition. Our Asset/Liability Management Committee is responsible for establishing and monitoring our liquidity targets and strategies in order to ensure that sufficient liquidity exists for meeting the borrowing needs of our customers as well as unanticipated contingencies. We seek to maintain a liquidity ratio (defined as the sum of cash and liquid assets divided by the sum of total deposits and short-term interest-bearing liabilities) of 10% or greater. At March 31, 2011, our liquidity ratio was 23.55%, compared to 22.15% at December 31, 2010.

We regularly adjust our investments in liquid assets based upon our assessment of (1) expected loan demand, (2) expected deposit flows, (3) yields available on interest-earning deposits and securities, and (4) the objectives of our asset/liability management program. Excess liquid assets are generally invested in interest-earning deposits and short- and intermediate-term securities.

 

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Our most liquid assets are cash and cash equivalents. The levels of these assets are dependent on our operating, financing, lending and investing activities during any given period. At March 31, 2011, cash and cash equivalents totaled $72.5 million. Securities classified as available-for-sale and held-to-maturity, which provide additional sources of liquidity, totaled $214.4 million and $125.2 million, respectively, at March 31, 2011. In addition, at March 31, 2011, we had the ability to borrow a total of approximately $376.3 million from the FHLBB. On that date, we had $139.6 million in advances outstanding.

Our cash flows are derived from operating activities, investing activities and financing activities as reported in our Consolidated Statements of Cash Flows included in our Consolidated Financial Statements.

At March 31, 2011, we had $14.6 million in loan commitments outstanding. In addition to commitments to originate loans, we had $236.6 million in unused lines of credit to borrowers, $4.4 million in standby letters of credit and $23.0 million to be disbursed under existing construction loan commitments. Certificates of deposit due within one year of March 31, 2011 totaled $273.1 million, or 18.0% of total deposits. If these deposits do not remain with us, we will be required to seek other sources of funds, including other certificates of deposit, FHLBB advances, borrowings from the Federal Reserve Bank and repurchase agreements. Depending on market conditions, we may be required to pay higher rates on such deposits or other borrowings than we currently pay on the certificates of deposit due on or before March 31, 2011. We believe however, based on past experience that a significant portion of our certificates of deposit will remain with us. We have the ability to attract and retain deposits by adjusting the interest rates offered.

Our primary investing activities are the origination of loans and the purchase of securities. For the three months ended March 31, 2011, we originated $72.4 million of loans and purchased $31.2 million of securities. In the comparable 2010 period, we originated $39.3 million of loans and purchased $11.6 million of securities.

Financing activities consist primarily of activity in deposit accounts and FHLBB advances. We experienced a net increase in total deposits of $30.6 million and $26.3 million for the three months ended March 31, 2011 and 2010, respectively. Deposit flows are affected by the overall level of interest rates, the interest rates and products offered by us and our local competitors and other factors. FHLBB advances decreased by $11.8 million and $48.0 million during the three months ended March 31, 2011 and 2010, respectively, reflecting the use of cash flows received from the loan and investment portfolios and excess deposit funds to pay down FHLBB advances.

Liquidity management is both a daily and long-term function of business management. If we require funds beyond our ability to generate them internally, borrowing agreements exist with the FHLBB, which provides an additional source of funds. We have also used FHLBB advances to “match-fund” certain longer-term one- to four-family residential mortgage loans and commercial real estate loans. The Bank’s unused borrowing capacity with the FHLBB, excluding its available line of credit balance of $2.0 million at March 31, 2011 and at December 31, 2010, was approximately $234.7 million at March 31, 2011 and $219.9 million at December 31, 2010. At March 31, 2011 and December 31, 2010, the Bank had no borrowing against the line of credit. We also have access to funding through the repurchase agreement and brokered CD markets and have received approval from the Federal Reserve Bank to access its discount window. The Bank’s unused borrowing capacity with the Federal Reserve Bank was approximately $66.6 million at March 31, 2011.

United Financial is a separate legal entity from the Bank and must provide for its own liquidity. In addition to its operating expenses, United Financial is responsible for paying any dividends declared to its shareholders. United Financial also repurchases shares of its common stock. At March 31, 2011, United Financial had liquid assets of $16.5 million.

 

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Off-Balance Sheet Arrangements and Aggregate Contractual Obligations

Commitments

As a financial services provider, we routinely are a party to various financial instruments with off-balance-sheet risks, such as commitments to extend credit, standby letters of credit and unused lines of credit. While these contractual obligations represent our future cash requirements, a significant portion of commitments to extend credit may expire without being drawn upon. Such commitments are subject to the same credit policies and approval process accorded to loans made by us. We consider commitments to extend credit in determining our allowance for loan losses.

Contractual Obligations

In the ordinary course of our operations, we enter into certain contractual obligations. Such obligations include operating leases for premises and equipment. The following table summarizes our significant fixed and determinable contractual obligations and other funding needs by payment date at March 31, 2011. The payment amounts represent those amounts due to the recipient and do not include any unamortized premiums or discounts or other similar carrying amount adjustments.

 

     Payments Due by Period (In Thousands)  
     Less Than
One Year
     One to Three
Years
     Three to Five
Years
     More than
Five Years
     Total  

Contractual Obligations:

              

Certificates of deposit

   $ 273,141       $ 129,064       $ 47,692       $ —         $ 449,897   

Federal Home Loan Bank advances

     40,086         54,008         22,245         23,245         139,584   

Repurchase agreements

     18,900         —           —           20,000         38,900   

Subordinated debentures

     —           —           —           7,732         7,732   

Standby letters of credit

     4,402         —           —           —           4,402   

Operating leases

     1,043         1,928         1,827         4,033         8,831   

Capitalized leases

     406         812         813         6,255         8,286   

Future benefits to be paid under retirement plans

     25         3,432         233         5,628         9,318   
                                            

Total

   $ 338,003       $ 189,244       $ 72,810       $ 66,893       $ 666,950   
                                            

Commitments:

              

Commitments to extend credit

   $ 278,661       $ —         $ —         $ —         $ 278,661   

Commitment to invest in venture capital fund

     500         —           —           —   &n