Attached files

file filename
EX-31.1 - EXHIBIT 31.1 - STEWARDSHIP FINANCIAL CORPex31_1.htm
EX-31.2 - EXHIBIT 31.2 - STEWARDSHIP FINANCIAL CORPex31_2.htm
EX-32.1 - EXHIBIT 32.1 - STEWARDSHIP FINANCIAL CORPex32_1.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-Q

 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2011
 
 
o
TRANSITION REPORT PURSUANT TO 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from________ to_______

Commission file number 0-21855

Stewardship Financial Corporation
(Exact name of registrant as specified in its charter)

New Jersey
22-3351447
(State or other jurisdiction of
(I.R.S. Employer Identification No.)
incorporation or organization)
 

630 Godwin Avenue, Midland Park,  NJ
07432
(Address of principal executive offices)
(Zip Code)

(201)  444-7100
(Registrant’s telephone number, including area code)

 
 (Former name, former address and former fiscal year, if changed since last report)

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

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 o  No  o

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

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

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

The number of shares outstanding, net of treasury stock, of the Issuer’s Common Stock, no par value, as of May 12, 2011 was 5,850,490.
 


 
 

 
 
Stewardship Financial Corporation

   
PAGE NUMBER
 
     
 
     
 
1
     
 
2
     
 
3
     
 
4
     
 
5 - 6
     
 
7 - 23
     
24 - 31
     
32
     
32
     
 
     
33
     
34
     
35
 
 
 



Item 1. Financial Statements

Stewardship Financial Corporation and Subsidiary
Consolidated Statements of Financial Condition
(Unaudited)

   
March 31,
2011
   
December 31,
2010
 
Assets
           
             
Cash and due from banks
  $ 28,643,000     $ 19,838,000  
Other interest-earning assets
    1,018,000       145,000  
Cash and cash equivalents
    29,661,000       19,983,000  
                 
Securities available for sale
    148,178,000       138,628,000  
Securities held to maturity; estimated fair value of $44,502,000 (2011) and $47,316,000 (2010)
               
      42,460,000       45,394,000  
FHLB-NY stock, at cost
    2,361,000       2,497,000  
Loans, net of allowance for loan losses of $9,874,000 (2011) and $8,490,000 (2010)
    449,548,000       443,245,000  
Mortgage loans held for sale
    827,000       9,818,000  
Premises and equipment, net
    6,320,000       6,395,000  
Accrued interest receivable
    2,671,000       2,806,000  
Other real estate owned
    313,000       615,000  
Bank owned life insurance
    9,900,000       9,819,000  
Other assets
    8,696,000       8,918,000  
Total assets
  $ 700,935,000     $ 688,118,000  
                 
Liabilities and stockholders' equity
               
                 
Liabilities
               
Deposits:
               
Noninterest-bearing
  $ 113,554,000     $ 99,723,000  
Interest-bearing
    477,955,000       475,880,000  
Total deposits
    591,509,000       575,603,000  
                 
Federal Home Loan Bank of New York Advances
    33,000,000       36,000,000  
Subordinated debentures
    7,217,000       7,217,000  
Securities sold under agreements to repurchase
    14,643,000       14,642,000  
Accrued interest payable
    839,000       977,000  
Accrued expenses and other liabilities
    1,501,000       1,547,000  
Total liabilities
    648,709,000       635,986,000  
                 
Commitments and contingencies
    -       -  
                 
Stockholders' equity
               
Preferred stock, no par value; 2,500,000 shares authorized; 10,000 shares
               
issued and outstanding at March 31, 2011 and December 31, 2010
               
Liquidation preference of $10,000,000
    9,811,000       9,796,000  
Common stock, no par value; 10,000,000 shares authorized;
               
5,850,470 and 5,847,844 shares issued: 5,850,470 and 5,846,927 shares
               
outstanding at March 31, 2011 and December 31, 2010, respectively
    40,536,000       40,516,000  
Treasury stock, 917 shares outstanding at December 31, 2010
    -       (13,000 )
Retained earnings
    2,009,000       1,959,000  
Accumulated other comprehensive loss, net
    (130,000 )     (126,000 )
Total stockholders' equity
    52,226,000       52,132,000  
                 
Total liabilities and stockholders' equity
  $ 700,935,000     $ 688,118,000  

See notes to unaudited consolidated financial statements.

 
1


Stewardship Financial Corporation and Subsidiary
Consolidated Statements of Income
(Unaudited)

   
Three Months Ended
March 31,
 
   
2011
   
2010
 
Interest income:
           
Loans
  $ 6,440,000     $ 6,874,000  
Securities held to maturity
               
Taxable
    183,000       422,000  
Non-taxable
    223,000       231,000  
Securities available for sale
               
Taxable
    839,000       880,000  
Non-taxable
    44,000       49,000  
FHLB dividends
    38,000       37,000  
Other interest-earning assets
    8,000       2,000  
Total interest income
    7,775,000       8,495,000  
                 
Interest expense:
               
Deposits
    1,289,000       1,820,000  
Borrowed money
    537,000       496,000  
Total interest expense
    1,826,000       2,316,000  
                 
Net interest income before provision for loan losses
    5,949,000       6,179,000  
Provision for loan losses
    1,675,000       1,550,000  
Net interest income after provision for loan losses
    4,274,000       4,629,000  
                 
Noninterest income:
               
Fees and service charges
    511,000       469,000  
Bank owned life insurance
    80,000       86,000  
Gain on sales of mortgage loans
    404,000       55,000  
Gain on calls and sales of securities
    -       328,000  
Other
    89,000       73,000  
Total noninterest income
    1,084,000       1,011,000  
                 
Noninterest expenses:
               
Salaries and employee benefits
    2,236,000       2,126,000  
Occupancy, net
    545,000       489,000  
Equipment
    258,000       309,000  
Data processing
    337,000       325,000  
FDIC insurance premium
    254,000       224,000  
Charitable contributions
    100,000       165,000  
Other
    954,000       786,000  
Total noninterest expenses
    4,684,000       4,424,000  
Income before income tax expense
    674,000       1,216,000  
Income tax expense
    191,000       345,000  
Net income
    483,000       871,000  
Dividends on preferred stock and accretion
    138,000       137,000  
Net income available to common stockholders
  $ 345,000     $ 734,000  
                 
Basic earnings per common share
  $ 0.06     $ 0.13  
Diluted earnings per common share
  $ 0.06     $ 0.13  
                 
Weighted average number of common shares outstanding
    5,849,723       5,839,974  
Weighted average number of diluted common
               
shares outstanding
    5,849,723       5,841,633  

See notes to unaudited consolidated financial statements.

 
2



Stewardship Financial Corporation and Subsidiary
Consolidated Statement of Changes in Stockholders' Equity
(Unaudited)

   
Three Months Ended March 31, 2011
 
                                 
Accumulated
       
                                 
Other
       
                                 
Comprehensive
       
   
Preferred
   
Common Stock
   
Retained
   
Treasury
   
Gain (Loss),
       
   
Stock
   
Shares
   
Amount
   
Earnings
   
Stock
   
Net
   
Total
 
                                           
Balance -- December 31, 2010
  $ 9,796,000       5,846,927     $ 40,516,000     $ 1,959,000     $ (13,000 )   $ (126,000 )   $ 52,132,000  
Cash dividends paid on common stock
    -       -       -       (293,000 )     -       -       (293,000 )
Payment of discount on dividend
                                                       
reinvestment plan
    -       -       (5,000 )     -       -       -       (5,000 )
Cash dividends accrued on preferred stock
    -       -       -       (125,000 )     -       -       (125,000 )
Common stock issued under stock plans
    -       3,543       12,000       -       13,000       -       25,000  
Stock option compensation expense
    -       -       13,000       -       -       -       13,000  
Accretion of discount on preferred stock
    13,000       -       -       (13,000 )     -               -  
Amortization of issuance costs
    2,000       -       -       (2,000 )     -               -  
Comprehensive income:
                                                       
Net income
    -       -       -       483,000       -       -       483,000  
Change in unrealized holding gains on
                                                       
securities available for sale arising during
                                                       
the period (net tax benefit of $47,000)
    -       -       -       -       -       (63,000 )     (63,000 )
Change in fair value of interest rate
                                                       
swap (net of tax expense of $39,000)
    -       -       -       -       -       59,000       59,000  
Total comprehensive income
                                                    479,000  
                                                         
Balance -- March 31, 2011
  $ 9,811,000       5,850,470     $ 40,536,000     $ 2,009,000     $ -     $ (130,000 )   $ 52,226,000  

   
Three Months Ended March 31, 2010
 
                                 
Accumulated
       
                                 
Other
       
                                 
Comprehensive
       
   
Preferred
   
Common Stock
   
Retained
   
Treasury
   
Gain (Loss),
       
   
Stock
   
Shares
   
Amount
   
Earnings
   
Stock
   
Net
   
Total
 
                                           
Balance -- December 31, 2009
  $ 9,736,000       5,834,515     $ 40,415,000     $ 2,922,000     $ -     $ 438,000     $ 53,511,000  
Cash dividends paid on common stock
    -       -       -       (526,000 )     -       -       (526,000 )
Payment of discount on dividend
                                                       
reinvestment plan
    -       -       (9,000 )     -       -       -       (9,000 )
Cash dividends accrued on preferred stock
    -       -       -       (125,000 )     -       -       (125,000 )
Common stock issued under stock plans
    -       3,037       24,000       -       -       -       24,000  
Stock option compensation expense
    -       -       13,000       -       -       -       13,000  
Stock options exercised
    -       9,376       55,000       -       (43,000 )     -       12,000  
Accretion of discount on preferred stock
    12,000       -       -       (12,000 )     -               -  
Amortization of issuance costs
    2,000       -       -       (2,000 )     -               -  
Comprehensive income:
                                                       
Net income
    -       -       -       871,000       -       -       871,000  
Change in unrealized holding gains on
                                                       
securities available for sale arising during
                                                       
the period (net tax expense of $76,000)
    -       -       -       -       -       141,000       141,000  
Reclassification adjustment for gains in
                                                       
net income (net of taxes of $131,000)
    -       -       -       -       -       196,000       196,000  
Change in fair value of interest rate
                                                       
swap (net of tax benefit of $70,000)
    -       -       -       -       -       (105,000 )     (105,000 )
Total comprehensive income
                                                    1,103,000  
                                                         
Balance -- March 31, 2010
  $ 9,750,000       5,846,928     $ 40,498,000     $ 3,128,000     $ (43,000 )   $ 670,000     $ 54,003,000  

See notes to unaudited consolidated financial statements.

 
3


Stewardship Financial Corporation and Subsidiary
Consolidated Statements of Comprehensive Income
(Unaudited)

   
Three Months Ended March 31,
 
   
2011
   
2010
 
             
Net income
  $ 483,000     $ 871,000  
                 
Other comprehensive (loss) income:
               
Change in unrealized holding (losses) gains on securities
               
available for sale arising during the period
    (110,000 )     872,000  
Reclassification adjustment for gains in net income
    -       (328,000 )
Net unrealized (losses) gains
    (110,000 )     544,000  
Tax effect
    47,000       (207,000 )
Net unrealized (losses) gains, net of tax amount
    (63,000 )     337,000  
                 
Change in fair value of interest rate swap
    98,000       (175,000 )
Tax effect
    (39,000 )     70,000  
Change in fair value of interest rate swap, net of tax amount
    59,000       (105,000 )
                 
Total other comprehensive (loss) income
    (4,000 )     232,000  
                 
Total comprehensive income
  $ 479,000     $ 1,103,000  

The following is a summary of the accumulated other comprehensive income balances, net of tax.

   
March 31, 2011
   
December 31, 2010
 
             
Unrealized gain on securities available for sale
  $ 209,000     $ 272,000  
Unrealized loss on fair value of interest rate swap
    (339,000 )     (398,000 )
                 
Accumulated other comprehensive income, net
  $ (130,000 )   $ (126,000 )
 
 
4


Stewardship Financial Corporation and Subsidiary
Consolidated Statements of Cash Flows
(Unaudited)

   
Three Months Ended
March 31,
 
   
2011
   
2010
 
Cash flows from operating activities:
           
Net income
  $ 483,000     $ 871,000  
Adjustments to reconcile net income to
               
net cash provided by operating activities:
               
Depreciation and amortization of premises and equipment
    153,000       214,000  
Amortization of premiums and accretion of discounts, net
    333,000       161,000  
Accretion of deferred loan fees
    (12,000 )     (14,000 )
Provision for loan losses
    1,675,000       1,550,000  
Originations of mortgage loans held for sale
    (24,113,000 )     (7,928,000 )
Proceeds from sale of mortgage loans
    33,508,000       5,919,000  
Gain on sales of mortgage loans
    (404,000 )     (55,000 )
Gain on sales and calls of securities
    -       (328,000 )
Deferred income tax benefit
    (600,000 )     (544,000 )
Decrease in accrued interest receivable
    135,000       122,000  
Decrease in accrued interest payable
    (138,000 )     (193,000 )
Earnings on bank owned life insurance
    (80,000 )     (86,000 )
Stock option expense
    13,000       13,000  
Decrease in other assets
    1,172,000       532,000  
Increase in other liabilities
    13,000       57,000  
Net cash provided by operating activities
    12,138,000       291,000  
                 
Cash flows from investing activities:
               
Purchase of securities available for sale
    (16,030,000 )     (3,085,000 )
Proceeds from maturities and principal repayments on securities available for sale
    5,101,000       3,944,000  
Proceeds from sales and calls on securities available for sale
    1,000,000       12,557,000  
Purchase of securities held to maturity
    -       (5,566,000 )
Proceeds from maturities and principal repayments on securities held to maturity
    1,868,000       1,443,000  
Proceeds from calls on securities held to maturity
    1,000,000       1,000,000  
Sale of FHLB-NY stock
    136,000       837,000  
Net increase in loans
    (7,966,000 )     (1,698,000 )
Additions to premises and equipment
    (78,000 )     (177,000 )
Net cash provided by (used in) investing activities
    (14,969,000 )     9,255,000  
                 
Cash flows from financing activities:
               
Net increase in noninterest-bearing deposits
    13,831,000       6,224,000  
Net increase in interest-bearing deposits
    2,075,000       6,776,000  
Net increase in securities sold under agreements to repurchase
    1,000       3,000  
Net decrease in short term borrowings
    -       (18,600,000 )
Repayment of long term borrowings
    (3,000,000 )     -  
Cash dividends paid on common stock
    (293,000 )     (526,000 )
Cash dividends paid on preferred stock
    (125,000 )     (125,000 )
Payment of discount on dividend reinvestment plan
    (5,000 )     (9,000 )
Exercise of stock options
    -       12,000  
Issuance of common stock
    25,000       24,000  
Net cash provided by (used in) financing activities
    12,509,000       (6,221,000 )
                 
Net increase in cash and cash equivalents
    9,678,000       3,325,000  
Cash and cash equivalents - beginning
    19,983,000       8,871,000  
Cash and cash equivalents - ending
  $ 29,661,000     $ 12,196,000  

 
5


Stewardship Financial Corporation and Subsidiary
Consolidated Statements of Cash Flows (continued)
(Unaudited)

   
Three Months Ended
March 31,
 
   
2010
   
2010
 
Supplemental disclosures of cash flow information:
           
Cash paid during the period for interest
  $ 1,964,000     $ 2,509,000  
Noncash investing activities - security purchases due brokers
  $ -     $ 3,523,000  

See notes to unaudited consolidated financial statements.

 
6


Stewardship Financial Corporation and Subsidiary
Notes to Consolidated Financial Statements
March 31, 2011
(Unaudited)

Note 1.  Summary of Significant Accounting Policies

Certain information and footnote disclosures normally included in the unaudited consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”).  These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Stewardship Financial Corporation Annual Report on Form 10-K for the fiscal year ended December 31, 2010, filed with the SEC on March 30, 2011 (the “2010 Annual Report”).

Principles of consolidation

The consolidated financial statements include the accounts of Stewardship Financial Corporation and its wholly owned subsidiary, Atlantic Stewardship Bank (the “Bank”), together referred to as “the Corporation”.  The Bank includes its wholly owned subsidiaries, Stewardship Investment Corporation, Stewardship Realty LLC, Atlantic Stewardship Insurance Company, LLC and several other subsidiaries formed to hold title to properties acquired through deed in lieu of foreclosure.  The Bank’s subsidiaries have an insignificant impact on the daily operations.  All intercompany accounts and transactions have been eliminated in the consolidated financial statements.  Certain prior period amounts have been reclassified to conform to the current presentation.

The consolidated financial statements of the Corporation have been prepared in conformity with U.S. generally accepted accounting principles (“GAAP”).  In preparing the financial statements, management is required to make estimates and assumptions, based on available information, that affect the amounts reported in the financial statements and disclosures provided.  Actual results could differ significantly from those estimates.

Material estimates

Material estimates that are particularly susceptible to significant changes relate to the determination of the allowance for loan losses and fair value of financial instruments.  Management believes that the allowance for loan losses is adequate.  While management uses available information to recognize probable incurred losses on loans, future additions to the allowance for loan losses may be necessary based on changes in economic conditions in the market area.

Basis of presentation

The interim unaudited consolidated financial statements included herein have been prepared in accordance with instructions for Form 10-Q and the rules and regulations of the SEC and, therefore, do not include information or footnotes necessary for a complete presentation of consolidated financial condition, results of operations, and cash flows in conformity with GAAP.  However, all adjustments, consisting only of normal recurring adjustments, which in the opinion of management are necessary for a fair presentation of the interim consolidated financial statements, have been included.  The results of operations for the three months ended March 31, 2011 are not necessarily indicative of the results which may be expected for the entire year.

Derivatives

Derivative financial instruments are recognized as assets or liabilities at fair value.  The Corporation’s derivative consists of an interest rate swap agreement, which is used as part of its asset liability management strategy to help manage interest rate risk related to its subordinated debentures issued in 2003 to Stewardship Statutory Trust I (the “Trust”), a statutory business trust (see Note 8 to the Notes to the Audited Consolidated Financial Statements of the Corporation contained in the 2010 Annual Report).  The Corporation does not use derivatives for trading purposes.

The Corporation designated the hedge as a cash flow hedge, which is a hedge of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability.  For a cash flow hedge, the gain or loss on the derivative is reported in other comprehensive income and is reclassified into earnings in the same periods during which the hedged transaction affects earnings.  Net cash settlements on derivatives that qualify for hedge accounting are recorded in interest income or interest expense, based on the item being hedged.

 
7


The Corporation formally documented the risk-management objective and the strategy for undertaking hedge transactions at the inception of the hedging relationship.  This documentation includes linking the fair value of cash flow hedge to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions.  The Corporation formally assessed, both at the hedge’s inception and on an ongoing basis, whether the derivative instrument used is highly effective in offsetting changes in fair values or cash flows of the hedged items.

When a cash flow hedge is discontinued but the hedged cash flows or forecasted transactions are still expected to occur, gains or losses that would be accumulated in other comprehensive income are amortized into earnings over the same periods in which the hedged transactions will affect earnings.

Recent Accounting Pronouncements

In April 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2011-02, “Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring”.  This ASU provides additional guidance for companies when determining whether a loan modification constitutes a troubled debt restructuring.  The ASU also provides additional disclosure requirements.  The guidance on identifying and disclosing troubled debt restructurings is effective for interim and annual periods beginning on or after June 15, 2011 and applies retroactively to restructurings occurring on or after the beginning of the year.  The guidance on measuring the impairment of a receivable restructured in a troubled debt restructuring is effective on a prospective basis.  Early adoption is allowed.  The Corporation does not expect the adoption of this ASU to have a significant impact on the Corporation’s consolidated financial statements.

Note 2.   Securities – Available for Sale and Held to Maturity

The fair value of the available for sale securities and the related gross unrealized gains and losses recognized in accumulated other comprehensive income were as follows:

   
March 31, 2011
 
   
Amortized
   
Gross Unrealized
   
Fair
 
   
Cost
   
Gains
   
Losses
   
Value
 
                         
U.S. Treasury
  $ 15,202,000     $ 77,000     $ 29,000     $ 15,250,000  
U.S. government-sponsored agencies
    16,081,000       71,000       109,000       16,043,000  
Obligations of state and political
                               
subdivisions
    6,242,000       148,000       64,000       6,326,000  
Mortgage-backed securities - residential
    107,135,000       1,074,000       846,000       107,363,000  
Other equity investments
    3,173,000       23,000       -       3,196,000  
    $ 147,833,000     $ 1,393,000     $ 1,048,000     $ 148,178,000  

   
December 31, 2010
 
   
Amortized
   
Gross Unrealized
   
Fair
 
   
Cost
   
Gains
   
Losses
   
Value
 
                         
U.S. Treasury
  $ 9,141,000     $ 109,000     $ 1,000     $ 9,249,000  
U.S. government-sponsored agencies
    13,600,000       97,000       111,000       13,586,000  
Obligations of state and political
                               
subdivisions
    4,219,000       79,000       19,000       4,279,000  
Mortgage-backed securities - residential
    108,078,000       1,169,000       920,000       108,327,000  
Other equity investments
    3,135,000       52,000       -       3,187,000  
    $ 138,173,000     $ 1,506,000     $ 1,051,000     $ 138,628,000  
 
 
8


The following is a summary of the held to maturity securities and related unrecognized gains and losses:

   
March 31, 2011
 
   
Amortized
   
Gross Unrecognized
   
Fair
 
   
Cost
   
Gains
   
Losses
   
Value
 
                         
U.S. government-sponsored agencies
  $ 2,797,000     $ 112,000       -     $ 2,909,000  
Obligations of state and political
                               
subdivisions
    25,948,000       1,279,000       1,000       27,226,000  
Mortgage-backed securities - residential
    13,715,000       652,000       -       14,367,000  
    $ 42,460,000     $ 2,043,000     $ 1,000     $ 44,502,000  

   
December 31, 2010
 
   
Amortized
   
Gross Unrecognized
   
Fair
 
   
Cost
   
Gains
   
Losses
   
Value
 
                         
U.S. government-sponsored agencies
  $ 4,208,000     $ 146,000     $ -     $ 4,354,000  
Obligations of state and political
                               
subdivisions
    26,148,000       1,046,000       20,000       27,174,000  
Mortgage-backed securities - residential
    15,038,000       750,000       -       15,788,000  
    $ 45,394,000     $ 1,942,000     $ 20,000     $ 47,316,000  

The following tables summarize the fair value and unrealized losses of those investment securities which reported an unrealized loss at March 31, 2011 and December 31, 2010, and if the unrealized loss was continuous for the twelve months prior to March 31, 2011 and December 31, 2010.

 
9


Available for Sale
                                   
March 31, 2011
 
Less than 12 Months
   
12 Months or Longer
   
Total
 
   
Fair
Value
   
Unrealized
Losses
   
Fair
Value
   
Unrealized
Losses
   
Fair
Value
   
Unrealized
Losses
 
                                     
U.S. Treasury
  $ 8,576,000     $ (29,000 )   $ -     $ -     $ 8,576,000     $ (29,000 )
U.S. government-
                                               
sponsored agencies
    5,911,000       (109,000 )     -       -       5,911,000       (109,000 )
Obligations of state and
                                               
political subdivisions
    1,840,000       (64,000 )     -       -       1,840,000       (64,000 )
Mortgage-backed
                                               
securities - residential
    56,894,000       (846,000 )     -       -       56,894,000       (846,000 )
Other equity investments
    -       -       -       -       -       -  
Total temporarily
                                               
impaired securities
  $ 73,221,000     $ (1,048,000 )   $ -     $ -     $ 73,221,000     $ (1,048,000 )

December 31, 2010
 
Less than 12 Months
   
12 Months or Longer
   
Total
 
   
Fair
Value
   
Unrealized
Losses
   
Fair
Value
   
Unrealized
Losses
   
Fair
Value
   
Unrealized
Losses
 
                                     
U.S. Treasury
  $ 1,522,000     $ (1,000 )   $ -     $ -     $ 1,522,000     $ (1,000 )
U.S. government-
                                               
sponsored agencies
    3,418,000       (111,000 )     -       -       3,418,000       (111,000 )
Obligations of state and
                                               
political subdivisions
    1,153,000       (19,000 )     -       -       1,153,000       (19,000 )
Mortgage-backed
                                               
securities - residential
    39,179,000       (920,000 )     -       -       39,179,000       (920,000 )
Other equity investments
    -       -       -       -       -       -  
Total temporarily
                                               
impaired securities
  $ 45,272,000     $ (1,051,000 )   $ -     $ -     $ 45,272,000     $ (1,051,000 )

Held to Maturity
                                   
March 31, 2011
 
Less than 12 Months
   
12 Months or Longer
   
Total
 
   
Fair
Value
   
Unrecognized
Losses
   
Fair
Value
   
Unrecognized
Losses
   
Fair
Value
   
Unrecognized
Losses
 
                                     
U.S. government-
                                   
sponsored agencies
  $ -     $ -     $ -     $ -     $ -     $ -  
Obligations of state and
                                               
political subdivisions
    1,021,000       (1,000 )     -       -       1,021,000       (1,000 )
Mortgage-backed
                                               
securities - residential
    -       -       -       -       -       -  
Total temporarily
                                               
impaired securities
  $ 1,021,000     $ (1,000 )   $ -     $ -     $ 1,021,000     $ (1,000 )

December 31, 2010
 
Less than 12 Months
   
12 Months or Longer
   
Total
 
   
Fair
Value
   
Unrecognized
Losses
   
Fair
Value
   
Unrecognized
Losses
   
Fair
Value
   
Unrecognized
Losses
 
                                     
U.S. government-
                                   
sponsored agencies
  $ -     $ -     $ -     $ -     $ -     $ -  
Obligations of state and
                                               
political subdivisions
    1,403,000       (20,000 )     -       -       1,403,000       (20,000 )
Mortgage-backed
                                               
securities - residential
    -       -       -       -       -       -  
Total temporarily
                                               
impaired securities
  $ 1,403,000     $ (20,000 )   $ -     $ -     $ 1,403,000     $ (20,000 )

 
10


Other-Than-Temporary-Impairment

At March 31, 2011 there were no securities in a continuous loss position for 12 months or longer.  The Corporation’s unrealized losses are primarily due to the changes in interest rates and other market conditions.  These securities have not been considered other than temporarily impaired as scheduled principal and interest payments have been made and management anticipates collecting the entire principal balance as scheduled.  Because the decline in fair value is attributable to changes in market conditions, and not credit quality, and because the Corporation does not have the intent to sell these securities and it is likely that it will not be required to sell the securities before their anticipated recovery, the Corporation does not consider these securities to be other-than-temporarily impaired at March 31, 2011.

Note 3.   Loans and Nonperforming Loans

The following table sets forth the composition of loans:

   
March 31,
2011
   
December 31,
2010
 
             
Commercial:
       
 
 
Secured by real estate
  $ 63,126,000     $ 65,200,000  
Other
    42,404,000       44,327,000  
Commercial real estate
    235,620,000       219,875,000  
Construction:
               
Commercial
    25,116,000       28,652,000  
Residential
    279,000       875,000  
Residential real estate
    45,892,000       42,145,000  
Consumer:
               
Secured by real estate 
    45,702,000       49,360,000  
Other
    1,308,000       1,280,000  
Other
    60,000       152,000  
Total gross loans 
    459,507,000       451,866,000  
                 
Less:  Deferred loan cost, net of fees
    85,000       131,000  
Allowance for loan losses
    9,874,000       8,490,000  
      9,959,000       8,621,000  
                 
Loans, net 
  $ 449,548,000     $ 443,245,000  
 
 
11


Activity in the allowance for loan losses is summarized as follows:

   
Three Months Ended March 31,
 
   
2011
   
2010
 
             
Balance, beginning of period
  $ 8,490,000     $ 6,920,000  
Provision charged to operations
               
Commercial:
               
Secured by real estate
    1,201,000          
Other
    150,000          
Commercial real estate
    297,000          
Construction:
               
Commercial
    (166,000 )        
Residential
    (3,000 )        
Residential real estate
    104,000          
Consumer:
               
Secured by real estate
    82,000          
Other
    (1,000 )        
Other
    3,000          
Unallocated
    8,000          
Total provision charged to operations
    1,675,000       1,550,000  
                 
Loans charged off
               
Commercial:
               
Secured by real estate
    91,000          
Other
    37,000          
Commercial real estate
    104,000          
Construction:
               
Commercial
    9,000          
Residential
    -          
Residential real estate
    -          
Consumer:
               
Secured by real estate
    59,000          
Other
    -          
Other
    3,000          
Total loans charged off
    303,000       369,000  
                 
Recoveries of loans charged off
               
Commercial:
               
Secured by real estate
    10,000          
Other
    1,000          
Commercial real estate
    -          
Construction:
               
Commercial
    -          
Residential
    -          
Residential real estate
    -          
Consumer:
               
Secured by real estate
    -          
Other
    -          
Other
    1,000          
Total recoveries of loans charged off
    12,000       73,000  
Balance, end of period
  $ 9,874,000     $ 8,174,000  
 
 
12


The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on the impairment method as of March 31, 2011 and December 31, 2010.
 
   
March 31, 2011
 
   
Commercial
   
Commercial
Real Estate
   
Construction
   
Residential
Real Estate
   
Consumer
   
Other
Loans
   
Unallocated
   
Total
 
                                                 
Allowance for loan
                                               
losses:
                                               
Ending allowance
                                               
balance attributable
                                               
to loans
                                               
                                                 
Individually
                                               
evaluated for
                                               
impairment
  $ 2,167,000     $ 157,000     $ 35,000     $ 10,000     $ -     $ -     $ -     $ 2,369,000  
                                                                 
Collectively
                                                               
evaluated for
                                                               
impairment
    2,812,000       3,148,000       717,000       278,000       532,000       3,000       15,000       7,505,000  
Total ending
                                                               
allowance
                                                               
balance
  $ 4,979,000     $ 3,305,000     $ 752,000     $ 288,000     $ 532,000     $ 3,000     $ 15,000     $ 9,874,000  
                                                                 
Loans:
                                                               
Loans
                                                               
individually
                                                               
evaluated for
                                                               
impairment
  $ 7,987,000     $ 11,912,000     $ 2,296,000     $ 1,106,000     $ 829,000     $ -     $ -     $ 24,130,000  
                                                                 
Loans
                                                               
collectively
                                                               
evaluated for
                                                               
impairment
    97,543,000       223,708,000       23,099,000       44,786,000       46,181,000       60,000       -       435,377,000  
Total ending
                                                               
loan balance
  $ 105,530,000     $ 235,620,000     $ 25,395,000     $ 45,892,000     $ 47,010,000     $ 60,000     $ -     $ 459,507,000  

 
13


   
December 31, 2010
 
   
Commercial
   
Commercial
Real Estate
   
Construction
   
Residential
Real Estate
   
Consumer
   
Other
Loans
   
Unallocated
   
Total
 
                                                 
Allowance for loan
                                               
losses:
                                               
Ending allowance
                                               
balance attributable
                                               
to loans
                                               
                                                 
Individually
                                               
evaluated for
                                               
impairment
  $ 1,336,000     $ 276,000     $ 29,000     $ 3,000     $ -     $ -     $ -     $ 1,644,000  
                                                                 
Collectively
                                                               
evaluated for
                                                               
impairment
    2,409,000       2,836,000       901,000       181,000       510,000       2,000       7,000       6,846,000  
Total ending
                                                               
allowance
                                                               
balance
  $ 3,745,000     $ 3,112,000     $ 930,000     $ 184,000     $ 510,000     $ 2,000     $ 7,000     $ 8,490,000  
                                                                 
Loans:
                                                               
Loans
                                                               
individually
                                                               
evaluated for
                                                               
impairment
  $ 7,852,000     $ 10,540,000     $ 2,303,000     $ 1,106,000     $ 829,000     $ -     $ -     $ 22,630,000  
                                                                 
Loans
                                                               
collectively
                                                               
evaluated for
                                                               
impairment
    101,675,000       209,335,000       27,224,000       41,039,000       49,811,000       152,000       -       429,236,000  
Total ending
                                                               
loan balance
  $ 109,527,000     $ 219,875,000     $ 29,527,000     $ 42,145,000     $ 50,640,000     $ 152,000     $ -     $ 451,866,000  

The following table presents the recorded investment in nonaccrual loans in the periods indicated:

   
March 31,
2011
   
December 31,
2010
 
             
Commercial:
           
Secured by real estate
  $ 6,139,000     $ 5,924,000  
Other
    1,728,000       1,798,000  
Commercial real estate
    11,912,000       10,540,000  
Construction:
               
Commercial
    2,017,000       2,020,000  
Residential
    279,000       283,000  
Residential real estate
    1,106,000       1,106,000  
Consumer:
               
Secured by real estate
    829,000       829,000  
Other
    -       -  
Other
    -       -  
                 
Total nonperfoming loans
  $ 24,010,000     $ 22,500,000  

 
14


The following presents loans individually evaluated for impairment by class of loans as of the periods indicated:

 
At and for the three months ended March 31, 2011
 
   
Unpaid
Principal
Balance
   
Recorded
Investment
   
Allowance for
Loan Losses
Allocated
   
Average
Recorded
Investment
   
Interest
Income
Recognized
 
                               
With no related allowance recorded:
                             
Commercial:
                             
Secured by real estate
  $ 1,623,000     $ 1,342,000           $ 1,127,000     $ -  
Other
    300,000       287,000             453,000       2,000  
Commercial real estate
    5,282,000       4,561,000             4,380,000       -  
Construction:
                                     
Commercial
    1,549,000       1,501,000             1,503,000       -  
Residential
    281,000       279,000             281,000       -  
Residential real estate
    287,000       287,000             502,000       -  
Consumer:
                                     
Secured by real estate
    1,037,000       829,000             829,000       -  
Other
    -       -             -       -  
Other
    -       -             -       -  
                                       
With an allowance recorded:
                                     
Commercial:
                                     
Secured by real estate
    5,667,000       4,797,000     $ 1,412,000       4,905,000       -  
Other
    1,578,000       1,561,000       755,000       1,436,000       -  
Commercial real estate
    7,829,000       7,351,000       157,000       6,846,000       -  
Construction:
                                       
Commercial
    959,000       516,000       35,000       516,000       -  
Residential
    -       -       -       -       -  
Residential real estate
    844,000       819,000       10,000       605,000       -  
Consumer:
                                       
Secured by real estate
    -       -       -       -       -  
Other
    -       -       -       -       -  
Other
    -       -       -       -       -  
Total nonperfoming loans
  $ 27,236,000     $ 24,130,000     $ 2,369,000     $ 23,383,000     $ 2,000  

 
15

 
   
At and for the year ended December 31, 2010
 
   
Unpaid Principal
Balance
   
Recorded
Investment
   
Allowance for
Loan Losses
Allocated
   
Average
Recorded
Investment
   
Interest
Income
Recognized
 
                               
With no related allowance recorded:
                             
Commercial:
                             
Secured by real estate
  $ 1,037,000     $ 911,000                        
Other
    646,000       618,000                        
Commercial real estate
    4,808,000       4,199,000                        
Construction:
                                     
Commercial
    1,540,000       1,504,000                        
Residential
    284,000       283,000                        
Residential real estate
    716,000       716,000                        
Consumer:
                                     
Secured by real estate
    1,037,000       829,000                        
Other
    -       -                        
Other
    -       -                        
                                       
With an allowance recorded:
                                     
Commercial:
                                     
Secured by real estate
    6,056,000       5,013,000     $ 730,000                  
Other
    1,311,000       1,310,000       606,000                  
Commercial real estate
    6,777,000       6,341,000       276,000                  
Construction:
                                       
Commercial
    959,000       516,000       29,000                  
Residential
    -       -       -                  
Residential real estate
    415,000       390,000       3,000                  
Consumer:
                                       
Secured by real estate
    -       -       -                  
Other
    -       -       -                  
Other
    -       -       -                  
Total nonperfoming loans
  $ 25,586,000     $ 22,630,000     $ 1,644,000     $ 23,766,000     $ 216,000  
 
The following table presents the aging of the recorded investment in past due loans by class of loans as of March 31, 2011 and December 31, 2010.  Nonaccrual loans are included in the disclosure by payment status.
 
   
March 31, 2011
 
   
30-59 Days
Past Due
   
60-89 Days
Past Due
   
Greater than
90 Days
Past Due
   
Total
Past Due
   
Loans
Not
Past Due
   
Total
 
                                     
Commercial:
                                   
Secured by real estate
  $ 3,233,000     $ 414,000     $ 5,565,000     $ 9,212,000     $ 53,914,000     $ 63,126,000  
Other
    50,000       -       1,728,000       1,778,000       40,626,000       42,404,000  
Commercial real estate:
    7,212,000       213,000       10,550,000       17,975,000       217,645,000       235,620,000  
Construction:
                                               
Commercial
    272,000       -       916,000       1,188,000       23,928,000       25,116,000  
Residential
    -       -       279,000       279,000       -       279,000  
Residential real estate
    1,302,000       -       1,106,000       2,408,000       43,484,000       45,892,000  
Consumer:
                                               
Secured by real estate
    290,000       -       829,000       1,119,000       44,583,000       45,702,000  
Other
    2,000       -       -       2,000       1,306,000       1,308,000  
Other
    -       -       -       -       60,000       60,000  
Total
  $ 12,361,000     $ 627,000     $ 20,973,000     $ 33,961,000     $ 425,546,000     $ 459,507,000  

 
16


   
December 31, 2010
 
   
30-59 Days
Past Due
   
60-89 Days
Past Due
   
Greater than
90 Days
Past Due
   
Total
Past Due
   
Loans
Not
Past Due
   
Total
 
                                     
Commercial:
                                   
Secured by real estate
  $ 490,000     $ 4,014,000     $ 2,296,000     $ 6,800,000     $ 58,400,000     $ 65,200,000  
Other
    -       -       1,798,000       1,798,000       42,529,000       44,327,000  
Commercial real estate:
    1,789,000       2,324,000       6,650,000       10,763,000       209,112,000       219,875,000  
Construction:
                                               
Commercial
    -       2,731,000       916,000       3,647,000       25,005,000       28,652,000  
Residential
    -       -       283,000       283,000       592,000       875,000  
Residential real estate
    -       458,000       1,106,000       1,564,000       40,581,000       42,145,000  
Consumer:
                                               
Secured by real estate
    114,000       449,000       829,000       1,392,000       47,968,000       49,360,000  
Other
    3,000       -       -       3,000       1,277,000       1,280,000  
Other
    -       -       -       -       152,000       152,000  
Total
  $ 2,396,000     $ 9,976,000     $ 13,878,000     $ 26,250,000     $ 425,616,000     $ 451,866,000  

The Corporation currently has one loan for $120,000 which is a troubled debt restructuring that is performing in accordance with its new terms.

The Corporation categorizes loans into risk categories based on relevant information about the ability of the borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors.  The Corporation analyzes loans individually by classifying the loans as to credit risk.  This analysis includes non-homogeneous loans, such as commercial, commercial real estate and commercial construction loans.  This analysis is performed at the time the loan is originated and annually thereafter.  The Corporation uses the following definitions for risk ratings.

 
Special Mention – A Special Mention asset has potential weaknesses that deserve management’s close attention, which, if left uncorrected, may result in deterioration of the repayment prospects for the asset or the Bank’s credit position at some future date. Special Mention assets are not adversely classified and do not expose the Bank to sufficient risk to warrant adverse classification. While potentially weak, the borrower is currently marginally acceptable and loss of principal or interest is not presently envisioned.

 
Substandard – Substandard loans are inadequately protected by the current net worth and paying capacity of the obligor or by the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the repayment and 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.

 
Doubtful – A loan with all weaknesses inherent in those classified as Substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently know facts, conditions, and values, highly questionable or improbable. The likelihood of loss is extremely high, but because of certain important and reasonably specific factors, an estimated loss is deferred until a more exact status can be determined.

 
Loss – A loan classified Loss is considered uncollectible and of such little value that its continuance as an asset is not warranted. This classification does not necessarily mean that an asset has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off a basically worthless asset even though partial recovery may be effected in the future.

Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans.  As of March 31, 2011 and December 31, 2010, and based on the most recent analysis performed at those times, the risk category of loans by class is as follows:

 
17


   
March 31, 2011
 
   
Pass
   
Special
Mention
   
Substandard
   
Doubtful
   
Loss
   
Total
 
                                     
Commercial:
                                   
Secured by real estate
  $ 56,987,000     $ 867,000     $ 2,074,000     $ 3,198,000     $ -     $ 63,126,000  
Other
    40,557,000       583,000       -       1,264,000       -       42,404,000  
Commercial real estate:
    223,709,000       5,689,000       5,440,000       782,000       -       235,620,000  
Construction:
                                               
Commercial
    23,098,000       1,611,000       407,000       -       -       25,116,000  
Residential
    -       279,000       -       -       -       279,000  
Total
  $ 344,351,000     $ 9,029,000     $ 7,921,000     $ 5,244,000     $ -     $ 366,545,000  

   
December 31, 2010
 
   
Pass
   
Special
Mention
   
Substandard
   
Doubtful
   
Loss
   
Total
 
                                     
Commercial:
                                   
Secured by real estate
  $ 59,206,000     $ 4,173,000     $ 1,801,000     $ -     $ 20,000     $ 65,200,000  
Other
    42,399,000       618,000       -       1,267,000       43,000       44,327,000  
Commercial real estate:
    209,512,000       4,668,000       5,695,000       -       -       219,875,000  
Construction:
                                               
Commercial
    26,631,000       1,614,000       407,000       -       -       28,652,000  
Residential
    592,000       283,000       -       -       -       875,000  
Total
  $ 338,340,000     $ 11,356,000     $ 7,903,000     $ 1,267,000     $ 63,000     $ 358,929,000  

For residential real estate and consumer loan segments, the Corporation also evaluates credit quality based on payment activity.  The following table presents the recorded investment in residential real estate and consumer loans based on payment activity as of March 31, 2011 and December 31, 2010.  For purposes of the following table, nonperforming represents loans that are 30 days or more past due:

   
March 31, 2011
 
   
Performing
   
Nonperforming
   
Total
 
                   
Residential real estate
  $ 43,483,000     $ 2,409,000     $ 45,892,000  
Consumer:
                       
Secured by real estate
    44,583,000       1,119,000       45,702,000  
Other
    1,306,000       2,000       1,308,000  
Total
  $ 89,372,000     $ 3,530,000     $ 92,902,000  

   
December 31, 2010
 
   
Performing
   
Nonperforming
   
Total
 
                   
Residential real estate
  $ 40,581,000     $ 1,564,000     $ 42,145,000  
Consumer:
                       
Secured by real estate
    47,968,000       1,392,000       49,360,000  
Other
    1,277,000       3,000       1,280,000  
Total
  $ 89,826,000     $ 2,959,000     $ 92,785,000  

Note 4.   Interest Rate Swap

The Corporation utilizes interest rate swap agreements as part of its asset liability management strategy to help manage its interest rate risk position.  The notional amount of the interest rate swaps does not represent amounts exchanged by the parties.  The amount exchanged is determined by reference to the notional amount and the other terms of the individual interest rate swap agreements.

 
18


Interest Rate Swap Designated as Cash Flow Hedge:  During the second quarter of 2009, the Corporation entered into a swap with an effective date of March 17, 2010.  An interest rate swap with a notional amount of $7 million was designated as a cash flow hedge of the subordinated debentures and was determined to be fully effective during the three months ended March 31, 2011.  As such, no amount of ineffectiveness has been included in net income.  Therefore, the aggregate fair value of the swap is recorded in other assets (liabilities) with changes in fair value recorded in other comprehensive income (loss).  The amount included in accumulated other comprehensive income (loss) would be reclassified to current earnings should the hedge no longer be considered effective.  The Corporation expects the hedge to remain fully effective during the remaining term of the swap.  As of March 31, 2011, the interest rate swap is secured by investment securities with a fair value of $1,043,000.

Summary information about the interest rate swap designated as a cash flow hedge as of March 31, 2011 is as follows:

Notional amount
    $7,000,000  
Pay rate
    7.00%  
Receive rate
 
3 month LIBOR plus 2.95%
 
Maturity
 
March 17, 2016
 
Unrealized loss
    $(566,000)  

The net expense recorded on the swap transaction totaled $66,000 and $10,000 for the quarters ended March 31, 2011 and 2010, respectively, and is reported as a component of interest expense – borrowed money.

The fair value of the interest rate swap of $566,000 and $664,000 at March 31, 2011 and December 31, 2010, respectively, was included in accrued expenses and other liabilities on the Consolidated Statements of Financial Condition.
 

Cash Flow Hedging Relationship
 
Amount of Gain (Loss), Net of Taxes,
Recognized in Other Comprehensive Income
on Derivative (Effective Portion)
 
   
For the three months ended March 31,
 
   
2011
   
2010
 
             
Cash flow hedge
  $ 59,000     $ (105,000 )
 
Note 5.   Fair Value of Financial Instruments

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in an orderly transaction between market participants on the measurement date.  There are three levels of inputs that may be used to measure fair value:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The fair values of investment securities are determined by matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs).

The interest rate swaps are reported at fair values obtained from brokers who utilize internal models with observable market data inputs to estimate the values of these instruments (Level 2 inputs).

The Corporation measures impairment of collateralized loans based on the estimated fair value of the collateral less estimated costs to sell, incorporating assumptions that experienced parties might use in estimating the value of such collateral (Level 3 inputs).

 
19


Assets and Liabilities Measured on a Recurring Basis

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

   
Fair Value Measurements Using:
 
   
Carrying
Value
   
Quoted Prices in
Active Markets
for Identical
Assets
(Level 1)
   
Significant
Other
Observable
Inputs
(Level 2)
   
Significant
Unobservable
Inputs
(Level 3)
 
   
At March 31, 2011
 
Assets:
                       
Available for sale securities
                       
U.S. Treasuries
  $ 15,250,000     $ -       15,250,000     $ -  
U.S. government -
                               
sponsered agencies
    16,043,000       -       16,043,000       -  
Obligations of state and
                               
political subdivisions
    6,326,000       -       6,326,000       -  
Mortgage-backed
                               
securities - residential
    107,363,000       -       107,363,000       -  
Other equity investments
    3,196,000       -       3,196,000       -  
Total available for
                               
sale securities
  $ 148,178,000     $ -     $ 148,178,000     $ -  
                                 
Liabilities:
                               
Interest rate swap
  $ 566,000     $ -     $ 566,000     $ -  

   
At December 31, 2010
 
Assets:
                       
Available for sale securities
                       
U.S. Treasuries
  $ 9,249,000     $ -     $ 9,249,000     $ -  
U.S. government -
                               
sponsered agencies
    13,586,000       -       13,586,000       -  
Obligations of state and
                               
political subdivisions
    4,279,000       -       4,279,000       -  
Mortgage-backed
                               
securities - residential
    108,327,000       -       108,327,000       -  
Other equity investments
    3,187,000       -       3,187,000       -  
Total available for
                               
sale securities
  $ 138,628,000     $ -     $ 138,628,000     $ -  
                                 
Liabilities:
                               
Interest rate swap
  $ 664,000     $ -     $ 664,000     $ -  

 
20


Assets and Liabilities Measured on a Non-Recurring Basis

Assets and liabilities measured at fair value on a non-recurring basis are summarized below:

         
Fair Value Measurements Using:
 
   
Carrying
Value
   
Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)
   
Significant
Other
Observable
Inputs
(Level 2)
   
Significant
Unobservable
Inputs
(Level 3)
 
   
At March 31, 2011
 
Assets:
                       
Impaired loans
                       
Commercial:
                       
Secured by real estate
  $ 3,385,000     $ -     $ -     $ 3,385,000  
Other
    498,000       -       -       498,000  
Commercial real estate
    7,194,000       -       -       7,194,000  
Construction:
                               
Commercial
    481,000       -       -       481,000  
Residential
    809,000       -       -       809,000  
    $ 12,367,000     $ -     $ -     $ 12,367,000  

   
At December 31, 2010
 
Assets:
                       
Impaired loans
                       
Commercial:
                       
Secured by real estate
  $ 4,283,000     $ -     $ -     $ 5,326,000  
Other
    704,000       -       -       704,000  
Commercial real estate
    6,065,000       -       -       6,065,000  
Construction:
                               
Commercial
    487,000       -       -       487,000  
Residential
    387,000       -       -       387,000  
    $ 11,926,000     $ -     $ -     $ 12,969,000  
 
Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $15,044,000 at March 31, 2011, with a valuation allowance of $2,677,000, resulting in an additional provision for loan losses of $1,265,000 for the three months ended March 31, 2011.

Impaired loans had a carrying amount of $13,570,000 with a valuation allowance of $1,644,000, resulting in an additional provision for loan losses of $1,886,000 for year ended December 31, 2010.

Fair value estimates, methods and assumptions are set forth below for the Corporation’s financial instruments.

 
21

 
   
March 31, 2011
   
December 31, 2010
 
   
Carrying
Amount
   
Estimated
Fair Value
   
Carrying
Amount
   
Estimated
Fair Value
 
   
(Dollars in thousands)
 
Financial assets:
                       
Cash and cash equivalents
  $ 29,661,000     $ 29,661,000     $ 19,983,000     $ 19,983,000  
Securities available for sale
    148,178,000       148,178,000       138,628,000       138,628,000  
Securities held to maturity
    42,460,000       44,502,000       45,394,000       47,316,000  
FHLB-NY stock
    2,361,000       N/A       2,497,000       N/A  
Net loans
    449,548,000       453,004,000       443,245,000       445,671,000  
Accrued interest receivable
    2,671,000       2,671,000       2,806,000       2,806,000  
                                 
Financial liabilities:
                               
Deposits
    591,509,000       592,871,000       575,603,000       577,485,000  
FHLB-NY Advances
    33,000,000       31,774,000       36,000,000       33,892,000  
Securities sold under agreements
                               
to repurchase
    14,643,000       14,643,000       14,642,000       14,642,000  
Subordinated debenture
    7,217,000       6,932,000       7,217,000       6,803,000  
Accrued interest payable
    839,000       839,000       977,000       977,000  
Interest rate swap
    566,000       566,000       664,000       664,000  

The following methods and assumptions were used to estimate the fair value of each class of financial instruments:

Cash and cash equivalents – The carrying amount approximates fair value.
Securities available for sale and held to maturity – The methods for determining fair values were described previously.
FHLB-NY stock – It is not practicable to determine the fair value of stock of the Federal Home Loan Bank of New York (“FHLB-NY”) due to restrictions placed on the transferability of the stock.
Net loans – Fair values are estimated for portfolios of loans with similar financial characteristics.  Loans are segregated by type such as residential and commercial mortgages, commercial and other installment.  The fair value of loans is estimated by discounting cash flows using estimated marked discount rates which reflect the credit and interest rate risk inherent in the loans.
Accrued interest receivable – The carrying amount approximates fair value.
Deposits – The fair value of deposits, with no stated maturity, such as noninterest-bearing demand deposits, savings, NOW and money market accounts, is equal to the amount payable on demand.  The fair value of the certificates of deposit is based on the discounted value of cash flows.  The discount rate is estimated using marked discount rates which reflect interest rate risk inherent in the certificates of deposit.
FHLB-NY advances – With respect to the FHLB-NY borrowings, the carrying amount of the borrowings which mature in one day approximates fair value.  For borrowings with a longer maturity, the fair value is based on the discounted value of cash flows.  The discount rate is estimated using market discount rates which reflect the interest rate risk inherent in the term borrowings.
Securities sold under agreements to repurchase – The carrying value approximates fair value due to the relatively short time before maturity.
Subordinated debenture – The fair value of the subordinated debenture is based on the discounted value of cash flows.  The discount rate is estimated using market rates which reflect the interest rate risk inherent in the debenture.
Accrued interest payable – The carrying amount approximates fair value.
Interest rate swap – The methods for determining fair values were described previously.
Commitments to extend credit – The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present credit worthiness of the counter parties, and at March 31, 2011 and December 31, 2010 the fair value of such commitments were not material.

Limitations

The preceding fair value estimates were made at March 31, 2011 and December 31, 2010 based on pertinent market data and relevant information on the financial instruments.  These estimates do not include any premiums or discounts that could result from an offer to sell at one time the Corporation’s entire holdings of a particular financial instrument or category thereof.  Since no market exists for a substantial portion of the Corporation’s financial instruments, fair value estimates were necessarily based on judgments with respect to future expected loss experience, current economic conditions, risk assessments of various financial instruments, and other factors.  Given the subjective nature of these estimates, the uncertainties surrounding them and the matters of significant judgment that must be applied, these fair

 
22


value estimates cannot be calculated with precision.  Modifications in such assumptions could meaningfully alter these estimates.

Since these fair value approximations were made solely for on and off balance sheet financial instruments at March 31, 2011 and December 31, 2010, no attempt was made to estimate the value of anticipated future business.  Furthermore, certain tax implications related to the realization of unrealized gains and losses could have a substantial impact on these fair value estimates and have not been incorporated into the estimates.

Note 6.   Earnings Per Share

Basic earnings per share is calculated by dividing net income available to common shareholders by the average daily number of common shares outstanding during the period.  Common stock equivalents are not included in the calculation.  Diluted earnings per share is computed similar to that of basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if all potential dilutive common shares were issued.

The following reconciles the income available to common shareholders (numerator) and the weighted average common stock outstanding (denominator) for both basic and diluted earnings per share.

   
Three Months Ended
March 31,
 
   
2011
   
2010
 
             
Net income
  $ 483,000     $ 871,000  
Dividends on preferred stock and accretion
    138,000       137,000  
Net income available to common stockholders
  $ 345,000     $ 734,000  
                 
Weighted average shares
    5,849,723       5,839,974  
Effect of dilutive stock options
    -       1,659  
Total weighted average dilutive shares
    5,849,723       5,841,633  
                 
Basic earnings per common share
  $ 0.06     $ 0.13  
                 
Diluted earnings per common share
  $ 0.06     $ 0.13  

For the three months ended March 31, 2011 and 2010, stock options to purchase 64,728 and 72,234 average shares of common stock, respectively, were not considered in computing diluted earnings per share of common stock because they were antidilutive.  The U.S. Treasury’s warrant to purchase 133,475 average shares of common stock in either of the three month periods ended March 31, 2011 and 2010 was not considered in computing diluted earnings per common share because it was antidilutive.

 
23


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

Cautionary Note Regarding Forward-Looking Statements

This Quarterly Report on Form 10-Q contains certain “forward looking statements” with respect to Stewardship Financial Corporation (the “Corporation”) within the meaning of the Private Securities Litigation Reform Act of 1995, which forward looking statements may be identified by the use of such words as “believe,” “expect,” “anticipate,” “should,” “plan,” “estimate,” and “potential.”  Examples of forward looking statements include, but are not limited to, estimates with respect to the financial condition, results of operations and business of the Corporation that are subject to various factors which could cause actual results to differ materially from these estimates.  These factors include: changes in general, economic and market conditions, legislative and regulatory conditions, or the development of an interest rate environment that adversely affects the Corporation’s interest rate spread or other income anticipated from operations and investments.  As used in this Form 10-Q, “we”, “us” and “our” refer to Stewardship Financial Corporation and its consolidated subsidiary, Atlantic Stewardship Bank, depending on the context.

Critical Accounting Policies and Estimates

“Management’s Discussion and Analysis of Financial Condition and Results of Operations,” as well as disclosures found elsewhere in this Quarterly Report on Form 10-Q, are based upon the Corporation’s consolidated financial statements, which have been prepared in conformity with U.S. generally accepted accounting principles (“GAAP”).  The preparation of these financial statements requires the Corporation to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses.  Note 1 to the Corporation’s Audited Consolidated Financial Statements for the year ended December 31, 2010 included in the 2010 Annual Report contains a summary of the Corporation’s significant accounting policies.  Management believes the Corporation’s policy with respect to the methodology for the determination of the allowance for loan losses involves a higher degree of complexity and requires management to make difficult and subjective judgments, which often require assumptions or estimates about highly uncertain matters.  Changes in these judgments, assumptions or estimates could materially impact results of operations.  This critical policy and its application are periodically reviewed with the Audit Committee and the Board of Directors.

The allowance for loan losses is based upon management’s evaluation of the adequacy of the allowance, including an assessment of known and inherent risks in the portfolio, giving consideration to the size and composition of the loan portfolio, actual loan loss experience, level of delinquencies, detailed analysis of individual loans for which full collectability may not be assured, the existence and estimated net realizable value of any underlying collateral and guarantees securing the loans, and current economic and market conditions.  Although management uses the best information available, the level of the allowance for loan losses remains an estimate, which is subject to significant judgment and short-term change.  Various regulatory agencies, as an integral part of their examination process, periodically review the Corporation’s allowance for loan losses.  Such agencies may require the Corporation to make additional provisions for loan losses based upon information available to them at the time of their examination.  Furthermore, the majority of the Corporation’s loans are secured by real estate in the State of New Jersey.  Accordingly, the collectability of a substantial portion of the carrying value of the Corporation’s loan portfolio is susceptible to changes in local market conditions and may be adversely affected should real estate values decline or the northern New Jersey area experience adverse economic changes.  Future adjustments to the allowance for loan losses may be necessary due to economic, operating, regulatory and other conditions beyond the Corporation’s control.

Financial Condition

Total assets increased $12.8 million, or 1.9%, to $700.9 million at March 31, 2011 from $688.1 million at December 31, 2010.  Cash and cash equivalents increased $9.7 million to $29.7 million at March 31, 2011 from $20.0 million at December 31, 2010, reflecting planned additional liquidity.  Securities available for sale increased $9.6 million to $148.2 million while securities held to maturity decreased $2.9 million to $42.5 million.  Net loans increased $6.3 million from $443.2 million at December 31, 2010 to $449.5 million at March 31, 2011.  Increases due to new loans originated were partially offset by a $1.4 million net increase in the allowance for loan losses and regular principal payments and payoffs in the first quarter.  Loans held for sale totaled $827,000 at March 31, 2011, a decrease from $9.8 million at December 31, 2011, reflecting a slowdown in loan application volume as mortgage rates have trended higher.

Deposits totaled $591.5 million at March 31, 2011, an increase of $15.9 million, or 2.8%, from $575.6 million at December 31, 2010.  The growth in deposits consisted of a $13.8 million increase in noninterest-bearing accounts and a $2.1 million increase in interest-bearing accounts.

 
24


FHLB – NY advances were $33.0 million at March 31, 2011 compared to $36.0 million at December 31, 2010.  The decrease in these borrowings was the result of an increase in deposits which was used to pay down maturing advances.

Results of Operations

General

The Corporation reported net income of $483,000, or $0.06 diluted earnings per common share for the three months ended March 31, 2011, compared to $871,000, or $0.13 diluted earnings per common share for the comparable prior year period.

Net Interest Income

Net interest income for the three months ended March 31, 2011 was $5.9 million compared to $6.2 million recorded in the prior year period.  Although the average balance of interest-earning assets increased, the overall decrease in net interest income in the current year period is primarily due to a decline in the yield on interest-earning assets partially offset by a decline in the cost of interest bearing liabilities.  The net interest rate spread and net yield on interest earning assets for the three months ended March 31, 2011 were 3.59% and 3.84%, respectively, compared to 3.74% and 4.08% for the three months ended March 31, 2010.  The net yield on interest earning assets during the current year period reflects a decline in loan interest rates and yields on securities offset by a decline in the interest rates on deposits and borrowings.

The following table reflects the components of the Corporation’s net interest income for the three months ended March 31, 2011 and 2010 including: (1) average assets, liabilities and stockholders’ equity based on average daily balances, (2) interest income earned on interest-earning assets and interest expense paid on interest-bearing liabilities, (3) average yields earned on interest-earning assets and average rates paid on interest-bearing liabilities, and (4) net yield on interest-earning assets.  Nontaxable income from investment securities and loans is presented on a tax-equivalent basis assuming a statutory tax rate of 34% for the periods presented.  This was accomplished by adjusting non-taxable income upward to make it equivalent to the level of taxable income required to earn the same amount after taxes.

 
25


Analysis of Net Interest Income (Unaudited)
For the Three Months Ended March 31,

   
2011
   
2010
 
   
Average
Balance
   
Interest
Income/
Expense
   
Average
Rates
Earned/
Paid
   
Average
Balance
   
Interest
Income/
Expense
   
Average
Rates
Earned/
Paid
 
   
(Dollars in thousands)
 
                                     
Assets
                                   
                                     
Interest-earning assets:
                                   
Loans (1) (2)
  $ 456,285     $ 6,451       5.73 %   $ 462,022     $ 6,886       6.04 %
Taxable investment securities (1)
    155,127       1,060       2.77       133,319       1,339       4.07  
Tax-exempt investment securities (1) (2)
    31,030       396       5.18       32,307       412       5.17  
Other interest-earning assets
    592       8       7.89       120       2       6.76  
Total interest-earning assets
    643,034       7,915       4.99       627,768       8,639       5.58  
                                                 
Non-interest-earning assets:
                                               
Allowance for loan losses
    (8,777 )                     (7,310 )                
Other assets
    51,857                       37,608                  
Total assets
  $ 686,114                     $ 658,066                  
                                                 
                                                 
Liabilities and Stockholders' Equity
                                               
                                                 
Interest-bearing liabilities:
                                               
Interest-bearing demand deposits
  $ 249,366     $ 476       0.77 %   $ 222,691     $ 769       1.40 %
Savings deposits
    48,369       31       0.26       47,299       50       0.42  
Time deposits
    175,300       782       1.81       171,333       1,001       2.37  
Repurchase agreements
    14,643       181       5.01       15,398       182       4.79  
FHLB-NY borrowing
    35,268       232       2.67       45,817       246       2.19  
Subordinated debenture
    7,217       124       6.97       7,217       68       3.82  
Total interest-bearing liabilities
    530,163       1,826       1.40       509,755       2,316       1.84  
Non-interest-bearing liabilities:
                                               
Demand deposits
    100,315                       89,993                  
Other liabilities
    3,125                       3,993                  
Stockholders' equity
    52,511                       54,325                  
Total liabilities and stockholders' equity
  $ 686,114                     $ 658,066                  
                                                 
Net interest income (taxable equivalent basis)
            6,089                       6,323          
Tax Equivalent adjustment
            (140 )                     (144 )        
Net interest income
          $ 5,949                     $ 6,179          
                                                 
Net interest spread (taxable equivalent basis)
                    3.59 %                     3.74 %
                                                 
Net yield on interest-earning
                                               
assets (taxable equivalent basis) (3)
                    3.84 %                     4.08 %
 

 
(1)
For purpose of these calculations, nonaccruing loans are included in the average balance.  Loans and total interest-earning assets are net of unearned income.  Securities are included at amortized cost.
 
(2)
The tax equivalent adjustments are based on a marginal tax rate of 34%.
 
(3)
Net interest income (taxable equivalent basis) divided by average interest-earning assets.
 
 
26


For the three months ended March 31, 2011, total interest income, on a tax equivalent basis, decreased $724,000 to $7.915 million, or 8.4%, when compared to the same prior year period.  The decrease was due to a decrease in yields on interest-earning assets partially offset by an increase in the average balance of interest-earning assets.  The average rate earned on interest-earning assets decreased 59 basis points from 5.58% for the three months ended March 31, 2010 to 4.99% in the current year period.  The decline in the asset yield reflects the effect of a prolonged low interest rate environment as well as the impact of nonaccrual loans.  Average interest-earning assets increased $15.3 million for the three months ended March 31, 2011, or 2.4%, when compared to the prior year period with average investment securities increasing $20.7 million.  Average loans decreased $5.7 million to an average of $456.3 million for the three months ended March 31, 2011 from an average of $462.0 million for the comparable period in 2010, primarily reflecting significant chargeoffs of loans since March 31, 2010.

Interest paid on deposits and borrowed money decreased $490,000 to $1.826 million, or 21.2%, for the three months ended March 31, 2011 compared to the same period for 2010.  The decline is due to general decreases in rates paid on deposits and borrowings, partially offset by increases in average interest-bearing liabilities.  The average balance of total interest-bearing deposits and borrowings increased $20.4 million for the three months ended March 31, 2011 from the comparable 2010 period.  For the three months ended March 31, 2011, the total cost for interest-bearing liabilities declined to 1.40% representing a 44 basis point decline when compared to the same prior year period.

Provision for Loan Losses

The Corporation maintains an allowance for loan losses at a level considered by management to be adequate to cover the probable incurred losses associated with its loan portfolio.  On an ongoing basis, management analyzes the adequacy of this allowance by considering the nature and volume of the Corporation’s loan activity, financial condition of the borrower, fair market value of the underlying collateral, and changes in general market conditions.  Additions to the allowance for loan losses are charged to operations in the appropriate period.  Actual loan losses, net of recoveries, serve to reduce the allowance.  The appropriate level of the allowance for loan losses is based on estimates, and ultimate losses may vary from current estimates.

The loan loss provision totaled $1.675 million for the three months ended March 31, 2011 compared to $1.550 million for the three months ended March 31, 2010.  Nonaccrual loans of $24.0 million at March 31, 2011 reflected a slight increase from $22.5 million of nonaccrual loans at December 31, 2010.  The allowance for loan losses related to the impaired loans increased from $1.6 million at December 31, 2010 to $2.7 million at March 31, 2011.  The current period loan loss provision primarily is indicative of continuing economic conditions that have contributed to an increase in loan delinquencies and the softness in the real estate market.  The Corporation monitors its loan portfolio and intends to continue to provide for loan loss reserves based on its ongoing periodic review of the loan portfolio and general market conditions.

See “Asset Quality” section below for a summary of the allowance for loan losses and nonperforming assets.

Noninterest Income

Noninterest income was $1.1 million for the three months ended March 31, 2011 compared to $1.0 million for the prior year period.  Gains on sales of mortgage loans totaled $404,000 for the current year period, an increase from $55,000 for the three months ended March 31, 2010 due to an increase in mortgage activity resulting from lower mortgage loan interest rates and the Corporation’s promotion of a no-cost closing program.  Prior year noninterest income included $328,000 from gains on calls and sales of securities for the three months ended March 31, 2010.

When compared to the same prior period in 2010, fees and service charges increased $42,000 to $571,000 for the three months ended March 31, 2011.  The increase was primarily due to growth in the deposit base.

Noninterest Expense

Noninterest expenses for the three months ended March 31, 2011 increased to $4.7 million compared to $4.4 million in the comparable prior year period.  The increase in noninterest expenses reflects the costs, such as legal and other collection-related expenses, incurred in connection with management of nonperforming assets.

 
27


Income Tax Expense

Income tax expense totaled $191,000 for the three months ended March 31, 2011 compared to an income tax expense of $345,000 for the three months ended March 31, 2010.  The effective tax rate for the three months ended March 31, 2011 was 28.3% compared to 28.4% for the three months ended March 31, 2010.

Asset Quality

The Corporation’s principal earning asset is its loan portfolio.  Inherent in the lending function is the risk of deterioration in the borrowers’ ability to repay loans under existing loan agreements.  Management realizes that because of this risk, reserves are maintained to absorb probable incurred loan losses.  In determining the adequacy of the allowance for loan losses, management of the Corporation considers the risks inherent in its loan portfolio and changes in the nature and volume of its loan activities, along with general economic and real estate market conditions.  Although management attempts to establish a reserve sufficient to offset probable incurred losses in the portfolio, changes in economic conditions, regulatory policies and borrowers’ performance could require future changes to the allowance.

Risk elements include nonaccrual loans, past due and restructured loans, potential problem loans, loan concentrations and other real estate owned.  The following table shows the composition of nonperforming assets at the end of the last four quarters:

   
March 31,
2011
   
December 31,
2010
   
September 30,
2010
   
June 30,
2010
 
                         
Nonaccrual loans (1)
  $ 24,010     $ 22,500     $ 24,334     $ 25,712  
Loans past due 90 days or more and accruing (2)
    -       -       10       -  
Restructured loans
    120       130       140       1,210  
Total nonperforming loans
    24,130       22,630       24,484       26,922  
                                 
Other real estate owned
    313       615       356       -  
Total nonperforming assets
  $ 24,443     $ 23,245     $ 24,840     $ 26,922  
                                 
Allowance for loan losses
  $ 9,874     $ 8,490     $ 9,327     $ 8,745  
                                 
Nonperforming loans to total gross loans
    5.25 %     5.01 %     5.43 %     5.88 %
Nonperforming assets to total assets
    3.49 %     3.38 %     3.65 %     3.99 %
Allowance for loan losses to total gross loans
    2.15 %     1.88 %     2.07 %     1.91 %
Allowance for loan losses to
                               
nonperforming loans
    40.92 %     37.52 %     38.09 %     32.48 %

(1)  Generally represents loans as to which the payment of principal or interest is in arrears for a period of more than 90 days.  Interest previously accrued on these loans and not yet paid is reversed and charged against income during the current period.  Interest earned thereafter is only included in income to the extent that it is received in cash.

(2)  Represents loans as to which payment of principal or interest is contractually past due 90 days or more but which are currently accruing income at the contractually stated rates.  A determination is made to continue accruing income on those loans which are sufficiently collateralized and on which management believes all interest and principal owed will be collected.

A loan is generally placed on nonaccrual when, based on current information and events, it is probable that the Corporation will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement.  The identification of nonaccrual loans reflects careful monitoring of the loan portfolio.  The Corporation has been diligent and proactive in identifying and dealing with problem credits and is focused on resolving the nonperforming loans and mitigating future losses in the portfolio.  All delinquent loans continue to be reviewed by management on a biweekly basis.

The nonaccrual loans are comprised of 61 loans, primarily commercial real estate loans, commercial loans and construction loans.  While the Corporation maintains strong underwriting requirements, a slight increase in the number and amount of nonaccrual loans is reflective of the prolonged weakened economic conditions and the corresponding effects it has had on our commercial borrowers and the current real estate environment.  Certain loans, including restructured loans, are current, but in accordance with applicable guidance and cautious review, management has continued to keep these loans on nonaccrual.  The ratio of allowance for loan losses to nonperforming loans increased to 40.92% at March 31, 2011 from 37.52% at December 31, 2010.

 
28


As of March 31, 2011, the level of loans past due 30-89 days was $13.0 million.  The Corporation will continue to monitor delinquencies for early identification of new problem loans.  As such, the entire commercial construction portfolio is being actively monitored.

The Corporation maintains an allowance for loan losses at a level considered by management to be adequate to cover the probable incurred losses associated with its loan portfolio.  The Corporation’s policy with respect to the methodology for the determination of the allowance for loan losses involves a high degree of complexity and requires management to make difficult and subjective judgments.  The adequacy of the allowance for loan losses is based upon management’s evaluation of the known and inherent risks in the portfolio, consideration to the size and composition of the loan portfolio, actual loan loss experience, the level of delinquencies, detailed analysis of individual loans for which full collectability may not be assured, the existence and estimated net realizable value of any underlying collateral and guarantees securing the loans, and current economic and market conditions.

In establishing the allowance for loan losses, the Corporation utilizes a two tier approach by (1) identifying problem loans and allocating specific loss allowances on such loans and (2) establishing a general valuation allowance on the remainder of its loan portfolio.  The Corporation maintains a loan review system that allows for a periodic review of its loan portfolio and the early identification of potential problem loans.  Such a system takes into consideration, among other things, delinquency status, size of loans, type of collateral and financial condition of the borrowers.

Allocations of specific loan loss allowances are established for identified loans based on a review of various information including appraisals of underlying collateral.  Appraisals are performed by independent licensed appraisers to determine the value of impaired, collateral-dependent loans.  Appraisals are periodically updated to ascertain any further decline in value.  General loan loss allowances are based upon a combination of factors including, but not limited to, actual loss experience, composition of the loan portfolio, current economic conditions and management’s judgment.

Primarily as a result of the continuing higher level of nonperforming loans, the Corporation recorded an elevated provision for loan losses.  For the three months ended March 31, 2011, the provision for loan losses was $1.675 million compared to $1.550 million for the three months ended March 31 2010.  The total allowance for loan losses increased to 2.15% of total loans from a comparable ratio of 1.88% at December 31, 2010.

When it is probable that some portion or all of a loan balance will not be collected, that amount is charged off as a loss against the allowance for loan losses.  After net chargeoffs of $291,000 for the three months ended March 31, 2011, the allowance for loan losses totaled $9.9 million as of March 31, 2011 compared to $8.5 million as of December 31, 2010.  In general, the chargeoffs reflect partial writedowns on nonaccrual loans due to the initial evaluation of market values of the underlying real estate collateral in accordance with Accounting Standards Codification (“ASC”) 310-40.  While we have taken the conservative position of partial and full chargeoffs on loans, we continue to aggressively pursue collection, including legal action.

Our allowance for loan losses to nonperforming loans increased to 40.92% at March 31, 2011, compared to 37.52% at December 31, 2010.  Although nonperforming loans increased $1.5 million to $24.1 million at the end of the most recent quarter, an increase in the allowance for loan losses resulted in the increase in this metric.  Evaluation of nonperforming loans includes the updating of appraisals and specific evaluation of such loans to determine estimated cash flows from business and/or collateral.  We have assessed these loans for collectability and considered, among other things, the borrower’s ability to repay, the value of the underlying collateral, and other market conditions to ensure the allowance for loan losses is adequate to absorb probable incurred losses.  The majority of our nonperforming loans are secured by real estate collateral.  While our nonperforming loans have remained elevated since March 31, 2010, the underlying collateral coverage for a considerable portion of the nonperforming loans supports the significant collection of our principal, and therefore, we do not estimate a proportionate upward trending in losses.  For  the three months ended March 31, 2011 net chargeoffs were $291,000.  The ratio of allowance for loan losses to nonperforming loans is reflective of detailed analysis and the probable incurred losses we have identified with these nonperforming loans.

As of March 31, 2011, there were $22.2 million of other loans not included in the above table, compared to $23.9 million at December 31, 2010, where credit conditions of borrowers caused management to have concerns about the possibility of the borrowers not complying with the present terms and conditions of repayment and which may result in disclosure of such loans as nonperforming at a future date.  These loans have been considered by management in conjunction with the analysis of the adequacy of the allowance for loan losses.

The Corporation’s lending activities are concentrated in loans secured by real estate located in northern New Jersey.  Accordingly, the collectability of a substantial portion of the Corporation’s loan portfolio is susceptible to changes in real estate market conditions in northern New Jersey.

 
29

 
Capital Adequacy

The Corporation is subject to capital adequacy guidelines promulgated by the Board of Governors of the Federal Reserve System (“FRB”).  The Bank is subject to similar capital adequacy requirements imposed by the Federal Deposit Insurance Corporation.  The FRB has issued regulations to define the adequacy of capital based upon the sensitivity of assets and off-balance sheet exposures to risk factors.   Four categories of risk weights (0%, 20%, 50%, and 100%) were established to be applied to different types of balance sheet assets and off-balance sheet exposures.  The aggregate of the risk-weighted items (risk-based assets) is the denominator of the ratio; the numerator of the ratio is risk-based capital.  Under the regulations, risk-based capital has been classified into two categories.  Tier 1 capital includes common and qualifying perpetual preferred shareholders’ equity less goodwill.  Tier 2 capital includes mandatory convertible debt, allowance for loan losses, subject to certain limitations, and certain subordinated and term debt securities.  Total qualifying capital consists of Tier 1 capital and Tier 2 capital; however; the amount of Tier 2 capital may not exceed the amount of Tier 1 capital.  At March 31, 2011, the minimum risk-based capital requirements to be considered adequately capitalized were 4% for Tier 1 capital and 8% for total capital.

Federal banking regulators have also adopted leverage capital guidelines to supplement the risk-based measures.  The leverage ratio is determined by dividing Tier 1 capital as defined under the risk-based guidelines by average total assets (non risk-adjusted) for the preceding quarter.  At March 31, 2011 the minimum leverage ratio requirement to be considered well capitalized was 4%.  The following table summarizes the capital ratios for the Corporation and the Bank at March 31, 2011.

   
Actual
   
Required for
Capital
Adequacy
Purposes
   
To Be Well
Capitalized
Under Prompt
Corrective
Action
Regulations
 
Leverage ratio
                 
Corporation
    8.65 %     4.00 %     N/A  
Bank
    8.14 %     4.00 %     5.00 %
                         
Risk-based capital
                       
Tier I
                       
Corporation
    12.21 %     4.00 %     N/A  
Bank
    11.46 %     4.00 %     6.00 %
Total
                       
Corporation
    13.47 %     8.00 %     N/A  
Bank
    12.72 %     8.00 %     10.00 %

Liquidity and Capital Resources

The Corporation’s primary sources of funds are deposits, amortization and prepayments of loans and mortgage-backed securities, maturities of investment securities and funds provided from operations.  While scheduled loan and mortgage-backed securities amortization and maturities of investment securities are a relatively predictable source of funds, deposit flow and prepayments on loans and mortgage-backed securities are greatly influenced by market interest rates, economic conditions and competition.  The Corporation’s liquidity, represented by cash and cash equivalents, is a product of its operating, investing and financing activities.

The primary source of cash from operating activities is net income.  Liquidity management is both a daily and long-term function of business management.  Excess liquidity is generally invested in short-term investments, such as federal funds sold.

Cash and cash equivalents increased $9.7 million during the first three months of 2011.  Net operating and financing activities provided $12.1 million and $12.5 million, respectively, and investing activities used $14.9 million.

We anticipate that the Corporation will have sufficient funds available to meet its current contractual commitments.  Should we need temporary funding, the Corporation has the ability to borrow overnight with the FHLB-NY.  The overall borrowing capacity is contingent on available collateral to secure borrowings and the ability to purchase additional activity-based

 
30


capital stock of the FHLB-NY.  In addition, the Corporation has available overnight variable repricing lines of credit with other correspondent banks totaling $16.0 million on an unsecured basis.

With respect to the payment of dividends on common stock, the Corporation has historically paid a quarterly cash dividend, however management recognizes that the payment of future dividends could be impacted by losses or reduced earnings and the Corporation cannot assure the payment of future dividends.

 
31


ITEM 3.  Quantitative and Qualitative Disclosures about Market Risk

Not applicable to smaller reporting companies.

ITEM 4.  Controls and Procedures

Evaluation of internal controls and procedures

Based on their evaluation as of the end of the period covered by this Quarterly Report on Form 10-Q, our principal executive officer and principal financial officer have concluded that our internal disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

Changes in Internal Controls over Financial Reporting

Pursuant to Rule 13a-15(d) under the Exchange Act, our management, with the participation of our principal executive officer and principal financial officer, has evaluated our internal controls over financial reporting and based upon such evaluation concluded that there were no changes in our internal control over financial reporting (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) during the quarter ended March 31, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 
32


 Part II -- Other Information


Item 6.                    Exhibits

See Exhibit Index following this report.
 
 
33



Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 

 
Stewardship Financial Corporation
 
     
     
Date: May 16, 2011
By: 
/s/ Paul Van Ostenbridge
 
   
Paul Van Ostenbridge
 
   
President and Chief Executive Officer
 
   
 (Principal Executive Officer)
 
       
       
       
Date: May 16, 2011
By:
/s/ Claire M. Chadwick
 
   
Claire M. Chadwick
 
   
Senior Vice President and Chief Financial Officer
 
   
 (Principal Financial and Accounting Officer)
 
 
 
34



Exhibit
Number
 
 
Description of Exhibits
     
 
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 
35