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EXCEL - IDEA: XBRL DOCUMENT - CITY HOLDING COFinancial_Report.xls

 

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

FORM 10-Q

(Mark One)
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For The Quarterly Period Ended June 30, 2014
OR
[  ] TRANSITION REPORT PURSANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For The Transition Period From ____________To_____________.

Commission File number 0-11733
CITY HOLDING COMPANY
(Exact name of registrant as specified in its charter)
West Virginia
55-0619957
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
 
 
25 Gatewater Road
 
Charleston, West Virginia
25313
(Address of principal executive offices)
(Zip Code)
(304) 769-1100
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant has (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes
[X]
No
[   ]
 
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes
[X]
No
[   ]
 
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer [   ]
 
Accelerated filer [X]
 
 
 
 
 
Non-accelerated filer [   ]
 
Smaller reporting company [   ]
 
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes
[   ]
No
[X]
 

1


 
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical date.
Common stock, $2.50 Par Value – 15,501,470 shares as of August 6, 2014.

2


FORWARD-LOOKING STATEMENTS

All statements other than statements of historical fact included in this Quarterly Report on Form 10-Q, including statements in Management’s Discussion and Analysis of Financial Condition and Result of Operations are, or may be deemed to be, forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Such information involves risks and uncertainties that could result in the Company’s actual results differing from those projected in the forward-looking statements. Important factors that could cause actual results to differ materially from those discussed in such forward-looking statements include, but are not limited to:  (1) the Company may incur additional loan loss provision due to negative credit quality trends in the future that may lead to a deterioration of asset quality; (2) the Company may incur increased charge-offs in the future; (3)  the Company could have adverse legal actions of a material nature; (4) the Company may face competitive loss of customers; (5) the Company may be unable to manage its expense levels; (6) the Company may have difficulty retaining key employees; (7) changes in the interest rate environment may have results on the Company’s operations materially different from those anticipated by the Company’s market risk management functions; (8) changes in general economic conditions and increased competition could adversely affect the Company’s operating results; (9) changes in other regulations and government policies affecting bank holding companies and their subsidiaries, including changes in monetary policies, could negatively impact the Company’s operating results; (10) the Company may experience difficulties growing loan and deposit balances; (11) the current economic environment poses significant challenges for us and could adversely affect the Company's financial condition and results of operations; (12) deterioration in the financial condition of the U.S. banking system may impact the valuations of investments the Company has made in securities of other financial institutions resulting in either actual losses or other than temporary impairments on such investments; and (13) the effects of the Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") and the regulations promulgated and to be promulgated thereunder, which may subject the Company and its subsidiaries to a variety of new and more stringent legal and regulatory requirements which adversely affect their respective businesses. Forward-looking statements made herein reflect management’s expectations as of the date such statements are made. Such information is provided to assist stockholders and potential investors in understanding current and anticipated financial operations of the Company and is included pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances that arise after the date such statements are made.


3


City Holding Company and Subsidiaries

Pages
 
 
 
Item 1.
Financial Statements (Unaudited).
 
 
 
 
 
 
Item 2.
Item 3.
Item 4.
 
 
 
 
 
 
 
Item 1.
Item 1A.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.
 
 
 
 


4


Part I -
Financial Information

Item 1 -
Financial Statements

Consolidated Balance Sheets
City Holding Company and Subsidiaries
(in thousands)
 
Assets
June 30, 2014
 
December 31, 2013
 
(Unaudited)
 
 
 
Cash and due from banks
$
93,962

 
$
75,999

 
Interest-bearing deposits in depository institutions
16,778

 
9,877

 
Cash and Cash Equivalents
110,740

 
85,876

 
 
 
 
 
 
Investment securities available for sale, at fair value
258,761

 
352,660

 
Investment securities held-to-maturity, at amortized cost (approximate fair value at June 30, 2014 and December 31, 2013, - $98,461 and $5,335, respectively)
96,039

 
4,117

 
Other securities
14,234

 
13,343

 
Total Investment Securities
369,034

 
370,120

 
 
 
 
 
 
Gross loans
2,577,777

 
2,606,197

 
Allowance for loan losses
(20,536
)
 
(20,575
)
 
Net Loans
2,557,241

 
2,585,622

 
 
 
 
 
 
Bank owned life insurance
93,567

 
92,047

 
Premises and equipment, net
80,171

 
82,548

 
Accrued interest receivable
7,727

 
6,866

 
Net deferred tax asset
37,793

 
42,165

 
Goodwill and other intangible assets
74,670

 
75,142

 
Other assets
33,771

 
27,852

 
Total Assets
$
3,364,714

 
$
3,368,238

 
Liabilities
 

 
 

 
Deposits:
 

 
 

 
Noninterest-bearing
$
500,391

 
$
493,228

 
Interest-bearing:
 

 
 

 
Demand deposits
609,584

 
601,527

 
Savings deposits
635,293

 
612,772

 
Time deposits
1,040,979

 
1,077,606

 
Total Deposits
2,786,247

 
2,785,133

 
 
 
 
 
 
Short-term borrowings:
 

 
 

 
Customer repurchase agreements
133,142

 
137,798

 
Long-term debt
16,495

 
16,495

 
Other liabilities
31,599

 
41,189

 
Total Liabilities
2,967,483

 
2,980,615

 
 
 
 
 
 
Shareholders’ Equity
 

 
 

 
Preferred stock, par value $25 per share: 500,000 shares authorized; none issued

 

 
Common stock, par value $2.50 per share: 50,000,000 shares authorized; 18,499,282 shares issued at June 30, 2014 and December 31, 2013, less 2,892,542 and 2,748,922 shares in treasury, respectively
46,249

 
46,249


5


 
 
 
 
Capital surplus
106,830

 
107,596

Retained earnings
348,018

 
333,970

Cost of common stock in treasury
(101,357
)
 
(95,202
)
Accumulated other comprehensive income (loss):
 

 
 

Unrealized gain (loss) on securities available-for-sale
371

 
(2,110
)
Underfunded pension liability
(2,880
)
 
(2,880
)
Total Accumulated Other Comprehensive Loss
(2,509
)
 
(4,990
)
Total Shareholders’ Equity
397,231

 
387,623

Total Liabilities and Shareholders’ Equity
$
3,364,714

 
$
3,368,238


See notes to consolidated financial statements.


6


Consolidated Statements of Income (Unaudited)
City Holding Company and Subsidiaries
(in thousands, except earnings per share data)
Interest Income
Three months ended June 30,
 
Six months ended June 30,
 
2014
 
2013
 
2014
 
2013
 
 
 
 
 
 
 
 
 
Interest and fees on loans
$
28,621

 
$
31,771

 
$
58,355

 
$
61,709

 
Interest and dividends on investment securities:
 

 
 

 
 

 
 

 
Taxable
2,930

 
2,632

 
5,933

 
5,382

 
Tax-exempt
277

 
312

 
558

 
636

 
Interest on federal funds sold

 
9

 

 
22

 
Total Interest Income
31,828

 
34,724

 
64,846

 
67,749

 
 
 
 
 
 
 
 
 
 
Interest Expense
 

 
 

 
 
 
 
 
Interest on deposits
2,737

 
3,195

 
5,490

 
6,422

 
Interest on short-term borrowings
85

 
79

 
160

 
149

 
Interest on long-term debt
151

 
153

 
301

 
309

 
Total Interest Expense
2,973

 
3,427

 
5,951

 
6,880

 
Net Interest Income
28,855

 
31,297

 
58,895

 
60,869

 
Provision for loan losses
435

 
2,011

 
1,798

 
3,749

 
Net Interest Income After Provision for Loan Losses
28,420

 
29,286

 
57,097

 
57,120

 
 
 
 
 
 
 
 
 
 
Non-interest Income
 

 
 

 
 
 
 
 
Gains on sale of investment securities
818

 
9

 
901

 
93

 
Service charges
6,739

 
6,897

 
12,899

 
13,432

 
Bankcard revenue
3,838

 
3,450

 
7,523

 
6,649

 
Insurance commissions
1,319

 
1,358

 
3,344

 
3,198

 
Trust and investment management fee income
1,111

 
964

 
2,148

 
1,954

 
Bank owned  life insurance
765

 
799

 
1,521

 
1,611

 
Other income
549

 
775

 
1,108

 
1,641

 
Total Non-interest Income
15,139

 
14,252

 
29,444

 
28,578

 
 
 
 
 
 
 
 
 
 
Non-interest Expense
 

 
 

 
 
 
 
 
Salaries and employee benefits
12,977

 
12,640

 
26,116

 
25,589

 
Occupancy and equipment
2,395

 
2,500

 
5,010

 
4,971

 
Depreciation
1,533

 
1,453

 
3,011

 
2,852

 
FDIC insurance expense
357

 
341

 
767

 
853

 
Advertising
925

 
819

 
1,749

 
1,554

 
Bankcard expenses
833

 
766

 
1,639

 
1,493

 
Postage, delivery, and statement mailings
530

 
552

 
1,105

 
1,158

 
Office supplies
420

 
463

 
830

 
904

 
Legal and professional fees
612

 
535

 
1,021

 
971

 
Telecommunications
506

 
465

 
844

 
910

 
Repossessed asset losses (gains), net of expenses
142

 
(23
)
 
521

 
(178
)
 
Merger related costs

 
65

 

 
5,604

 
Other expenses
3,075

 
3,383

 
5,068

 
6,682

 
Total Non-interest Expense
24,305

 
23,959

 
47,681

 
53,363

 
Income Before Income Taxes
19,254

 
19,579

 
38,860

 
32,335

 
Income tax expense
6,497

 
6,573

 
12,300

 
11,342

 

7


Net Income Available to Common Shareholders
$
12,757

 
$
13,006

 
$
26,560

 
$
20,993

 
 
 
 
 
 
 
 
 
 
Total comprehensive income
$
14,462

 
$
8,798

 
$
29,041

 
$
16,875

 
 
 
 
 
 
 
 
 
 
Average common shares outstanding
15,556

 
15,582

 
15,583

 
15,521

 
Effect of dilutive securities:
 

 
 

 
 
 
 
 
Employee stock awards and warrant outstanding
150

 
170

 
155

 
166

 
Shares for diluted earnings per share
15,706

 
15,752

 
15,738

 
15,687

 
 
 
 
 
 
 
 
 
 
Basic earnings per common share
$
0.81

 
$
0.83

 
$
1.69

 
$
1.34

 
Diluted earnings per common share
$
0.80

 
$
0.82

 
$
1.67

 
$
1.33

 
Dividends declared per common share
$
0.40

 
$
0.37

 
$
0.80

 
$
0.74

 

See notes to consolidated financial statements.


8




Consolidated Statements of Comprehensive Income (Unaudited)
City Holding Company and Subsidiaries
(in thousands)

 
Three Months Ended
 
Six Months Ended
 
 
June 30,
 
June 30,
 
 
2014
 
2013
 
2014
 
2013
 
 
 
 
 
 
 
 
 
 
Net income
$
12,757

 
$
13,006

 
$
26,560

 
$
20,993

 
 
 
 
 
 
 
 
 
 
Unrealized gains (losses) on available-for-sale securities arising during the period
3,521

 
(6,661
)
 
4,834

 
(6,434
)
 
Reclassification adjustment for gains
(818
)
 
(9
)
 
(901
)
 
(93
)
 
   Other comprehensive income (loss) before income taxes
2,703

 
(6,670
)
 
3,933

 
(6,527
)
 
Tax effect
(998
)
 
2,462

 
(1,452
)
 
2,409

 
   Other comprehensive income (loss), net of tax
1,705

 
(4,208
)
 
2,481

 
(4,118
)
 
 
 
 
 
 
 
 
 
 
    Comprehensive income, net of tax
$
14,462

 
$
8,798

 
$
29,041

 
$
16,875

 

See notes to consolidated financial statements.

9



Consolidated Statements of Changes in Shareholders’ Equity (Unaudited)
City Holding Company and Subsidiaries
Six Months Ended June 30, 2014 and 2013
(in thousands)

 
Common Stock
 
Capital Surplus
 
Retained Earnings
 
Treasury Stock
 
Accumulated Other Comprehensive Income (Loss)
 
Total Shareholders’ Equity
Balance at December 31, 2012
$
46,249

 
$
103,524

 
$
309,270

 
$
(124,347
)
 
(1,422
)
 
$
333,274

Net income
 

 
 

 
20,993

 
 

 
 

 
20,993

Other comprehensive loss
 

 
 

 
 

 
 

 
(4,118
)
 
(4,118
)
Acquisition of Community Financial Corporation
 
 
4,236

 
 
 
24,272

 
 
 
28,508

Cash dividends declared ($0.74 per share)
 

 
 

 
(11,866
)
 
 

 
 

 
(11,866
)
Stock-based compensation expense, net
 

 
(512
)
 
 

 
1,215

 
 

 
703

Exercise of 62,685 stock options
 

 
(13
)
 
 

 
1,410

 
 

 
1,397

Balance at June 30, 2013
$
46,249

 
$
107,235

 
$
318,397

 
$
(97,450
)
 
$
(5,540
)
 
$
368,891



 
Common Stock
 
Capital Surplus
 
Retained Earnings
 
Treasury Stock
 
Accumulated Other Comprehensive Income (Loss)
 
Total Shareholders’ Equity
Balance at December 31, 2013
46,249

 
$
107,596

 
$
333,970

 
(95,202
)
 
$
(4,990
)
 
$
387,623

Net income
 

 
 

 
26,560

 
 

 
 

 
26,560

Other comprehensive income
 

 
 

 
 

 
 

 
2,481

 
2,481

Cash dividends declared ($0.80 per share)
 

 
 

 
(12,512
)
 
 

 
 

 
(12,512
)
Stock-based compensation expense, net
 

 
(494
)
 
 

 
1,383

 
 

 
889

Exercise of 19,000 stock options
 

 
(272
)
 
 

 
825

 
 

 
553

Purchase of 194,651 treasury shares
 
 
 
 
 
 
(8,363
)
 
 
 
(8,363
)
Balance at June 30, 2014
46,249

 
$
106,830

 
$
348,018

 
(101,357
)
 
$
(2,509
)
 
$
397,231


See notes to consolidated financial statements.


10


Consolidated Statements of Cash Flows (Unaudited)
City Holding Company and Subsidiaries
(in thousands)

 
Six months ended June 30,
2014
 
2013
Net income
$
26,560

 
$
20,993

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

 
 

Accretion and amortization
(2,599
)
 
(3,694
)
Provision for loan losses
1,798

 
3,749

Depreciation of premises and equipment
3,011

 
2,852

Deferred income tax expense
2,615

 
3,268

Net periodic employee benefit cost
286

 
378

Realized investment securities gains
(901
)
 
(93
)
Stock-compensation expense
889

 
703

Increase in value of bank-owned life insurance
(1,520
)
 
(1,608
)
Loans originated for sale
(2,454
)
 
(15,656
)
Proceeds from the sale of loans originated for sale
3,129

 
19,576

Gain on sale of loans
(84
)
 
(427
)
Change in accrued interest receivable
(861
)
 
(189
)
Change in other assets
(5,986
)
 
15,945

Change in other liabilities
(9,919
)
 
(11,469
)
Net Cash Provided by Operating Activities
13,964

 
34,328

 
 
 
 
Proceeds from sales of securities available-for-sale
1,660

 
18,438

Proceeds from maturities and calls of securities available-for-sale
26,237

 
60,543

Proceeds from maturities and calls of securities held-to-maturity
1,254

 
9,188

Purchases of securities available-for-sale
(13,530
)
 
(22,335
)
Purchases of securities held-to-maturity
(10,226
)
 

Net decrease (increase) in loans
29,225

 
(11,732
)
Purchases of premises and equipment
(664
)
 
(3,276
)
Acquisition of Community Financial Corporation, net of cash acquired of $8,888

 
(21,852
)
Net Cash Provided by Investing Activities
33,956

 
28,974

 
 
 
 
Net increase in noninterest-bearing deposits
7,163

 
37,908

Net (decrease) increase in interest-bearing deposits
(5,638
)
 
6,291

Net (decrease) increase in short-term borrowings
(4,656
)
 
9,697

Purchases of treasury stock
(8,363
)
 

Proceeds from exercise of stock options, net of tax benefit
553

 
1,397

Dividends paid
(12,115
)
 
(11,255
)
Net Cash (Used in) Provided by Financing Activities
(23,056
)
 
44,038

Increase in Cash and Cash Equivalents
24,864

 
107,340

Cash and cash equivalents at beginning of period
85,876

 
84,994

Cash and Cash Equivalents at End of Period
$
110,740

 
$
192,334


See notes to consolidated financial statements.

11


Notes to Consolidated Financial Statements (Unaudited)
June 30, 2014

Note A –Background and Basis of Presentation

City Holding Company is a financial holding company headquartered in Charleston, West Virginia and conducts its principal activities through its wholly-owned subsidiary, City National Bank of West Virginia ("City National"). City National operates a network of 82 branch offices primarily along the I-64 corridor from Grayson, Kentucky through Lexington, Virginia; and along the I-81 corridor through the Shenandoah Valley from Staunton, Virginia to Martinsburg, West Virginia. City's branch network includes 57 offices in West Virginia, 14 offices in Virginia, 8 offices in Kentucky and 3 offices in Ohio. City National provides credit, deposit, investment advisory and insurance products and services to a broad geographical area that includes many rural and small community markets in addition to larger cities such as Charleston (WV), Huntington (WV), Winchester (VA), Staunton (VA), Virginia Beach (VA), Ashland (KY) and Martinsburg (WV). In addition to its branch network, the bank's delivery channels include ATMs, mobile banking, on-line banking, debit cards, cash management tools and telephone banking systems.

The accompanying consolidated financial statements, which are unaudited, include all of the accounts of the City Holding Company and its wholly-owned subsidiaries (collectively, “the Company”). All material intercompany transactions have been eliminated. The consolidated financial statements include all adjustments that, in the opinion of management, are necessary for a fair presentation of the results of operations and financial condition for each of the periods presented. Such adjustments are of a normal recurring nature. The results of operations for six months ended June 30, 2014 are not necessarily indicative of the results of operations that can be expected for the year ending December 31, 2014. The Company’s accounting and reporting policies conform with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Such policies require management to make estimates and develop assumptions that affect the amounts reported in the consolidated financial statements and related footnotes. Actual results could differ from management’s estimates.

The consolidated balance sheet as of December 31, 2013 has been derived from audited financial statements included in the Company’s 2013 Annual Report to Shareholders.  Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with U.S. generally accepted accounting principles have been omitted.  These financial statements should be read in conjunction with the financial statements and notes thereto included in the 2013 Annual Report of the Company.

Certain amounts in the financial statements have been reclassified.  Such reclassifications had no impact on shareholders’ equity or net income for any period.

Note B - Recent Accounting Pronouncements
 
In January 2014, the FASB issued ASU No. 2014-01, "Investments - Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects." This ASU permits reporting entities to make an accounting policy election to account for their investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance in the income statement as a component of income tax expense (benefit). For those investments in qualified affordable housing projects not accounted for using the proportional amortization method, the investment should be accounted for as an equity method investment or a cost method investment. The ASU also requires reporting entities to disclose information that enable users of its financial statements to understand the nature of its investments in qualified affordable housing projects, and the effect of the measurement of its investments in qualified affordable housing projects and the related tax credits on its financial position and results of operations. This ASU will become effective for the Company on January 1, 2015. The adoption of ASU 2014-01 is not expected to have a material impact on the Company's financial statements.

In January 2014, the FASB issued ASU No. 2014-04, "Receivables - Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure." This ASU clarifies that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through similar legal agreement. Additionally, the amendments require interim and annual disclosures of both (1) the amount of foreclosed residential real estate property held by the creditor and (2) the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local

12


requirements of the applicable jurisdiction. This ASU will become effective for the Company on January 1, 2015. The adoption of ASU 2014-04 is not expected to have a material impact on the Company's financial statements.

In April 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No 2014-08, "Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity" This ASU changes the requirements for reporting discontinued operations. A disposal of a component or a group of components of an entity is required to be reported in discontinued operations if the disposal represents a strategic shift that has (or will have) a major effect on an entity’s operations when certain criteria are met. Additional disclosures are also required for disposals that meet the criteria to be reported in discontinued operations. This ASU will become effective for the Company on January 1, 2015. The adoption of ASU 2014-08 is not expected to have a material impact on the Company's financial statements.

In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No 2014-09, "Revenue from Contracts with Customers (Topic 606)". The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The core principle will be achieved using a five step process. This ASU will become effective for the Company on January 1, 2016. The adoption of ASU 2014-09 is not expected to have a material impact on the Company's financial statements.

In June 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No 2014-11, "Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures". The amendments in this update require two accounting changes. First, the amendments in this update change the accounting for repurchase-to-maturity transactions to secured borrowing accounting. Second, for repurchase financing arrangements, the amendments require separate accounting for a transfer of a financial asset executed contemporaneously with a repurchase agreement with the same counter-party, which will result in secured borrowing accounting for the repurchase agreement. This update also requires certain disclosures for these types of transactions. This ASU will become effective for the Company on January 1, 2015. The adoption of ASU 2014-11 is not expected to have a material impact on the Company's financial statements.

In June 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No 2014-12, "Compensation-Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period". The amendments in this update require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. Performance targets should not be reflected in estimating the grant date fair value of the award, but compensation cost should be recognized in the period for which the requisite service has already been rendered. This ASU will become effective for the Company on January 1, 2016, with early adoption permitted. The adoption of ASU 2014-12 is not expected to have a material impact on the Company's financial statements.

Note C –Investments

The amortized cost and estimated fair values of the Company's securities are shown in the following table (in thousands):

13


 
 
June 30, 2014
 
December 31, 2013
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Losses
 
Estimated Fair Value
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Losses
 
Estimated Fair Value
Securities available-for-sale:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Treasuries and U.S.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
government agencies
 
$
2,049

 
$
29

 
$

 
$
2,078

 
$
2,317

 
$
48

 
$

 
$
2,365

Obligations of states and
 
 
 
 
 
 
 
 

 
 

 
 

 
 

 
 

political subdivisions
 
39,276

 
883

 
19

 
40,140

 
41,027

 
627

 
106

 
41,548

Mortgage-backed securities:
 
 
 
 
 
 
 
 

 
 

 
 

 
 

 
 

U.S. government agencies
 
192,241

 
3,361

 
3,072

 
192,530

 
282,653

 
2,765

 
7,310

 
278,108

Private label
 
1,946

 
15

 

 
1,961

 
2,184

 
16

 
3

 
2,197

Trust preferred
 
 
 
 
 
 
 
 

 
 

 
 

 
 

 
 

securities
 
10,445

 
277

 
1,698

 
9,024

 
12,943

 
2,113

 
1,900

 
13,156

Corporate securities
 
7,797

 
230

 
357

 
7,670

 
9,788

 
183

 
843

 
9,128

Total Debt Securities
 
253,754

 
4,795

 
5,146

 
253,403

 
350,912

 
5,752

 
10,162

 
346,502

Marketable equity  securities
 
2,537

 
1,309

 

 
3,846

 
3,334

 
1,339

 

 
4,673

Investment funds
 
1,525

 

 
13

 
1,512

 
1,525

 

 
40

 
1,485

Total Securities
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Available-for-Sale
 
$
257,816

 
$
6,104

 
$
5,159

 
$
258,761

 
$
355,771

 
$
7,091

 
$
10,202

 
$
352,660

 
 
 
June 30, 2014
 
December 31, 2013
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Losses
 
Estimated Fair Value
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Losses
 
Estimated Fair Value
Securities held-to-maturity
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Mortgage-backed securities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
US government agencies
 
$
91,916

 
$
1,841

 
$

 
$
93,757

 
$

 
$

 
$

 
$

Trust preferred securities
 
4,123

 
581

 

 
4,704

 
4,117

 
1,218

 

 
5,335

Total Securities
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Held-to-Maturity
 
$
96,039


$
2,422

 
$

 
$
98,461

 
$
4,117

 
$
1,218

 
$

 
$
5,335

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other investment securities:
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Non-marketable equity securities
 
$
14,234

 
$

 
$

 
$
14,234

 
$
13,343

 
$

 
$

 
$
13,343

Total Other Investment
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

   Securities
 
$
14,234

 
$

 
$

 
$
14,234

 
$
13,343

 
$

 
$

 
$
13,343

 
Securities with limited marketability, such as stock in the Federal Reserve Bank or the Federal Home Loan Bank, are carried at cost and are reported as non-marketable equity securities in the table above.

Certain investment securities owned by the Company were in an unrealized loss position (i.e., amortized cost basis exceeded the estimated fair value of the securities).  The following table shows the gross unrealized losses and fair value of the Company’s investments aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position (in thousands):

14


 
 
June 30, 2014
 
Less Than Twelve Months
 
Twelve Months or Greater
 
Total
 
Estimated Fair Value
 
Unrealized Loss
 
Estimated Fair Value
 
Unrealized Loss
 
Estimated Fair Value
 
Unrealized Loss
Securities available-for-sale:
 
 
 
 
 
 
 
 
 
 
 
 
Obligations of states and political subdivisions
 
$
1,549

 
$
1

 
$
468

 
$
18

 
$
2,017

 
$
19

Mortgage-backed securities:
 
 
 
 
 
 
 
 
 
 

 
 

U.S. Government agencies
 
12,610

 
302

 
94,963

 
2,770

 
107,573

 
3,072

Trust preferred securities
 
477

 
201

 
4,809

 
1,497

 
5,286

 
1,698

Corporate securities
 

 

 
4,377

 
357

 
4,377

 
357

Investment funds
 

 

 
1,488

 
13

 
1,488

 
13

Total
 
$
14,636

 
$
504

 
$
106,105

 
$
4,655

 
$
120,741

 
$
5,159



 
 
December 31, 2013
 
Less Than Twelve Months
 
Twelve Months or Greater
 
Total
 
Estimated Fair Value
 
Unrealized Loss
 
Estimated Fair Value
 
Unrealized Loss
 
Estimated Fair Value
 
Unrealized Loss
Securities available-for-sale:
 
 
 
 
 
 
 
 
 
 
 
 
Obligations of states and political subdivisions
 
$
5,600

 
$
87

 
$
243

 
$
19

 
$
5,843

 
$
106

Mortgage-backed securities:
 
 

 
 

 
 

 
 

 
 

 
 

U.S. Government agencies
 
195,661

 
7,113

 
5,040

 
197

 
200,701

 
7,310

      Private label
 
1,491

 
3

 

 

 
1,491

 
3

Trust preferred securities
 

 

 
4,400

 
1,900

 
4,400

 
1,900

Corporate securities
 
5,881

 
843

 

 

 
5,881

 
843

Investment funds
 
$
1,460

 
$
40

 
$

 
$

 
1,460

 
40

Total
 
$
210,093

 
$
8,086

 
$
9,683

 
$
2,116

 
$
219,776

 
$
10,202


Marketable equity securities consist of investments made by the Company in equity positions of various regional community bank holding companies, with ownership positions ranging from nominal to a 4% ownership position in First National Corporation (FXNC).
During the six months ended June 30, 2014 and 2013, the Company had no credit-related net investment impairment losses. Also, for the year ended December 31, 2013, the Company had no credit-related net investment impairment losses.
Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other-than-temporary would be reflected in earnings as realized losses.  In estimating other-than-temporary impairment losses, management considers, among other things (i) the length of time and the extent to which the fair value has been less than cost, (ii) the financial condition, capital strength, and near-term (12 months) prospects of the issuer, including any specific events which may influence the operations of the issuer such as changes in technology that may impair the earnings potential of the investment or the discontinuance of a segment of the business that may affect the future earnings potential; (iii) the historical volatility in the market value of the investment and/or the liquidity or illiquidity of the investment; (iv) adverse conditions specifically related to the security, an industry, or a geographic area; or (v) the intent to sell the investment security and if it’s more likely than not that the Company will not have to sell the security before recovery of its cost basis.  In addition, management also employs a continuous monitoring process in regards to its marketable equity securities, specifically its portfolio of regional community bank holding company stocks.  Although the regional community bank holding company stocks that are owned by the Company are publicly traded, the trading activity for these stocks is minimal, with trading volumes of less than 0.2% of each respective company being traded on a daily basis.  As part of management’s review process for these securities, management reviews the financial condition of each respective regional community bank for any indications of financial weakness.

Management has the ability and intent to hold the securities classified as held to maturity until they mature, at which time the Company will receive full value for the securities.  Furthermore, as of June 30, 2014, management does not intend to sell an impaired security and it is not more than likely that it will be required to sell the security before the recovery of its amortized cost basis.  The unrealized losses on debt securities are primarily the result of interest rate changes, credit spread widening on agency-issued mortgage related securities, general financial market uncertainty and market volatility.  These conditions will not prohibit the Company from receiving its contractual principal and interest payments on its debt securities.  The fair value is expected to recover as the securities approach their maturity date or repricing date.   As of June 30, 2014, management believes the unrealized

15


losses detailed in the table above are temporary and no impairment loss has been recognized in the Company’s consolidated income statement.  Should the impairment of any of these securities become other-than-temporary, the cost basis of the investment will be reduced and the resulting loss recognized in net income in the period of the other-than-temporary impairment is identified, while any noncredit loss will be recognized in other comprehensive income.

At June 30, 2014, the book value of the Company’s five pooled trust preferred securities totaled $3.0 million with an estimated fair value of $1.8 million.  All of these securities are mezzanine tranches.  Pooled trust preferred securities represent beneficial interests in securitized financial assets that the Company analyzes within the scope of ASC 320, “Investments-Debt and Equity Securities” and are evaluated quarterly for other-than-temporary-impairment (“OTTI”).  Management performs an analysis of OTTI utilizing its internal methodology as described below to estimate expected cash flows to be received in the future.  The Company reviews each of its pooled trust preferred securities to determine if an OTTI charge would be recognized in current earnings in accordance with ASC 320, “Investments-Debt and Equity Securities”.  There is a risk that collateral deterioration could cause the Company to recognize additional OTTI charges in earnings in the future.

When evaluating pooled trust preferred securities for OTTI, the Company determines a credit related portion and a noncredit related portion.  The credit related portion is recognized in earnings and represents the difference between the present value of expected future cash flows and the amortized cost basis of the security.  The noncredit related portion is recognized in other comprehensive income, and represents the difference between the book value and the fair value of the security less the amount of the credit related impairment.  The determination of whether it is probable that an adverse change in estimated cash flows has occurred is evaluated by comparing estimated cash flows to those previously projected as further described below.  The Company considers this process to be its primary evidence when determining whether credit related OTTI exists.  The results of these analyses are significantly affected by other variables such as the estimate of future cash flows, credit worthiness of the underlying issuers and determination of the likelihood of defaults of the underlying collateral.

The Company utilizes a third party model to compute the present value of expected cash flows which considers the structure and term of each of the five respective pooled trust preferred securities and the financial condition of the underlying issuers.  Specifically, the third party model details interest rates, principal balances of note classes and underlying issuers, the timing and amount of interest and principal payments of the underlying issuers, and the allocation of the payments to the note classes. The current estimate of expected cash flows is based on the most recent trustee reports and any other relevant market information including announcements of interest payment deferrals or defaults of underlying trust preferred securities. For issuing banks that have defaulted, management generally assumes no recovery. For issuing banks that have deferred its interest payments, management excludes the collateral balance associated with these banks and assumes no recoveries of such collateral balance in the future. The exclusion of such issuing banks in a current deferral position is based on such bank experiencing a certain level of financial difficulty that raises doubt about its ability to satisfy its contractual debt obligation, and accordingly, the Company excludes the associated collateral balance from its estimate of expected cash flows. Other assumptions used in the estimate of expected cash flows include expected future default rates and prepayments. Specifically, the model assumes annual prepayments of 1.0% with 100% at maturity and assumes 150 basis points of additional annual defaults from banks that are currently not in default or deferral.  In addition, the model assumes no recoveries except for one trust preferred security which assumes that one of the banks currently deferring will cure such positions.  Management compares the present value of expected cash flows to those previously projected to determine if an adverse change in cash flows has occurred. If an adverse change in cash flows has occurred, management determines the credit loss to be recognized in the current period and the portion related to noncredit factors to be recognized in other comprehensive income.

The following table presents a progression of the credit loss component of OTTI on debt and equity securities recognized in earnings during the six months ended June 30, 2014 and for the year ended December 31, 2013 (in thousands).  The credit loss component represents the difference between the present value of expected future cash flows and the amortized cost basis of the security.  The credit component of OTTI recognized in earnings during a period is presented in two parts based upon whether the credit impairment in the current period is the first time the security was credit impaired (initial credit impairment) or if there is additional credit impairment on a security that was credit impaired in previous periods.

16


 
 
Debt Securities
 
Equity Securities
 
Total
Balance at January 1, 2013
 
$
21,186

 
$
4,813

 
$
25,999

Additions:
 
 

 
 

 
 

  Initial credit impairment
 

 

 

  Additional credit impairment
 

 

 

Deductions:
 
 

 
 

 
 

   Sold
 

 
(115
)
 
(115
)
Balance at December 31, 2013
 
21,186

 
4,698

 
25,884

Additions:
 
 

 
 

 
 

  Initial credit impairment
 

 

 

  Additional credit impairment
 

 

 

Deductions:
 
 

 
 

 
 

Sold
 

 
(2,060
)
 
(2,060
)
Balance at June 30, 2014
 
$
21,186

 
$
2,638

 
$
23,824


The following table presents additional information about the Company’s trust preferred securities with a credit rating of below investment grade as of June 30, 2014 (dollars in thousands):
Deal Name
 
Type
 
Class
 
Original Cost
 
Amortized Cost
 
Fair Value
 
Difference (1)
 
Lowest Credit Rating
 
# of issuers currently performing
 
Actual deferrals/defaults (as a % of original dollar)
 
Expected deferrals/defaults (as a % of remaining performing collateral)
 
Excess Subordination as a Percentage of Current Performing Collateral (4)
 
 
 
Pooled trust preferred securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other-than-temporarily impaired
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Available for Sale:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
P1
 
 
Pooled
 
Mezz
 
$
826

 
$
190

 
$
352

 
162

 
Caa1
 
7

 
19.5
%
 
20.0
%
(2) 
 
52.1
%
P2
 
 
Pooled
 
Mezz
 
2,535

 

 

 

 
Ca
 
6

 
22.3
%
 
%
(2) 
 
%
P3

 
Pooled
 
Mezz
 
2,962

 
1,419

 
671

 
(748
)
 
Caa3
 
22

 
24.1
%
 
8.2
%
(2) 
 
42.8
%
P4
 
 
Pooled
 
Mezz
 
4,060

 
400

 
151

 
(249
)
 
Ca
 
9

 
19.2
%
 
7.1
%
(3) 
 
26.9
%
P5
 
 
Pooled
 
Mezz
 
6,062

 
678

 
477

 
(201
)
 
Ca
 
9

 
22.7
%
 
20.0
%
(2) 
 
49.2
%
 
 
 
Held to Maturity:
 
 

 
 

 
 
 
 

 
 

 
 

 
 
 

P6
 
 
Pooled
 
Mezz
 
1,599

 
123

 
704

 
581

 
Caa1
 
7

 
19.5
%
 
20.0
%
(2) 
 
52.1
%
P7
 
 
Pooled
 
Mezz
 
3,367

 

 

 

 
Ca
 
6

 
22.3
%
 
%
(2) 
 
%
 
 
 
Single issuer trust preferred securities
 
 

 
 

 
 
 
 

 
 

 
 

 
 
 

 
 
 
Available for sale:
 
 
 
 
 
 

 
 

 
 

 
 
 
 

 
 

 
 

 
 
 

S5
 
 
Single
 
 
 
261

 
235

 
336

 
101

 
NR
 
1

 
%
 
%
 
 
 

 
 
 
Held to Maturity:
 
 
 
 
 
 

 
 

 
 

 
 
 
 

 
 

 
 

 
 
 

S9
 
 
Single
 
 
 
4,000

 
4,000

 
4,000

 

 
NR
 
1

 
%
 
%
 
 
 

 
(1)
The differences noted consist of unrealized gains (losses) recorded at June 30, 2014 and noncredit other-than-temporary impairment losses recorded subsequent to April 1, 2009 that have not been reclassified as credit losses.
(2)
Performing collateral is defined as total collateral minus all collateral that has been called, is currently deferring, or currently in default. This model for this security assumes that all collateral that is currently deferring will default with a zero recovery rate. The underlying issuers can cure, thus this bond could recover at a higher percentage upon default than zero.
(3)
Performing collateral is defined as total collateral minus all collateral that has been called, is currently deferring, or currently in default.  The model for this security assumes that one of the banks that is currently deferring will cure.  If additional underlying issuers cure, this bond could recover at a higher percentage.
(4)
Excess subordination is defined as the additional defaults/deferrals necessary in the next reporting period to deplete the entire credit enhancement (excess interest and over-collateralization) beneath our tranche within each pool to the point that would cause a "break in yield." This amount assumes that all currently performing collateral continues to perform. A break in yield means that our security would not be expected to receive all the contractual cash flows (principal and interest) by maturity. The "percent of current performing collateral" is the ratio of the "excess subordination amount" to current performing collateral—a higher percent means there is more excess subordination to absorb additional defaults/deferrals, and the better our security is protected from loss.

The amortized cost and estimated fair value of debt securities at June 30, 2014, by contractual maturity, are shown in the following table (in thousands).  Expected maturities will differ from contractual maturities because the issuers of the securities

17


may have the right to prepay obligations without prepayment penalties.  Mortgage-backed securities have been allocated to their respective maturity groupings based on their contractual maturity.
 
Cost
 
Estimated Fair Value
Securities Available-for-Sale
 
 
 
Due in one year or less
$
8,566

 
$
8,606

Due after one year through five years
17,995

 
18,533

Due after five years through ten years
30,416

 
31,321

Due after ten years
196,777

 
194,943

 
$
253,754

 
$
253,403

Securities Held-to-Maturity
 

 
 

Due in one year or less
$

 
$

Due after one year through five years

 

Due after five years through ten years

 

Due after ten years
96,039

 
98,461

 
$
96,039

 
$
98,461


Gross gains and gross losses realized by the Company from investment security transactions are summarized in the table below (in thousands). The specific identification method is used to determine the cost basis of securities sold.
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2014
 
2013
 
2014
 
2013
 
 
 
 
 
 
 
 
Gross realized gains
$
818

 
$
9

 
$
901

 
$
93

Gross realized losses

 

 

 
 
Net investment security gains
$
818

 
$
9

 
$
901

 
$
93

    
The carrying value of securities pledged to secure public deposits and for other purposes as required or permitted by law approximated $264 million and $278 million at June 30, 2014 and December 31, 2013, respectively.

Statement of Cash Flows - Investing Activities - Supplemental Information

During the second quarter, the Company transferred certain securities from available-for-sale to held-to-maturity. The non-cash transfers of securities into the held-to-maturity categories from available-for-sale were made at fair value on the date of the transfer. The securities had an aggregate fair value of $83.4 million, with an aggregate net unrealized loss of $0.1 million on the date of transfer. The net unamortized, unrealized loss on the transferred securities included in accumulated other comprehensive income in the accompanying balance sheet as of June 30, 2014 totaled $0.1 million. This amount will be amortized out of accumulated other comprehensive income over the remaining life of the underlying securities as an adjustment of the yield on those securities.

18



 
Note D –Loans

The following summarizes the Company’s major classifications for loans (in thousands):
 
June 30, 2014
 
December 31, 2013
Residential real estate
$
1,242,972

 
$
1,204,450

Home equity – junior liens
145,452

 
146,090

Commercial and industrial
149,442

 
164,484

Commercial real estate
993,552

 
1,040,866

Consumer
42,858

 
46,402

DDA overdrafts
3,501

 
3,905

Gross loans
2,577,777

 
2,606,197

Allowance for loan losses
(20,536
)
 
(20,575
)
Net loans
$
2,557,241

 
$
2,585,622


Construction loans of $20.1 million and $17.3 million are included within residential real estate loans at June 30, 2014 and December 31, 2013, respectively.  Construction loans of $24.6 million and $24.0 million are included within commercial real estate loans at June 30, 2014 and December 31, 2013, respectively.  The Company’s commercial and residential real estate construction loans are primarily secured by real estate within the Company’s principal markets.  These loans were originated under the Company’s loan policy, which is focused on the risk characteristics of the loan portfolio, including construction loans.  Adequate consideration has been given to these loans in establishing the Company’s allowance for loan losses.

The following table details the loans acquired in conjunction with the Virginia Savings Bancorp, Inc. ("Virginia Savings") and Community Financial Corporation ("Community") acquisitions (in thousands):
 
Virginia
 
 
 
 
 
Savings
 
Community
 
Total
June 30, 2014
 
 
 
 
 
Outstanding loan balance
$
43,261

 
$
245,314

 
$
288,575

 
 
 
 
 
 
Credit-impaired loans:
 
 
 
 
 
Carrying value
3,098

 
17,902

 
21,000

Contractual principal and interest
3,735

 
27,394

 
31,129

 
 
 
 
 
 
December 31, 2013
 
 
 
 
 
Outstanding loan balance
$
48,833

 
$
279,890

 
$
328,723

 
 
 
 
 
 
Credit-impaired loans:
 
 
 
 
 
Carrying value
3,182

 
26,330

 
29,512

Contractual principal and interest
3,932

 
38,566

 
42,498


    





    

19


Changes in the accretable yield of the credit-impaired loans for the six months ended June 30, 2014 is as follows (in thousands):
 
Virginia Savings
 
Community
 
Total
 
 
 
Carrying
 
 
 
Carrying
 
 
 
Carrying
 
Accretable
 
Amount
 
Accretable
 
Amount
 
Accretable
 
Amount
 
Yield
 
of Loans
 
Yield
 
of Loans
 
Yield
 
of Loans
Balance at the beginning of the period
$
698

 
$
3,182

 
$
10,389

 
$
26,330

 
$
11,087

 
$
29,512

Accretion
(127
)
 
127

 
(1,289
)
 
1,488

 
(1,416
)
 
1,615

Net reclassifications to accretable yield from
 
 
 
 
 
 
 
 
 
 
 
   non-accretable yield
149

 

 
3,205

 

 
3,354

 

Payments received, net

 
(211
)
 

 
(9,916
)
 

 
(10,127
)
Disposals
(2
)
 

 
(242
)
 

 
(244
)
 

Balance at the end of period
$
718

 
$
3,098

 
$
12,063

 
$
17,902

 
$
12,781

 
$
21,000


Increases in expected cash flow subsequent to the acquisition are recognized first as a reduction of any previous impairment, then prospectively through adjustment of the yield on the loans or pools over its remaining life, while decreases in expected cash flows are recognized as impairment through a provision for loan loss and an increase in the allowance for purchased credit-impaired loans.

Note E – Allowance For Loan Losses
 
Management systematically monitors the loan portfolio and the adequacy of the allowance for loan losses on a quarterly basis to provide for probable losses inherent in the portfolio.  Management assesses the risk in each loan type based on historical trends, the general economic environment of its local markets, individual loan performance and other relevant factors.
 
Individual credits are selected throughout the year for detailed loan reviews, which are utilized by management to assess the risk in the portfolio and the adequacy of the allowance.  Due to the nature of commercial lending, evaluation of the adequacy of the allowance as it relates to these loan types is often based more upon specific credit reviews, with consideration given to the potential impairment of certain credits and historical loss rates, adjusted for economic conditions and other inherent risk factors.
 
The following table summarizes the activity in the allowance for loan loss, by portfolio segment, for the six months ended June 30, 2014 and 2013 (in thousands).  The following table also presents the balance in the allowance for loan loss disaggregated on the basis of the Company’s impairment measurement method and the related recorded investment in loans, by portfolio segment, as of June 30, 2014 and December 31, 2013 (in thousands).
 

20


 
Commercial &
Commercial
Residential
 
 
DDA
 
 
Industrial
Real Estate
Real Estate
Home equity
Consumer
Overdrafts
Total
Six months ended June 30, 2014
 
 
 
 
 
 
 
Allowance for loan loss
Beginning balance
$
1,139

$
10,775

$
6,057

$
1,672

$
77

$
855

$
20,575

Charge-offs
5

969

743

146

122

662

2,647

Recoveries
81

83

63


129

454

810

Provision
(248
)
508

1,087

(83
)
(3
)
399

1,660

   Provision for acquired loans
$
138

$

$

$

$

$

138

Ending balance
$
1,105

$
10,397

$
6,464

$
1,443

$
81

$
1,046

$
20,536

 
 
 
 
 
 
 
 
Six months ended June 30, 2013
 

 

 

 

 

 

 

Allowance for loan loss
 

 

 

 

 

 

 

Beginning balance
$
498

$
10,440

$
5,229

$
1,699

$
81

$
862

$
18,809

Charge-offs
392

622

1,111

270

224

687

3,306

Recoveries
21

34

68


217

477

817

Provision
939

642

1,792

222

7

147

3,749

Ending balance
$
1,066

$
10,494

$
5,978

$
1,651

$
81

$
799

$
20,069

 
 
 
 
 
 
 
 
As of June 30, 2014
 

 

 

 

 

 

 

Allowance for loan loss
 

 

 

 

 

 

 

Evaluated for impairment:
 

 

 

 

 

 

 

Individually
$

$
240

$

$

$

$

$
240

Collectively
1,063

9,500

6,428

1,443

81

1,046

19,561

Acquired with deteriorated
 

 

 

 

 

 

 

credit quality
42

657

36




735

Total
$
1,105

$
10,397

$
6,464

$
1,443

$
81

$
1,046

$
20,536

 
 
 
 
 
 
 
 
Loans
 

 

 

 

 

 

 

Evaluated for impairment:
 

 

 

 

 

 

 

Individually
$

$
7,239

$
453

$
297

$

$

$
7,989

Collectively
147,711

970,095

1,242,007

142,736

42,738

3,501

2,548,788

Acquired with deteriorated
 

 

 

 

 

 

 

credit quality
1,731

16,218

512

2,419

120


21,000

Total
$
149,442

$
993,552

$
1,242,972

$
145,452

$
42,858

$
3,501

$
2,577,777

 
 
 
 
 
 
 
 
As of December 31, 2013
 

 

 

 

 

 

 

Allowance for loan loss
 

 

 

 

 

 

 

Evaluated for impairment:
 

 

 

 

 

 

 

Individually
$

$
880

$

$

$

$

$
880

Collectively
827

9,615

6,054

1,672

77

855

19,100

Acquired with deteriorated
 
 
 
 
 
 
 
  credit quality
312

280

3




595

Total
$
1,139

$
10,775

$
6,057

$
1,672

$
77

$
855

$
20,575

 
 
 
 
 
 
 
 
Loans
 

 

 

 

 

 

 

Evaluated for impairment:
 

 

 

 

 

 

 

Individually
$

$
11,837

$
459

$
298

$

$

$
12,594

Collectively
162,500

1,004,475

1,201,894

145,025

46,292

3,905

2,564,091

Acquired with deteriorated
 
 
 
 
 
 
 
  credit quality
1,984

24,554

2,097

767

110


29,512

Total
$
164,484

$
1,040,866

$
1,204,450

$
146,090

$
46,402

$
3,905

$
2,606,197


21




Credit Quality Indicators
 
All commercial loans within the portfolio are subject to internal risk grading.  All non-commercial loans are evaluated based on payment history.  The Company’s internal risk ratings for commercial loans are:  Pass, Special Mention, Substandard and Doubtful.  Each internal risk rating is defined in the loan policy using the following criteria:  balance sheet yields, ratios and leverage, cash flow spread and coverage, prior history, capability of management, market position/industry, potential impact of changing economic, legal, regulatory or environmental conditions, purpose, structure, collateral support, and guarantor support.  Risk grades are generally assigned by the primary lending officer and are periodically evaluated by the Company’s internal loan review process.  Based on an individual loan’s risk grade, estimated loss percentages are applied to the outstanding balance of the loan to determine the amount of probable loss.
 
The Company categorizes loans into risk categories based on relevant information regarding the customer’s debt service ability, capacity, overall collateral position along with other economic trends, and historical payment performance.  The risk grades for each credit are updated when the Company receives current financial information, the loan is reviewed by the Company’s internal loan review/credit administration departments, or the loan becomes delinquent or impaired.  The risk grades are updated a minimum of annually for loans rated exceptional, good, acceptable, or pass/watch.  Loans rated special mention, substandard or doubtful are reviewed at least quarterly.  The Company uses the following definitions for its risk ratings:

Risk Rating
Description
Pass ratings:
 
   (a) Exceptional
Loans classified as exceptional are secured with liquid collateral conforming to the internal loan policy.  Loans rated within this category pose minimal risk of loss to the bank and the risk grade within this pool of loans is generally updated on an annual basis. 
   (b) Good
Loans classified as good have similar characteristics that include a strong balance sheet, satisfactory debt service coverage ratios, strong management and/or guarantors, and little exposure to economic cycles.  Loans within this category are generally reviewed on an annual basis.  Loans in this category generally have a low chance of loss to the bank.
   (c) Acceptable
Loans classified as acceptable have acceptable liquidity levels, adequate debt service coverage ratios, experienced management, and have average exposure to economic cycles.  Loans within this category generally have a low risk of loss to the bank. 
   (d) Pass/watch
Loans classified as pass/watch have erratic levels of leverage and/or liquidity, cash flow is volatile and the borrower is subject to moderate economic risk.  A borrower in this category poses a low to moderate risk of loss to the bank. 
Special mention
Loans classified as special mention have a potential weakness(es) that deserves management’s close attention.  The potential weakness could result in deterioration of the loan repayment or the bank’s credit position at some future date.  A loan rated in this category poses a moderate loss risk to the bank. 
Substandard
Loans classified as substandard reflect a customer with a well defined weakness that jeopardizes the liquidation of the debt.  Loans in this category have the possibility that the bank will sustain some loss if the deficiencies are not corrected and the bank’s collateral value is weakened by the financial deterioration of the borrower. 
Doubtful
Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristics that make collection of the full contract amount highly improbable.  Loans rated in this category are most likely to cause the bank to have a loss due to a collateral shortfall or a negative capital position. 













22


The following table presents loans by the Company’s commercial loans by credit quality indicators, by class (in thousands):
 
Commercial and industrial
 
Commercial real estate
 
Total
June 30, 2014
 
 
 
 
 
Pass
$
132,766

 
$
920,647

 
$
1,053,413

Special mention
10,643

 
19,771

 
30,414

Substandard
5,611

 
52,703

 
58,314

Doubtful
422

 
431

 
853

Total
$
149,442

 
$
993,552

 
$
1,142,994

 
 
 
 
 
 
December 31, 2013
 

 
 

 
 

Pass
$
158,000

 
$
958,186

 
$
1,116,186

Special mention
648

 
20,072

 
20,720

Substandard
5,416

 
62,139

 
67,555

Doubtful
420

 
469

 
889

Total
$
164,484

 
$
1,040,866

 
$
1,205,350

     
The following table presents the Company's non-commercial loans by payment performance, by class (in thousands):
 
Performing
 
Non-Performing
 
Total
June 30, 2014
 
 
 
 
 
Residential real estate
$
1,239,717

 
$
3,255

 
$
1,242,972

Home equity - junior lien
145,217

 
235

 
145,452

Consumer
42,841

 
17

 
42,858

DDA overdrafts
3,501

 

 
3,501

Total
$
1,431,276

 
$
3,507

 
$
1,434,783

 
 
 
 
 
 
December 31, 2013
 
 
 
 
 
Residential real estate
$
1,201,631

 
$
2,819

 
$
1,204,450

Home equity - junior lien
145,812

 
278

 
146,090

Consumer
46,353

 
49

 
46,402

DDA overdrafts
3,900

 
5

 
3,905

Total
$
1,397,696

 
$
3,151

 
$
1,400,847


Aging Analysis of Accruing and Non-Accruing Loans
 
Interest income on loans is accrued and credited to operations based upon the principal amount outstanding, using methods that generally result in level rates of return.  Loan origination fees, and certain direct costs, are deferred and amortized as an adjustment to the yield over the term of the loan.  The accrual of interest generally is discontinued when a loan becomes 90 days past due as to principal or interest for all loan types.  However, any loan may be placed on non-accrual if the Company receives information that indicates a borrower is unable to meet the contractual terms of their respective loan agreement.  Other indicators considered for placing a loan on non-accrual status include the borrower’s involvement in bankruptcies, foreclosures, repossessions, litigation and any other situation resulting in doubt as to whether full collection of contractual principal and interest is attainable.  When interest accruals are discontinued, unpaid interest recognized in income in the current year is reversed, and interest accrued in prior years is charged to the allowance for loan losses.  Management may elect to continue the accrual of interest when the net realizable value of collateral exceeds the principal balance and related accrued interest, and the loan is in the process of collection.

Generally for all loan classes, interest income during the period the loan is non-performing is recorded on a cash basis after recovery of principal is reasonably assured.  Cash payments received on nonperforming loans are typically applied directly against the outstanding principal balance until the loan is fully repaid.  Generally, loans are restored to accrual status when the obligation is brought current, has performed in accordance with the contractual terms for a reasonable period of time, and the ultimate collectability of the total contractual principal and interest is no longer in doubt.
 
Generally, all loan types are considered past due when the contractual terms of a loan are not met and the borrower is 30 days or more past due on a payment.  Furthermore, residential and home equity loans are generally subject to charge-off

23


when the loan becomes 120 days past due, depending on the estimated fair value of the collateral less cost to dispose, versus the outstanding loan balance.  Commercial loans are generally charged off when the loan becomes 120 days past due.  Open-end consumer loans are generally charged off when the loan becomes 180 days past due.

A loan acquired and accounted for under ASC Topic 310-30 is reported as an accruing loan and a performing asset provided that the loan is performing in accordance with the initial expectations. The loan would be considered non-performing if the loan's performance deteriorates below the initial expectations.
 
The following table presents an aging analysis of the Company’s accruing and non-accruing loans, by class, as of June 30, 2014 and December 31, 2013 (in thousands):
 
 
Originated Loans
 
June 30, 2014
 
Accruing
 
 
 
 
 
Current
 
30-59 days
 
60-89 days
 
Over 90 days
 
Purchased-Credit Impaired
 
Non-accrual
 
Total
Residential real estate
$
1,140,373

 
$
4,421

 
$
789

 
$
584

 
$

 
$
2,240

 
$
1,148,407

Home equity - junior lien
141,927

 
761

 
120

 
44

 

 
191

 
143,043

Commercial and industrial
133,028

 

 
25

 

 

 
137

 
133,190

Commercial real estate
817,777

 
443

 

 

 

 
9,087

 
827,307

Consumer
33,674

 
79

 
1

 

 

 

 
33,754

DDA overdrafts
3,220

 
276

 
5

 

 

 

 
3,501

Total
$
2,269,999

 
$
5,980

 
$
940

 
$
628

 
$

 
$
11,655

 
$
2,289,202

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Acquired Loans
 
June 30, 2014
 
Accruing
 
 
 
 
 
Current
 
30-59 days
 
60-89 days
 
Over 90 days
 
Purchased-Credit Impaired
 
Non-accrual
 
Total
Residential real estate
$
93,392

 
$
699

 
$
42

 
$
132

 
$

 
$
300

 
$
94,565

Home equity - junior lien
2,406

 
3

 

 

 

 

 
2,409

Commercial and industrial
14,119

 
43

 
15

 

 

 
2,075

 
16,252

Commercial real estate
159,741

 
1,010

 
165

 
18

 
917

 
4,394

 
166,245

Consumer
8,730

 
330

 
27

 
17

 

 

 
9,104

DDA overdrafts

 

 

 

 

 

 

Total
$
278,388

 
$
2,085

 
$
249

 
$
167

 
$
917

 
$
6,769

 
$
288,575

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total Loans
 
June 30, 2014
 
Accruing
 
 
 
 
 
Current
 
30-59 days
 
60-89 days
 
Over 90 days
 
Purchased-Credit Impaired
 
Non-accrual
 
Total
Residential real estate
$
1,233,765

 
$
5,120

 
$
831

 
$
716

 
$

 
$
2,540

 
$
1,242,972

Home equity - junior lien
144,333

 
764

 
120

 
44

 

 
191

 
145,452

Commercial and industrial
147,147

 
43

 
40

 

 

 
2,212

 
149,442

Commercial real estate
977,518

 
1,453

 
165

 
18

 
917

 
13,481

 
993,552

Consumer
42,404

 
409

 
28

 
17

 

 

 
42,858

DDA overdrafts
3,220

 
276

 
5

 

 

 

 
3,501

Total
$
2,548,387

 
$
8,065

 
$
1,189

 
$
795

 
$
917

 
$
18,424

 
$
2,577,777

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

24


 
Originated Loans
 
December 31, 2013
 
Accruing
 
 
 
 
 
Current
 
30-59 days
 
60-89 days
 
Over 90 days
 
Purchased-Credit Impaired
 
Non-accrual
 
Total
Residential real estate
$
1,096,911

 
$
4,123

 
$
495

 
$
231

 
$

 
$
1,905

 
$
1,103,665

Home equity - junior lien
141,967

 
880

 

 
42

 

 
236

 
143,125

Commercial and industrial
144,197

 

 

 

 

 
79

 
144,276

Commercial real estate
835,908

 
668

 

 

 

 
13,097

 
849,673

Consumer
32,647

 
172

 
7

 
4

 

 

 
32,830

DDA overdrafts
3,511

 
374

 
15

 
5

 

 

 
3,905

Total
$
2,255,141

 
$
6,217

 
$
517

 
$
282

 
$

 
$
15,317

 
$
2,277,474

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Acquired Loans
 
December 31, 2013
 
Accruing
 
 
 
 
 
Current
 
30-59 days
 
60-89 days
 
Over 90 days
 
Purchased-Credit Impaired
 
Non-accrual
 
Total
Residential real estate
$
99,089

 
$
842

 
$
172

 
$

 
$

 
$
682

 
$
100,785

Home equity - junior lien
2,965

 

 

 

 

 

 
2,965

Commercial and industrial
18,253

 

 
80

 

 

 
1,875

 
20,208

Commercial real estate
176,018

 
2,772

 
273

 
109

 
7,534

 
4,487

 
191,193

Consumer
12,876

 
622

 
29

 
45

 

 

 
13,572

DDA overdrafts

 

 

 

 

 

 

Total
$
309,201

 
$
4,236

 
$
554

 
$
154

 
$
7,534

 
$
7,044

 
$
328,723

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total Loans
 
December 31, 2013
 
Accruing
 
 
 
 
 
Current
 
30-59 days
 
60-89 days
 
Over 90 days
 
Purchased-Credit Impaired
 
Non-accrual
 
Total
Residential real estate
$
1,196,000

 
$
4,965

 
$
667

 
$
231

 
$

 
$
2,587

 
$
1,204,450

Home equity - junior lien
144,932

 
880

 

 
42

 

 
236

 
146,090

Commercial and industrial
162,450

 

 
80

 

 

 
1,954

 
164,484

Commercial real estate
1,011,926

 
3,440

 
273

 
109

 
7,534

 
17,584

 
1,040,866

Consumer
45,523

 
794

 
36

 
49

 

 

 
46,402

DDA overdrafts
3,511

 
374

 
15

 
5

 

 

 
3,905

Total
$
2,564,342

 
$
10,453

 
$
1,071

 
$
436

 
$
7,534

 
$
22,361

 
$
2,606,197
















25


The following table presents the Company’s impaired loans, by class, as of June 30, 2014 and December 31, 2013 (in thousands). The difference between the unpaid principal balance and the recorded investment generally reflects amounts that have been previously charged-off.

 
June 30, 2014
 
December 31, 2013
 
 
 
Unpaid
 
 
 
 
 
Unpaid
 
 
 
Recorded
 
Principal
 
Related
 
Recorded
 
Principal
 
Related
 
Investment
 
Balance
 
Allowance
 
Investment
 
Balance
 
Allowance
With no related allowance recorded:
 
 
 
 
 
 
 
 
 
 
 
Residential real estate
$
453

 
$
453

 
$

 
$
459

 
$
459

 
$

Home equity - junior liens
297

 
297

 

 
298

 
298

 

Commercial and industrial

 

 

 

 

 

Commercial real estate
5,837

 
6,629

 

 
8,421

 
8,361

 

Consumer

 

 

 

 

 

DDA overdrafts

 

 

 

 

 

Total
$
6,587

 
$
7,379

 
$

 
$
9,178

 
$
9,118

 
$

 
 
 
 
 
 
 
 
 
 
 
 
With an allowance recorded
 
 
 
 
 
 
 
 
 
 
 
Residential real estate
$

 
$

 
$

 
$

 
$

 
$

Home equity - junior liens

 

 

 

 

 

Commercial and industrial

 

 

 

 

 

Commercial real estate
1,403

 
4,333

 
240

 
3,416

 
3,416

 
880

Consumer

 

 

 

 

 

DDA overdrafts

 

 

 

 

 

Total
$
1,403

 
$
4,333

 
$
240

 
$
3,416

 
$
3,416

 
$
880


     The following table presents information related to the average recorded investment and interest income recognized on the Company’s impaired loans, by class (in thousands):
 
For the six months ended
 
June 30, 2014
 
June 30, 2013
 
Average
 
Interest
 
Average
 
Interest
 
Recorded
 
Income
 
Recorded
 
Income
 
Investment
 
Recognized
 
Investment
 
Recognized
With no related allowance recorded:
 
 
 
 
 
 
 
Residential real estate
$
455

 
$

 
$
464

 
$

Home equity - junior liens
297

 

 
297

 

Commercial and industrial

 

 

 

Commercial real estate
8,120

 
9

 
9,450

 

Consumer

 

 

 

DDA overdrafts

 

 

 

Total
$
8,872

 
$
9

 
$
10,211

 
$

 
 
 
 
 
 
 
 
With an allowance recorded
 
 
 
 
 
 
 
Residential real estate
$

 
$

 
$

 
$

Home equity - junior liens

 

 

 

Commercial and industrial

 

 

 

Commercial real estate
2,055

 
68

 
3,103

 

Consumer

 

 

 

DDA overdrafts

 

 

 

Total
$
2,055

 
$
68

 
$
3,103

 
$



26


     Approximately $0.2 million and $0.3 million of interest income would have been recognized during the six months ended June 30, 2014 and 2013, if such loans had been current in accordance with their original terms.  There were no commitments to provide additional funds on non-accrual, impaired or other potential problem loans at June 30, 2014.

Loan Modifications

The Company’s policy on loan modifications typically does not allow for modifications that would be considered a concession from the Company.  However, when there is a modification, the Company evaluates each modification to determine if the modification constitutes a troubled debt restructuring (“TDR”) in accordance with ASU 2011-2, whereby a modification of a loan would be considered a TDR when both of the following conditions are met: (1) a borrower is experiencing financial difficulty and (2) the modification constitutes a concession.  When determining whether the borrower is experiencing financial difficulties, the Company reviews whether the debtor is currently in payment default on any of its debt or whether it is probable that the debtor would be in payment default in the foreseeable future without the modification.  Other indicators of financial difficulty include whether the debtor has declared or is in the process of declaring bankruptcy, the debtor’s ability to continue as a going concern, or the debtor’s projected cash flow to service its debt (including principal and interest) in accordance with the contractual terms for the foreseeable future, without a modification.

Regulatory guidance requires loans to be accounted for as collateral-dependent loans when borrowers have filed Chapter 7 bankruptcy, the debt has been discharged by the bankruptcy court and the borrower has not reaffirmed the debt. The filing of bankruptcy is deemed to be evidence that the borrower is in financial difficulty and the discharge of the debt by the bankruptcy court is deemed to be a concession granted to the borrower.

The following tables set forth the Company’s TDRs (in thousands):

 
June 30, 2014
 
December 31, 2013
 
 
Non-
 
 
 
 
 
Non-
 
 
Accruing
 
Accruing
 
Total
 
Accruing
 
Accruing
 
Total
Commercial and industrial
$
86

 
$

 
$
86

 
$
88

 
$

 
$
88

Commercial real estate
2,281

 

 
2,281

 
1,783

 

 
1,783

Residential real estate
18,893

 
320

 
19,213

 
18,651

 
1,693

 
20,344

Home equity
2,803

 
55

 
2,858

 
2,859

 
14

 
2,873

Consumer

 

 

 

 

 

 
$
24,063

 
$
375

 
$
24,438

 
$
23,381

 
$
1,707

 
$
25,088

 
 
New TDRs
 
New TDRs
 
For the six months ended
 
For the six months ended
 
June 30, 2014
 
June 30, 2013
 
 
Pre
 
Post
 
 
 
Pre
 
Post
 
 
Modification
 
Modification
 
 
 
Modification
 
Modification
 
 
Outstanding
 
Outstanding
 
 
 
Outstanding
 
Outstanding
Number of
 
Recorded
 
Recorded
 
Number of
 
Recorded
 
Recorded
Contracts
 
Investment
 
Investment
 
Contracts
 
Investment
 
Investment
Commercial and industrial
1

 
$
5

 
$
5

 
1

 
$
95

 
$
95

Commercial real estate
1

 
434

 
434

 
3

 
1,571

 
1,571

Residential real estate
16

 
1,209

 
1,209

 
26

 
2,845

 
2,845

Home equity
7

 
170

 
170

 
8

 
185

 
185

Consumer

 

 

 

 

 

 
25

 
$
1,818

 
$
1,818

 
38

 
$
4,696

 
$
4,696

    

27



Note F – Long-Term Debt

The components of long-term debt are summarized below (in thousands):
 
June 30, 2014
 
December 31, 2013
Junior subordinated debentures owed to City Holding Capital Trust III, due 2038, interest at a rate of 3.73% and 3.74%, respectively
$
16,495

 
$
16,495

 
The Company formed a statutory business trust, City Holding Capital Trust III (“Capital Trust III”), under the laws of Delaware.  Capital Trust III was created for the exclusive purpose of (i) issuing trust-preferred capital securities (“Capital Securities”), which represent preferred undivided beneficial interests in the assets of the trust, (ii) using the proceeds from the sale of the Capital Securities to acquire junior subordinated debentures (“Debentures”) issued by the Company, and (iii) engaging in only those activities necessary or incidental thereto.  The trust is considered a variable interest entity for which the Company is not the primary beneficiary.  Accordingly, the accounts of the trusts are not included in the Company’s consolidated financial statements.

Distributions on the Debentures are cumulative and will be payable quarterly at an interest rate of 3.50% over the three month LIBOR rate, reset quarterly.  Interest payments are due in March, June, September and December.  The Debentures are redeemable prior to maturity at the option of the Company (i) in whole or at any time or in part from time-to-time, or (ii) in whole, but not in part, at any time within 90 days following the occurrence and during the continuation of certain pre-defined events.

Payments of distributions on the trust preferred securities and payments on redemption of the trust preferred securities are guaranteed by the Company.  The Company also entered into an agreement as to expenses and liabilities with the trust pursuant to which it agreed, on a subordinated basis, to pay any cost, expenses or liabilities of the trust other than those arising under the trust preferred securities.  The obligations of the Company under the junior subordinated debentures, the related indentures, the trust agreement establishing the trust, the guarantees and the agreements as to expenses and liabilities, in the aggregate, constitute a full and unconditional guarantee by the Company of the trust’s obligations under the trust preferred securities.  The Capital Securities issued by the statutory business trusts qualify as Tier 1 capital for the Company under current Federal Reserve Board guidelines.

Note G – Derivative Instruments

As of June 30, 2014 and December 31, 2013, the Company has derivative financial instruments not included in hedge relationships.  These derivatives consist of interest rate swaps used for interest rate management purposes and derivatives executed with commercial banking customers to facilitate their interest rate management strategies.

The following table summarizes the fair value of these derivative instruments (in thousands):
 Fair Value:
June 30, 2014
 
December 31, 2013
 
Other Assets
$
8,383

 
$
3,538

Other Liabilities
8,383

 
3,538


The following table summarizes the change in fair value of these derivative instruments (in thousands):
 
Three months ended June 30,
 
Six months ended June 30,
 
2014
 
2013
 
2014
 
2013
 
Change in Fair Value:
 
 
 
 
 
 
 
 
Other income - derivative asset
$
2,552

 
$
(6,211
)
 
$
4,606

 
$
(7,790
)
 
Other income - derivative liability
(2,552
)
 
6,211

 
(4,606
)
 
7,790

 

Certain financial instruments, including derivatives, may be eligible for offset in the consolidated balance sheet and/or subject to master netting arrangements. The Company's derivative transactions with financial institution counterparties are generally executed under International Swaps and Derivative Association ("ISDA") master agreements which include "right of setoff" provisions. In such cases there is generally a legally enforceable right to offset recognized amounts and there may be an intention to settle such amounts on a net basis. Nonetheless, the Company does not generally offset financial instruments for
financial reporting purposes. Information about financial instruments that are eligible for offset in the consolidated balance sheet as of June 30, 2014 is presented in the following tables (in thousands):

 
 
 
 
Gross Amounts
 
 
 
 
 
 
Not Offset in the Statement
 
 
 
 
 
 
of Financial Position
 
 
 
 
 
 
 
 
Total
 
 
 
 
 
 
 
of Gross
 
 
 
 
 
 
 
Amounts
 
 
 
 
 
 
 
Not Offset in
 
 
 
 
 
 
 
the Statement
 
 
 
 
 
 
 
of Financial
 
 
 
 
 
 
 
Position
 
 
 
 
 
Netting
 
Including
 
 
 
Gross
Net Amounts
Adjustment
 
Applicable
 
 
 
Amounts
of Assets
per
 
Netting
 
 
Gross
Offset in the
presented in
Applicable
 
Agreement
 
 
Amounts of
Statement of
the Statement
Master
Fair Value
and Fair
 
 
Recognized
Financial
of Financial
Netting
of Financial
Value of
 
Description
Assets
Position
Position
Arrangements
Collateral
Collateral
Net Amount
 
(a)
(b)
(c)=(a)-(b)
 
 
(d)
(c)-(d)
Derivative assets:
 
 
 
 
 
 
 
Interest rate swap agreements
$
8,383

$

$
8,383

$

$
8,383

$
8,383

$


 
 
 
 
Gross Amounts
 
 
 
 
 
 
Not Offset in the Statement
 
 
 
 
 
 
of Financial Position
 
 
 
 
 
 
 
 
Total
 
 
 
 
 
 
 
of Gross
 
 
 
 
 
 
 
Amounts
 
 
 
 
 
 
 
Not Offset in
 
 
 
 
 
 
 
the Statement
 
 
 
 
 
 
 
of Financial
 
 
 
 
 
 
 
Position
 
 
 
 
 
Netting
 
Including
 
 
 
Gross
Net Amounts
Adjustment
 
Applicable
 
 
 
Amounts
of Liabilities
per
 
Netting
 
 
Gross
Offset in the
presented in
Applicable
 
Agreement
 
 
Amounts of
Statement of
the Statement
Master
Fair Value
and Fair
 
 
Recognized
Financial
of Financial
Netting
of Financial
Value of
 
Description
Liabilities
Position
Position
Arrangements
Collateral
Collateral
Net Amount
 
(a)
(b)
(c)=(a)-(b)
 
 
(d)
(c)-(d)
Derivative liabilities:
 
 
 
 
 
 
Interest rate swap agreements
$
8,383

$

$
8,383

$

$
11,720

$
11,720

$


28



Note H – Employee Benefit Plans

Pursuant to the terms of the City Holding Company 2003 Incentive Plan and the City Holding Company 2013 Incentive Plan (the "2003 Plan” and "2013 Plan", respectively), the Compensation Committee of the Board of Directors, or its delegate, may, from time-to-time, grant stock options, stock appreciation rights (“SARs”), or stock awards to employees, directors and individuals who provide service to the Company (collectively, "Plan Participants").  The 2003 Plan expired in April of 2013 and the 2013 Plan was approved by the shareholders in April 2013. A maximum of 750,000 shares of the Company’s common stock may be issued upon the exercise of stock options, SARs and stock awards.  These limitations may be adjusted in the event of a change in the number of outstanding shares of common stock by reason of a stock dividend, stock split or other similar event.  Specific terms of options and SARs awarded, including vesting periods, exercise prices (stock price at date of grant) and expiration dates are determined at the date of grant and are evidenced by agreements between the Company and the awardee.  The exercise price of the option grants equals the market price of the Company’s stock on the date of grant.  All incentive stock options and SARs will be exercisable up to 10 years from the date granted and all options and SARs are exercisable for the period specified in the individual agreement. As of June 30, 2014, under the 2003 Plan and 2013 Plan, 411,601 stock options had been awarded and 228,009 restricted stock awards had been awarded, respectively.

Each award from the Plan is evidenced by an award agreement that specifies the option price, the duration of the option, the number of shares to which the option pertains, and such other provisions as the Compensation Committee, or its delegate, determines.  The option price for each grant is equal to the fair market value of a share of the Company’s common stock on the date of the grant.  Options granted expire at such time as the Compensation Committee, or its delegate, determines at the date of the grant and in no event does the exercise period exceed a maximum of ten years.  Upon a change-in-control of the Company, as defined in the Plan, all outstanding options and awards shall immediately vest.
 
Stock Options
 
A summary of the Company’s stock option activity and related information is presented below:
 
Six months ended June 30,
 
2014
 
2013
Options
 
Weighted-Average Exercise Price
 
Options
 
Weighted-Average Exercise Price
Outstanding at January 1
173,601

 
$
35.26

 
289,544

 
$
34.38

Granted
13,953

 
44.43

 
15,475

 
37.74

Exercised
(19,000
)
 
29.13

 
(62,685
)
 
32.89

Forfeited

 

 
(1,500
)
 
36.90

Outstanding at June 30
168,554

 
$
36.71

 
240,834

 
$
34.96

 
Additional information regarding stock options outstanding and exercisable at June 30, 2014, is provided in the following table:
Ranges of Exercise Prices
No. of Options Outstanding
Weighted-Average Exercise Price
Weighted-Average Remaining Contractual Life (Years)
Aggregate Intrinsic Value (in thousands)
No. of Options Currently Exercisable
Weighted-Average Exercise Price of Options Currently Exercisable
Weighted-Average Remaining Contractual Life (Years)
Aggregate Intrinsic Value of Options Currently Exercisable (in thousands)
$26.62 - $33.90
40,250

$
30.83

4.1
$
575

19,332

$
30.46

2.7
$
283

$35.09 - $44.43
128,304

38.55

5.3
843

66,000

39.15

2.6
394

 
168,554

 

 
$
1,418

85,332

 

 
$
677

 
Proceeds from stock option exercises were $0.6 million and $1.4 million during the six months ended June 30, 2014 and 2013, respectively. Shares issued in connection with stock option exercises are issued from available treasury shares. If no treasury shares are available, new shares are issued from available authorized shares. During the six months ended June 30, 2014 and 2013 all shares issued in connection with stock option exercises and restricted stock awards were issued from available treasury stock.


29


The total intrinsic value of stock options exercised was $0.3 million and $0.2 million during the six months ended June 30, 2014 and 2013, respectively.

Stock-based compensation expense was approximately $0.1 million for the both the six months ended June 30, 2014 and 2013.  Unrecognized stock-based compensation expense related to stock options approximated $0.5 million at June 30, 2014. At such date, the weighted-average period over which this unrecognized expense was expected to be recognized was 1.6 years.

The fair value of the options is estimated at the date of grant using a Black-Scholes option-pricing model.   The following weighted average assumptions were used to estimate the fair value of options granted:

 
Six months ended June 30,
 
2014
 
2013
Risk-free interest rate
2.42
%
 
1.88
%
Expected dividend yield
3.60
%
 
3.70
%
Volatility factor
48.75
%
 
41.35
%
Expected life of option
8.0 years
 
8.0 years
 
Restricted Shares

The Company records compensation expense with respect to restricted shares in an amount equal to the fair value of the common stock covered by each award on the date of grant. The restricted shares awarded become fully vested after various periods of continued employment from the respective dates of grant. The Company is entitled to an income tax deduction in an amount equal to the taxable income reported by the holders of the restricted shares when the restrictions are released and the shares are issued. Compensation is being charged to expense over the respective vesting periods.

Restricted shares are forfeited if officers and employees terminate prior to the lapsing of restrictions. The Company records forfeitures of restricted stock as treasury share repurchases and any compensation cost previously recognized is reversed in the period of forfeiture.  Recipients of restricted shares do not pay any cash consideration to the Company for the shares, have the right to vote all shares subject to such grant and receive all dividends with respect to such shares, whether or not the shares have vested.  Stock-based compensation expense related to restricted shares was approximately $0.5 million and $0.3 million for the six months ended June 30, 2014 and 2013, respectively.  Unrecognized stock-based compensation expense related to non-vested restricted shares was $3.3 million at June 30, 2014. At June 30, 2014, this unrecognized expense is expected to be recognized over 3.7 years based on the weighted average-life of the restricted shares.
 
A summary of the Company’s restricted shares activity and related information is presented below:
 
Six months ended June 30,
 
2014
 
2013
Restricted Awards
 
Average Market Price at Grant
 
Restricted Awards
 
Average Market Price at Grant
Outstanding at January 1
142,469

 
 
 
116,711

 
 
Granted
25,062

 
$
43.05

 
32,083

 
$
37.57

Forfeited/Vested
(6,200
)
 
 

 
(8,075
)
 
 

Outstanding at June 30
161,331

 
 

 
140,719

 
 


Benefit Plans
 
The Company provides retirement benefits to its employees through the City Holding Company 401(k) Plan and Trust (“the 401(k) Plan”), which is intended to be compliant with Employee Retirement Income Security Act (ERISA) section 404(c). The Company’s total expense associated with the retirement benefit plan approximated $0.4 million for both the six months ended June 30, 2014 and 2013.

The Company maintains two frozen defined benefit pension plans (“the Defined Benefit Plans”), which were inherited from the Company's acquisition of the plan sponsors (Horizon Bancorp, Inc. and Community Financial Corporation). The Company made contributions of approximately $0.2 million to the Defined Benefit Plans during the six months ended June 30, 2014 and 2013.


30


The following table presents the components of the net periodic pension cost of the Defined Benefit Plans (in thousands):

 
Three months ended June 30,
 
Six months ended June 30,
 
2014
 
2013
 
2014
 
2013
 
Components of net periodic cost:
 
 
 
 
 
 
 
 
Interest cost
$
209

 
$
186

 
$
425

 
$
332

 
Expected return on plan assets
(252
)
 
(233
)
 
(527
)
 
(419
)
 
Net amortization and deferral
150

 
245

 
388

 
465

 
Net Periodic Pension Cost
$
107

 
$
198

 
$
286

 
$
378

 
 
Note I – Commitments and Contingencies

The Company is a party to certain financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers.  The Company has entered into agreements with its customers to extend credit or provide a conditional commitment to provide payment on drafts presented in accordance with the terms of the underlying credit documents. The Company also provides overdraft protection to certain demand deposit customers that represent an unfunded commitment.  Overdraft protection commitments, which are included with other commitments below, are uncollateralized and are paid at the Company’s discretion.  Conditional commitments generally include standby and commercial letters of credit. Standby letters of credit represent an obligation of the Company to a designated third party contingent upon the failure of a customer of the Company to perform under the terms of the underlying contract between the customer and the third party. Commercial letters of credit are issued specifically to facilitate trade or commerce. Under the terms of a commercial letter of credit, drafts will be drawn when the underlying transaction is consummated, as intended, between the customer and a third party. The funded portion of these financial instruments is reflected in the Company’s balance sheet, while the unfunded portion of these commitments is not reflected in the balance sheet.  The table below presents a summary of the contractual obligations of the Company resulting from significant commitments (in thousands):

 
June 30, 2014
 
December 31, 2013
Commitments to extend credit:
 
 
 
Home equity lines
$
175,284

 
$
174,417

Commercial real estate
31,653

 
42,209

Other commitments
163,960

 
201,065

Standby letters of credit
14,199

 
14,122

Commercial letters of credit
1,661

 
1,555

 
Loan commitments and standby and commercial letters of credit have credit risks essentially the same as that involved in extending loans to customers and are subject to the Company’s standard credit policies. Collateral is obtained based on management’s credit assessment of the customer. Management does not anticipate any material losses as a result of these commitments.

The Company is engaged in various legal actions that it deems to be in the ordinary course of business. As these legal actions are resolved, the Company could realize positive and/or negative impact to its financial performance in the period in which these legal actions are ultimately decided. There can be no assurance that current actions will have immaterial results, either positive or negative, or that no material actions may be presented in the future.
 

31



Note J – Accumulated Other Comprehensive Loss

The activity in accumulated other comprehensive loss for the six months ended June 30, 2014 and 2013 is presented in the tables below (in thousands). All amounts are shown net of tax, which is calculated using a combined Federal and state income tax rate approximating 37%.
 
 
Accumulated Other Comprehensive Loss
 
 
 
Unrealized
 
 
 
 
 
Gains (Losses) on
 
 
 
Defined Benefit
 
Securities
 
 
 
Pension Plans
 
Available-for-Sale
 
Total
 
 
 
 
 
 
Balance at December 31, 2012
$
(4,995
)
 
$
3,573

 
$
(1,422
)
 
 
 
 
 
 
   Other comprehensive income before reclassifications

 
(4,059
)
 
(4,059
)
   Amounts reclassified from other comprehensive loss

 
(59
)
 
(59
)
 

 
(4,118
)
 
(4,118
)
 
 
 
 
 
 
Balance at June 30, 2013
$
(4,995
)
 
$
(545
)
 
$
(5,540
)
 
 
 
 
 
 
Balance at December 31, 2013
$
(2,880
)
 
$
(2,110
)
 
$
(4,990
)
 
 
 
 
 
 
   Other comprehensive income before reclassifications

 
3,050

 
3,050

   Amounts reclassified from other comprehensive loss

 
(569
)
 
(569
)
 

 
2,481

 
2,481

 
 
 
 
 
 
Balance at June 30, 2014
$
(2,880
)
 
$
371

 
$
(2,509
)

 
Amount reclassified from Other Comprehensive Loss
 
 
Three months ended
 
Six months ended
Affected line item
 
June 30,
 
June 30,
in the Statements
 
2014
2013
 
2014
2013
of Income
 
 
 
 
 
 
 
Securities available-for-sale:
 
 
 
 
 
 
Net securities gains reclassified into earnings
$
(818
)
$
(9
)
 
$
(901
)
$
(93
)
Security gains (losses)
Related income tax expense
301

3

 
332

34

Income tax expense
  Net effect on accumulated other comprehensive loss
$
(517
)
$
(6
)
 
$
(569
)
$
(59
)
 

 

32



Note K – Earnings per Share
The following table sets forth the computation of basic and diluted earnings per share (in thousands, except per share data):
 
 
Three months ended June 30,
 
Six months ended June 30,
 
2014
 
2013
 
2014
 
2013
 
Distributed earnings allocated to  common stock
$
6,178

 
$
5,751

 
$
12,356

 
$
11,502

 
Undistributed earnings allocated to common stock
6,448

 
7,139

 
13,931

 
9,303

 
Net earnings allocated to common shareholders
$
12,626

 
$
12,890

 
$
26,287

 
$
20,805

 
 
 
 
 
 
 
 
 
 
Average shares outstanding
15,556

 
15,582

 
15,583

 
15,521

 
Effect of dilutive securities:
 

 
 

 
 
 
 
 
Warrant outstanding
62

 
62

 
62

 
59

 
Employee stock awards
88

 
108

 
93

 
107

 
Shares for diluted earnings per share
15,706

 
15,752

 
15,738

 
15,687

 
 
 
 
 
 
 
 
 
 
Basic earnings per share
$
0.81

 
$
0.83

 
$
1.69

 
$
1.34

 
Diluted earnings per share
$
0.80

 
$
0.82

 
$
1.67

 
$
1.33

 

Options to purchase approximately 57,500 shares of common stock at an exercise price between $39.34 and $40.88 per share were outstanding during the second quarter of 2013 but were not included in the computation of diluted earnings per share because the options’ exercise price was greater than the average market price of the common shares and therefore, the effect would have been anti-dilutive.  During the second quarter of 2014, there were no anti-dilutive options outstanding.
 
Note L – Fair Value Measurements

Fair value of an asset or liability is the price that would be received to sell that asset or paid to transfer that liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.  ASC Topic 820 establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

Level 1: Quoted prices (unadjusted) or 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, and other inputs that are observable or can be corroborated by observable market data.

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

The Company bases fair value of assets and liabilities on quoted market prices, prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.  If such information is not available, fair value is based upon internally developed models that primarily use, as inputs, observable market-based parameters.  Valuation adjustments may be made to ensure that financial instruments are recorded at fair value.  These adjustments may include amounts to reflect counterparty credit quality and the Company’s creditworthiness, among other things, as well as unobservable parameters.  Any such valuation adjustments are applied consistently over time.  The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values.  While management believes the company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.  Furthermore, the reported fair value amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amount presented herein.  A more detailed description of the valuation methodologies used for assets and liabilities measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.

33



Financial Assets and Liabilities

The Company used the following methods and significant assumptions to estimate fair value for financial assets and liabilities measured on a recurring basis.

Securities Available for Sale.  Securities available for sale are reported at fair value utilizing Level 1, Level 2, and Level 3 inputs.  The fair value of securities available for sale is determined by utilizing a market approach by obtaining quoted prices on nationally recognized securities exchanges (other than forced or distressed transactions) that occur in sufficient volume or matrix pricing, which is a mathematical technique used widely 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.  If such measurements are unavailable, the security is classified as Level 3.  Significant judgment is required to make this determination.

The Company utilizes a third party pricing service provider to value its Level 1 and Level 2 investment securities.  Annually, the Company obtains an independent auditor’s report from its third party pricing service provider regarding its controls over investment securities.  Although no control deficiencies were noted, the report did contain caveats and disclaimers regarding the pricing information, such as the Company should review fair values for reasonableness.  On a quarterly basis, the Company selects a sample of its debt securities and reprices those securities with a third party that is independent of the primary pricing service provider to verify the reasonableness of the fair values. In addition, the Company selects a sample of securities and reviews the underlying support from the primary pricing service provider.

The Company has determined that its pooled trust preferred securities should be priced using Level 3 inputs in accordance with ASC Topic 820 and guidance issued by the SEC.  The Company has determined that there are few observable transactions and market quotations available for pooled trust preferred securities and they are not reliable for purposes of determining fair value at June 30, 2014.  Due to these circumstances, the Company has elected to utilize an income valuation approach produced by a third party pricing source.  This third party model utilizes deferral and default probabilities for the underlying issuers, estimated prepayment rates and assumes no future recoveries of any defaults or deferrals.  The Company then compares the values provided by the third party model with other external sources.  At such time as there are observable transactions or quoted prices that are associated with an orderly and active market for pooled trust preferred securities, the Company will incorporate such market values in its estimate of fair values for these securities.

Derivatives. Derivatives are reported at fair value utilizing Level 2 inputs.  The Company utilizes a market approach by obtaining dealer quotations to value its customer interest rate swaps.  The Company’s derivatives are included within its Other Assets and Other Liabilities in the accompanying consolidated balance sheets. Derivative assets are typically secured through securities with financial counterparties or cross collateralization with a borrowing customer. Derivative liabilities are typically secured through the Company pledging securities to financial counterparties or, in the case of a borrowing customer, by the right of setoff. The Company considers such factors such as the likelihood of default by itself and its counterparties, right of setoff, and remaining maturities in determining the appropriate fair value adjustments. All derivative counterparties approved by the Company's Asset and Liability Committee ("ALCO") are regularly reviewed, and appropriate business action is taken to adjust the exposure to certain counterparties, if necessary. Counterparty exposure is evaluated by netting positions that are subject to master netting agreements, as well as considering the amount of marketable collateral securing the position. This approach used to estimate impacted exposures to counterparties is also used by the Company to estimate its own credit risk in derivative liability positions. To date, no material losses have been incurred due to a counterparty's inability to pay any undercollateralized position. There was no significant change in the value of derivative assets and liabilities attributed to credit risk during the three and six months ended June 30, 2014.

The Company may be required, from time to time, to measure certain financial assets and financial liabilities at fair value on a nonrecurring basis.  Financial assets measured at fair value on a nonrecurring basis include impaired loans reported at the fair value of the underlying collateral if repayment is expected solely from the collateral.  Collateral values are estimated using Level 2 inputs based on observable market data for real estate collateral or Level 3 inputs for non-real estate collateral.  The following table presents assets and liabilities measured at fair value (in thousands):

34


 
Total
 
Level 1
 
Level 2
 
Level 3
 
Total Gains (Losses)
June 30, 2014
 
 
 
 
 
 
 
 
 
Recurring fair value measurements
 
 
 
 
 
 
 
 
 
Financial Assets
 
 
 
 
 
 
 
 
 
U.S. Government agencies
$
2,078

 
$

 
$
2,078

 
$

 
 
Obligations of states and political subdivisions
40,140

 

 
40,140

 

 
 
Mortgage-backed securities:
 

 
 

 
 

 
 

 
 
U.S. Government agencies
192,530

 

 
192,530

 

 
 
Private label
1,961

 

 
1,961

 

 
 
Trust preferred securities
9,024

 

 
7,037

 
1,987

 
 
Corporate securities
7,670

 

 
7,670

 

 
 
Marketable equity securities
3,846

 
3,846

 

 

 
 
Investment funds
1,512

 
1,512

 

 

 
 
Derivative assets
8,383

 

 
8,383

 

 
 
Financial Liabilities
 

 
 

 
 

 
 

 
 
Derivative liabilities
8,383

 

 
8,383

 

 
 
 
 
 
 
 
 
 
 
 
 
Nonrecurring fair value measurements
 

 
 

 
 

 
 

 
 
Impaired loans
$
7,750

 
$

 
$

 
$
7,750

 
$
(130
)
     Other real estate owned
9,128

 

 

 
9,128

 
(374
)
 
 
 
 
 
 
 
 
 
 
December 31, 2013
 

 
 

 
 

 
 

 
 

Recurring fair value measurements
 

 
 

 
 

 
 

 
 

Financial Assets
 

 
 

 
 

 
 

 
 

U.S. Government agencies
$
2,365

 
$

 
$
2,365

 
$

 
 

Obligations of states and political subdivisions
41,548

 

 
41,548

 

 
 

Mortgage-backed securities:
 

 
 

 
 

 
 

 
 

U.S. Government agencies
278,108

 

 
278,108

 

 
 

Private label
2,197

 

 
2,197

 

 
 

Trust preferred securities
13,156

 

 
9,269

 
3,887

 
 

Corporate securities
9,128

 

 
9,128

 

 
 

Marketable equity securities
4,673

 
4,673

 

 

 
 

Investment funds
1,485

 
1,485

 

 

 
 

Derivative assets
3,538

 

 
3,538

 

 
 

Financial Liabilities
 

 
 

 
 

 
 

 
 

Derivative liabilities
3,538

 

 
3,538

 

 
 

 
 
 
 
 
 
 
 
 
 
Nonrecurring fair value measurements
 

 
 

 
 

 
 

 
 

Impaired loans
$
11,714

 
$

 
$

 
$
11,714

 
$
(880
)
Other real estate owned
$
8,470

 
$

 
$

 
$
8,470

 
$
(1,108
)

The table below presents a reconcilement of the Company’s financial assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) (in thousands):

 
Six months ended June 30,
2014
 
2013
Beginning balance
$
3,887

 
$
2,385

Impairment losses on investment securities

 

Included in other comprehensive income
(1,900
)
 
1,840

Dispositions

 
(1,776
)
Transfers into Level 3

 

Ending Balance
$
1,987

 
$
2,449


35



The Company utilizes a third party model to compute the present value of expected cash flows which considers the structure and term of each of the five respective pooled trust preferred securities and the financial condition of the underlying issuers.  Specifically, the third party model details interest rates, principal balances of note classes and underlying issuers, the timing and amount of interest and principal payments of the underlying issuers, and the allocation of the payments to the note classes. The current estimate of expected cash flows is based on the most recent trustee reports and any other relevant market information including announcements of interest payment deferrals or defaults of underlying trust preferred securities. For issuing banks that have defaulted, management generally assumes no recovery. For issuing banks that have deferred its interest payments, management excludes the collateral balance associated with these banks and assumes no recoveries of such collateral balance in the future. The exclusion of such issuing banks in a current deferral position is based on such bank experiencing a certain level of financial difficulty that raises doubt about its ability to satisfy its contractual debt obligation, and accordingly, the Company excludes the associated collateral balance from its estimate of expected cash flows. Other assumptions used in the estimate of expected cash flows include expected future default rates and prepayments. Specifically, the model assumes annual prepayments of 1.0% with 100% at maturity and assumes 150 basis points of additional annual defaults from banks that are currently not in default or deferral.  In addition, the model assumes no recoveries except for one trust preferred security which assumes that one of the banks currently deferring or in default will cure such positions.

The table below presents a reconcilement of the Company's financial assets and liabilities measured at fair value on a nonrecurring basis using significant unobservable inputs (Level 3), which solely relates to impaired loans that were remeasured and reported at fair value through a specific valuation allowance allocation of the allowance for loan losses based upon the fair value of the underlying collateral (in thousands).  The fair value of impaired loans is estimated using one of several methods, including collateral value, liquidation value and discounted cash flows.  The significant unobservable inputs used in the fair value measurement of collateral for collateral-dependent impaired loans primarily relate to discounts applied to the customers’ reported amount of collateral.  The amount of collateral discount depends upon the marketability of the underlying collateral.  During the six months ended June 30, 2014 and 2013, collateral discounts ranged from 20% to 30%. During the six months ended June 30, 2014 and 2013, the Company had no Level 2 financial assets and liabilities that were measured on a nonrecurring basis.

 
Six months ended June 30,
2014
 
2013
 
 
 
 
Beginning balance
$
11,714

 
$
10,679

 
 
 
 
Loans classified as impaired during the period

 
3,085

Specific valuation allowance allocations

 
(750
)
 

 
2,335

 
 
 
 
(Additional) reduction in specific valuation allowance allocations
640

 

 
 
 
 
Paydowns, payoffs, other activity
(4,604
)
 
(498
)
 
 
 
 
Ending balance
$
7,750

 
$
12,516


Non-Financial Assets and Liabilities

The Company has no non-financial assets or liabilities measured at fair value on a recurring basis.  Certain non-financial assets measured at fair value on a non-recurring basis include other real estate owned (“OREO”), which is measured at the lower of cost or fair value, and goodwill and other intangible assets, which are measured at fair value for impairment assessments.
The table below presents OREO that was remeasured and reported at fair value based on significant unobservable inputs (Level 3) (in thousands):

36



 
Six months ended June 30,
 
2014
 
2013
 
 
 
 
Beginning balance
$
8,470

 
$
8,162

 
 
 
 
OREO remeasured at initial recognition:
 
 
 
   Carrying value of foreclosed assets prior to remeasurement
3,264

 
3,307

   Charge-offs recognized in the allowance for loan losses

 
(1,059
)
     Fair value
3,264

 
2,248

 
 
 
 
OREO remeasured subsequent to initial recognition
 
 
 
   Carrying value of foreclosed assets prior to remeasurement
480

 
85

   Fair value
106

 
65

     Write-downs included in other non-interest expense
(374
)
 
(20
)
 
 
 
 
Acquired

 
3,492

Disposed
(2,232
)
 
(3,045
)
 
 
 
 
Ending balance
$
9,128

 
$
10,837


ASC Topic 825 “Financial Instruments” as amended, requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value.  In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques.  Those techniques are significantly affected by the assumptions used, including discount rate and estimate of future cash flows.  In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument.  ASC Topic 825 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements.  Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company. The following methods and assumptions were used in estimating fair value for financial instruments:

Cash and cash equivalents: Due to their short-term nature, the carrying amounts reported in the consolidated balance sheets approximate fair value.

Securities:  The fair value of securities, both available-for-sale and held-to-maturity, are generally based on quoted market prices or matrix pricing, which is a mathematical technique used widely 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.

Net loans:  The fair value of the loan portfolio is estimated by discounting the expected future cash flows using the current interest rates at which similar loans would be made to borrowers for the same remaining maturities. Loans were first segregated by type such as commercial, real estate and consumer, and were then further segmented into fixed, adjustable and variable rate categories. Expected future cash flows were projected based on contractual cash flows, adjusted for estimated prepayments.

Deposits:  The fair values of demand deposits (i.e., interest and noninterest-bearing deposits, regular savings and other money market demand accounts) are, by definition, equal to their carrying values. The fair values of time deposits were estimated using discounted cash flow analyses. The discount rates used were based on rates currently offered for deposits with similar remaining maturities. The fair values of the time deposit liabilities do not take into consideration the value of the Company’s long-term relationships with depositors, which may have significant value.

Short-term debt: Securities sold under agreements to repurchase represent borrowings with original maturities of less than 90 days. The carrying amount of borrowings under purchase agreements approximate their fair value.

Long-term debt: The fair value of long-term borrowings is estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements and market conditions of similar debt instruments.

37



Commitments and letters of credit: The fair values of commitments are estimated based on fees currently charged to enter into similar agreements, taking into consideration the remaining terms of the agreements and the counterparties’ credit standing.  The fair value of letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date.  The amounts of fees currently charged on commitments and letters of credit are deemed insignificant, and therefore, the estimated fair values and carrying values have not been reflected in the table below.

The following table represents the estimates of fair value of financial instruments (in thousands). This table excludes financial instruments for which the carrying amount approximates fair value. For short-term financial assets such as cash and cash equivalents, the carrying amount is a reasonable estimate of fair value due to the relatively short time between the origination of the instrument and its expected realization. For financial liabilities such as noninterest-bearing demand, interest-bearing demand and savings deposits, the carrying amount is a reasonable estimate of fair value due to these products having no stated maturity.
 
Carrying Amount
 
Fair Value
 
Level 1
 
Level 2
 
Level 3
June 30, 2014
 
 
 
 
 
 
 
 
 
Assets:
Cash and cash equivalents
$
110,740

 
$
110,740

 
$
110,740

 
$

 
$

Securities available-for-sale
258,761

 
258,761

 
5,357

 
251,417

 
1,987

Securities held-to-maturity
96,039

 
98,461

 

 
98,461

 

Other securities
14,234

 
14,234

 

 
14,234

 

Net loans
2,557,241

 
2,571,046

 

 

 
2,571,046

Accrued interest receivable
7,727

 
7,726

 
7,726

 

 

Derivative assets
8,383

 
8,383

 

 
8,383

 

 
 
 
 
 
 
 
 
 
 
Liabilities:
 

 
 

 
 

 
 

 
 

Deposits
2,786,247

 
2,793,781

 
1,745,268

 
1,048,513

 

Short-term debt
133,142

 
133,149

 

 
133,149

 

Long-term debt
16,495

 
16,464

 

 
16,464

 

Derivative liabilities
8,383

 
8,383

 

 
8,383

 

 
 
 
 
 
 
 
 
 
 
December 31, 2013
 

 
 

 
 

 
 

 
 

Assets:
 

 
 

 
 

 
 

 
 

Cash and cash equivalents
85,876

 
85,876

 
85,876

 

 

Securities available-for-sale
352,660

 
352,660

 
6,158

 
342,615

 
3,887

Securities held-to-maturity
4,117

 
5,335

 

 
5,335

 

Other securities
13,343

 
13,343

 

 
13,343

 

Net loans
2,585,622

 
2,609,524

 

 

 
2,609,524

Accrued interest receivable
6,866

 
6,866

 
6,866

 

 

Derivative assets
3,538

 
3,538

 

 
3,538

 

 
 
 
 
 
 
 
 
 
 
Liabilities:
 

 
 

 
 

 
 

 
 

Deposits
2,785,133

 
2,793,620

 
1,707,527

 
1,086,093

 

Short-term debt
137,798

 
137,801

 

 
137,801

 

Long-term debt
16,495

 
16,495

 

 
16,495

 

Derivative liabilities
3,538

 
3,538

 

 
3,538

 


38



Note M – Merger Related Costs

During the six months ended June 30, 2013, the Company incurred $5.6 million of merger-related costs in connection with the acquisition of Community on January 10, 2013. These costs were primarily for severance ($2.6 million), professional fees ($1.5 million) and data processing costs ($1.2 million). No merger related costs were incurred during the six months ended June 30, 2014.


39



Item 2 -
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Critical Accounting Policies
 
The accounting policies of the Company conform with U.S. generally accepted accounting principles and require management to make estimates and develop assumptions that affect the amounts reported in the financial statements and related footnotes. These estimates and assumptions are based on information available to management as of the date of the financial statements. Actual results could differ significantly from management’s estimates. As this information changes, management’s estimates and assumptions used to prepare the Company’s financial statements and related disclosures may also change. The most significant accounting policies followed by the Company are presented in Note One to the audited financial statements included in the Company’s 2013 Annual Report to Shareholders. The information included in this Quarterly Report on Form 10-Q, including the Consolidated Financial Statements, Notes to Consolidated Financial Statements, and Management’s Discussion and Analysis of Financial Condition and Results of Operations, should be read in conjunction with the financial statements and notes thereto included in the 2013 Annual Report of the Company.  Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for loan losses, income taxes, other-than-temporary impairment on investment securities and purchased credit-impaired loans to be the accounting areas that require the most subjective or complex judgments and, as such, could be most subject to revision as new information becomes available.

The section Allowance and Provision for Loan Losses provides management’s analysis of the Company’s allowance for loan losses and related provision. The allowance for loan losses is maintained at a level that represents management’s best estimate of probable losses in the loan portfolio. Management’s determination of the adequacy of the allowance for loan losses is based upon an evaluation of individual credits in the loan portfolio, historical loan loss experience, current economic conditions, and other relevant factors. This determination is inherently subjective as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. The allowance for loan losses related to loans considered to be impaired is generally evaluated based on the discounted cash flows using the impaired loan’s initial effective interest rate or the fair value of the collateral for certain collateral dependent loans.

The Company is subject to federal and state income taxes in the jurisdictions in which it conducts business.  In computing the provision for income taxes, management must make judgments regarding interpretation of laws in those jurisdictions.  Because the application of tax laws and regulations for many types of transactions is susceptible to varying interpretations, amounts reported in the financial statements could be changed at a later date upon final determinations by taxing authorities.  On a quarterly basis, the Company estimates its annual effective tax rate for the year and uses that rate to provide for income taxes on a year-to-date basis.  The amount of unrecognized tax benefits could change over the next twelve months as a result of various factors.  However, management cannot currently estimate the range of possible change.  The Company is currently open to audit under the statute of limitations by the Internal Revenue Service for the years ended December 31, 2010 through 2012. The Company and its subsidiaries state income tax returns are open to audit under the statute of limitations for the years ended December 31, 2010 through 2012.

On a quarterly basis, the Company performs a review of investment securities to determine if any unrealized losses are other-than-temporarily impaired.  Management considers the following, amongst other things, in its determination of the nature of the unrealized losses, (i) the length of time and the extent to which the fair value has been less than cost, (ii) the financial condition, capital strength, and near-term (12 months) prospects of the issuer, including any specific events which may influence the operations of the issuer such as changes in technology that may impair the earnings potential of the investment or the discontinuance of a segment of the business that may affect the future earnings potential; (iii) the historical volatility in the market value of the investment and/or the liquidity or illiquidity of the investment; (iv) adverse conditions specifically related to the security, an industry, or a geographic area; or (v) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.  The Company continues to actively monitor the market value of these investments along with the financial strength of the issuers behind these securities, as well as its entire investment portfolio.  Based on the market information available, the Company believes that the recent declines in market value are temporary and that the Company does not have the intent to sell any of the securities classified as available for sale and believes it is more likely than not that the Company will not have to sell any such securities before recovery of costs.  The Company cannot guarantee that such securities will recover and if additional information becomes available in the future to suggest that the losses are other than temporary, the Company may need to record impairment charges in future periods.  No impairment charges were recognized during the three and six months ended June 30, 2014 as a result of this review.  The Company continues to actively monitor the market values of these investments along with the financial strength of the issuers behind these securities, as well as our entire investment portfolio.


40


The Company values purchased credit-impaired loans at fair value in accordance with ASC Topic 310-30. In determining the estimated fair value, management considers several factors, such as estimated future credit losses, estimated prepayments, remaining lives of the acquired loans, estimated value of the underlying collateral and the net present value of the cash flows expected to be received. For these loans, the expected cash flows that exceed the fair value of the loan represent the accretable yield, which is recognized as interest income on a level-yield basis over the expected cash flow periods of the loans. The non-accretable difference represents the difference between the contractually required principal and interest payments and the cash flows expected to be collected based upon management's estimation. Subsequent decreases in the expected cash flows will require the Company to evaluate the need for additions to the Company's allowance for loan losses. Subsequent increases in the expected cash flows will result in a reversal of the provision for loan losses to the extent of prior charges with a corresponding adjustment to the accretable yield, which will result in the recognition of additional interest income over the remaining lives of the loans.


Financial Summary

Six months ended June 30, 2014 vs. 2013

The Company reported consolidated net income of $26.6 million, or $1.67 per diluted common share, for the six months ended June 30, 2014, compared to $21.0 million, or $1.33 per diluted common share, for the six months ended June 30, 2013. Return on average assets (“ROA”) was 1.57% and return on average equity (“ROE”) was 13.4% for the six months ended June 30, 2014 compared to 1.25% and 11.5%, respectively, for the six months ended June 30, 2013.

The Company’s net interest income for the first six months of 2014 decreased $2.0 million compared to the first six months of 2013 (see Net Interest Income). The Company recorded a provision for loan losses of $1.8 million for the six months ended June 30, 2014 compared to $3.7 million for the six months ended June 30, 2013 (see Allowance and Provision for Loan Losses).  As further discussed under the caption Non-Interest Income and Expense, non-interest income increased $0.9 million.  Non-interest expenses for the six months ended June 30, 2014 decreased $5.7 million from the six months ended June 30, 2013.

Three months ended June 30, 2014 vs. 2013

The Company reported consolidated net income of $12.8 million, or $0.80 per diluted common share, for the three months ended June 30, 2014, compared to $13.0 million, or $0.82 per diluted common share, for the three months ended June 30, 2013. Return on average assets (“ROA”) was 1.50% and return on average equity (“ROE”) was 12.8% for the three months ended June 30, 2014 compared to 1.53% and 14.0%, respectively, for the second quarter of 2013.

The Company’s net interest income for the second quarter of 2014 decreased $2.4 million compared to the second quarter of 2013 (see Net Interest Income). The Company recorded a provision for loan losses of $0.4 million for the second quarter of 2014 compared to $2.0 million for the second quarter of 2013 (see Allowance and Provision for Loan Losses).  As further discussed under the caption Non-Interest Income and Expense, non-interest income increased $0.9 million from the three months ended June 30, 2013.  Non-interest expenses for the three months ended June 30, 2014 increased $0.3 million from the three months ended June 30, 2013.

Net Interest Income

Six months ended June 30, 2014 vs. 2013
The Company’s tax equivalent net interest income decreased $2.0 million, or 3.3%, from $61.2 million for the six months ended June 30, 2013 to $59.2 million for the six months ended June 30, 2014. The Company’s reported net interest margin decreased from 4.26% for the six months ended June 30, 2013 to 4.05% for the six months ended June 30, 2014. This is primarily due to the expected decrease in accretion related to the acquisitions of Virginia Savings and Community Bank ($5.7 million and $3.6 million, respectively). Excluding the favorable impact of the accretion from the fair value adjustments , the net interest margin for the six months ended June 30, 2014 and 2013 would have been 3.80% and 3.87%, respectively.

Three months ended June 30, 2014 vs. 2013
The Company’s tax equivalent net interest income decreased $2.5 million, or 7.8%, from $31.5 million for the second quarter of 2013 to $29.0 million for the second quarter of 2014. The Company’s reported net interest margin decreased from 4.35% for the quarter ended June 30, 2013 to 3.95% for the quarter ended June 30, 2014. This is primarily due to the expected decrease in accretion related to the acquisitions of Virginia Savings and Community Bank ($3.5 million and $1.5 million, respectively).

41


Excluding the favorable impact of the accretion from the fair value adjustments, the net interest margin for the three months ended June 30, 2014 and 2013 would have been 3.75% and 3.86%, respectively.
The following schedule presents the actual and estimated future accretion related to the fair value adjustments on net interest income as a result of the Company's acquisitions (in thousands). The amounts in the table below require management to make significant assumptions based on estimated future default, prepayment and discount rates. Actual performance could be significantly different from that assumed, which could result in actual results being materially different than those estimated below.
 
Virginia Savings
Community
 
 
Year Ended
Loan
Accretion
Certificates of Deposit
Loan
Accretion
Certificates of Deposit
Total
 
 
 
 
 
 
2013
$
3,512

$
542

$
9,907

$
682

$
14,643

 
 
 
 
 
 
1Q 2014
299

131

1,628

93

2,151

2Q 2014
284

135

1,023

52

1,494

Total
583

266

2,651

145

3,645

 
 
 
 
 
 
Remainder 2014 (estimated)
384

270

1,472

105

2,231

2015 (estimated)
492

518

2,276

160

3,446

2016 (estimated)
304

497

1,526

43

2,370



42



Table One
Average Balance Sheets and Net Interest Income
(In thousands)

Assets
Six months ended June 30,
2014
2013
Average
Balance
Interest
Yield/
Rate
Average
Balance
Interest
Yield/
Rate
 
 
 
 
 
 
Loan portfolio(1):
Residential real estate(2)
$
1,358,564

$
27,442

4.07
%
$
1,283,907

$
27,284

4.29
%
Commercial, financial, and agriculture(2)
1,155,235

27,496

4.80

1,139,187

29,845

5.28

   Installment loans to individuals(2),(3)
53,340

2,275

8.60

66,649

3,217

9.73

   Previously securitized loans(4)

1,142

***

1,363

***
Total loans
2,567,139

58,355

4.58

2,489,743

61,709

5.00

Securities:
 

 

 

 

 

 

Taxable
345,699

5,933

3.46

338,627

5,382

3.21

   Tax-exempt(5)
27,424

859

6.32

32,386

978

6.09

Total securities
373,123

6,792

3.67

371,013

6,360

3.46

Deposits in depository institutions
8,970



8,238



Federal funds sold



26,320

21

0.16

Total interest-earning assets
2,949,232

65,147

4.45

2,895,314

68,090

4.74

Cash and due from banks
137,232

 

 

144,096

 

 

Bank premises and equipment
81,635

 

 

81,604

 

 

Other assets
246,804

 

 

260,449

 

 

Less: allowance for loan losses
(21,347
)
 

 

(19,782
)
 

 

Total assets
$
3,393,556

 

 

$
3,361,681

 

 

Liabilities
 

 

 

 

 

 

   Interest-bearing demand deposits
$
611,139

$
341

0.11
%
$
607,339

$
358

0.12
%
Savings deposits
626,610

407

0.13

593,880

430

0.15

Time deposits(2)
1,060,887

4,742

0.90

1,111,696

5,634

1.02

Short-term borrowings
126,067

160

0.26

118,838

149

0.25

Long-term debt
16,495

301

3.68

16,495

309

3.78

Total interest-bearing liabilities
2,441,198

5,951

0.49

2,448,248

6,880

0.57

Noninterest-bearing demand deposits
522,472

 

 

508,865

 

 

Other liabilities
33,717

 

 

40,142

 

 

Stockholders’ equity
396,169

 

 

364,426

 

 

Total liabilities and stockholders’ equity
$
3,393,556

 

 

$
3,361,681

 

 

Net interest income
 

$
59,196

 

 

$
61,210

 

Net yield on earning assets
 

 

4.05
%
 

 

4.26
%

43


(1)
For purposes of this table, non-accruing loans have been included in average balances and loan fees, which are immaterial, have been included in interest income.
(2)
Included in the above table are the following amounts for the accretion of the fair value adjustments related to the acquisitions of Virginia Savings and Community:
 
 
Six months ended June 30, 2014
 
 
Virginia Savings
Community
Total
 
Residential real estate
$
258

$
258

$
516

 
Commercial, financial and agriculture
255

2,039

2,294

 
Installment loans to individuals
70

354

424

 
Time deposits
266

145

411

 
 
$
849

$
2,796

$
3,645

 
 
 
 
 
 
 
Six months ended June 30, 2013
 
 
Virginia Savings
Community
Total
 
Residential real estate
$
519

$
243

$
762

 
Commercial, financial and agriculture
1,720

1,923

3,643

 
Installment loans to individuals
80

579

659

 
Time deposits
300

334

634

 
 
$
2,619

$
3,079

$
5,698

 
 
 
 
 
(3)
Includes the Company’s consumer and DDA overdrafts loan categories.
(4)
Effective January 1, 2012, there is no carrying value of the Company’s previously securitized loans.
(5)
Computed on a fully federal tax-equivalent basis assuming a tax rate of approximately 35%.

































44


Table Two
Rate/Volume Analysis of Changes in Interest Income and Interest Expense
(In thousands)

 
Six months ended June 30, 2014 vs. 2013
Interest-earning assets:
Increase (Decrease)
Due to Change In:
Volume
Rate
Net
 
 
 
Loan portfolio
Residential real estate
$
1,587

$
(1,429
)
$
158

Commercial, financial, and agriculture
420

(2,769
)
(2,349
)
Installment loans to individual
(642
)
(300
)
(942
)
Previously securitized loans

(221
)
(221
)
Total loans
1,365

(4,719
)
(3,354
)
Securities:
 

 

 

Taxable
112

439

551

   Tax-exempt(1)
(150
)
31

(119
)
Total securities
(38
)
470

432

Federal funds sold
(21
)

(21
)
Total interest-earning assets
$
1,306

$
(4,249
)
$
(2,943
)
Interest-bearing liabilities:
 

 

 

   Interest-bearing demand deposits
$
2

$
(19
)
$
(17
)
Savings deposits
24

(47
)
(23
)
Time deposits
(257
)
(635
)
(892
)
Short-term borrowings
9

2

11

Long-term debt

(8
)
(8
)
Total interest-bearing liabilities
$
(222
)
$
(707
)
$
(929
)
Net Interest Income
$
1,528

$
(3,542
)
$
(2,014
)
(1)
Fully federal taxable equivalent using a tax rate of approximately 35%.


45


Table Three
Average Balance Sheets and Net Interest Income
(In thousands)

Assets
Three months ended June 30,
2014
2013
Average
Balance
Interest
Yield/
Rate
Average
Balance
Interest
Yield/
Rate
 
 
 
 
 
 
Loan portfolio(1):
Residential real estate(2)
$
1,366,485

$
13,696

4.02
%
$
1,290,188

$
13,564

4.22
%
Commercial, financial, and agriculture(2)
1,143,001

13,260

4.65

1,156,269

15,654

5.43

   Installment loans to individuals(2),(3)
54,115

1,097

8.13

67,426

1,839

10.94

   Previously securitized loans(4)

568

***

714

***
Total loans
2,563,601

28,621

4.48

2,513,883

31,771

5.07

Securities:
 

 

 

 

 

 

Taxable
345,419

2,930

3.40

327,252

2,632

3.23

   Tax-exempt(5)
27,343

428

6.28

31,789

479

6.04

Total securities
372,762

3,358

3.61

359,041

3,111

3.48

Deposits in depository institutions
9,108



7,451



Federal funds sold



22,747

9

0.16

Total interest-earning assets
2,945,471

31,979

4.35

2,903,122

34,891

4.82

Cash and due from banks
149,111

 

 

175,837

 

 

Bank premises and equipment
81,061

 

 

82,243

 

 

Other assets
247,510

 

 

261,552

 

 

Less: allowance for loan losses
(21,474
)
 

 

(20,089
)
 

 

Total assets
$
3,401,679

 

 

$
3,402,665

 

 

Liabilities
 

 

 

 

 

 

   Interest-bearing demand deposits
$
610,489

$
165

0.11
%
$
611,334

$
179

0.12
%
Savings deposits
634,718

198

0.13

603,604

216

0.14

Time deposits(2)
1,051,811

2,374

0.91

1,116,358

2,800

1.01

Short-term borrowings
133,282

85

0.26

125,729

79

0.25

Long-term debt
16,495

151

3.67

16,495

153

3.72

Total interest-bearing liabilities
2,446,795

2,973

0.49

2,473,520

3,427

0.56

Noninterest-bearing demand deposits
527,679

 

 

519,212

 

 

Other liabilities
28,783

 

 

37,698

 

 

Stockholders’ equity
398,422

 

 

372,235

 

 

Total liabilities and stockholders’ equity
$
3,401,679

 

 

$
3,402,665

 

 

Net interest income
 

$
29,006

 

 

$
31,464

 

Net yield on earning assets
 

 

3.95
%
 

 

4.35
%

46


(1)
For purposes of this table, non-accruing loans have been included in average balances and loan fees, which are immaterial, have been included in interest income.
(2)
Included in the above table are the following amounts for the accretion of the fair value adjustments related to the acquisitions of Virginia Savings and Community:
 
 
Three months ended June 30, 2014
 
 
Virginia Savings
Community
Total
 
Residential real estate
$
107

$
143

$
250

 
Commercial, financial and agriculture
141

715

856

 
Installment loans to individuals
36

165

201

 
Time deposits
135

52

187

 
 
$
419

$
1,075

$
1,494

 
 
 
 
 
 
 
Three months ended June 30, 2013
 
 
Virginia Savings
Community
Total
 
Residential real estate
$
243

$
55

$
298

 
Commercial, financial and agriculture
1,047

1,313

2,360

 
Installment loans to individuals
44

519

563

 
Time deposits
122

174

296

 
 
$
1,456

$
2,061

$
3,517

 
 
 
 
 
(3)
Includes the Company’s consumer and DDA overdrafts loan categories.
(4)
Effective January 1, 2012, there is no carrying value of the Company’s previously securitized loans.
(5)
Computed on a fully federal tax-equivalent basis assuming a tax rate of approximately 35%.

































47


Table Four
Rate/Volume Analysis of Changes in Interest Income and Interest Expense
(In thousands)

 
Three months ended June 30, 2014 vs. 2013
Interest-earning assets:
Increase (Decrease)
Due to Change In:
Volume
Rate
Net
 
 
 
Loan portfolio
Residential real estate
$
802

$
(670
)
$
132

Commercial, financial, and agriculture
(180
)
(2,214
)
(2,394
)
Installment loans to individuals
(363
)
(379
)
(742
)
Previously securitized loans

(146
)
(146
)
Total loans
259

(3,409
)
(3,150
)
Securities:
 

 

 

Taxable
146

152

298

   Tax-exempt(1)
(67
)
16

(51
)
Total securities
79

168

247

Federal funds sold
(9
)

(9
)
Total interest-earning assets
$
329

$
(3,241
)
$
(2,912
)
Interest-bearing liabilities:
 

 

 

   Interest-bearing demand deposits
$

$
(14
)
$
(14
)
Savings deposits
11

(29
)
(18
)
Time deposits
(162
)
(264
)
(426
)
Short-term borrowings
5

1

6

Long-term debt

(2
)
(2
)
Total interest-bearing liabilities
$
(146
)
$
(308
)
$
(454
)
Net Interest Income
$
475

$
(2,933
)
$
(2,458
)
(1)
Fully federal taxable equivalent using a tax rate of approximately 35%.

Loans
 
The composition of the Company’s loan portfolio as of the dates indicated follows:

Table Five
Loan Portfolio
(In thousands)
 
June 30, 2014
 
December 31, 2013
 
June 30, 2013
Residential real estate
$
1,242,972

 
$
1,204,450

 
$
1,166,858

Home equity – junior liens
145,452

 
146,090

 
141,632

Commercial and industrial
149,442

 
164,484

 
138,299

Commercial real estate
993,552

 
1,040,866

 
1,023,311

Consumer
42,858

 
46,402

 
54,242

DDA overdrafts
3,501

 
3,905

 
3,103

Total loans
$
2,577,777

 
$
2,606,197

 
$
2,527,445


Loan balances decreased $28.4 million from December 31, 2013 to June 30, 2014. Residential real estate loans increased $38.5 million, or 3.2%, from December 31, 2013 to June 30, 2014.   Residential real estate loans primarily consist of: (i) single-family 3 and 5 year adjustable rate mortgages with terms that amortize the loans over periods from 15-30 years and (ii) home equity loans secured by first liens.  The Company’s mortgage products do not include sub-prime, interest only, or option adjustable

48


rate mortgage products.  The Company’s home equity loans are underwritten differently than 1-4 family residential mortgages with typically less documentation but lower loan-to-value ratios.  Home equity loans consist of lines of credit, short-term fixed amortizing loans and non-purchase adjustable rate loans.  At June 30, 2014, $20.1 million of the residential real estate loans were for properties under construction.

Junior lien home equity loans decreased $0.6 million during the first six months of 2014.  Junior lien home equity loans consist of lines of credit, short-term fixed amortizing loans, and non-purchase adjustable rate loans with second lien positions.

Commercial real estate loans decreased $47.3 million, or 4.5%, from December 31, 2013 to June 30, 2014.  At June 30, 2014, $24.6 million of the commercial real estate loans were for commercial properties under construction.  Commercial and industrial loans (“C&I”) decreased $15.0 million from December 31, 2013 to June 30, 2014.  During the year ended June 30, 2014, a variety of factors led to the decline in commercial real estate and C&I loans - a $14 million participation loan was repurchased by the lead bank (a large community bank); a $9 million loan from an acquisition that was classified as substandard was repaid in full; a financially weak $9 million loan was refinanced by a smaller competitor that provided the borrower a cash out option; a more competitive lending environment; and various lines of credit experienced balance reductions.

Consumer loans decreased $3.5 million during the first six months of 2014.  The consumer loan portfolio primarily consists of new and used automobile loans, personal loans secured by cash and cash equivalents, unsecured revolving credit products, and other similar types of credit facilities. The Company strategically decided to reduce consumer loans due to the acquisition of an indirect portfolio of loans associated with Community. These loans have higher loss percentages compared to the Company's historical consumer portfolio.

Allowance and Provision for Loan Losses

Management systematically monitors the loan portfolio and the adequacy of the allowance for loan losses (“ALLL”) on a quarterly basis to provide for probable losses inherent in the portfolio. Management assesses the risk in each loan type based on historical trends, the general economic environment of its local markets, individual loan performance, and other relevant factors. Individual credits are selected throughout the year for detailed loan reviews, which are utilized by management to assess the risk in the portfolio and the adequacy of the allowance. Due to the nature of commercial lending, evaluation of the adequacy of the allowance as it relates to these loan types is often based more upon specific credit review, with consideration given to the potential impairment of certain credits and historical loss rates, adjusted for general economic conditions and other inherent risk factors. Conversely, due to the homogeneous nature of the real estate and installment portfolios, the portions of the allowance allocated to those portfolios are primarily based on prior loss history of each portfolio, adjusted for general economic conditions and other inherent risk factors.

In evaluating the adequacy of the ALLL, management considers both quantitative and qualitative factors. Quantitative factors include actual repayment characteristics and loan performance, cash flow analyses, and estimated fair values of underlying collateral. Qualitative factors generally include overall trends within the portfolio, composition of the portfolio, changes in pricing or underwriting, seasoning of the portfolio, and general economic conditions.

The allowance not specifically allocated to individual credits is generally determined by analyzing potential exposure and other qualitative factors that could negatively impact the adequacy of the allowance.  Loans not individually evaluated for impairment are grouped by pools with similar risk characteristics and the related historical loss rates are adjusted to reflect current inherent risk factors, such as unemployment, overall economic conditions, concentrations of credit, loan growth, classified and impaired loan trends, staffing, adherence to lending policies, and loss trends.

Determination of the ALLL is subjective in nature and requires management to periodically reassess the validity of its assumptions. Differences between actual losses and estimated losses are assessed such that management can timely modify its evaluation model to ensure that adequate provision has been made for risk in the total loan portfolio.

As a result of the Company’s quarterly analysis of the adequacy of the ALLL, the Company recorded a provision for loan losses of $1.8 million in the first six months of 2014 and $3.7 million in the first six months of 2013.  The provision for loan losses recorded in 2014 reflects the modest growth in the loan portfolio, changes in the quality of the portfolio and general improvement in the Company's historical loss rates used to compute the allowance not specifically allocated to individual credits. Additionally, the improvement in non-performing assets also contributed to a lower provision for loan losses during 2014. Changes in the amount of the provision and related allowance are based on the Company’s detailed systematic methodology and are directionally consistent with changes in the composition and quality of the Company’s loan portfolio.  The Company believes its methodology for determining its ALLL adequately provides for probable losses inherent in the loan portfolio and produces a provision and allowance for loan losses that is directionally consistent with changes in asset quality and loss experience.

49



The Company had net charge-offs of $1.8 million and $2.5 million for the first six months of 2014 and 2013, respectively.  Net charge-offs in the first six months of 2014 consisted primarily of net charge-offs on residential real estate loans of $0.7 million, commercial real estate loans of $0.9 million and DDA overdrafts of $0.2 million.  

The Company’s ratio of non-performing assets to total loans and other real estate owned decreased from 1.20% at December 31, 2013 to 1.10% at June 30, 2014.  Excluded from this ratio are purchased credit-impaired loans in which the Company estimated cash flows and estimated a credit mark. These loans are considered performing loans provided that the loan is performing in accordance with the estimated expectations. Such loans would be considered non-performing loans if the loan's performance deteriorates below the initial expectations. The Company’s ratio of non-performing assets to total loans and other real estate owned is less than half of the 2.99% non-performing asset ratio reported by the Company’s peer group (bank holding companies with total assets between $1 and $5 billion), as of the most recently reported quarter ended December 31, 2013.

The ALLL at June 30, 2014 was $20.5 million compared to $20.6 million at December 31, 2013.  Below is a summary of the changes in the components of the ALLL from December 31, 2013 to June 30, 2014.

The allowance allocated to the commercial real estate loan portfolio (see Table Nine) decreased $0.4 million, or 3.51%, from $10.8 million at December 31, 2013 to $10.4 million at June 30, 2014. This decrease was mainly attributable to lower loan balances due to a more competitive lending environment coupled with an improvement in historical loss rates.

The allowance related to the commercial and industrial loan portfolio remained flat at $1.1 million at June 30, 2014 (see Table Seven).

The allowance allocated to the residential real estate portfolio (see Table Nine) increased $0.4 million from $6.1 million at December 31, 2013 to $6.5 million at June 30, 2014. This increase was due to growth in the portfolio.

The allowance allocated to the home equity loan portfolio (see Table Nine) decreased from $1.7 million at December 31, 2013 to $1.4 million at June 30, 2014.

The allowance allocated to the consumer loan portfolio (see Table Nine) remained flat at $0.1 million at June 30, 2014.

The allowance allocated to overdraft deposit accounts (see Table Nine) increased modestly from $0.9 million at December 31, 2013 to $1.0 million at June 30, 2014.

Based on the Company’s analysis of the adequacy of the allowance for loan losses and in consideration of the known factors utilized in computing the allowance, management believes that the allowance for loan losses as of June 30, 2014, is adequate to provide for probable losses inherent in the Company’s loan portfolio. Future provisions for loan losses will be dependent upon trends in loan balances including the composition of the loan portfolio, changes in loan quality and loss experience trends, and recoveries of previously charged-off loans, among other factors.





















50



Table Six
Analysis of the Allowance for Loan Losses
(In thousands)
 
Six months ended June 30,
 
Year ended
December 31,
2014
 
2013
 
2013
Balance at beginning of period
$
20,575

 
$
18,809

 
$
18,809

Charge-offs:
 

 
 

 
 

Commercial and industrial
5

 
392

 
1,040

Commercial real estate
969

 
622

 
2,187

Residential real estate
743

 
1,111

 
2,181

Home equity
146

 
270

 
295

Consumer
122

 
224

 
454

DDA overdrafts
662

 
687

 
1,483

Total charge-offs
2,647

 
3,306

 
7,640

Recoveries:
 

 
 

 
 

Commercial and industrial
81

 
21

 
84

Commercial real estate
83

 
34

 
785

Residential real estate
63

 
68

 
234

Home equity

 

 

Consumer
129

 
217

 
327

DDA overdrafts
454

 
477

 
1,128

Total recoveries
810

 
817

 
2,558

Net charge-offs
1,837

 
2,489

 
5,082

Provision for acquired loans
138

 
177

 
597

Provision for loan losses
1,660

 
3,572

 
6,251

Balance at end of period
$
20,536

 
$
20,069

 
$
20,575

As a Percent of Average Total Loans:
 

 
 

 
 

Net charge-offs (annualized)
0.14
%
 
0.20
%
 
0.20
%
Provision for loan losses (annualized)
0.14
%
 
0.30
%
 
0.27
%
As a Percent of Non-Performing Loans:
 

 
 

 
 

Allowance for loan losses
106.86
%
 
119.63
%
 
90.25
%

Table Seven
Non-Accrual, Past-Due and Restructured Loans
(In thousands)

 
As of June 30,
 
December 31,
2014
 
2013
 
2013
Non-accrual loans
$
18,423

 
$
15,706

 
$
22,361

Accruing loans past due 90 days or more
794

 
1,070

 
436

Total non-performing loans
19,217

 
16,776

 
22,797


The average recorded investment in impaired loans during the six months ended June 30, 2014 and 2013 was $10.9 million and $13.3 million, respectively.  The Company recognized less than $0.1 million of interest income received in cash on non-accrual and impaired loans for the six months ended June 30, 2014. There was no interest income received in cash on non-accrual and impaired loans for the three months ended June 30, 2013.  Approximately $0.2 million of interest income would have been recognized during both the six months ended June 30, 2014 and June 30, 2013, if such loans had been current in accordance with their original terms.  There were no commitments to provide additional funds on non-accrual, impaired, or other potential problem loans at June 30, 2014.  


51


Interest on loans is accrued and credited to operations based upon the principal amount outstanding.  The accrual of interest income is generally discontinued when a loan becomes 90 days past due as to principal or interest unless the loan is well collateralized and in the process of collection.  When interest accruals are discontinued, interest credited to income in the current year that is unpaid and deemed uncollectible is charged to operations.  Prior-year interest accruals that are unpaid and deemed uncollectible are charged to the allowance for loan losses, provided that such amounts were specifically reserved.

Table Eight
Impaired Loans
(In thousands)

 
As of June 30,
 
As of December 31,
2014
 
2013
 
2013
Impaired loans with a valuation allowance
$
1,403

 
$
3,085

 
$
3,416

Impaired loans with no valuation allowance
6,587

 
10,181

 
9,178

Total impaired loans
$
7,990

 
$
13,266

 
$
12,594

Allowance for loan losses allocated to impaired loans
$
240

 
$
750

 
$
880


Table Nine
Allocation of the Allowance for Loan Losses
(In thousands)

 
As of June 30,
 
As of December 31,
2014
 
2013
 
2013
Commercial and industrial
$
1,105

 
$
1,066

 
$
1,139

Commercial real estate
10,397

 
10,494

 
10,775

Residential real estate
6,464

 
5,978

 
6,057

Home equity
1,443

 
1,651

 
1,672

Consumer
81

 
81

 
77

DDA overdrafts
1,046

 
799

 
855

Allowance for Loan Losses
$
20,536

 
$
20,069

 
$
20,575



Non-Interest Income and Non-Interest Expense

Six months ended June 30, 2014 vs. 2013
(In thousands)
 
Six months ended June 30,
 
 
 
 
 
2014
 
2013
 
$ Change
 
% Change
 
 
 
 
 
 
 
 
Gains on sale of investment securities
$
0.9

 
$
0.1

 
$
0.8

 
800.0
 %
Non-interest income, excluding gains on sale of investment securities
28.5

 
28.5

 

 
 %
Non-interest expense
47.7

 
53.4

 
(5.7
)
 
(10.7
)%

Non-Interest Income: During 2014, the Company realized investment gains of $0.9 million from the sale of certain equity positions related to community banks and bank holding companies. Excluding investment security gains, non-interest income remained flat at $28.5 million compared to the first six months of 2013.

Non-Interest Expense: During 2013, the Company completed its acquisition of Community and recognized $5.6 million of acquisition and integration expenses. Excluding these expenses, non-interest expenses decreased $0.1 million, from $47.8 million in the first six months of 2013 to $47.7 million in the first six months of 2014. This decrease was largely attributable to a decline in other expenses of $1.6 million due to a decrease in non-income based taxes as a result of the recognition of previously

52


unrecognized tax position resulting from the close of the statute of limitations for a previous tax year. This favorable difference was discrete to the first quarter of 2014. This decrease was partially offset by an increase in repossessed asset losses of $0.7 million and salaries and employee benefits of $0.5 million.
Income Tax Expense: The Company’s effective income tax rate for the six months ended June 30, 2014 was 31.7% compared to 34.4% for the year ended December 31, 2013, and 35.1% for the six months ended June 30, 2013.  During the six months ended June 30, 2014, the Company reduced income tax expense due to the recognition of previously unrecognized tax position resulting from the close of the statute of limitations for a previous tax year. Exclusive of this discrete item recognized in the six months ended June 30, 2014, the Company’s tax rate from operations was 33.6%.

In the preparation of income tax returns, tax positions are taken based on interpretations of Federal and state income tax laws, for which the outcome of such positions may not be certain. The Company periodically reviews and evaluates the status of uncertain tax positions and may establish tax reserves for tax benefits that may not be realized. The amount of any such reserves are based on the standards for determining such reserves as set forth in current accounting guidance and the Company's estimate the amounts that may ultimately be due or owed (including interest). These estimates may change from time to time based on the Company's evaluation of developments subsequent to the filing of the income tax return, such as tax authority audits, court decisions, other tax law interpretations, or the closing of the statute of limitations. During the first quarter of 2014, the Company recognized $1.3 million of unrecognized tax benefits due to the expiration of the statute of limitations on certain items. The Company may release another $1.5 million over the next 12 months from its unrecognized tax benefit balance due to the expiration of the applicable statute of limitations, although there can be no assurances that this will occur.

Three months ended June 30, 2014 vs. 2013
(In thousands)
 
Three months ended June 30,
 
 
 
 
 
2014
 
2013
 
$ Change
 
% Change
 
 
 
 
 
 
 
 
Gains on sale of investment securities
$
0.8

 
$

 
$
0.8

 
-

Non-interest income, excluding gains on sale of investment securities
14.3

 
14.2

 
0.1

 
0.7
%
Non-interest expense
24.3

 
24.0

 
0.3

 
1.3
%

Non-Interest Income: During the second quarter of 2014, the Company realized investment gains of $0.8 million from the sale of certain equity positions related to community banks and bank holding companies. Excluding investment security gains, non-interest income increased $0.1 million to $14.3 million in the second quarter of 2014. Bankcard revenues increased $0.4 million, or 11.2%, due to increased usage by our customers from the second quarter of 2013 and trust and investment management fee income increased $0.1 million or 15.2% to $1.1 million in the second quarter of 2014. These increases were partially offset by a decrease in other income of $0.2 million from the second quarter of 2013 due to a decline in fixed rate mortgage lending activity and service charges were down as a result of a sluggish economy.

Non-Interest Expense: Non-interest expenses increased $0.3 million, from $24.0 million in the second quarter of 2013 to $24.3 million in the second quarter of 2014. This increase was primarily related to higher salaries and employee benefits of $0.3 million, repossessed asset losses of $0.2 million and advertising of $0.1 million. These expenses were partially offset by a decrease in other expenses of $0.3 million.
Income Tax Expense: The Company’s effective income tax rate for the three months ended June 30, 2014 was 33.7% compared to 34.4% for the year ended December 31, 2013, and 33.6% for the three months ended June 30, 2013.  The effective rate is based upon the Company's expected tax rate for the year ending December 31, 2014.

Risk Management

Market risk is the risk of loss due to adverse changes in current and future cash flows, fair values, earnings or capital due to adverse movements in interest rates and other factors, including foreign exchange rates and commodity prices. Because the Company has no significant foreign exchange activities and holds no commodities, interest rate risk represents the primary risk factor affecting the Company’s balance sheet and net interest margin. Significant changes in interest rates by the Federal Reserve could result in similar changes in LIBOR interest rates, prime rates, and other benchmark interest rates that could affect the estimated fair value of the Company’s investment securities portfolio, interest paid on the Company’s short-term and long-term borrowings, interest earned on the Company’s loan portfolio and interest paid on its deposit accounts.

53



The Company’s Asset and Liability Committee (“ALCO”) has been delegated the responsibility of managing the Company’s interest-sensitive balance sheet accounts to maximize earnings while managing interest rate risk. ALCO, comprised of various members of executive and senior management, is also responsible for establishing policies to monitor and limit the Company’s exposure to interest rate risk and to manage the Company’s liquidity position. ALCO satisfies its responsibilities through monthly meetings during which product pricing issues, liquidity measures, and interest sensitivity positions are monitored.

In order to measure and manage its interest rate risk, the Company uses an asset/liability management and simulation software model to periodically update the interest sensitivity position of the Company’s balance sheet. The model is also used to perform analyses that measure the impact on net interest income and capital as a result of various changes in the interest rate environment. Such analyses quantify the effects of various interest rate scenarios on projected net interest income.

The Company’s policy objective is to avoid negative fluctuations in net income or the economic value of equity of more than 15% within a 12-month period, assuming an immediate parallel increase or decrease of 400 basis points. The Company measures the long-term risk associated with sustained increases and decreases in rates through analysis of the impact to changes in rates on the economic value of equity.  Due to the current Federal Funds target rate of 25 basis points, the Company has chosen not to reflect a decrease of 25 basis points from current rates in its analysis.

The following table summarizes the sensitivity of the Company’s net income to various interest rate scenarios. The results of the sensitivity analyses presented below differ from the results used internally by ALCO in that, in the analyses below, interest rates are assumed to have an immediate and sustained parallel shock. The Company recognizes that rates are volatile, but rarely move with immediate and parallel effects. Internally, the Company considers a variety of interest rate scenarios that are deemed to be possible while considering the level of risk it is willing to assume in “worst-case” scenarios such as shown by the following:

Immediate Basis Point Change in Interest Rates
 
Implied Federal Funds Rate Associated with Change in Interest Rates
 
Estimated Increase (Decrease) in Net Income Over 12 Months
 
Estimated Increase (Decrease) in Economic Value of Equity
June 30, 2014
 
 
 
 
 
 
+400

 
4.25
%
 
+3.4
%
 
(1.7
)%
+300

 
3.25

 
+4.5

 
+1.7

+200

 
2.25

 
+3.9

 
+3.5

+100

 
1.25

 
+1.2

 
+1.8

December 31, 2013
 
 

 
 

 
 

+400

 
4.25
%
 
+3.3
%
 
(6.4
)%
+300

 
3.25

 
+4.3

 
(2.0
)
+200

 
2.25

 
+3.3

 
+0.6

+100

 
1.25

 
+0.6

 
+0.4

 
These estimates are highly dependent upon assumptions made by management, including, but not limited to, assumptions regarding the manner in which interest-bearing demand deposit and saving deposit accounts reprice in different interest rate scenarios, changes in the composition of deposit balances, pricing behavior of competitors, prepayments of loans and deposits under alternative rate environments, and new business volumes and pricing. As a result, there can be no assurance that the estimates above will be achieved in the event that interest rates increase during 2014 and beyond.  The estimates above do not necessarily imply that the Company will experience increases in net income if market interest rates rise.  The table above indicates how the Company’s net income and the economic value of equity behave relative to an increase or decrease in rates compared to what would otherwise occur if rates remain stable.

Based upon the estimates above, the Company believes that its net income is positively correlated with increasing rates as compared to the level of net income the Company would expect if interest rates remain flat.



54


Liquidity

The Company evaluates the adequacy of liquidity at both the Parent Company level and at the banking subsidiary level. At the Parent Company level, the principal source of cash is dividends from its banking subsidiary, City National Bank ("City National"). Dividends paid by City National to the Parent Company are subject to certain legal and regulatory limitations. Generally, any dividends in amounts that exceed the earnings retained by City National in the current year plus retained net profits for the preceding two years must be approved by regulatory authorities. At June 30, 2014, City National could pay dividends up to $25.8 million plus net profits for the remainder of 2014, as defined by statute, up to the dividend declaration date without prior regulatory permission.

The Parent Company used cash obtained from the dividends received primarily to: (1) pay common dividends to shareholders, (2) remit interest payments on the Company’s junior subordinated debentures, and (3) fund repurchase of the Company’s common shares.

Over the next 12 months, the Parent Company has an obligation to remit interest payments approximating $0.6 million on the junior subordinated debentures held by City Holding Capital Trust III. Additionally, the Parent Company anticipates continuing the payment of dividends, which are expected to approximate $25.0 million on an annualized basis over the next 12 months based on common shareholders of record at June 30, 2014.  However, interest payments on the debentures can be deferred for up to five years under certain circumstances and dividends to shareholders can, if necessary, be suspended.  In addition to these anticipated cash needs, the Parent Company has operating expenses and other contractual obligations, which are estimated to require $1.6 million of additional cash over the next 12 months. As of June 30, 2014, the Parent Company reported a cash balance of $9.4 million and management believes that the Parent Company’s available cash balance, together with cash dividends from City National will be adequate to satisfy its funding and cash needs over the next twelve months.

Excluding the interest and dividend payments discussed above, the Parent Company has no significant commitments or obligations in years after 2014 other than the repayment of its $16.5 million obligation under the debentures held by City Holding Capital Trust III. However, this obligation does not mature until June 2038, or earlier at the option of the Parent Company. It is expected that the Parent Company will be able to obtain the necessary cash, either through dividends obtained from City National or the issuance of other debt, to fully repay the debentures at their maturity.

City National manages its liquidity position in an effort to effectively and economically satisfy the funding needs of its customers and to accommodate the scheduled repayment of borrowings. Funds are available to City National from a number of sources, including depository relationships, sales and maturities within the investment securities portfolio, and borrowings from the FHLB and other financial institutions. As of June 30, 2014, City National’s assets are significantly funded by deposits and capital. Additionally, City National maintains borrowing facilities with the FHLB and other financial institutions that are accessed as necessary to fund operations and to provide contingency funding mechanisms. As of June 30, 2014, City National has the capacity to borrow an additional $1.5 billion from the FHLB and other financial institutions under existing borrowing facilities. City National maintains a contingency funding plan, incorporating these borrowing facilities, to address liquidity needs in the event of an institution-specific or systemic financial industry crisis. Also, although it has no current intention to do so, City National could liquidate its unpledged securities, if necessary, to provide an additional funding source.  City National also segregates certain mortgage loans, mortgage-backed securities, and other investment securities in a separate subsidiary so that it can separately monitor the asset quality of these primarily mortgage-related assets, which could be used to raise cash through securitization transactions or obtain additional equity or debt financing if necessary.

The Company manages its asset and liability mix to balance its desire to maximize net interest income against its desire to minimize risks associated with capitalization, interest rate volatility, and liquidity. With respect to liquidity, the Company has chosen a conservative posture and believes that its liquidity position is strong. The Company’s net loan to asset ratio is 76.0% as of June 30, 2014 and deposit balances fund 82.8% of total assets. The Company has obligations to extend credit, but these obligations are primarily associated with existing home equity loans that have predictable borrowing patterns across the portfolio. The Company has investment security balances with carrying values that totaled $369.0 million million at June 30, 2014, and that greatly exceeded the Company’s non-deposit sources of borrowing which totaled $149.6 million.  Further, the Company’s deposit mix has a very high proportion of transaction and savings accounts that fund 51.9% of the Company’s total assets.

As illustrated in the Consolidated Statements of Cash Flows, the Company generated $14.0 million of cash from operating activities during the first six months of 2014, primarily from interest income received on loans and investments, net of interest expense paid on deposits and borrowings.  The Company generated $34.0 million of cash in investing activities during the first six months of 2014 primarily from the repayment of loans.   The Company used $23.1 million of cash in financing activities during the first six months of 2014, principally a result of purchases of treasury stock of $8.4 million, as well as cash dividends paid to the Company’s common stockholders of $12.1 million.

55



Capital Resources

During the first six months of 2014, Shareholders’ Equity increased $9.6 million, or 2.5%, from $387.6 million at December 31, 2013 to $397.2 million at June 30, 2014.  This increase was primarily due to net income of $26.6 million, partially offset by dividends declared of $12.5 million.

Regulatory guidelines require the Company to maintain a minimum total capital to risk-adjusted assets ratio of 8.0%, with at least one-half of capital consisting of tangible common stockholders’ equity and a minimum Tier I leverage ratio of 4.0%. Similarly, City National Bank is also required to maintain minimum capital levels as set forth by various regulatory agencies. Under capital adequacy guidelines, City National Bank is required to maintain minimum total capital, Tier I capital, and leverage ratios of 8.0%, 4.0%, and 4.0%, respectively. To be classified as “well capitalized,” City National Bank must maintain total capital, Tier I capital, and leverage ratios of 10.0%, 6.0%, and 5.0%, respectively.

The Company’s regulatory capital ratios for both City Holding and City National Bank as illustrated in the following table:

City Holding:
Minimum
 
Well-
Capitalized
 
Actual
 
June 30, 2014
 
December 31, 2013
 
 
 
 
 
 
 
Total
8.0
%
 
10.0
%
 
14.5
%
 
13.8
%
Tier I Risk-based
4.0

 
6.0

 
13.7

 
13.0

Tier I Leverage
4.0

 
5.0

 
10.2

 
9.8

City National Bank:
 

 
 

 
 
 
 

Total
8.0
%
 
10.0
%
 
13.7
%
 
12.2
%
Tier I Risk-based
4.0

 
6.0

 
12.9

 
11.4

Tier I Leverage
4.0

 
5.0

 
9.5

 
8.6

 
As of June 30, 2014, management believes that City Holding Company, and its banking subsidiary, City National Bank, were “well capitalized.”  City Holding is subject to regulatory capital requirements administered by the Federal Reserve, while City National Bank is subject to regulatory capital requirements administered by the Office of the Comptroller of the Currency (“OCC”) and the Federal Deposit Insurance Corporation (“FDIC”).  Regulatory agencies can initiate certain mandatory actions if either City Holding or City National Bank fails to meet the minimum capital requirements, as shown above.  As of June 30, 2014, management believes that City Holding and City National Bank meet all capital adequacy requirements.

In July 2013, the Federal Reserve published the final rules that establish a new comprehensive capital framework for banking organizations, commonly referred to as Basel III. These final rules substantially revise the risk-based capital requirements applicable to bank holding companies and depository institutions. The final rule is effective January 1, 2015 for smaller, non-complex banking organizations with full implementation by January 1, 2019.

Item 3 -
Quantitative and Qualitative Disclosure About Market Risk

The information called for by this item is provided under the caption “Risk Management” under Item 2—Management’s Discussion and Analysis of Financial Condition and Results of Operations.
 
Item 4 -
Controls and Procedures

Pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934, the Company carried out an evaluation, with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures (as defined under Rule 13a-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company required to be included in the Company’s periodic SEC filings.  There has been no change in the Company’s internal control over financial reporting during the quarter ended June 30, 2014 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

56




Part II -
OTHER INFORMATION

Item 1.
Legal Proceedings

The Company is engaged in various legal actions that it deems to be in the ordinary course of business. As these legal actions are resolved, the Company could realize positive and/or negative impact to its financial performance in the period in which these legal actions are ultimately decided. There can be no assurance that current actions will have immaterial results, either positive or negative, or that no material actions may be presented in the future.

Item 1A.
Risk Factors

There have been no material changes to the factors disclosed in Item 1A. Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2013.

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

The following table sets forth information regarding the Company's common stock repurchases transacted during the quarter:

 
 
 
Total Number
Maximum Number
 
 
 
of Shares Purchased
of Shares that May
 
 
 
as Part of Publicly
Yet Be Purchased
 
Total Number of
Average Price
Announced Plans
Under the Plans
Period
Shares Purchased
Paid per Share
or Programs
or Programs
 
 
 
 
 
April 1 - April 30, 2014
9,681

$
42.50

9,681

376,662

 
 
 
 
 
May 1 - May 31, 2014
86,101

$
42.26

86,101

290,561

 
 
 
 
 
June 1 - June 30, 2014
30,724

$
44.86

30,724

259,837

 
 
 
 
 
 
 
 
 
 


Item 3.
Defaults Upon Senior Securities.

None.



57



Item 4.
Mine Safety Disclosures.

None.

Item 5.
Other Information.

None.
Item 6.
Exhibits
 
 
(a) Exhibits
 
 
31(a)
Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 for Charles R. Hageboeck
 
 
31(b)
Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 for David L. Bumgarner
 
 
32(a)
Certification pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 for Charles R. Hageboeck
 
 
32(b)
Certification pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 for David L. Bumgarner
 
 
101.INS
XBRL Instance Document*
 
 
101.SCH
XBRL Taxonomy Extension Schema*
 
 
101.CAL
XBRL Taxonomy Extension Calculation Linkbase*
 
 
101.DEF
XBRL Taxonomy Extension Definition Linkbase*
 
 
101.LAB
XBRL Taxonomy Extension Label Linkbase*
 
 
101.PRE
XBRL Taxonomy Extension Presentation Linkbase*
·

Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934 and otherwise are not subject to liability.

SIGNATURES

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.

 
City Holding Company
 
 
(Registrant)
 
 
 
/s/ Charles R. Hageboeck
 
 
Charles R. Hageboeck
 
President and Chief Executive Officer
 
(Principal Executive Officer)
 
 
 
/s/ David L. Bumgarner
 
 
David L. Bumgarner
 
Senior Vice President, Chief Financial Officer and Principal Accounting Officer
 
(Principal Financial Officer)


Date: August 7, 2014


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