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Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

[X] QUARTERLY REPORT UNDER 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 001-34292

ORRSTOWN FINANCIAL SERVICES, INC.

(Exact name of registrant as specified in its charter)

 

Commonwealth of Pennsylvania                                           

     23-2530374                                   .

(State or other jurisdiction of incorporation or organization)

     (I.R.S. Employer Identification No.)

77 East King Street, P.O. Box 250, Shippensburg, Pennsylvania

      

    17257    

(Address of principal executive offices)

     (Zip Code)

(717) 532-6114

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filled 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  x

   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 definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer

 

¨

  

Accelerated filer x

 

Non-accelerated filer

 

¨

  

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

As of May 5, 2011, 7,996,493 shares of common stock, no par value, of the registrant were outstanding.


Table of Contents

ORRSTOWN FINANCIAL SERVICES, INC.

INDEX

 

     Page

Part I - FINANCIAL INFORMATION

  

Item 1. Financial Statements (unaudited)

  

Condensed consolidated balance sheets – March 31, 2011 and December 31, 2010

   3

Condensed consolidated statements of income - Three months ended March 31, 2011 and 2010

   4

Condensed consolidated statements of changes in shareholders’ equity - March 31, 2011 and 2010

   5

Condensed consolidated statements of cash flows - March 31, 2011 and 2010

   6

Notes to condensed consolidated financial statements

   7 - 27

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

   28 - 47

Item 3. Quantitative and Qualitative Disclosures About Market Risk

   47

Item 4. Controls and Procedures

   48

PART II - OTHER INFORMATION

  

Item 1. Legal Proceedings

   48

Item 1A. Risk Factors

   48

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

   48

Item 3. Defaults upon Senior Securities

   49

Item 4. (Removed and Reserved)

   49

Item 5. Other Information

   49

Item 6. Exhibits

   49

SIGNATURES

   49

EXHIBIT INDEX

   50

 

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Table of Contents

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY

Consolidated Balance Sheets (Unaudited)

 

              March 31,                      December 31,          

(Dollars in Thousands, Except per Share Data)

   2011      2010  

Assets

     

Cash and due from banks

       $ 14,751             $ 10,400     

Federal funds sold

     21,500           8,800     
                 

Cash and cash equivalents

     36,251           19,200     
                 

Short-term investments

     2,746           2,728     

Interest bearing deposits with banks

     557           925     

Member stock, at cost which approximates market value

     8,515           8,798     

Securities available for sale

     395,792           431,772     

Loans held for sale

     3,807           2,693     

Loans

     984,967           964,293     

Allowance for loan losses

     (18,398)           (16,020)     
                 

Net loans

     970,376           950,966     
                 

Premises and equipment, net

     27,557           27,774     

Cash surrender value of life insurance

     22,946           22,649     

Goodwill and intangible assets

     20,646           20,698     

Accrued interest receivable

     5,849           5,715     

Other assets

     21,158           20,497     
                 

Total assets

       $ 1,512,393             $ 1,511,722     
                 

Liabilities

     

Deposits:

     

Non-interest bearing

       $ 116,418             $ 104,646     

Interest bearing

     1,090,955           1,083,731     
                 

Total deposits

     1,207,373           1,188,377     
                 

Short-term borrowings

     86,750           87,850     

Long-term debt

     45,068           65,178     

Accrued interest and other liabilities

     10,529           9,833     
                 

Total liabilities

     1,349,720           1,351,238     
                 

Shareholder’s Equity

     

Preferred stock $1.25 par value per share; 500,000
shares authorized; no shares issued or outstanding

     0           0     

Common stock, no par value - $0.05205 stated value per share;
50,000,000 shares authorized; 7,991,791 and 7,986,966
shares issued; 7,991,512 and 7,985,667 shares outstanding

     416           416     

Additional paid-in capital

     121,579           121,508     

Retained earnings

     40,670           38,680     

Accumulated other comprehensive income (loss)

     15           (88)     

Treasury stock - common, 279 and 1,299, at cost

     (7)           (32)     
                 

Total shareholders’ equity

     162,673           160,484     
                 

Total liabilities and shareholders’ equity

       $ 1,512,393             $ 1,511,722     
                 

The Notes to Consolidated Financial Statements are an integral part of these statements.

 

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ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY

Consolidated Statements of Income (Unaudited)

 

     Three Months Ended  
             March 31,                      March 31,          

(Dollars in Thousands, Except per Share Data)

   2011      2010  

Interest and dividend income

     

Interest and fees on loans

       $ 12,435             $ 11,839     

Interest and dividends on investment securities

     

Taxable

     2,095           1,546     

Tax-exempt

     771           368     

Short term investments

     24           30     
                 

Total interest and dividend income

     15,325           13,783     
                 

Interest expense

     

Interest on deposits

     2,525           2,680     

Interest on short-term borrowings

     123           164     

Interest on long-term debt

     289           442     
                 

Total interest expense

     2,937           3,286     
                 

Net interest income

     12,388           10,497     

Provision for loan losses

     3,195           1,420     
                 

Net interest income after provision for loan losses

     9,193           9,077     
                 

Other income

     

Service charges on deposit accounts

     1,485           1,439     

Other service charges, commissions and fees

     370           396     

Trust department income

     1,012           760     

Brokerage income

     404           373     

Mortgage banking activities

     696           361     

Earnings on life insurance

     330           162     

Merchant processing fees

     255           257     

Other income

     145           201     

Investment securities gains

     379           398     
                 

Total other income

     5,076           4,347     
                 

Other expenses

     

Salaries and employee benefits

     4,832           4,598     

Occupancy and equipment

     562           559     

Furniture and equipment

     681           601     

Data processing

     312           294     

Telephone

     176           172     

Advertising and bank promotions

     258           180     

FDIC insurance

     550           544     

Professional services

     322           293     

Taxes other than income

     205           133     

Intangible asset amortization

     52           65     

Other operating expense

     1,489           1,221     
                 

Total other expense

     9,439           8,660     
                 

Income before income tax

     4,830           4,764     

Income tax expense

     1,003           1,358     
                 

Net income

       $ 3,827             $ 3,406     
                 

Per share information:

     

Basic earnings per share

       $ 0.48             $ 0.52     

Diluted earnings per share

     0.48           0.52     

Dividends per share

     0.23           0.22     

The Notes to Consolidated Financial Statements are an integral part of these statements

 

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ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY

Consolidated Statements of Changes in Shareholder’s Equity (Unaudited)

 

     Three Months Ended March 31, 2011 and 2010  

(Dollars in thousands)

     Common  
Stock
       Additional  
Paid-In
Capital
       Retained  
Earnings
       Accumulated Other  
Comprehensive
Income (Loss)
       Treasury  
Stock
     Total
  Shareholders’  
Equity
 

Balance, January 1, 2010

     $337          $82,895          $28,857          ($501)          ($702)          $110,886    
                       

Comprehensive income

                 

Net income

                     3,406                          3,406    

Net unrealized securities gains

                             681                  681    

Net unrealized gains on derivatives

                             404                  404    
                       

Comprehensive income

                    4,491    
                       

Cash dividends ($0.22 per share)

                     (1,417)                          (1,417)    

Issuance of treasury stock (18,324 shares)

             11                          461          472    

Proceeds from issuance of common stock (1,481,481 shares)

     77          37,473                                  37,550    
                                                     

Balance, March 31, 2010

     $414          $120,379          $30,846          $584          ($241)          $151,982    
                                                     

Balance, January 1, 2011

     $416          $121,508          $38,680          ($88)          ($32)          $160,484    

Comprehensive income

                 

Net income

                     3,827                          3,827    

Net unrealized securities gains

                             355                  355    

Net unrealized losses on derivatives

                             (252)                  (252)    
                       

Comprehensive income

                    3,930    
                       

Cash dividends ($0.23 per share)

                     (1,837)                          (1,837)    

Issuance of stock:

                 

Stock-based compensation plans (4,825 shares)

             79                                  79    

Issuance of treasury stock (1,020 shares)

             (8)                          25          17    
                                                     

Balance, March 31, 2011

     $416          $121,579          $40,670          $15          ($7)          $162,673    
                                                     

The Notes to Consolidated Financial Statements are an integral part of these statements

 

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ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY

Consolidated Statements of Cash Flows (Unaudited)

 

     Three Months Ended  
             March 31,                      March 31,          

(Dollars in Thousands, Except per Share Data)

   2011      2010  

CASH FLOWS FROM OPERATING ACTIVITIES

     

Net income

       $ 3,827             $ 3,406     

Adjustments to reconcile net income to net cash provided by operating activities:

     

Amortization (accretion) of premiums (discounts) on securities available for sale

     1,633           432     

Depreciation and amortization

     775           666     

Provision for loan losses

     3,195           1,420     

Net change in loans held for sale

     (1,114)           (38)     

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

     18           (8)     

Net (gain) on disposal of bank premises and equipment

     0           (119)     

Investment securities (gains) losses

     (379)           (398)     

Earnings on cash surrender value of life insurance

     (297)           (150)     

Increase in accrued interest receivable

     (134)           (109)     

Increase in accrued interest payable

     63           41     

Other, net

     (906)           (209)     
                 

Net cash provided by operating activities

     6,681           4,934     
                 

CASH FLOWS FROM INVESTING ACTIVITIES

     

Net (increase) decrease in interest bearing deposits with banks and short term investments

     350           (55)     

Sales of available for sale securities

     27,658           51,968     

Maturities, repayments and calls of available for sale securities

     14,879           7,738     

Purchases of available for sale securities

     (7,335)           (115,566)     

Net redemption of FHLB & FRB Stock

     283           -     

Net (increase) in loans

     (21,441)           (17,631)     

Investment in limited partnerships

     (55)           (823)     

Purchases of bank premises and equipment

     (302)           (143)     

Proceeds from disposal of other real estate owned

     180           199     

Proceeds from disposal of bank premises and equipment

     0           373     

Proceeds from sale of rate swap

     118           0     
                 

Net cash provided (used) by investing activities

     14,335           (73,940)     
                 

CASH FLOWS FROM FINANCING ACTIVITIES

     

Net increase in deposits

     18,986           82,505     

Net increase (decrease) in short term purchased funds

     (1,100)           12,299     

Payments on long-term debt

     (20,110)           (17,374)     

Dividends paid

     (1,837)           (1,417)     

Proceeds from issuance of common stock

     79           37,550     

Net proceeds from issuance of treasury stock

     17           472     
                 

Net cash provided (used) by financing activities

     (3,965)           114,035     
                 

Net increase in cash and cash equivalents

     17,051           45,029     

Cash and cash equivalents at beginning of period

     19,200           21,940     
                 

Cash and cash equivalents at end of period

     36,251           $ 66,969     
                 

Supplemental disclosure of cash flow information:

     

Cash paid during the period for:

     

Interest

       $ 2,874             $ 3,327     

Income taxes

     2,200           2,000     

Supplemental schedule of noncash investing and financing activities

     

Other real estate acquired in settlement of loans

     69           -     

The Notes to Consolidated Financial Statements are an integral part of these statements

     

 

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Table of Contents

ORRSTOWN FINANCIAL SERVICES, INC.

Notes to Consolidated Financial Statements

March 31, 2011

NOTE 1. SUMMARY OF CONSOLIDATED SIGNIFICANT ACCOUNTING POLICIES

Nature of Operations - Orrstown Financial Services, Inc. (the Company) is a financial holding company whose primary activity consists of supervising its wholly-owned subsidiary, Orrstown Bank (the Bank). The Company operates through its office in Shippensburg, Pennsylvania. Orrstown Bank provides services through its network of offices in Franklin, Cumberland and Perry Counties of Pennsylvania and in Washington County, Maryland. The bank engages in lending services for commercial loans, residential loans, commercial mortgages and various forms of consumer lending. Deposit services include checking, savings, time and money market deposits. Orrstown Bank also provides investment and brokerage services through its Orrstown Financial Advisors division. Orrstown Bank has twenty-one branches located in Shippensburg (2), Carlisle (5), Spring Run, Orrstown, Chambersburg (3), Mechanicsburg (2), Camp Hill, Greencastle, Newport (2), Duncannon, and New Bloomfield, Pennsylvania and Hagerstown, Maryland. The Company and its subsidiary are subject to the regulation of certain federal and state agencies and undergo periodic examinations by such regulatory authorities.

Basis of Presentation - The unaudited financial statements of Orrstown Financial Services, Inc. (the Company) and its subsidiary are presented for the three months ended March 31, 2011 and 2010 and have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information, the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. However, unaudited information reflects all adjustments (consisting solely of normal recurring adjustments) that are, in the opinion of management, considered necessary for a fair presentation of the financial position, results of operations and cash flows for the interim period. Information presented at December 31, 2010 is condensed from audited year-end financial statements. For further information, refer to the audited consolidated financial statements and footnotes thereto, included in the annual report on Form 10-K for the year ended December 31, 2010.

All significant intercompany transactions and accounts have been eliminated. Operating results for the three months ended March 31, 2011, are not necessarily indicative of the results that may be expected for the year ending December 31, 2011.

Use of Estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for losses on loans and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowance for losses on loans and foreclosed real estate, management obtains independent appraisals for significant properties.

While management uses available information to recognize losses on loans and foreclosed real estate, future additions to the allowances may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for losses on loans and foreclosed real estate. Such agencies may require the Company to recognize additions to the allowance based on their judgments concerning information available to them at the time of their examination. Because of these factors, management’s estimate of credit losses inherent in the loan portfolio and the related allowance may change in the near term.

Subsequent Events - Generally accepted accounting principles establishes standards for accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued. The subsequent events principle sets forth the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition in the financial statements, identifies the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements, and the disclosures that should be made about events or transactions that occur after the balance sheet date. In preparing these financial statements, the Company evaluated the events and transactions that occurred after March 31, 2011, through the date these financial statements were filed with the Commission.

 

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Concentration of Credit Risk - The Company grants agribusiness, commercial, residential and consumer loans to customers in its market area. Although the Company maintains a diversified loan portfolio, a significant portion of its customers’ ability to honor their contracts is dependent upon economic sectors for construction contractors, residential and non-residential building operators, sales finance, sub-dividers and developers. Management evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if collateral is deemed necessary by the Company upon the extension of credit, is based on management’s credit evaluation of the customer. Collateral held varies, but generally includes real estate and equipment.

The types of securities the Company invests in are included in Note 2, and the type of lending the Company engages in are included in Note 3.

Cash and Cash Equivalents - For purposes of the consolidated statements of cash flows, cash and cash equivalents include cash, balances due from banks and federal funds sold and all of which have original maturities of 90 days or less.

Loans Held for Sale - Loans originated and intended for sale in the secondary market are carried at lower of aggregate cost or fair value (LOCM). Gains and losses on loans sales (sales proceeds minus carrying value) are recorded in non-interest income.

Securities - Certain debt securities that management has the positive intent and ability to hold to maturity are classified as “held to maturity” and recorded at amortized cost. “Trading” securities are recorded at fair value with changes in fair value included in earnings. As of the periods presented, the Company has no held to maturity or trading securities. Securities not classified as held to maturity or trading, including equity securities with readily determinable fair values, are classified as “available for sale” and recorded at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income. Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.

The Company follows accounting guidance related to recognition and presentation of other-than-temporary impairment (FASB ASC 320-10). This accounting guidance specifies that (a) if a company does not have the intent to sell a debt security prior to recovery and (b) it is more likely than not that it will not have to sell the debt security prior to recovery, the security would not be considered other-than-temporarily impaired unless there is a credit loss. When an entity does not intend to sell the security, and it is more likely than not, the entity will not have to sell the security before recovery of its cost basis, it will recognize the credit component of an other-than-temporary impairment of a debt security in earnings and the remaining portion in other comprehensive income.

The Company had no debt securities it deemed to be other than temporarily impaired for the periods presented.

The Company’s securities are exposed to various risks, such as interest rate, market risk, currency and credit risks. Due to the level of risk associated with certain investments and the level of uncertainty related to changes in the value of investments, it is at least reasonably possible that changes in risks in the near term would materially affect investment assets reported in the consolidated financial statements.

For equity securities, when the Company has decided to sell an impaired available-for-sale security and the entity does not expect the fair value of the security to fully recover before the expected time of sale, the security is deemed other-than-temporarily impaired in the period in which the decision to sell is made. The Company recognizes an impairment loss when the impairment is deemed other than temporary even if a decision to sell has not been made.

Loans - The Company grants commercial, mortgage, and consumer loans to its customers located principally in south-central Pennsylvania and northern Maryland. The ability of the Company’s debtors to honor their contracts is dependent upon the real estate and general economic conditions in this area.

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and amortized as a yield adjustment over the respective term of the loan.

 

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For all classes of loans, the accrual of interest income on loans, including impaired loans, ceases when principal or interest is past due 90 days or more or immediately if, in the opinion of management, full collection is unlikely. Interest will continue to accrue on loans past due 90 days or more if the collateral is adequate to cover principal and interest, and the loan is in the process of collection. Interest accrued, but not collected, as of the date of placement on nonaccrual status, is reversed and charged against current interest income, unless fully collateralized. Subsequent payments received are either applied to the outstanding principal balance or recorded as interest income, depending upon management’s assessment of the ultimate collectability of principal. Loans are returned to accrual status, for all loan classes, when all the principal and interest amounts contractually due are brought current, has performed in accordance with the contractual terms of the note for a reasonable period of time, generally six months, and the ultimate collectability of the total contractual principal and interest is reasonably assured. Past due status is based on contractual terms of the loan for all loan classes.

Loans the terms of which are modified are classified as troubled debt restructurings if a concession was granted, for legal or economic reasons, related to a debtor’s financial difficulties. Concessions granted under a troubled debt restructuring typically involve a temporary deferral of scheduled loan payments, an extension of a loan’s stated maturity date or a temporary reduction in interest rates. If a modification occurs while the loan is on accruing status, it will continue to accrue interest under the modified terms. Nonaccrual troubled debt restructurings are restored to accrual status if scheduled principal and interest payments, under the modified terms, are current for six months after modification, and the borrower continues to demonstrate its ability to meet the modified terms. Troubled debt restructurings are evaluated individually for impairment if they have been restructured during the most recent calendar year, or if they are not performing according to their modified terms.

Allowance for Loan Losses - The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

See Note 3, “Loans Receivable and Allowance for Loan Losses,” for additional details.

Stock Compensation Plans - The Company has stock option plans for its employees and non-employee directors. Stock compensation accounting guidance (FASB ASC 718, Compensation - Stock Compensation) requires that the compensation cost relating to share-based payment transactions be recognized in financial statements. That cost is measured based on the grant date fair value of the stock options, using a Black-Scholes model. Compensation cost for all stock awards are calculated and recognized over the employees’ service period, generally defined as the vesting period.

Earnings Per Share - Basic earnings per share represent income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflect the additional common shares that would have been outstanding if dilutive potential common shares had been issued. Potential common shares that may be issued by the Company relate solely to outstanding stock options. Treasury shares are not deemed outstanding for earnings per share calculations.

Comprehensive Income - Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains on securities available for sale, and unrealized losses related to factors other than credit on debt securities and unrealized gains and losses on cash flow hedges.

Derivative Instruments - Generally accepted accounting principles require that all derivatives be recognized in the Consolidated Financial Statements at their fair values. On the dates that derivative contracts are entered into, the Company designates derivatives as (a) hedges of fair values of recognized assets or liabilities or of unrecognized firm commitments (fair-value hedges); (b) hedges of forecasted

 

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transactions or variable cash flows to be received or paid in conjunction with recognized assets or liabilities (cash-flow hedges) or (c) instruments that are held for trading or non-hedging purposes (trading or economic-hedging instruments). For a derivative treated as a fair-value hedge, the effective portion of a change in fair value is recorded as an adjustment to the hedged item. The ineffective portion of the fair-value hedge is recognized in current period earnings. Upon termination of a fair-value hedge of a debt instrument, the resulting gain or loss is amortized to earnings through the maturity date of the debt instrument. For a derivative treated as a cash flow hedge, the ineffective portion of changes in fair value is reported in current period earnings. The effective portion of the cash flow hedge is recorded as an adjustment to the hedged item through other comprehensive income. For a derivative treated as a trading or economic hedging instrument, changes in fair value are reported in current period earnings. Fair values are determined based upon quoted market prices and mathematical models using current and historical data.

The Company formally assesses, both at the hedges’ inception, and on an on-going basis, whether derivatives used in hedging transactions have been highly effective in offsetting changes in fair values or cash flows of hedged items and whether those derivatives are expected to remain highly effective in subsequent periods. The Company discontinues hedge accounting when (a) it determines that a derivative is no longer effective in offsetting changes in fair value or cash flows of a hedged item; (b) the derivative expires or is sold, terminated or exercised; (c) probability exists that the forecasted transaction will no longer occur or (d) management determines that designating the derivative as a hedging instrument is no longer appropriate. In all cases in which hedge accounting is discontinued and a derivative remains outstanding, the Company will carry the derivative at fair value in the Consolidated Financial Statements, recognizing changes in fair value in current period income in the statement of income.

The Company follows generally accepted accounting principles, regarding disclosures about derivative instruments and hedging activities, which includes disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance and cash flows.

Segment Reporting - The Company only operates in one significant segment – Community Banking. The Company’s non-banking activities are insignificant to the consolidated financial statements.

Reclassifications - Certain amounts in the 2010 consolidated financial statements have been reclassified to conform to the 2011 presentation.

Recent Accounting Pronouncements

In January 2010, the FASB issued ASU 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. ASU 2010-06 amends Subtopic 820-10 to clarify existing disclosures, require new disclosures, and includes conforming amendments to guidance on employers’ disclosures about postretirement benefit plan assets. ASU 2010-06 was effective for interim and annual periods beginning after December 15, 2009, except for disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures were effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

In July 2010, the FASB issued ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. The new disclosure guidance significantly expanded the existing requirements leading to greater transparency into the company’s exposure to credit losses from lending arrangements. The extensive new disclosures of information as of the end of a reporting period was effective for annual reporting periods ending on or after December 15, 2010 and has been presented in Note 3 to the Consolidated Financial Statements. Specific disclosures regarding activity that occurred before the issuance of the ASU, such as the allowance roll forward and modification disclosures was required to be adopted for periods beginning on or after December 15, 2010, and are also incorporated in Note 3.

In December 2010, the FASB issued ASU 2010-28, Intangibles—Goodwill and Other (Topic 350), When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts. ASU 2010-28 affects all entities that have recognized goodwill and have one or more reporting units whose carrying amount for purposes of performing Step 1 of the goodwill impairment test is zero or negative. ASU 2010-28 modifies Step 1 so that for those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining

 

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whether it is more likely than not that a goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that impairment may exist. The qualitative factors are consistent with existing guidance, which requires that goodwill of a reporting unit be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. This guidance is effective for the Company for fiscal years, and interim periods within those years, beginning after December 15, 2010. Adoption of ASU 2010-28 guidance did not have a material impact on the Company’s consolidated financial statements.

In April 2011, the FASB issued ASU 2011-2, A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring. This guidance clarifies which loan modifications constitute troubled debt restructurings and is intended to assist creditors in determining whether a modification of the terms of a receivable meets the criteria to be considered a troubled debt restructuring, both for the purpose of recording an impairment charge and for disclosure of troubled debt restructurings. In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude, under the guidance clarified by ASU 2011-2, that both of the following exist: (a) the restructuring constitutes a concession; and (b) the debtor is experiencing financial difficulties. ASU 2011-2 will be effective for the Company on July 1, 2011, and applies retrospectively to restructurings occurring on or after January 1, 2011. The adoption ASU 2011-2 is not expected to have a material impact on the Company’s consolidated financial statements.

NOTE 2. SECURITIES AVAILABLE FOR SALE

At March 31, 2011 and December 31, 2010, the investment securities portfolio was comprised exclusively of securities classified as “available for sale”, resulting in investment securities being carried at fair value. The amortized cost and fair values of investment securities available for sale at March 31, 2011 and December 31, 2010 were:

 

(Dollars in thousands)

       Amortized    
Cost
         Unrealized    
Gains
         Unrealized    
Losses
         Fair Value      

March 31, 2011

           

U.S. Government Sponsored Enterprises (GSE)

       $ 97,641             $ 572             $ 1,999             $ 96,214     

States and political subdivisions

     100,746           987           967           100,766     

GSE residential mortgage-backed securities

     195,368           1,240           472           196,136     
                                   

Total debt securities

     393,755           2,799           3,438           393,116     

Equity securities

     2,544           168           36           2,676     
                                   

Totals

       $ 396,299             $ 2,967             $ 3,474             $ 395,792     
                                   

(Dollars in thousands)

                           

December 31, 2010

           

U.S. Government Sponsored Enterprises (GSE)

       $ 120,318             $ 1,491             $ 1,523             $ 120,286     

States and political subdivisions

     98,133           566           1,551           97,148     

GSE residential mortgage-backed securities

     212,260           960           1,044           212,176     
                                   

Total debt securities

     430,711           3,017           4,118           429,610     

Equity securities

     2,114           93           45           2,162     
                                   

Totals

       $ 432,825             $ 3,110             $ 4,163             $ 431,772     
                                   

The following table shows gross unrealized losses and fair value of the Company’s available for sale securities that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at March 31:

 

     Less than 12 Months      12 Months or More      Total  

(Dollars in thousands)

       Fair Value              Unrealized    
Losses
         Fair Value              Unrealized    
Losses
         Fair Value              Unrealized    
Losses
 

March 31, 2011

                 

GSE’s

       $ 52,836             $ 1,999             $ 0             $ 0             $ 52,836             $ 1,999     

States and political subdivisions

     43,286           732           1,047           235           44,333           967     

GSE residential mortgage-
backed securities

     75,578           472           0           0           75,578           472     
                                                     

Total debt securities

     171,700           3,203           1,047           235           172,747           3,438     

Equity securities

     606           33           38           3           644           36     
                                                     

Total temporarily impaired
securities

       $ 172,306             $ 3,236             $ 1,085             $ 238             $ 173,391             $ 3,474     
                                                     

 

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     Less than 12 Months      12 Months or More      Total  

(Dollars in thousands)

       Fair Value              Unrealized    
Losses
         Fair Value              Unrealized    
Losses
         Fair Value              Unrealized    
Losses
 

December 31, 2010

                 

GSE’s

       $ 44,737             $ 1,523             $ 0             $ 0             $ 44,737             $ 1,523     

States and political subdivisions

     61,718           1,303           1,026           248           62,744           1,551     

GSE residential mortgage-
backed securities

     124,685           1,044           0           0           124,685           1,044     
                                                     

Total debt securities

     231,140           3,870           1,026           248           232,166           4,118     

Equity securities

     312           12           312           33           624           45     
                                                     

Total temporarily impaired
securities

       $ 231,452             $ 3,882             $ 1,338             $ 281             $ 232,790             $ 4,163     
                                                     

The Company has 94 securities and 126 securities at March 31, 2011 and December 31, 2010 in which the amortized cost exceeds their values, as discussed below.

U.S. Government Sponsored Enterprises (GSE). 44 GSE securities, including mortgage-backed securities, have amortized costs which exceed their fair values, all of which are in the less than 12 months at March 31, 2011. At December 31, 2010, the Company had 50 GSE with unrealized losses, all of which were category less than 12 months. These unrealized losses have been caused by a rise in interest rates from the time the securities were purchased. The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost bases of the investments. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired at March 31, 2011 or at December 31, 2010.

State and Political Subdivisions. 39 state and political subdivision securities have amortized cost which exceeds their fair value, including 3 of which have been for greater than 12 months at March 31, 2011. At December 31, 2010, 63 state and political subdivisions had unrealized losses, 3 of which were greater than 12 months. These unrealized losses have been caused by a rise in interest rates from the time the securities were purchased. All but two state and political subdivision securities in which the amortized cost exceeds fair value have investment grade ratings. The two without investment grade ratings have had an unrealized loss for greater than 12 months, and the unrealized loss is less than 0.50% of carrying value. Management considers the investment rating, the state of the issuer of the security and other credit support in determining whether the security is other-than-temporarily impaired. One security which has had an unrealized loss for over 24 months at March 31, 2011 is a California issue that is carrying a low market value due to it being a zero coupon bond, which is hindered by the state’s economic issues, and not the underlying credit worthiness of the issuer. This security carries an investment grade rating. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired at March 31, 2011.

Equity Securities. 11 equity securities have cost which exceeds their fair value, including 3 of which have been greater than 12 month at March 31, 2011. At December 31, 2010, 13 equity securities had unrealized losses, of which 7 had unrealized losses for greater than 12 months. These securities are among various industries, including financial, industrial, consumer, energy, health care and a large cap fund, In considering whether the equity securities are other-than-temporarily impaired, management reviews the severity and duration of decline in fair value, research reports, analysts recommendations, credit rating changes, news stories and other relevant information. Management believes the equity securities are not other-than-temporarily impaired and will equal or exceed our cost basis within a reasonable period of time. None of the individual unrealized losses exceed $10,000 at March 31, 2011. Since these companies are considered viable and carry the possibility of price appreciation in the future, impairments are considered temporary. The Company recorded no other than temporary impairment expense on equity securities for the quarters ended March 31, 2011 and December 31, 2010.

 

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The amortized cost and fair values of securities available for sale at March 31, 2011 by contractual maturity are shown below. Contractual maturities will differ from expected maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

     Available for Sale  

(Dollars in thousands)

       Amortized Cost              Fair Value      

Due in one year or less

       $ 9,812             $ 9,836     

Due after one year through five years

     20,585           20,711     

Due after five years through ten years

     92,117           90,982     

Due after ten years

     75,873           75,451     

GSE residential mortgage-backed securities

     195,368           196,136     
                 

Total debt securities

     393,755           393,116     

Equity securities

     2,544           2,676     
                 
       $ 396,299             $ 395,792     
                 

Proceeds from sales of securities available for sale for the quarters ended March 31, 2011 and 2010 were $27,658,000 and $51,968,000. Gross gains on the sales of securities were $421,000 and $695,000 for the quarters ended March 31, 2011 and 2010. Gross losses on securities available for sale were $42,000 and $297,000.

Securities with a fair value of $280,805,000 and $271,689,000 at March 31, 2011 and December 31, 2010 were pledged to secure public funds and for other purposes as required or permitted by law.

NOTE 3.    LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES

The Bank’s loan portfolio is broken down into segments to an appropriate level of disaggregation to allow management to monitor the performance by the borrower and to monitor the yield on the portfolio. In 2010, management incorporated the provisions of ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Loan Losses, resulting in a refinement in its portfolio segregation. Consistent with the standard, the segments were further broken down into classes, to allow for differing risk characteristics within a segment.

The risks associated with lending activities differ among the various loan classes, and are subject to the impact of changes in interest rates, market conditions of collateral securing the loans, and general economic conditions. All of these factors may adversely impact the borrower’s ability to repay its loans, and impact the associated collateral.

The Company has various types of commercial real estate which have differing levels of credit risk associated with them. Owner-occupied commercial real estate loans are generally dependent upon the successful operation of the borrowers business, with the cash flows generated from the business being the primary source of repayment of the loan. If the business suffers a downturn in sales or profitability, the borrower’s ability to repay the loan could be in jeopardy. In order to minimize this credit risk, the Company has conservative underwriting standards which include the credit worthiness of the borrower, limitation on loan amounts to 75% of the value of the property securing the loan, and strong debt service coverage ratios.

Non-owner occupied and multi-family commercial real estate loans present a different credit risk to the Company than owner-occupied commercial real estate, as the repayment of the loan is dependent upon the borrower’s ability to generate a sufficient level of occupancy to produce rental income that exceeds debt service requirement and operating expenses. Lower occupancy or lease rates may result in reduction in cash flows, which hinder the ability of the borrower to meet debt service requirements, and may result in lower collateral values. The Company generally follows the same underwriting standards as with owner-occupied commercial real estate, but recognizes the greater risk inherent in these credit relationships in its loan pricing.

Acquisition and development loans consist of 1-4 family residential construction and commercial and land development loans. The risk of loss on these loans is largely dependent on the Company’s ability to assess the property’s value at the completion of the project, which should exceed the property’s construction costs. During the construction phase, a number of factors could potentially negatively impact the collateral value, including cost overruns, delays in completing the project, competition, and real estate market conditions which may change based on the supply of similar properties in the area. In the event the collateral value at the completion

 

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of the project is not sufficient to cover the outstanding loan balance, the Company must rely upon other repayment sources, including the guarantors of the project or other collateral securing the loan. The Company attempts to mitigate credit risk through strict underwriting standards including evaluation of the credit worthiness of the borrower and their success in other projects, aggressive release fees, loan-to-value ratios not to exceed 75%, and continual monitoring of the project during its construction phase to determine the impact that overruns and delays may have on the project.

Commercial and industrial loans include advances to local and regional businesses for general commercial purposes and include permanent and short-term working capital, machinery and equipment financing, and may be either in the form of lines of credit or term loans. Although commercial and industrial loans may be unsecured to our highest rated borrowers, the majority of these loans are secured by the borrower’s accounts receivable, inventory and machinery and equipment. In a majority of these loans, the collateral also includes the business real estate or the business owner’s personal real estate or assets. Commercial and industrial loans present credit exposure to the Company, as they are more susceptible to risk of loss during a downturn in the economy, as borrowers may have greater difficulty in meeting their debt service requirements and the value of the collateral may decline. The Company attempts to mitigate this risk through strict underwriting standards, including evaluating the credit worthiness of the borrower and to the extent available, credit ratings on the business. Additionally, monitoring of the loans through annual renewals and meetings with the borrowers are common. However, these procedures cannot eliminate the risk of loss associated with commercial and industrial lending.

The Company originates loans to its retail customers, including fixed-rate and adjustable first lien mortgage loans with the underlying 1-4 family owner-occupied residential property securing the credit. The Company’s risk exposure is minimized in these types of loans through the evaluation of the credit worthiness of the borrower, including credit scores and debt-to-income ratios, and underwriting standards which limits the loan-to-value ratio to generally no more than 80%, unless the borrower obtains private mortgage insurance.

Home equity loans, including term loans and lines of credit, present a slightly higher risk to the Company than 1-4 family first liens, as these loans can be first or second liens on 1-4 family owner occupied residential property, but can have loan-to-value ratios of no greater than 90% of the value of the real estate taken as collateral. The credit worthiness of the borrower is considered including credit scores and debt-to-income ratios, which generally cannot exceed 38%.

Installment and other loans’ credit risk are mitigated through conservative underwriting standards, including the evaluation of the credit worthiness of the borrower, including credit scores and debt-to-income ratios, and if secured, the collateral value of the assets. As these loans can be unsecured or secured by assets the value of which may depreciate quickly or may fluctuate, they present a greater risk to the Company than 1-4 family residential loans.

The loan portfolio, excluding residential loans held for sale, broken out by classes as of March 31, 2011 and December 31, 2010 is as follows:

 

(Dollars in thousands)

       March 31,    
2011
         December 31,    
2010
 

Commercial real estate:

     

Owner-occupied

       $ 181,468             $ 172,000     

Non-owner occupied

     133,338           143,372     

Multi-family

     27,860           24,649     

Acquisition and development:

     

1-4 family residential construction

     15,546           29,297     

Commercial and land development

     95,528           88,105     

Commercial and industrial

     285,277           263,943     

Residential mortgage:

     

First lien

     123,158           119,450     

Home equity - term

     40,008           40,818     

Home equity - Lines of credit

     71,476           71,547     

Installment and other loans

     11,308           11,112     
                 
       $ 984,967             $ 964,293     
                 

In order to monitor ongoing risk associated with its loan portfolio and specific credits within the segments, management uses an eight point internal grading system. The first four rating categories, representing the lowest risk to the Bank, are combined and given a “Pass” rating. The “Special Mention” category includes loans that have potential weaknesses that may, if not monitored or corrected, weaken the asset or inadequately protect the Bank’s position at some future date. These assets pose elevated risk, but their weakness does not

 

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yet justify a more severe, or criticized rating. Management generally follows regulatory definitions in assigning criticized ratings to loans, including substandard, doubtful or loss. “Substandard” loans are classified as they have a well-defined weakness, or weaknesses that jeopardize liquidation of the debt. These loans are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. “Substandard” loans include loans that management has determined not to be impaired, as well as loans considered to be impaired. A “doubtful” loan has a high probability of total or substantial loss, but because of specific pending events that may strengthen the asset, its classification of loss is deferred. “Loss” assets are considered uncollectible, as the underlying borrowers are often in bankruptcy, have suspended debt repayments, or ceased business operations. Once a loan is classified as “Loss”, there is little prospect of collecting the loan’s principal or interest and it is generally written off.

The Bank has a loan review policy and program which is designed to reduce and control risk in the lending function. The Credit Administration Committee, comprised of members of the Board, is charged with the overall credit quality and risk exposure of the Company’s loan portfolio. This includes the monitoring of the lending activities of all bank personnel with respect to underwriting and processing new loans and the timely follow-up and corrective action for loans showing signs of deterioration in quality. The loan review program provides the Bank with an internal, independent review of the Bank’s loan portfolio on an ongoing basis. Generally, consumer and residential mortgage loans are included in the Pass categories unless a specific action, such as extended delinquencies, bankruptcy, repossession or death of the borrower occurs, which heightens awareness as to a possible credit event.

The Loan Review department performs annual reviews of all commercial relationships with a committed loan balance in excess of $750,000, with ratification of the rating from the Board of Directors’ Credit Administration Committee for loans between $750,000 - $1,000,000. Loans reviewed in excess of $1,000,000 are presented to the Credit Administration Committee with a formal review and rating. All relationships rated Substandard, Doubtful or Loss are reviewed by the Credit Administration Committee on a quarterly basis, including reaffirmation of the rating, review of detailed collateral analysis and the development of an action plan.

The following summarizes the Bank’s ratings based on its internal risk rating system as of March 31, 2011 and December 31, 2010:

 

(Dollars in thousands)

   Pass      Special
    Mention    
     Non-
Impaired
     Substandard    
     Impaired -
    Substandard    
         Doubtful          Total  

March 31, 2011:

                 

Commercial real estate:

                 

Owner-occupied

       $ 163,446             $ 6,769             $ 10,101             $ 466             $ 686             $ 181,468     

Non-owner occupied

     110,105           7,985           14,149           1,099           0           133,338     

Multi-family

     20,955           535           6,370           0           -           27,860     

Acquisition and development:

                 

1-4 family residential
construction

     14,671           600           275           0           0           15,546     

Commercial and land
development

     71,878           7,532           16,118           0           0           95,528     

Commercial and industrial

     220,138           27,643           26,660           9,827           1,009           285,277     

Residential mortgage:

                 

First lien

     120,673           0           2,018           467           0           123,158     

Home equity - term

     39,214           0           84           710           0           40,008     

Home equity - Lines of credit

     71,152           0           324           0           0           71,476     

Installment and other loans

     11,255           0           53           0           0           11,308     
                                                     
       $     843,487             $ 51,064             $ 76,152             $ 12,569             $ 1,695             $     984,967     
                                                     

 

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December 31, 2010:

                 

Commercial real estate:

                 

Owner-occupied

       $ 162,968             $ 2,035             $ 6,311           0             $ 686             $ 172,000     

Non-owner occupied

     120,633           4,274           15,495           2,970           0           143,372     

Multi-family

     20,030           676           3,853           0           90           24,649     

Acquisition and development:

                 

1-4 family residential construction

     24,199           2,297           2,801           0           0           29,297     

Commercial and land development

     79,391           2,487           6,134           93           0           88,105     

Commercial and industrial

     221,111           17,062           14,992           9,770           1,008           263,943     

Residential mortgage:

                 

First lien

     117,607           0           1,373           470           0           119,450     

Home equity - term

     39,279           0           828           711           0           40,818     

Home equity - Lines of credit

     71,364           0           183           0           0           71,547     

Installment and other loans

     11,062           0           50           0           0           11,112     
                                                     
       $     867,644             $     28,831             $     52,020             $     14,014             $     1,784             $     964,293     
                                                     

Classified loans may also be evaluated for impairment. For commercial real estate, acquisition and development and commercial and industrial loans, a loan is considered impaired when, based on current information and events, it is probable that the Bank 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. Generally, loans that are more than 90 days past due are assigned a ‘Substandard’ rating. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Nonaccrual loans in the commercial and commercial real estate portfolios are, by definition, deemed to be impaired. Impairment is measured on a loan-by-loan basis for commercial, construction and restructured loans by either the present value of the expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. A loan is collateral dependent if the repayment of the loan is expected to be provided solely by the underlying collateral. For loans that are deemed to be impaired for extended periods of time, periodic updates on fair values are obtained, which may include updated appraisals. The updated fair values will be incorporated into the impairment analysis as of the next reporting period. In the event an updated appraisal that requires a higher impairment reserve is received after a reporting period, but prior to the issuance of the financial statements, an evaluation is made as to the significance of the difference and whether the amounts need to be reflected in the financial statements not yet issued.

Loan charge-offs, which may include, from time-to-time, a partial charge-off, are taken on an impaired loan that is collateral dependent if the loan’s carrying balance exceeds its collateral’s appraised value, the loan has been identified as uncollectible, and it is deemed to be a confirmed loss. Typically, impaired loans with a charge-off or partial charge-off will continue to be considered impaired, unless the note is split into two, and management expects the performing note to continue to perform and is adequately secured. The second, or non-performing note, would be charged-off. As of the periods presented, the Company has no loans to borrowers that resulted from splitting impaired loans into multiple notes. Further, an impaired loan with a partial charge-off may continue to have an impairment reserve on it after the partial charge-off, if factors warrant.

As of March 31, 2011 and December 31, 2010, nearly all of the Company’s impaired loans’ extent of impairment was measured based on the estimated fair value of the collateral securing the credit. For real estate loans, collateral generally consists of commercial real estate, but in the case of commercial and industrial loans, it would also consist of accounts receivable, inventory, equipment or other business assets. Commercial and industrial loans may also have real estate collateral.

At the time a real-estate secured loan is deemed impaired, management determines whether an updated certified appraisal of the real estate is necessary to assist in determining the extent of an impairment reserve, if any. The decision for requiring an updated appraisal takes into consideration the age of the most recent appraisal, the loan-to-value ratio based on the original certified appraisal, the Company’s recent experience and knowledge of market conditions, recent list prices or broker opinions, the condition of the property, and environmental factors. If market conditions have changed significantly from the date of the most recent appraisal, an updated appraisal will be obtained. The “as is value” provided in the appraisal is often used as the fair value of the collateral in determining impairment, unless circumstances, such as subsequent improvements, approvals, or other circumstances dictate that another value provided by the appraiser is more appropriate.

 

 

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As of March 31, 2011, approximately 91% of impaired loans secured by real estate were measured at fair value using certified real estate appraisals that had been completed within the last year. Appraised values are further discounted for estimated costs to sell the property and other selling considerations to arrive at the properties’ fair value.

In those situations in which it is determined an updated appraisal is not required for loans individually evaluated for impairment, fair values are based on one or a combination of the following approaches. In those situations in which a combination of approaches is considered, the factor that carries the most consideration will be the one management believes is warranted. The approaches are as follows:

 

 

 

Original appraisal - if the original appraisal provides a strong loan-to-value (generally 80% or lower) and, after consideration of market conditions and knowledge of the property and area, it is determined by the loan review staff that there has not been a significant deterioration in the collateral value, the original certified appraised value will be used. Discounts as deemed appropriate for selling costs are factored into the appraised value in arriving at fair value.

 

 

 

Discounted cash flows - In limited cases, discounted cash flows may be used on projects in which the collateral is liquidated to reduce the borrowings outstanding, and is used to validate collateral values derived from other approaches.

Collateral on certain impaired loans is not limited to real estate, and consists of accounts receivable, inventory, equipment or other business assets. Estimated fair values are determined based on borrowers’ financial statements, inventory ledgers, accounts receivable agings or appraisals from individuals with knowledge in the business. Stated balances are generally discounted for the age of the financial information or the quality of the assets. In determining fair value, liquidation discounts are applied to this collateral based on existing loan evaluation policies.

In the fourth quarter of 2010, the Company began to distinguish Substandard loans on both an impaired and non-impaired basis, as it placed less emphasis on a loan’s classification, and increased reliance on whether the loan was performing in accordance with the contractual terms. “Substandard” classification does not automatically meet the definition of “impaired”. A substandard credit is one that is inadequately protected by current sound worth, paying capacity of the obligor or the collateral pledged, if any. Extensions of credit so classified have well-defined weaknesses which may jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard credits, does not have to exist in individual extensions of credit classified substandard. As a result, the Company revised its methodology in its evaluation of certain accruing commercial real estate, acquisition and development and commercial and industrial loans rated “substandard” collectively for impairment as opposed to evaluating these loans individually for impairment. Although we believe these loans have well defined weaknesses and meet the definition of “substandard”, they are generally performing and management has concluded that it is likely it will be able to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Approximately $53,201,000 of loans that were in previous years evaluated individually for impairment were collectively evaluated for impairment at December 31, 2010, resulting in an additional allowance for loan losses allocation of $3,710,000.

Larger groups of smaller balance homogenous loans are collectively evaluated for impairment. Accordingly, the Bank does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement due to financial difficulties of the borrower.

The following summarizes impaired loans by class, segregated by those for which a specific allowance was required and those for which a specific allowance was not required as of March 31, 2011 and December 31, 2010:

 

    Impaired Loans with a Specific Allowance     Impaired Loans with No Specific Allowance  

(Dollars in thousands)

  Recorded
Investment
    (Book Balance)    
    Unpaid
    Principal Balance    
(Legal  Balance)
    Related
    Allowance    
    Interest
income
Recognized
     on Cash Basis    
    Recorded
Investment
    (Book Balance)    
    Unpaid
Principal Balance
    (Legal Balance)    
    Interest income
Recognized
    on Cash Basis    
 

March 31,
2011

             

Commercial
real
estate:

             

Owner-
occupied

      $ 1,153            $ 1,153            $ 196            $ 1            $ -            $ -            $ 0     

Non-owner
occupied

    1,099          1,101          548          -          -          -          -     

Multi-family

    -          -          -          -          -          -          -     

Commercial
and
industrial

    9,715          10,306          3,522          0          968          968          1     

Residential
mortgage:

             

First lien

    467          467          4          4          0          0          0     

Home
equity -
term

    710          710          5          8          0          0          0     
                                                       
      $     13,144            $     13,737            $     4,275            $     13            $ 968            $ 968            $ 1     
                                                       

 

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December 31, 2010

                    

Commercial real estate:

                    

Owner-occupied

       $ 686             $ 687             $ 181             $ 0             $ 0             $ 0         $ 0     

Non-owner occupied

     2,064           2,065           980           0           0           0           0     

Multi-family

     90           90           90           0           0           0           0     

Commercial and industrial

     9,600           10,191           3,232           -           1,118           1,118           6     

Residential mortgage:

                    

First lien

     470           470           12           32           0           0           0     

Home equity - term

     711           711           8           44           0           0           0     
                                                              
       $ 13,621             $ 14,214             $ 4,503             $ 76             $     1,118             $     1,118             $     6     
                                                              

The following summarizes the average recorded investment in impaired loans recognized for the three months ended March 31, 2011:

 

(Dollars in thousands)

      

Commercial real estate:

  

Owner-occupied

       $ 920     

Non-owner occupied

     1,582     

Multi-family

     45     

Commercial and industrial

     10,701     

Residential mortgage:

  

First lien

     469     

Home equity - term

     711     
        

Total

       $     14,428     
        

The following presents impaired loans that are troubled debt restructurings, as well as the number of loans modified during the three and twelve month periods, as of March 31, 2011 and December 31, 2010.

 

            New Troubled Debt Restructurings  
     Troubled Debt Restructurings      During Current YTD Period  
         Number of          Recorded          Number of          Recorded  

(Dollars in thousands)

   Contracts          Investment          Contracts          Investment      

March 31, 2011

           

Accruing:

           

Residential mortgage:

           

First lien

     1             $ 467           -           $ -     

Home equity - term

     1           710           -         -     
                                   
     2             $ 1,177           -           $ -     
                                   

December 31, 2010

           

Accruing:

           

Residential mortgage:

           

First lien

     1             $ 470           1             $ 470     

Home equity - term

     1           711           1           711     
                                   
     2             $ 1,181           2             $ 1,181     
                                   

The loans presented above were considered troubled debt restructurings as the result of the Company agreeing to a temporary reduction in interest rates for periods not exceeding 12 months in order to assist the borrowers to improve cash flows during such periods. To date, the only concessions the Company has made to borrowers in the form of troubled debt restructurings are reduced interest rates. No additional commitments have been made to borrowers whose loans are considered troubled debt restructurings.

 

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Management further monitors the performance and credit quality of the loan portfolio by analyzing the length of time a portfolio is past due, by aggregating loans based on its delinquencies. The following table presents the classes of loan portfolio summarized by aging categories of performing loans and nonaccrual loans as of March 31, 2011 and December 31, 2010:

 

            Days Past Due                       
         Current              30-59              60-89          90+
    (still accruing)    
     Total
    Past Due    
     Non-
    Accrual    
     Total
    Loans    
 

March 31, 2011:

                    

Commercial real estate:

                    

Owner-occupied

       $ 178,910             $ 1,331             $ 74             $ -             $ 1,405             $ 1,153             $     181,468     

Non-owner occupied

     130,844           1,395           -           -           1,395           1,099           133,338     

Multi-family

     27,663           197           -           -           197           -           27,860     

Acquisition and development:

                    

1-4 family residential
construction

     15,503           43           -           -           43           -           15,546     

Commercial and land
development

     89,688           542           4,568           637           5,747           93           95,528     

Commercial and industrial

     270,346           3,276           132           928           4,336           10,595           285,277     

Residential mortgage:

                    

First lien

     119,026           2,006           146           1,842           3,994           138           123,158     

Home equity - term

     39,561           186           85           151           422           25           40,008     

Home equity - Lines of
credit

     71,213           134           -           129           263           -           71,476     

Installment and other loans

     11,148           147           10           -           157           3           11,308     
                                                              
       $ 953,902             $ 9,257             $ 5,015             $ 3,687             $ 17,959             $ 13,106             $ 984,967     
                                                              
            Days Past Due                       
         Current              30-59              60-89          90+
    (still accruing)    
     Total
    Past Due    
     Non-
    Accrual    
     Total
    Loans    
 

December 31, 2010:

                    

Commercial real estate:

                    

Owner-occupied

       $ 169,030             $ 986             $ 832             $ 466             $ 2,284             $ 686             $ 172,000     

Non-owner occupied

     141,095           213           -           -           213           2,064           143,372     

Multi-family

     24,559           -           -           -           -           90           24,649     

Acquisition and development:

                    

1-4 family residential
construction

     29,297           -           -           -           -           -           29,297     

Commercial and land
development

     87,995           1           16           -           17           93           88,105     

Commercial and industrial

     252,144           287           466           420           1,174           10,625           263,943     

Residential mortgage:

                    

First lien

     116,182           1,359           535           1,095           2,989           279           119,450     

Home equity - term

     40,503           161           62           75           298           17           40,818     

Home equity - Lines of
credit

     71,215           60           89           142           291           41           71,547     

Installment and other loans

     10,793           251           17           50           318           1           11,112     
                                                              
       $ 942,813             $ 3,318             $     2,017             $ 2,248             $ 7,584             $ 13,896             $ 964,293     
                                                              

The Bank maintains the allowance for loan losses at a level believed adequate by management to absorb losses inherent in the portfolio. It is established and maintained through a provision for loan losses charged to earnings. Quarterly, management asses the adequacy of the allowance for loan losses utilizing a defined methodology, which considers specific credit evaluation of impaired loans as discussed above, past loan loss historical experience, and qualitative factors. Management believes the approach properly addresses the requirements of ASC Section 310-10-35 for loans individually identified as impaired, and ASC Subtopic 450-20 for loans collectively evaluated for impairment, and other bank regulatory guidance.

For each loan class presented above, general allowances are provided for loans that are collectively evaluated for impairment, which is based on quantitative factors, principally historical loss trends for the respective loan class, adjusted for qualitative factors. As of December 31, 2010, the historical loss factor was based on average charge-offs for the last 8 quarters (e.g. January 1, 2009 – December 31, 2010), whereas prior to December 31, 2010, the historical loss factor was based on an equally weighted rolling 12 quarters. Effective December 31, 2010, for loans rated special mention and substandard not deemed impaired, a weighted average rolling 8 quarters average charge-off percentage on the related graded loan type, with a two-third weight to the most recent four quarters, and a one-third weight for the furthest four quarters was utilized. For non-rated loans evaluated collectively for impairment, the charge-off factor for the last 8 quarters is factored into the reserve

 

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allocation. The refinement to the methodology was made as management determined that the most recent eight quarters, and in particular, the most recent four quarters for rated loans, is a better reflection of the losses inherent in the loan portfolio at December 31, 2010. Additional reserve allocations of approximately $730,000 resulted due to the change to the most recent 8 quarter history, which management believes is a better reflection of losses inherent in the portfolio based on recent loss history. In making this determination, management considered current economic and real estate conditions, trends in historical charge-off percentages at the Company as well as peers, and feedback from regulators.

In addition to the quantitative analysis, additional reserves are allocated on loans collectively evaluated for impairment based on additional qualitative factors. The qualitative factors used by management to adjust the historical loss percentage to the anticipated loss allocation, which range from 0 – 10 bp per factor, include:

National and local economic trends (five factors) – Ratios and factors considered include trends in the consumer price index (CPI); unemployment rates; housing price index; housing starts compared to the prior year; and bankruptcy rates.

Credit quality trends (four factors) – Ratios and factors considered include trends in delinquency ratios; 90 days plus and nonaccrual loans; average net loan losses to loans outstanding; and classified loans to total loans.

Underwriting policies (three factors) – Factors considered including the number of exceptions to loan policy; supervisory loan to value exceptions; and the instances of repeat criticisms of ratings.

Experience, ability and depth of lending and loan review staff (four factors) – Factors considered include the years experience of the lending and loan review staff; turnover of the staff; instances of loan grade migration; and the penetration of loans reviewed.

Other (two factors) – Other factors considered include concentrations of credit from loan type or shifts in industry or geographic region.

Activity in the allowance for loan losses for three months ended March 31, 2011 is as follows:

 

         Commercial         

Acquisition

and

         Commercial    
and
         Residential              Installment                    

(Dollars in thousands)

   Real Estate          Development          Industrial      Mortgage      and Other          Unallocated          Total  

Balance, beginning of
period

       $ 5,324             $ 1,767             $ 6,795             $ 1,863             $ 106             $ 165             $     16,020     

Provision for loan
losses

     272           1,478           1,461           (90)           (13)           87           3,195     

Charge-offs

     (712)           -           (44)           (61)           (7)           -           (824)     

Recoveries

     -           -           -           -           7           -           7     
                                                              

Balance, end of period

       $ 4,884             $ 3,245             $ 8,212             $ 1,712             $ 93             $ 252             $     18,398     
                                                              

Activity in the allowance for loan losses for the three months ended March 31, 2010 is as follows:

 

(Dollars in thousands)

      

Balance, beginning of period

       $ 11,067     

Provision for loan losses

     1,420     

Chargeoffs

     (485)     

Recoveries

     18     
        

Balance, end of period

       $ 12,020     
        

The following summarizes the ending loan balance individually evaluated for impairment based upon loan segment, as well as the related allowance for loan loss allocation for each at March 31, 2011 and December 31, 2010:

 

        Commercial         Acquisition and         Commercial    
and
        Residential             Installment                  

(Dollars in thousands)

  Real Estate         Development         Industrial     Mortgage     and Other         Unallocated         Total  

March 31, 2011

             

Loans allocated by:

             

Individually evaluated
for impairment

      $ 2,252            $ -            $ 10,683            $ 1,177            $ -            $ -            $ 14,112     

Collectively evaluated
for impairment

    340,414          111,074          274,594          233,465          11,308          -          970,855     
                                                       
      $ 342,666            $ 111,074            $ 285,277            $ 234,642            $ 11,308            $ -            $     984,967     
                                                       

 

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Allowance for loan losses allocated
by:

                    

Individually evaluated for
impairment

       $     744             $      -             $      3,522             $      9             $     -             $     -             $      4,275     

Collectively evaluated for
impairment

     4,140           3,245           4,690           1,703           93           252           14,123     
                                                              
       $     4,884             $     3,245             $     8,212             $     1,712             $     93             $     252             $     18,398     
                                                              

December 31, 2010

                    

Loans allocated by:

                    

Individually evaluated for
impairment

       $     2,840             $     -             $     10,718             $     1,181             $     -             $     -             $     14,739     

Collectively evaluated for
impairment

     337,181           117,402           253,225           230,634           11,112           -           949,554     
                                                              
       $     340,021             $     117,402             $     263,943             $     231,815             $     11,112             $     -             $     964,293     
                                                              

Allowance for loan losses allocated
by:

                    

Individually evaluated for
impairment

       $     1,251             $     -             $      3,232             $     20             $     -             $     -             $      4,503     

Collectively evaluated for
impairment

     4,073           1,767           3,563           1,843           106           165           11,517     
                                                              
       $     5,324             $     1,767             $     6,795             $     1,863             $     106             $     165             $     16,020     
                                                              

NOTE 4.    DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITY

The Company entered into three (3) rate swap agreements - two on November 24, 2008, and one on May 22, 2009 related to fixed rate loans. The Company uses these interest rate swaps to reduce interest rate risks and to manage interest income. By entering into these agreements, the Company converts floating rate assets into fixed rate assets. These interest rate swap agreements are considered cash flow hedge derivative instruments that qualify for hedge accounting. A portion of the amount included in other comprehensive income is reclassified from other comprehensive income to the appropriate income statement line item as net settlements occur.

The notional amounts of the interest rate swaps are not exchanged and do not represent exposure to credit loss. In the event of default by a counter party, the risk in these transactions is the cost of replacing the agreements at current market rates. During the three months ended March 31, 2011, the Company sold one of its rate swaps and recognized a $118,000 gain on the sale, which is included in the ineffective portion of the following table, once it no longer qualified as a hedge.

The balances of the derivative instruments on the consolidated financial statements as of March 31, 2011 and December 31, 2010 are as follows:

 

(Dollars in thousands)

       Notional/    
Contract
Amount
         Estimated    
Net Fair Value
     Fair Value
    Balance Sheet    
Location
         Expiration    
Date
         Fixed    
Rate
 

March 31, 2011:

              

Interest rate swap - 5 year cash flow

       $     20,000             $ 638           Other assets         11/26/2013             5.28%     
                                

December 31, 2010:

              

Interest rate swap - 5 year cash flow

       $ 20,000             $ 804           Other assets         11/26/2013             5.28%     

Interest rate swap - 4 year cash flow

     10,000           209           Other assets         05/27/2013             4.54%     
                                
       $ 30,000             $     1,013                     5.03%     
                                

 

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The effects of the interest rate swaps on the Company’s income statement for the quarters ended March 31, 2011 and 2010 are as follows:

 

Derivatives in cash

        flow hedging

        relationships

   Amount of Gain (Loss)
Recognized in OCI on
    Derivatives (Effective Portion)    
     Location of Gain
or (Loss)
Recognized in
Income on
Derivative
    (Ineffective Portion)    
     Amount of Gain (Loss)
Reclassified from Accumulated
    OCI into Income (realized portion)    
 

(Dollars in thousands)

       2011              2010                     2011              2010      

Interest rate swap - 4 year cash flow

       $ -             $     254           Interest income           $     -             $     118     

Interest rate swap - 5 year cash flow

     (179)           246           Interest income         101           93     

Interest rate swap - 4 year cash flow

     (92)           120           Interest income         32           29     
                                      
       $     (271)           620                $     133           240     
                                      

 

Derivatives in cash flow hedging relationships

   Location of Gain or
(Loss) Recognized in
    Income on Derivative    
(Ineffective Portion)
     Amount of Gain (Loss) Recognized
in
    Income on Derivative (Ineffective Portion)    
    
 

(Dollars in thousands)

          2011      2010  

Interest rate swap - 4 year cash flow

     Other income           $ -             $     17     

Interest rate swap - 5 year cash flow

     Other income         13           11     

Interest rate swap - 4 year cash flow

     Other income         118           0     
                    
          $     131             $     28     
                    

Under the terms of the agreement, the Bank pays interest monthly at the rate equivalent to Wall Street Journal prime and receives interest income monthly at the fixed rate shown above. The estimated net amount of the existing gains at March 31, 2011 that is expected to be reclassified into interest income over the next twelve months is approximately $400,000.

NOTE 5.   SHAREHOLDERS’ EQUITY AND REGULATORY CAPITAL

On February 9, 2010, the Company filed a shelf registration statement on Form S-3 with the Securities and Exchange Commission that provided the Company the ability to raise capital, from time to time, up to an aggregate of $80,000,000, through the sale of stock, preferred stock, debt securities, warrants and other securities. The Company completed a public stock offering of 1,481,481 shares of common stock at a price of $27.00 per share, for gross proceeds of approximately $40,000,000 during the first quarter of 2010. Net proceeds after underwriting commissions and expenses were $37,585,000. The Company believes that with this additional capital, it positions itself well to weather the economy and take advantage of future opportunities that may arise. The Company has no current plans to issue additional shares of common stock.

NOTE 6.   EARNINGS PER SHARE

Earnings per share for the three months ended March 31, 2011 and March 2010 were as follows:

 

(Dollars In Thousands, except per share data)

       March 31,    
2011
         March 31,    
2010
 

Net income

       $     3,827             $     3,406     
                 

Weighted average shares outstanding (basic)

     7,988           6,498     

Impact of common stock equivalents

     38           48     
                 

Weighted average shares outstanding (diluted)

     8,026           6,546     
                 

Per share information:

     

Basic earnings per share

       $     0.48             $     0.52     

Diluted earnings per share

     0.48           0.52     

Stock options for 206,108 and 143,822 shares of common stock were not considered in computing diluted earnings per share for the three months ended March 31, 2011 and 2010, as their exercise would have been antidilutive, and the exercise price exceeded the average market value.

 

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NOTE 7.   COMPREHENSIVE INCOME

The Company’s other comprehensive income (loss) items are limited to unrealized gains (losses) on securities available for sale and unrealized gains (losses) on derivatives used for cash flow hedges. The components of other comprehensive income (loss) for the three months ended March 31, 2011 and 2010 were as follows:

 

         Three Months Ended    
March 31,
 

(Dollars in thousands)

       2011              2010      

Unrealized holding gains (losses) on securities available for sale arising during the period

       $     925             $     1,446     

Reclassification adjustment for (gains) losses realized in net income

     (379)           (398)     
                 

Net unrealized gains (losses)

     546           1,048     

Tax effect

     (191)           (367)     
                 
     355           681     
                 

Unrealized holding gains (losses) in fair value of derivatives used for cash flow hedges

     (270)           621     

Reclassification adjustment for (gains) realized in net income

     (118)           0     
                 

Net unrealized gains (losses)

     (388)           621     

Tax effect

     136           (217)     
                 
     (252)           404     
                 

Total other comprehensive income, net of tax and reclassification adjustments

       $     103             $     1,085     
                 

The components of accumulated other comprehensive income, net of taxes, are as follows:

 

         March 31,    
2011
         December 31,    
2010
 

Unrealized gains (losses) on securities available for sale

       $     (330)             $     (685)     

Unrealized gains (losses) on derivatives used for cash flow hedges

     345           597     
                 
       $ 15             $     (88)     
                 

NOTE 8.   OTHER COMMITMENTS

In the normal course of business, the Bank makes various commitments and incurs certain contingent liabilities which are not reflected in the accompanying financial statements. These commitments include various guarantees and commitments to extend credit. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The Company’s subsidiary bank evaluates each customer’s credit-worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on management’s credit evaluation of the customer. Standby letters of credit and financial guarantees written are conditional commitments to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. The Bank holds collateral supporting those commitments when deemed necessary by management. At March 31, 2011 and December 31, 2010, $28,599,000 and $29,558,000 of performance standby letters of credit have been issued. The Company does not anticipate any losses as a result of these transactions.

NOTE 9.   FAIR VALUE DISCLOSURES

Fair Value Measurements under generally accepted accounting principles defines fair value, describes a framework for measuring fair value and requires disclosures about fair value measurements by establishing a three-level hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure the assets or liabilities fall within different levels of the hierarchy, the classification is based on the lowest level input that is significant to the fair value measurement of the asset or liability. Classification of assets and liabilities within the hierarchy considers the markets in which the assets and liabilities are traded and the reliability and transparency of the assumptions used to determine fair value.

 

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The three levels are defined as follows: Level 1 – inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 – inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar instruments in markets that are not active or by model-based techniques in which all significant inputs are observable in the market for the asset or liability, for substantially the full term of the financial instrument. Level 3-the valuation methodology is derived from model-based techniques in which at least one significant input is unobservable to the fair value measurement and based on the Company’s own assumptions about market participants’ assumptions.

Following is a description of the valuation methodologies used for instruments measured on a recurring basis at estimated fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy:

Securities

Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities would include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, securities are classified within Level 2 and fair values are estimated by using pricing models, quoted prices of securities with similar characteristics or discounted cash flow. Level 2 securities would include U.S. agency securities, mortgage-backed agency securities, obligations of states and political subdivisions and certain corporate, asset backed and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy. All of the Company’s securities are classified as available for sale.

Interest Rate Swaps

Cash flow interest rate swaps are classified within Level 2 with fair values determined by quoted market prices and mathematical models using current and historical data.

The Company had no fair value liabilities at March 31, 2011 or December 31, 2010. A summary of assets at March 31, 2011 and December 31, 2010, measured at estimated fair value on a recurring basis were as follows:

 

(Dollars in Thousands)

       Level 1              Level 2              Level 3              Total Fair Value    
Measurements
 

March 31, 2011

           

Securities available for sale:

           

U.S. Government Sponsored Enterprises (GSE)

     $0               $96,214           $0           $96,214     

States and political subdivisions

     0           100,766           0           100,766     

GSE residential mortgage-backed securities

     0           196,136           0           196,136     
                                   

Total debt securities

     0           393,116           0           393,116     
                                   

Equity securities:

           

Diversified

     233           0           0           233     

Energy

     150           0           0           150     

Financial services

     280           70           0           350     

Industrials

     128           0           0           128     

Technology

     379           0           0           379     

Other

     1,436           0           0           1,455     
                                   

Total equity securities

     2,606           70           0           2,676     
                                   

Total securities

     2,606           393,186           0           395,792     
                                   

Interest rate swaps

     $0           $      638           $0             $ 638     

December 31, 2010

           

Securities available for sale:

           

U.S. Government Sponsored Enterprises (GSE)

     $0           $120,286           $0           $120,286     

States and political subdivisions

     0           97,148           0           97,148     

GSE residential mortgage-backed securities

     0           212,176           0           212,176     
                                   

Total debt securities

     0           429,610           0           429,610     
                                   

Equity securities:

           

Diversified

     267           0           0           267     

Energy

     60           0           0           60     

Financial services

     351           279           0           630     

Industrials

     208           0           0           208     

Technology

     147           0           0           147     

Other

     784           66           0           850     
                                   

Total equity securities

     1,817           345           0           2,162     
                                   

Total securities

     1,817           429,955           0           431,772     
                                   

Interest rate swaps

     $0             $ 1,013           $0             $ 1,013     

 

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Certain financial assets are measured at fair value on a nonrecurring basis in accordance with accounting principles generally accepted in the United States. Adjustments to the fair value of these assets usually result from the application of lower-of-cost or fair value accounting or write-down of individual assets.

The following describes the valuation techniques used by the Company to measure certain financial assets recorded at fair value on a nonrecurring basis in the financial statements.

Impaired Loans

Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due, according to the contractual terms of the loan agreement, will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Fair value is measured based on the value of the collateral securing the loan, less estimated costs to sell. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The value of the real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the collateral is a house or building in the process of construction or if an appraisal of the real estate property is older than two years, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal, if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Impaired loans with an allocation to the allowance for loan losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the consolidated statement of income. Specific allocations to the allowance for loan losses were $4,275,000 and $4,503,000 at March 31, 2011 and December 31, 2010, respectively.

Foreclosed Real Estate Owned

Other real estate property acquired through foreclosure is initially recorded at fair value of the property at the transfer date less estimated selling cost. Subsequently, other real estate owned is carried at the lower of its carrying value or the fair value less estimated selling cost. Fair value is usually determined based upon an independent third-party appraisal of the property or occasionally upon a recent sales offer. There were 8 other real estate owned properties with write-downs totaling $64,000 for the quarter ended March 31, 2011.

Mortgage Servicing Rights

The fair value of mortgage servicing rights is estimated to be equal to its carrying value, unless the quarterly valuation model calculates the present value of the estimated net servicing income is less than its carrying value, in which case a lower of cost or market (LOCM) charge is taken. In the fourth quarter of 2010, a $200,000 lower of cost or market charge was taken on the mortgage servicing right portfolio. Due to increases in mortgage servicing rights values, this LOCM reserve was reversed in the first quarter of 2011.

A summary of assets at March 31, 2011 and December 31, 2010 measured at fair value on a nonrecurring basis is as follows:

 

(Dollars in Thousands)

       Level 1              Level 2              Level 3              Total Fair Value    
Measurements
 

March 31, 2011

           

Impaired loans, net

       $     0             $     0             $     8,869             $     8,869     

Foreclosed real estate

     0           0           72           72     

December 31, 2010

           

Impaired loans, net

       $     0             $     0             $     9,118             $     9,118     

Foreclosed real estate

     0           0           259           259     

Mortgage servicing rights

     0           0           2,057           2,057     

 

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Fair values of financial instruments

The Company meets the requirements for disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. Certain financial instruments and all non-financial instruments are excluded from disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.

In addition to those disclosed above, the following methods and assumptions were used by the Company in estimating fair values of financial instruments as disclosed herein:

Cash, Due from Banks, Short-Term Investments, Interest Bearing Deposits with Banks and Federal Funds Sold

The carrying amounts of cash, due from banks, short-term investments, interest bearing deposits with banks and federal funds sold approximate their fair value.

Loans Held for Sale

Loans held for sale are carried at the lower of cost or fair value. These loans typically consist of one-to-four family residential loans originated for sale in the secondary market. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data which is not materially different than cost due to the short duration between origination and sale.

Loans Receivable

For variable-rate loans that reprice frequently and have no significant change in credit risk, fair values are based on carrying values. Fair values for fixed rate loans are estimated using discounted cash flow analyses, using interest rates currently being offered in the market for loans with similar terms to borrowers of similar credit quality.

Restricted Investment in Bank Stock

These investments are carried at cost. The Company is required to maintain minimum investment balances in these stocks, which are not actively traded and therefore have no readily determinable market value.

Deposit Liabilities

The fair values disclosed for demand deposits are, by definition, equal to the amount payable on demand at the reporting date (that is, their carrying amounts). The carrying amounts of variable-rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date. Fair values for fixed-rate certificates of deposits and IRA’s are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market to a schedule of aggregated expected maturities on time deposits.

Short-Term Borrowings

The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings maturing within 90 days approximate their fair values. Fair values of other short-term borrowings are estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

Long-Term Debt

The fair value of the Company’s fixed rate long-term borrowings is estimated using a discounted cash flow analysis based on the Company’s current incremental borrowing rate for similar types of borrowing arrangements. The carrying amounts of variable-rate long-term borrowings approximate their fair values at the reporting date.

Accrued Interest

The carrying amounts of accrued interest approximate their fair values.

 

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Off-Balance-Sheet Instruments

The Company generally does not charge commitment fees. Fees for standby letters of credit and other off-balance-sheet instruments are not significant.

The estimated fair values of the Company’s financial statements were as follows at March 31, 2011 and December 31, 2010:

 

     2011      2010  

(Dollars in thousands)

       Carrying    
Amount
     Fair
    Value     
         Carrying    
Amount
     Fair
    Value     
 

Financial Assets

           

Cash and due from banks

       $     14,751             $     14,751             $     10,400             $     10,400     

Federal funds sold

     21,500           21,500           8,800           8,800     

Short-term investments

     2,728           2,728           2,728           2,728     

Interest bearing deposits with banks

     557           557           925           925     

Restricted investments in bank stock

     8,515           8,515           8,798           8,798     

Securities available for sale

     395,792           395,792           431,772           431,772     

Loans held for sale

     3,807              2,693        

Loans

     984,867              964,293        

Allowance for loan losses

     (18,397)              (16,020)        
                                   

Net loans

     970,376           957,138           950,966           937,928     

Accrued interest receivable

     5,849           5,849           5,715           5,715     

Mortgage servicing rights

     2,303           2,303           2,057           2,057     

Interest rate swaps

     638           638           1,013           1,013     

Financial Liabilities

           

Deposits

       $     1,207,373             $     1,210,601             $     1,188,377             $     1,192,028     

Short-term borrowings

     86,750           86,750           87,850           87,850     

Long-term debt

     45,068           45,835           65,178           66,397     

Accrued interest payable

     1,116           1,116           1,053           1,053     

Off-balance sheet instruments

     0           0           0           0     

 

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PART I - FINANCIAL INFORMATION

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

OVERVIEW

Orrstown Financial Services, Inc. (the Company) is a financial holding Company with a wholly-owned bank subsidiary, Orrstown Bank. The following is a discussion of our consolidated financial condition at March 31, 2011 and results of operations for the three ended March 31, 2011 and March 31, 2010. Throughout this discussion, the yield on earning assets is stated on a fully taxable-equivalent basis and balances represent average daily balances unless otherwise stated. The discussion and analysis should be read in conjunction with our Condensed Consolidated Financial Statements (Unaudited) and Notes thereto presented in this report. Certain prior period amounts, presented in this discussion and analysis, have been reclassified to conform to current period classifications.

Certain statements appearing herein which are not historical in nature are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements refer to a future period or periods, reflecting management’s current views as to likely future developments, and use words like “may,” “will,” “expect,” “estimate,” “anticipate” or similar terms. Because forward-looking statements involve certain risks, uncertainties and other factors over which the Company has no direct control, actual results could differ materially from those contemplated in such statements. These factors include (but are not limited to) the following: general economic conditions, changes in interest rates, changes in the Company’s cost of funds, changes in government monetary policy, changes in government regulation and taxation of financial institutions, including changes resulting from the Dodd-Frank Wall Street Reform and Consumer Protection Act and related regulations, changes in the rate of inflation, changes in technology, the intensification of competition within the Company’s market area and other similar factors. For a discussion of these forward-looking statements and important factors that could cause results to differ materially from the forward-looking statements contained in this Report, see “Important Factors Relating to Forward Looking Statements” contained in our Annual Report on Form 10-K for the year ended December 31, 2010.

Critical Accounting Policies

Orrstown’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP) and follow general practices within the financial services industry in which it operates. Management, in order to prepare the Company’s consolidated financial statements, is required to make estimates, assumptions and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the balance sheet date through the date the financial statements are filed with the Commission. As this information changes, the consolidated financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources.

The most significant accounting policies followed by the Company are presented in Note 1 to the consolidated financial statements. These policies, along with the disclosures presented in the other financial statement notes, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, the Company has identified the adequacy of the allowance for loan losses, evaluation of goodwill for potential impairment, and accounting for income taxes as critical accounting policies.

The allowance for loan losses represents Management’s estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheet.

 

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Goodwill and other intangible assets have been recorded on the books of the Company in connection with its acquisitions. Goodwill and other intangible assets are reviewed for potential impairment on an annual basis, or more often if events or circumstances indicate that there may be impairment. Goodwill is tested for impairment at the reporting unit level and an impairment loss is recorded to the extent that the carrying amount of goodwill exceeds its implied fair value. Various market valuation methodologies are used to determine the fair value of the reporting unit. If the fair values of the reporting units exceed their book values, no write-downs of recorded goodwill are necessary. If the fair value of the reporting unit is less than its book value, an impairment expense may be required to be recorded to write down the related goodwill to the proper carrying value. To date, the Company has not had to take an impairment charge on its goodwill.

The Company recognizes deferred tax assets and liabilities for the future effects of temporary differences and tax credits. Enacted tax rates are applied to cumulative temporary differences based on expected taxable income in the periods in which the deferred tax asset or liability is anticipated to be realized. Future tax rate changes could occur that would require the recognition of income or expense in the statement of operations in the period in which they are enacted. Deferred tax assets must be reduced by a valuation allowance if in management’s judgment it is “more likely than not” that some portion of the asset will not be realized. Management may need to modify their judgments in this regard from one period to another should a material change occur in the business environment, tax legislation, or in any other business factor that could impair the Company’s ability to benefit from the asset in the future. As of March 31, 2011, Management has concluded that a valuation allowance is not needed on its net deferred tax asset.

Readers of the consolidated financial statements should be aware that the estimates and assumptions used in the Company’s current financial statements may need to be updated in future financial presentations for changes in circumstances, business or economic conditions in order to fairly represent the condition of the Company at that time.

SUMMARY OF FINANCIAL RESULTS

Orrstown Financial Services, Inc. recorded net income of $3,827,000 for the first quarter of 2011 compared to $3,406,000 for the same period in 2010, representing an increase of $421,000 or 12.4%. Basic and diluted earnings per share (EPS) for the first quarter of 2011 were $0.48, compared to $0.52 for the first quarter of 2010. Earnings per share declined in 2011 compared to 2010, as a result of the issuance of approximately 1.481 million shares on March 31, 2010 in connection with the Company’s highly successful common stock offering.

Included below are ratios for the return on average tangible assets (ROTA) and return on average tangible equity (ROTE) which exclude intangibles from the balance sheet and related amortization and tax expense from net income due to the associated goodwill and intangibles from the acquisition of companies and purchased deposits.

 

    Three Months Ended  
        March 31,    
2011
        March 31,    
2010
 

Return on average assets

    1.03%          1.12%     

Return on average tangible assets

    1.05%          1.15%     

Return on average equity

    9.63%          12.18%     

Return on average tangible equity

    11.15%          15.12%     

Average equity / average assets

    10.65%          9.17%     

 

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Supplemental Reporting of Non-GAAP-based Financial Measures

Tangible book value per share is computed by dividing shares outstanding into tangible common equity. Management uses tangible book value per share because it believes such ratio is useful in understanding the Company’s capital position and ratios. A reconciliation of book value per share to tangible book value per share is as follows:

 

(Dollars in thousands, except per share data)

       March 31, 2011              December 31, 2010      

Common shareholder’s equity

       $ 162,673             $ 160,484     

Less: intangible assets

     20,646           20,698     
                 

Tangible common equity

       $ 142,027             $ 139,786     
                 

Book value per share

       $ 20.36             $ 20.10     

Less: intangible assets per share

     2.58           2.60     
                 

Tangible book value per share

       $ 17.76             $ 17.50     
                 

Total assets

     1,512,393           1,511,722     

Less intangible assets

     20,646           20,698     
                 

Tangible assets

       $     1,491,747             $     1,491,024     
                 

Return on average tangible assets and return on average tangible equity are non-GAAP-based financial measures calculated using non-GAAP-based amounts. The most directly comparable measure is return on average assets and return on average equity, which are calculated using GAAP-based amounts. The Company calculates the return on average tangible assets and equity by excluding the balance of intangible assets and their related amortization expense, net of tax, from the calculation of return on average assets and equity. Management uses the return on average tangible assets and equity to assess the Company’s core operating results and believes that this is a better measure of our operating performance as it is based on the Company’s tangible assets and capital. Further we believe that by excluding the impact of purchase accounting adjustments it allows for a meaningful comparison with the Company’s peers; particularly those that may not have acquired other companies. Lastly, the exclusion of goodwill and other intangible assets is consistent with the treatment by bank regulatory agencies from the calculation of risk-based capital ratios, which excludes these amounts. However, these non-GAAP financial measures are supplemental and are not a substitute for an analysis based on GAAP measures. A reconciliation of return on average assets and equity to the return on average tangible assets and equity, is set forth below.

 

For Quarter Ended:

   March 31, 2011      March 31, 2010  

Return on Average Assets (GAAP basis)

     1.03%           1.12%     

Effect of excluding average intangible assets and related amortization, net of tax

     0.02%           0.03%     
                 

Return on Average Tangible Assets

     1.05%           1.15%     
                 

Return on Average Equity (GAAP basis)

     9.63%           12.18%     

Effect of excluding average intangible assets and related amortization, net of tax

     1.52%           2.94%     
                 

Return on Average Tangible Equity

     11.15%           15.12%     
                 

RESULTS OF OPERATIONS

Net Interest Income

The primary component of the Company’s revenue is net interest income, which is the difference between interest income and fees on interest-earning assets and interest expense on interest-bearing liabilities. Earning assets include loans, securities and federal funds sold. Interest bearing liabilities include deposits and borrowed funds. To compare the tax-exempt yields to taxable yields, amounts are adjusted to pretax equivalents based on a 35% federal corporate tax rate.

Net interest income is affected by changes in interest rates, volumes of interest-earning assets and interest-bearing liabilities and the composition of those assets and liabilities. The “net interest spread” and “net interest margin” (NIM) are two common statistics related to changes in net interest income. The net interest rate spread represents the difference between the yields earned on interest-earning assets and the rates paid for interest-bearing liabilities. The net interest margin is defined as the ratio of net interest income to average earning assets. Through the use of demand deposits and stockholders’ equity, the net interest margin exceeds the net interest rate spread, as these funding sources are non-interest bearing.

The “Average Balances and Interest Rates” table presents net interest income on a fully taxable equivalent basis, net interest rate spread and net interest margin for the quarters ended March 31, 2011 and 2010.

 

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For the three months ended March 31, 2011, net interest income measured on a full tax equivalent basis, increased $2,188,000, or 20.1%, to $13,073,000 from $10,885,000 in the corresponding period in 2010. The primary reason for the increase in net interest income was an increase in average earning assets from $1,142,675,000 for the first three months of 2010 to $1,419,720,000 in 2011. Offsetting the growth in average interest earning assets was a decline in net interest margin by 8 basis points (b. p.), from 3.76% in 2010 to 3.68% for 2011. The net interest spread for the three months ending March 31, 2011 was 3.59%, compared to 3.64% for the same period in 2010. The net interest spread has been steadily increasing from 3.48% earned in the third quarter of 2010 and 3.54% earned in the fourth quarter of 2010. Despite the fact that we became more asset sensitive during the first quarter of 2011, we were still able to increase the net interest margin from 3.60% during the fourth quarter 2010 to 3.68% during 2011’s first quarter.

The largest portion of the increase in interest income was the result of interest earned on the securities portfolio, which totaled $3,281,000 for the three months ended March 31, 2011, an increase of 55.4%, or $1,169,000 over 2010. Quarter-over-quarter average securities increased $196,802,000, or 86.0%. Partially offsetting the increase on securities earnings due to volume was a reduction in the interest rate earned of 3.62% in 2010 to 3.08% in 2011.

The growth in securities was funded principally through the growth in money market and time deposit accounts. Average interest bearing deposits increased $206,850,000, or 20.1%, resulting from the Company’s overall customer service model, its market position in several attractive markets, and due to the favorable rating the Bank has received from IDC Financial Publishing, Inc. (IDC), an independent bank safety rating agency which uses its unique rankings of financial ratios to determine the quality ratings of financial institutions. This strong rating facilitates the Company’s ability to attract time deposits and brokered deposits. Average balance of time deposits of $599,833,000 for the quarter ended March 31, 2011 exceeded 2010’s average balance of $441,121,000 by 36.0%, however, interest expense only increased $86,000, or 4.4%. The Company recognizes that brokered funds are more volatile funding source than core deposits. However, given the current interest rate environment and the steepness of the interest rate curve, the Company elected to collect these funds and earn a spread on them in order to enhance net interest income. Given the increased volatility in brokered deposits, the Company invested a large portion of these amounts in mortgage backed securities, which provide a regular stream of monthly cash flows, which can be used to meet the maturity needs of time and brokered deposits. We have matched cash flows from the debt securities portfolio with nontraditional cash flows to enable us to unwind the strategy if loan demand continues to increase or if the yield curve flattens.

Interest income earned on loans increased from $12,026,000 for the quarter ended March 31, 2010 to $12,705,000 in 2011, a 5.7% increase. The growth in the loan portfolio was the primary reason for the increase in net interest income. Quarter-over-quarter, average loans increased $86,077,000, or 9.7%, from the quarter ended March 31, 2010 to March 31, 2011. The increase in average loans is the result of the Company’s desire to continue to grow its loan portfolio and deploy its capital. This growth has come principally in some of the Company’s less mature markets, in which we have hired additional lending officers, which has increased opportunities in these markets served. The growth experienced in the loan portfolio in the second half of 2010, supplemented with the loan demand in the first quarter of 2011, provided the strong growth in average loan balances. Due to the variable nature of a large portion of the loan portfolio, along with the implementation of floors as loans renewed, the decline in average rate earned on loans was not as severe as the securities portfolio or that paid on longer term borrowings. Additionally, the Company continued to utilize $30,000,000 in notional amount of interest rate swaps which serve as a hedge against variable rate commercial loans linked to prime and converts them to a fixed rate of interest. The interest rate swaps that the Company had outstanding during 2011 yielded $133,000, which was credited and included as commercial loan interest income. As part of the Company’s asset/liability management, one swap with a notional amount of $10,000,000 was settled at the end of the first quarter in 2011, and a $118,000 gain was recognized. This swap was settled in an effort to increase our asset sensitivity in the event of rising rates. The rate earned on loans was 5.22%, or 16 b.p. less than 2010, and partially offset the increase in interest income that resulted from higher average balances.

As a result of the increase in its deposit base, the Company has placed less reliance on more costly long-term borrowings. Interest expense on long-term debt has decreased $153,000 from $442,000 for the quarter ended March 31, 2010 to $289,000 in the corresponding quarter in 2011. Reduction in average daily balance of $3,269,000 for 2011 compared to 2010 and the lower rate paid of 2.32% in 2011 compared to 3.32% in 2010 resulted in reduced interest expense.

 

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The Company’s net interest spread and net interest margin have declined by 5 b.p. and 8 b.p. in the quarter ended March 31, 2011 compared to 2010. Given the continued low interest rate, reduced rates earned on interest earning assets outpaced the reduction in rates that we could pass on to our customers, and resulted in the lower interest rate spread and margin. The net interest spread was 3.59% and net interest margin was 3.68% in the first quarter of 2011.

The table that follows shows average balances and interest yields on a fully taxable equivalent basis (FTE):

Average Balances and Interest Rates

 

     Three Months Ended  
     March 31, 2011     March 31, 2010  

(Dollars in thousands)

       Average    
Balance
     Tax
    Equivalent    
Interest
     Tax
    Equivalent    
Rate
    Average
    Balance    
     Tax
    Equivalent    
Interest
     Tax
    Equivalent    
Rate
 

Assets

                

Federal funds sold & interest
bearing bank balances

       $ 17,877             $ 24           0.54         $     23,711             $ 30           0.51  

Securities

     425,701           3,281           3.08          228,899           2,112           3.62     

Loans

     976,142           12,705           5.22          890,065           12,026           5.38     
                            

Total interest-earning assets

     1,419,720           16,010           4.52          1,142,675           14,168           4.92     
                                        

Other assets

     92,215                93,616           
                            

Total

       $     1,511,935                  $     1,236,291           
                            

Liabilities and Shareholders’
Equity

                

Interest bearing demand deposits

       $ 420,235             $ 449           0.43            $ 350,336             $ 681           0.79     

Savings deposits

     67,643           38           0.23          60,459           47           0.30     

Time deposits

     599,833           2,038           1.32          441,121           1,952           1.78     

Short term borrowings

     96,162           123           0.52          121,838           164           0.55     

Long term debt

     50,027           289           2.32          53,296           442           3.32     
                                                    

Total interest bearing liabilities

     1,233,900           2,937           0.93          1,027,050           3,286           1.28     
                                        

Non-interest bearing Demand
deposits

     107,119                88,328           

Other

     9,849                7,523           
                            

Total Liabilities

     1,350,868                1,122,901           

Shareholders’ Equity

     161,067                113,390           
                                        

Total

       $     1,511,935              0.84         $ 1,236,291              1.16  
                                        

Net interest income (FTE)/ net
interest spread

        13,073           3.59            $     10,885           3.64  
                            

Net interest margin

           3.68             3.76  
                            

Tax-equivalent adjustment

        (685)                (388)        
                            

Net interest income

          $     12,388                  $     10,497        
                            

 

NOTES:

Yields and interest income on tax-exempt assets have been computed on a fully taxable equivalent basis assuming a 35% tax rate. For yield calculation purposes, nonaccruing loans are included in the average loan balance.

Other Income

Noninterest income increased to $5,076,000 for the three months ended March 31, 2011, as compared to $4,347,000 in the same prior year period. Noninterest income generation increased across all business lines including Orrstown Financial Advisors, mortgage originations and retail fees generated from deposit accounts. These business lines have been able to capitalize on favorable market conditions, which include:

 

 

 

Service charges on deposit accounts increased 3.2%, from $1,439,000 for the three months ended March 31, 2010 to $1,485,000 in 2011. The increase was principally the result of increased revenues earned on debit cards, partially offset by a decline in overdraft charges to depositors in the period.

 

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An increase in trust department and brokerage income of $283,000, or 25.0% for the three months ended March 31, 2011 compared to 2010, the result of increases in trust and brokerage activity as the stock market has started to show signs of recovery, and additional trust assets under management, which increased from $854,327,000 at March 31, 2010 to $977,819,000 at March 31, 2011.

 

 

 

The continued low interest rate environment and additional mortgage originators have led to an increase in new mortgage loan applications as well as refinancing activities. Given these low interest rates, the Company generally sells its 30-year conforming mortgage loans to investors. Mortgage banking activities increased $335,000 from $361,000 for the three months ended March 31, 2010 to $696,000 for three months ended March 31, 2011.

 

 

 

The Company continues to see an increase in its deposit accounts and other customer related services, which has resulted in an increase in service charges. Service charges on deposit accounts totaled $1,485,000 for the quarter ended March 31, 2011, an increase of $46,000, or 3.2%, over $1,439,000 for the quarter ended March 31, 2010.

 

 

 

Earnings on life insurance increased $168,000 from $162