SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the Quarterly Period ended March 31, 2011. Commission File Number 000-27894
COMMERCIAL BANCSHARES, INC.
(Exact name of registrant as specified in its charter)
118 S. Sandusky Avenue, Upper Sandusky, Ohio 43351
(Address of principal executive offices including zip code)
Registrant’s telephone number, including area code: (419) 294-5781
(Former Name, Former Address and Former Fiscal Year,
if Changed Since Last Report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes þ No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (check one).
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No þ
As of May 12, 2011, the latest practicable date, there were 1,153,787 outstanding of the registrant’s common stock, no par value.
COMMERCIAL BANCSHARES, INC.
NOTE 1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation: The accompanying consolidated financial statements include the accounts of Commercial Bancshares, Inc. (the “Corporation”) and its wholly owned subsidiaries, Commercial Financial and Insurance Agency, LTD (“Commercial Financial”) and The Commercial Savings Bank (the “Bank”). The Bank also owns a 49.9% interest in Beck Title Agency, Ltd., which is accounted for by using the equity method of accounting. All significant intercompany balances and transactions have been eliminated in consolidation.
The condensed consolidated financial statements have been prepared without audit. In the opinion of management, all adjustments (which include normal recurring adjustments) necessary to present fairly the Corporation’s financial position at March 31, 2011, and the results of operations and changes in cash flows for the periods presented have been made.
Certain information and footnote disclosures typically included in financial statements prepared in accordance with U.S. generally accepted principles have been omitted. The Annual Report for the year ended December 31, 2010, contains consolidated financial statements and related footnote disclosures, which should be read in conjunction with the accompanying consolidated financial statements. The results of operations for the period ended March 31, 2011 are not necessarily indicative of the operating results for the full year or any future interim period.
NOTE 2 EARNINGS PER SHARE
Weighted average shares used in determining basic and diluted earnings per share for the three months ended March 31:
NOTE 3 LOANS
(Amounts in thousands)
At March 31, 2011 and December 31, 2010, total loans included loans to farmers for agricultural purposes of approximately $27,138,000 and $28,631,000, respectively.
NOTE 4 CREDIT QUALITY INDICATORS
Amounts in thousands
Commercial Credit Exposure
Credit risk profile by credit worthiness category
Consumer Credit Exposure
Credit risk by credit worthiness category
Consumer Credit Exposure
Credit risk by credit worthiness category
The Corporation’s strategy for credit risk management includes ongoing credit examinations and management reviews of loans exhibiting deterioration of credit quality. A deteriorating credit indicates an elevated likelihood of delinquency. When a loan becomes delinquent, its credit grade is reviewed and changed accordingly. Each downgrade to a classified credit results in a higher percentage of reserve to reflect the increased likelihood of loss for similarly graded credits. Further deterioration could result in a certain credit being deemed impaired resulting in a collateral valuation for purposes of establishing a specific reserve which reflects the possible extent of such loss for that credit.
The Corporation uses a risk rating system, on a scale of 1 through 9, to grade each loan. A general description of the characteristics of the risk grades is as follows:
NOTE 5 ALLOWANCE FOR LOAN LOSSES
(Amounts in thousands)
NOTE 6 SUMMARY OF IMPAIRED LOANS
(Amounts in thousands)
NOTE 7 AGE ANALYSIS OF PAST DUE FINANCING RECEIVABLES
(Amounts in thousands)
NOTE 8 FINANCING RECEIVABLES ON NONACCRUAL STATUS
(Amounts in thousands)
NOTE 9 OTHER COMPREHENSIVE INCOME
Other comprehensive income (in thousands) for the three months ended March 31:
NOTE 10 FAIR VALUES AND MEASUREMENTS OF FINANCIAL INSTRUMENTS
The Corporation groups its assets and liabilities measured at fair value into a three-level hierarchy for valuation techniques used to measure assets and liabilities at fair value. This hierarchy is based on whether the valuation inputs are observable or unobservable. These levels are:
In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest level input that is significant to the valuation. The Corporation’s assessment of the significance of particular inputs to these fair value measurements requires significant management judgment or estimation and considers factors specific to each asset or liability.
The following table presents information about the Corporation’s assets and liabilities measured at fair value on a recurring basis as of March 31, 2011 and December 31, 2010, and the valuation techniques used by the Corporation to determine those fair values.
Assets and liabilities, (in thousands) measured at fair value on a recurring basis for the periods shown:
Obligations of U.S. Government and federal agencies and securities from government-sponsored organizations have Level 1 inputs available for valuation. Securities characterized as having Level 2 inputs generally consist of obligations of state and political subdivisions. There were no significant transfers in or out of Levels 1 and 2 for the period ending March 31, 2011.
The Corporation also has assets that, under certain conditions, are subject to measurement at fair value on a non-recurring basis. At March 31, 2011, such assets consist primarily of impaired loans and other real estate owned. The Corporation has estimated the fair values of these assets using Level 3 inputs, specifically, discounted present value of cash flow projections.
The following table presents financial assets and liabilities measured on a nonrecurring basis:
Fair Value Measurements at Reporting Date Using
A loan is considered impaired when, based on current information and events it is probable the Corporation will be unable to collect all amounts due (both interest and principal) according to the contractual terms of the loan agreement. Impaired loans are subject to nonrecurring fair value adjustments to reflect (1) partial write downs that are based on the observable market price or current appraised value of the collateral, or (2) the full charge-off of the loan carrying value. The Corporation estimates the fair value of the loans based on the present value of expected future cash flows using management’s best estimate of key assumptions. These assumptions include future payment ability, timing of payment streams, and estimated realizable values of available collateral (typically based on outside appraisals).
Other real estate owned (“OREO”) acquired through or instead of loan foreclosure is initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. Management considers third party appraisals as well as independent fair market value assessments from realtors or persons involved in selling OREO when determining the fair value of particular properties. Accordingly, the valuations of OREO and other repossessed assets are subject to significant judgment. If fair value declines subsequent to foreclosure, a valuation allowance is recorded through expense. Additionally, any operating costs incurred after acquisition are also expensed.
The estimated fair values of financial instruments (in thousands) were as follows:
The following describes the valuation methodologies used by management to measure financial assets and liabilities at fair value. Where appropriate, the description includes information about the valuation models and key inputs to those models.
NOTE 11 STOCK-BASED COMPENSATION
The Corporation has two stock option plans, the 1997 Stock Option Plan and the 2009 Incentive Stock Option Plan. No additional grants may be made under the 1997 Stock Option Plan. The 2009 Plan, which is shareholder approved, permits the grant of stock options, restricted stock and certain other stock-based awards for up to 150,000 shares. At March 31, 2011, a total of 116,850 shares remained available for issuance. Stock-based compensation expense is based on the estimated fair value of the award at the date of grant. The fair value of each option award is estimated on the date of grant using an option-pricing model, requiring the use of subjective assumptions. The fair value is amortized as compensation expense on a straight-line basis over the vesting period of the grants. Compensation expense recognized is included in personnel expense in the consolidated statements of income.
Assumptions are used in estimating the fair value of stock options granted. Expected stock volatility is based on several factors including the historical volatility of the Corporation’s stock, implied volatility determined from traded options and other factors. The Corporation uses historical data to estimate option exercises and employee terminations to estimate the expected life of options. The risk-free interest rate for the expected life of the options is based on the U.S. Treasury yield curve in effect on the date of grant. The expected dividend yield is based on the Corporation’s expected dividend yield over the life of the options.
Activity in the stock option plans for the three months ended March 31, 2011 was as follows:
The following is a summary of outstanding and exercisable stock options as of March 31, 2011:
Intrinsic value represents the amount by which the fair market value of the underlying stock exceeds the exercise price of the stock option. At March 31, 2011, the aggregate intrinsic value of stock options outstanding and exercisable was $157,000 and $35,000, respectively compared to an aggregate intrinsic value of $54,000 and $13,000 at December 31, 2010.
For the three-month period ended March 31, 2011 and 2010, the Corporation recognized compensation expense of $5,000 and $3,000, respectively, for the vesting of stock options. For the full year 2010, the Corporation recognized compensation expense of $17,000 for the vesting of stock options. At March 31, 2011, the Corporation had $35,000 of unrecognized compensation expense related to stock options that is expected to be recognized over the remaining requisite service periods that extend predominantly through the third quarter 2013.
The following table summarizes information about the Corporation’s nonvested stock option activity for the three months ended March 31, 2011.
The fair value of restricted stock is equal to the fair market value of the Corporation’s common stock on the date of grant. Restricted stock awards are recorded as deferred compensation, a component of shareholders’ equity, and amortized to compensation expense over a three year vesting period. Compensation expense for restricted stock awards of approximately $4,000 and $2,000 was recorded during the three-month period ended March 31, 2011 and 2010, respectively. For the full year 2010, the Corporation recognized $11,000 in compensation expense for restricted stock awards. At March 31, 2011, the Corporation had $32,000 of unrecognized compensation expense related to restricted stock options that is expected to be recognized over the remaining requisite service periods that extend predominantly through the third quarter 2013.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following review presents management’s discussion and analysis of the consolidated financial condition of Commercial Bancshares, Inc. and its wholly owned subsidiaries, Commercial Savings Bank and Commercial Financial Insurance Agency, LTD at March 31, 2011, compared to December 31, 2010, and the consolidated results of operations for the quarter ended March 31, 2011 compared to the same period in 2010. The purpose of this discussion is to provide the reader with a more thorough understanding of the consolidated financial statements and related footnotes.
Due to the weak economic conditions, financial institutions continue to experience heightened credit losses and higher levels of nonperforming assets, charge-offs and foreclosures. In light of these conditions, financial institutions also face heightened levels of scrutiny from regulators. These factors negatively influenced earning asset yields at a time when the market for loans and deposits was intensely competitive. As a result, financial institutions experienced pressure on credit costs, loan yields, deposit and other borrowing costs, liquidity and capital.
The Corporation’s net earnings, after taxes, increased 19.34% to $617,000 at March 31, 2011, from $517,000 at March 31, 2010. The increase in earnings was primarily due to a decline in cost of funds, down 60 basis points to 1.04% at March 31, 2011, from 1.64% a year ago. The decline in cost of funds was largely due to lowering the offering rates on new time deposits and other interest-bearing deposit accounts in response to the current rate environment and high level of on-balance sheet liquidity.
The Corporation’s return on average equity and return on average assets for the first quarter of 2011 was 10.08% and 0.82%, respectively, compared to 9.11% and 0.72% in 2010. The Corporation’s efficiency ratio, on a fully taxable equivalent basis, was 69.77% for the three months ended March 31, 2011, a slight improvement from 71.15% for the three months ended March 31, 2010. The efficiency ratio is calculated by dividing noninterest expense by the sum of net interest income before provision and other noninterest income and measures the amount of expense incurred to generate a dollar of revenue. For the three months ended March 31, 2011, basic weighted average shares outstanding totaled 1,153,326 and diluted weighted average shares outstanding totaled 1,160,413 resulting in basic earnings per share and diluted earnings per share of $0.53 per share for the period. For the three months ended March 31, 2010, basic and diluted weighted average shares outstanding totaled 1,138,497 resulting in basic earnings per share and diluted earnings per share of $0.45 per share for the period.
The Corporation is designated as a financial holding company by the Federal Reserve Bank of Cleveland. This status can help the Corporation take advantage of changes in existing law made by the Financial Modernization Act of 1999. As a result of being a financial holding company, the Corporation may be able to engage in an expanded array of activities determined to be financial in nature. This will help the Corporation remain competitive in the future with other financial service providers in the markets in which the Corporation does business. There are more stringent capital requirements associated with being a financial holding company. The Corporation intends to maintain its categorization as a “well capitalized” bank, as defined by regulatory capital requirements.
Management believes there have been no changes with respect to its determinations regarding the Corporation’s critical accounting policies as disclosed in the Corporation’s annual report on Form 10-K for the fiscal year ended December 31, 2010.
Certain statements contained in this report that are not historical facts are forward-looking statements that are subject to certain risks and uncertainties. When used herein, the terms “anticipates,” “plans,” “expects,” “believes” and similar expressions as they relate to the Corporation or its management are intended to identify such forward-looking statements. The Corporation’s actual results, performance or achievements may materially differ from those expressed or implied in the forward-looking statements. Risks and uncertainties that could cause or contribute to such material differences include, but are not limited to, general economic conditions, interest rate environment, competitive conditions in the financial services industry, changes in law, government policies and regulations, and rapidly changing technology affecting financial services.
Total assets decreased $3,620,000 or 1.19% to $300,783,000 at March 31, 2011, from $304,403,000 at December 31, 2010, largely due to a decline in net loans of $8,568,000 offset by an increase in interest-bearing deposits in other financial institutions of $3,410,000 and an increase in securities available for sale of $1,228,000. Total deposits decreased $3,611,000, primarily due to a decrease in savings and time deposits of $6,989,000, offset by an increase in demand deposit accounts of $3,378,000.
Securities available for sale are carried at fair value, with unrealized gains or losses based on the difference between amortized cost and fair value, reported net of deferred tax, as accumulated other comprehensive income (loss), a separate component of shareholders’ equity. Declines in the fair value of individual available for sale securities below their cost that are other-than temporary result in write downs of the individual securities to their fair values. Securities available for sale increased $1,228,000 or 3.63% to $35,071,000 at March 31, 2011, from $33,843,000 at year-end 2010, predominantly due to purchases of U.S. government-sponsored agencies of $2,119,000 offset with calls, maturities and repayments of $916,000.
Loans are reported at their outstanding principal balances less unearned income, the allowance for loan losses and any deferred fees or costs on originated loans. Total loans receivable, before allowance for loan losses, decreased $8,524,000 or 3.70% to $222,134,000 at March 31, 2011, from $230,658,000 at December 31, 2010, predominantly in the commercial and agricultural loan portfolio, down $7,262,000 or 4.21% from year-end 2010. The decrease in commercial and agricultural loans was primarily due to the competitive rate environment and the continued softening in loan demand as economic recovery in commercial markets remains sluggish.
The Corporation’s loan portfolio represents its largest and highest yielding assets. It also contains the most risk of loss. This risk is largely due to changes in borrowers’ primary repayment capacity, general economic conditions and to collateral values that are subject to change over time. These risks are managed with specific underwriting guidelines, loan review procedures, third party reviews and continued personnel training. Executive management continues to monitor economic conditions in the real estate market as well as the overall economy and has implemented the following measures to proactively manage credit risk in the loan portfolios:
Although executive management continues to aggressively engage in other loss mitigation techniques such as tightening underwriting standards and lowering LTV ratios on in-house real estate lending, a prolonged economic slowdown would place significant pressure on consumers and businesses in the Corporation’s local markets.
The allowance for loan losses is maintained to provide for losses that can reasonably be anticipated. The allowance is based on ongoing quarterly assessments of the probable losses inherent in the loan portfolio. The allowance for loan losses is increased by provisions charged to operations during the current period and reduced by loan charge-offs, net of recoveries. Loans are charged against the allowance when management believes that the collection of the principal is unlikely. The allowance is an amount that management believes will be adequate to absorb losses inherent in existing loans, based on evaluations of the probability of collection. In evaluating the probability of collection, management is required to make estimates and assumptions that affect the reported amounts of loans, allowance for loan losses and the provision for credit losses charged to operations. Actual results could differ significantly from those estimates. These evaluations take into consideration such factors as the composition of the loan portfolio, overall portfolio quality, loan concentrations, specific problem loans, and current economic conditions that may affect the borrowers’ ability to pay.
The allowance allocation for commercial and commercial real estate loans begins with a process of estimating the probable losses inherent for these types of loans. The estimates for these loans are established by category and based on an internal system of credit risk ratings and historical loss data. The estimated loan loss allocation rate for the internal system of credit risk grades for commercial and commercial real estate loans is based on management’s experience with similarly graded loans as well as historical loss data.
The allowance allocation for consumer and consumer real estate loans which includes consumer mortgages, installment, home equity, automobile and others is established for each of the categories by estimating probable losses inherent in that particular category of consumer and consumer real estate loans. The estimated loan loss allocation rate for each category is based on management’s experience, discussions with banking regulators, consideration of actual loss rates, industry loss rates and loss rates of various peer banking groups. Consumer and consumer real estate loans are evaluated as a group by category (i.e. retail real estate, installment, etc.) rather than on an individual loan basis because these loans are smaller and homogeneous.
The estimated loan loss allocation for all three loan portfolio segments (commercial, residential real estate and consumer) is then adjusted for management’s estimate of probable losses for several “environmental” factors. The allocation for environmental factors is particularly subjective and does not lend itself to exact mathematical calculation. This amount represents estimated probable inherent credit losses which exist, but have not yet been identified, as of the balance sheet date, and are based upon monthly actual and quarterly trend assessments in delinquent and nonaccrual loans, credit concentration changes and prevailing economic conditions, changes in lending personnel experience, changes in lending policies or procedures and other influential factors. These environmental factors are considered for each of the three loan segments and the allowance allocation, as determined by the processes noted above for each component, is increased or decreased based on the incremental assessment of these various environmental factors.
The allowance for loan losses totaled $3,242,000 at March 31, 2011, an increase of $44,000 or 1.38% from $3,198,000 at December 31, 2010. The ratio of annualized net charge-offs to average outstanding loans was 0.27% at March 31, 2011, compared to 0.41% at year-end 2010. The ratio of the allowance for loan losses to total loans was 1.46% at March 31, 2011, compared to 1.39% at year-end 2010. The Corporation provided $195,000 to the allowance for loan losses during the three months ended March 31, 2011 to maintain the balance at an adequate level following net charge-offs of $151,100.
Before loans are charged off, they typically go through a phase of nonperforming status. Various stages exist when dealing with such nonperformance. The first state is simple delinquency, where customers consistently start paying late, 30, 60, 90 days at a time. These accounts are then put on a list of loans to “watch” as they continue to under-perform according to original terms. Repeat offenders are moved to nonaccrual status when their delinquencies have been frequent or sustained enough to assume that normal payments may never be reestablished. This prevents the Corporation from recognizing income it may never collect and may create small negative spikes in earnings as any accrued interest already on the books is reversed from prior earnings estimates.
Loans are placed on nonaccrual status when management believes the collection of interest is doubtful, or when accruals are continued on loans deemed by management to be fully collateralized and in the process of being collected. At March 31, 2011 and December 31, 2010, there were no 90 day delinquent loans that were on accrual status. In such cases, the loans are individually evaluated in order to determine whether to continue income recognition after 90 days beyond the due dates. When loans are charged off, any accrued interest recorded in the current fiscal year is charged against interest income. The remaining balance is treated as a loan charged off. Nonaccrual loans decreased $241,000 or 12.46% to $1,693,000 at March 31, 2011, from $1,934,000 at December 31, 2010.
The impairment of a loan occurs when it is probable that the Corporation will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impairment is measured as the difference between the recorded investment in the loan and the evaluation of the present value of expected future cash flows or the observable market price of the loan. Loans that are collateral dependent, that is, loans where repayment is expected to be provided solely by the underlying collateral, and for which management has determined foreclosure is probable, are measured for impairment based on the fair value of the collateral. Management’s general practice is to charge down impaired, nonperforming loans to the fair value of the underlying collateral of the loan, so no specific loss allocations are necessary for these loans. The allowance for loan losses, specifically related to impaired loans at March 31, 2011 and December 31, 2010 was $238,000 and $156,000, respectively, related to loans with principal balances of $1,965,000 and $980,000. The recorded investment of impaired loans with no specific allowance was $791,000 at March 31, 2011, compared to $884,000 at December 31, 2010. The Corporation’s financial statements are prepared on the accrual basis of accounting, including the recognition of interest income on the loan portfolio, unless a loan is placed on nonaccrual. Amounts received on nonaccrual loans generally are applied first to principal and then to interest only after all principal has been collected. During the three months ended March 31, 2011, interest payments of $37,000 have been recorded on impaired loans.
Other assets of $19,051,000 increased $291,000 or 1.55% at March 31, 2011 from $18,760,000 at December 31, 2010. Accrued interest receivable increased $123,000, primarily due to semi-annual interest payments of tax-exempt securities rebuilding their balances to payout in June, 2011 as well as an increase in prepaid expenses of $44,000, an increase in the cash surrender value of company-owned life insurance of $70,000 and an increase of $28,000 in OREO and other repossessed assets.
OREO and other repossessed assets are carried at the lower of cost or estimated fair market value less estimated expenses to be incurred to sell the property. OREO represents properties acquired by the Corporation through customer loan defaults. At March 31, 2011, the Corporation held four properties in OREO with a carrying value of $96,000 compared to two properties held in OREO at December 31, 2010 with a carrying value of $20,000. Other repossessed assets totaled $43,000 at March 31, 2011 compared to $92,000 at December 31, 2010.
Total deposits decreased $3,611,000 or 1.30% predominantly in small and large certificate of deposit balances, down $4,240,000 and $3,746,000, respectively offset with an increase of $3,137,000 in interest-bearing demand deposits. The increases in low cost savings demand deposit and money market accounts from year-end 2010 appear to reflect customer preference for the liquidity these types of deposits provide over the rates currently offered on longer term certificates of deposit.
Shareholders’ equity increased $573,000 or 2.35% to $24,962,000 at March 31, 2011 from $24,389,000 at December 31, 2010. The increase in capital represents current earnings of $617,000, offset by dividends of $137,000 paid to shareholders, as well as an increase in the market value of investment securities, net of tax of $53,000 plus adjustments related to employee compensation costs and stock option accounting of $40,000. During the three months of 2011, the Corporation returned 22.20% of earnings through dividends of $137,000 at $0.12 per share. At March 31, 2011, total shareholders’ equity to total assets was 8.30% compared to 8.01% at December 31, 2010.
RESULTS OF OPERATIONS
During the three months ended March 31, 2011, the Corporation recorded net income, after taxes, of $617,000, compared to net income, after taxes, of $517,000 for the three months ended March 31, 2010. The following discussion details the contributing factors influencing these operating results.
The largest component of the Corporation’s operating income is net interest income. The level of net interest income is dependent upon the interest rate environment and the volume and composition of interest-earning assets and interest-bearing liabilities. The following discussion of net interest income is presented on a taxable equivalent basis to facilitate performance comparisons among various taxable and tax-exempt assets, such as certain state and municipal securities. A tax rate of 34% was used in adjusting interest on tax-exempt assets to a fully taxable equivalent basis.
Net interest income increased $130,000 or 4.28% to $3,167,000 at March 31, 2011, compared to $3,037,000 in 2010. The increase in interest income was largely driven by the rate payable on interest-bearing liabilities declining more rapidly than the yield on interest-earning assets. The interest rate spread and net interest margin (on a tax-equivalent basis) at March 31, 2011 was 4.46% and 4.59%, respectively, compared to 4.42% and 4.60% for the same period in 2010. With approximately 74% of the loan portfolio in floating rate instruments at March 31, 2011, the effects of low market rates continue to impact loan yields. The Corporation has successfully sought to mitigate the low-interest rate environment with loan floors included in new and renewed loans over the past year. Loans yielded 6.25% during the three months ended March 31, 2011, compared to 6.62% for the same period last year. The Corporation’s cost of funds continued to decline during 2011, positively impacting net interest margin. The Corporation’s average cost of funds was 1.04% for the three months ended March 31, 2011, compared to 1.64% for the same period last year.
Interest and fee income for the first quarter of 2011 totaled $3,795,000, a decrease of $211,000 or 5.27% compared to $4,006,000 for the first quarter of 2010. Average net loans, comprising 78.88% and 81.52% of average earning assets in the three months ended March 31, 2011 and 2010, respectively, decreased $2,461,000 or 1.13%, while the average tax-equivalent yield earned decreased 37 basis points. The decline in interest income on loans was largely due to the downward repricing of variable rate loans. Average federal funds sold, comprising 8.10% and 5.03% of average earning assets in the first quarter of 2011 and 2010, respectively, increased $9,200,000 or 68.28%, while the average tax-equivalent yield earned increased 3 basis points. Average securities available for sale, comprising 13.02% and 13.45% of average earning assets, increased $420,000 or 1.17% while the average tax-equivalent yield earned decreased 62 basis points.
During the first quarter of 2011, interest expense was $628,000, representing a decrease of $341,000 or 35.19% from the same period in 2010. For the three months ended March 31, 2011, average interest-bearing demand deposits, comprising 43.16% and 40.16% of interest-bearing liabilities, respectively, increased $9,211,000 or 9.54% while the average rate paid decreased 42 basis points. Average time deposits, comprising 49.84% and 51.52% of interest-bearing liabilities, respectively, decreased $1,717,000 or 1.39% while the average rate paid decreased 62 basis points.
The provision charged against income during the three-month period ending March 31, 2011 was $195,000 compared to $245,000 in 2010. The allowance for loan losses as a percentage to loans increased from 1.39% at December 31, 2010 to 1.46% at March 31, 2011. The increase in the level of allowance to total loans for 2011 was largely due to the increase in the allocated reserve percentages assigned to certain loan types. Reserve percentages began increasing in 2009 as charge-off and overall delinquencies started growing as a result of deteriorating local and national economies. Although various indices, such as net charge-offs, nonaccrual loans and delinquencies, show improvement from year-end, the economic conditions of the local economies within the Corporation’s lending areas have not yet begun to show significant improvement causing the reserve percentages to remain at their elevated levels.
TABLE 1 YIELD ANALYSIS
The following table presents an analysis of average yields earned on interest-earning assets as well as the average rates paid on interest-bearing liabilities on a fully taxable equivalent basis for the three months ended March 31: