Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

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

For the quarterly period ended September 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: 0-20957

 

 

SUN BANCORP, INC.

(Exact name of registrant as specified in its charter)

 

 

 

New Jersey		52-1382541
(State or other jurisdiction of incorporation or organization		(I.R.S. Employer Identification No.)

350 Fellowship Road, Suite 101, Mount Laurel, New Jersey 08054

(Address of principal executive offices)

(Zip Code)

(856) 691-7700

(Registrant’s telephone number, including area code)

N/A

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

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer		¨		Accelerated filer		x
Non-accelerated filer		¨		Smaller reporting company		¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12-b2 of the Exchange Act).    Yes  ¨    No  x

Common Stock, $5.00 Par Value – 18,586,134 Shares Outstanding at November 3, 2014

 

 

 

 

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Table of Contents

TABLE OF CONTENTS

 

		Page Number
PART I – FINANCIAL INFORMATION
Item 1. Financial Statements
Unaudited Condensed Consolidated Statements of Financial Condition at September  30, 2014 and December 31, 2013			3
Unaudited Condensed Consolidated Statements of Operations for the Three and Nine months Ended September  30, 2014 and 2013			4
Unaudited Condensed Consolidated Statements of Comprehensive Loss for the Three and Nine months Ended September 30, 2014 and 2013			5
Unaudited Condensed Consolidated Statements of Shareholders’ Equity for the Nine months Ended September  30, 2014 and 2013			6
Unaudited Condensed Consolidated Statements of Cash Flows for the Nine months Ended September  30, 2014 and 2013			7
Notes to Unaudited Condensed Consolidated Financial Statements			8
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			44
Item 3. Quantitative and Qualitative Disclosures about Market Risk			60
Item 4. Controls and Procedures			61
PART II – OTHER INFORMATION
Item 1. Legal Proceedings			62
Item 1A. Risk Factors			62
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			62
Item 3. Defaults Upon Senior Securities			62
Item 4. Mine Safety Disclosures			62
Item 5. Other Information			62
Item 6. Exhibits			63
Signatures			63
Exhibits:
Exhibit 3.1 Amended and Restated Certificate of Incorporation of Sun Bancorp, Inc.
Exhibit 3.2 Amended and Restated Bylaws of Sun Bancorp, Inc.
Exhibit 4.1 Common Security Specimen
Exhibit 31(a) Section 302 Certification of CEO
Exhibit 31(b) Section 302 Certification of Chief Financial Officer
Exhibit 32 Section 906 Certifications
Exhibit 101.INS XBRL Instance Document
Exhibit 101.SCH XBRL Taxonomy Extension Schema Document
Exhibit 101.CAL XBRL Taxonomy Extension Calculation Linkbase Document
Exhibit 101.LAB XBRL Taxonomy Extension Label Linkbase Document
Exhibit 101.PRE XBRL Taxonomy Extension Presentation Linkbase Document
Exhibit 101.DEF XBRL Taxonomy Definition Linkbase Document

 

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SUN BANCORP, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands, except par value amounts)

 

		September 30, 2014				December 31, 2013
ASSETS
Cash and due from banks		$	37,032			$	38,075
Interest-earning bank balances			467,321				229,687
Cash and cash equivalents			504,353				267,762
Restricted cash			13,000				26,000
Investment securities available for sale (amortized cost of $410,354 and $452,023 at September 30, 2014 and December 31, 2013, respectively)			409,496				440,097
Investment securities held to maturity (estimated fair value of $621 and $692 at September 30, 2014 and December 31, 2013, respectively)			604				681
Loans receivable (net of allowance for loan losses of $26,540 and $35,537 at September 30, 2014 and December 31, 2013, respectively)			1,649,869				2,102,167
Loans held-for-sale, at fair value			4,595				20,662
Loans held-for-sale, at lower of cost or market			2,770				—
Branch assets held-for-sale			31,408				—
Restricted equity investments, at cost			14,979				17,019
Bank properties and equipment, net			41,610				49,095
Real estate owned, net			1,084				2,503
Accrued interest receivable			5,652				7,112
Goodwill			38,188				38,188
Intangible assets, net			—				805
Deferred taxes, net			—				4,575
Bank owned life insurance (BOLI)			78,650				77,236
Other assets			23,944				33,651
Total assets		$	2,820,202			$	3,087,553
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities:
Deposits		$	2,170,627			$	2,621,571
Deposits held-for-sale			192,068				—
Securities sold under agreements to repurchase – customers			963				478
Advances from the Federal Home Loan Bank of New York (FHLBNY)			60,830				60,956
Obligations under capital lease			7,111				7,331
Junior subordinated debentures			92,786				92,786
Deferred taxes, net			971				—
Other liabilities			47,799				59,094
Total liabilities			2,573,155				2,842,216
Commitments and contingencies (see Note 11)
Shareholders’ equity:
Preferred stock, $1 par value, 1,000,000 shares authorized; none issued			—				—
Common stock, $5 par value, 40,000,000 shares authorized; 18,884,782 shares issued and 18,585,036 shares outstanding at September 30, 2014; 17,742,207 shares issued and 17,342,883 shares outstanding at December 31, 2013(1)			94,424				88,711
Additional paid-in capital			514,932				506,719
Retained deficit			(344,933	)			(317,954	)
Accumulated other comprehensive loss			(508	)			(7,055	)
Deferred compensation plan trust			(599	)			(522	)
Treasury stock at cost, 299,746 shares at September 30, 2014; and 399,324 shares at December 31, 2013(1)			(16,269	)			(24,562	)
Total shareholders’ equity			247,047				245,337
Total liabilities and shareholders’ equity		$	2,820,202			$	3,087,553

See Notes to Unaudited Condensed Consolidated Financial Statements.

 

(1)	Prior period share data was retroactively adjusted for the impact of the 1-for-5 reverse stock split on August 11, 2014

 

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SUN BANCORP, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in thousands, except share and per share amounts)

 

		For the Three Months Ended September 30,								For the Nine months Ended September 30,
		2014				2013				2014				2013
INTEREST INCOME
Interest and fees on loans		$	19,307			$	24,576			$	62,223			$	73,420
Interest on taxable investment securities			2,140				1,680				6,583				4,449
Interest on non-taxable investment securities			306				310				923				1,028
Dividends on restricted equity investments			202				222				643				685
Total interest income			21,955				26,788				70,372				79,582
INTEREST EXPENSE
Interest on deposits			2,057				2,813				6,526				8,773
Interest on funds borrowed			435				445				1,314				1,332
Interest on junior subordinated debentures			542				550				1,607				1,643
Total interest expense			3,034				3,808				9,447				11,748
Net interest income			18,921				22,980				60,925				67,834
PROVISION FOR LOAN LOSSES			—				724				14,803				(988	)
Net Interest income after provision for loan losses			18,921				22,256				46,122				68,822
NON-INTEREST INCOME
Service charges on deposit accounts			2,285				2,314				6,651				6,793
Mortgage banking revenue, net			423				1,593				1,587				10,598
Gain on sale of investment securities			—				2				50				3,489
Investment products income			635				678				1,967				2,085
BOLI income			484				482				1,414				1,416
Derivative credit valuation adjustment			11				(380	)			(1,189	)			(878	)
Other			857				1,110				3,141				3,436
Total non-interest income			4,695				5,799				13,621				26,939
NON-INTEREST EXPENSE
Salaries and employee benefits			11,265				12,656				40,141				39,967
Commission expense			553				2,001				2,261				6,598
Occupancy expense			2,980				3,456				10,798				10,113
Equipment expense			1,695				1,796				5,800				5,485
Data processing expense			1,299				995				3,777				3,021
Amortization of intangible assets			238				540				805				2,002
Insurance expense			1,443				1,496				4,268				4,468
Professional fees			1,423				5,947				5,262				13,355
Advertising expense			567				676				1,676				1,927
Problem loan expense			294				816				1,492				2,638
Real estate owned expense, net			71				252				917				1,741
Office supplies expense			217				192				753				612
Other			2,087				2,094				7,747				5,565
Total non-interest expense			24,132				32,917				85,697				97,492
LOSS BEFORE INCOME TAXES			(516	)			(4,862	)			(25,954	)			(1,731	)
INCOME TAX EXPENSE			309				—				1,025				—
NET LOSS AVAILABLE TO COMMON SHAREHOLDERS		$	(825	)		$	(4,862	)		$	(26,979	)		$	(1,731	)
Basic loss per share(1)		$	(0.05	)		$	(0.28	)		$	(1.54	)		$	(0.10	)
Diluted loss per share(1)		$	(0.05	)		$	(0.28	)		$	(1.54	)		$	(0.10	)
Weighted average shares – basic(1)			17,949,643				17,299,917				17,574,246				17,271,373
Weighted average shares – diluted(1)			17,946,643				17,299,917				17,574,246				17,271,373

See Notes to Unaudited Condensed Consolidated Financial Statements.

 

(1)	Prior period share data was retroactively adjusted for the impact of the 1-for-5 reverse stock split on August 11, 2014

 

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SUN BANCORP, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

(Dollars in thousands)

 

		For the Three Months Ended September 30,								For the Nine Months Ended September 30,
		2014				2013				2014				2013
NET LOSS AVAILABLE TO COMMON SHAREHOLDERS		$	(825	)		$	(4,862	)		$	(26,979	)		$	(1,731	)
Other Comprehensive Loss, net of tax
Unrealized (losses) gains on securities:
Unrealized holding (losses) gains arising during period		$	(193	)		$	(19	)		$	6,517			$	(3,024	)
Less: reclassification adjustment for (losses) gains included in net income			—				(1	)			30				(2,071	)
Other comprehensive (loss) income			(193	)			(20	)			6,547				(5,095	)
COMPREHENSIVE LOSS		$	(1,018	)		$	(4,882	)		$	(20,432	)		$	(6,826	)

See Notes to Unaudited Condensed Consolidated Financial Statements.

 

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SUN BANCORP, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(Dollars in thousands)

 

		Preferred Stock				Common Stock				Additional Paid-In Capital				Retained Deficit				Accumulated Other Comprehensive (Loss)				Deferred Compensation				Treasury Stock				Total
BALANCE, JANUARY 1, 2013		$	—			$	88,301			$	506,537			$	(308,011	)		$	2,186			$	(256	)		$	(26,162	)		$	262,595
Net loss			—				—				—				(1,731	)			—				—				—				(1,731	)
Other comprehensive loss			—				—				—				—				(5,095	)			—				—				(5,095	)
Issuance of common stock			—				272				(27	)			—				—				(150	)			730				825
Stock-based compensation			—				45				501				—				—				—				—				546
BALANCE, September 30, 2013		$	—			$	88,618			$	507,011			$	(309,742	)		$	(2,909	)		$	(406	)		$	(25,432	)		$	257,140
BALANCE, JANUARY 1, 2014		$	—			$	88,711			$	506,719			$	(317,954	)		$	(7,055	)		$	(522	)		$	(24,562	)		$	245,337
Net loss			—				—				—				(26,979	)			—				—				—				(26,979	)
Other comprehensive income			—				—				—				—				6,547				—				—				6,547
Exercise of stock options											(30	)															37				7
Capital raise							5,666				14,259																—				19,925
Issuance of common stock			—				47				(5,810	)			—				—				(77	)			7,542				1,702
Stock-based compensation			—				—				(206	)			—				—				—				714				508
BALANCE, September 30, 2014		$	—			$	94,424			$	514,932			$	(344,933	)		$	(508	)		$	(599	)		$	(16,269	)		$	247,047

See Notes to Unaudited Condensed Consolidated Financial Statements.

 

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SUN BANCORP, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

 

		For the Nine months Ended September 30,
		2014				2013
OPERATING ACTIVITIES
Net loss		$	(26,979	)		$	(1,731	)
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses			14,803				(988	)
Increase (decrease) in reserve for unfunded commitments			285				(214	)
Depreciation, amortization and accretion			5,536				8,045
Impairment of bank properties and equipment and real estate owned			489				295
Loss on sale of real estate owned			331				886
Net gain on sales and calls of investment securities available-for-sale			(50	)			(3,500	)
Gain on sale of mortgage loans			(1,811	)			(10,805	)
Gain on bulk sale of jumbo residential mortgage loans, net			(135	)			(1,916	)
Gain on bulk sale of other consumer loans			(311	)			—
Change in fair value of loans held-for-sale			947				1,624
Decrease in fair value of interest rate lock commitments			119				499
Derivative credit valuation adjustments			(140	)			504
Increase in cash surrender value of BOLI			(1,414	)			(1,416	)
Deferred income taxes			1,025				—
Stock-based compensation			508				546
Shares contributed to employee benefit plans			1,787				976
Mortgage loans originated for sale			(76,596	)			(418,984	)
Proceeds from the sale of mortgage loans			88,442				535,733
Change in assets and liabilities which provided (used) cash:
Accrued interest receivable			1,460				1,488
Other assets			21				3,062
Other liabilities			(1,635	)			(3,718	)
Net cash provided by operating activities			6,682				110,386
INVESTING ACTIVITIES
Purchases of available-for-sale securities			(23,523	)			(248,543	)
Net redemption of restricted equity securities			2,040				727
Proceeds from maturities, prepayments or calls of investment securities available for sale			46,572				80,854
Proceeds from maturities, prepayments or calls of investment securities held to maturity			75				209
Proceeds from the sale of investment securities available-for-sale			18,276				197,019
Proceeds from sale of commercial real estate loans			57,147				20,771
Proceeds from sale of repossessed assets			123				231
Proceeds from bulk sale of jumbo residential mortgage loans			46,729				117,184
Proceeds from bulk sale of consumer loans			15,682				—
Restricted cash transferred to cash and cash equivalents			13,000				—
Cash transferred to held-for-sale			(1,078	)			—
Return of surrender value of BOLI			—				1,504
Net decrease (increase) in loans			294,021				(36,022	)
Purchases of bank properties and equipment			(1,629	)			(2,846	)
Proceeds from sale of real estate owned			1,391				5,063
Net cash provided by investing activities			468,826				136,151
FINANCING ACTIVITIES
Net (decrease) increase in deposits			(451,124	)			39,469
Net increase in deposits held-for-sale			192,068				—
Net issuances (redemptions) of securities sold under agreements to repurchase – customer			485				(1,414	)
Repayments of advances from FHLBNY			(126	)			(418	)
Repayment of obligations under capital leases			(220	)			(207	)
Proceeds from issuance of common stock			20,000				—
Net cash (used in) provided by financing activities			(238,917	)			37,430
NET INCREASE IN CASH AND CASH EQUIVALENTS			236,591				283,967
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR			267,762				143,616
CASH AND CASH EQUIVALENTS, END OF PERIOD		$	504,353			$	427,583
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Interest paid		$	9,698			$	11,997
Income taxes paid			—				—
SUPPLEMENTAL DISCLOSURE OF NON-CASH ITEMS
Transfer of loans and bank property to real estate owned			567				3,702

See Notes to Unaudited Condensed Consolidated Financial Statements.

 

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SUN BANCORP, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(All dollar amounts presented in the tables, except share and per share amounts, are in thousands)

(1) Summary of Significant Accounting Policies

Basis of Presentation. The accompanying unaudited condensed consolidated financial statements were prepared in accordance with instructions to Form 10-Q, and therefore, do not include information or footnotes necessary for a complete presentation of financial condition, results of operations, comprehensive loss, changes in equity and cash flows in conformity with Accounting Principles Generally Accepted in the United States of America (“GAAP”).

All normal recurring adjustments that, in the opinion of management, are necessary for a fair presentation of the unaudited condensed consolidated financial statements have been included. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the accompanying notes thereto included in the Annual Report on Form 10-K of Sun Bancorp, Inc. (the “Company”) for the year ended December 31, 2013. The results for the three and nine months ended September 30, 2014 are not necessarily indicative of the results that may be expected for the year ending December 31, 2014 or any other period. The preparation of the unaudited condensed consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expense during the reporting period. The significant estimates include the allowance for loan losses, other-than-temporary impairment on investment securities, goodwill, intangible assets, income taxes, stock-based compensation and the fair value of financial instruments. Actual results may differ from these estimates under different assumptions or conditions.

Prior Period Revision. Previously, the Company presented restricted cash, with respect to amounts held as collateral against letters of credit, in “Cash and due from banks” on the consolidated statements of financial condition. During the fourth quarter of 2013, the Company identified that certain of these balances should be classified as restricted cash. The table below reports the impact of these revisions to the consolidated statements of cash flows for the nine months ended September 30, 2013:

 

Nine months Ended September 30,		Revised 2013				As reported 2013
Cash and cash equivalents, beginning of year		$	143,616			$	169,616
Cash and cash equivalents, end of period			427,583				453,583

Basis of Consolidation. The unaudited condensed consolidated financial statements include, after all intercompany balances and transactions have been eliminated, the accounts of the Company, its principal wholly-owned subsidiary, Sun National Bank (the “Bank”), and the Bank’s wholly-owned subsidiaries, Sun Financial Services, L.L.C., 2020 Properties, L.L.C., and 4040 Properties, L.L.C. In accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“FASB ASC”) 810-10, Consolidation, Sun Capital Trust V, Sun Capital Trust VI, Sun Capital Trust VII, Sun Statutory Trust VII, and Sun Capital Trust VIII, collectively, the “Issuing Trusts”, are presented on a deconsolidated basis.

Segment Information. As defined in accordance with FASB ASC 280, Segment Reporting, the Company has one reportable and operating segment, “Community Banking.” All of the Company’s activities are interrelated, and each activity is dependent and assessed based on how each of the activities of the Company supports the others. For example, lending is dependent upon the ability of the Company to fund itself with deposits and other borrowings and manage interest rate and credit risk. Accordingly, all significant operating decisions are based upon analysis of the Company as one segment or unit.

 

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Loans Held-For-Sale. Loans held-for-sale totaled $7.4 million and $20.7 million at September 30, 2014 and December 31, 2013, respectively. The balance at September 30, 2014 and December 31, 2013 includes $4.6 million and $20.7 million, respectively, of residential mortgages originated with the intent to sell which were recorded at fair value. At September 30, 2014, loans held-for-sale also included $2.8 million of consumer loans recorded at lower of cost or market.

Allowance for Loan Losses. The allowance for loan losses is determined by management based upon past experience, evaluation of estimated loss and impairment in the loan portfolio, current economic conditions and other pertinent factors. The allowance for loan losses is maintained at a level that management considers adequate to provide for estimated losses and impairment based upon an evaluation of known and inherent risk in the loan portfolio. Loan impairment is evaluated based on the fair value of collateral. While management uses the best information available to make such evaluations, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the evaluations.

The provision for loan losses is based upon historical loan loss experience, a series of qualitative factors and an evaluation of estimated losses in the current loan portfolio, including the evaluation of impaired loans under FASB ASC 310, Receivables (“FASB ASC 310”). Values assigned to the qualitative factors and those developed from historic loss experience provide a dynamic basis for the calculation of reserve factors for both pass-rated loans (general pooled allowance) and those criticized and classified loans that continue to perform. A loan is considered to be impaired when, based upon current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan. An insignificant delay or insignificant shortfall in amount of payments does not necessarily result in the loan being identified as impaired. For this purpose, delays of less than 90 days are considered to be insignificant. Impairment losses are included in the provision for loan losses. Loans not individually reviewed are evaluated as a group using reserve factor percentages based on historic loss experience and qualitative factors. Included in these qualitative factors are:

 

•

Levels of past due, classified and non-accrual loans, and troubled debt restructurings;

 

•

Nature, volume, and concentration of loans;

 

•

Historical loss trends;

 

•

Changes in lending policies and procedures, underwriting standards, collections, and for commercial loans, the level of loans being approved with exceptions to policy;

 

•

Experience, ability and depth of management and staff;

 

•

National and local economic and business conditions, including various market segments;

 

•

Quality of the Company’s loan review system and degree of Board oversight; and

 

•

Effect of external factors, including the deterioration of collateral values, on the level of estimated credit losses in the current portfolio.

Commercial loans, including commercial real estate loans, are placed on non-accrual status at the time the loan has been delinquent for 90 days unless the loan is well secured and in the process of collection. Generally, commercial loans and commercial real estate loans are charged-off no later than 180 days after becoming delinquent unless the loan is well secured and in the process of collection, or other extenuating circumstances support collection. Residential real estate loans are typically placed on non-accrual status at the time the loan has been delinquent for 90 days. Other consumer loans are typically charged-off at 180 days delinquent. In all cases, loans must be placed on non-accrual status or charged-off at an earlier date if collection of principal or interest is considered doubtful.

Goodwill and Intangible Assets. Goodwill is the excess of the fair value of liabilities assumed over the fair value of tangible and identifiable intangible assets acquired in a business combination. Goodwill is not amortized but is tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. The Company tests goodwill for impairment annually as of December 31, unless circumstances indicate that a test is required at an earlier date. The Company elected to not apply the qualitative evaluation option permitted under Accounting Standards Update (“ASU”) 2011-8, Intangibles – Goodwill and Other (Topic 35): Testing Goodwill for Impairment issued in September 2011. Therefore, the Company utilizes the two-step goodwill impairment test outlined in FASB ASC 350, Intangibles – Goodwill and

 

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Other (“FASB ASC 350”). Step one, which is used to identify potential impairment, compares the fair value of the reporting unit with its carrying amount, including goodwill. A reporting unit is an operating segment, or one level below an operating segment, as defined in FASB ASC 280. If the fair value of a reporting unit exceeds its carrying value, goodwill of the reporting unit is not considered impaired and step two is therefore unnecessary. If the carrying amount of the reporting unit exceeds its fair value, the second step is performed to measure the amount of the impairment loss, if any. At December 31, 2013, the Company performed its annual goodwill impairment test, and step one of the analysis indicated that the Company’s fair value was greater than its carrying value; therefore, the Company’s goodwill was not impaired at December 31, 2013. Since that time, no event has occurred nor have circumstances changed that would more likely than not reduce the fair value of the reporting unit below its carrying amount. The carrying amount of goodwill totaled $38.2 million at September 30, 2014 and December 31, 2013.

Intangible assets, net on the consolidated statements of financial condition, consist of core deposit intangibles, net of accumulated amortization from the Bank’s previous acquisitions. Core deposit intangibles are amortized using the straight-line method based on the characteristics of the particular deposit type and are evaluated annually for impairment.

Bank Owned Life Insurance (“BOLI”). The Company has purchased life insurance policies on certain key employees. These policies are recorded at their cash surrender value, or the amount that can be realized in accordance with FASB ASC 325-30, Investments in Insurance Contracts. At September 30, 2014, the Company had $26.8 million invested in a general account and $51.9 million in a separate account, for a total BOLI cash surrender value of $78.7 million. The BOLI separate account is invested in a mortgage-backed securities fund, which is managed by an independent investment firm. Pricing volatility of these underlying instruments may have an impact on investment income; however, the fluctuations would be partially mitigated by a stable value wrap agreement which is a component of the separate account. Income from these policies and changes in the cash surrender value are recorded in BOLI income of the unaudited condensed consolidated statements of operations.

Income Taxes. The Company accounts for income taxes in accordance with FASB ASC 740, Income Taxes (“FASB ASC 740”). FASB ASC 740 requires the recording of deferred income taxes that reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Management exercises significant judgment in the evaluation of the amount and timing of the recognition of the resulting tax assets and liabilities. The judgments and estimates required for the evaluation are updated based upon changes in business factors and the tax laws. If actual results differ from the assumptions and other considerations used in estimating the amount and timing of tax recognized, there can be no assurance that additional expenses will not be required in future periods. The Company recognizes, when applicable, interest and penalties related to unrecognized tax benefits in the provision for income taxes in the unaudited condensed consolidated statements of operations. Assessment of uncertain tax positions under FASB ASC 740 requires careful consideration of the technical merits of a position based on management’s analysis of tax regulations and interpretations. Significant judgment is applied when addressing the requirements of FASB ASC 740. At September 30, 2014, the Company had a valuation allowance of $131.8 million against its gross deferred tax asset. As the Company remained in a cumulative loss position, the deferred tax valuation allowance is still appropriate at September 30, 2014. The net deferred tax liability of $971 thousand in the unaudited condensed consolidated statements of financial condition at September 30, 2014 primarily represents the tax liability created from the goodwill amortization recorded for tax purposes and not for book. For those securities in an unrealized loss position, the Company intends to hold these securities until maturity or until such time that they are in an unrealized gain position.

Mortgage Banking Revenue, Net. Mortgage banking revenue, net includes revenues associated with the sale of residential mortgage loans originated with the intent to sell, net of recourse liability provision as well as gain on bulk sales of jumbo residential mortgage loans. The components of this line item are as follows:

 

		For the Nine months Ended September 30,
		2014				2013
Gains on the sale of residential mortgage loans		$	2,271			$	11,105
Gain on bulk sale of jumbo residential mortgage loans			135				1,916
Market value adjustment on loans held-for-sale			(240	)			(1,624	)
Fair value adjustment on interest rate lock commitments			(119	)			(499	)
Recourse liability provision			(460	)			(300	)
Mortgage banking revenue, net		$	1,587			$	10,598

 

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		For the Three Months Ended September 30,
		2014				2013
Gains on the sale of residential mortgage loans		$	854			$	3,182
Loss on bulk sale of jumbo residential mortgage loans			—				(447	)
Market value adjustment on loans held-for-sale			(206	)			(585	)
Fair value adjustment on interest rate lock commitments			(225	)			(457	)
Recourse liability provision			—				(100	)
Mortgage banking revenue, net		$	423			$	1,593

Accumulated Other Comprehensive Income. The Company classifies items of accumulated comprehensive income by their nature and displays the details of other comprehensive loss in the unaudited condensed consolidated statements of comprehensive loss. Amounts categorized as comprehensive loss/income represent net unrealized gains or losses on investment securities available for sale, net of tax and the non-credit portion of any other-than-temporary impairment (“OTTI”) loss not recorded in earnings. Reclassifications are made to avoid double counting items which are displayed as part of net income (loss) for the period. These reclassifications for the three and nine months ended September 30, 2014 and 2013 were as follows:

 

		For the Three Months Ended September 30,
		2014												2013
		Pre-tax				Tax				After-tax				Pre-tax				Tax				After-tax
Unrealized holding gain (loss) on securities available for sale during the period		$	(327	)		$	134			$	(193	)		$	(32	)		$	13			$	(19	)
Reclassification adjustment for net gains included in net income(1)			—				—				—				(2	)			1				(1	)
Net unrealized gain on securities available for sale		$	(327	)		$	134			$	(193	)		$	(34	)		$	14			$	(20	)

 

(1)	All amounts are included in gain on sale of investment securities in the unaudited condensed consolidated statements of operations.

 

		For the Nine months Ended September 30,
		2014												2013
		Pre-tax				Tax				After-tax				Pre-tax				Tax				After-tax
Unrealized holding gain (loss) on securities available for sale during the period		$	11,017			$	(4,500	)		$	6,517			$	(5,112	)		$	2,088			$	(3,024	)
Reclassification adjustment for net gains included in net income(1)			50				(20	)			30				(3,500	)			1,410				(2,071	)
Net unrealized gain on securities available for sale		$	11,067			$	(4,520	)		$	6,547			$	(8,612	)		$	3,517			$	(5,095	)

 

(1)	All amounts are included in gain on sale of investment securities in the unaudited condensed consolidated statements of operations.

Recent Accounting Principles.

In August 2014, the FASB issued ASU 2014-15: Presentation of Financial Statements – Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern. The amendments in this Update provide guidance about management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern and to provide related footnote disclosures. The amendments are intended to reduce diversity in the timing and content of footnote disclosures. The amendments in this Update are effective for the annual period ending after December 15, 2016, and for annual periods and interim periods thereafter. Early application is permitted. The Company is currently evaluating the impact of the adoption of this accounting standards update on its financial statements.

In August 2014, the FASB issued ASU 2014-14: Receivables – Troubled Debt Restructurings by Creditors (Subtopic 310-40). The amendments in this Update affect creditors that hold government-guaranteed mortgage loans, including those guaranteed by the FHA and the VA. The amendments in this Update require that a mortgage loan be derecognized and that a separate other receivable be recognized upon foreclosure if certain conditions are met. Upon foreclosure, the separate other receivable should be measured based on the amount of the loan balance (principal and interest) expected to be recovered from the guarantor. The Company is currently evaluating the impact of the adoption of this accounting standards update on its financial statements. The amendments in this Update are effective for public entities for annual periods and interim periods within those annual periods, beginning after December 15, 2014.

In June 2014, the FASB issued ASU 2014-11: Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures. The accounting changes in the amendment affect all entities that enter into repurchase-to-maturity transactions or repurchase financings. The amendments in this update change the accounting for repurchase-to-maturity transactions to secured borrowing accounting and for repurchase financing arrangements, the amendments require separate accounting for a transfer of a financial asset executed contemporaneously with a repurchase agreement with the same counterparty which will result in secured borrowing accounting for the repurchase agreement. All entities are subject to new disclosure requirements for certain transactions that involve a transfer of a financial asset accounted for as a sale. The accounting changes in this Update are effective for public business entities for the first interim or annual period beginning after December 15, 2014. The Company is currently evaluating the impact of the adoption of this accounting standards update on its financial statements.

In May 2014, the FASB issued ASU 2014-09: Revenue from Contracts with Customers (Topic 606): Summary and Amendments That Create Revenue from Contracts with Customers (Topic 606) and Other Assets and Deferred Costs-Contracts with Customers (Subtopic 340-40), Conforming Amendments to Other Topics and Subtopics in the Codification and Status Tables, Background Information and Basis for Conclusions. The core

 

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principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the considerations to which the entity expects to be entitled in exchange for those goods or services. The guidance in this Update affects any entity that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets, unless those contracts are within the scope of other standards. For a public entity, the amendments in this Update are effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Early application is not permitted. The Company is currently evaluating the impact of the adoption of this accounting standards update on its financial statements.

In January 2014, the FASB issued ASU 2014-4, Receivables – Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure. The amendments in this update clarify that an in-substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either the creditor obtaining legal title to the residential real estate property upon completion of foreclosure or the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additionally, the amendments require interim and annual disclosure of both the amount of foreclosed residential real estate property held by the creditor and the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. For public entities, the amendments are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. The Company is currently evaluating the impact of the adoption of this accounting standards update on its financial statements.

In July 2013, the FASB issued Accounting Standards Update (“ASU”) 2013-11, Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. The amendments in this update seek to eliminate the diversity in practice in the presentation of unrecognized tax benefits when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists by presenting the unrecognized tax benefit, or a portion of the unrecognized tax benefit, in the financial statements as a reduction to a deferred tax asset. To the extent that a net operating loss carryforward, a similar tax loss, or a tax credit carryforward are not available at the reporting date under the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position or the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset for such purpose, the unrecognized tax benefit should be presented in the financial statements as a liability and should not be combined with deferred tax assets. For public entities, the amendments are effective prospectively for reporting periods beginning after December 15, 2013. The Company has evaluated the impact of the adoption of this accounting standards update on its financial statements and determined that there currently is no impact to the Company’s presentation.

(2) Branch Sale

On July 2, 2014 the Company entered into a Purchase and Assumption Agreement (the “Purchase Agreement”) with Sturdy Savings Bank, pursuant to which the Bank agreed to sell certain assets and certain liabilities relating to seven branch offices in and around Cape May County, New Jersey. The Purchase Agreement provides for a purchase price equal to the sum of a deposit premium of 8.765% of the average daily closing balance of deposits for the 31 days prior to the closing date, the Company’s carrying value of loans identified and approved by both parties, the aggregate amount of cash on hand and accrued interest on the loans acquired.

The Purchase Agreement contains certain customary representations, warranties, indemnities and covenants of the parties, and is subject to termination in certain circumstances. Sturdy Savings Bank recently received all regulatory approvals required for the acquisition of the branches. The transaction is expected to be completed during the first quarter of 2015, subject to customary closing conditions.

The following summarizes the branch assets and liabilities classified as held-for-sale at September 30, 2014 related to the Purchase Agreement:

 

Assets:
Cash		$	1,078
Loans held-for-sale			26,297
Properties and equipment, net			4,033
Total branch assets held-for-sale		$	31,408
Liabilities:
Deposits held-for-sale		$	192,068

 

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(3) Stock-Based Compensation

The Company accounts for stock-based compensation issued to employees, and when appropriate, non-employees, in accordance with the fair value recognition provisions of FASB ASC 718, Compensation – Stock Compensation, (“FASB ASC 718”). Under the fair value provisions of FASB ASC 718, stock-based compensation cost is measured at the grant date based on the fair value of the award and it is recognized as expense over the appropriate vesting period using the straight-line method. However, consistent with FASB ASC 718, the amount of stock-based compensation cost recognized at any date must at least equal the portion of the grant date value of the award that is vested at that date and, as a result, it may be necessary to recognize the expense using a ratable method. Although the provisions of FASB ASC 718 should generally be applied to non-employees, FASB ASC 505-50, Equity-Based Payments to Non-Employees, is used in determining the measurement date of the compensation expense for non-employees.

Determining the fair value of stock-based awards at measurement date requires judgment, including estimating the expected term of the stock options and the expected volatility of the Company’s stock. In addition, judgment is required in estimating the amount of stock-based awards that are expected to be forfeited. If actual results differ significantly from these estimates or different key assumptions were used, it could have a material effect on the Company’s unaudited condensed consolidated financial statements.

The Company’s stock-based incentive plans authorize the issuance of shares of common stock pursuant to awards that may be granted in the form of stock options to purchase common stock (“Options”) and awards of shares of common stock (“Stock Awards”). The purpose of the Company’s stock-based incentive plans is to attract and retain personnel for positions of substantial responsibility and to provide additional incentive to certain officers, directors, advisory directors, employees and other persons to promote the success of the Company. Under the Company’s stock-based incentive plans, Options generally expire ten years after the date of grant, unless terminated earlier under the Option’s terms. A committee of non-employee directors has the authority to determine the conditions upon which the Options granted will vest. Options are granted at the then fair market value of the Company’s stock. All or a portion of any Stock Awards earned as compensation by a director may be deferred under the Company’s Directors’ Deferred Fee Plan.

The Company declared a 1-for-5 reverse stock split effective August 11, 2014 for shareholders of record as of August 8, 2014. Prior periods have been revised to reflect the impact of this transaction.

Activity in the stock option plans for the nine months ended September 30, 2014 and September 30, 2013 was as follows:

Summary of Options Activity

 

		Number of Options				Weighted Average Exercise Price				Number of Options Exercisable
January 1, 2014			298,308			$	36.80				249,853
Granted			143,296				19.33				—
Exercised			(298	)			15.43				—
Forfeited			(19,496	)			16.98				—
Expired			(88,016	)			43.87				—
September 30, 2014			333,794			$	28.61				171,549
Options vested or expected to vest(1)			321,224			$	29.06				—

 

(1)	Includes vested shares and nonvested shares after the application of a forfeiture rate, which is based upon historical data.

 

		Number of Options				Weighted Average Exercise Price				Number of Options Exercisable
January 1, 2013			357,031			$	36.75				235,755
Granted			17,722				17.85				—
Exercised			—				—				—
Forfeited			(19,891	)			)18.25				—
Expired			(9,435				)53.65				—
September 30, 2013			345,427			$	36.40				277,775
Options vested or expected to vest(1)			285,582			$	36.60				—

 

(1)	Includes vested shares and nonvested shares after the application of a forfeiture rate, which is based upon historical data.

 

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The weighted average remaining contractual term was approximately 6.9 years for Options outstanding and 4.7 years for Options exercisable as of September 30, 2014.

At September 30, 2014, the aggregate intrinsic value was $114 thousand for Options outstanding and $27 thousand for Options exercisable.

During the nine months ended September 30, 2014 and 2013, the Company granted 143,296 Options and 17,722 Options, respectively. In accordance with FASB ASC 718, the fair value of the Options granted are estimated on the date of grant using the Black-Scholes option pricing model which uses the assumptions in the table below. The expected term of an Option is estimated using historical exercise behavior of employees at a particular level of management who were granted Options with a comparable term. The Options have historically been granted with a 10 year term. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of the grant. The expected volatility is based on the historical volatility of the Company’s stock price.

Significant weighted average assumptions used to calculate the fair value of the Options for the nine months ended September 30, 2014 and 2013 are as follows:

 

		For the Nine months Ended September 30,
		2014				2013
Weighted average fair value of Options granted		$	9.08			$	8.40
Weighted average risk-free rate of return			0.65	%			0.80	%
Weighted average expected option life in months			59				59
Weighted average expected volatility			46	%			62	%
Expected dividends(1)		$	—			$	—

 

(1)	To date, the Company has not paid cash dividends on its common stock.

A summary of the Company’s nonvested Stock Award activity during the nine months ended September 30, 2014 and 2013 are presented in the following tables:

Summary of Nonvested Stock Award Activity

 

		Number of Shares				Weighted Average Grant Date Fair Value
Nonvested Stock Awards outstanding, January 1, 2014			86,367			$	15.65
Issued			112,803				19.80
Vested			(8,403	)			17.26
Forfeited			(34,600	)			15.41
Nonvested Stock Awards outstanding, September 30, 2014			156,167			$	18.60

 

		Number of Shares				Weighted Average Grant Date Fair Value
Nonvested Stock Awards outstanding, January 1, 2013			127,807			$	16.50
Issued			82,019				17.70
Vested			(19,980	)			23.65
Forfeited			(35,531	)			15.35
Nonvested Stock Awards outstanding, September 30, 2013			154,315			$	16.50

There were 112,803 shares of nonvested Stock Awards issued during the nine months ended September 30, 2014 and 82,019 nonvested Stock Awards issued during the nine months ended September 30, 2013. The value of these shares is based upon the closing price of the common stock on the date of grant. Compensation expense is recognized on a straight-line basis over the service period for all of the nonvested Stock Awards issued.

 

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Total compensation expense recognized related to Options and nonvested Stock Awards, including that for non-employee directors, during the three and nine months ended September 30, 2014 was $276 thousand and $508 thousand, respectively, as compared to $193 thousand and $649 thousand, respectively, for the three and nine months ended September 30, 2013. As of September 30, 2014, there was approximately $1.1 million and $2.5 million of total unrecognized compensation cost related to Options and nonvested Stock Awards, respectively. The cost of the Options and Stock Awards is expected to be recognized over a weighted average period of 2.3 years and 3.4 years, respectively.

(4) Investment Securities

The amortized cost of investment securities and the approximate fair value at September 30, 2014 and December 31, 2013 were as follows:

 

		Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Estimated Fair Value
September 30, 2014
Available for sale:
U.S. Treasury securities		$	2,498			$	6			$	—			$	2,504
U.S. Government agency securities			4,972				—				(277	)			4,695
U.S. Government agency mortgage-backed securities			279,172				2,006				(1,572	)			279,606
Other mortgage-backed securities			268				1				—				269
State and municipal securities			28,977				2,044				—				31,021
Trust preferred securities			12,038				—				(2,338	)			9,700
Collateralized loan obligations			79,929				—				(728	)			79,201
Other securities			2,500				—				—				2,500
Total available for sale			410,354				4,057				(4,916	)			409,496
Held to maturity:
U.S. Government agency mortgage-backed securities			354				17				—				371
Other securities			250				—				—				250
Total held to maturity			604				17				—				621
Total investment securities		$	410,958			$	4,074			$	(4,916	)		$	410,116
December 31, 2013
Available for sale:
U.S. Treasury securities		$	2,496			$	4			$	—			$	2,500
U.S. Government agency securities			4,969				—				(562	)			4,407
U.S. Government agency mortgage-backed securities			325,316				1,043				(8,295	)			318,064
Other mortgage-backed securities			277				16				—				293
State and municipal obligations			29,240				1,213				—				30,453
Trust preferred securities			12,626				—				(4,659	)			7,967
Collateralized loan obligations			73,915				—				(686	)			73,229
Other securities			3,184				—				—				3,184
Total available for sale			452,023				2,276				(14,202	)			440,097
Held to maturity:
U.S. Government agency mortgage-backed securities			431				11				—				442
Other securities			250				—				—				250
Total held to maturity			681				11				—				692
Total investment securities		$	452,704			$	2,287			$	(14,202	)		$	440,789

 

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The following table provides the gross unrealized losses and fair value, aggregated by investment category and length of time the individual securities have been in a continuous unrealized loss position at September 30, 2014 and December 31, 2013:

Gross Unrealized Losses by Investment Category

 

		Less than 12 Months								12 Months or Longer								Total
		Estimated Fair Value				Gross Unrealized Losses				Estimated Fair Value				Gross Unrealized Losses				Estimated Fair Value				Gross Unrealized Losses
September 30, 2014
U.S. Government agency securities		$	—			$	—			$	4,695			$	(277	)		$	4,695			$	(277	)
U.S. Government agency mortgage-backed securities			37,212				(291	)			33,543				(1,281	)			70,755				(1,572	)
Trust preferred securities			—				—				9,700				(2,339	)			9,700				(2,339	)
Collateralized loan obligations			57,048				(381	)			22,153				(347	)			79,201				(728	)
Total		$	94,260			$	(672	)		$	70,091			$	(4,244	)		$	164,351			$	(4,916	)
December 31, 2013
U.S. Government agency securities		$	—			$	—			$	4,407			$	(562	)		$	4,407			$	(562	)
U.S. Government agency mortgage-backed securities			246,348				(7,374	)			7,961				(921	)			254,309				(8,295	)
Trust preferred securities			—				—				7,967				(4,659	)			7,967				(4,659	)
Collateralized Loan Obligations			45,729				(686	)											45,729				(686	)
Total		$	292,077			$	(8,060	)		$	20,335			$	(6,142	)		$	312,412			$	(14,202	)

The Company determines whether unrealized losses are temporary in accordance with FASB ASC 325-40, Investments – Other, when applicable, and FASB ASC 320-10, Investments – Overall, (“FASB ASC 320-10”). The evaluation is based upon factors such as the creditworthiness of the underlying borrowers, performance of the underlying collateral, if applicable, and the level of credit support in the security structure. Management also evaluates other factors and circumstances that may be indicative of an OTTI condition. These include, but are not limited to, an evaluation of the type of security, length of time and extent to which the fair value has been less than cost and near-term prospects of the issuer.

FASB ASC 320-10 requires the Company to assess if an OTTI exists by considering whether the Company has the intent to sell the security or it is more likely than not that it will be required to sell the security before recovery. If either of these situations applies, the guidance requires the Company to record an OTTI charge to earnings for the difference between the amortized cost basis of the security and the fair value of the security. If neither of these situations applies, the Company is required to assess whether it is expected to recover the entire amortized cost basis of the security. If the Company is not expected to recover the entire amortized cost basis of the security, the guidance requires the Company to bifurcate the identified OTTI into a credit loss component and a component representing loss related to other factors. A discount rate is applied which equals the effective yield of the security. The difference between the present value of the expected cash flows and the amortized book value is considered a credit loss. When a market price is not readily available, the market value of the security is determined using the same expected cash flows; the discount rate is a rate the Company determines from open market and other sources as appropriate for the security. The difference between the market value and the present value of cash flows expected to be collected is recognized in accumulated other comprehensive loss on the consolidated statements of financial condition. Application of this guidance resulted in no OTTI charges during the nine months ended September 30, 2014 and 2013.

 

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The following is a roll-forward for the three and nine months ended September 30, 2014 and 2013 of OTTI charges recognized in earnings as a result of credit losses on investments:

 

		For the Three Months Ended September 30,
		2014				2013
Cumulative OTTI, beginning of period		$	10,203			$	10,203
Additional increase as a result of net impairment losses recognized on investments			—				—
Decrease as a result of the sale of an investment with net impairment losses			—				—
Cumulative OTTI, end of period		$	10,203			$	10,203

 

		For the Nine months Ended September 30,
		2014				2013
Cumulative OTTI, beginning of period		$	10,203			$	10,203
Additional increase as a result of net impairment losses recognized on investments			—				—
Decrease as a result of the sale of an investment with net impairment losses			—				—
Cumulative OTTI, end of period		$	10,203			$	10,203

On December 10, 2013, the Board of Governors of the Federal Reserve System (“FRB”), the Office of the Comptroller of the Currency (“OCC”), the Federal Deposit Insurance Corporation (“FDIC”), the Commodity Futures Trading Commission (“CFTC”) and the Securities and Exchange Commission (“SEC’) issued final rules to implement the Volcker Rule contained in section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), generally to become effective on July 21, 2015. The Volcker Rule prohibits an insured depository institution and its affiliates (referred to as “banking entities”) from: (i) engaging in “proprietary trading” and (ii) investing in or sponsoring certain types of funds (“covered funds”) subject to certain limited exceptions. These prohibitions impact the ability of U.S. banking entities to provide investment management products and services that are competitive with nonbanking firms generally and with non-U.S. banking organizations in overseas markets. The rule also effectively prohibits short-term trading strategies by any U.S. banking entity if those strategies involve instruments other than those specifically permitted for trading.

U.S. Government Agency Securities. At September 30, 2014, the gross unrealized loss in the category of 12 months or longer of $277 thousand consisted of one agency security with an estimated fair value of $4.7 million issued and guaranteed by a U.S. Government sponsored agency. The Company monitors certain factors such as market rates and possible credit deterioration to determine if an OTTI exists. As of September 30, 2014, management concluded that an OTTI did not exist on the aforementioned security based upon its assessment. Management also concluded that it does not intend to sell the security, and that it is not more likely than not it will be required to sell the security before recovery, which may be maturity, and management expects to recover the entire amortized cost basis of the security.

U.S. Government Agency Mortgage-Backed Securities. At September 30, 2014, the gross unrealized loss in the category of less than 12 months of $291 thousand consisted of seven mortgage-backed securities with an estimated fair value of $37.2 million, the gross unrealized loss in the category of 12 months or longer of $1.3 million consisted of six mortgage-backed securities with an estimated fair value of $33.5 million issued and guaranteed by a U.S. Government sponsored agency. The Company monitors certain factors such as market rates and possible credit deterioration to determine if an OTTI exists. As of September 30, 2014, management concluded that an OTTI did not exist on any of the aforementioned securities based upon its assessment. Management also concluded that it does not intend nor will it be required to sell the securities, before their recovery, which may be maturity, and management expects to recover the entire amortized cost basis of these securities.

Collateralized Loan Obligation Securities. At September 30, 2014, the gross unrealized loss in the category of less than 12 months of $381 thousand consisted of five AAA and five AA-rated collateralized loan obligation securities with an estimated fair value of $57.0 million, the gross unrealized loss in the category of 12 months or longer of

 

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$347 thousand consisted of two AAA and one AA-rated collateralized loan obligation securities with an estimated fair value of $22.2 million The Company monitors key credit metrics such as delinquencies, defaults, cumulative losses and credit support levels to determine if an OTTI exists. As of September 30, 2014, management concluded that an OTTI did not exist on any of the aforementioned securities based upon its assessment. Management also concluded that it does not intend nor will it be required to sell the securities, before their recovery, which may be maturity, and management expects to recover the entire amortized cost basis of these securities.

At September 30, 2014, the Company had 13 collateralized loan obligation securities with an amortized cost of $79.9 million and an estimated fair value of $79.2 million. These securities are subject to the provisions of the Volcker Rule. However, a final determination has yet to be made whether banks will be required to divest these investments. Discussion has been ongoing among the regulators, Congress and the investors in the collateralized loan obligations. Based on the current status of these discussions and through the Company’s communication with its investment advisors, the Company believes it will either be able to hold these collateralized loan obligation investments in its portfolio or have them modified such that the perceived risk will be adequately eliminated. As such, the Company believes it will not be required to sell these securities prior to recovery and therefore would not be required to record an OTTI charge on these securities. To ensure compliance, in the three months ended June 30, 2014, the Company began proactively transitioning its collateralized loan obligation investments into similar securities which are structured such that they satisfy the provisions of the Volcker Rule.

Trust Preferred Securities. At September 30, 2014, the gross unrealized loss in the category of 12 months or longer of $2.3 million consisted of two trust preferred securities. The trust preferred securities are comprised of one non-rated single issuer security with an amortized cost of $3.2 million and an estimated fair value of $2.9 million, and one investment grade rated pooled security with an amortized cost of $8.8 million and an estimated fair value of $6.8 million. As this security recently received ratings upgrades from multiple agencies, it is no longer deemed non-investment grade.

For the pooled security, the Company monitors each issuer in the collateral pool with respect to financial performance using data from the issuer’s most recent regulatory reports as well as information on issuer deferrals and defaults. Also, the security structure is monitored with respect to collateral coverage and current levels of subordination. Expected future cash flows are projected assuming additional defaults and deferrals based on the performance of the collateral pool. The pooled security is in a senior position in the capital structure. The security had a 3.2 times principal coverage. As of the most recent reporting date, interest has been paid in accordance with the terms of the security. The Company reviews projected cash flow analysis for adverse changes in the present value of projected future cash flows that may result in an other-than-temporary credit impairment to be recognized through earnings. The most recent valuations assumed no recovery on any defaulted collateral, no recovery on any deferring collateral and an additional 3.6% of defaults or deferrals’ every three years with no recovery rate. As of September 30, 2014, management concluded that an OTTI did not exist on the aforementioned security based upon its assessment. Management also concluded that it does not intend to sell the security, and that it is not more likely than not it will be required to sell the security, before its recovery, which may be maturity, and management expects to recover the entire amortized cost basis of this security.

The financial performance of the non-rated single issuer trust preferred security is monitored on a quarterly basis using data from the issuer’s most recent regulatory reports to assess the probability of cash flow impairment. Expected future cash flows are projected by incorporating the contractual cash flow of the security adjusted, if necessary, for potential changes in the amount or timing of cash flows due to the underlying creditworthiness of the issuer and covenants in the security.

In August 2009, the issuer of the non-rated single issuer trust preferred security elected to defer its normal quarterly dividend payment. As contractually permitted, the issuer may defer dividend payments up to five years with accumulated dividends, and interest on those deferred dividends, payable upon the resumption of its scheduled dividend payments. The issuer is currently operating under an agreement with its regulators. The agreement stipulates that the issuer must receive permission from its regulators prior to resuming its scheduled dividend payments. In September 2014, the deferred dividends of $590 thousand were paid by the issuer. This payment was recorded as a reduction of outstanding principal for this security.

During the nine months ended September 30, 2014, the Company did not record an OTTI credit-related charge related to this deferring single issuer trust preferred security. Based on the Company’s most recent evaluation, and based upon the aforementioned receipt of dividend payments, the Company does not expect the issuer to default on the security based primarily on the issuer’s subsidiary bank reporting that it meets the minimum regulatory requirements to be considered a “well capitalized” institution. The Company recognizes that the difficult economic environment and some weakened performance measures, while recently improving, increased the probability that a full recovery of principal may not be realized. The cumulative OTTI on this security as of September 30, 2014 was $1.2 million. Based upon the current capital position of the issuer and recent improvements in the financial performance of the issuer, the Company concluded that an additional impairment charge was not warranted at September 30, 2014.

 

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The pooled security was included in the non-exclusive list of issuers that meet the requirements of the interim final rule release by the agencies and therefore will not be required to be sold by the Company. The single issuer security is not subject to the provisions of the Volcker rule.

The amortized cost and estimated fair value of the investment securities, by contractual maturity, at September 30, 2014 and December 31, 2013 are shown below. Actual maturities will differ from contractual maturities as borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

September 30, 2014		Available for Sale								Held to Maturity
		Amortized Cost				Estimated Fair Value				Amortized Cost				Estimated Fair Value
Due in one year or less		$	2,252			$	2,252			$	—			$	—
Due after one year through five years			3,043				3,072				250				250
Due after five years through ten years			27,912				28,461				—				—
Due after ten years			97,707				95,836				—				—
Total investment securities, excluding mortgage-backed securities			130,914				129,621				250				250
U.S. Government agency mortgage-backed securities			279,172				279,606				354				371
Other mortgage-backed securities			268				269				—				—
Total investment securities		$	410,354			$	409,496			$	604			$	621
December 31, 2013
Due in one year or less		$	3,184			$	3,184			$	—			$	—
Due after one year through five years			3,430				3,490				250				250
Due after five years through ten years			35,452				35,460				—				—
Due after ten years			84,364				79,606				—				—
Total investment securities, excluding mortgage-backed securities			126,430				121,740				250				250
U.S. Government agency mortgage-backed securities			325,316				318,064				431				442
Other mortgage-backed securities			277				293				—				—
Total investment securities		$	452,023			$	440,097			$	681			$	692

At September 30, 2014, the Company had $28.0 million, amortized cost, and $29.9 million, estimated fair value, of investment securities pledged to secure public deposits. As of September 30, 2014, the Company had $165.3 million, amortized cost, and $166.1 million, estimated fair value, of investment securities pledged as collateral on secured borrowings.

(5) Loans

The components of loans as of September 30, 2014 and December 31, 2013 were as follows:

Loan Components

 

		September 30, 2014				December 31, 2013
Commercial:
Commercial and industrial		$	297,909			$	478,734
CRE owner occupied			321,597				468,442
CRE non-owner occupied			505,823				576,084
Land and development			71,438				64,306
Consumer:
Home equity lines of credit			151,369				188,478
Home equity term loans			21,858				25,279
Residential real estate			299,838				305,552
Other			6,577				30,829
Total gross loans held-for-investment			1,676,409				2,137,704
Allowance for loan losses			(26,540	)			(35,537	)
Net loans held-for-investment		$	1,649,869			$	2,102,167

 

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Loans on Non-Accrual Status

 

		September 30, 2014				December 31, 2013
Commercial:
Commercial & industrial		$	305			$	2,358
CRE owner occupied			2,321				14,408
CRE non-owner occupied			352				1,969
Land and development			—				2,158
Consumer:
Home equity lines of credit			3,021				3,749
Home equity lines of credit, held-for-sale			1,137
Home equity term loans			696				1,240
Home equity term loans, held-for-sale			327
Residential real estate			6,651				3,341
Residential real estate, held-for-sale			1,306
Other			206				591
Other, held-for-sale			—
Total non-accrual loans		$	16,322			$	29,814
Troubled debt restructuring, non-accrual		$	528			$	8,163

Many of the Company’s commercial and industrial loans have a real estate component as part of the collateral securing the loan. Additionally, the Company makes commercial real estate loans for the acquisition, refinance, improvement and construction of real property. Loans secured by owner-occupied properties are dependent upon the successful operation of the borrower’s business. If the operating company experiences difficulties in terms of sales volume and/or profitability, the borrower’s ability to repay the loan may be impaired. Loans secured by properties where repayment is dependent upon payment of rent by third-party tenants or the sale of the property may be impacted by loss of tenants, lower lease rates needed to attract new tenants or the inability to sell a completed project in a timely fashion and at a profit.

As of September 30, 2014, the Company had $66.4 million outstanding on 15 residential construction, commercial construction and land development relationships for which the agreements included interest reserves. As of December 31, 2013, the Company had $54.5 million outstanding on 17 residential construction, commercial construction and land development relationships for which the agreements included interest reserves. The total amount available in those reserves to fund interest payments was $3.0 million and $4.3 million at September 30, 2014 and December 31, 2013, respectively. There were no relationships with interest reserves which were on non-accrual status at September 30, 2014 and December 31, 2013. Construction projects are monitored throughout their lives by the Company through either internal resources or professional inspectors engaged by the Company. The budgets for loan advances and borrower equity injections are developed at the time of underwriting in conjunction with the review of the plans and specifications for the project being financed. Advances of the Company’s funds are based on the prepared budgets and will not be made unless the project has been inspected by the Company’s professional inspector who must certify that the work related to the advance is in place and properly complete. As it relates to construction project financing, the Company does not extend, renew or restructure terms unless its borrower posts cash collateral in an interest reserve.

Included in the Company’s loan portfolio are modified commercial loans. Per FASB ASC 310-40, Troubled Debt Restructuring, (“FASB ASC 310-40”), a modification is one in which the creditor, for economic or legal reasons related to the debtor’s financial difficulties, grants a concession to the debtor that it would not otherwise consider, such as providing a below market interest rate and/or forgiving principal or previously accrued interest; this modification may stem from an agreement or be imposed by law or a court, and may involve a multiple note structure. Generally, prior to the modification, the loans which are modified as a troubled debt restructuring (“TDR”) are already classified as non-performing. These loans may only be returned to performing (i.e. accrual status) after considering the borrower’s sustained repayment performance for a reasonable amount of time, generally six months; this sustained repayment performance may include the period of time just prior to the restructuring.

 

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(6) Allowance for Loan Losses

Changes in the allowance for loan losses were as follows:

Allowance for Loan Losses and Recorded Investment in Financing Receivables

 

		For the Nine months Ended September 30, 2014
		Commercial				Home Equity(1)				Residential Real Estate				Other(2)				Total
Allowance for loan losses:
Beginning balance		$	27,828			$	3,375			$	2,898			$	1,436			$	35,537
Charge-offs			(18,859	)			(2,639	)			(1,811	)			(3,262	)			(26,571	)
Recoveries			2,111				199				193				267				2,771
Net charge-offs			(16,747	)			(2,440	)			(1,618	)			(2,995	)			(23,800	)
Provision for loan losses			8,355				2,481				2,041				1,926				14,803
Ending balance		$	19,436			$	3,416			$	3,321			$	367			$	26,540
Ending balance: individually evaluated for impairment		$	—			$	—			$	—			$	—			$	—
Ending balance: collectively evaluated for impairment		$	19,436			$	3,416			$	3,321			$	367			$	26,540
Financing Receivables:
Ending balance		$	1,196,767			$	173,227			$	299,838			$	6,577			$	1,676,409
Ending balance: individually evaluated for impairment		$	3,202			$	3,550			$	6,948			$	142			$	13,842
Ending balance: collectively evaluated for impairment		$	1,193,565			$	169,677			$	292,890			$	6,435			$	1,662,567

 

(1)	Amount includes both home equity lines of credit and term loans.

(2)	Includes the unallocated portion of the allowance for loan losses.

 

		For the Nine months Ended September 30, 2013
		Commercial				Home Equity(1)				Residential Real Estate				Other(2)				Total
Allowance for loan losses:
Beginning balance		$	33,197			$	2,734			$	3,333			$	6,609			$	45,873
Charge-offs			(5,234	)			(1,391	)			(180	)			(664	)			(7,469	)
Recoveries			10,786				401				10				241				11,438
Net recoveries (charge-offs)			5,552				(990	)			(170	)			(423	)			3,969
Provision for loan losses			1,914				1,826				(277	)			(4,451	)			(988	)
Ending balance		$	40,663			$	3,570			$	2,886			$	1,735			$	48,854
Ending balance: individually evaluated for impairment		$	8,372			$	36			$	13			$	19			$	8,440
Ending balance: collectively evaluated for impairment		$	32,291			$	3,534			$	2,873			$	1,716			$	40,414
Financing Receivables:
Ending balance		$	1,636,856			$	218,163			$	281,537			$	32,984			$	2,169,540
Ending balance: individually evaluated for impairment		$	45,297			$	4,543			$	4,814			$	632			$	55,286
Ending balance: collectively evaluated for impairment		$	1,591,559			$	213,620			$	276,723			$	32,352			$	2,114,254

 

(1)	Amount includes both home equity lines of credit and term loans

(2)	Includes the unallocated portion of the allowance for loan losses.

 

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Risk Characteristics

Commercial Loans. Included in this segment is commercial and industrial, commercial real estate owner occupied, commercial real estate non-owner occupied, and land and development. Many of the Company’s commercial and industrial loans have a real estate component as part of the collateral securing the accommodation. Commercial real estate owner occupied loans rely on the cash flow from the successful operation of the borrower’s business to make repayment. If the operating company experiences difficulties in terms of sales volume and/or profitability, the borrower’s ability to repay the loan may be impaired. Commercial real estate non-owner occupied loans rely on the payment of rent by third-party tenants. The borrower’s ability to repay the loan or sell the property may be impacted by loss of tenants, lower lease rates needed to attract new tenants or the inability to sell a completed project in a timely fashion and at a profit. Commercial and industrial loans are primarily secured by assets of the business, such as accounts receivable and inventory. Due to the nature of the collateral securing these loans, the liquidation of these assets may be problematic and costly. Commercial real estate owner occupied and non-owner occupied loans are secured by the underlying properties. The local economy and real estate market affect the appraised value of these properties which may impact the ultimate repayment of these loans. Land and development loans are primarily repaid by the sale of the developed properties or by conversion to a permanent term loan. These loans are dependent upon the completion of the project on time and within budget, which may be impacted by general economic conditions. The Company requires cash collateral in an interest reserve in order to extend credit on construction projects to mitigate the credit risk.

Home Equity Loans. This segment consists of both home equity lines of credit and home equity term loans on single family residences. These loans rely on the personal income of the borrower for repayment which may be impacted by economic conditions, such as unemployment levels, interest rates and the housing market. These loans are primarily secured by second liens on properties. The secondary source of repayment may be impaired by the real estate market and local regulations.

Residential Real Estate Loans. Included in this segment are residential mortgages on single family residences. These loans rely on the personal income of the borrower for repayment which may be impacted by economic conditions, such as unemployment levels, interest rates and the housing market. These loans are primarily secured by liens on the underlying properties. The secondary source of repayment may be impaired by the real estate market and local regulations.

Other Loans. Other loans consist of personal credit lines, mobile home loans and consumer installment loans. These loans rely on the borrowers’ personal income for repayment and are either unsecured or secured by personal use assets and mobile homes. These loans may be impacted by economic conditions such as unemployment levels. The liquidation of the assets securing these loans may be difficult and costly.

The allowance for loan losses was $26.5 million and $35.5 million at September 30, 2014 and December 31, 2013, respectively. The ratio of allowance for loan losses to gross loans held-for-investment was 1.58% at September 30, 2014 and 1.66% at December 31, 2013.

The provision for loan losses charged to expense is based upon historical loan loss and recovery experience, a series of qualitative factors and an evaluation of estimated losses in the current loan portfolio, including the evaluation of impaired loans under FASB ASC 310, Receivables (“FASB ASC 310”). Values assigned to the qualitative factors and those developed from historic loss and recovery experience provide a dynamic basis for the calculation of reserve factors for both pass-rated loans (general pooled allowance) and those criticized and classified loans that continue to perform.

A loan is considered to be impaired when, based upon current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan. An insignificant delay or insignificant shortfall in amount of payments does not necessarily result in a loan being identified as impaired. For this purpose, delays less than 90 days are considered to be insignificant. Impairment losses are included in the provision for loan losses in the unaudited condensed consolidated statements of operations. Loans not individually reviewed are evaluated as a group using reserve factor percentages based on historical loss and recovery experience and qualitative factors. Such loans generally include consumer loans, residential real estate loans and small business loans. In determining the appropriate level of the general pooled allowance, management makes estimates based on internal risk ratings, which take into account such factors as debt service coverage, loan-to-value ratios, management’s abilities and external factors.

 

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The following table presents the Company’s components of impaired loans receivable, segregated by class of loans. Commercial and consumer loans that were collectively evaluated for impairment are not included in the data that follows:

 

		Recorded Investment				Unpaid Principal Balance				Related Allowance				Average Recorded Investment				Accrued Interest Income Recognized				Cash Interest Income Recognized
For the Nine months Ended September 30, 2014
With no related allowance:
Commercial:
Commercial & industrial		$	295			$	297			$	—			$	1,041			$	19			$	—
CRE owner occupied			2,541				3,086				—				2,157				—				—
CRE non-owner occupied			352				352				—				97				—				—
Land and development			140				223				—				302				—				—
Consumer:
Home equity lines of credit			695				776				—				549				—				—
Home equity lines of credit, held-for-sale			327				602				—				449				—				—
Home equity term loans			3,020				3,578				—				2,054				—				—
Home equity term loans, held-for-sale			1,172				3,361				—				1,849				—				—
Residential real estate			6,853				7,997				—				4,923				—				97
Residential real estate, held-for-sale			1,306				1,298				—				1,136				—				—
Other			206				398				—				141				—				—
Other, held-for-sale			—				—				—				—				—				—
Total commercial		$	3,237			$	3,958			$	—			$	3,597			$	19			$	—
Total consumer		$	13,578			$	18,012			$	—			$	11,099			$	—			$	97
For the Year Ended December 31, 2013
With no related allowance:
Commercial:
Commercial & industrial		$	3,206			$	3,281			$	—			$	1,884			$	—			$	—
CRE owner occupied			18,503				27,367				—				13,528				—				—
CRE non-owner occupied			1,969				2,251				—				66				—				—
Land and development			2,512				2,549				—				2,669				—				—
Consumer:
Residential real estate			2,569				3,135				—				1,689				—				—
Home Equity Lines of Credit			3,749				5,051				—				3,132				—				—
Home Equity Term Loans			1,238				1,456				—				918				—				—
Other			560				1,567				—				481				—				—
With an allowance recorded:
Commercial:
Commercial & industrial		$	423			$	425			$	423			$	73			$	—			$	—
CRE owner occupied			2,164				2,164				494				47				—				—
Consumer:
Other			26				27				17				16				—				—
Total commercial		$	28,777			$	38,037			$	917			$	18,267			$	—			$	—
Total consumer		$	8,142			$	11,236			$	17			$	6,236			$	—			$	—

 

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In accordance with FASB ASC 310, those impaired loans which are collateral dependent do not result in a specific allowance for loan losses. Included in impaired loans at September 30, 2014 were three TDRs, all of which were collateral dependent. In addition, there were no TDRs at September 30, 2014 that included a commitment to lend additional funds as of September 30, 2014.

There were no new TDR agreements entered into during the three and nine months ended September 30, 2014 or the three months ended September 30, 2013. The following table presents a summary of the Company’s TDR agreements entered into during the nine months ended September 30, 2013.

 

		Troubled Debt Restructurings
		For the Nine months Ended September 30, 2013
		Number of Contracts				Pre-Modification Outstanding Recorded Investment				Post- Modification Outstanding Recorded Investment
Commercial and industrial			1			$	1,417				1,392
CRE Owner occupied			1				413				406
Residential real estate			1				199				197

The following tables present information regarding the types of concessions granted on loans that were restructured during the nine months ended September 30, 2013:

 

		Troubled Debt Restructurings
		For the Nine months Ended September 30, 2013
		Number of Contracts				Concession Granted
Commercial and industrial			1			Modified principal repayment terms.
CRE Owner occupied			1			Interest rate concession.
Residential real estate			1			Modified term debt to interest only for a six month period.

During the three and nine months ended September 30, 2014 and 2013, the Company did not have any TDR agreements that had subsequently defaulted that were entered into within the respective preceding twelve months. All TDRs are currently on non-accrual status.

The following table presents the Company’s distribution of risk ratings within the held-for-investment loan portfolio, segregated by class, as of September 30, 2014 and December 31, 2013:

Credit Quality Indicators by Internally Assigned Grade

 

		Commercial & industrial				CRE owner occupied				CRE non- owner occupied				Land and development				Home Equity Lines of Credit				Home Equity Term Loans				Residential Real Estate				Other
As of September 30, 2014
Grade:
Pass		$	292,564			$	300,262			$	494,448			$	71,301			$	146,204			$	21,146			$	298,885			$	6,418
Special Mention			3,773				15,836				10,539				—				—				—				—				—
Substandard			1,572				5,499				836				137				5,165				712				6,953				159
Doubtful			—				—				—				—				—				—				—				—
Total		$	297,909			$	321,597			$	505,823			$	71,438			$	151,369			$	21,858			$	299,838			$	6,577
As of December 31, 2013
Grade:
Pass		$	415,875			$	407,486			$	550,426			$	61,303			$	181,796			$	24,016			$	299,625			$	29,994
Special Mention			37,064				17,741				9,464				494				—				—				—				—
Substandard			25,372				41,051				16,194				2,509				6,682				1,263				5,927				809
Doubtful			423				2,164				—				—				—				—				—				26
Total		$	478,734			$	468,442			$	576,084			$	64,306			$	188,478			$	25,279			$	305,552			$	30,829

 

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The Company’s primary tool for assessing risk when evaluating a loan in terms of its underwriting, structure, documentation and eventual collectability is a risk rating system where the loan is assigned a numeric value. Behind each numeric category is a defined set of characteristics reflective of the particular level of risk.

The risk rating system is based on a fourteen point grade using a two-digit scale. The upper seven grades are for “pass” categories, the middle grade is for the “criticized” category, while the lower six grades represent “classified” categories which are equivalent to the guidelines utilized by the OCC.

The portfolio manager is responsible for assigning, maintaining, and documenting accurate risk ratings for all commercial loans and commercial real estate loans. The portfolio manager assigns a risk rating at the inception of the loan, reaffirms it annually, and adjusts the rating based on the performance of the loan. As part of the loan review process, a regional credit officer will review risk ratings for accuracy. The portfolio manager’s risk rating will also be reviewed periodically by the loan review department and the Bank’s regulators.

To calculate risk ratings in a consistent fashion, the Company uses a Risk Rating Methodology that assesses quantitative and qualitative components which include elements of its financial condition, abilities of management, position in the market, collateral and guarantor support and the impact of changing conditions. When combined with professional judgment, an overall risk rating is assigned.

Aging of Receivables

 

		30-59 Days Past Due				60-89 Days Past Due				90 Days Past Due				Total Past Due				Current				Total Financing Receivables				Loans 90 Days Past Due and Accruing
As of September 30, 2014
Commercial:
Commercial & industrial		$	48			$	201			$	299			$	548			$	296,813			$	297,909			$	—
CRE owner occupied			918				—				351				1,269				319,059				321,597				—
CRE non-owner occupied			3,474				124				1,607				5,205				500,618				505,823				—
Land and development			—				—				140				140				71,298				71,438				—
Consumer:																											—
Home equity lines of credit			1,715				908				1,781				4,404				146,965				151,369
Home equity term loans			272				274				306				852				21,006				21,858				—
Residential real estate			3,572				1,496				4,780				9,848				289,990				299,838				—
Other			37				85				186				308				6,269				6,577				—
Total		$	10,036			$	3,088			$	9,450			$	22,574			$	1,653,835			$	1,676,409			$	—
As of December 31, 2013
Commercial:
Commercial & industrial		$	9,149			$	2,726			$	3,452			$	15,327			$	463,407			$	478,734			$	—
CRE owner occupied			4,901				5,865				3,753				14,519				453,923				468,442				—
CRE non-owner occupied			899				4,661				1,070				6,630				569,454				576,084				—
Land and development			—				—				2,512				2,512				61,794				64,306				—
Consumer:
Home equity lines of credit			3,030				1,457				2,324				6,811				181,667				188,478				—
Home equity term loans			1,032				223				825				2,080				23,199				25,279				—
Residential real estate			12,776				1.927				1,086				15,789				289,763				305,552				—
Other			340				202				378				920				29,909				30,829				—
Total		$	32,127			$	17,061			$	15,400			$	64,588			$	2,073,116			$	2,137,704			$	—

 

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(7) Real Estate Owned

Real estate owned at September 30, 2014 and December 31, 2013 was as follows:

 

		September 30, 2014				December 31, 2013
Commercial properties		$	1,030			$	1,227
Residential properties			54				1,276
Bank properties			—				—
Total		$	1,084			$	2,503

Summary of Real Estate Owned Activity

 

		Commercial Properties				Residential Properties				Bank Properties				Total
Beginning balance, January 1, 2014		$	1,227			$	1,276			$	—			$	2,503
Transfers into real estate owned			—				567				—				567
Sale of real estate owned			—				(1,721	)			—				(1,721	)
Reserve for losses in real estate owned			(197	)			(68	)			—				(265	)
Ending balance, September 30, 2014		$	1,030				54				—				1,084

(8) Derivative Financial Instruments and Hedging Activities

The Company is exposed, to varying degrees, to interest rate, market and credit risk through the use of derivative financial instruments. The Company manages these risks as part of its asset and liability management process and through credit policies and procedures. The Company seeks to minimize counterparty credit risk by establishing credit limits and collateral agreements. The Company utilizes certain derivative financial instruments to enhance its ability to manage interest rate risk that exists as part of its ongoing business operations. In general, the derivative transactions entered into by the Company fall into one of two types: a fair value hedge of a specific fixed-rate loan agreement and an economic hedge of a derivative offering to a Bank customer. The Company does not use derivative financial instruments for trading purposes.

Fair Value Hedges – Interest Rate Swaps. The Company utilizes interest rate swap agreements to hedge interest rate risk. The designated hedged items are subordinated notes related to commercial loans that provide a fixed interest receipt for the Company. The interest rate risk is the uncertainty of future interest rate levels and the impact of changes in rates on the fair value of the loans. The hedging of interest rate risk is intended to reduce the volatility of the fair value of the loans due to changes in the interest rate market.

The Company previously entered into interest rate swaps with a counterparty whereby the Company makes payments based on a fixed interest rate and receives payments from the counterparty based on a floating interest rate, both calculated based on the principal amount of the underlying subordinated note, without the exchange of the underlying principal. The Company no longer enters into these interest rate swap transactions, the last of which occurred in August 2007. The interest rate swaps are designated as fair value hedges under FASB ASC 815, Derivatives and Hedging (“FASB ASC 815”). The critical terms assessed by the Company for each hedge of subordinated notes include the notional amounts of the swap compared to the principal amount of the notes, expiration/maturity dates, benchmark interest rate, prepayment terms and cash payment dates. At September 30, 2014 and December 31, 2013, the total outstanding notional amount of these swaps was $10.5 million and $21.2 million, respectively. For each of these swap agreements, the floating rate is based on the one-month London Interbank Offered Rate (“LIBOR”) paid on the first day of the month which matches the interest payment date on each subordinated note. The expiration dates for these swap agreements range from February 1, 2015 to August 1, 2022 and are consistent with the underlying subordinated note maturities and the swaps had a fair value of $0 at inception. At hedge inception and on an ongoing basis, conditions supporting hedge effectiveness are evaluated. The Company believes that all conditions required in paragraph ASC 815-20-25-104 have been met, as all terms of the subordinated note and the interest rate swap match. Because the Company’s evaluations have concluded that the critical terms of the subordinated notes and the interest rate swaps meet the criteria outlined in ASC 815-20-25-104, the “short-cut” method of accounting is applied, which assumes there is no ineffectiveness of a hedging arrangement’s ability to hedge risk as changes in the interest rate component of the swaps’ fair value are expected to exactly offset the corresponding changes in the fair value of the underlying subordinated notes, as described above. Because the hedging arrangement is considered perfectly effective, changes to the underlying benchmark interest rates considered in the valuation of these instruments do not result in a net impact to earnings; however, there may be fair value adjustments related to credit quality variations between counterparties, which may impact earnings as required by FASB ASC 820, Fair Value Measurements and Disclosures (“FASB ASC 820”). The fair value adjustments related to credit quality were not material as of September 30, 2014 and December 31, 2013.

 

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The following tables provide information pertaining to interest rate swaps designated as fair value hedges under FASB ASC 815 at September 30, 2014 and December 31, 2013:

Summary of Interest Rate Swaps Designated As Fair Value Hedges

 

		September 30, 2014								December 31, 2013
Balance Sheet Location		Notional				Fair Value				Notional				Fair Value
Other liabilities		$	10,472			$	(953	)		$	21,172			$	(1,632	)

Summary of Interest Rate Swap Components

 

		September 30, 2014				December 31, 2013
Weighted average pay rate			7.15	%			6.94	%
Weighted average receive rate			2.06	%			2.04	%
Weighted average maturity in years			2.30				1.9

Customer Derivatives – Interest Rate Swaps/Floors. The Company enters into interest rate swaps that allow our commercial loan customers to effectively convert a variable-rate commercial loan agreement to a fixed-rate commercial loan agreement. Under these agreements, the Company enters into a variable-rate loan agreement with a customer in addition to an interest rate swap agreement, which serves to effectively swap the customer’s variable-rate loan into a fixed-rate loan. The Company then enters into a corresponding swap agreement with a third party in order to economically hedge its exposure on the variable and fixed components of the customer agreement. The interest rate swaps with both the customers and third parties are not designated as hedges under FASB ASC 815 and are marked to market through earnings. As the interest rate swaps are structured to offset each other, changes to the underlying benchmark interest rates considered in the valuation of these instruments do not result in an impact to earnings; however, there may be fair value adjustments related to credit quality variations between counterparties, which may impact earnings as required by FASB ASC 820. The Company recognized $140 thousand in expense and $510 thousand in income resulting from fair value adjustments during the nine months ended September 30, 2014 and 2013, respectively, which were included in the derivative credit valuation adjustment in the unaudited condensed consolidated statements of operations in other income.

 

		September 30, 2014								December 31, 2013
Balance Sheet Location		Notional				Fair Value				Notional				Fair Value
Other assets		$	205,970			$	14,257			$	251,207			$	23,299
Other liabilities			(205,970	)			(14,380	)			251,207				(23,526	)

In addition, the Company has entered into an interest rate floor sale transaction with one commercial customer. The Company entered into corresponding interest rate floor purchase transactions with a third party in order to offset its exposure on the variable and fixed components of the customer agreements. As the interest rate floors with both the customer and the third party are not designated as hedges under FASB ASC 815, the instruments are marked to market through earnings. As the interest rate floors are structured to offset each other, changes to the underlying benchmark interest rates considered in the valuation of these instruments do not result in a net impact to earnings; however, there may be fair value adjustments related to credit quality variations between counterparties, which may impact earnings as required by FASB ASC 820. There were no fair value adjustments for the interest rate floor transactions for the three and nine months ended September 30, 2014 and 2013. The combined notional amount of the two interest rate floors was $14.6 million and $15.2 million at September 30, 2014 and December 31, 2013, respectively. These transactions are recorded in other assets in the unaudited condensed consolidated statements of financial condition.

Interest rate lock commitments on residential mortgages. As a part of its normal residential mortgage operations, the Bank entered into an interest rate lock commitment with a potential borrower. The Bank entered into a corresponding commitment to an investor to sell that loan at a specific price shortly after origination. In accordance with FASB ASC 820, adjustments are recorded through earnings in mortgage banking revenue, net in the unaudited condensed consolidated statements of operations to account for the net change in fair value of these transactions. For the three and nine months ended September 30, 2014, the Company recognized an decrease of $225 thousand and $119 thousand, respectively, compared to a decrease of $457 thousand and an increase of $499 thousand for the three and nine months ended September 30, 2013, respectively, in fair value adjustments. The interest rate lock commitments are recorded at fair value in other assets in the unaudited condensed consolidated statements of financial condition. The fair value of the interest rate lock commitments was $0 and $119 thousand at September 30, 2014 and December 31, 2013, respectively. There were no loans in the held-for-sale pipeline at September 30, 2014.

 

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(9) Deposits

Deposits consist of the following major classifications:

 

		September 30, 2014				December 31, 2013
Interest-bearing demand deposits		$	909,484			$	1,179,292
Non-interest-bearing demand deposits			519,814				561,006
Savings deposits			230,857				266,573
Time certificates under $100,000			227,824				300,309
Time certificates $100,000 or more			179,395				206,461
Brokered time deposits			103,253				107,930
Total		$	2,170,627			$	2,621,571

(10) Loss Per Share

Basic (loss) earnings per share is computed by dividing net (loss) income available to common shareholders by the weighted average number of shares of common stock outstanding, net of any treasury shares, during the period. Diluted earnings per share is calculated by dividing net (loss) income available to common shareholders by the weighted average number of shares of common stock outstanding, net of any treasury shares, after consideration of the potential dilutive effect of common stock equivalents, based upon the treasury stock method using an average market price for the period.

The Company declared a 1 for 5 reverse stock split effective August 11, 2014 for shareholders of record as of August 8, 2014. Prior periods have been revised to reflect the impact of this transaction.

Loss Per Share Computation

 

		For the Three Months Ended September 30,
		2014				2013
Net loss		$	(825	)		$	(4,862	)
Average common shares outstanding			17,949,643				17,299,917
Net effect of dilutive common stock equivalents			—				—
Adjusted average shares outstanding – dilutive			17,949,643				17,299,917
Basic loss per share		$	(0.05	)		$	(0.28	)
Diluted loss per share		$	(0.05	)		$	(0.28	)

 

		For the Nine Months Ended September 30,
		2014				2013
Net loss		$	(26,979	)		$	(1,731	)
Average common shares outstanding			17,574,246				17,271,273
Net effect of dilutive common stock equivalents			—				—
Adjusted average shares outstanding – dilutive			17,574,246				17,271,273
Basic loss per share		$	(1.54	)		$	(0.10	)
Diluted loss per share		$	(1.54	)		$	(0.10	)

 

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(11) Commitments and Contingent Liabilities

Letters of Credit

In the normal course of business, the Company has various commitments and contingent liabilities, such as customers’ letters of credit (including standby letters of credit of $24.5 million and $34.6 million at September 30, 2014 and December 31, 2013, respectively) which are not reflected in the accompanying unaudited condensed consolidated financial statements. Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

Reserve for Unfunded Commitments

The Company maintains a reserve for unfunded loan commitments and letters of credit which is reported in other liabilities in the unaudited condensed consolidated statements of financial condition consistent with FASB ASC 825, Financial Instruments. As of September 30, 2014, the Company recorded estimated losses inherent with unfunded loan commitments in accordance with FASB ASC 450, Contingencies, and estimated future obligations under letters of credit in accordance with FASB ASC 460, Guarantees. The methodology used to determine the adequacy of this reserve is integrated in the Company’s process for establishing the allowance for loan losses and considers the probability of future losses and obligations that may be incurred under these off-balance sheet agreements. The reserve for unfunded loan commitments and letters of credit at September 30, 2014 and December 31, 2013 was $739 thousand and $454 thousand, respectively. Management believes this reserve level is sufficient to absorb estimated probable losses related to these commitments.

Reserve for Residential Mortgage Loans Sold with Recourse

The Company maintains a reserve for residential mortgage loans sold with recourse to third-party purchasers which is reported in other liabilities in the unaudited condensed consolidated statements of financial condition. The Company records estimated losses inherent with residential mortgage loans sold with recourse in accordance with FASB ASC 450, Contingencies. This reserve is determined based upon the probability of future losses which is calculated using historical Company and industry loss data. The reserve for residential mortgage loan recourse as of September 30, 2014 and December 31, 2013 was $765 thousand and $647 thousand, respectively. Management believes this reserve level is sufficient to address potential recourse exposure.

(12) Fair Value of Financial Instruments

The Company accounts for fair value measurement in accordance with FASB ASC 820. FASB ASC 820 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. FASB ASC 820 does not require any new fair value measurements. The definition of fair value retains the exchange price notion in earlier definitions of fair value. FASB ASC 820 clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability. The definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price). FASB ASC 820 emphasizes that fair value is a market-based measurement, not an entity-specific measurement and also clarifies the application of fair value measurement in a market that is not active.

FASB ASC 820 describes three levels of inputs that may be used to measure fair value:

— Level 1 – Quoted prices in active markets for identical assets or liabilities.

— Level 2 – Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include: quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability; and inputs that are derived principally from or corroborated by observable market data by correlation or other means.

— Level 3 – Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.

 

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FASB ASC 820 requires the Company to disclose the fair value for financial assets on both a recurring and non-recurring basis. The assets and liabilities measured at fair value on a recurring basis are as follows:

 

						Category Used for Fair Value Measurement
September 30, 2014		Total				Level 1				Level 2				Level 3
Assets:
Investment securities available for sale:
U.S. Treasury securities		$	2,504			$	2,504			$	—			$	—
U.S. Government agency securities			4,695				—				4,695				—
U.S. Government agency mortgage-backed securities			279,606				—				279,606				—
Other mortgage-backed securities			269				—				269				—
State and municipal securities			31,021				—				31,021				—
Trust preferred securities			9,700				—				—				9,700
Collateralized loan obligations			79,201				—				79,201				—
Other securities			2,500				2,500				—				—
Hedged commercial loans			11,429				—				11,429				—
Residential mortgage loans held-for-sale			4,298				—				4,298				—
Interest rate swaps			14,257				—				14,257				—
Interest rate floor			24				—				24				—
Liabilities:
Fair value interest rate swaps			953				—				953				—
Interest rate swaps			14,355				—				14,355				—
Interest rate floor			24				—				24				—
December 31, 2013
Assets:
Investment securities available for sale:
U.S. Treasury securities		$	2,500			$	2,500			$	—			$	—
U.S. Government agency securities			4,407				—				4,407				—
U.S. Government agency mortgage-backed securities			318,064				—				318,064				—
Other mortgage-backed securities			293				—				293				—
State and municipal obligations			30,453				—				30,453				—
Trust preferred securities			7,967				—				—				7,967
Collateralized loan obligations			73,229				—				73,229				—
Other securities			3,184				3,184				—				—
Hedged commercial loans			22,435				—				22,435				—
Residential loans held-for-sale			20,662				—				20,662				—
Interest rate lock commitments on residential mortgages			119				—				—				119
Interest rate swaps			23,299				—				23,299				—
Interest rate floor			132				—				132				—
Liabilities:
Fair value interest rate swaps			1,635				—				1,635				—
Interest rate swaps			23,526				—				23,526				—
Interest rate floor			132				—				132				—

Level 1 Valuation Techniques and Inputs

U.S. Treasury securities. The Company reports U.S. Treasury securities at fair value utilizing Level 1 inputs. These securities are priced using observable quotations for the indicated security.

Other securities. The other securities category is comprised of money market mutual funds. Given the short maturity structure and the expectation that the investment can be redeemed at par value, the fair value of these investments is assumed to be the book value.

 

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Level 2 Valuation Techniques and Inputs

The majority of the Company’s investment securities are reported at fair value utilizing Level 2 inputs. Prices of these securities are obtained through independent, third-party pricing services. Prices obtained through these sources include market derived quotations and matrix pricing and may include both observable and unobservable inputs. Fair market values take into consideration data such as dealer quotes, new issue pricing, trade prices for similar issues, prepayment estimates, cash flows, market credit spreads and other factors. The Company reviews the output from the third-party providers for reasonableness by the pricing consistency among securities with similar characteristics, where available, and by comparing values with other pricing sources available to the Company.

In general, the Level 2 valuation process uses the following significant inputs in determining the fair value of the Company’s different classes of investments:

U.S. Government agency securities. These securities are evaluated based on either a nominal spread basis for non-callable securities or on an option adjusted spread (“OAS”) basis for callable securities. The nominal spread and OAS levels are based on observations of identical or comparable securities actively trading in the markets.

U.S. Government agency mortgage-backed securities. The Company’s agency mortgage-backed securities generally fall into one of two categories, fixed-rate agency mortgage-backed pools or adjustable-rate agency mortgage-backed pools.

Fixed-rate agency mortgage-backed pools are valued based on spreads to actively traded To-Be-Announced (“TBA”) and seasoned securities, the pricing of which is provided by inter-dealer brokers, broker dealers and other contributing firms active in trading the security class. Further delineation is made by weighted average coupon (“WAC”) and weighted average maturity (“WAM”) with spreads on individual securities relative to actively traded securities as determined and quality controlled using OAS valuations.

Adjustable-rate agency mortgage-backed pools are valued on a bond equivalent effective margin (“BEEM”) basis obtained from broker-dealers and other contributing firms active in the market. BEEM levels are established for key sectors using characteristics such as month-to-roll, index, periodic and life caps and index margins and convertibility. Individual securities are then evaluated based on how their characteristics map to the sectors established.

Other mortgage-backed securities. The Company’s other mortgage-backed securities consist of whole loan, non-agency collateralized mortgage obligations (“CMOs,” individually, each a “CMO”). These securities are valued based on generic tranches and generic prepayment speed estimates of various types of collateral from contributing firms and broker/dealers in the whole loan CMO market.

State and municipal obligations. These securities are valued using information on identical or similar securities provided by market makers, broker/dealers and buy-side firms, new issue sales and bid-wanted lists. The individual securities are then priced based on mapping the characteristics of the security such as obligation type (general obligation, revenue, etc.), maturity, state discount and premiums, call features, taxability and other considerations.

Collateralized loan obligations. The fair value measurements for collateralized loan obligations are obtained through quotes obtained from broker/dealers based on similar actively traded securities. Those valuations are classified as Level 2.

Hedged commercial loans. The hedged commercial loans are one component of a declared hedging relationship as defined under FASB ASC 815. The interest rate swap component of the declared hedging relationship is carried at its fair value and the carrying value of the commercial loans included a similar change in fair values. The fair value of these loans is estimated through discounted cash flow analysis which utilizes available credit and interest rate market data on performance of similar loans. This is considered a Level 2 input.

Residential mortgage loans held-for-sale. The Company’s residential mortgage loans held-for-sale are recorded at fair value utilizing Level 2 measurements. This fair value measurement is determined based upon third party quotes obtained on similar loans. The Company believes the fair value measurement of such loans reduces certain timing differences between related revenue and expense recognition in the Company’s financial statements and better aligns with the management of the portfolio from a business perspective. The fair value option allows the Company to record the mortgage loans held-for-sale portfolio at fair market value as opposed to the lower of cost or market. The Company economically hedges its residential loans held for sale portfolio with forward sale agreements which are reported at fair value. A lower of cost or market accounting treatment would not allow the Company to record the excess of the fair market value over book value but would require the Company to record the corresponding reduction in value on the hedges. Both the loans and related hedges are carried at fair value which reduces earnings volatility. For loans held-for-sale for which the fair value option has been elected, the aggregate fair value exceeded the aggregate principal balance by $73 thousand as of

 

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September 30, 2014. Interest income on these loans is recognized in interest and fees on loans in the unaudited condensed consolidated statements of operations. There were no residential mortgage loans held-for-sale that were nonaccrual or 90 or more days past due as of September 30, 2014 or December 31, 2013.

Interest rate swaps. The Company’s interest rate swaps, including fair value interest rate swaps and small exposures in interest rate caps and floors, are reported at fair value utilizing models provided by an independent, third-party and observable market data. When entering into an interest rate swap agreement, the Company is exposed to fair value changes due to interest rate movements, and also the potential nonperformance of our contract counterparty. Interest rate swaps are evaluated based on a zero coupon LIBOR curve created from readily observable data on LIBOR, interest rate futures and the interest rate swap markets. The zero coupon curve is used to discount the projected cash flows on each individual interest rate swap. In addition, the Company has developed a methodology to value the nonperformance risk based on internal credit risk metrics and the unique characteristic of derivative instruments, which include notional exposure rather than principal at risk and interest payment netting. The results of this methodology are used to adjust the base fair value of the instrument for the potential counterparty credit risk. Interest rate caps and floors are evaluated using industry standard options pricing models and observed market data on LIBOR and Eurodollar option and cap/floor volatilities.

Level 3 Valuation Techniques and Inputs

Trust preferred securities. The trust preferred securities are evaluated on a quarterly basis based on whether the security is an obligation of a single issuer or part of a securitization pool. For single issuer obligations, the Company uses discounted cash flow models which incorporate the contractual cash flow for each issue adjusted as necessary for any potential changes in amount or timing of cash flows. The cash flow model of a pooled issue incorporates anticipated loss rates and severities of the underlying collateral as well as credit support provided within the securitization. At least quarterly, the Company’s Treasury personnel reviews the modeling assumptions which include default assumptions, discount and forward rates. Changes in those assumptions could potentially have a significant impact on the fair value of the trust preferred securities.

The cash flow model for the pooled issue owned by the Company at September 30, 2014 assumes no recovery on defaulted collateral, no recovery on securities in deferral and an additional 3.6% future default rate assumption on the remaining performing collateral every three years with no recovery rate.

For trust preferred securities, projected cash flows are discounted at a rate based on a trading group of similar securities quoted on the New York Stock Exchange (“NYSE”) or over-the-counter markets which is reviewed for market data points such as credit rating, maturity, price and liquidity. The Company indexes the securities to a comparable maturity interest rate swap to determine the market spread, which is then used as the discount rate in the cash flow models. As of the reporting date, the market spreads were 3.0% for the pooled security and 6.00% for the single issuer that is currently deferring interest payments. An increase or decrease of three percentage points in the discount rate on the pooled issue would result in a decrease of $1.9 million or an increase of $2.8 million in the security fair value, respectively. An increase or decrease of three percentage points in the discount on the single issuer would result in a decrease of $793 thousand or an increase of $1.3 million in the security fair value, respectively.

The following provides details of the Level 3 fair value measurement activity for the three and nine months ended September 30, 2014 and 2013:

Fair Value Measurements Using Significant Unobservable Inputs-Level 3

Investment Securities

 

		For the Three Months Ended September 30,
		2014				2013
Balance, beginning of period		$	9,473			$	7,675
Total gains, realized/unrealized:
Included in earnings			—				—
Included in accumulated other comprehensive income			816				97
Purchases			—
Maturities			—				—
Prepayments			(589	)			—
Calls			—				—
Transfers out of Level 3			—				—
Balance, end of period		$	9,700			$	7,772

 

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		For the Nine Months Ended September 30,
		2014				2013
Balance, beginning of period		$	7,967			$	5,882
Total gains, realized/unrealized:
Included in earnings			—				—
Included in accumulated other comprehensive income			2,322				1,890
Purchases			—				10,500
Maturities			—				—
Prepayments			(589	)			—
Calls			—				—
Transfers into Level 3			—				(10,500	)
Balance, end of period		$	9,700			$	7,772

There were no transfers between the three levels for the three or nine months ended September 30, 2014. There was a transfer between Level 3 and Level 2 of the fair value hierarchy during the nine months ended September 30, 2013 for a change in valuation method of collateralized loan obligation investment securities. The valuation method used as of March 31, 2013 was a third party pricing service that utilized model-based valuations, whereby the inputs could change based on changes in market indices, selling prices of similar securities, management’s assumptions related to the credit rating of the security, prepayment assumptions and other factors such as credit loss assumptions and management’s assertion of the current market conditions. The transfer occurred on April 1, 2013 and the fair value valuation method was changed as of that same date to utilize market-based broker quotes, which is deemed a Level 2 input. The Company evaluates its hierarchy on a quarterly basis to ensure proper classification.

Interest rate lock commitments on residential mortgages. The determination of the fair value of interest rate lock commitments is based on agreed upon pricing with the respective investor on each loan and includes a pull through percentage. The pull through percentage represents an estimate of loans in the pipeline to be delivered to an investor versus the total loans committed for delivery. Significant changes in this input could result in a significantly higher or lower fair value measurement. As the pull through percentage is a significant unobservable input, this is deemed a Level 3 valuation input. The pull through percentage, which is based upon historical experience, was 75% at December 31, 2013. The fair value of interest rate lock commitments was $0 at September 30, 2014 and $119 thousand at December 31, 2013.

Fair Value Measurements Using Significant Unobservable Inputs-Level 3

Interest Rate Lock Commitments on Residential Mortgages

 

		For the Three Months Ended September 30,
		2014				2013
Balance, beginning of period		$	225			$	804
Total gains, realized/unrealized:
Included in earnings(1)			(225	)			(456	)
Included in accumulated other comprehensive income			—				—
Purchases			—				—
Maturities			—				—
Prepayments			—				—
Calls			—				—
Transfers into Level 3			—				—
Balance, end of period		$	—			$	348

 

(1)	Amount included in mortgage banking revenue, net on the consolidated statements of operations.

 

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		For the Nine months Ended September 30,
		2014				2013
Balance, beginning of period		$	119			$	847
Total gains, realized/unrealized:
Included in earnings(1)			(119	)			(499	)
Included in accumulated other comprehensive income			—				—
Purchases			—				—
Maturities			—				—
Prepayments			—				—
Calls			—				—
Transfers into Level 3			—				—
Balance, end of period		$	—			$	348

 

(1)	Amount included in mortgage banking revenue, net on the consolidated statements of operations.

Certain assets are measured at fair value on a nonrecurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). The Company measures impaired loans, Small Business Administration (“SBA”) servicing assets, restricted equity investments, goodwill, loans held-for-sale, and loans or bank properties transferred into other real estate owned at fair value on a non-recurring basis. At September 30, 2014 and 2013, these assets were valued in accordance with GAAP and, except for impaired loans, loans held-for-sale, and real estate owned included in the following table, did not require fair value disclosure under the provisions of FASB ASC 820. The related changes in fair value for the nine months ended September 30, 2014 and 2013 are as follows:

 

						Category Used for Fair Value Measurement												Total Losses Or Changes in Net Assets / Liabilities
		Total				Level 1				Level 2				Level 3
September 30, 2014
Assets:
Impaired loans		$	2,796			$	—			$	—			$	2,796			$	(3,711	)
Loans held-for-sale, at lower of cost or market			2,770								2,770								(3,079	)
Real estate owned			226				—				—				226				(264	)
September 30, 2013
Assets:
Impaired loans		$	45,802			$	—			$	—			$	45,802			$	(11,332	)
Real estate owned			837				—				—				837				(167	)

Under FASB ASC 310, the fair value of collateral dependent impaired loans is based on the fair value of the underlying collateral, typically real estate, which is based on valuations. It is the policy of the Company to obtain a current appraisal or evaluation when a loan has been identified as non-performing. The type of appraisal obtained will be commensurate with the size and complexity of the loan. The resulting value will be adjusted for the potential cost of liquidation and decline of values in the market. New appraisals will be obtained on an annual basis until the loan is repaid in full, liquidated, or returns to performing status.

While the loan policy dictates that a loan be assigned to the special assets department when it is placed on non-accrual status, there is a need for loan officers to consistently and accurately determine collateral values when a loan is initially designated as criticized or classified. The most effective means of determining the fair value of real estate collateral at a point in time is by obtaining a current appraisal or evaluation of the property. In anticipation of the receipt of a current appraisal or evaluation, the Company has provided for an alternative and interim means of determining the fair value of the real estate collateral.

The most recent appraisal or reported value of the collateral securing a loan, net of a discount for the estimated cost of liquidation, is the Company’s basis for determining fair value.

The following table summarizes the Company’s appraisal approach based upon loan category.

 

Loan Category Used for Impairment Review		Method of Determining the Value
Loans less than $1 million		Evaluation report or restricted use appraisal
Loans $1 million or greater
Existing appraisal 18 months or less		Restricted use appraisal
Existing appraisal greater than 18 months		Summary form appraisal
Commercial loans secured primarily by residential real estate
Loans less than $1 million		Automated valuation model
Loans $1 million or greater		Summary form appraisal
Non-commercial loans secured primarily by residential real estate
Loans less than $250 thousand		Automated valuation model or summary form appraisal
Loans $250 thousand or greater		Summary form appraisal

 

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An evaluation report, as defined by the OCC, is a written report prepared by an appraiser that describes the real estate collateral, its condition, current and projected uses and sources of information used in the analysis, and provides an estimate of value in situations when an appraisal is not required.

A restricted use appraisal is defined as a written report prepared under the Uniform Standards of Professional Appraisal Practice (“USPAP”). A restricted use appraisal is for the Company’s use only and should contain a brief statement of information significant to the determination of the value of the collateral under review. This report can be used for ongoing collateral monitoring.

A summary form appraisal is defined as a written report prepared under the USPAP which contains a detailed summary of all information significant to the determination of the collateral valuation. This report is more detailed than a restricted use report and provides sufficient information to enable the user to understand the rationale for the opinions and conclusions in the report.

An automated valuation model is an internal computer program that estimates a property’s market value based on market, economic, and demographic factors.

On a quarterly basis, or more frequently as necessary, the Company will review the circumstances of each collateral dependent loan and real estate owned property. A collateral dependent loan is defined as one that relies solely on the operation or the sale of the collateral for repayment. Adjustments to any specific reserve relating to a collateral shortfall, as compared to the outstanding loan balance, will be made if justified by appraisals, market conditions or current events concerning the loan.

All appraisals received which are utilized to determine valuations for criticized and classified loans or properties placed in real estate owned are provided under an “as is” value. Partially charged off loans are measured for impairment upon receipt of an updated appraisal based on the relationship between the remaining balance of the charged down loan and the discounted appraised value. Such loans will remain on non-accrual status unless performance by the borrower warrants a return to accrual status. Recognition of non-accrual status occurs at the time a loan can no longer support principal and interest payments in accordance with the original terms and conditions of the loan documents. When impairment is determined, a specific reserve reflecting any calculated shortfall between the value of the collateral and the outstanding balance of the loan is recorded. Subsequent adjustments, prior to receipt of a new appraisal, to any related specific reserve will be made if justified by market conditions or current events concerning the loan. If an internal discount-based evaluation is being used, the discount percentage may be adjusted to reflect market changes, changes to the collateral value of similar loans or circumstances of the individual loan itself. The amount of the charge-off is determined by calculating the difference between the current loan balance and the current collateral valuation, plus estimated cost to liquidate.

Impaired loan fair value measurements are based upon unobservable inputs, and therefore, are categorized as a Level 3 measurement. There were no impaired loans with specific reserves at September 30, 2014. Impaired loans with an aggregate gross carrying amount of $6.8 million at September 30, 2013, included specific reserves in the allowance for loan losses of $6.3 million as the collateral underlying these loans had a fair value of $498 thousand. There were no charge-offs recorded on impaired loans with a specific reserve during the nine months ended September 30, 2014, and 2013. Impaired loans held-for-investment with an aggregate carrying amount of $2.8 million and $45.3 million at September 30, 2014 and 2013, respectively, did not include specific reserves as the value of the underlying collateral was not below the carrying amount. However, these loans did include charge-offs of $4.0 million, of which $3.7 million related to loans that were fully charged off at September 30, 2014 and $5.1 million, of which $2.9 million related to loans which were fully charged off at September 30, 2013.

Loans held-for-sale, at lower of cost or market with an aggregate carrying amount of $2.8 million at September 30, 2014, included market adjustments of $707 thousand and charge-offs of $2.4 million, respectively, in the three and nine months ended September 30, 2014 to reduce the balance of the loans to fair value. The fair value of these loans was determined through the use of broker quotes based on market data; therefore, this is a level 2 input.

 

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Once a loan is determined to be uncollectible, the underlying collateral is repossessed and reclassified as other real estate owned. The balance of other real estate owned can also include bank properties transferred from operations. These assets are carried at lower of cost or fair value of the collateral, less cost to sell. In some cases, adjustments are made to the appraised values for various factors including age of the appraisal, age of comparable properties included in the appraisal, and known changes in the market and the collateral. During the nine months ended September 30, 2014 and 2013, the Company recorded a decrease in fair value on commercial properties of $197 thousand and $167 thousand, respectively, and $68 thousand and $0 on consumer properties, respectively. These adjustments were based upon unobservable inputs, and therefore categorized as Level 3 measurements.

Carrying Amounts and Estimated Fair Values of Financial Assets and Liabilities

 

		September 30, 2014								December 31, 2013
		Carrying Amount				Estimated Fair Value				Carrying Amount				Estimated Fair Value
Assets:
Cash and due from banks		$	36,603			$	36,603			$	38,075			$	38,075
Interest-earning bank balances			467,321				467,321				229,687				229,687
Restricted cash			13,000				13,000				26,000				26,000
Investment securities available for sale			409,496				409,496				440,097				440,097
Investment securities held-to-maturity			604				621				681				692
Loans receivable, net			1,638,440				1,569,079				2,079,732				1,964,856
Loans held-for-sale, at fair value			4,595				4,595				20,662				20,662
Loans held-for-sale, at lower of cost or market			2,770				3,350				—				—
Hedged commercial loans(1)			11,429				11,429				22,435				22,435
Branch assets held-for-sale			27,375				27,375				—				—
Restricted equity investments			14,979				14,979				17,019				17,019
Interest rate lock commitments on residential mortgages			—				—				119				119
Interest rate swaps			14,257				14,257				23,299				23,299
Interest rate floor			24				24				132				132
Liabilities:
Demand deposits			1,429,299				1,461,968				1,740,298				1,795,685
Savings deposits			230,857				234,695				266,573				272,264
Time deposits			510,471				510,137				614,700				615,735
Deposits held-for-sale			192,068				208,903				—				—
Securities sold under agreements to repurchase – customers			963				963				478				478
Advances from FHLBNY			60,830				60,917				60,956				61,072
Junior subordinated debentures			92,786				67,681				92,786				63,747
Fair value interest rate swaps			953				953				1,632				1,632
Interest rate swaps			14,356				14,356				23,526				23,526
Interest rate floor			24				24				132				132

 

(1)	Includes positive market value adjustment of $953 thousand and $1.6 million at September 30, 2014 and December 31, 2013, respectively, which is equal to the change in value of related interest rate swaps designated as fair value hedges of these hedged loans in accordance with FASB ASC 815.

Cash and cash equivalents. For cash and cash equivalents, the carrying amount is a reasonable estimate of fair value. This is a Level 1 fair value input.

Restricted cash. For restricted cash, the carrying amount is a reasonable estimate of fair value. This is a Level 1 fair value input.

Investment securities. For investment securities, fair values are based on a combination of quoted prices for identical assets in active markets, quoted prices for similar assets in markets that are either actively or not actively traded and price models, discounted cash flow methodologies, or similar techniques that may contain unobservable inputs that are supported by little or no market activity and require significant judgment. The fair value of available-for-sale securities is measured utilizing Level 1, Level 2, and Level 3 inputs. The fair value of held-to-maturity securities is measured utilizing Level 2 inputs.

Loans receivable. The fair value of loans receivable is estimated using discounted cash flow analysis. Projected future cash flows are calculated using loan characteristics, and assumptions of voluntary and involuntary prepayment speeds. For performing loans, Level 2 inputs are utilized as the cash flow analysis is

 

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performed using available market data on the performance of similar loans. Projected cash flows are prepared using discount rates believed to represent current market rates. For non-performing loans, the cash flow assumptions are considered Level 3 inputs as market data is not readily available.

Loans held-for-sale, at fair value. Loans held-for-sale, at fair value generally includes residential mortgage loans that are originated with the intent to sell. These loans are recorded at fair value under FASB ASC 825. The fair value of loans held-for-sale is valued using the quoted market price of such loans, which is a Level 2 input.

Loans held-for-sale, at lower of cost or market. Loans held-for-sale, at lower of cost or market includes consumer loans identified for sale out of the portfolio. These loans are recorded at lower of cost or market. The fair value of these loans is determined through the use of broker quotes based on market data; therefore, this is a level 2 input.

Hedged commercial loans. The hedged commercial loans are one component of a declared hedging relationship as defined under FASB ASC 815. The interest rate swap component of the declared hedging relationship is carried at its fair value and the carrying value of the commercial loans includes a similar change in fair values. The fair value of these loans is measured utilizing Level 2 inputs.

Branch assets held-for-sale. This category includes loans receivable and cash balances, identified at certain branches for sale. As these assets are under agreement of sale at net book value, the carrying value is deemed to equal fair value. This is a level 2 fair value input.

Restricted equity securities. Ownership in equity securities of Federal Reserve Bank of Philadelphia (the “Federal Reserve Bank”), FHLBNY and Atlantic Central Bankers Bank is restricted and there is no established market for their resale. The carrying amount is a reasonable estimate of fair value. The fair value is based on Level 2 inputs.

Interest rate lock commitments on residential mortgages. The fair value of interest rate lock commitments is estimated using pricing from existing purchase commitments on each loan in the pipeline. This value is adjusted for a pull through estimate which is determined based on historical experience with loan deliveries from the residential mortgage pipeline. As this estimate is unobservable and can result in significant fluctuation in the fair value determination, this is considered a Level 3 input under the fair value hierarchy.

Interest rate swaps/floors and fair value interest rate swaps. The Company’s derivative financial instruments are not exchange-traded and therefore are valued utilizing models with the primary input being readily observable market parameters, specifically the LIBOR swap curve. In addition, the Company incorporates a qualitative fair value adjustment related to credit quality variations between counterparties as required by FASB ASC 820. This is a level 2 input.

Demand deposits, savings deposits and time deposits. The fair value of demand deposits and savings deposits is determined by projecting future cash flows using an estimated economic life based on account characteristics, a Level 2 input. The resulting cash flow is discounted using rates available on alternative funding sources. The fair value of time deposits is estimated using the rate and maturity characteristics of the deposits to estimate their cash flow. This cash flow is discounted at rates for similar term wholesale funding.

Deposits held-for-sale. The fair value is determined by applying the agreed upon deposit premium per a branch sale agreement. This is a level 2 input.

Securities sold under agreements to repurchase – customer. The fair value is estimated to be the amount payable at the reporting date. This is considered a Level 2 input.

Securities sold under agreements to repurchase – FHLBNY advances. The fair value is estimated through Level 2 inputs by determining the cost or benefit for early termination of the individual borrowing.

Junior subordinated debentures. The fair value was estimated by discounting approximate cash flows of the borrowings by yields estimating the fair value of similar issues. The valuation model considers current market spreads, known and anticipated credit issues of the underlying collateral, term and reinvestment period and market transactions of similar issues, if available. This is a Level 3 input under the fair value hierarchy.

The fair value estimates presented herein are based on pertinent information available to management as of September 30, 2014 and December 31, 2013. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these condensed consolidated financial statements since those dates and, therefore, current estimates of fair value may differ significantly from the amount presented herein.

 

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(13) Regulatory Matters

The Company is subject to risk-based capital guidelines adopted by the FRB for bank holding companies. The Bank is also subject to similar capital requirements adopted by the OCC. Under the requirements the federal bank regulatory agencies have established quantitative measures to ensure that minimum thresholds for Total Capital, Tier 1 Capital and Leverage (Tier 1 Capital divided by average assets) ratios (set forth in the table below) are maintained. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets and certain off-balance sheet items as calculated under regulatory practices.

The Company’s and the Bank’s capital amounts and classifications are also subject to qualitative judgments by the federal bank regulators about components, risk weightings and other factors. The Company’s and the Bank’s risk-based capital ratios have been computed in accordance with regulatory practices. The Company and the Bank were in compliance with these regulatory capital requirements of the FRB and the OCC as of September 30, 2014. As discussed below and elsewhere herein, additional capital requirements have been imposed on the Bank by the OCC, which the Bank was also in full compliance with as of September 30, 2014 and December 31, 2013.

On April 15, 2010, the Bank entered into a written agreement with the OCC (the “OCC Agreement”) which contained requirements to develop and implement a profitability and capital plan which provides for the maintenance of adequate capital to support the Bank’s risk profile in the current economic environment. The capital plan was also required to contain a dividend policy allowing dividends only if the Bank is in compliance with the capital plan, and obtains prior approval from the OCC. During the second quarter of 2010, the Company delivered its profit and capital plans to the OCC. Updated profit and capital plans were subsequently submitted as required.

The Bank also agreed to: (a) implement a program to protect the Bank’s interest in criticized or classified assets, (b) review and revise the Bank’s loan review program; (c) implement a program for the maintenance of an adequate allowance for loan losses; and (d) revise the Bank’s credit administration policies. During the second quarter of 2010, the Company revised and implemented changes to policies and procedures pursuant to the OCC Agreement. The Bank initially agreed that its brokered deposits would not exceed 3.5% of its total liabilities unless approved by the OCC. However, effective October 18, 2012, the OCC approved an increase of this limit to 6.0%. Management does not expect this restriction will limit its access to liquidity as the Bank does not rely on brokered deposits as a major source of funding. As of September 30, 2014, the Bank’s brokered deposits represented 4.0% of its total liabilities.

In addition, the Company is required to seek the prior approval of the Federal Reserve Bank before paying interest, principal or other sums on trust preferred securities or any related subordinated debentures, declaring or paying cash dividends or taking dividends from the Bank, repurchasing outstanding stock or incurring indebtedness. The Company is also required to take certain remedial steps and submit plans and progress reports to the Federal Reserve Bank.

The Bank is also subject to individual minimum capital ratios established by the OCC requiring the Bank to continue to maintain a Leverage ratio at least equal to 8.50% of adjusted total assets, to continue to maintain Tier 1 Capital ratio at least equal to 9.50% of risk-weighted assets and to maintain a Total Capital ratio at least equal to 11.50% of risk-weighted assets. At September 30, 2014, the Bank met all of the three capital ratios established by the OCC as its Leverage ratio was 9.41%, its Tier 1 Capital ratio was 15.00%, and its Total Capital ratio was 16.26%.

 

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The following table provides both the Company’s and the Bank’s risk-based capital ratios as of September 30, 2014 and December 31, 2013.

Regulatory Capital Levels

 

		Actual								For Capital Adequacy Purposes								To Be Well Capitalized Under Prompt Corrective Action Provision(1)
		Amount				Ratio				Amount				Ratio				Amount				Ratio
September 30, 2014
Total capital (to risk-weighted assets):
Sun Bancorp, Inc.		$	321,777				17.98	%		$	143,139				8.00	%			N/A
Sun National Bank			289,955				16.24				142,854				8.00			$	178,567				10.00	%
Tier I capital (to risk-weighted assets):
Sun Bancorp, Inc.			279,140				15.60				71,569				4.00				N/A
Sun National Bank			267,902				15.01				71,427				4.00				107,140				6.00
Leverage ratio:
Sun Bancorp, Inc.			279,140				9.79				114,027				4.00				N/A
Sun National Bank			267,902				9.41				113,892				4.00				142,365				5.00
December 31, 2013
Total capital (to risk-weighted assets):
Sun Bancorp, Inc.		$	332,295				14.41	%		$	184,494				8.00	%			N/A
Sun National Bank			314,107				13.65				184,070				8.00			$	230,088				10.00	%
Tier I capital (to risk-weighted assets):
Sun Bancorp, Inc.			284,781				12.34				92,247				4.00				N/A
Sun National Bank			285,257				12.40				92,035				4.00				138,053				6.00
Leverage ratio:
Sun Bancorp, Inc.			284,781				8.99				126,682				4.00				N/A
Sun National Bank			285,257				9.02				126,479				4.00				158,099				5.00

 

(1)	Not applicable for bank holding companies.

On June 30, 2014, for regulatory capital purposes, the Company contributed $7.5 million in additional capital to the Bank.

In August 2014, the Company raised approximately $20 million in equity through a privately negotiated sale of its common stock to several institutions and private investors. The Company issued a total of 1,133,144 shares of common stock in this transaction at a price per share of $17.65.

At September 30, 2014 and December 31, 2013, although the Company and the Bank exceeded the regulatory minimum ratios for classification as “well capitalized,” due to the fact that it was subject to the OCC Agreement, it cannot be deemed “well capitalized.”

On July 2, 2013, the federal banking regulatory agencies, including the FRB and the OCC, approved the final Basel III capital rules for U.S. banking institutions.

The ability of the Bank to pay dividends to the Company is controlled by certain regulatory restrictions. Generally, dividends declared in a given year by a national bank are limited to its net profit, as defined by regulatory agencies, for that year, combined with its retained net income for the preceding two years, less any required transfer to surplus or to fund for the retirement of any preferred stock. In addition, a national bank may not pay any dividends in an amount greater than its undivided profits and a national bank may not declare any dividends if such declaration would leave the bank inadequately capitalized. Therefore, the ability of the Bank to declare dividends will depend on its future net income and capital requirements. Also, banking regulators have indicated that national banks should generally pay dividends only out of current operating earnings. Following this guidance, the Bank would not be able to pay a dividend to the Company at September 30, 2014. Moreover, per the OCC Agreement and the Federal Reserve Bank requirements referenced above, a dividend may only be declared if it is in accordance with the approved capital plan, the Bank remains in compliance with the capital plan following the payment of the dividend and the dividend is approved by the OCC and the Federal Reserve Bank.

 

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The Company’s capital securities qualify as Tier 1 capital under federal regulatory guidelines. These instruments are subject to a 25% capital limitation under risk-based capital guidelines developed by the FRB. Under FRB rules, restricted core capital elements, which are qualifying trust preferred securities, qualifying cumulative perpetual preferred stock (and related surplus) and certain minority interests in consolidated subsidiaries, are limited in the aggregate to no more than 25% of a bank holding company’s core capital elements (including restricted core capital elements), net of goodwill less any associated deferred tax liability. However, under the Dodd-Frank Act, bank holding companies are prohibited from including in their Tier 1 capital hybrid debt and equity securities, including trust preferred securities, issued on or after May 19, 2010. Any such instruments issued before May 19, 2010 by a bank holding company, such as the Company, with total consolidated assets of less than $15 billion as of December 31, 2009, may continue to be included as Tier 1 capital (subject to the 25% limitation). The portion that exceeds the 25 percent capital limitation qualifies as Tier 2, or supplementary capital of the Company. At September 30, 2014, $69.8 million of a total of $90.0 million in capital securities qualified as Tier 1 with $20.2 million qualifying as Tier 2.

On December 10, 2013, the FRB, the OCC, the FDIC, the CFTC and the SEC issued final rules to implement the Volcker Rule, which prohibits an insured depository institution and its affiliates from: (i) engaging in “proprietary trading” and (ii) investing in or sponsoring certain types of funds. On January 14, 2014, these five federal agencies approved a related interim final rule pertaining to the ability of banking entities to retain interests in certain collateralized debt obligations backed primarily by trust preferred securities.

The Bank’s deposits are insured to applicable limits by the FDIC. Pursuant to Dodd-Frank Act, the Federal Deposit Insurance Act was amended to increase the maximum deposit insurance amount from $100,000 to $250,000.

FDIC assessment expense of $953 thousand and $2.9 million was recognized during the three months ended September 30, 2014, respectively, and $1.1 million and $3.2 million during the three and nine months ended September 30, 2013, respectively.

 

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Forward-Looking Statements

This Quarterly Report on Form 10-Q of the Company and the documents incorporated by reference herein may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and are intended to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. We are including this statement for the purpose of invoking those safe harbor provisions. Forward-looking statements often include the words “believes,” “expects,” “anticipates,” “estimates,” “forecasts,” “intends,” “plans,” “targets,” “potentially,” “probably,” “projects,” “outlook,” “view,” “opportunity,” “allow,” “continues,” “reflects,” “typically,” “usually” or similar expressions or future or conditional verbs such as “may,” “will,” “should,” “would” and “could.” These forward-looking statements may include, among other things:

 

•

statements and assumptions relating to financial performance;

 

•

statements relating to the anticipated effects on results of operations or financial condition from recent or future developments or events;

 

•

statements relating to our business and growth strategies and our regulatory capital levels;

 

•

statements relating to potential sales of our criticized and classified assets; and

 

•

any other statements, projections or assumptions that are not historical facts.

Actual future results may differ materially from our forward-looking statements, and we qualify all forward-looking statements by various risks and uncertainties we face, some of which are beyond our control, as well as the assumptions underlying the statements, including, among others, the following factors:

 

•

the strength of the United States economy in general and the strength of the local economies in which we conduct operations;

 

•

market volatility;

 

•

the credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs;

 

•

the overall quality of the composition of our loan and securities portfolios;

 

•

the market for criticized and classified assets that we may sell;

 

•

legislative and regulatory changes, including the Dodd-Frank Act and impending regulations, changes in banking, securities and tax laws and regulations and their application by our regulators and changes in the scope and cost of FDIC insurance and other coverages;

 

•

the effects of, and changes in, monetary and fiscal policies and laws, including interest rate policies of the FRB;

 

•

inflation, interest rate, market and monetary fluctuations;

 

•

fluctuations in the demand for loans, the number of unsold homes and other properties and fluctuations in real estate values in our market areas;

 

•

the effect of and our compliance with the terms of the OCC Agreement and the Federal Reserve Bank requirements as well as compliance with the individual minimum capital ratios established for the Bank by the OCC;

 

•

the results of examinations of us by the Federal Reserve Bank and of the Bank by the OCC, including the possibility that the OCC may, among other things, require the Bank to increase its allowance for loan losses or to write-down assets;

 

•

our ability to control operating costs and expenses;

 

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•

our ability to manage delinquency rates;

 

•

our ability to retain key members of our senior management team;

 

•

the costs of litigation, including settlements and judgments;

 

•

the increased competitive pressures among financial services companies;

 

•

the timely development of and acceptance of new products and services and the perceived overall value of these products and services by businesses and consumers, including the features, pricing and quality compared to our competitors’ products and services;

 

•

technological changes;

 

•

acquisitions;

 

•

changes in consumer and business spending, borrowing and saving habits and demand for financial services in our market area;

 

•

adverse changes in securities markets;

 

•

the inability of key third-party providers to perform their obligations to us;

 

•

changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies, the Financial Accounting Standards Board;

 

•

war or terrorist activities;

 

•

other economic, competitive, governmental, regulatory and technological factors affecting our operations, pricing, products and services and the other risks described elsewhere herein or in the documents incorporated by reference herein and our other filings with the SEC; and

 

•

our success at managing the risks involved in the foregoing.

Some of these and other factors are discussed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2013, the Company’s Quarterly Report on Form 10-Q for the three months ended June 30, 2014, and March 31, 2014 and in this Quarterly Report on Form 10-Q, under “Item 1A Risk Factors” and “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” as such sections may be amended or supplemented herein or in other filings pursuant to the Exchange Act. The development of any or all of these factors could have an adverse impact on our financial position and results of operations.

Any forward-looking statements are based upon management’s beliefs and assumptions at the time they are made. We undertake no obligation to publicly update or revise any forward-looking statements included or incorporated by reference herein or to update the reasons why actual results could differ from those contained in such statements, whether as a result of new information, future events or otherwise, unless otherwise required to do so by law or regulation. In light of these risks, uncertainties and assumptions, the forward-looking statements discussed herein or in the documents incorporated by reference herein might not occur, and you should not put undue reliance on any forward-looking statements.

 

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NON-GAAP FINANCIAL MEASURES

This Quarterly Report on Form 10-Q of the Company contains financial information prepared pursuant to methods other than in accordance with GAAP. Management uses these “non-GAAP” measures in their analysis of the Company’s performance. Management believes that these non-GAAP financial measures provide a greater understanding of ongoing operations and enhance comparability of results with prior periods as well as demonstrating the effects of significant gains and charges in the current period. The Company believes that a meaningful analysis of its financial performance requires an understanding of the factors underlying that performance. These disclosures should not be viewed as a substitute for operating results determined in accordance with GAAP, nor are they necessarily comparable to non-GAAP performance measures that may be presented by other companies. Management uses these measures to evaluate the underlying performance and efficiency of operations. Management believes these measures reflect core trends of the business.

Tax Equivalent Net Interest Income:

This Quarterly Report on Form 10-Q references tax-equivalent interest income. Tax-equivalent interest income is a non-GAAP financial measure. Tax-equivalent interest income assumes a 35% marginal federal tax rate for all periods. The fully taxable equivalent adjustments for the three and nine months ended September 30, 2014 were $166 thousand and $498 thousand, respectively. The fully taxable equivalent adjustment for the three and nine months ended September 30, 2013 were $167 thousand and $554 thousand, respectively, for September 30, 2013. Tax-equivalent net interest income is net interest income plus the taxes that would have been paid had tax-exempt securities been taxable. This number attempts to enhance the comparability of the performance of assets that have different tax liabilities. The following table provides a reconciliation of tax equivalent net interest income to GAAP net interest income using a 35% tax rate:

For the Three Months Ended:

 

September 30,		2014				2013
Net interest income, as presented		$	18,921			$	22,980
Effect of tax-exempt income			166				167
Net interest income, tax equivalent		$	19,087			$	23,147

For the Nine Months Ended:

 

September 30,		2014				2013
Net interest income, as presented		$	60,925			$	67,834
Effect of tax-exempt income			498				554
Net interest income, tax equivalent		$	61,423			$	68,388

Core Deposits:

Core deposits is calculated by excluding time deposits and brokered deposits from total deposits. The following table provides a reconciliation of core deposits to GAAP total deposits at September 30, 2014 and December 31, 2013:

 

		September 30, 2014				December 31, 2013
Total deposits		$	2,170,627			$	2,621,571
Less: Time deposits			407,219				506,770
Less: Brokered deposits			103,253				107,930
Core deposits		$	1,660,155			$	2,006,871

 

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

(All dollar amounts presented in the tables are in thousands)

Overview

The Company is a bank holding company with headquarters in Mt. Laurel, New Jersey. The Bank is the Company’s principal subsidiary. Through the Bank, the Company provides commercial and consumer banking services. The Company offers an array of lending, depository and financial services to its commercial and consumer customers throughout the marketplace. The Company funds its lending activities primarily through retail and brokered deposits, the scheduled maturities of its investment portfolio and other wholesale funding sources. As a financial institution with a primary focus on traditional banking activities, the Company generates the majority of its revenue through net interest income, which is defined as the difference between interest income earned on loans and investments and interest paid on deposits and borrowings. Growth in net interest income is dependent upon the Company’s ability to prudently manage the balance sheet for growth, combined with how successfully it maintains or increases net interest margin. The Company has historically generated revenue through fees earned on the various services and products offered to its customers and through sales of loans, primarily residential mortgages. Offsetting these revenue sources are provisions for credit losses on loans, operating expenses and income taxes.

The Company is implementing a comprehensive strategic restructuring to refocus on serving commercial borrowers in the communities in which the Bank operates. As a part of this restructuring, the origination and sale of residential mortgages will no longer be a source of revenue for the Bank. On June 30, 2014, the Board of Directors of the Company and the Bank approved a comprehensive restructuring plan, which includes, among other things, the Bank exiting Sun Home Loans, its retail, consumer mortgage banking origination business and exiting its healthcare and asset-based lending businesses, the sale of seven branch offices in the Cape May County area, significant classified asset and operating expense reductions and the declaration of a 1-for-5 reverse stock split. The Company also announced the consolidation of four additional branch offices, which is expected to be completed during the fourth quarter of 2014. During the second quarter of 2014, the Company recorded approximately $20 million one-time charges relating to restructuring initiatives, which primarily included approximately $16 million in losses on commercial and consumer loan sales and approximately $3 million of severance related costs.

On July 2, 2014 the Company entered into a Purchase and Assumption Agreement (the “Purchase Agreement”) with Sturdy Savings Bank, pursuant to which the Bank agreed to sell certain assets and assume certain liabilities relating to seven branch offices in and around Cape May County, New Jersey. The Purchase Agreement provides for a purchase price equal to the sum of a deposit premium of 8.765% of the average daily closing balance of deposits for the 31 days prior to the closing date, the carrying value of loans identified and approved by both parties, the aggregate amount of cash on hand and accrued interest on the loans acquired. The Purchase Agreement contains certain customary representations, warranties, indemnities and covenants of the parties, and is subject to termination in certain circumstances. Sturdy Savings Bank recently received all regulatory approvals required for the acquisition of the branches. The transaction is expected to be completed during the first quarter of 2015, subject to customary closing conditions. At September 30, 2014, the Company had approximately $26.3 million of loans and $192.1 million of deposits held-for-sale. Upon settlement after all accounts are identified for sale, the transaction is anticipated to include approximately $65 million of loans.

As a result of the restructuring plan, the Company recorded approximately $2.7 million in severance and related benefit expenses in the nine months ended September 30, 2014. During the three months ended September 30, 2014, the Company experienced reduced levels of non-interest expense as a result of the implementation of the restructuring plan and reduced non-interest income as a result of the exit from Sun Home Loans.

At September 30, 2014, the Company had total assets of $2.82 billion, total liabilities of $2.57 billion and total shareholders’ equity of $247.0 million. The Company reported a net loss available to common shareholders of $825 thousand, or a loss of $0.05 per diluted share, for the quarter ended September 30, 2014. For the nine months ended September 30, 2014, the Company reported a net loss available to common shareholders of $27.0 million, or a loss of $1.54 per diluted share,

The economic recovery has been slower than anticipated. Although interest rates have begun to rise slightly, they remained near historical lows. The unemployment rate in the U.S. declined to 5.9% in September 2014 from 6.7% in December 2013. Based upon initial estimates, the U.S. gross domestic product for the third quarter of 2014 increased at an annual rate of 3.5% as compared to a 4.6% increase in the 2nd quarter of 2014. The growth in the third quarter was mainly driven by gains in personal consumption, exports and government spending. These increases were partly offset by reductions in private inventory investment. At the state level, according to the latest South Jersey Business Survey produced by the Federal Reserve Bank, growth in business activity continued in the third quarter of 2014. Additionally, employment showed further signs of improvement in the third quarter of 2014; however, expectations for future employment opportunities have declined. The economy in Southern New Jersey could also be impacted by several casino closures in Atlantic City in 2014, which resuted in significant job reductions. The Company is currently evaluating the impact of the casino closures on its operations on its consumer loan portfolio. In Northern New Jersey, business activity is expected to continue to increase at a modest pace. Overall, New Jersey’s unemployment rate remains one of the highest in the U.S. but has declined in the past year and a half to 6.5% as of September 2014 from 9.0% as of December 2012.

 

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At its latest meeting in October 2014, the FRB decided to keep the Federal Funds target rate unchanged in a continued effort to help stimulate economic growth. Since December 2008, the FRB has kept the Federal Funds rate, a key indicator of short-term rates such as credit card rates and home equity line of credit rates, at a range of 0.00%-0.25% with the intent of encouraging consumers and businesses to borrow and spend to help jump start the economy. The FRB expects to maintain the current target range for a considerable period of time, but will continue to assess longer term inflation levels, and has expressed that increases in rates can occur should inflation levels increase to unexpected levels. In October 2014, the FRB decided to cease its asset purchase program, effective October 2014.

Although moderately improving, the economy is still experiencing uncertainty in certain sectors, and, together with the challenging regulatory environment, will continue to affect the Company and the markets in which it does business and may adversely impact the Company’s results in the future. The following discussion provides further detail on the financial condition and results of operations of the Company at and for the quarter ended September 30, 2014.

Critical Accounting Policies, Judgments and Estimates

The discussion and analysis of the financial condition and results of operations are based on the unaudited condensed consolidated financial statements, which are prepared in conformity with GAAP. The preparation of these financial statements requires management to make estimates and assumptions affecting the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities, and the reported amounts of income and expenses. Management evaluates these estimates and assumptions on an ongoing basis, including those related to the allowance for loan losses, goodwill, intangible assets, income taxes and the fair value of financial instruments. Management bases its estimates on historical experience and various other factors and assumptions that are believed to be reasonable under the circumstances. These form the basis for making judgments on the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Allowance for Loan Losses. Through the Bank, the Company originates loans that it intends to hold for the foreseeable future or until maturity or repayment. The Company may not be able to collect all principal and interest due on these loans. The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio as of the balance sheet date. The determination of the allowance for loan losses requires management to make significant estimates with respect to the amounts and timing of losses and market and economic conditions. The allowance for loan losses is maintained at a level that management considers adequate to provide for estimated losses and impairment based upon an evaluation of known and inherent risk in the loan portfolio. Loan impairment is evaluated based on the fair value of collateral or estimated net realizable value. A provision for loan losses is charged to operations based on management’s evaluation of the estimated losses that have been incurred in the Company’s loan portfolio. It is the policy of management to provide for losses on unidentified loans in its portfolio in addition to classified loans.

Management monitors its allowance for loan losses on a monthly basis and makes adjustments to the allowance through the provision for loan losses as economic conditions and other pertinent factors warrant. The quarterly review and adjustment of the qualitative factors employed in the allowance methodology and the updating of historic loss and recovery experience allow for timely reaction to emerging conditions and trends. In this context, a series of qualitative factors are used in a methodology as a measurement of how current circumstances are affecting the loan portfolio. Included in these qualitative factors are:

 

•

Levels of past due, classified and non-accrual loans, troubled debt restructurings and modifications;

 

•

Nature and volume of loans;

 

•

Historical loss trends;

 

•

Changes in lending policies and procedures, underwriting standards, collections, and for commercial loans, the level of loans being approved with exceptions to policy;

 

•

Experience, ability and depth of management and staff;

 

•

National and local economic and business conditions, including various market segments;

 

•

Quality of the Company’s loan review system and degree of Board oversight; and

 

•

Effect of external factors, including the deterioration of collateral values, on the level of estimated credit losses in the current portfolio.

Additionally, for the commercial loan portfolio, historic loss and recovery experience over a three-year horizon, based on a rolling 12-quarter migration analysis, is taken into account for the quantitative factor component. For the non-commercial loan quantitative component, the average historic loss and recovery experience over a 12-quarter time period is utilized for the allowance calculation. In determining the allowance for loan losses, management has established both specific and general pooled allowances. Values assigned to the qualitative factors and those developed from historic loss and recovery experience provide a dynamic basis for the calculation of reserve factors for

 

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both pass-rated loans and those criticized and classified loans through the use of both a general pooled allowance and a specific allowance. In determining the appropriate level of the general pooled allowance, management makes estimates based on internal risk ratings, which take into account such factors as debt service coverage, loan-to-value ratios and external factors. Estimates are periodically measured against actual loss experience. A specific allowance is calculated on individually identified impaired loans. Loans not individually reviewed are evaluated as a group using reserve factor percentages based on historic loss and recovery experience and the qualitative factors described above.

As changes in the Company’s operating environment occur and as recent loss experience fluctuates, the factors for each category of loan based on type and risk rating will change to reflect current circumstances and the quality of the loan portfolio. Given that the components of the allowance are based partially on historical losses, recoveries and on risk rating changes in response to recent events, required reserves may trail the emergence of any unforeseen deterioration in credit quality.

Although the Company maintains its allowance for loan losses at levels considered adequate to provide for the inherent risk of loss in its loan portfolio, if economic conditions differ substantially from the assumptions used in making the evaluations, there can be no assurance that future losses will not exceed estimated amounts or that additional provisions for loan losses will not be required in future periods. Accordingly, the current state of the national economy and local economies of the areas in which the loans are concentrated and their slow recovery from a severe recession could result in an increase in loan delinquencies, foreclosures or repossessions resulting in increased charge-off amounts and the need for additional loan loss allowances in future periods. In addition, the Company’s determination as to the amount of its allowance for loan losses is subject to review by the Bank’s primary regulator, the OCC, as part of its examination process, which may result in the establishment of an additional allowance based upon the judgment of the OCC after a review of the information available at the time of the OCC examination.

Accounting for Income Taxes. The Company accounts for income taxes in accordance with FASB ASC 740, Income Taxes. (“FASB ASC 740”). FASB ASC 740 requires the recording of deferred income taxes that reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Management exercises significant judgment in the evaluation of the amount and timing of the recognition of the resulting tax assets and liabilities. The judgments and estimates required for the evaluation are updated based upon changes in business factors and the tax laws. If actual results differ from the assumptions and other considerations used in estimating the amount and timing of tax recognized, there can be no assurance that additional expenses will not be required in future periods. The Company recognizes, when applicable, interest and penalties related to unrecognized tax benefits in the provision for income taxes in the unaudited condensed consolidated statements of operations. Assessment of uncertain tax positions under FASB ASC 740 requires careful consideration of the technical merits of a position based on management’s analysis of tax regulations and interpretations. Significant judgment may be involved in applying the requirements of FASB ASC 740.

Management expects that the Company’s adherence to FASB ASC 740 may result in increased volatility in quarterly and annual effective income tax rates, as FASB ASC 740 requires that any change in judgment or change in measurement of a tax position taken in a prior period be recognized as a discrete event in the period in which it occurs. Factors that could impact management’s judgment include changes in income, tax laws and regulations, and tax planning strategies.

Fair Value Measurement. The Company accounts for fair value measurement in accordance with FASB ASC 820, Fair Value Measurements and Disclosures. FASB ASC 820 establishes a framework for measuring fair value. FASB ASC 820 defines fair value as 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, emphasizing that fair value is a market-based measurement and not an entity-specific measurement. FASB ASC 820 clarifies the application of fair value measurement in a market that is not active. FASB ASC 820 also includes additional factors for determining whether there has been a significant decrease in market activity, affirms the objective of fair value when a market is not active, eliminates the presumption that all transactions are not orderly unless proven otherwise, and requires an entity to disclose inputs and valuation techniques, and changes therein, used to measure fair value. FASB ASC 820 addresses the valuation techniques used to measure fair value. These valuation techniques include the market approach, income approach and cost approach. The market approach uses price or relevant information generated by market transactions involving identical or comparable assets or liabilities. The income approach involves converting future amounts to a single present value. The measurement is valued based on current market expectations about those future amounts. The cost approach is based on the amount that currently would be required to replace the service capacity of the asset.

FASB ASC 820 establishes a fair value hierarchy, which prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the instrument’s fair value measurement. The three levels within the fair value hierarchy are described as follows:

 

•

Level 1 – Quoted prices in active markets for identical assets or liabilities.

 

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•

Level 2 – Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include: quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability; and inputs that are derived principally from or corroborated by observable market data by correlation or other means.

 

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Level 3 – Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.

The Company’s policy is to recognize transfers that occur between the fair value hierarchy, Levels 1, 2 and 3, at the beginning of the quarter of when the transfer occurred.

Investment securities available for sale. Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. If quoted market prices are not available, then fair values are estimated using quoted prices of securities with similar characteristics or discounted cash flows based on observable market inputs and are classified within Level 2 of the fair value hierarchy. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy. Level 3 market value measurements include an internally developed discounted cash flow model combined with using market data points of similar securities with comparable credit ratings in addition to market yield curves with similar maturities in determining the discount rate. In addition, significant estimates and unobservable inputs are required in the determination of Level 3 market value measurements. If actual results differ significantly from the estimates and inputs applied, it could have a material effect on the Company’s unaudited condensed consolidated financial statements.

Derivative financial instruments. The Company’s derivative financial instruments are not exchange-traded and therefore are valued utilizing models that use as their basis readily observable market parameters, specifically the LIBOR swap curve, and are classified within Level 2 of the valuation hierarchy.

Residential mortgage loans held-for-sale. The Company’s residential mortgage loans held-for-sale are recorded at fair value utilizing Level 2 measurements. This fair value measurement is determined based upon third party quotes obtained on similar loans.

The Company adopted the fair value option on these loans which allows the Company to record the mortgage loans held-for-sale portfolio at fair market value as opposed to the lower of cost or market. The Company economically hedges its residential loans held-for-sale portfolio with forward sale agreements which are reported at fair value. A lower of cost or market accounting treatment would not allow the Company to record the excess of the fair market value over book value but would require the Company to record the corresponding reduction in value on the hedges. Both the loans and related hedges are carried at fair value which reduces earnings volatility as the amounts more closely offset, particularly in environments in which interest rates are declining. For loans held-for-sale for which the fair value option has been elected, the aggregate fair value exceeded the aggregate principal balance by $73 thousand as of September 30, 2014 and $312 thousand at December 31, 2013.

Interest rate lock commitments on residential mortgages. The Company entered into interest rate lock commitments on its residential mortgage loans originated for sale. The determination of the fair value of interest rate lock commitments was based on agreed upon pricing with the respective investor on each loan and includes a pull through percentage. The pull through percentage represents an estimate of loans in the pipeline to be delivered to an investor versus the total loans committed for delivery. Significant changes in this input could result in a significantly higher or lower fair value measurement. As the pull through percentage is a significant unobservable input, this is deemed a Level 3 valuation input. The pull through percentage, which is based upon historical experience, was 75%.

In addition, certain assets are measured at fair value on a nonrecurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). The Company measures loans held-for-sale, impaired loans, SBA servicing assets, restricted equity investments and loans or bank properties transferred in other real estate owned at fair value on a non-recurring basis.

Valuation techniques and models utilized for measuring financial assets and liabilities are reviewed and validated by the Company at least quarterly.

Goodwill. Goodwill is the excess of the fair value of liabilities assumed over the fair value of tangible and identifiable intangible assets acquired in a business combination. Goodwill is not amortized but is tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. FASB ASC 350-20-35,

 

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Intangibles – Goodwill and Other – Goodwill, outlines a two-step goodwill impairment test. Significant judgment is applied when goodwill is assessed for impairment. Step one, which is used to identify potential impairment, compares the fair value of the reporting unit with its carrying amount, including goodwill. As defined in FASB ASC 280, Segment Reporting, a reporting unit is an operating segment or one level below an operating segment. The Company has one reportable operating segment, “Community Banking”, as noted in Note 1 of the notes to the unaudited condensed consolidated financial statements. If the fair value of a reporting unit exceeds its carrying value, goodwill of the reporting unit is considered not impaired and step two is therefore unnecessary. If the carrying amount of the reporting unit exceeds it implied fair value, the second step is performed to measure the amount of the impairment loss, if any. An impairment loss is recorded to the extent that the carrying amount of goodwill exceeds its implied fair value. The Company typically evaluates its goodwill for impairment annually at December 31, unless circumstances indicate that a test is required at an earlier date.

Recent Accounting Principles.

In August 2014, the FASB issued ASU 2014-15: Presentation of Financial Statements – Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern. The amendments in this Update provide guidance about management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern and to provide related footnote disclosures. The amendments are intended to reduce diversity in the timing and content of footnote disclosures. The amendments in this Update are effective for the annual period ending after December 15, 2016, and for annual periods and interim periods thereafter. Early application is permitted. The Company is currently evaluating the impact of the adoption of this accounting standards update on its financial statements.

In August 2014, the FASB issued ASU 2014-14: Receivables – Troubled Debt Restructurings by Creditors (Subtopic 310-40). The amendments in this Update affect creditors that hold government-guaranteed mortgage loans, including those guaranteed by the FHA and the VA. The amendments in this Update require that a mortgage loan be derecognized and that a separate other receivable be recognized upon foreclosure if certain conditions are met. Upon foreclosure, the separate other receivable should be measured based on the amount of the loan balance (principal and interest) expected to be recovered from the guarantor. The Company is currently evaluating the impact of the adoption of this accounting standards update on its financial statements. The amendments in this Update are effective for public entities for annual periods and interim periods within those annual periods, beginning after December 15, 2014.

In June 2014, the FASB issued ASU 2014-11: Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures. The accounting changes in the amendment affect all entities that enter into repurchase-to-maturity transactions or repurchase financings. The amendments in this update change the accounting for repurchase-to-maturity transactions to secured borrowing accounting and for repurchase financing arrangements, the amendments require separate accounting for a transfer of a financial asset executed contemporaneously with a repurchase agreement with the same counterparty which will result in secured borrowing accounting for the repurchase agreement. All entities are subject to new disclosure requirements for certain transactions that involve a transfer of a financial asset accounted for as a sale. The accounting changes in this Update are effective for public business entities for the first interim or annual period beginning after December 15, 2014. The Company is currently evaluating the impact of the adoption of this accounting standards update on its financial statements.

In May 2014, the FASB issued ASU 2014-09: Revenue from Contracts with Customers (Topic 606): Summary and Amendments That Create Revenue from Contracts with Customers (Topic 606) and Other Assets and Deferred Costs-Contracts with Customers (Subtopic 340-40), Conforming Amendments to Other Topics and Subtopics in the Codification and Status Tables, Background Information and Basis for Conclusions. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the considerations to which the entity expects to be entitled in exchange for those goods or services. The guidance in this Update affects any entity that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets, unless those contracts are within the scope of other standards. For a public entity, the amendments in this Update are effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Early application is not permitted. The Company is currently evaluating the impact of the adoption of this accounting standards update of its financial statements.

In January 2014, the FASB issued ASU 2014-4, Receivables – Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure. The amendments in this update clarify that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either the creditor obtaining legal title to the residential real estate property upon completion of foreclosure or the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additionally, the amendments require interim and annual disclosure of both the amount of foreclosed residential real estate property held by the creditor and the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. For public entities, the amendments are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. The Company is currently evaluating the impact of the adoption of this accounting standards update on its financial statements.

In July 2013, the FASB issued Accounting Standards Update (“ASU”) 2013-11, Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. The amendments in this update seek to eliminate the diversity in practice in the presentation of unrecognized tax benefits when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists

 

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by presenting the unrecognized tax benefit, or a portion of the unrecognized tax benefit, in the financial statements as a reduction to a deferred tax asset. To the extent that a net operating loss carryforward, a similar tax loss, or a tax credit carryforward are not available at the reporting date under the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position or the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset for such purpose, the unrecognized tax benefit should be presented in the financial statements as a liability and should not be combined with deferred tax assets. For public entities, the amendments are effective prospectively for reporting periods beginning after December 15, 2013. The Company has evaluated the impact of the adoption of this accounting standards update on its financial statements and determined that there currently is no impact to the Company’s presentation.

Financial Condition

Total assets were $2.82 billion at September 30, 2014 as compared to $3.09 billion at December 31, 2013. Loans receivable, net of allowance for loan losses, decreased $452.3 million to $1.65 billion at September 30, 2014 as compared to $2.10 billion at December 31, 2013. This was caused by a decrease of $361.7 million in commercial loans, primarily due to the sale of $160.9 million of problem commercial loans and performing asset backed loans, combined with commercial loan payoffs. Also, there was a decrease of $23.6 million in consumer loans due primarily to $24.4 million of problem consumer loans being moved to held-for-sale at lower of cost or market. Commercial loan production has been slow due to a competitive environment and the Company maintaining a very selective approach to new loan relationships. Cash and cash equivalents increased by $236.6 million due to the decrease in loans, partially offset by the corresponding decline in deposits noted below. The Company has positioned itself to take advantage of a rising interest rate environment with an asset sensitive balance sheet.

Total liabilities decreased $269.1 million, or 9.5%, to $2.57 billion at September 30, 2014, compared to $2.84 billion at December 31, 2013. The decrease in total liabilities is primarily attributable to a decrease of $258.9 million in total deposits. The Company has proactively been reducing its deposit balances, specifically public fund deposits. Shareholders’ equity increased $1.7 million to $247.0 million at September 30, 2014, as compared to $245.3 million at December 31, 2013.

As of September 30, 2014, the Company had $66.4 million outstanding on 15 residential construction, commercial construction and land development relationships for which the agreements included interest reserves. As of December 31, 2013, the Company had $54.5 million outstanding on 17 residential construction, commercial construction and land development relationships for which the agreements included interest reserves. The total amount available in those reserves to fund interest payments was $3.0 million and $4.3 million at September 30, 2014 or December 31, 2013, respectively. There were no relationships with interest reserves which were on non-accrual status at September 30, 2014 and December 31, 2013. Construction projects are monitored throughout their lives by professional inspectors engaged by the Company. The budgets for loan advances and borrower equity injections are developed at the time of underwriting in conjunction with the review of the plans and specifications for the project being financed. Advances of the Company’s funds are based on the prepared budgets and will not be made unless the project has been inspected by the Company’s professional inspector who must certify that the work related to the advance is in place and properly completed. As it relates to construction project financing, the Company does not extend, renew or restructure terms unless its borrower posts cash collateral in an interest reserve.

Table 1 provides detail regarding the Company’s non-performing assets and TDRs at September 30, 2014 and December 31, 2013.

Table 1: Summary of Non-performing Assets and TDRs

 

		September 30, 2014				December 31, 2013
Non-performing assets:
Non-accrual loans held-for-investment		$	13,561			$	29,814
Non-accrual loans held-for-sale			2,770
Troubled debt restructuring, non-accruing			528				8,163
Loans past due 90 days and accruing			—				—
Real estate owned, net			1,084				2,503
Total non-performing assets		$	17,943			$	40,480

The Company’s allowance for losses on loans decreased to $26.5 million, or 1.58% of gross loans held-for-investment, at September 30, 2014 from $35.5 million, or 1.66% of gross loans held-for-investment, at December 31, 2013. Provision expense of $14.8 million was recorded during the nine months ended September 30, 2014 compared to a negative provision of $988 thousand for the same period in 2013. The decrease in reserve balances is due to net charge-offs of $23.8 million offset by the $14.8 million provision expense for that period. The charge-offs were primarily driven by transfers of mostly problem loans identified to be sold, which occurred during the quarter ended June 30, 2014. Across the commercial and consumer loan portfolio, the Company continues to closely monitor areas of weakness and take expedient and appropriate action as necessary to ensure adequate reserves are in place to absorb losses inherent in the loan portfolio. During the third quarter of 2014, the Company implemented certain risk rating system enhancements which resulted in the need for additional reserves.

 

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Total non-performing loans held-for-investment decreased $23.9 million to $14.1 million at September 30, 2014 from $38.0 million at December 31, 2013. Total non-accruing TDRs at September 30, 2014 were $528 thousand, a decrease of $7.6 million from December 31, 2013.

Real estate owned, net decreased $1.4 million to $1.1 million at September 30, 2014 as compared to $2.5 million at December 31, 2013. During the nine months ended September 30, 2014, the Company transferred four residential properties totaling $567 thousand from loans into real estate owned. During the same period, the Company recorded $265 thousand of write-downs of real estate owned, of which $68 thousand related to two residential properties and $197 thousand related to one commercial property. There were 17 residential properties with a total carrying amount of $1.7 million sold resulting in a net loss of $259 thousand. At September 30, 2014, the Company had three properties in the real estate owned portfolio.

The net deferred tax asset decreased $5.5 million from December 31, 2013 to a net deferred tax liability of $971 thousand at September 30, 2014 due to a decrease in the unrealized losses on investment securities. The Company maintains a valuation allowance of $131.8 million against the remaining portion of the gross deferred tax asset as the Company is a three-year cumulative loss company and it is more likely than not that the full deferred tax asset will not be realized.

Investment securities available for sale decreased $30.6 million, or 7.0%, from $440.1 million at December 31, 2013 to $409.5 million at September 30, 2014 due primarily to principal payments of $45.8 million, investment sales and calls of $19.0 million, partially offset by purchases of $24.1 million, and positive market value adjustments of $11.1 million. Investment securities held to maturity decreased $77 thousand, or 11.3%, from $681 thousand at December 31, 2013 to $604 thousand at September 30, 2014.

Other assets decreased $9.7 million, or 28.9%, to $23.9 million at September 30, 2014 from $33.7 million at December 31, 2013. This decrease was primarily the result of paydowns on swap transactions recorded during the nine months ended September 30, 2014. For more information on the Company’s financial derivative instruments, see Note 8 of the notes to unaudited condensed consolidated financial statements.

Total borrowings, excluding debentures held by trusts, increased $139 thousand from $68.8 million at December 31, 2013 to $68.9 million at September 30, 2014.

Other liabilities decreased $11.3 million, or 19.1%, to $47.8 million at September 30, 2014 from $59.1 million at December 31, 2013. The decrease was primarily due to paydowns on swap transactions since December 31, 2013.

Comparison of Operating Results for the Three Months Ended September 30, 2014 and 2013

Overview. The Company’s net loss available to shareholders for the three months ended September 30, 2014 was $825 thousand, or a loss of $0.05 per common share, compared to net loss of $4.9 million, or a loss of $0.28 per common share, for the same period in 2013. During the three months ended September 30, 2014, the Company had zero provision expense, as compared to provision expense of $724 thousand in the same prior year period. During the three months ended September 30, 2014 and 2013, the Company recorded mortgage banking revenue of $423 thousand and $1.6 million, respectively. This decrease was due to lower production volume during the three months ended September 30, 2014 due to the Company’s strategic decision to exit the mortgage banking business.

Net Interest Income. Net interest income is the most significant component of the Company’s income from operations. Net interest income is the difference between interest earned on total interest-earning assets (primarily loans and investment securities), on a fully taxable equivalent basis, where appropriate, and interest paid on total interest-bearing liabilities (primarily deposits and borrowed funds). Fully taxable equivalent basis represents income on total interest-earning assets that is either tax-exempt or taxed at a reduced rate, adjusted to give effect to the prevailing incremental federal tax rate, and adjusted for nondeductible carrying costs and state income taxes, where applicable. Yield calculations, where appropriate, include these adjustments. Net interest income depends on the volume and interest rate earned on interest-earning assets and the volume and interest rate paid on interest-bearing liabilities.

Net interest income, on a tax-equivalent basis, decreased $4.1 million to $19.1 million for the three months ended September 30, 2014, from $23.2 million for the same period in 2013.

Tax equivalent interest income decreased $4.9 million, or 18.1%, from $27.0 million for the three months ended September 30, 2013, to $22.1 million for the three months ended September 30, 2014. Compared to the comparable prior year quarter, average total loans receivable decreased $399.4 million and the yield on total loans decreased 19 basis points, which resulted in a decrease in interest income on loans of $5.3 million. This decrease was partially offset by an increase of $359 thousand in interest income from investments which was primarily due to an increase of 23 basis points in yield from the three months ended September 30, 2013 to the three months ended September 30, 2014.

 

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Interest expense decreased $774 thousand, or 20.3%, for the three months ended September 30, 2014, as compared to the same period in 2013. The decrease was primarily rate driven. The average cost of interest-bearing deposit accounts decreased six basis points compared to the prior year period resulting in a decrease in interest expense of $756 thousand.

The interest rate spread and net interest margin for the three months ended September 30, 2014 were 2.71% and 2.87%, respectively, compared to 2.96% and 3.10%, respectively, for the same period in 2013.

Table 2 provides detail regarding the Company’s average daily balances with corresponding interest income (on a tax-equivalent basis) and interest expense as well as yield and cost information for the three months ended September 30, 2014 and 2013. Average balances are derived from daily balances.

Table 2: Average Balance Sheets

SUN BANCORP, INC. AND SUBSIDIARIES

AVERAGE BALANCE SHEETS (Unaudited)

(Dollars in thousands)

 

		For the Three Months Ended September 30,
		2014												2013
		Average Balance				Income/ Expense				Yield/ Cost				Average Balance				Income/ Expense				Yield/ Cost
Interest-earning assets:
Loans receivable(1),(2):
Commercial and industrial		$	1,292,705			$	14,438				4.47	%		$	1,671,302			$	19,205				4.60	%
Home equity			179,226				1,749				3.90				194,622				1,892				3.89
Second mortgage			22,528				313				5.56				27,041				384				5.68
Residential real estate			322,751				2,737				3.39				299,667				2,620				3.50
Other			3,755				70				7.46				27,723				475				6.87
Total loans receivable			1,820,965				19,307				4.24				2,220,355				24,576				4.43
Investment securities(3)			434,721				2,562				2.36				414,189				2,157				2.13
Interest-earning bank balances			405,820				252				0.25				349,386				222				0.25
Total interest-earning assets			2,661,506				22,121				3.32				2,983,930				26,955				3.62
Non-interest earning assets:
Cash and due from banks			44,380												46,336
Restricted Cash			13,000												26,000
Bank properties and equipment, net			46,162												48,590
Goodwill and intangible assets, net			38,281												39,717
Other assets			85,591												120,311
Total non-interest-earning assets			227,414												280,954
Total assets		$	2,888,920											$	3,264,884
Interest-bearing liabilities:
Interest-bearing deposit accounts:
Interest-bearing demand deposits		$	1,010,830			$	707				0.28	%		$	1,263,160				1,064				0.34	%
Savings deposits			256,909				164				0.26				270,394				213				0.32
Time deposits			549,092				1,186				0.86				663,582				1,536				0.93
Total interest-bearing deposit accounts			1,816,831				2,057				0.45				2,197,136				2,813				0.51
Short-term borrowings:
Securities sold under agreements to repurchase – customers			875				—				—				555				—				—
Long-term borrowings:
FHLBNY advances(4)			60,845				318				2.09				61,011				321				2.10
Obligations under capital lease			7,143				117				6.55				7,435				124				6.67
Junior subordinated debentures			92,786				542				2.34				92,786				550				2.37
Total borrowings			161,649				977				2.42				161,787				995				2.46
Total interest-bearing liabilities			1,978,480				3,034				0.61				2,358,923				3,808				0.65
Non-interest bearing liabilities:
Non-interest-bearing demand deposits			612,775												549,684
Other liabilities			54,645												95,576
Total non-interest bearing liabilities			667,420												645,260
Total liabilities			2,645,900												3,004,183
Shareholders’ equity			243,020												260,701
Total liabilities and shareholders’ equity		$	2,888,920											$	3,264,884
Net interest income						$	19,087											$	23,147
Interest rate spread(5)											2.71	%											2.96	%
Net interest margin(6)											2.87	%											3.10	%
Ratio of average interest-earning assets to average interest-bearing liabilities											135	%											127	%

 

(1)	Average balances include non-accrual loans, loans held-for-sale, branch assets held-for-sale and deposits held-for-sale.

 

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(2)	Loan fees are included in interest income and the amount is not material for this analysis.

(3)	Interest earned on non-taxable investment securities is shown on a tax-equivalent basis assuming a 35% marginal federal tax rate for all periods. The fully taxable equivalent adjustments for the three months ended September 30, 2014 and 2013 were $166 thousand and $167 thousand, respectively.

(4)	Amounts include Advances from FHLBNY and Securities sold under agreements to repurchase – FHLBNY.

(5)	Interest rate spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.

(6)	Net interest margin represents net interest income as a percentage of average interest-earning assets.

Table 3: Rate/Volume⁽¹⁾

 

		For the Three Months Ended September 30, 2014 vs. 2013
		Increase (Decrease) Due To
		Volume				Rate				Net
Interest income:
Loans receivable:
Commercial and industrial		$	(4,238	)		$	(529	)		$	(4,767	)
Home equity lines of credit			(148	)			5				(143	)
Home equity term loan			(63	)			(8	)			(71	)
Residential real estate			201				(84	)			117
Other			(444	)			38				(406	)
Total loans receivable			(4,692	)			(578	)			(5,270	)
Investment securities			113				246				359
Interest-earning deposits with banks			28				2				30
Total interest-earning assets			(4,551	)			(330	)			(4,881	)
Interest expense:
Interest-bearing deposit accounts:
Interest-bearing demand deposits			(190	)			(167	)			(357	)
Savings deposits			(10	)			(39	)			(49	)
Time deposits			(244	)			(106	)			(350	)
Total interest-bearing deposit accounts			(444	)			(312	)			(756	)
Short-term borrowings:
Securities sold under agreements to repurchase – customers			—				—				—
Long-term borrowings:
FHLBNY advances(2)			(1	)			(2	)			(3	)
Obligations under capital lease			—				(8	)			(8	)
Junior subordinated debentures			(5	)			(2	)			(7	)
Total borrowings			(6	)			(12	)			(18	)
Total interest-bearing liabilities			(450	)			(324	)			(774	)
Net change in net interest income		$	(4,101	)		$	(6	)		$	(4,107	)

 

(1)

For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (changes in average volume multiplied by old rate) and (ii) changes in rate (changes in rate multiplied by old average volume). The combined effect of changes in both volume and rate has been allocated to volume or rate changes in proportion to the absolute dollar amounts of the change in each.

(2)	Amounts include Advances from FHLBNY and Securities sold under agreements to repurchase – FHLBNY.

Provision for Loan Losses. The Company recorded no provision for loan losses during the three months ended September 30, 2014, as compared to provision expense of $724 thousand for the same period in 2013. Total non-performing loans held-for-investment decreased $23.9 million from $38.0 million at December 31, 2013 to $14.1 million at September 30, 2014. The ratio of allowance for loan losses to gross loans held-for-investment was 1.58% at September 30, 2014, as compared to 1.66% at December 31, 2013. Net charge-offs for the three months ended September 30, 2014 were $1.9 million as compared to net charge offs of $123 thousand during the same period in 2013.

 

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The provision recorded is the amount deemed appropriate by management based on the current risk profile of the portfolio to absorb losses existing at the balance sheet date. At least monthly, management performs an analysis to identify the inherent risk of loss in the Company’s loan portfolio. This analysis includes a qualitative evaluation of concentrations of credit, past loss experience, current economic conditions, amount and composition of the loan portfolio (including loans being specifically monitored by management), estimated fair value of underlying collateral, delinquencies, and other factors. Additionally, management updates the migration analysis and historic loss and recovery experience on a quarterly basis.

Non-Interest Income. Non-interest income decreased $1.1 million to $4.7 million for the three months ended September 30, 2014, as compared to $5.8 million for the same period in 2013. This decrease was primarily attributable to a decrease in mortgage banking revenue, net of $1.2 million due to a decline in residential mortgage production volume resulting from the strategic decision to exit the residential mortgage banking business.

Non-Interest Expense. Non-interest expense decreased $8.8 million to $24.1 million for the three months ended September 30, 2014 as compared to $32.9 million for the same period in 2013. This decrease was primarily due to decreases in professional fees of $4.5 million, salaries and employee benefits expense of $1.4 million, commission expense of $1.4 million and problem loan expense of $522 thousand. The reduction in professional fees is due primarily to the Company’s significantly reduced reliance upon consultants for its operational infrastructure improvements and regulatory compliance. The decreases in salaries and employee benefits expense and commission expense were due to reduced head count as a result of the comprehensive restructuring plan initiated in the quarter ending June 30, 2014. Problem loan expense has declined due to the significant reduction in the Company’s problem loans between the three months ended September 30, 2013 and the three months ended September 30, 2014.

Comparison of Operating Results for the Nine months Ended September 30, 2014 and 2013

Overview. The Company recognized net loss available to shareholders for the nine months ended September 30, 2014 of $27.0 million, or a loss of $1.54 per common share, compared to a net loss of $1.7 million, or a loss of $0.10 per common share, for the same period in 2013. During the nine months ended September 30, 2014 and 2013, the Company recorded a loan loss provision of $14.8 million and recovery of $988 thousand, respectively.

Net Interest Income. Net interest income, on a tax-equivalent basis, decreased $6.6 million to $61.4 million for the nine months ended September 30, 2014, from $68.0 million for the same period in 2013.

Tax equivalent interest income decreased $8.9 million, or 11.2%, from $79.8 million for the nine months ended September 30, 2013, to $70.9 million for the nine months ended September 30, 2014. Average total loans receivable decreased $280.9 million and the yield on total loans decreased 14 basis points which resulted in a decrease in interest income on loans of $11.2 million, from the nine months ended September 30, 2013 to the same period in 2014. This decrease was partially offset by an increase of $2.3 million in interest income from investments, which was primarily due to an increase of 49 basis points in the yield and $42.8 million in average balance from the nine months ended September 30, 2013 to the nine months ended September 30, 2014.

Interest expense decreased $2.3 million, or 19.6%, for the nine months ended September 30, 2014, as compared to the same period in 2013. The decrease was due to the combined effects of decreased rates and average balances of interest-bearing liabilities as the cost of interest-bearing deposits decreased eight basis points from 0.53% at September 30, 2013 to 0.45% at September 30, 2014.

The interest rate spread and net interest margin for the nine months ended September 30, 2014 were 2.84% and 2.98%, respectively, compared to 2.93% and 3.07%, respectively, for the same period in 2013.

Table 4 provides detail regarding the Company’s average daily balances with corresponding interest income (on a tax-equivalent basis) and interest expense as well as yield and cost information for the nine months ended September 30, 2014 and 2013. Average balances are derived from daily balances.

 

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Table 4: Average Balance Sheets

SUN BANCORP, INC. AND SUBSIDIARIES

AVERAGE BALANCE SHEETS (Unaudited)

(Dollars in thousands)

 

		For the Nine months Ended September 30,
		2014												2013
		Average Balance				Income/ Expense				Yield/ Cost				Average Balance				Income/ Expense				Yield/ Cost
Interest-earning assets:
Loans receivable(1),(2):
Commercial and industrial		$	1,443,565			$	46,173				4.25	%		$	1,711,443			$	56,786				4.41	%
Home equity			183,967				5,288				3.82				198,688				5,709				3.82
Second mortgage			23,907				996				5.54				28,677				1,244				5.77
Residential real estate			330,706				8,881				3.57				312,496				8,176				3.48
Other			17,244				884				6.82				29,010				1,504				6.90
Total loans receivable			1,999,389				62,222				4.14				2,280,314				73,419				4.28
Investment securities(3)			447,894				8,103				2.41				405,124				6,192				1.92
Interest-earning bank balances			290,342				544				0.25				279,288				525				0.25
Total interest-earning assets			2,737,625				70,869				3.44				2,964,726				80,136				3.58
Non-interest earning assets:
Cash and due from banks			42,317												46,025
Restricted Cash			21,619												26,000
Bank properties and equipment, net			47,442												49,375
Goodwill and intangible assets, net			38,565												40,314
Other assets			85,400												104,931
Total non-interest-earning assets			235,343												266,645
Total assets		$	2,972,968											$	3,231,371
Interest-bearing liabilities:
Interest-bearing deposit accounts:
Interest-bearing demand deposits		$	1,086,050			$	2,304				0.28	%		$	1,249,777			$	3,269				0.35	%
Savings deposits			262,829				521				0.26				268,488				648				0.32
Time deposits			579,833				3,701				0.85				676,742				4,856				0.95
Total interest-bearing deposit accounts			1,928,712				6,526				0.45				2,195,007				8,773				0.53
Short-term borrowings:
Federal funds purchased			—				—				—				—				—				—
Securities sold under agreements to repurchase – customers			627				—				—				1,920				2				0.14
Long-term borrowings:
FHLBNY advances(4)			60,887				946				2.07				61,073				955				2.08
Obligations under capital lease			7,219				367				6.76				7,503				375				6.65
Junior subordinated debentures			92,786				1,607				2.30				92,786				1,643				2.36
Total borrowings			161,519				2,920				2.40				163,282				2,975				2.42
Total interest-bearing liabilities			2,090,231				9,446				0.60				2,358,289				11,748				0.66
Non-interest bearing liabilities:
Non-interest-bearing demand deposits			582,085												529,322
Other liabilities			51,321												81,476
Total non-interest bearing liabilities			633,406												610,798
Total liabilities			2,723,637												2,969,087
Shareholders’ equity			249,331												262,284
Total liabilities and shareholders’ equity		$	2,972,968											$	3,231,371
Net interest income						$	61,423											$	68,388
Interest rate spread(5)											2.84	%											2.93	%
Net interest margin(6)											2.98	%											3.07	%
Ratio of average interest-earning assets to average interest-bearing liabilities											131	%											125	%

 

(1)	Average balances include non-accrual loans, loans held-for-sale, branch assets held-for-sale and deposits held-for-sale.

 

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(2)	Loan fees are included in interest income and the amount is not material for this analysis.

(3)	Interest earned on non-taxable investment securities is shown on a tax-equivalent basis assuming a 35% marginal federal tax rate for all periods. The fully taxable equivalent adjustments for the nine months ended September 30, 2014 and 2013 were $498 thousand and $554 thousand, respectively.

(4)	Amounts include Advances from FHLBNY and Securities sold under agreements to repurchase – FHLBNY.

(5)	Interest rate spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.

(6)	Net interest margin represents net interest income as a percentage of average interest-earning assets.

Table 5: Rate/Volume⁽¹⁾

 

		For the Nine months Ended September 30, 2014 vs. 2013
		Increase (Decrease) Due To
		Volume				Rate				Net
Interest income:
Loans receivable:
Commercial and industrial		$	(8,616	)		$	(1,997	)		$	(10,613	)
Home equity lines of credit			(421	)			—				(421	)
Home equity term loan			(200	)			(48	)			(248	)
Residential real estate			488				217				705
Other			(604	)			(17	)			(621	)
Total loans receivable			(9,353	)			(1,845	)			(11,198	)
Investment securities			659				1,594				2,253
Interest-earning deposits with banks			14				5				19
Total interest-earning assets			(8,680	)			(246	)			(8,926	)
Interest expense:
Interest-bearing deposit accounts:
Interest-bearing demand deposits			(383	)			(582	)			(965	)
Savings deposits			(13	)			(114	)			(127	)
Time deposits			(666	)			(489	)			(1,155	)
Total interest-bearing deposit accounts			(1,062	)			(1,185	)			(2,247	)
Short-term borrowings:
Federal funds purchased			—				—				—
Securities sold under agreements to repurchase – customers			(2	)			—				(2	)
Long-term borrowings:
FHLBNY advances(2)			(5	)			(4	)			(9	)
Obligations under capital lease			(1	)			(7	)			(8	)
Junior subordinated debentures			—				(36	)			(36	)
Total borrowings			(8	)			(47	)			(55	)
Total interest-bearing liabilities			(1,070	)			(1,232	)			(2,302	)
Net change in net interest income		$	(7,610	)		$	986			$	(6,624	)

 

(1)

For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (changes in average volume multiplied by old rate) and (ii) changes in rate (changes in rate multiplied by old average volume). The combined effect of changes in both volume and rate has been allocated to volume or rate changes in proportion to the absolute dollar amounts of the change in each.

(2)	Amounts include Advances from FHLBNY and Securities sold under agreements to repurchase – FHLBNY.

        Provision for Loan Losses. The Company recorded provision expense of $14.8 million during the nine months ended September 30, 2014, as compared to provision recovery of $988 thousand for the same period in 2013. Total non-performing loans held-for-investment decreased $23.9 million from $38.0 million at December 31, 2013 to $14.1 million at September 30, 2014. The ratio of allowance for loan losses to gross loans receivable was 1.58% at September 30, 2014 as compared to 1.66% at December 31, 2013. Net charge-offs for the nine months ended September 30, 2014 were $23.8 million as compared to net charge-offs of $4.0 million during the same period in 2013.

The provision recorded is the amount deemed appropriate by management based on the current risk profile of the portfolio to absorb losses existing at the balance sheet date. At least monthly, management performs an analysis to identify the inherent risk of loss in the Company’s loan portfolio. This analysis includes a qualitative evaluation of concentrations of credit, past loss experience, current economic conditions, amount and composition of the loan portfolio (including loans being specifically monitored by management), estimated fair value of underlying collateral, delinquencies, and other factors. Additionally, management updates the migration analysis and historic loss and recovery experience on a quarterly basis.

 

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Non-Interest Income. Non-interest income decreased $13.3 million to $13.6 million for the nine months ended September 30, 2014, as compared to $26.9 million for the same period in 2013. During the nine months ended September 30, 2014, the Company recorded $1.6 million of mortgage banking revenue, net, a decrease of $9.0 million compared to the prior year period, due to the Company’s strategic decision to exit the mortgage banking business. The non-interest income decrease was also driven by a $3.4 million decrease in gain on sale of investment securities from $3.5 million recorded during the nine months ended September 30, 2013 to $50 thousand recorded during the nine months ended September 30, 2014.

Non-Interest Expense. Non-interest expense decreased $11.8 million to $85.7 million for the nine months ended September 30, 2014 as compared to $97.5 million for the same period in 2013. The decrease was primarily due to decreases of $4.3 million in commission expense, $8.1 million in professional fees, and $1.1 million in problem loan expense, partially offset by an increase of $2.2 million in other non-interest expense. Commission expense declined due to reduced mortgage origination volume and professional fees declined significantly as the Company reduced its reliance on external consultants for operational infrastructure improvements and regulatory remediation. Problem loan expense declined due to the significant reduction in the Company’s problem loans over that period. Other expense includes $1.1 million of costs associated with loan sale transactions in the nine months ended September 30, 2014.

Liquidity and Capital Resources

The liquidity of the Company is the ability to maintain cash flows that are adequate to fund operations and meet its other obligations on a timely and cost-effective basis in various market conditions. The ability of the Company to meet its current financial obligations is a function of balance sheet structure, the ability to liquidate assets and the availability of alternative sources of funds. To meet the needs of the clients and manage the risk of the Company, the Company engages in liquidity planning and management.

The major source of the Company’s funding on a consolidated basis is deposits, which management believes will be sufficient to meet the Company’s daily and long-term operating liquidity needs. The ability of the Company to retain and attract new deposits is dependent upon the variety and effectiveness of its customer account products, customer service and convenience, and rates paid to customers. The Company also obtains funds from the repayment and maturities of loans, loan sales or participations and maturities or calls of investment securities. Additional liquidity can be obtained in a variety of wholesale funding sources as well, including, but not limited to, federal funds purchased, FHLBNY advances, securities sold under agreements to repurchase, and other securities and unsecured borrowings. Through the Bank, the Company also purchases brokered deposits for funding purposes; however, this funding source is currently limited to 6.0% of the Bank’s total liabilities in accordance with a written agreement between the Bank and the OCC and the OCC’s subsequent approved increase in the limit on brokered deposits, as discussed later in this section. In a continued effort to balance deposit growth and net interest margin, especially in the current interest rate environment and with competitive local deposit pricing, the Company continually evaluates these other funding sources for funding cost efficiencies. Deposit rates continued to decrease in the third quarter of 2014, but at a rate slower than in previous quarters. Core deposits, which exclude all certificates of deposit, decreased by $377.1 million to $1.63 billion, or 75.1% of total deposits at September 30, 2014, as compared to $2.01 billion, or 76.6% of total deposits at December 31, 2013. This decrease was primarily due to the reclassification of $192.1 million of deposits to deposits held-for-sale on the unaudited condensed consolidated statements of financial condition at September 30, 2014 as well as planned declines in public funds deposits. The Company has additional secured borrowing capacity with the Federal Reserve Bank of approximately $158.3 million, of which none was utilized, and the FHLBNY of approximately $164.1 million, of which $60.8 million was utilized. In addition to secured borrowings, the Company also has unsecured borrowing capacity through lines of credit with other financial institutions of $35.0 million, of which none were utilized as of September 30, 2014. Management continues to monitor the Company’s liquidity and has taken measures to increase its borrowing capacity by providing additional collateral through the pledging of loans. As of September 30, 2014, the Company had a par value of $234.5 million and $162.8 million in loans and securities, respectively, pledged as collateral on secured borrowings.

The Company’s primary uses of funds are the origination of loans, the funding of the Company’s maturing certificates of deposit, deposit withdrawals, the repayment of borrowings and general operating expenses. Certificates of deposit scheduled to mature during the 12 months ending September 30, 2015 total $356.6 million, or approximately 65.7% of total certificates of deposit. The Company continues to operate with a core deposit relationship strategy that values a long-term stable customer relationship. This strategy employs a pricing strategy that rewards customers that establish core accounts and maintain a certain minimum threshold account balance. Based on market conditions and other liquidity considerations, the Company may also avail itself to the secondary borrowings discussed above.

The Company anticipates that deposits, cash and cash equivalents on hand, the cash flow from assets, as well as other sources of funds will provide adequate liquidity for the Company’s future operating, investing and financing needs.

 

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The Bank’s deposits are insured to applicable limits by the FDIC. Pursuant to the Dodd-Frank Act, the Federal Deposit Insurance Act was amended to increase the maximum deposit insurance amount from $100,000 to $250,000.

On April 15, 2010, the Bank entered into the OCC Agreement which contained requirements to develop and implement a profitability and capital plan which provides for the maintenance of adequate capital to support the Bank’s risk profile in the current economic environment. The capital plan was required to contain a dividend policy allowing dividends only if the Bank is in compliance with the capital plan, and obtains prior approval from the OCC. In addition, we are required to seek the prior approval of the Federal Reserve Bank before paying interest, principal or other sums on trust preferred securities or any related subordinated debentures, declaring or paying cash dividends or taking dividends from the Bank, repurchasing outstanding stock or incurring indebtedness. The Company is also required to take certain remedial steps and submit plans and progress reports to the Federal Reserve Bank. All requirements noted above were met as of September 30, 2014.

The Bank also agreed to: (a) implement a program to protect the Bank’s interest in criticized or classified assets, (b) review and revise the Bank’s loan review program; (c) implement a program for the maintenance of an adequate allowance for loan losses; and (d) revise the Bank’s credit administration policies. The Bank initially agreed that its brokered deposits would not exceed 3.5% of its total liabilities unless approved by the OCC. However, effective October 18, 2012, the OCC approved an increase of this limit to 6.0%. Management does not expect this restriction will limit its access to liquidity as the Bank does not rely on brokered deposits as a major source of funding. At September 30, 2014, the Bank’s brokered deposits represented 4.0% of its total liabilities.

On June 30, 2014, for regulatory capital purposes, the Company contributed $7.5 million in additional capital to the Bank.

Management believes it is taking all necessary actions for the Bank to achieve full compliance with all requirements of the OCC Agreement and the Federal Reserve Bank requirements discussed above.

The Bank is also subject to individual minimum capital ratios established by the OCC for the Bank requiring the Bank to continue to maintain a Leverage ratio at least equal to 8.50% of adjusted total assets, to continue to maintain a Tier 1 Capital ratio at least equal to 9.50% of risk-weighted assets and maintain a Total Capital ratio at least equal to 11.50% of risk-weighted assets. At September 30, 2014, the Bank met all of the three capital ratios established by the OCC as its Leverage ratio was 9.12%, Tier 1 Capital ratio was 13.20%, and Total Capital ratio was 14.45%.

In August 2014, the Company raised approximately $20 million in new equity through a privately negotiated sale of its common stock to several institutions and private investors. The Company issued a total of 1,133,144 shares of common stock in this transaction at a price per share of $17.65.

The following table provides both the Company’s and the Bank’s regulatory capital ratios as of September 30, 2014:

Table 6: Regulatory Capital Levels

 

		Actual								For Capital Adequacy Purposes								To Be Well Capitalized Under Prompt Corrective Action Provision(1)
		Amount				Ratio				Amount				Ratio				Amount				Ratio
September 30, 2014
Total capital (to risk-weighted assets):
Sun Bancorp, Inc.		$	321,774				17.99	%		$	143,139				8.00	%			N/A
Sun National Bank			289,955				16.24				142,854				8.00			$	178,567				10.00	%
Tier I capital (to risk-weighted assets):
Sun Bancorp, Inc.			279,139				15.60				71,569				4.00				N/A
Sun National Bank			267,902				15.01				71,427				4.00				107,140				6.00
Leverage ratio:
Sun Bancorp, Inc.			279,139				9.79				114,027				4.00				N/A
Sun National Bank			267,902				9.41				113,892				4.00				142,365				5.00

 

(1)	Not applicable for bank holding companies.

The Company’s capital securities qualify as Tier 1 capital under federal regulatory guidelines. These instruments are subject to a 25% capital limitation under risk-based capital guidelines developed by the FRB. Under FRB rules, restricted core capital elements, which are qualifying trust preferred securities, qualifying cumulative perpetual preferred stock (and related surplus) and certain minority interests in consolidated subsidiaries, are limited in the aggregate to no more than 25% of a bank holding company’s core capital elements (including restricted core capital elements), net of goodwill less any associated deferred tax liability. However, under the Dodd-Frank Act, bank holding companies are prohibited from including in their Tier 1 capital hybrid debt and equity securities, including trust preferred securities, issued on or after May 19, 2010. Any such instruments issued before May 19, 2010 by a bank holding company, such

 

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as the Company, with total consolidated assets of less than $15 billion as of December 31, 2009, may continue to be included as Tier 1 capital (subject to the 25% limitation). The portion that exceeds the 25 percent capital limitation qualifies as Tier 2, or supplementary capital of the Company. At September 30, 2014, $69.8 million of a total of $90.0 million in capital securities qualified as Tier 1 with $20.2 million qualifying as Tier 2.

Basel III Capital Rules

Regulatory reforms have recently been instituted, which will also impose restrictions on our current business practices. Recent items affecting us include the final Basel III rule.

On July 2, 2013, the federal banking regulators, including the FRB and the OCC, approved the final Basel III capital rules for U.S. banking organizations. The final rules establish an integrated regulatory capital framework and will implement in the United States the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision and certain changes required by the Dodd-Frank Act. Under the final rule, minimum requirements will increase for both the quantity and quality of capital held by banking organizations. Consistent with the international Basel framework, the final rule includes a new minimum ratio of common equity tier 1 capital to risk-weighted assets that will apply to all covered financial institution holding companies and all supervised financial institutions. The rule also raises the minimum ratio of tier 1 capital to risk-weighted assets and includes a minimum leverage ratio of 4 percent for all banking organizations. These new minimum capital ratios will become effective for us on January 1, 2015 and will be fully phased-in on January 1, 2019. These requirements are separate from the individual minimum capital ratios established by the OCC.

In addition, the final rule will impose limits on capital distributions by, and discretionary bonus payments to executive officers of, banking organizations that do not maintain a common equity tier 1 capital conservation buffer of 2.5% of risk-weighted assets. The capital conservation buffer will be phased-in over a transition period from January 1, 2016 to January 1, 2019.

The final rule emphasizes common equity tier 1 capital, the most loss-absorbing form of capital, and implements strict eligibility criteria for regulatory capital instruments. The final rule also improves the methodology for calculating risk-weighted assets to enhance risk sensitivity. Banks and regulators use risk weighting to assign different levels of risk to different classes of assets.

The chart below contains the Basel III regulatory capital levels that we must satisfy during the applicable transition period, from January 1, 2015 until January 1, 2019, which are in addition to and separate from the individual minimum capital ratios established by the OCC.

 

		Basel III Regulatory Capital Levels
		January 1, 2015				January 1, 2016				January 1, 2017				January 1, 2018				January 1, 2019
Tier 1 common equity			4.5	%			5.125	%			5.75	%			6.375	%			7.0	%
Tier 1 risk-based capital ratio			6.0	%			6.625	%			7.25	%			7.875	%			8.5	%
Total risk-based capital ratio			8.0	%			8.625	%			9.25	%			9.875	%			10.5	%

The Basel III Capital Rules also revise the “prompt corrective action” regulations pursuant to Section 38 of the Federal Deposit Insurance Act, by (i) introducing a common equity tier 1 capital ratio requirement at each level (other than critically undercapitalized), with the required common equity tier 1 capital ratio being 6.5% for well-capitalized status; (ii) increasing the minimum Tier 1 capital ratio requirement for each category (other than critically undercapitalized), with the minimum Tier 1 capital ratio for well-capitalized status being 8% (as compared to the current 6%), and (iii) eliminating the current provision that provides that a bank with a composite supervisory rating of 1 may have a 3% leverage ratio and still be adequately capitalized. The Basel III Capital Rules do not change the total risk-based capital requirement for any prompt corrective action category.

We currently anticipate that our capital ratios, on a Basel III basis, will exceed the regulatory minimum requirements to be considered well-capitalized. However, we are evaluating options to mitigate the capital impact of the final rule prior to its effective implementation date.

 

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Dividend Restrictions

The ability of the Bank to pay dividends to the Company is governed by certain regulatory restrictions. Generally, dividends declared in a given year by a national bank are limited to its net profit, as defined by regulatory agencies, for that year, combined with its retained net income for the preceding two years, less any required transfer to surplus or to fund for the retirement of any preferred stock. In addition, a national bank may not pay any dividends in an amount greater than its undivided profits and a national bank may not declare any dividends if such declaration would leave the bank inadequately capitalized. Therefore, the ability of the Bank to declare dividends will depend on its future net income and capital requirements. Also, banking regulators have indicated that national banks should generally pay dividends only out of current operating earnings. Following this guidance, the Bank was not able to pay a dividend to the Company at June 30, 2014. Moreover, per the OCC Agreement and the Federal Reserve Bank requirements, a dividend may only be declared if it is in accordance with the approved capital plan, the Bank remains in compliance with the capital plan following the payment of the dividend and the dividend is approved by the OCC and the Federal Reserve Bank.

Volcker Rule

On December 10, 2013, the FRB, the OCC, the FDIC, the CFTC and the SEC issued final rules to implement the Volcker Rule contained in section 619 of the Dodd-Frank Act, generally to become effective on July 21, 2015. The Volcker Rule prohibits an insured depository institution and its affiliates (referred to as “banking entities”) from: (i) engaging in “proprietary trading” and (ii) investing in or sponsoring certain types of funds (“covered funds”) subject to certain limited exceptions. These prohibitions impact the ability of U.S. banking entities to provide investment management products and services that are competitive with nonbanking firms generally and with non-U.S. banking organizations in overseas markets. The rule also effectively prohibits short-term trading strategies by any U.S. banking entity if those strategies involve instruments other than those specifically permitted for trading.

The final Volcker Rule regulations do provide certain exemptions allowing banking entities to continue underwriting, market-making and hedging activities and trading certain government obligations, as well as various exemptions and exclusions from the definition of “covered funds.” However, the level of required compliance activity depends on the size of the banking entity and the extent of its trading.

On January 14, 2014, the five federal agencies approved an interim final rule to permit banking entities to retain interests in certain collateralized debt obligations backed primarily by trust preferred securities from the investment prohibitions of the Volcker Rule. Under the interim final rule, the agencies permit the retention of an interest in or sponsorship of covered funds by banking entities if certain qualifications are met. In addition, the agencies released a non-exclusive list of issuers that meet the requirements of the interim final rule. At September 30, 2014, the Company had an investment in one pool of trust preferred securities with an amortized cost of $8.8 million and estimated fair value of $6.8 million. This pool was included in the non-exclusive list of issuers that meet the requirements of the interim final rule released by the agencies and therefore will not be required to be sold by the Company. On April 17, 2014 the FRB released guidance stating that it would extend the conformance period for banks holding collateralized loan obligations by two years to July 2017.

At September 30, 2014, the Bank had 13 collateralized loan obligation securities with an amortized cost of $79.9 million and an estimated fair value of $79.2 million. These securities are subject to the provisions of the Volcker Rule. However, a final determination has yet to be made on whether banks will be required to divest these investments. Discussion has been ongoing among the regulators, Congress and the investors in collateralized loan obligations. Based on the current status of these discussions and through the Bank’s communication with its investment advisors, the Bank’s management believes it will either be able to hold these collateralized loan obligation investments in its portfolio or have them modified such that the perceived risk will be adequately eliminated.

At September 30, 2014, the Bank had one non-rated single issuer security with an amortized cost of $3.2 million and an estimated fair value of $2.9 million. This security is not subject to the provisions of the Volcker Rule.

See Note 13 of the notes to unaudited condensed consolidated financial statements for additional information regarding regulatory matters.

Disclosures about Commitments

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The guarantees are primarily issued to support private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. In the event of a draw by the beneficiary that complies with the terms of the letter of credit, the Company would be required to honor the commitment. The Company takes various forms of collateral, such as real estate assets and customer business assets, to secure the commitment. Additionally, all letters of credit are supported by indemnification agreements executed by the customer. The maximum undiscounted exposure related to these commitments at September 30, 2014 was $24.5 million and the portion of the exposure not covered by collateral was approximately $449 thousand. We believe that the utilization rate of these letters of credit will continue to be substantially less than the amount of these commitments, as has been our experience to date.

 

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The Company maintains a reserve for unfunded loan commitments and letters of credit, which is reported in other liabilities in the unaudited condensed consolidated statements of financial condition, consistent with FASB ASC 825. As of the balance sheet date, the Company records estimated losses inherent with unfunded loan commitments in accordance with FASB ASC 450, Contingencies, and estimated future obligations under letters of credit in accordance with FASB ASC 460, Guarantees. The methodology used to determine the adequacy of this reserve is integrated in the Company’s process for establishing the allowance for loan losses and considers the probability of future losses and obligations that may be incurred under these off-balance sheet agreements. The reserve for unfunded loan commitments and letters of credit at September 30, 2014 and December 31, 2013 was $739 thousand and $454 thousand, respectively. Management believes this reserve level is sufficient to absorb estimated probable losses related to these commitments.

The Company maintains a reserve for residential mortgage loans sold with recourse to third-party purchasers which is reported in other liabilities in the unaudited condensed consolidated statements of financial condition. As of September 30, 2014, the Company records estimated losses inherent with residential mortgage loans sold with recourse in accordance with FASB ASC 460, Guarantees. This reserve is determined based upon the probability of future losses which is calculated using historical Company and industry loss data. The reserve for residential mortgage loan recourse as of September 30, 2014 and December 31, 2013 was $765 thousand and $647 thousand, respectively. Management believes this reserve level is sufficient to address potential recourse exposure.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Asset and Liability Management

Interest rate, credit and operational risks are among the most significant market risks impacting the performance of the Company. The Company has an Asset Liability Committee (“ALCO”), composed of senior management representatives from a variety of areas within the Company. ALCO devises strategies and tactics to maintain the net interest income of the Company within acceptable ranges over a variety of interest rate scenarios. Should the Company’s risk modeling indicate an undesired exposure to changes in interest rates, there are a number of remedial options available including changing the investment portfolio characteristics, and changing loan and deposit pricing strategies. Two of the tools used in monitoring the Company’s sensitivity to interest rate changes are gap analysis and net interest income simulation.

Gap Analysis. Banks are concerned with the extent to which they are able to match maturities or re-pricing characteristics of interest-earning assets and interest-bearing liabilities. Such matching is facilitated by examining the extent to which such assets and liabilities are interest-rate sensitive and by monitoring the bank’s interest rate sensitivity gap. Gap analysis measures the volume of interest-earning assets that will mature or re-price within a specific time period, compared to the interest-bearing liabilities maturing or re-pricing within that same time period. On a monthly basis the Company and the Bank monitor their gap, primarily cumulative through both nine months and one year maturities.

At September 30, 2014, the Company’s gap analysis showed an asset sensitive position with total interest-earning assets maturing or re-pricing within one year exceeding interest-bearing liabilities maturing or re-pricing during the same time period by $586.4 million representing a positive one-year gap ratio of 20.8%. All amounts are categorized by their actual maturity or anticipated call or re-pricing date with the exception of interest-bearing demand deposits and savings deposits. Though the rates on interest-bearing demand and savings deposits generally trend with open market rates, they often do not fully adjust to open market rates and frequently adjust with a time lag. As a result of prior experience during periods of rate volatility and management’s estimate of future rate sensitivities, the Company allocates the interest-bearing demand deposits and savings deposits based on an estimated decay rate for those deposits.

Net Interest Income Simulation. Due to the inherent limitations of gap analysis, the Company also uses simulation models to measure the impact of changing interest rates on its operations. The simulation model attempts to capture the cash flow and re-pricing characteristics of the current assets and liabilities on the Company’s balance sheet. Assumptions regarding such things as prepayments and rate change behaviors are incorporated into the simulation model. Net interest income is simulated over a twelve month horizon under a variety of linear yield curve shifts, subject to certain limits agreed to by ALCO.

Net interest income simulation analysis at September 30, 2014 shows a position that is relatively neutral to interest rates with a more negative bias as rates decrease. The net income simulation results are impacted by an expected continuation of deposit pricing competition which may limit deposit pricing flexibility in both increasing and decreasing rate environments, floating-rate loan floors initially limiting loan rate increases and a relatively short liability maturity structure including retail certificates of deposit.

Actual results may differ from the simulated results due to such factors as the timing, magnitude and frequency of interest rate changes, changes in market conditions, management strategies and differences in actual versus forecasted balance sheet composition and activity. Table 7 provides the Company’s estimated earnings sensitivity profile as of September 30, 2014. The Company anticipates that strong deposit pricing competition will continue to limit deposit pricing flexibility in an increasing and a decreasing rate environment.

 

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Table 7: Sensitivity Profile

 

Change in Interest Rates (Basis Points)		Percentage Change in Net Interest Income Year 1
+200			8.4	%
+100			4.0	%
-100			(1.5	)%
-200			(2.5	)%

Derivative Financial Instruments. The Company utilizes certain derivative financial instruments to enhance its ability to manage interest rate risk that exists as part of its ongoing business operations. In general, the derivative transactions entered into by the Company fall into one of two types: a fair value hedge of a specific fixed-rate loan agreement and an economic hedge of a derivative offering to a Bank customer. Derivative financial instruments involve, to varying degrees, interest rate, market and credit risk. The Company manages these risks as part of its asset and liability management process and through credit policies and procedures. The Company seeks to minimize counterparty credit risk by establishing credit limits and collateral agreements. The Company does not use derivative financial instruments for trading purposes. For more information on the Company’s financial derivative instruments, please see Note 8 of the notes to unaudited condensed consolidated financial statements.

Item 4. Controls and Procedures

(a) Evaluation of disclosure controls and procedures. Based on their evaluation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act), the Company’s principal executive officer and principal financial officer have concluded that as of the end of the period covered by this Quarterly Report on Form 10-Q, such disclosure controls and procedures were designed and functioning effectively to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms and (ii) accumulated and communicated to the Company’s management, including the principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosures.

(b) Changes in internal control over financial reporting. During the quarter under report, there was no change in the Company’s internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

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PART II – OTHER INFORMATION

Item 1. Legal Proceedings

The Company and the Bank are periodically involved in various claims and lawsuits, such as claims to enforce liens, condemnation proceedings on properties in which the Bank holds security interests, and claims involving the making and servicing of real property loans. While the ultimate outcome of these proceedings cannot be predicted with certainty, management, after consultation with counsel representing the Company in these proceedings, does not expect that the resolution of these proceedings will have a material effect on the Company’s financial condition, results of operations or cash flows.

Item 1A. Risk Factors

Management of the Company does not believe there have been any material changes to the Risk Factors previously disclosed under Item 1A of the Company’s Form 10-K for the year ended December 31, 2013 and Form 10-Q for the three months ended June 30, 2014 previously filed with the Securities and Exchange Commission.

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

Not applicable

Item 3. Defaults Upon Senior Securities

Not applicable

Item 4. Mine Safety Disclosures.

Not applicable

Item 5. Other Information

Not Applicable

 

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Item 6. Exhibits

 

Exhibit 3.1		Amended and Restated Certificate of Incorporation of Sun Bancorp, Inc.
Exhibit 3.2		Amended and Restated Bylaws of Sun Bancorp, Inc. (1)
Exhibit 4.1		Common Security Specimen (2)
Exhibit 31(a)		Certification of Principal Executive Officer Pursuant to §302 of the Sarbanes-Oxley Act of 2002.
Exhibit 31(b)		Certification of Principal Financial Officer Pursuant to §302 of the Sarbanes-Oxley Act of 2002.
Exhibit 32		Certifications of Principal Executive Officer and Principal Financial Officer Pursuant to §906 of the Sarbanes-Oxley Act of 2002.
Exhibit 101.INS		XBRL Instance Document
Exhibit 101.SCH		XBRL Taxonomy Extension Schema Document
Exhibit 101.CAL		XBRL Taxonomy Extension Calculation Linkbase Document
Exhibit 101.LAB		XBRL Taxonomy Extension Label Linkbase Document
Exhibit 101.PRE		XBRL Taxonomy Extension Presentation Linkbase Document
Exhibit 101.DEF		XBRL Taxonomy Definition Linkbase Document

 

(1)	Incorporated by reference to the exhibits to the Company’s Current Report on Form 8-K filed on July 7, 2014 (File No. 0-20957).

(2)	Incorporated by reference to the registrant’s Registration Statement on Form S-1 filed with the Commission on February 14, 1997 (File No. 333-21903).

SIGNATURES

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

 

		Sun Bancorp, Inc.
		Registrant
Date: November 6, 2014
		/s/ Thomas M. O’Brien
		Thomas M. O’Brien
		President and Chief Executive Officer
		(Duly Authorized Representative)
Date: November 6, 2014
		/s/ Thomas R. Brugger
		Thomas R. Brugger
		Executive Vice President and
		Chief Financial Officer
		(Duly Authorized Representative)

 

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