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EX-32.1 - EXHIBIT 32.1 - FIRST KEYSTONE CORPv384820_ex32-1.htm
EX-31.2 - EXHIBIT 31.2 - FIRST KEYSTONE CORPv384820_ex31-2.htm
EX-31.1 - EXHIBIT 31.1 - FIRST KEYSTONE CORPv384820_ex31-1.htm
EX-32.2 - EXHIBIT 32.2 - FIRST KEYSTONE CORPv384820_ex32-2.htm

  

UNITED STATES

 

SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C. 20549

 

FORM 10Q

 

xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended June 30, 2014

 

or

 

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

 

For the transition period from ________ to ________

 

Commission File Number: 2-88927

 

FIRST KEYSTONE CORPORATION
(Exact name of registrant as specified in its charter)

 

Pennsylvania   23-2249083
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification No.)
     
111 West Front Street, Berwick, PA   18603
(Address of principal executive offices)   (Zip Code)

 

Registrant’s telephone number, including area code: (570) 752-3671

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x    No  ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “small 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 Act).

Yes ¨     No x

 

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 Par Value, 5,543,486 shares as of August 1, 2014.

 

 
 

 

PART I - FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

FIRST KEYSTONE CORPORATION AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

  June 30,   December 31, 
(Dollars in thousands, except per share data)  2014   2013 
ASSETS          
Cash and due from banks  $9,746   $8,257 
Interest-bearing deposits in other banks   1,000    22,366 
Total cash and cash equivalents   10,746    30,623 
Investment securities available-for-sale   348,877    353,698 
Investment securities held-to-maturity (fair value 2014 - $1,072; 2013 - $1,083)   1,064    1,072 
Restricted investment in bank stocks   6,661    4,761 
Loans   463,174    446,518 
Allowance for loan losses   (6,477)   (6,519)
Net loans   456,697    439,999 
Premises and equipment, net   21,301    21,516 
Accrued interest receivable   3,321    3,616 
Cash surrender value of bank owned life insurance   20,905    20,556 
Investments in low-income housing partnerships   1,210    1,289 
Goodwill   19,133    19,133 
Core deposit intangible, net   258    395 
Foreclosed assets held for resale   237    480 
Deferred income taxes   86    2,080 
Other assets   2,267    2,296 
TOTAL ASSETS  $892,763   $901,514 
           
LIABILITIES          
Deposits:          
Non-interest bearing  $94,757   $85,156 
Interest bearing   547,819    604,919 
Total deposits   642,576    690,075 
Short-term borrowings   88,434    68,233 
Long-term borrowings   55,380    40,429 
Accrued interest payable   406    392 
Other liabilities   2,940    6,034 
TOTAL LIABILITIES   789,736    805,163 
           
STOCKHOLDERS’ EQUITY          
Preferred stock, par value $2.00 per share; authorized 1,000,000 shares in 2014 and 2013; issued 0 in 2014 and 2013        
Common stock, par value $2.00 per share; authorized 20,000,000 shares in 2014 and 2013; issued 5,778,635 in 2014 and 5,756,474 in 2013; outstanding 5,543,486 in 2014 and 5,521,325 in 2013   11,557    11,513 
Surplus   32,141    31,626 
Retained earnings   61,269    59,089 
Accumulated other comprehensive income (loss)   3,883    (54)
Treasury stock, at cost, 235,149 in 2014 and 2013   (5,823)   (5,823)
           
TOTAL STOCKHOLDERS’ EQUITY   103,027    96,351 
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY  $892,763   $901,514 

 

See accompanying notes to consolidated financial statements.

 

1
 

 

FIRST KEYSTONE CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2014 AND 2013

(Unaudited)

 

   Three Months Ended   Six Months Ended 
(Dollars in thousands, except per share data)  June 30,   June 30, 
   2014  2013   2014   2013 
INTEREST INCOME                    
Interest and fees on loans  $5,065   $5,130   $10,026   $10,306 
Interest and dividend income on investment securities:                    
Taxable   2,005    1,644    4,008    3,274 
Tax-exempt   607    1,028    1,240    2,049 
Dividends   16    16    32    29 
Dividend income on restricted investment in bank stocks   83    4    102    8 
Interest on interest bearing deposits in other banks       2    1    2 
Total interest income   7,776    7,824    15,409    15,668 
                     
INTEREST EXPENSE                    
Interest on deposits   743    900    1,557    1,796 
Interest on short-term borrowings   53    25    88    49 
Interest on long-term borrowings   312    304    588    630 
Total interest expense   1,108    1,229    2,233    2,475 
                     
Net interest income   6,668    6,595    13,176    13,193 
Provision for loan losses   200    200    333    600 
Net interest income after provision for loan losses   6,468    6,395    12,843    12,593 
                     
NON-INTEREST INCOME                    
Trust department   269    200    495    412 
Service charges and fees   394    395    711    677 
Bank owned life insurance income   167    174    349    347 
ATM fees and debit card income   289    254    549    486 
Gains on sales of mortgage loans   56    230    80    440 
Net investment securities gains   1,203    2,412    1,800    2,680 
Other   140    100    249    175 
Total non-interest income   2,518    3,765    4,233    5,217 
                     
NON-INTEREST EXPENSE                    
Salaries and employee benefits   2,825    2,708    5,642    5,428 
Occupancy, net   439    424    895    777 
Furniture and equipment   153    231    307    360 
Computer expense   280    262    543    502 
Professional services   134    125    297    241 
Pennsylvania shares tax   158    204    317    408 
FDIC insurance   119    102    237    209 
ATM and debit card fees   175    124    291    255 
Data processing fees   158        196     
Foreclosed assets held for resale expense (income)   19    1    122    (26)
Advertising   183    90    308    171 
FHLB prepayment penalties       345        345 
Other   796    707    1,536    1,334 
Total non-interest expense   5,439    5,323    10,691    10,004 
                     
Income before income tax expense   3,547    4,837    6,385    7,806 
Income tax expense   791    965    1,331    1,408 
NET INCOME  $2,756   $3,872   $5,054   $6,398 
PER SHARE DATA                    
Net income per share:                    
Basic  $0.50   $0.70   $0.91   $1.17 
Diluted   0.50    0.70    0.91    1.17 
Dividends per share   0.26    0.26    0.52    0.52 

 

See accompanying notes to consolidated financial statements.

 

2
 

 

FIRST KEYSTONE CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Unaudited)

 

(Dollars in thousands)

   Three Months Ended 
   June 30, 
   2014   2013 
         
Net Income  $2,756   $3,872 
           
Other comprehensive income (loss):          
Unrealized net holding gains (losses) on available-for-sale investment securities arising during the period, net of income taxes of $1,244 and $(3,490), respectively   2,417    (6,786)
Less reclassification adjustment for net gains included in net income, net of income taxes of $(409) and $(820), respectively (a) (b)   (794)   (1,592)
Total other comprehensive income (loss)   1,623    (8,378)
Total Comprehensive Income (Loss)  $4,379   $(4,506)

 

 

(a) Gross amounts are included in net investment securities gains on the Consolidated Statements of Income in non-interest income.

(b) Income tax amounts are included in income tax expense on the Consolidated Statements of Income.

 

(Dollars in thousands)

   Six Months Ended 
   June 30, 
   2014   2013 
         
Net Income  $5,054   $6,398 
           
Other comprehensive income (loss):          
Unrealized net holding gains (losses) on available-for-sale investment securities arising during the period, net of income taxes of $2,638 and $(3,790), respectively   5,125    (7,405)
Less reclassification adjustment for net gains included in net income, net of income taxes of $(612) and $(911), respectively (a) (b)   (1,188)   (1,769)
Total other comprehensive income (loss)   3,937    (9,174)
Total Comprehensive Income (Loss)  $8,991   $(2,776)

 

 

(a) Gross amounts are included in net investment securities gains on the Consolidated Statements of Income in non-interest income.

(b) Income tax amounts are included in income tax expense on the Consolidated Statements of Income.

 

See accompanying notes to consolidated financial statements.

 

3
 

 

FIRST KEYSTONE CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

SIX MONTHS ENDED JUNE 30, 2014 AND 2013

(Unaudited)

 (Dollars in thousands, except per share data)

                   Accumulated         
                   Other       Total 
   Common Stock       Retained   Comprehensive   Treasury   Stockholders’ 
   Shares   Amount   Surplus   Earnings   Income (Loss)   Stock   Equity 
Balance at January 1, 2014   5,756,474   $11,513   $31,626   $59,089   $(54)  $(5,823)  $96,351 
                                    
Net Income                  5,054              5,054 
Other comprehensive income, net of taxes                       3,937         3,937 
Issuance of common stock under dividend reinvestment plan   22,161    44    515                   559 
Dividends - $0.52 per share              (2,874)             (2,874)
Balance at June 30, 2014   5,778,635   $11,557   $32,141   $61,269   $3,883   $(5,823)  $103,027 
                                    
Balance at January 1, 2013   5,717,400   $11,435   $30,725   $54,532   $12,528   $(5,890)  $103,330 
                                    
Net Income                  6,398              6,398 
Other comprehensive loss, net of taxes                       (9,174)        (9,174)
Issuance of common stock under dividend reinvestment and stock purchase plans   19,684    39    460              17    516 
Dividends - $0.52 per share                  (2,853)             (2,853)
Balance at June 30, 2013   5,737,084   $11,474   $31,185   $58,077   $3,354   $(5,873)  $98,217 

 

See accompanying notes to consolidated financial statements.

 

4
 

 

FIRST KEYSTONE CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE SIX MONTHS ENDED JUNE 30, 2014 AND 2013

(Unaudited)

(Dollars in thousands)

   2014   2013 
OPERATING ACTIVITIES          
Net income  $5,054   $6,398 
Adjustments to reconcile net income to net cash provided by operating activities:          
Provision for loan losses   333    600 
Depreciation and amortization   804    731 
Net premium amortization on investment securities   843    802 
Deferred income tax benefit   (32)   (177)
Gains on sales of mortgage loans   (80)   (440)
Proceeds from sales of mortgage loans originated for resale   3,298    18,860 
Originations of mortgage loans originated for resale   (4,173)   (18,932)
Gains on sales of investment securities   (1,800)   (2,680)
Losses (gains) on sales of foreclosed real estate held for resale, including write-downs   47    (70)
Decrease in accrued interest receivable   295    40 
Earnings on investment in bank owned life insurance   (349)   (347)
Losses on disposals of premises and equipment       133 
Decrease in other assets   49    141 
Decrease in prepaid FDIC insurance       1,002 
Increase (decrease) in accrued interest payable   14    (113)
(Decrease) increase in other liabilities   (3,110)   75 
NET CASH PROVIDED BY OPERATING ACTIVITIES   1,193    6,023 
           
INVESTING ACTIVITIES          
Proceeds from sales of investment securities available-for-sale   120,202    27,811 
Proceeds from maturities and redemptions of investment securities available-for-sale   19,243    25,762 
Purchases of investment securities available-for-sale   (127,704)   (89,847)
Proceeds from maturities and redemptions of investment securities held-to-maturity   8    7 
Net change in restricted investment in bank stocks   (1,900)   (680)
Net increase in loans   (16,295)   (3,995)
Purchases of premises and equipment   (400)   (1,800)
Proceeds from sales of foreclosed assets held for resale   458    443 
NET CASH USED IN INVESTING ACTIVITIES   (6,388)   (42,299)
           
FINANCING ACTIVITIES          
Net (decrease) increase in deposits   (47,499)   27,799 
Net increase in short-term borrowings   20,201    4,855 
Proceeds from long-term borrowings   20,000    5,000 
Repayment of long-term borrowings   (5,049)   (7,045)
Common stock issued   539    492 
Dividends paid   (2,874)   (2,853)
NET CASH (USED IN) PROVIDED BY FINANCING ACTIVITIES   (14,682)   28,248 
           
DECREASE IN CASH AND CASH EQUIVALENTS   (19,877)   (8,028)
CASH AND CASH EQUIVALENTS, BEGINNING   30,623    20,920 
CASH AND CASH EQUIVALENTS, ENDING  $10,746   $12,892 
           
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION          
Interest paid  $2,219   $2,588 
Income taxes paid   1,119    453 
Loans transferred to foreclosed assets held for resale   262    420 

 

See accompanying notes to consolidated financial statements.

 

5
 

 

FIRST KEYSTONE CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

NOTE 1 ― BASIS OF PRESENTATION AND ACCOUNTING POLICIES

 

The consolidated financial statements include the accounts of First Keystone Corporation (the “Corporation”) and its wholly owned subsidiary, First Keystone Community Bank (the “Bank”). All significant intercompany accounts and transactions have been eliminated.

 

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial information. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete consolidated financial statements. In the opinion of management, all adjustments considered necessary for fair presentation have been included. Operating results for the three and six month periods ended June 30, 2014, are not necessarily indicative of the results for the year ending December 31, 2014. For further information, refer to the consolidated financial statements and notes thereto included in First Keystone Corporation’s Annual Report on Form 10-K for the year ended December 31, 2013.

 

For comparative purposes, the June 30, 2013 and December 31, 2013 balances have been reclassified to conform to the 2014 presentation. Such reclassifications had no impact on net income.

 

The Corporation has evaluated events and transactions occurring subsequent to the consolidated balance sheet date of June 30, 2014 for items that should potentially be recognized or disclosed in these consolidated financial statements. The evaluation was conducted through the date these consolidated financial statements were issued.

 

NOTE 2 ― RECENT ACCOUNTING STANDARDS UPDATES (“ASU”)

 

Except as disclosed below, there were no new accounting pronouncements affecting the Corporation during the three and six months ended June 30, 2014 that were not already adopted by the Corporation in previous periods.

 

In January 2014, the Financial Accounting Standards Board (“FASB”) issued ASU 2014-01, Investments – Equity Method and Joint Ventures (Topic 323). The ASU provides guidance on accounting for investments by a reporting entity in flow-through limited liability entities that manage or invest in affordable housing projects that qualify for the low-income housing tax credit. This ASU is effective for annual periods and interim reporting periods within those annual periods beginning after December 15, 2014, and will be applied retrospectively to all periods presented. The Corporation is currently evaluating the impact of this ASU on its consolidated financial statements.

 

In January 2014, the FASB issued ASU 2014-04, Receivables – Troubled Debt Restructurings by Creditors (Subtopic 310-40). The ASU clarifies that a creditor is considered to have physical possession of residential real estate that is collateral for a residential mortgage loan when it obtains legal title to the collateral or a deed in lieu of foreclosure or similar legal agreement is completed. Consequently, the creditor should reclassify the loan to other real estate owned at that time. The new guidance is intended to resolve the diversity in current practice as to when a creditor should reclassify a loan to other real estate on the balance sheet. This ASU is effective for annual periods beginning after December 15, 2014, and interim periods within those annual periods after December 15, 2015. The Corporation is currently evaluating the impact of this ASU on its consolidated financial statements.

 

In June 2014, the FASB issued ASU No. 2014-11, Transfers and Servicing (Topic 860). The ASU provides guidance on accounting for repurchase-to-maturity transactions and certain linked repurchase financings. This guidance will result in accounting for both types of arrangements as secured borrowings on the balance sheet. Additionally, the ASU introduces new disclosures to (i) increase transparency about the types of collateral pledged in secured borrowing transactions and (ii) enable users to better understand transactions in which the transferor retains substantially all of the exposure to the economic return on the transferred financial asset throughout the term of the transaction. This ASU is effective for annual periods beginning after December 15, 2014, and for interim periods beginning after March 15, 2015. The Corporation is currently evaluating the impact of this ASU on its consolidated financial statements.

 

6
 

 

NOTE 3INVESTMENT SECURITIES

 

The Corporation classifies its investment securities as either “Held-to-Maturity” or “Available-for-Sale” at the time of purchase. Investment securities are accounted for on a trade date basis. Debt securities are classified as Held-to-Maturity when the Corporation has the ability and positive intent to hold the securities to maturity. Investment securities classified as Held-to-Maturity are carried at cost adjusted for amortization of premium and accretion of discount to maturity.

 

Debt securities not classified as Held-to-Maturity and equity securities are included in the Available-for-Sale category and are carried at fair value. The amount of any unrealized gain or loss, net of the effect of deferred income taxes, is reported as accumulated other comprehensive income (loss) in the Consolidated Balance Sheets and Consolidated Statements of Changes in Stockholders’ Equity. Management’s decision to sell Available-for-Sale securities is based on changes in economic conditions controlling the sources and applications of funds, terms, availability of and yield of alternative investments, interest rate risk and the need for liquidity.

 

The cost of debt securities classified as Held-to-Maturity or Available-for-Sale is adjusted for amortization of premiums and accretion of discounts to expected maturity. Such amortization and accretion, as well as interest and dividends, are included in interest and dividend income from investment securities. Realized gains and losses are included in net investment securities gains and losses. The cost of investment securities sold, redeemed or matured is based on the specific identification method.

 

The amortized cost, related estimated fair value, and unrealized gains and losses for investment securities classified as “Available-For-Sale” or “Held-to-Maturity” were as follows at June 30, 2014 and December 31, 2013:

 

   Available-for-Sale Securities 
       Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
(Dollars in thousands)  Cost   Gains   Losses   Value 
June 30, 2014:                    
U.S. Treasury securities  $1,043   $1   $   $1,044 
Obligations of U.S. Government Corporations and Agencies:                    
Mortgage-backed   155,748    1,624    (456)   156,916 
Other   27,960    226    (17)   28,169 
Obligations of state and political subdivisions   120,078    4,920    (881)   124,117 
Corporate debt securities   36,533    207    (629)   36,111 
Marketable equity securities   1,533    1,007    (20)   2,520 
Total  $342,895   $7,985   $(2,003)  $348,877 

 

   Held-to-Maturity Securities 
       Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
(Dollars in thousands)  Cost   Gains   Losses   Value 
June 30, 2014:                    
Obligations of U.S. Government Corporations and Agencies:                    
Mortgage-backed  $64   $3   $   $67 
Other   1,000    5        1,005 
Total  $1,064   $8   $   $1,072 

 

7
 

 

   Available-for-Sale Securities 
       Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
(Dollars in thousands)  Cost   Gains   Losses   Value 
December 31, 2013:                    
U.S. Treasury securities  $   $   $   $ 
Obligations of U.S. Government Corporations and Agencies:                    
Mortgage-backed   122,661    598    (2,035)   121,224 
Other   32,107    238    (60)   32,285 
Obligations of state and political subdivisions   147,112    4,136    (2,859)   148,389 
Corporate debt securities   50,266    416    (1,417)   49,265 
Marketable equity securities   1,533    1,004    (2)   2,535 
Total  $353,679   $6,392   $(6,373)  $353,698 

 

   Held-to-Maturity Securities 
      Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
(Dollars in thousands)  Cost   Gains   Losses   Value 
December 31, 2013:                    
Obligations of U.S. Government Corporations and Agencies:                    
Mortgage-backed  $72   $3   $   $75 
Other   1,000    8        1,008 
Total  $1,072   $11   $   $1,083 

 

Securities Available-for-Sale with an aggregate fair value of $218,541,000 at June 30, 2014 and $242,839,000 at December 31, 2013, and securities Held-to-Maturity with an aggregate book value of $1,064,000 at June 30, 2014 and $1,072,000 at December 31, 2013, were pledged to secure public funds, trust funds, securities sold under agreements to repurchase, FHLB advances and other balances of $142,952,000 at June 30, 2014 and $178,814,000 at December 31, 2013.

 

8
 

 

The amortized cost, estimated fair value and weighted average yield of debt and equity securities, by contractual maturity, are shown below at June 30, 2014. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

(Dollars in thousands)

 

   June 30, 2014 
   Available-For-Sale   Held-To-Maturity 
       U.S. Government   Obligations           U.S. Government 
       Corporations &   of State   Marketable   Corporate   Corporations & 
   U.S. Treasury   Agencies   & Political   Equity   Debt   Agencies 
   Securities   Obligations1   Subdivisions2   Securities3   Securities   Obligations1 
Within 1 Year:                              
Amortized cost  $   $4,504   $   $   $3,540   $ 
Fair value       4,512            3,605     
Weighted average yield       0.96%           3.03%    
                               
1 - 5 Years:                              
Amortized cost   1,043    2,551    11,067        2,595    1,064 
Fair value   1,044    2,572    11,562        2,665    1,072 
Weighted average yield   0.96%   0.92%   4.01%       1.98%   0.84%
                               
5 - 10 Years:                              
Amortized cost       5,380    42,636        30,398     
Fair value       5,492    42,932        29,841     
Weighted average yield       2.37%   3.58%       2.94%    
                               
After 10 Years:                              
Amortized cost       171,273    66,375    1,533         
Fair value       172,509    69,623    2,520         
Weighted average yield       2.45%   6.04%   4.29%        
                               
Total:                              
Amortized cost  $1,043   $183,708   $120,078   $1,533   $36,533   $1,064 
Fair value   1,044    185,085    124,117    2,520    36,111    1,072 
Weighted average yield   0.96%   2.39%   4.98%   4.29%   2.88%   0.84%

 

 

1Mortgage-backed securities are allocated for maturity reporting at their original maturity date.

2Average yields on tax-exempt obligations of state and political subdivisions have been computed on a tax-equivalent basis using a 34% tax rate.

3Marketable equity securities are not considered to have defined maturities and are included in the after ten year category.

 

9
 

 

There were no aggregate investments with a single issuer (excluding the U.S. Government and its agencies) which exceeded ten percent of consolidated stockholders’ equity at June 30, 2014. The quality rating of the obligations of state and political subdivisions are generally investment grade, as rated by Moody’s, Standard and Poor’s or Fitch. The typical exceptions are local issues which are not rated, but are secured by the full faith and credit obligations of the communities that issued these securities.

 

Proceeds from sales of investments in Available-for-Sale debt and equity securities for the three months ended June 30, 2014 and 2013 were $40,037,000 and $23,606,000, respectively. Gross gains realized on these sales were $1,514,000 and $2,536,000, respectively. Gross losses on these sales were $311,000 and $124,000, respectively. There were no other-than-temporary impairment losses during the three months ended 2014 or 2013.

 

Proceeds from sales of investments in Available-for-Sale debt and equity securities for the six months ended June 30, 2014 and 2013 were $120,202,000 and $27,811,000, respectively. Gross gains realized on these sales were $2,322,000 and $2,826,000, respectively. Gross losses on these sales were $522,000 and $146,000, respectively. There were no other-than-temporary impairment losses during the six months ended 2014 or 2013.

 

There were no proceeds from sales of investments in Held-to-Maturity debt and equity securities during the three or six month periods ended June 30, 2014 or 2013. Therefore, there were no gains or losses realized during these periods.

 

Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. Investment securities classified as available-for-sale or held-to-maturity are generally evaluated for OTTI under FASB ASC 320, Investments - Debt and Equity Securities. In determining OTTI under the FASB ASC 320 model, management considers many factors, including (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.

 

When other-than-temporary impairment occurs on debt securities, the amount of the other-than-temporary impairment recognized in earnings depends on whether an entity intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss. If an entity intends to sell or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the other-than-temporary impairment shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis less any current-period loss, the other-than-temporary impairment shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total other-than-temporary impairment related to the credit loss is determined based on the present value of cash flows expected to be collected, and the realized loss is recognized in net investment securities gains on the Consolidated Statements of Income. The amount of the total other-than-temporary impairment related to the other factors shall be recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the other-than-temporary impairment recognized in earnings shall become the new amortized cost basis of the investment.

 

The fair market value of the equity securities tends to fluctuate with the overall equity markets as well as the trends specific to each institution. The equity securities portfolio is reviewed in a similar manner as that of the debt securities with greater emphasis placed on the length of time the market value has been less than the carrying value and the financial sector outlook. The Corporation also reviews dividend payment activities, levels of non-performing assets and loan loss reserves. The starting point for the equity analysis is the length and severity of market value decline. The realized loss is recognized in net investment securities gains on the Consolidated Statements of Income. The amount of the total other-than-temporary impairment is recognized in other comprehensive income, net of applicable taxes.

 

The Corporation and its investment advisors monitor the entire portfolio monthly with particular attention given to securities in a continuous loss position of at least ten percent for over twelve months. Based on the factors described above, management did not consider any securities to be other-than-temporarily impaired at June 30, 2014 and December 31, 2013.

 

10
 

 

In accordance with disclosures required by FASB ASC 320-10-50, Investments - Debt and Equity Securities, the summary below shows the gross unrealized losses and fair value of the Corporation’s investments, aggregated by investment category, that individual securities have been in a continuous unrealized loss position for less than 12 months or 12 months or more as of June 30, 2014 and December 31, 2013:

 

June 30, 2014

 

   Less Than 12 Months   12 Months or More   Total 
   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
(Dollars in thousands)  Value   Loss   Value   Loss   Value   Loss 
Available-for-Sale:                              
Obligations of U.S. Government                              
Corporations and Agencies:                              
Mortgage-backed  $5,661   $(20)  $22,848   $(436)  $28,509   $(456)
Other   5,932    (17)           5,932    (17)
Obligations of state and political subdivisions   3,530    (44)   22,590    (837)   26,120    (881)
Corporate debt securities   12,984    (266)   13,292    (363)   26,276    (629)
Marketable equity securities   30    (20)           30    (20)
   $28,137   $(367)  $58,730   $(1,636)  $86,867   $(2,003)

 

December 31, 2013

 

   Less Than 12 Months   12 Months or More   Total 
   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
(Dollars in thousands)  Value   Loss   Value   Loss   Value   Loss 
Available-for-Sale:                              
Obligations of U.S. Government                              
Corporations and Agencies:                              
Mortgage-backed  $98,760   $(2,035)  $   $   $98,760   $(2,035)
Other   4,956    (60)           4,956    (60)
Obligations of state and political subdivisions   48,853    (2,859)           48,853    (2,859)
Corporate debt securities   26,099    (1,417)           26,099    (1,417)
Marketable equity securities   21    (2)           21    (2)
   $178,689   $(6,373)  $   $   $178,689   $(6,373)

 

The Corporation invests in various forms of agency debt including mortgage backed securities and callable debt. The mortgage-backed securities are issued by FHLMC (“Federal Home Loan Mortgage Corporation”), FNMA (“Federal National Mortgage Association”) or GNMA (“Government National Mortgage Association”). The municipal securities consist of general obligations and revenue bonds. The marketable equity securities consist of stocks in other bank holding companies. The fair market value of the above securities is influenced by market interest rates, prepayment speeds on mortgage securities, bid offer spreads in the market place and credit premiums for various types of agency debt. These factors change continuously and therefore the market value of these securities may be higher or lower than the Corporation’s carrying value at any measurement date. Management does not believe any of their 53 debt securities in an unrealized loss position as of June 30, 2014 represents an other-than-temporary impairment, as these unrealized losses relate principally to changes in interest rates subsequent to the acquisition of the specific securities.

 

NOTE 4LOANS AND ALLOWANCE FOR LOAN LOSSES

 

Loans are stated at their outstanding unpaid principal balances, net of deferred fees or costs, unearned income and the allowance for loan losses. Interest on loans is recognized as income over the term of each loan, generally, by the accrual method. Loan origination fees and certain direct loan origination costs have been deferred with the net amount amortized using the straight line method or the interest method over the contractual life of the related loans as an interest yield adjustment.

 

Residential mortgage loans held for resale are carried at the lower of cost or market on an aggregate basis determined by independent pricing from appropriate federal or state agency investors. These loans are sold without recourse.

 

11
 

 

Past-Due Loans — Generally, a loan is considered to be past-due when scheduled loan payments are in arrears 15 days or more. Delinquent notices are generated automatically when a loan is 15 days past-due. Collection efforts continue on past-due loans that have not been brought current, when it is believed that some chance exists for improvement in the status of the loan. Past-due loans are continually evaluated with the determination for charge-off being made when no reasonable chance remains that the status of the loan can be improved.

 

Charge-Offs — Commercial Real Estate and Commercial and Industrial loans are charged off in whole or in part when they become sufficiently delinquent based upon the terms of the underlying loan contract and when a collateral deficiency exists. Because all or part of the contractual cash flows are not expected to be collected, the loan is considered to be impaired, and the Bank estimates the impairment based on its analysis of the cash flows and/or collateral estimated at fair value less cost to sell.

 

Residential Real Estate and Consumer loans are charged off when they become non-performing assets, or when the value of the underlying collateral is not sufficient to support the loan balance and a loss is expected. At that time, the amount of estimated collateral deficiency, if any, is charged off for loans secured by collateral, and all other loans are charged off in full. Loans in which the borrower is in bankruptcy are considered on a case by case basis and are either charged off by the Bank or reaffirmed by the borrower. Loans with collateral are charged down to the estimated fair value of the collateral less cost to sell.

 

Non-Accrual Loans — Generally, a loan is classified as non-accrual and the accrual of interest on such a loan is discontinued when the contractual payment of principal or interest has become 90 days past due or management has serious doubts about further collectability of principal or interest, even though the loan may currently be performing. A loan may remain on accrual status if it is in the process of collection and is either guaranteed or well secured. When a loan is placed on non-accrual status, unpaid interest credited to income in the current year is reversed and unpaid interest accrued in prior years is charged against interest income. Certain non-accrual loans may continue to perform, that is, payments are still being received. Generally, the payments are applied to principal. These loans remain under constant scrutiny and if performance continues, interest income may be recorded on a cash basis based on management's judgment as to collectability of principal.

 

Impaired Loans — A loan is considered impaired when, based on current information and events, it is probable that the Corporation will be unable to collect all amounts due according to the contractual terms of the original loan agreement. Under current accounting standards, the allowance for loan losses related to impaired loans is based on discounted cash flows using the loan’s effective interest rate or the fair value of the collateral for certain collateral dependent loans.

 

Troubled Debt Restructurings (“TDRs”) — The restructuring of a loan is considered a “troubled debt restructuring” if both the following conditions are met: (i) the borrower is experiencing financial difficulties, and (ii) the Bank has granted a concession. The most common concessions granted include one or more modifications to the terms of the debt, such as (a) a reduction in the interest rate for the remaining life of the debt, (b) an extension of the maturity date at an interest rate lower than the current market rate for new debt with similar risk, (c) a temporary period of interest-only payments, and (d) a reduction in the contractual payment amount for either a short period or remaining term of the loan. A less common concession is the forgiveness of a portion of the principal.

 

The determination of whether a borrower is experiencing financial difficulties takes into account not only the current financial condition of the borrower, but also the potential financial condition of the borrower were a concession not granted. Similarly, the determination of whether a concession has been granted is very subjective in nature. For example, simply extending the term of a loan at its original interest rate or even at a higher interest rate could be interpreted as a concession unless the borrower could readily obtain similar credit terms from a different lender.

 

Loans modified in a troubled debt restructuring may or may not be placed on non-accrual status until the Bank determines the future collection of principal and interest is reasonably assured, which generally requires that the borrower demonstrates a period of performance according to the restructured terms of six months. Loans classified as troubled debt restructurings are designated as impaired.

 

Allowance for Loan Losses — The allowance for loan losses is established through provisions for loan losses charged against income. Loans deemed to be uncollectible are charged against the allowance for loan losses and subsequent recoveries, if any, are credited to the allowance.

 

The allowance for loan losses is maintained at a level estimated by management to be adequate to absorb potential loan losses. Management’s periodic evaluation of the adequacy of the allowance for loan losses is based on the Corporation’s past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay (including the timing of future payments), the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions, and other relevant factors. This evaluation 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.

 

12
 

 

The Corporation is subject to periodic examination by its federal and state examiners, and may be required by such regulators to recognize additions to the allowance for loan losses based on their assessment of credit information available to them at the time of their examinations.

 

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are individually classified as impaired. Select loans are not aggregated for collective impairment evaluation, as such; all loans are subject to individual impairment evaluation should the facts and circumstances pertinent to a particular loan suggest that such evaluation is necessary. Factors considered by management in determining impairment include payment status and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. If a loan is impaired, a portion of the allowance may be allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from collateral. Troubled debt restructurings are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a troubled debt restructuring is considered to be a collateral dependent loan, the loans may be reported, net, at the fair value of the collateral. For troubled debt restructurings that subsequently default, the Corporation determines the amount of reserve in accordance with the accounting policy for the allowance for loan losses.

 

The general component covers all other loans not identified as impaired and is based on historical losses adjusted for current factors. The historical loss component of the allowance is determined by losses recognized by portfolio segment over the preceding eight quarters. In calculating the historical component of our allowance, loans are aggregated into one of four portfolio segments: Commercial and Industrial, Commercial Real Estate, Residential Real Estate and Consumer. Risk factors impacting loans in each of the portfolio segments include broad deterioration of property values, reduced consumer and business spending as a result of continued high unemployment and reduced credit availability and lack of confidence in a sustainable recovery. Actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment. These economic factors include consideration of the following: the concentration of special mention, substandard and doubtful loans as a percentage of total loans, levels of loan concentration within the portfolio segment or division of a portfolio segment, broad economic conditions, delinquency trends, volume trends and terms, and policy and management changes.

 

The unallocated component of the allowance is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

 

The Bank utilizes a risk grading matrix as a tool for managing credit risk in the loan portfolio and assigns an asset quality rating (risk grade) to all retail Residential Real Estate and retail Consumer, Commercial and Industrial, and Commercial Real Estate borrowings. An asset quality rating is assigned using the guidance provided in the Bank’s loan policy. Primary responsibility for assigning the asset quality rating rests with the lender. The asset quality rating is validated periodically by both an internal and external loan review process.

 

The commercial loan grading system focuses on a borrower’s financial strength and performance, experience and depth of management, primary and secondary sources of repayment, the nature of the business and the outlook for the particular industry. Primary emphasis will be on the financial condition and trends. The grade also reflects current economic and industry conditions; as well as other variables such as liquidity, cash flow, revenue/earnings trends, management strengths or weaknesses, quality of financial information, and credit history.

 

The retail loan grading system for Residential Real Estate and Consumer loans focuses on the borrower’s credit score and credit history, debt-to-income ratio and income sources, collateral position and loan-to-value ratio, as well as other variables such as current economic conditions, and individual strengths and weaknesses.

 

13
 

 

Risk grade characteristics are as follows:

 

Risk Grade 1 – MINIMAL RISK through Risk Grade 6 – MANAGEMENT ATTENTION (Pass Grade Categories)

 

Risk is evaluated via examination of several attributes including but not limited to financial trends, strengths and weaknesses, likelihood of repayment when considering both cash flow and collateral, sources of repayment, leverage position, management expertise, and repayment history.

 

At the low-risk end of the rating scale, a risk grade of 1 - Minimal Risk is the grade reserved for loans with exceptional credit fundamentals and virtually no risk of default or loss. Loan grades then progress through escalating ratings of 2 through 6 based upon risk. Risk Grade 2 - Modest Risk are loans with sufficient cash flows; Risk Grade 3 - Average Risk are loans with key balance sheet ratios slightly above the borrower’s peers; Risk Grade 4 - Acceptable Risk are loans with key balance sheet ratios usually near the borrower’s peers, but one or more ratios may be higher; and Risk Grade 5 – Marginally Acceptable are loans with strained cash flow, increasing leverage and/or weakening markets. Risk Grade 6 - Management Attention are loans with weaknesses resulting from declining performance trends and the borrower’s cash flows may be temporarily strained. Loans in this category are performing according to terms, but present some type of potential concern.

 

Risk Grade 7 − SPECIAL MENTION (Non-Pass Category)

 

Generally, these loans or assets are currently protected, but are “Potentially Weak”. They constitute an undue and unwarranted credit risk but not to the point of justifying a classification of substandard.

 

Assets in this category are currently protected but have potential weakness which may, if not checked or corrected, weaken the asset or inadequately protect the Bank’s credit position at some future date. No loss of principal or interest is envisioned, however they constitute an undue credit risk that may be minor but is unwarranted in light of the circumstances surrounding a specific asset. Risk is increasing beyond that at which the loan originally would have been granted. Historically, cash flows are inconsistent; financial trends show some deterioration. Liquidity and leverage are above industry averages. Financial information could be incomplete or inadequate. A Special Mention asset has potential weaknesses that deserve management’s close attention.

 

Risk Grade 8 − SUBSTANDARD (Non-Pass Category)

 

Generally, these assets are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified must have “well-defined” weaknesses that jeopardize the full liquidation of the debt.

 

They are characterized by the distinct possibility that the Bank will sustain some loss if in the aggregate amount of substandard assets, is not fully covered by the liquidation of the collateral used as security. Substandard loans are inadequately protected by current sound net worth, paying capacity of the borrower, or pledged collateral, and have a high probability of payment default, or they have other well-defined weaknesses. Such assets require more intensive supervision by Bank Management.

 

Risk Grade 9 − DOUBTFUL (Non-Pass Category)

 

Generally, loans graded doubtful have all the weaknesses inherent in a substandard loan with the added factor that the weaknesses are pronounced to a point where the basis of current information, conditions, and values, collection or liquidation in full is highly improbable. The possibility of loss is extremely high, but because of certain important and reasonably specific pending factors that may work to strengthen the asset, its classification is deferred until, for example, a proposed merger, acquisition, liquidation procedures, capital injection, perfection of liens on additional collateral and/or refinancing plans are completed. Loans are graded doubtful if they contain weaknesses so serious that collection or liquidation in full is questionable.

 

14
 

 

The credit quality indicators by loan segment are summarized below at June 30, 2014 and December 31, 2013:

 

   Commercial and     
(Dollars in thousands)  Industrial   Commercial Real Estate 
   June 30,   December 31,   June 30,   December 31, 
  2014   2013   2014   2013 
Grade:                    
1-6  Pass  $59,796   $60,614   $227,233   $219,925 
7    Special Mention   178    65    6,327    1,717 
8    Substandard   132    21    4,343    3,782 
9    Doubtful                
Add (deduct): Unearned discount and                
  Net deferred loan fees and costs   155    122    (2)   (19)
Total loans  $60,261   $60,822   $237,901   $225,405 

 

   Residential Real Estate     
   Including Home Equity   Consumer Loans 
   June 30,   December 31,   June 30,   December 31, 
   2014   2013   2014   2013 
Grade:                    
1-6  Pass  $157,758   $153,292   $5,422   $5,612 
7    Special Mention   294    180    2    2 
8    Substandard   1,234    931    7     
9    Doubtful                
Add (deduct): Unearned discount and           (67)   (87)
  Net deferred loan fees and costs   273    272    89    89 
Total loans  $159,559   $154,675   $5,453   $5,616 

 

   Total Loans 
   June 30,   December 31, 
   2014   2013 
Grade:          
1-6  Pass  $450,209   $439,443 
7    Special Mention   6,801    1,964 
8    Substandard   5,716    4,734 
9    Doubtful        
Add (deduct): Unearned discount and   (67)   (87)
  Net deferred loan fees and costs   515    464 
Total loans  $463,174   $446,518 

 

Commercial and Industrial and Commercial Real Estate include loans categorized as tax free loans in the amounts of $31,690,000 and $3,856,000 at June 30, 2014 and $27,299,000 and $3,945,000 at December 31, 2013, respectively. Loans held for sale amounted to $954,000 at June 30, 2014 and $0 at December 31, 2013.

 

15
 

 

The activity in the allowance for loan losses, by loan segment, is summarized below for the periods indicated.

 

As of and for the three month period ended June 30, 2014:

 

   Commercial   Commercial   Residential             
(Dollars in thousands)  and Industrial   Real Estate   Real Estate   Consumer   Unallocated   Total 
Allowance for Loan Losses:                              
Beginning balance  $825   $3,298   $1,567   $52   $735   $6,477 
Charge-offs       (96)   (144)   (7)       (247)
Recoveries   19    25    2    1        47 
Provision   (101)   223    194    5    (121)   200 
Ending Balance  $743   $3,450   $1,619   $51   $614   $6,477 
Ending balance: individually evaluated for impairment  $   $26   $18   $   $   $44 
Ending balance: collectively evaluated for impairment  $743   $3,424   $1,601   $51   $614   $6,433 

 

As of and for the six month period ended June 30, 2014:

 

   Commercial   Commercial   Residential             
(Dollars in thousands)  and Industrial   Real Estate   Real Estate   Consumer   Unallocated   Total 
Allowance for Loan Losses:                              
Beginning balance  $776   $3,320   $1,565   $53   $805   $6,519 
Charge-offs   (7)   (237)   (174)   (15)       (433)
Recoveries   21    25    11    1        58 
Provision   (47)   342    217    12    (191)   333 
Ending Balance  $743   $3,450   $1,619   $51   $614   $6,477 
Ending balance: individually evaluated for impairment  $   $26   $18   $   $   $44 
Ending balance: collectively evaluated for impairment  $743   $3,424   $1,601   $51   $614   $6,433 
                               
Financing Receivables:                              
Ending Balance  $60,261   $237,901   $159,559   $5,453   $   $463,174 
Ending balance: individually evaluated for impairment  $441   $5,233   $1,217   $7   $   $6,898 
Ending balance: collectively evaluated for impairment  $59,820   $232,668   $158,342   $5,446   $   $456,276 

 

16
 

 

As of and for the three month period ended June 30, 2013:

 

   Commercial   Commercial   Residential             
(Dollars in thousands)  and Industrial   Real Estate   Real Estate   Consumer   Unallocated   Total 
Allowance for Loan Losses:                              
Beginning balance  $684   $2,803   $1,531   $74   $810   $5,902 
Charge-offs       (30)   (139)   (17)       (186)
Recoveries   8        4    2        14 
Provision   8    62    51    17    62    200 
Ending Balance  $700   $2,835   $1,447   $76   $872   $5,930 
Ending balance: individually evaluated for impairment  $   $221   $15   $   $   $236 
Ending balance: collectively evaluated for impairment  $700   $2,614   $1,432   $76   $872   $5,694 

 

As of and for the six month period ended June 30, 2013:

 

   Commercial   Commercial   Residential             
(Dollars in thousands)  and Industrial   Real Estate   Real Estate   Consumer   Unallocated   Total 
Allowance for Loan Losses:                              
Beginning balance  $573   $2,837   $1,524   $80   $758   $5,772 
Charge-offs       (175)   (271)   (22)       (468)
Recoveries   19        4    3        26 
Provision   108    173    190    15    114    600 
Ending Balance  $700   $2,835   $1,447   $76   $872   $5,930 
Ending balance: individually evaluated for impairment  $   $221   $15   $   $   $236 
Ending balance: collectively evaluated for impairment  $700   $2,614   $1,432   $76   $872   $5,694 
                               
Financing Receivables:                              
Ending Balance  $59,981   $223,086   $147,498   $6,019   $   $436,584 
Ending balance: individually evaluated for impairment  $29   $4,714   $870   $   $   $5,613 
Ending balance: collectively evaluated for impairment  $59,952   $218,372   $146,628   $6,019   $   $430,971 

 

As of December 31, 2013:

 

   Commercial   Commercial   Residential             
(Dollars in thousands)  and Industrial   Real Estate   Real Estate   Consumer   Unallocated   Total 
Allowance for Loan Losses:                              
Ending Balance  $776   $3,320   $1,565   $53   $805   $6,519 
Ending balance: individually evaluated for impairment  $   $125   $15   $   $   $140 
Ending balance: collectively evaluated for impairment  $776   $3,195   $1,550   $53   $805   $6,379 
                               
Financing Receivables:                              
Ending Balance  $60,822   $225,405   $154,675   $5,616   $   $446,518 
Ending balance: individually evaluated for impairment  $21   $5,022   $931   $   $   $5,974 
Ending balance: collectively evaluated for impairment  $60,801   $220,383   $153,744   $5,616   $   $440,544 

 

17
 

 

From time to time, the Bank may agree to modify the contractual terms of a borrower’s loan. In cases where the modifications represent a concession to a borrower experiencing financial difficulty, the modification is considered a troubled debt restructuring (“TDR”).

 

The outstanding balance of TDRs as of June 30, 2014 and December 31, 2013 was $4,301,000 and $3,961,000, respectively. The increase in TDRs was attributable to deterioration in the respective borrowers’ financial position, and in some cases a declining collateral value, along with the Bank’s proactive monitoring of the loan portfolio. As of June 30, 2014 and December 31, 2013, there were no unfunded commitments on any TDRs.

 

During the three months ended June 30, 2014, four loans with a combined post modification balance of $476,000 were classified as TDRs, as compared to the same period in 2013, when one loan with a post modification balance of $25,000 was classified as a TDR. The loan modifications for the three months ended June 30, 2014 consisted of one interest rate modification, two term modifications, and one payment modification. The loan modification for the three months ended June 30, 2013 was a term modification.

 

During the six months ended June 30, 2014, nine loans with a combined post modification balance of $922,000 were classified as TDRs, as compared to the same period in 2013, when nine loans with a combined post modification balance of $3,638,000 were classified as TDRs. The loan modifications for the six months ended June 30, 2014 consisted of one interest rate modification, three term modifications, and five payment modifications. The loan modifications for the six months ended June 30, 2013 consisted of two interest rate modifications, one term modification, and six payment modifications.

 

The following table presents the unpaid balance of TDRs at the dates indicated:

 

   June 30,   December 31, 
(Dollars in thousands)  2014   2013 
Non-accrual TDRs  $1,413   $1,538 
Accruing TDRs   2,888    2,423 
Total  $4,301   $3,961 

 

At June 30, 2014, seven Commercial Real Estate loans classified as TDRs with a combined recorded investment of $970,000 were not in compliance with the terms of their restructure, compared to June 30, 2013 when three Commercial Real Estate loans classified as TDRs with a combined recorded investment of $304,000 were not in compliance with the terms of their restructure.

 

The following table presents information regarding the loan modifications categorized as TDRs during the three and six months ended June 30, 2014 and June 30, 2013:

 

(Dollars in thousands, except number of contracts)

 

   Three Months Ended June 30, 2014 
       Pre-Modification   Post-Modification     
   Number   Outstanding Recorded   Outstanding Recorded   Recorded 
   of Contracts   Investment   Investment   Investment 
Commercial and Industrial   1   $309   $309   $309 
Commercial Real Estate   3    167    167    166 
Consumer                
Total   4   $476   $476   $475 

 

18
 

 

(Dollars in thousands, except number of contracts)

 

   Three Months Ended June 30, 2013 
       Pre-Modification   Post-Modification     
   Number   Outstanding Recorded   Outstanding Recorded   Recorded 
   of Contracts   Investment   Investment   Investment 
Commercial and Industrial      $   $   $ 
Commercial Real Estate   1    25    25    25 
Consumer                
Total   1   $25   $25   $25 

 

(Dollars in thousands, except number of contracts)

 

   Six Months Ended June 30, 2014 
       Pre-Modification   Post-Modification     
   Number   Outstanding Recorded   Outstanding Recorded   Recorded 
   of Contracts   Investment   Investment   Investment 
Commercial and Industrial   2   $327   $327   $327 
Commercial Real Estate   6    588    588    197 
Consumer   1    7    7    7 
Total   9   $922   $922   $531 

 

(Dollars in thousands, except number of contracts)

 

   Six Months Ended June 30, 2013 
       Pre-Modification   Post-Modification     
   Number   Outstanding Recorded   Outstanding Recorded   Recorded 
   of Contracts   Investment   Investment   Investment 
Commercial and Industrial      $   $   $ 
Commercial Real Estate   9    3,638    3,638    3,397 
Consumer                
Total   9   $3,638   $3,638   $3,397 

 

The following table provides detail regarding the types of loan modifications made for loans categorized as TDRs during the three and six months ended June 30, 2014 and June 30, 2013 with the total number of each type of modification performed.

 

   Three Months Ended June 30, 2014   Six Months Ended June 30, 2014 
   Rate   Term   Payment   Number   Rate   Term   Payment   Number 
   Modification   Modification   Modification   Modified   Modification   Modification   Modification   Modified 
Commercial and Industrial           1    1            2    2 
Commercial Real Estate   1    2        3    1    3    2    6 
Consumer                           1    1 
Total   1    2    1    4    1    3    5    9 

 

   Three Months Ended June 30, 2013   Six Months Ended June 30, 2013 
   Rate   Term   Payment   Number   Rate   Term   Payment   Number 
   Modification   Modification   Modification   Modified   Modification   Modification   Modification   Modified 
Commercial and Industrial                                
Commercial Real Estate       1        1    2    1    6    9 
Consumer                                
Total       1        1    2    1    6    9 

 

19
 

The recorded investment, unpaid principal balance, and the related allowance of the Corporation’s impaired loans are summarized below for the periods ended June 30, 2014 and December 31, 2013.

 

(Dollars in thousands)  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:                              
Commercial and Industrial  $441   $587   $   $21   $167   $ 
Commercial Real Estate   5,177    5,799        4,810    5,503     
Residential Real Estate   1,140    1,305        868    1,176     
Consumer   7    7                 
                               
With an allowance recorded:                              
Commercial and Industrial                        
Commercial Real Estate   56    71    26    212    212    125 
Residential Real Estate   77    77    18    63    63    15 
Consumer                        
Total  $6,898   $7,846   $44   $5,974   $7,121   $140 
                               
Total consists of:                              
Commercial and Industrial  $441   $587   $   $21   $167   $ 
Commercial Real Estate  $5,233   $5,870   $26   $5,022   $5,715   $125 
Residential Real Estate  $1,217   $1,382   $18   $931   $1,239   $15 
Consumer  $7   $7   $   $   $   $ 

 

 

At June 30, 2014 and December 31, 2013, $4,301,000 and $3,961,000 of loans classified as TDRs were included in impaired loans with a total allocated allowance of $0, respectively. The recorded investment represents the loan balance reflected on the Consolidated Balance Sheets net of any charge-offs. The unpaid balance is equal to the gross amount due on the loan.

 

20
 

 

The average recorded investment and interest income recognized for the Corporation’s impaired loans are summarized below for the three and six month periods ended June 30, 2014 and 2013.

 

(Dollars in thousands)  For the Three Months Ended   For the Three 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:                    
Commercial and Industrial  $239   $15   $176   $ 
Commercial Real Estate   5,205    55    4,763    37 
Residential Real Estate   1,027        1,213     
Consumer   7             
                     
With an allowance recorded:                    
Commercial Real Estate   41        530    3 
Residential Real Estate   77        63     
Total  $6,596   $70   $6,745   $40 
                     
Total consists of:                    
Commercial and Industrial  $239   $15   $176   $ 
Commercial Real Estate  $5,246   $55   $5,293   $40 
Residential Real Estate  $1,104   $   $1,276   $ 
Consumer  $7   $   $   $ 

 

(Dollars in thousands)  For the Six Months Ended   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:                    
Commercial and Industrial  $166   $15   $177   $ 
Commercial Real Estate   5,122    77    4,783    55 
Residential Real Estate   969        1,217     
Consumer   5             
                     
With an allowance recorded:                    
Commercial Real Estate   40        532    3 
Residential Real Estate   77        66     
Total  $6,379   $92   $6,775   $58 
                     
Total consists of:                    
Commercial and Industrial  $166   $15   $177   $ 
Commercial Real Estate  $5,162   $77   $5,315   $58 
Residential Real Estate  $1,046   $   $1,283   $ 
Consumer  $5   $   $   $ 

 

21
 

 

Financing receivables on non-accrual status, loans past-due 90 days or more and still accruing, and foreclosed assets held for resale as of June 30, 2014 and December 31, 2013 were as follows:

 

(Dollars in thousands)

   June 30,   December 31, 
   2014   2013 
Commercial and Industrial  $114   $21 
Commercial real estate   2,679    2,599 
Residential real estate   1,217    931 
Total non-accrual loans   4,010    3,551 
Foreclosed assets held for resale   237    480 
Loans past-due 90 days or more and still accruing   63    318 
Total non-performing assets  $4,310   $4,349 

 

The following tables present the classes of the loan portfolio summarized by the past-due status at June 30, 2014 and December 31, 2013:

 

(Dollars in thousands)

                           90 Days 
                          Or Greater 
           90 Days           Total   Past Due 
   30-59 Days   60-89 Days   or Greater   Total       Financing   and Still 
   Past Due   Past Due   Past Due   Past Due   Current   Receivables   Accruing 
June 30, 2014:                                   
Commercial and Industrial  $70   $5   $14   $89   $60,172   $60,261   $ 
Commercial Real Estate   1,903    564    2,684    5,151    232,750    237,901    63 
Residential Real Estate   1,992    204    1,178    3,374    156,185    159,559     
Consumer   22    8        30    5,423    5,453     
Total  $3,987   $781   $3,876   $8,644   $454,530   $463,174   $63 

 

(Dollars in thousands)

                           90 Days 
                          Or Greater 
           90 Days           Total   Past Due 
   30-59 Days   60-89 Days   or Greater   Total       Financing   and Still 
   Past Due   Past Due   Past Due   Past Due   Current   Receivables   Accruing 
December 31, 2013:                                   
Commercial and Industrial  $7   $7   $40   $54   $60,768   $60,822   $19 
Commercial Real Estate   875    653    1,367    2,895    222,510    225,405    180 
Residential Real Estate   1,751    248    926    2,925    151,750    154,675    119 
Consumer   30    12        42    5,574    5,616     
 Total  $2,663   $920   $2,333   $5,916   $440,602   $446,518   $318 

 

At June 30, 2014 and December 31, 2013, there were no commitments to lend additional funds with respect to impaired loans.

 

NOTE 5BORROWINGS

 

Short-term borrowings include federal funds purchased, securities sold under agreements to repurchase, Federal Discount Window, and Federal Home Loan Bank (“FHLB”) advances, which generally represent overnight or less than 30-day borrowings.

 

22
 

 

Securities Sold Under Agreements to Repurchase (“Repurchase Agreements”)

 

The Corporation enters into agreements under which it sells securities subject to an obligation to repurchase the same or similar securities. Under these arrangements, the Corporation may transfer legal control over the assets but still retain effective control through an agreement that both entitles and obligates the Corporation to repurchase the assets.

 

As a result, these repurchase agreements are accounted for as collateralized financing agreements (i.e., secured borrowings) and not as a sale and subsequent repurchase of securities. The obligation to repurchase the securities is reflected as a liability on the Corporation’s Consolidated Balance Sheets, while the securities underlying the repurchase agreements remain in the respective investment securities asset accounts. In other words, there is not offsetting or netting of the investment securities assets with the repurchase agreement liabilities. In addition, as the Corporation does not enter into reverse repurchase agreements, there is no such offsetting to be done with the repurchase agreements.

 

The right of setoff for a repurchase agreement resembles a secured borrowing, whereby the collateral would be used to settle the fair value of the repurchase agreement should the Corporation be in default (e.g., fails to make an interest payment to the counterparty). The collateral is held by a correspondent bank in the counterparty’s custodial account. The counterparty has the right to sell or repledge the investment securities.

 

The following table presents the short-term borrowings subject to an enforceable master netting arrangement or repurchase agreements as of June 30, 2014 and December 31, 2013.

 

(Dollars in thousands)      Gross   Net Amounts             
       Amounts   of Liabilities             
       Offset   Presented             
   Gross   in the   in the             
   Amounts of   Consolidated   Consolidated       Cash     
   Recognized   Balance   Balance   Financial   Collateral   Net 
   Liabilities   Sheet   Sheet   Instruments   Pledge   Amount 
June 30, 2014                              
Repurchase agreements (a)  $14,937   $   $14,937   $(14,937)  $   $ 
                               
December 31, 2013                              
Repurchase agreements (a)  $16,261   $   $16,261   $(16,261)  $   $ 

 

 

(a) As of June 30, 2014 and December 31, 2013, the fair value of securities pledged in connection with repurchase agreements was $25,272,000 and $26,575,000, respectively.

 

Long-term borrowings are comprised of advances from FHLB and a capital lease assumed as a result of the acquisition of Pocono Community Bank. Under terms of a blanket agreement, collateral for the FHLB loans is certain qualifying assets of the Corporation’s banking subsidiary. The principal assets are real estate mortgages and certain investment securities.

 

NOTE 6COMMITMENTS AND CONTINGENCIES

 

In the normal course of business, there are various pending legal actions and proceedings that are not reflected in the consolidated financial statements. Management does not believe the outcome of these actions and proceedings will have a material effect on the consolidated financial position or results of operations of the Corporation.

 

NOTE 7 —FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND CONCENTRATIONS
OFCREDIT RISK

 

The Corporation is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contract or notional amounts of those instruments reflect the extent of involvement the Corporation has in particular classes of financial instruments. The Corporation does not engage in trading activities with respect to any of its financial instruments with off-balance sheet risk.

 

23
 

 

The Corporation’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments.

 

The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

 

The Corporation may require collateral or other security to support financial instruments with off-balance sheet credit risk.

 

The contract or notional amounts at June 30, 2014 and December 31, 2013, were as follows:

 

(Dollars in thousands)

   June 30, 2014   December 31, 2013 
Financial instruments whose contract amounts represent credit risk:          
Commitments to extend credit  $80,739   $73,700 
Financial standby letters of credit  $661   $418 
Performance standby letters of credit  $4,774   $4,449 

 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses that may require payment of a fee. Since some of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Corporation evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation upon extension of credit, is based on management’s credit evaluation of the borrower. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, owner-occupied income-producing commercial properties, and residential real estate.

 

Standby letters of credit are conditional commitments issued by the Corporation to guarantee payment to a third party when a customer either fails to repay an obligation or fails to perform some non-financial obligation. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Corporation may hold collateral to support standby letters of credit for which collateral is deemed necessary.

 

The Corporation grants commercial, agricultural, real estate mortgage and consumer loans to customers primarily in the counties of Columbia, Luzerne, Montour and Monroe, Pennsylvania. The concentrations of credit by type of loan are set forth in Note 4 – Loans and Allowance for Loan Losses. It is management’s opinion that the loan portfolio was well balanced and diversified at June 30, 2014, to the extent necessary to avoid any significant concentration of credit risk. However, it is the debtor’s ability to honor their contracts, which may be influenced by the region’s economy.

 

NOTE 8FAIR VALUE MEASUREMENTS

 

Fair value measurement and disclosure guidance defines fair value as the price that would be received to sell the asset or transfer the liability in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. This guidance provides additional information on determining when the volume and level of activity for the asset or liability has significantly decreased. The guidance also includes information on identifying circumstances when a transaction may not be considered orderly.

 

Fair value measurement and disclosure guidance provides a list of factors that a reporting entity should evaluate to determine whether there has been a significant decrease in the volume and level of activity for the asset or liability in relation to normal market activity for the asset or liability. When the reporting entity concludes there has been a significant decrease in the volume and level of activity for the asset or liability, further analysis of the information from that market is needed and significant adjustments to the related prices may be necessary to estimate fair value in accordance with the fair value measurement and disclosure guidance.

 

24
 

 

This guidance clarifies that when there has been a significant decrease in the volume and level of activity for the asset or liability, some transactions may not be orderly. In those situations, the entity must evaluate the weight of the evidence to determine whether the transaction is orderly. The guidance provides a list of circumstances that may indicate that a transaction is not orderly. A transaction price that is not associated with an orderly transaction is given little, if any, weight when estimating fair value.

 

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from independent sources, or unobservable, meaning those that reflect the reporting entity’s own belief about the assumptions market participants would use in pricing the asset or liability based upon the best information available in the circumstances. Fair value measurement and disclosure guidance 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 Inputs:      Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;

 

Level 2 Inputs:     Quoted prices in markets that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability;

 

Level 3 Inputs:     Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity).

 

A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth as follows.

 

Financial Assets Measured at Fair Value on a Recurring Basis

 

At June 30, 2014 and December 31, 2013, investments measured at fair value on a recurring basis and the valuation methods used are as follows:

 

(Dollars in thousands)

 

June 30, 2014                
   Level 1   Level 2   Level 3  

Total

 
Available-for-Sale Securities:                    
U.S. Treasury securities  $   $1,044   $   $1,044 
Obligations of U.S. Government Corporations and Agencies:                    
Mortgaged-backed       156,916        156,916 
Other       28,169        28,169 
Obligations of state and political subdivisions       124,117        124,117 
Corporate debt securities       36,111        36,111 
Marketable equity securities   2,520            2,520 
Total  $2,520   $346,357   $   $348,877 

 

25
 

 

(Dollars in thousands)

 

December 31, 2013                
   Level 1   Level 2   Level 3  

Total

 
Available-for-Sale Securities:                    
U.S. Treasury securities  $   $   $   $ 
Obligations of U.S. Government Corporations and Agencies:                    
Mortgaged-backed       121,224        121,224 
Other       32,285        32,285 
Obligations of state and political subdivisions       148,389        148,389 
Corporate debt securities       49,265        49,265 
Marketable equity securities   2,535            2,535 
Total  $2,535   $351,163   $   $353,698 

 

The estimated fair values of equity securities classified as Level 1 are derived from quoted market prices in active markets; these assets consist mainly of stocks held in other banks. The estimated fair values of all debt securities classified as Level 2 are obtained from nationally-recognized third-party pricing agencies. The estimated fair values are derived primarily from cash flow models, which include assumptions for interest rates, credit losses, and prepayment speeds. The significant inputs utilized in the cash flow models are based on market data obtained from sources independent of the Corporation (observable inputs), and are therefore classified as Level 2 within the fair value hierarchy. The Corporation does not have any Level 3 inputs for investments. There were no transfers between Level 1 and Level 2 during 2014 or 2013.

 

Financial Assets Measured at Fair Value on a Nonrecurring Basis

 

At June 30, 2014 and December 31, 2013, impaired loans measured at fair value on a non-recurring basis and the valuation methods used are as follows:

 

(Dollars in thousands)

   Level 1   Level 2   Level 3   Total 
Assets at June 30, 2014                    
Impaired loans:                    
Commercial and Industrial  $   $   $14   $14 
Commercial Real Estate           1,843    1,843 
Residential Real Estate           432    432 
Total impaired loans  $   $   $2,289   $2,289 

 

(Dollars in thousands)

   Level 1   Level 2   Level 3   Total 
Assets at December 31, 2013                    
Impaired loans:                    
Commercial and Industrial  $   $   $21   $21 
Commercial Real Estate           656    656 
Residential Real Estate           621    621 
Total impaired loans  $   $   $1,298   $1,298 

 

The Bank’s impaired loan valuation procedure for any loans greater than $250,000 requires an appraisal to be obtained and reviewed annually at year end. A quarterly collateral evaluation is performed which may include a site visit, property pictures and discussions with realtors and other similar business professionals to ascertain current values. For impaired loans less than $250,000 upon classification and annually at year end, the Bank completes a Certificate of Inspection, which includes an onsite inspection, insured values, tax assessed values, recent sales comparisons and a review of the previous evaluations. These assets are included as Level 3 fair values, based upon the lowest level that is significant to the fair value measurements. The fair value consists of the impaired loan balances less the valuation allowance and/or charge-offs. There were no transfers between valuation levels in 2014 and 2013.

 

26
 

 

Nonfinancial Assets Measured at Fair Value on a Nonrecurring Basis

 

At June 30, 2014 and December 31, 2013, foreclosed assets held for resale measured at fair value on a non-recurring basis and the valuation methods used are as follows:

 

(Dollars in thousands)

   Level 1   Level 2   Level 3   Total 
Assets at June 30, 2014                    
Other foreclosed assets held for resale:                    
Commercial Real Estate  $   $   $20   $20 
Total foreclosed assets held for resale  $   $   $20   $20 

 

(Dollars in thousands)

    Level 1    Level 2    Level 3    Total 
Assets at December 31, 2013                    
Other foreclosed assets held for resale:                    
Commercial Real Estate  $   $   $   $ 
Total foreclosed assets held for resale  $   $   $   $ 

 

The Bank’s foreclosed asset valuation procedure requires an appraisal, which considers the sales prices of similar properties in the proximate vicinity, to be completed periodically with the exception of those cases which the Bank has obtained a sales agreement. These assets are included as Level 3 fair values, based upon the lowest level that is significant to the fair value measurements. There were no transfers between valuation levels in 2014 and 2013.

 

The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis and for which the Bank has utilized Level 3 inputs to determine the fair value:

 

(Dollars in thousands)

   Quantitative Information about Level 3 Fair Value Measurements 
   Fair Value                Weighted 
   Estimate   Valuation Technique    Unobservable Input    Range  Average 
Assets at June 30, 2014                       
Impaired loans  $2,289   Appraisal of collateral 1,3  Appraisal adjustments 2  (0%) – (62%)   (38%)
Foreclosed assets                       
held for resale   20   Appraisal of collateral 1,3  Appraisal adjustments 2  (67%) – (67%)   (67%)

 

(Dollars in thousands)

 

   Quantitative Information about Level 3 Fair Value Measurements 
   Fair Value                Weighted 
   Estimate   Valuation Technique    Unobservable Input    Range  Average 
Assets at December 31, 2013                     
Impaired loans  $1,298   Appraisal of collateral 1,3  Appraisal adjustments 2  (10%) – (35%)   (23%)
Foreclosed assets                       
held for resale      Appraisal of collateral 1,3  Appraisal adjustments 2  (0%) – (0%)   (0%)

 

 

1Fair value is generally determined through independent appraisals of the underlying collateral, as defined by Bank regulators.

2Appraisals may be adjusted downward by management for qualitative factors such as economic conditions and estimated liquidation expenses. The typical range of appraisal adjustments are presented as a percent of the appraisal value.

3Includes qualitative adjustments by management and estimated liquidation expenses.

 

27
 

 

Fair Value of Financial Instruments

 

(Dollars in thousands)

   Carrying   Fair Value Measurements at June 30, 2014 
   Amount   Level 1   Level 2   Level 3   Total 
FINANCIAL ASSETS:                         
Cash and due from banks  $9,476   $9,746   $   $   $9,746 
Interest-bearing deposits in other banks   1,000        1,000        1,000 
Investment securities available-for-sale   348,877    2,520    346,357        348,877 
Investment securities held-to-maturity   1,064        1,072        1,072 
Restricted investment in bank stocks   6,661        6,661        6,661 
Net loans   456,697            462,577    462,577 
Mortgage servicing rights   487            487    487 
Accrued interest receivable   3,321        3,321        3,321 
                          
FINANCIAL LIABILITIES:                         
Deposits   642,576        642,897        642,897 
Short-term borrowings   88,434        88,434        88,434 
Long-term borrowings   55,380        56,715        56,715 
Accrued interest payable   406        406        406 
                          
OFF-BALANCE SHEET FINANCIAL INSTRUMENTS                    

 

(Dollars in thousands)

   Carrying   Fair Value Measurements at December 31, 2013 
   Amount   Level 1   Level 2   Level 3   Total 
FINANCIAL ASSETS:                         
Cash and due from banks  $8,257   $8,257   $   $   $8,257 
Interest-bearing deposits in other banks   22,366        22,366        22,366 
Investment securities available-for-sale   353,698    2,535    351,163        353,698 
Investment securities held-to-maturity   1,072        1,083        1,083 
Restricted investment in bank stocks   4,761        4,761        4,761 
Net loans   439,999            443,844    443,844 
Mortgage servicing rights   521            521    521 
Accrued interest receivable   3,616        3,616        3,616 
                          
FINANCIAL LIABILITIES:                         
Deposits   690,075        690,771        690,771 
Short-term borrowings   68,233        68,233        68,233 
Long-term borrowings   40,429        41,288        41,288 
Accrued interest payable   392        392        392 
                          
OFF-BALANCE SHEET FINANCIAL INSTRUMENTS                    

 

The preceding information should not be interpreted as an estimate of the fair value of the entire Corporation since a fair value calculation is only provided for a limited portion of the Corporation’s assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between the Corporation’s disclosures and those of other companies may not be meaningful. The following methods and assumptions were used to estimate the fair values of the Corporation’s financial instruments at June 30, 2014 and December 31, 2013:

 

Cash and Due From Banks, Interest-Bearing Deposits in Other Banks, Restricted Investment in Bank Stocks, Accrued Interest Receivable and Accrued Interest Payable

 

The fair values are equal to the current carrying values.

 

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Investment Securities

 

The fair value of investment securities are determined by obtaining quoted market prices on nationally recognized securities exchanges (Level 1) or matrix pricing (Level 2), which is a mathematical technique used widely in the industry to value debt securities without relying on the securities’ relationship to other benchmark quoted prices.

 

Loans

 

Fair values are estimated for categories of loans with similar financial characteristics. Loans were segregated by type such as Commercial and Industrial, Commercial and Residential Real Estate mortgages and Consumer. For estimation purposes, each loan category was further segmented into fixed and adjustable rate interest terms.

 

The fair value of each category of performing loans is calculated by discounting future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.

 

Fair value for impaired loans is based on management’s estimate of future cash flows discounted using a rate commensurate with the risk associated with the estimated future cash flows or based on the value of the collateral if repayment is expected solely from collateral. The assumptions used by management are judgmentally determined using information regarding each specific borrower.

 

Mortgage Servicing Rights

 

The fair value of servicing rights is based on the present value of estimated future cash flows on pools of mortgages stratified by rate and maturity date.

 

Deposits

 

The fair value of deposits with no stated maturity, such as demand deposits, savings accounts and money market accounts, is equal to the amount payable on demand at June 30, 2014 and December 31, 2013.

 

Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on similar term borrowings, to a schedule of aggregated expected monthly maturities on time deposits.

 

Short-Term and Long-Term Borrowings

 

The fair values of short-term borrowings are equal to the current carrying values, and long-term borrowings are estimated using discounted cash flow analyses based on the Corporation’s incremental borrowing rate for similar instruments.

 

Off-Balance Sheet Financial Instruments

 

The fair values for the Corporation’s off-balance sheet financial instruments (lending commitments and letters of credit) are based on fees currently charged in the market to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.

 

29
 

 

NOTE 9EARNINGS PER SHARE

 

Basic earnings per share (“EPS”) is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Corporation. Potential common shares that may be issued by the Corporation relate solely to outstanding stock options and are determined using the treasury stock method. The following table sets forth the computation of basic and diluted earnings per share.

 

(In thousands, except earnings per share)

   Three Months Ended 
   June 30, 
   2014   2013 
Net income  $2,756   $3,872 
Weighted-average common shares outstanding   5,532    5,490 
Basic earnings per share  $0.50   $0.70 
           
Weighted-average common shares outstanding   5,532    5,490 
Common stock equivalents due to effect of stock options   5    12 
Total weighted-average common shares and equivalents   5,537    5,502 
Diluted earnings per share  $0.50   $0.70 

 

(In thousands, except earnings per share)

   Six Months Ended 
   June 30, 
   2014   2013 
Net income  $5,054   $6,398 
Weighted-average common shares outstanding   5,527    5,455 
Basic earnings per share  $0.91   $1.17 
           
Weighted-average common shares outstanding   5,527    5,455 
Common stock equivalents due to effect of stock options   5    12 
Total weighted-average common shares and equivalents   5,532    5,467 
Diluted earnings per share  $0.91   $1.17 

 

30
 

 

Item 2. First Keystone Corporation Management’s Discussion and Analysis of Financial Condition and Results of Operation

  

This quarterly report contains certain forward-looking statements, which are included pursuant to the “safeharbor” provisions of the Private Securities Litigation Reform Act of 1995, and reflect management’s beliefs and expectations based on information currently available. These forward-looking statements are inherently subject to significant risks and uncertainties, including changes in general economic and financial market conditions, the Corporation’s ability to effectively carry out its business plans and changes in regulatory or legislative requirements. Other factors that could cause or contribute to such differences are changes in competitive conditions, and pending or threatened litigation. Although management believes the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially.

 

CRITICAL ACCOUNTING ESTIMATES

 

The Corporation has chosen accounting policies that it believes are appropriate to accurately and fairly report its operating results and financial position, and the Corporation applies those accounting policies in a consistent manner. The Significant Accounting Policies are summarized in Note 1 to the consolidated financial statements included in the 2013 Annual Report on Form 10-K. There have been no changes to the Critical Accounting Estimates since the Corporation filed its Annual Report on Form 10-K for the year ended December 31, 2013.

 

RESULTS OF OPERATIONS

 

Quarter ended June 30, 2014 compared to quarter ended June 30, 2013

 

First Keystone Corporation realized earnings for the three months ended June 30, 2014 of $2,756,000, a decrease of $1,116,000, or 28.8% from the three months ended June 30, 2013. The decrease in net income for the three months ended June 30, 2014 was primarily due to a decrease in non-interest income. While net interest income was higher, the provision for loan losses remained the same, non-interest income decreased significantly, and non-interest expense increased slightly as compared to the same period one year ago.

 

On a per share basis, for the three months ended June 30, 2014, net income was $0.50 versus $0.70 in the three months ended June 30, 2013. Cash dividends amounted to $0.26 per share for the three months ended June 30, 2014 and 2013.

 

NET INTEREST INCOME

 

The major source of operating income for the Corporation is net interest income, defined as interest income less interest expense. For the three months ended June 30, 2014, interest income amounted to $7,776,000, a decrease of $48,000 or 0.6% from the three months ended June 30, 2013, while interest expense amounted to $1,108,000 for the three months ended June 30, 2014, a decrease of $121,000, or 9.8% from the three months ended June 30, 2013. As a result, net interest income increased $73,000 or 1.1% for the three months ended June 30, 2014 to $6,668,000 from $6,595,000 for the same period in 2013.

 

The Corporation’s net interest margin for the three months ended June 30, 2014 was 3.48% compared to 3.84% for the same period in 2013. The decrease in net interest margin was a result of the unprecedented continuing low interest rate environment.

 

PROVISION FOR LOAN LOSSES

 

The provision for loan losses for the three months ended June 30, 2014 and June 30, 2013 was $200,000. After the Corporation’s analysis of the current loan portfolio, including historic losses, past-due trends, current economic conditions, and other relevant factors, the provision for loan losses remained consistent with the same period in the prior year. Net charge-offs for the three months ended June 30, 2014 and 2013 were $200,000 and $172,000, respectively. See Allowance for Loan Losses on page 36 for further discussion.

 

31
 

 

NON-INTEREST INCOME

 

Total non-interest income was $2,518,000 for the three months ended June 30, 2014, as compared to $3,765,000 for the same period in 2013, a decrease of $1,247,000, or 33.1%. Gains on sales of mortgage loans decreased $174,000 over the three months ended June 30, 2013 to $56,000. Mortgage originations fell as rates continued to rise slightly and fewer customers qualified for secondary market loans during the three months ended June 30, 2014. Net gains on sales of investment securities decreased $1,209,000 to $1,203,000 as compared to the three months ended June 30, 2013. The Bank has taken gains and losses in the portfolio to reduce market risk and protect from further changes in value in the face of increases in long-term interest rates.

 

Excluding net investment securities gains, non-interest income was $1,315,000 for the three months ended June 30, 2014, a decrease of $38,000, or 2.8% from the second quarter of 2013.

 

While Trust Department income and ATM and debit card fees both increased, they were not large enough to offset the $174,000 reduction in gains on sales of mortgage loans.

 

NON-INTEREST EXPENSE

 

Total non-interest expense was $5,439,000 for the quarter ended June 30, 2014, as compared to $5,323,000 for the quarter ended June 30, 2013. Non-interest expense increased $116,000, or 2.2%.

 

Expenses associated with employees (salaries and employee benefits) continue to be the largest category of non-interest expense. Salaries and benefits amounted to $2,825,000, or 51.9% of total non-interest expense for the three months ended June 30, 2014, as compared to 50.9% for the same three months of 2013. Net occupancy, furniture and equipment, and computer expense amounted to $872,000 for the quarter ended June 30, 2014, a decrease of $45,000, or 4.9%. All other non-interest expenses amounted to $1,742,000 for the three months ended June 30, 2014, an increase of $44,000, or 2.6% as compared to the same three months of 2013.

 

The overall increase in non-interest expense related primarily to expenses associated with our new Dallas and Shickshinny offices along with the opening of our new administrative facility in Berwick. In addition, the Corporation experienced increased costs related to data processing expenses. In the second quarter of 2014, the Bank began to incur data processing costs as a result of the planned outsourcing of its core processing system for data security, disaster recovery and system efficiency goals. Advertising expenses were also higher due to the rollout of the Bank’s new suite of rewards checking products called Kasasa in the first quarter of 2014.

 

INCOME TAXES

 

Effective tax planning has helped produce favorable net income. Income tax expense amounted to $791,000 for the three months ended June 30, 2014, as compared to $965,000 for the three months ended June 30, 2013, a decrease of $174,000. The effective total income tax rate was 22.3% for the second quarter of 2014 as compared to 20.0% for the second quarter of 2013. The increase in the effective tax rate was due to the sales of tax-free municipal securities during the past year and the impact of the tax credits from the low-income housing partnerships. The Corporation looks to maximize its tax-exempt income derived from both tax-free loans and tax-free municipal securities.

 

Six months ended June 30, 2014 compared to six months ended June 30, 2013

 

First Keystone Corporation realized earnings for the six months ended June 30, 2014 of $5,054,000, a decrease of $1,344,000, or 21.0% from the six months ended June 30, 2013. The decrease in net income for the first six months of 2014 was due to several factors, including a decrease in non-interest income and an increase in non-interest expense, offset by a decrease in the provision for loan losses.

 

On a per share basis, for the six months ended June 30, 2014, net income was $0.91 versus $1.17 in the first six months of 2013. Cash dividends amounted to $0.52 per share in the first six months of 2014 and 2013.

 

Year-to-date net income annualized as of June 30, 2014, amounted to a return on average common equity of 10.03%, a return on tangible equity net of goodwill of 12.38% and a return on assets of 1.14%. For the six months ended June 30, 2013, these measures were 12.19%, 14.91%, and 1.57%, respectively, on an annualized basis.

 

32
 

 

NET INTEREST INCOME

 

For the six months ended June 30, 2014, interest income amounted to $15,409,000, a decrease of $259,000 or 1.7% from the same six month period in 2013, while interest expense amounted to $2,233,000 for the six months ended June 30, 2014, a decrease of $242,000, or 9.8% from the six months ended June 30, 2013. As a result, net interest income decreased $17,000 or 0.1% for the six months ended June 30, 2014 to $13,176,000 from $13,193,000 for the same period in 2013.

 

Our net interest margin for the six months ended June 30, 2014 was 3.46% compared to 3.91% for the six months ended June 30, 2013. The decrease in the net interest margin was a result of the unprecedented continuing low interest rate environment.

 

PROVISION FOR LOAN LOSSES

 

The provision for loan losses for the six months ended June 30, 2014 was $333,000 as compared to $600,000 for the six months ended June 30, 2013. The decrease in the provision for loan losses resulted from the Corporation’s analysis of the current loan portfolio, including historic losses, past-due trends, current economic conditions, and other relevant factors. Net charge-offs for the six months ended June 30, 2014 and 2013 were $375,000 and $442,000, respectively. See Allowance for Loan Losses on page 36 for further discussion.

 

NON-INTEREST INCOME

 

Total non-interest income was $4,233,000 for the six months ended June 30, 2014, as compared to $5,217,000 for the six months ended June 30, 2013, a decrease of $984,000, or 18.9%. Gains on sales of mortgage loans decreased $360,000 over the first half of 2014 to $80,000. Mortgage originations fell as rates continued to rise slightly and fewer customers qualified for secondary market loans. Net gains on sales of investment securities decreased $880,000 to $1,800,000 as compared to the six months ended June 30, 2013. The Bank has taken gains and losses in the portfolio to reduce market risk and protect from further changes in value in the face of increases in long-term interest rates.

 

Excluding net investment securities gains, non-interest income was $2,433,000 for the first half of 2014, a decrease of $104,000, or 4.1% from the first half of 2013.

 

While Trust Department income, service charges and fees and ATM and debit card fees increased, they were not large enough to offset the $360,000 reduction in gains on sales of mortgage loans.

 

NON-INTEREST EXPENSE

 

Total non-interest expense was $10,691,000 for the six months ended June 30, 2014, as compared to $10,004,000 for the six months ended June 30, 2013. Non-interest expense increased $687,000, or 6.9%.

 

Expenses associated with employees (salaries and employee benefits) continue to be the largest category of non-interest expense. Salaries and benefits amounted to $5,642,000, or 52.8% of total non-interest expense for the six months ended June 30, 2014, as compared to 54.3% for the six months of 2013. Net occupancy, furniture and equipment, and computer expense amounted to $1,745,000 for the six months ended June 30, 2014, an increase of $106,000, or 6.5%. All other non-interest expenses amounted to $3,304,000 for the six months ended June 30, 2014, an increase of $367,000, or 12.5% as compared to the same six months ended June 30, 2013.

 

The overall increase in non-interest expense related primarily to expenses associated with our new Dallas and Shickshinny offices along with the opening of our new administrative facility in Berwick. In addition, the Corporation experienced increased costs related to data processing, collections and foreclosed real estate expenses. In the second quarter of 2014, the Bank began to incur data processing costs as a result of the planned outsourcing of its core processing system for data security, disaster recovery and system efficiency goals. Advertising expenses were also higher due to the rollout of the Bank’s new suite of rewards checking products called Kasasa in the first quarter of 2014.

 

33
 

 

INCOME TAXES

 

Income tax expense amounted to $1,331,000 for the six months ended June 30, 2014, as compared to $1,408,000 for the six months ended June 30, 2013, a decrease of $77,000. The effective total income tax rate was 20.8% for the six months ended June 30, 2014 as compared to 18.0% for the six months ended June 30, 2013. The increase in the effective tax rate was due to the sales of tax-free municipal securities during the past year and the impact of the tax credits from the low-income housing partnerships.

 

FINANCIAL CONDITION

 

SUMMARY

 

Total assets decreased to $892,763,000 as of June 30, 2014, a decrease of $8,751,000, or 1.0% from year-end 2013. As of June 30, 2014, total deposits amounted to $642,576,000, a decrease of 6.9% from year-end 2013.

 

Total loans increased by $16,656,000 or 3.7%. Loan demand appears to be increasing as the Bank has seen an increase in loan originations.

 

Total cash and cash equivalents decreased compared to year-end 2013 due to reductions in balances held at correspondent banks.

 

The Corporation continues to maintain and manage its asset growth. The Corporation’s strong equity capital position provides an opportunity to further leverage its asset growth. Total borrowings increased in the first six months of 2014 by $35,152,000 to $143,814,000 from $108,662,000 as of December 31, 2013. Borrowings increased to support increased loan balances and replace decreased deposit balances.

 

SEGMENT REPORTING

 

Currently, management measures the performance and allocates the resources of the Corporation as a single segment.

 

EARNING ASSETS

 

Earning assets are defined as those assets that produce interest income. By maintaining a healthy asset utilization rate, i.e., the volume of earning assets as a percentage of total assets, the Corporation maximizes income. The earning asset ratio (average interest earning assets divided by average total assets) equaled 91.7% at June 30, 2014, compared to 91.5% at June 30, 2013. This indicates that the management of earning assets is a priority and non-earning assets, primarily cash and due from banks, fixed assets and other assets, are maintained at minimal levels. The primary earning assets are loans and investment securities.

 

Our primary earning asset, total loans, increased to $463,174,000 as of June 30, 2014, up $16,656,000, or 3.7% since year-end 2013. The loan portfolio continues to be diversified. Overall asset quality has remained consistent with non-performing assets decreasing slightly since year-end 2013. Total non-performing assets were $4,310,000 as of June 30, 2014, a decrease of $39,000, or 0.9% from $4,349,000 reported in non-performing assets as of December 31, 2013. Total allowance for loan losses to total non-performing assets was 150.3% as of June 30, 2014 and 149.9% at December 31, 2013.

 

In addition to loans, another primary earning asset is our overall investment portfolio, which decreased in size from December 31, 2013, to June 30, 2014. Available-for-sale securities amounted to $348,877,000 as of June 30, 2014, a decrease of $4,821,000 from year-end 2013. Interest-bearing deposits in other banks decreased as of June 30, 2014, to $1,000,000 from $22,366,000 at year-end 2013.

 

LOANS

 

Total loans increased to $463,174,000 as of June 30, 2014 as compared to $446,518,000 as of December 31, 2013. The table on page 15 provides data relating to the composition of the Corporation’s loan portfolio on the dates indicated. Total loans increased by $16,656,000 or 3.7%.

 

34
 

 

Increasing demand for borrowing by both individuals and businesses accounted for the 3.7% increase in the loan portfolio from December 31, 2013 to June 30, 2014. The Commercial and Industrial portfolio decreased $561,000 to $60,261,000 as of June 30, 2014 as compared to $60,822,000 as of December 31, 2013. The decrease in the Commercial and Industrial portfolio (which includes tax-free commercial and industrial loans) was attributed to weak loan demand, which was offset by loan payoffs, along with typical loan amortization. The Commercial Real Estate portfolio (which includes tax-free commercial real estate loans) increased $12,496,000 to $237,901,000 as of June 30, 2014, as compared to $225,405,000 at December 31, 2013. The increase was mainly attributed to new loan originations totaling $24,207,000, which were offset by loan payoffs of $6,992,000, combined with typical amortizations in the loan portfolio. The Residential Real Estate portfolio increased $4,884,000 to $159,559,000 as of June 30, 2014, as compared to $154,675,000 as of December 31, 2013. The increase was the result of new originations, and to a lesser extent, refinances held in the Bank’s portfolio. The Corporation continued to originate and sell certain long-term fixed rate residential mortgage loans which conform to secondary market requirements. The Corporation derives ongoing income from the servicing of mortgages sold in the secondary market. The Corporation continues its efforts to lend to creditworthy borrowers despite the continued slow economic conditions.

 

Management believes that the loan portfolio is well diversified. The total commercial portfolio was $298,162,000 of which $237,901,000 or 51.4% of total loans is secured by commercial real estate.

 

The largest relationship is comprised of various real estate entities, with a related owner who began real estate investment and development activities in 1989. The relationship had outstanding loan balances and unused commitments of $12,354,000 at June 30, 2014. The individual owns a diverse mix of real estate entities which specialize in construction/development projects, leasing of commercial office space, and rental of multi-tenant residential units. This relationship is comprised of $4,744,000 in long term debt, two construction mortgages totaling $6,610,000, and a $1,000,000 line of credit. The relationship is well secured by first lien mortgages on income producing commercial and residential real estate, plus collateral pledge of cash accounts and marketable securities.

 

The second largest relationship is a manufacturing/fabrication company and its related entities. The company has a long history of successful operations dating back to 1980. The relationship had outstanding loan balances and unused commitments of $9,147,000 at June 30, 2014. The debt consists of approximately $6,652,000 in term debt secured by various real estate holdings, and approximately $2,495,000 in operating lines of credit secured by business assets and guaranties.

 

The third largest relationship at June 30, 2014 consists of $8,377,000 in a tax free loan and an unused commitment to a municipality founded in 1816 consisting of 35 square miles. According to township officials, the population has been increasing steadily since 2001 and is currently in excess of 11,000 people. In 2012, the township completed its $74,000,000 sewer expansion project. The Bank’s loan is secured by project receivables and the full faith, credit, and taxing power of the township.

 

The fourth largest relationship is a real estate development company and its related entities, specializing in the design, construction, and management of multi-tenant residential housing. The company was established in the late 1980s with its primary market being the Corporation’s immediate central market area. The relationship had outstanding loan balances and unused commitments of $8,238,000 at June 30, 2014. The debt consists of approximately $5,526,000 in term debt secured by various real estate holdings, and approximately $2,712,000 in lines of credit secured by various real estate holdings. The loans are secured primarily by income producing multi-tenant real estate.

 

The fifth largest relationship consists of a real estate development/holding company that was established in 2006 to construct a multi-tenant medical complex, as well as the medical-related entities that operate out of the complex. The relationship had outstanding loan balances and unused commitments of $8,120,000 at June 30, 2014. The debt is comprised of approximately $6,428,000 in term debt, as well as $1,692,000 in operating lines of credit. This relationship is well secured by business assets, undeveloped land, and commercial and residential real estate.

 

Each of the relationships is located within the Corporation’s market area.

 

Each of the loans is paying as agreed and none of the loans are considered criticized or classified. The property securing each of the loans was appraised at the time the loan was originated. Appraisals are ordered independently of the loan approval process from appraisers on an approved list. All appraisals are reviewed internally for conformity with accepted standards of the Bank.

 

35
 

 

All loan relationships in excess of $1,500,000 are reviewed internally and through an external loan review process on an annual basis. Such review is based upon analysis of current financial statements of the borrower, co-borrowers/guarantors, payment history, and economic conditions.

 

Overall, the portfolio risk profile as measured by loan grade is considered low risk, as $450,209,000 or 97.2% of total loans are graded Pass; $6,801,000 or 1.5% are graded Special Mention; $5,716,000 or 1.3% are graded Substandard; and $0 are graded Doubtful. The rating is intended to represent the best assessment of risk available at a given point in time, based upon a review of the borrower’s financial statements, credit analysis, payment history with the Bank, credit history and lender knowledge of the borrower. See Note 4 — Loans and Allowance for Loan Losses for risk grading tables.

 

Overall, non-pass grades increased to $12,517,000 at June 30, 2014, as compared to $6,698,000 at December 31, 2013. Commercial and Industrial non-pass grades increased to $310,000 as of June 30, 2014 as compared to $86,000 as of December 31, 2013. Commercial Real Estate non-pass grades increased to $10,670,000 as of June 30, 2014 as compared to $5,499,000 as of December 31, 2013. The Residential Real Estate and Consumer loan non-pass grades increased to $1,537,000 as of June 30, 2014 as compared to $1,113,000 as of December 31, 2013.

 

The increase in Commercial Real Estate non-pass grade loans was mainly the result of the downgrade of nine loans. Eight of the downgraded loans totaling $638,000 are with a single individual for various multi-tenant housing projects. Unpaid real estate taxes and municipal liens have had a negative impact on the relationship. Despite the circumstances, the borrower continues to perform. One loan of $4,971,000 is with a real estate development company. The weak real estate market has hindered the process of the development plans and expected sales have not materialized. However, the borrower remains strong and continues to perform.

 

The Corporation continues to internally underwrite each of its loans to comply with prescribed policies and approval levels established by its Board of Directors.

 

Total Loans

 

(Dollars in thousands)  June 30, 
2014
   December 31, 
2013
 
Commercial and Industrial  $60,261   $60,822 
Commercial Real Estate   237,901    225,405 
Residential Real Estate   159,559    154,675 
Consumer   5,453    5,616 
Total loans  $463,174   $446,518 

 

ALLOWANCE FOR LOAN LOSSES

 

The allowance for loan losses constitutes the amount available to absorb losses within the loan portfolio. As of June 30, 2014, the allowance for loan losses was $6,477,000 as compared to $6,519,000 as of December 31, 2013. The allowance for loan losses is established through a provision for loan losses charged to expenses. Loans are charged against the allowance for possible loan losses when management believes that the collectability of the principal is unlikely. The risk characteristics of the loan portfolio are managed through the various control processes, including credit evaluations of individual borrowers, periodic reviews, and diversification by industry. Risk is further mitigated through the application of lending procedures such as the holding of adequate collateral and the establishment of contractual guarantees.

 

Management performs a quarterly analysis to determine the adequacy of the allowance for loan losses. The methodology in determining adequacy incorporates specific and general allocations together with a risk/loss analysis on various segments of the portfolio according to an internal loan review process. This assessment results in an allocated allowance. Management maintains its loan review and loan classification standards consistent with those of its regulatory supervisory authority.

 

Management considers, based upon its methodology, that the allowance for loan losses is adequate to cover foreseeable future losses. However, there can be no assurance that the allowance for loan losses will be adequate to cover significant losses, if any, that might be incurred in the future.

 

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The Analysis of Allowance for Loan Losses table contains an analysis of the allowance for loan losses indicating charge-offs and recoveries for the six month periods ended June 30, 2014 and 2013. For the first six months of 2014, net charge-offs as a percentage of average loans was 0.08% as compared to 0.10% for the six month period ended June 30, 2013. Net charge-offs amounted to $375,000 for the first six months of 2014 as compared to $442,000 for the first six months of 2013. The decrease in net charge-offs in the first six months of 2014 as compared to the first six months of 2013 related primarily to decreased losses in Commercial and Residential Real Estate loans. During the first six months of 2014, $411,000 in Commercial and Residential Real Estate loans were charged off as compared to $446,000 for the first six months of 2013.

 

For the first six months of 2014, the provision for loan losses was $333,000 as compared to $600,000 for the first six months of 2013. The provision, net of charge-offs and recoveries, increased the quarter end Allowance for Loan Losses to $6,477,000 of which 11.4% was attributed to the Commercial and Industrial component; 53.3% attributed to the Commercial Real Estate component; 25.0% attributed to the Residential Real Estate component (primarily residential mortgages); 0.8% attributed to the Consumer component; and 9.5% being the unallocated component (refer to the activity in Note 4 – Loans and Allowance for Loan Losses on page 16). The Corporation determined that the provision for loan losses made during the current quarter was sufficient to maintain the allowance for loan losses at a level necessary for the probable losses inherent in the loan portfolio as of June 30, 2014.

 

Analysis of Allowance for Loan Losses

 

(Dollars in thousands)        
   June 30,   June 30, 
   2014   2013 
Balance at beginning of the six month period  $6,519   $5,772 
Charge-offs:          
Commercial and Industrial   7     
Real Estate – Commercial and Residential   411    446 
Consumer   15    22 
    433    468 
Recoveries:          
Commercial and Industrial   21    19 
Real Estate – Commercial and Residential   36    4 
Consumer   1    3 
    58    26 
           
Net charge-offs   375    442 
Additions charged to operations   333    600 
Balance at end of the six month period  $6,477   $5,930 
           
Ratio of net charge-offs during the period to  average loans outstanding during the period   0.08%   0.10%
Allowance for loan losses to average loans outstanding during the period   1.42%   1.38%

 

It is the policy of management and the Corporation’s Board of Directors to make a provision for both identified and unidentified losses inherent in its loan portfolio. A provision for loan losses is charged to operations based upon an evaluation of the potential losses in the loan portfolio. This evaluation takes into account such factors as portfolio concentrations, delinquency trends, trends of non-accrual and classified loans, economic conditions, and other relevant factors.

 

The loan review process, which is conducted quarterly, is an integral part of the Bank’s evaluation of the loan portfolio. A detailed quarterly analysis to determine the adequacy of the Corporation’s allowance for loan losses is reviewed by the Board of Directors.

 

With the Bank’s manageable level of net charge-offs and the additions to the reserve from the provision out of operations, the allowance for loan losses as a percentage of average loans amounted to 1.42% at June 30, 2014 and 1.38% at June 30, 2013.

 

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NON-PERFORMING ASSETS

 

The table on page 39 detail the Corporation’s non-performing assets and impaired loans as of the dates indicated. Generally, a loan is classified as non-accrual and the accrual of interest on such a loan is discontinued when the contractual payment of principal or interest has become 90 days past due or management has serious doubts about further collectability of principal or interest, even though the loan currently is performing. A loan may remain on accrual status if it is in the process of collection and is either guaranteed or well secured. When a loan is placed on non-accrual status, unpaid interest credited to income in the current year is reversed and unpaid interest accrued in prior years is charged against current period income. A modification of a loan constitutes a troubled debt restructuring (“TDR”) when a borrower is experiencing financial difficulty and the modification constitutes a concession that the Corporation would not otherwise consider. Modifications to loans classified as TDRs generally include reductions in contractual interest rates, principal deferments and extensions of maturity dates at a stated interest rate lower than the current market for a new loan with similar risk characteristics. While unusual, there may be instances of loan principal forgiveness. Foreclosed assets held for resale represent property acquired through foreclosure, or considered to be an in-substance foreclosure.

 

Total non-performing assets amounted to $4,310,000 as of June 30, 2014 as compared to $4,349,000 as of December 31, 2013. The economy, in particular, high unemployment, weak job markets, unsettled fuel prices, rising energy costs, and the continued slowness in the housing industry had a direct effect on the Corporation’s non-performing assets. The Corporation is closely monitoring its Commercial Real Estate portfolio because of the current economic environment. In particular, vacancy rates are rising and rents and property values in some markets have fallen. Non-accrual loans totaled $4,010,000 as of June 30, 2014 as compared to $3,551,000 as of December 31, 2013. Foreclosed assets held for resale decreased to $237,000 as of June 30, 2014 from $480,000 as of December 31, 2013. Loans past-due 90 days or more and still accruing interest amounted to $63,000 as of June 30, 2014 as compared to $318,000 as of December 31, 2013. At June 30, 2014, Loans past-due 90 days or more and still accruing interest consisted of one Commercial Real Estate loan, which is deemed to be well secured by collateral and is in the process of collection. Non-performing assets to total loans was 0.9% as of June 30, 2014 compared to 1.0% at December 31, 2013. Non-performing assets to total assets was 0.5% as of June 30, 2014 and December 31, 2013. The allowance for loan losses to total non-performing assets was 150.3% as of June 30, 2014 as compared to 149.9% as of December 31, 2013. Additional detail can be found on page 39 in the Non-Performing Assets and Impaired Loans table and page 22 in the Financing Receivables on Non-Accrual Status table. Asset quality is a priority and the Corporation retains a full-time loan review officer to closely track and monitor overall loan quality, along with a full-time workout specialist to manage collection and liquidation efforts.

 

Impaired loans were $6,898,000 at June 30, 2014 and $5,974,000 at December 31, 2013. The largest impaired loan relationship at June 30, 2014 consisted of a purchased participation loan secured by commercial real estate. The Corporation’s participation share of the loan was $1,413,000. The collateral evaluation at June 30, 2014 carried a value of $5,813,000, after considering estimated appraisal adjustments and cost to sell of 40% and considering the total participation outstanding note balance, resulting in the Corporation’s specific allocation of $0. At June 30, 2014, the second largest impaired loan relationship was represented by one performing loan carrying a balance of $880,000 secured by commercial real estate. The collateral evaluation at June 30, 2014 carried a value of $1,012,000, after estimated appraisal adjustments and cost to sell of 56%, resulting in a specific allocation of $0. The third largest impaired loan relationship at June 30, 2014 was represented by three non-performing loans carrying a balance of $619,000 secured by residential real estate. The collateral evaluation at June 30, 2014 carried a value of $638,000 after estimated appraisal adjustments and cost to sell of 9%, resulting in a specific allocation of $0. The estimated appraisal adjustments and cost to sell percentages are determined based on the market area in which the real estate securing the loan is located, among other factors, and therefore, can differ from one loan to another. Of the $6,898,000 in impaired loans at June 30, 2014, none were located outside the Corporation’s primary market area.

 

Loans categorized as TDRs carried an unpaid balance of $4,301,000 as of June 30, 2014 as compared to $3,961,000 as of December 31, 2013. The increase was attributable to deterioration in the respective borrowers’ financial position, and in some cases a declining collateral value, along with the Bank’s proactive monitoring of the loan portfolio resulting in the identification of additional loans classified as TDRs. Of the nineteen restructured loans at June 30, 2014, two loans are classified in the Commercial and Industrial portfolio, sixteen loans are classified in the Commercial Real Estate portfolio, and one loan is classified in the Consumer portfolio. At June 30, 2014, seven Commercial Real Estate loans classified as TDRs with a combined recorded investment of $970,000 were not in compliance with the terms of their restructure, compared to June 30, 2013 when three Commercial Real Estate loans classified as TDRs with a combined recorded investment of $304,000 were not in compliance with the terms of their restructure. The troubled debt restructurings at June 30, 2014 consisted of five term modifications beyond the original stated term, five interest rate modifications, and nine payment modifications. TDRs are separately identified for impairment disclosures, and if necessary, a specific allocation is established. As of June 30, 2014, no specific allocations were attributable to the TDRs.

 

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The Corporation’s non-accrual loan valuation procedure for any loans greater than $250,000 requires an appraisal to be obtained and reviewed annually at year end. A quarterly collateral evaluation is performed which may include a site visit, property pictures and discussions with realtors and other similar business professionals to ascertain current values.

 

For non-accrual loans less than $250,000 upon classification and typically at year end, the Corporation completes a Certificate of Inspection, which includes the results of an onsite inspection, insured values, tax assessed values, recent sales comparisons and a review of the previous evaluations.

 

Improving loan quality is a priority. The Corporation actively works with borrowers to resolve credit problems and will continue its close monitoring efforts in 2014. Excluding the assets disclosed in the Non-Performing Assets and Impaired Loans tables below and the Troubled Debt Restructurings section in Note 4 — Loans and Allowance for Loan Losses, management is not aware of any information about borrowers’ possible credit problems which cause serious doubt as to their ability to comply with present loan repayment terms.

 

Should the economic climate no longer continue to be stable or deteriorate further, borrowers may experience difficulty, and the level of impaired loans and non-performing assets, charge-offs and delinquencies could rise and possibly require additional increases in the Corporation’s allowance for loan losses.

 

In addition, regulatory authorities, as an integral part of their examinations, periodically review the allowance for possible loan losses. They may require additions to allowances based upon their judgments about information available to them at the time of examination.

 

A concentration of credit exists when the total amount of loans to borrowers, who are engaged in similar activities that are similarly impacted by economic or other conditions, exceed 10% of total loans. As of June 30, 2014 and December 31, 2013, management is of the opinion that there were no loan concentrations exceeding 10% of total loans.

 

(Dollars in thousands)        
  June 30,   December 31, 
   2014   2013 
Non-performing assets          
Non-accrual loans  $4,010   $3,551 
Foreclosed assets held for resale   237    480 
Loans past-due 90 days or more and still accruing interest   63    318 
Total non-performing assets  $4,310   $4,349 
           
Impaired loans          
Non-accrual loans  $4,010   $3,551 
Accruing TDRs   2,888    2,423 
Total impaired loans   6,898    5,974 
Allocated allowance for loan losses