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

 

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

 

Commission File Number: 000-29829

 

PACIFIC FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 

Washington		91-1815009
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

 

1101 S. Boone Street

Aberdeen, Washington 98520-5244

(Address of principal executive offices) (Zip Code)

 

(360) 533-8870

(Registrant's telephone number, including area code)

 

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

 

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

Yes  x    No ¨

 

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

Large accelerated filer ¨    Accelerated filer  ¨    Non-accelerated filer   ¨        Smaller Reporting Company x

 

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

 

The number of shares outstanding of Registrant's common stock as of November 7, 2014 was 10,367,460.

 

 

Form 10-Q

Table of Contents

 

Part I	FINANCIAL INFORMATION
Item I.	FINANCIAL STATEMENTS (UNAUDITED)	3
	CONDENSED CONSOLIDATED BALANCE SHEETS SEPTEMBER 30, 2014 AND DECEMBER 31, 2013	3
	CONDENSED CONSOLIDATED STATEMENTS OF INCOME THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2014 AND 2013	4
	CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2014 AND 2013	5
	CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY NINE MONTHS ENDED SEPTEMBER 30, 2014 AND 2013	6
	CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS NINE MONTHS ENDED SEPTEMBER 30, 2014 AND 2013	7
	NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS	8
Item 2.	MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	41
Item 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	64
Item 4.	CONTROLS AND PROCEDURES	64
Part II	OTHER INFORMATION
Item 1.	LEGAL PROCEEDINGS	64
Item 1A.	RISK FACTORS	64
Item 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	64
Item 3.	DEFAULTS UPON SENIOR SECURITIES	65
Item 4.	MINE SAFETY DISCLOSURES	65
Item 5.	OTHER INFORMATION	65
Item 6.	EXHIBITS	66
SIGNATURES		66

 

 

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

 

PACIFIC FINANCIAL CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(Dollars in Thousands, except per share data)

(UNAUDITED)

 

		September 30,				December 31,
		2014				2013
ASSETS
Cash and cash equivalents:
Cash and due from banks		$	15,284			$	12,214
Interest-bearing deposits in banks			25,497				23,734
Total cash and cash equivalents			40,781				35,948
Interest-bearing certificates of deposit (original maturities greater than 90 days)			2,727				2,727
Federal Home Loan Bank stock, at cost			2,926				3,013
Pacific Coast Bankers' Bank stock, at cost			1,000				-
Investment securities:
Investment securities available-for-sale, at fair market value			89,328				96,144
Investment securities held-to-maturity, at amortized cost (fair value of $1,873 and $2,158)			1,857				2,132
Total investment securities			91,185				98,276
Loans held-for-sale			8,161				7,765
Loans, net of deferred loan fees			552,140				504,666
Allowance for loan losses			(8,255	)			(8,359	)
Loans, net			543,885				496,307
Premises and equipment, net of accumulated depreciation and amortization			16,460				16,790
Other real estate owned and foreclosed assets			1,210				2,771
Accrued interest receivable			2,337				2,307
Cash surrender value of life insurance			18,615				18,237
Goodwill			12,168				12,168
Other intangible assets			1,449				1,481
Other assets			6,143				7,249
TOTAL ASSETS		$	749,047			$	705,039
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES
Deposits:
Demand		$	182,259			$	145,028
Interest-bearing demand and savings			343,524				336,260
Time deposits			118,221				126,059
Total deposits			644,004				607,347
Accrued interest payable			141				167
Short-term borrowings			-				-
Long-term borrowings			11,491				10,000
Junior subordinated debentures			13,403				13,403
Other liabilities			6,751				6,985
Total liabilities			675,790				637,902
COMMITMENTS AND CONTINGENCIES (Note 7)
SHAREHOLDERS' EQUITY
Preferred Stock, par value none 5,000,000 shares authorized, none outstanding
Common Stock, par value $1 25,000,000 shares authorized, 10,367,460 shares issued and outstanding at 09/30/2014 and 10,182,083 at 12/31/2013			10,367				10,182
Additional paid-in-capital			42,940				41,817
Retained earnings			20,312				16,507
Accumulated other comprehensive income/(loss)			(362	)			(1,369	)
Total shareholders' equity			73,257				67,137
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY		$	749,047			$	705,039

 

See accompanying notes.

 

 

PACIFIC FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

(Dollars in Thousands, Except per Share Data)

(UNAUDITED)

 

		For the Three Months Ended								For the Nine Months Ended
		September 30,				September 30,				September 30,				September 30,
		2014				2013				2014				2013
INTEREST AND DIVIDEND INCOME
Loans		$	6,894			$	6,116			$	20,132			$	18,158
Deposits in banks and federal funds sold			24				34				62				85
Investment securities:
Taxable			298				220				980				471
Tax-exempt			183				234				645				761
FHLB dividends			1				1				2				1
Total interest and dividend income			7,400				6,605				21,821				19,476
INTEREST EXPENSE
Deposits:
Interest-bearing demand and savings			134				167				415				547
Time			269				307				835				1,026
Long-term borrowings			54				54				158				168
Junior subordinated debentures			61				62				181				186
Total interest expense			518				590				1,589				1,927
Net interest income			6,882				6,015				20,232				17,549
LOAN LOSS PROVISION			100				-				200				(450	)
Net interest income after loan loss provision			6,782				6,015				20,032				17,999
NON-INTEREST INCOME
Service charges on deposit accounts			450				440				1,359				1,281
Net gains (loss) on sale of other real estate owned			(85	)			18				(179	)			43
Net gains from sales of loans			1,120				1,128				2,717				4,306
Net gains (loss) on sales of securities available for sale			38				14				88				401
Net other-than-temporary impairment (net of $0, $7, $15, $2 respectively recognized in other comprehensive income before taxes)			-				(4	)			(48	)			(38	)
Earnings on bank owned life insurance			127				105				378				342
Other operating income			624				531				1,743				1,698
Total non-interest income			2,274				2,232				6,058				8,033
NON-INTEREST EXPENSE
Salaries and employee benefits			4,286				4,098				12,624				12,983
Occupancy			483				473				1,494				1,338
Equipment			261				233				775				619
Data processing			492				449				1,387				1,688
Professional services			220				198				606				696
Other real estate owned write-downs			1				176				67				636
Other real estate owned operating costs			100				67				191				276
State taxes			110				110				314				360
FDIC and state assessments			119				129				381				395
Other non-interest expense			1,061				1,156				3,189				3,389
Total non-interest expense			7,133				7,089				21,028				22,380
INCOME BEFORE PROVISION FOR INCOME TAXES			1,923				1,158				5,062				3,652
PROVISION FOR INCOME TAXES			549				249				1,257				710
NET INCOME APPLICABLE TO COMMON SHAREHOLDERS		$	1,374			$	909			$	3,805				2,942
EARNINGS PER COMMON SHARE:
BASIC		$	0.13			$	0.09			$	0.37				0.29
DILUTED		$	0.13			$	0.09			$	0.37				0.29
WEIGHTED AVERAGE SHARES OUTANDING:
BASIC			10,281,745				10,121,853				10,218,103				10,121,853
DILUTED			10,379,166				10,194,826				10,309,436				10,179,928

 

See accompanying notes.

 

 

PACIFIC FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Dollars in Thousands)

(UNAUDITED)

 

		For the Three Months Ended								For the Nine Months Ended
		September 30,				September 30,				September 30,				September 30,
		2014				2013				2014				2013
NET INCOME		$	1,374			$	909			$	3,805			$	2,942
OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX:
Change in fair value of securities available-for-sale			(42	)			509				920				(1,494	)
Defined benefit plan			29				28				87				84
Total other comprehensive income (loss), net of tax			(13	)			537				1,007				(1,410	)
COMPREHENSIVE INCOME		$	1,361			$	1,446			$	4,812			$	1,532

 

See accompanying notes.

 

 

PACIFIC FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY

(Dollars in Thousands, Except Share Amounts)

(UNAUDITED)

 

																		Accumulated
		Common Stock								Additional				Retained				Other Comprehensive				Total Shareholders'
		Shares				Amount				Paid-in Capital				Earnings				Income/(Loss)				Equity
BALANCE - December 31, 2012			10,121,853			$	10,122			$	41,366			$	14,812			$	421			$	66,721
Net income			-				-								2,942				-				2,942
Other comprehensive income, net of tax
Unrealized holding loss on securities less reclassification adjustments for net gains included in net income			-				-				-				-				(1,494	)			(1,494	)
Amortization of unrecognized prior service costs and net gains			-				-				-				-				84				84
Stock-based compensation expense			-				-				83				-				-				83
BALANCE - September 30, 2013			10,121,853			$	10,122			$	41,449			$	17,754			$	(989	)		$	68,336
BALANCE - December 31, 2013			10,182,083			$	10,182			$	41,817			$	16,507			$	(1,369	)		$	67,137
Net income			-				-								3,805				-				3,805
Other comprehensive income, net of tax
Unrealized holding gain on securities less reclassification adjustments for net gains included in net income			-				-				-				-				920				920
Amortization of unrecognized prior service costs and net gains			-				-				-				-				87				87
Stock repurchased (RSU)			-				-				(3	)			-				-				(3	)
Issuance of common stock			185,377				185				1,020				-				-				1,205
Stock-based compensation expense			-				-				106				-				-				106
BALANCE - September 30, 2014			10,367,460			$	10,367			$	42,940			$	20,312			$	(362	)		$	73,257

 

See accompanying notes.

 

 

PACIFIC FINANCIAL CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in Thousands)

(UNAUDITED)

 

		For the Nine Months Ended
		September 30,				September 30,
		2014				2013
CASH FLOWS FROM OPERATING ACTIVITIES
Net Income		$	3,805			$	2,942
Adjustments to reconcile net income to net cash from operating activities
Provision for credit losses			200				(450	)
Depreciation and amortization			1,981				1,710
Originations of loans held for sale			(112,797	)			(201,278	)
Proceeds from sales of loans held for sale			115,117				211,204
Net (gain) on sales of loans			(2,717	)			(4,306	)
Net gain on sales of securities available for sale			(88	)			(401	)
Net OTTI recognized in earnings			48				38
(Gain) loss on sales of other real estate owned			179				(43	)
(Gain) loss on sale of premises and equipment			6				18
Earnings on bank owned life insurance			(378	)			(342	)
Increase in accrued interest receivable			(30	)			(241	)
Decrease in accrued interest payable			(26	)			(33	)
Other real estate owned write-downs			67				636
(Increase) decrease in prepaid expenses			(39	)			2,127
Other — net			2,524				1,192
Net cash provided by operating activities			7,853				12,773
CASH FLOWS FROM INVESTING ACTIVITIES
Net increase in interest bearing balances with banks			(1,763	)			(11,476	)
Purchase of certificates of deposits held for investment, net			-				1,250
Activity in securities available for sale:
Sales			17,755				7,237
Maturities, prepayments and calls			5,552				8,467
Purchases			(16,779	)			(48,892	)
Activity in securities held to maturity:
Maturities, prepayments and calls			275				4,549
(Increase) decrease in loans made to customers, net of principal collections			(47,925	)			(36,395	)
Purchases of premises and equipment			(683	)			(2,012	)
Proceeds from sales of other real estate owned			1,463				1,343
Proceeds from sales of premises and equipment			8				-
Cash received in acquisition, net of cash paid			-				31,941
Net cash used in investing activities			(42,097	)			(43,988	)
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposits			36,657				33,041
Net decrease in short-term borrowings			-				(3,000	)
Proceeds from issuance of long-term debt			1,500				2,500
Repayments of long-term debt			(9	)			-
Warrants exercised			1,205				-
Repurchase of stock (RSU)			(3	)			-
Cash dividends paid			(2,036	)			-
Net cash provided by financing activities			37,314				32,541
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS			3,070				1,326
CASH AND DUE FROM BANKS - BEGINNING OF THE PERIOD			12,214				14,168
CASH AND DUE FROM BANKS - END OF THE PERIOD		$	15,284			$	15,494
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid for interest		$	1,615			$	1,958
Cash paid for taxes		$	-			$	440
SUPPLEMENTAL SCHEDULE OF NON CASH INVESTING AND
FINANCING ACTIVITIES
Change in fair value of securities available-for-sale, net of tax		$	920			$	(1,494	)
Transfer of loans held for sale to loans held for investment		$	-			$	64
Other real estate owned acquired in settlement of loans		$	(842	)		$	(1,591	)
Financed sale of other real estate owned		$	694			$	-

 

See accompanying notes.

 

 

PACIFIC FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

As of and for the nine months ended September 30, 2014

(Unaudited)

(Dollars in thousands, except per share amounts)

 

NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Organization – Pacific Financial Corporation (the “Company” or “Pacific”) is a bank holding company headquartered in Aberdeen, Washington. The Company owns one banking subsidiary, Bank of the Pacific (the “Bank”), which is also located in Washington. The Company was incorporated in the State of Washington in February, 1997, pursuant to a holding company reorganization of the Bank.

 

The Company conducts its banking business through the Bank, which operates 17 branches located in communities in Grays Harbor, Pacific, Whatcom, Clark, Skagit and Wahkiakum counties in the state of Washington and three in Clatsop County, Oregon. In addition, the Bank operates two loan production offices in Burlington and Dupont, Washington and has a residential real estate mortgage department. During second quarter 2013, the Bank completed the acquisition of three branches from Sterling Savings Bank. Total deposits assumed were $37.6 million and loans acquired totaled $4.0 million. Of the three branches purchased, two were consolidated into existing Pacific branches to maximize branch efficiencies resulting in one new branch in Astoria, Oregon. Separately, the Company opened a full-service branch in Warrenton, Oregon in October 2013 that further expands operations on the northern Oregon coast.

 

The accompanying unaudited condensed consolidated financial statements have been prepared by the Company in accordance with accounting principles generally accepted in the United States of America ("GAAP") for interim financial information and with instructions to Form 10-Q. Accordingly, these financial statements do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of Management, adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the nine months ended September 30, 2014, are not necessarily indicative of the results anticipated for the year ending December 31, 2014. Certain information and footnote disclosures included in the Company's consolidated financial statements for the year ended December 31, 2013, have been condensed or omitted from this report. Accordingly, these statements should be read in conjunction with the financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2013 (the “2013 Annual Report”).

 

Basis of presentation – The consolidated financial statements include the accounts of Pacific Financial Corporation and its wholly-owned subsidiary. All intercompany accounts and transactions have been eliminated in consolidation.

 

The interim consolidated financial statements are not audited, but include all adjustments that Management considers necessary for a fair presentation of consolidated financial condition and results of operations for the interim periods presented.

 

Method of accounting and use of estimates – The Company prepares its consolidated financial statements in conformity with accounting principles generally accepted in the United States of America and prevailing practices within the banking industry. This requires Management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of income and expenses during the reporting periods. Actual results could differ from those estimates. Significant estimates made by Management involve the calculation of the allowance for loan losses, impaired loans, the fair value of available-for-sale investment securities, deferred tax assets, and the value of other real estate owned and foreclosed assets.

 

The Company utilizes the accrual method of accounting, which recognizes income when earned and expenses when incurred.

 

In preparing these financial statements, the Company has evaluated events and transactions subsequent to September 30, 2014, for potential recognition or disclosure in the financial statements. In Management’s opinion, all accounting adjustments necessary to accurately reflect the financial position and results of operations on the accompanying financial statements have been made. These adjustments include normal and recurring accruals considered necessary for a fair and accurate presentation.

 

 

NOTE 2 – EARNINGS PER SHARE

 

The Company’s basic earnings per common share is computed by dividing net income available to common shareholders (net income less dividends declared by the weighted average number of common shares outstanding during the period). The Company’s diluted earnings per common share is computed similar to basic earnings per common share except that the numerator is equal to net income available to common shareholders and the denominator is increased to include the number of additional common shares that would have been outstanding if dilutive potential common shares had been issued. Included in the denominator are the dilutive effects of stock options computed under the treasury stock method and outstanding warrants as if converted to common stock.

 

The following table illustrates the computation of basic and diluted earnings per share.

 

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2014				2013				2014				2013
Basic:
Net income		$	1,374			$	909			$	3,805			$	2,942
Weighted average shares outstanding			10,281,745				10,121,853				10,218,103				10,121,853
Basic earnings per share		$	0.13			$	0.09			$	0.37			$	0.29
Diluted:
Net income		$	1,374			$	909			$	3,805			$	2,942
Weighted average shares outstanding			10,281,745				10,121,853				10,218,103				10,121,853
Effect of dilutive stock options			97,421				72,973				91,333				58,075
Weighted average shares outstanding assuming dilution			10,379,166				10,194,826				10,309,436				10,179,928
Diluted earnings per share		$	0.13			$	0.09			$	0.37			$	0.29

 

		September 30, 2014				September 30, 2013
Shares subject to outstanding options			367,595				433,995
Shares subject to outstanding warrants			-				699,642

 

As of September 30, 2014 and 2013, the shares subject to outstanding options and for September 30, 2013, the shares subject to outstanding warrants, had exercise prices in excess of the current market value. All of these shares are not included in the table above, as exercise of these options and warrants would not be dilutive to shareholders.

 

 

NOTE 3 – INVESTMENT SECURITIES

 

Investment securities consist principally of short and intermediate term debt instruments issued by the U.S. Treasury, other U.S. government agencies, state and local government units, other corporations, and mortgage backed securities (MBS).

 

		September 30, 2014
At September 30, 2014		Amortized Cost				Gross unrealized gains				Gross unrealized losses				Fair value
Available-for-sale:
Collateralized mortgage obligations: agency issued		$	40,562			$	209			$	732			$	40,039
Collateralized mortgage obligations: non agency			592				-				13				579
Mortgage-backed securities: agency issued			12,710				24				235				12,499
U.S. Government agency securities			8,637				64				46				8,655
State and municipal securities			26,825				834				103				27,556
Total available-for-sale		$	89,326			$	1,131			$	1,129			$	89,328
Held-to-maturity:
Mortgage-backed securities: agency issued		$	131			$	13			$	-			$	144
State and municipal securities			1,726				4				-				1,730
Total held-to-maturity		$	1,857			$	17			$	-			$	1,874

 

		December 31, 2013
At September 30, 2014		Amortized Cost				Gross unrealized gains				Gross unrealized losses				Fair value
Available-for-sale:
Collateralized mortgage obligations: agency issued		$	39,791			$	246			$	1,246			$	38,791
Collateralized mortgage obligations: non agency			2,251				3				243				2,011
Mortgage-backed securities: agency issued			13,671				21				303				13,389
U.S. Government agency securities			8,859				34				82				8,811
State and municipal securities			31,973				774				587				32,160
Corporate bonds			991				-				9				982
Total available-for-sale		$	97,536			$	1,078			$	2,470			$	96,144
Held-to-maturity:
Mortgage-backed securities: agency issued		$	159			$	13			$	-			$	172
State and municipal securities			1,973				13				-				1,986
Total held-to-maturity		$	2,132			$	26			$	-			$	2,158

 

 

Unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in continuous unrealized loss position, as of September 30, 2014, and December 31, 2013, are summarized as follows:

 

(Dollars in Thousands)

 

		Less than 12 months								12 months or more								Total
						Unrealized								Unrealized								Unrealized
At September 30, 2014		Fair Value				Losses				Fair Value				Losses				Fair Value				Losses
Available-for-sale:
Collateralized mortgage obligations: agency issued		$	10,548			$	75			$	18,934			$	657			$	29,482			$	732
Collateralized mortgage obligations: non agency			361				2				217				11				578				13
Mortgage-backed securities: agency issued			3,442				103				7,576				132				11,018				235
U.S. Government agency securities			-				-				3,607				46				3,607				46
State and municipal securities			1,752				16				6,795				87				8,547				103
Corporate bonds			-				-				-				-				-				-
Total		$	16,103			$	196			$	37,129			$	933			$	53,232			$	1,129

 

		Less than 12 months								12 months or more								Total
						Unrealized								Unrealized								Unrealized
At December 31, 2013		Fair Value				Losses				Fair Value				Losses				Fair Value				Losses
Available-for-sale:
Collateralized mortgage obligations: agency issued		$	21,043			$	778			$	6,265			$	468			$	27,308			$	1,246
Collateralized mortgage obligations: non agency			389				27				1,619				216				2,008				243
Mortgage-backed securities: agency issued			7,752				218				2,643				85				10,395				303
U.S. Government agency securities			5,550				82				-				-				5,550				82
State and municipal securities			11,551				485				1,821				102				13,372				587
Corporate bonds			982				9				-				-				982				9
Total		$	47,267			$	1,599			$	12,348			$	871			$	59,615			$	2,470

 

At September 30, 2014, there were 66 investment securities in an unrealized loss position, of which 46 were in a continuous loss position for 12 months or more. The unrealized losses on these securities were caused by changes in interest rates, widening pricing spreads and market illiquidity, leading to a decline in the fair value subsequent to their purchase. The Company has evaluated the securities shown above and anticipates full recovery of amortized cost with respect to these securities at maturity or sooner in the event of a more favorable market environment. Based on management’s evaluation, and because the Company does not have the intent to sell these securities and it is not more likely than not that it will have to sell the securities before recovery of cost basis, the Company does not consider these investments to be other-than-temporarily impaired at September 30, 2014.

 

 

For non-agency mortgage-backed securities (MBS) the Company estimates expected future cash flows of the underlying collateral, together with any credit enhancements. The expected future cash flows of the underlying collateral are determined using the remaining contractual cash flows adjusted for future expected credit losses (which considers current delinquencies, future expected default rates and collateral value by vintage) and prepayments. The expected cash flows of the security are then discounted to arrive at a present value amount. For the nine months ended September 30, 2014, no non-agency MBS was determined to be other-than-temporarily-impaired. For the nine months ended September 30, 2013, one non-agency MBS was determined to be other-than-temporarily-impaired. This security was sold in second quarter 2014, incurring a loss of $69,000. The Company recorded $48,000 and $38,000 in impairments related to credit losses through earnings for the nine months ended September 30, 2014 and 2013, respectively.

 

The following table presents the cash proceeds from the sales of securities and their associated gross realized gains and gross realized losses that are included in earnings for the nine months ended September 30, 2014 and 2013:

 

Investment securities gross gains and losses

 

(Dollars in Thousands)

 

		For the Three Months Ended								For the Nine Months Ended
		September 30, 2014				September 30, 2013				September 30, 2014				September 30, 2013
Gross realized gain on sale of securities		$	94			$	57			$	315			$	444
Gross realized loss on sale of securities			(56	)			(43	)			(227	)			(43	)
Net realized gain on sale of securities		$	38			$	14			$	88			$	401
Proceeds from sale of securities		$	3,928			$	308			$	17,755			$	7,237

 

The Company did not engage in originating subprime mortgage loans, and it does not believe that it has material exposure to subprime mortgage loans or subprime mortgage backed securities. Additionally, the Company does not own any sovereign debt of Eurozone nations or structured financial products, such as collateralized debt obligations or structured investment vehicles, which are known by the Company to have elevated risk characteristics.

 

The amortized cost and estimated fair value of investment securities at September 30, 2014, by maturity are shown below.  The amortized cost and fair value of collateralized mortgage obligations and mortgage-backed securities are presented by expected average life, rather than contractual maturity.  Expected maturities may differ from contractual maturities because borrowers may have the right to prepay underlying loans without prepayment penalties.

 

(Dollars in Thousands)

 

		Held-to-maturity								Available-for-sale
		Amortized								Amortized
		Cost				Fair Value				Cost				Fair Value
Due in one year or less		$	-			$	-			$	1,079			$	1,080
Due after one year through five years			-				-				7,120				7,108
Due after five years through ten years			1,124				1,127				14,334				14,594
Due after ten years			602				603				12,928				13,429
Mortgage-backed securities			131				144				53,865				53,117
Total investment securities		$	1,857			$	1,874			$	89,326			$	89,328

 

At September 30, 2014, investment securities with an estimated fair value of $49.2 million were pledged to secure public deposits, certain nonpublic deposits and borrowings.

 

 

As required of all members of the Federal Home Loan Bank (“FHLB”) system, the Company maintains an investment in the capital stock of the FHLB in an amount equal to the greater of $500,000 or 0.5% of home mortgage loans and pass-through securities plus 5.0% of the outstanding balance of mortgage home loans sold to FHLB under the Mortgage Purchase Program. The FHLB system, the largest government sponsored entity in the United States, is made up of 12 regional banks, including the FHLB of Seattle. Participating banks record the value of FHLB stock equal to its par value at $100 per share. At September 30, 2014, the Company held approximately $2.9 million in FHLB stock.

 

The Company is required to hold FHLB’s stock in order to receive advances and views this investment as long-term. Thus, when evaluating it for impairment, the value is determined based on the recovery of the par value through redemption by the FHLB or from the sale to another member, rather than by recognizing temporary declines in value. The FHLB of Seattle disclosed that it reported net income for the three and nine month periods ended September 30, 2014, at which time it declared a cash dividend. On November 22, 2013, the FHLB of Seattle entered into an amended Stipulation and Consent to the Issuance of a Consent Order with the Federal Housing Finance Agency (“Finance Agency”), modifying the previous order issued on October 25, 2010. The Finance Agency now deems the FHLB of Seattle to be “adequately capitalized” under the Finance Agency’s Prompt Corrective Action rule. The Company has concluded that its investment in FHLB is not impaired as of September 30, 2014, and believes that it will ultimately recover the par value of its investment in this stock.

 

The Company owns $1.0 million in common stock in Pacific Coast Bankers’ Bancshares (PCBB), from which the Company receives a variety of corresponding banking services through its banking subsidiary Pacific Coast Bankers Bank. An investment by the Company in such an entity is permissible under 12 CFR 362.3(a)(2)(iv). When evaluating this investment for impairment, the value is determined based on the recovery of the par value through any redemption by PCBB or from the sale to another eligible purchaser, rather than by recognizing temporary declines in value. PCBB disclosed that it reported net income for the three and nine month periods ended September 30, 2014 and maintains capital ratios that exceed “well capitalized” standards for regulatory purposes.

 

NOTE 4 – LOANS AND ALLOWANCE FOR LOAN LOSSES AND CREDIT QUALITY

 

Loans

 

Loans held in the portfolio at September 30, 2014 and December 31, 2013, are as follows:

 

(Dollars in Thousands)		September 30, 2014				December 31, 2013
Commercial and agricultural		$	112,873			$	104,111
Real estate:
Construction and development			25,419				29,096
Residential 1-4 family			94,101				87,762
Multi-family			20,554				17,520
Commercial real estate — owner occupied			122,090				105,594
Commercial real estate — non owner occupied			120,569				117,294
Farmland			22,926				23,698
Consumer/Finance			34,787				20,728
Gross loans			553,319				505,803
Less:  deferred fees			(1,179	)			(1,137	)
Portfolio Loans		$	552,140			$	504,666

 

 

Allowance for loan losses and credit quality

The allowance for loan losses represents the Company’s estimate as to the probable credit losses inherent in its loan portfolio. The allowance for loan losses is increased through periodic charges to earnings through provision for loan losses and represents the aggregate amount, net of loans charged-off and recoveries on previously charged-off loans, that is needed to establish an appropriate reserve for credit losses. The allowance is estimated based on a variety of factors and using a methodology as described below:

 

·

The Company classifies loans into relatively homogeneous pools by loan type in accordance with regulatory guidelines for regulatory reporting purposes. The Company regularly reviews all loans within each loan category to establish risk ratings for them that include Pass, Watch, Special Mention, Substandard, Doubtful and Loss. Pursuant to ASC 310 “Accounting by Creditors for Impairment of a Loan”, the impaired portion of collateral dependent loans is charged-off. Other risk-related loans not considered impaired have loss factors applied to the various loan pool balances to establish loss potential for provisioning purposes.

  

·

Analyses are performed to establish the loss factors based on historical experience, as well as expected losses based on qualitative evaluations of such factors as the economic trends and conditions, industry conditions, levels and trends in delinquencies and impaired loans, levels and trends in charge-offs and recoveries, among others. The loss factors are applied to loan category pools segregated by risk classification to estimate the loss inherent in the Company’s loan portfolio pursuant to ASC 450 “Accounting for Contingencies.”

 

·

Additionally, impaired loans are evaluated for loss potential on an individual basis in accordance with ASC 310 “Accounting by Creditors for Impairment of a Loan,” and specific reserves are established based on thorough analysis of collateral values where loss potential exists. When an impaired loan is collateral dependent and a deficiency exists in the fair value of collateral securing the loan in comparison to the associated loan balance, the deficiency is charged-off at that time or a specific reserve is established. Impaired loans are reviewed no less frequently than quarterly.

  

·

In the event that a current appraisal to support the fair value of the real estate collateral underlying an impaired loan has not yet been received, but the Company believes that the collateral value is insufficient to support the loan amount, an impairment reserve is recorded. In these instances, the receipt of a current appraisal triggers an updated review of the collateral support for the loan and any deficiency is charged-off or reserved at that time. In those instances where a current appraisal is not available in a timely manner in relation to a financial reporting cut-off date, the Company discounts the most recent third-party appraisal depending on a number of factors including, but not limited to, property location, local price volatility, local economic conditions, and recent comparable sales. In all cases, the costs to sell the subject property are deducted in arriving at the fair value of the collateral.

 

Changes in the allowance for credit losses for the three and nine months ended September 30, 2014 and 2013 were as follows:

 

Allowance for Credit Losses

 

Dollars in Thousands						Commercial Real				Residential
		Commercial				Estate ("CRE")				Real Estate				Consumer				Unallocated				Total
For the three months ended September 30, 2014
Beginning balance		$	904			$	3,807			$	702			$	882			$	2,020			$	8,315
Charge-offs and concessions			-				(127	)			(61	)			(12	)			-				(200	)
Recoveries			7				29				4				-				-				40
Provision / (recapture)			78				(96	)			102				41				(25	)			100
Ending balance		$	989			$	3,613			$	747			$	911			$	1,995			$	8,255
For the nine months ended September 30, 2014
Beginning balance		$	775			$	3,506			$	675			$	744			$	2,659			$	8,359
Charge-offs and concessions			(26	)			(523	)			(105	)			(59	)			-				(713	)
Recoveries			9				381				17				2				-				409
Provision / (recapture)			231				249				160				224				(664	)			200
Ending balance		$	989			$	3,613			$	747			$	911			$	1,995			$	8,255

 

 

Allowance for Credit Losses

 

Dollars in Thousands						Commercial Real				Residential
		Commercial				Estate ("CRE")				Real Estate				Consumer				Unallocated				Total
For the three months ended September 30, 2013
Beginning balance		$	809			$	3,414			$	813			$	638			$	3,288			$	8,962
Charge-offs and concessions			(40	)			(37	)			(29	)			(79	)			-				(185	)
Recoveries			20				5				3				1				-				29
Provision / (recapture)			45				164				(16	)			149				(342	)			-
Ending balance		$	834			$	3,546			$	771			$	709			$	2,946			$	8,806
For the nine months ended September 30, 2013
Beginning balance		$	923			$	4,098			$	829			$	531			$	2,977			$	9,358
Charge-offs and concessions			(40	)			(83	)			(95	)			(145	)			-				(363	)
Recoveries			35				220				4				2				-				261
Provision / (recapture)			(84	)			(689	)			33				321				(31	)			(450	)
Ending balance		$	834			$	3,546			$	771			$	709			$	2,946			$	8,806

 

Recorded investment in loans as of September 30, 2014 and 2013 are as follows:

 

Recorded Investment in Financing Receivables

 

Dollars in Thousands						Commercial Real				Residential
		Commercial				Estate ("CRE")				Real Estate				Consumer				Unallocated				Total
As of September 30, 2014
Allowance for Credit Losses:
Ending balance: individually evaluated for impairment		$	-			$	-			$	-			$	-			$	-			$	-
Ending balance: collectively evaluated for impairment		$	989			$	3,613			$	747			$	911			$	1,995			$	8,255
Loans:
Ending balance		$	112,873			$	291,004			$	114,655			$	34,787			$	-			$	553,319
Ending balance: individually evaluated for impairment		$	402			$	5,938			$	1,089			$	-			$	-			$	7,429
Ending balance: collectively evaluated for impairment		$	112,471			$	285,066			$	113,566			$	34,787			$	-			$	545,890
Less deferred fees																						$	(1,179	)
Ending balance total loans																						$	552,140

 

 

Recorded Investment in Financing Receivables

 

Dollars in Thousands						Commercial Real				Residential
		Commercial				Estate ("CRE")				Real Estate				Consumer				Unallocated				Total
As of December 31, 2013
Allowance for Credit Losses:
Ending balance: individually evaluated for impairment		$	-			$	-			$	-			$	-			$	-			$	-
Ending balance: collectively evaluated for impairment		$	775			$	3,506			$	675			$	744			$	2,659			$	8,359
Loans:
Ending balance		$	104,111			$	275,682			$	105,282			$	20,728			$	-			$	505,803
Ending balance: individually evaluated for impairment		$	587			$	8,656			$	626			$	53			$	-			$	9,922
Ending balance: collectively evaluated for impairment		$	103,524			$	267,026			$	104,656			$	20,675			$	-			$	495,881
Less deferred fees																						$	(1,137	)
Ending balance total loans																						$	504,666

 

Credit Quality Indicators

 

Federal regulations require that the Bank periodically evaluate the risks inherent in its loan portfolios. In addition, the Washington Division of Banks and the Federal Deposit Insurance Corporation (“FDIC”) have authority to identify problem loans and, if appropriate, require them to be reclassified. There are three classifications for problem loans: Substandard, Doubtful, and Loss. These terms are used as follows:

 

·

“Substandard” loans have one or more defined weaknesses and are characterized by the distinct possibility some loss will be sustained if the deficiencies are not corrected.

 

·

“Doubtful” loans have the weaknesses of loans classified as "Substandard," with additional characteristics that suggest the weaknesses make collection or recovery in full after liquidation of collateral questionable on the basis of currently existing facts, conditions, and values. There is a high possibility of loss in loans classified as "Doubtful."

 

·

“Loss” loans are considered uncollectible and of such little value that continued classification of the credit as a loan is not warranted. If a loan or a portion thereof is classified as "Loss," it must be charged-off; meaning the amount of the loss is charged against the allowance for credit losses, thereby reducing that reserve.

 

The Bank also classifies some loans as “Pass” or Other Loans Especially Mentioned (“OLEM”). Within the Pass classification certain loans are “Watch” rated because they have elements of risk that require more monitoring than other performing loans. Pass grade loans include a range of loans from very high credit quality to acceptable credit quality. These borrowers generally have strong to acceptable capital levels and consistent earnings and debt service capacity. Loans with higher grades within the Pass category may include borrowers who are experiencing unusual operating difficulties, but have acceptable payment performance to date. Overall, loans with a Pass grade show no immediate loss exposure. Loans classified as OLEM continue to perform but have shown deterioration in credit quality and require close monitoring.

 

 

Credit quality indicators as of September 30, 2014 and December 31, 2013 were as follows:

(Dollars in Thousands)

 

September 30, 2014						Other Loans
						Especially
		Pass				Mentioned				Substandard				Doubtful				Total
Commercial and agricultural		$	104,073			$	6,648			$	2,152			$	-			$	112,873
Real estate:
Construction and development			24,288				50				1,081				-				25,419
Residential 1-4 family			90,387				448				3,266				-				94,101
Multi-family			20,285				269				-				-				20,554
Commercial real estate — owner occupied			114,120				1,675				6,295				-				122,090
Commercial real estate — non owner occupied			97,102				17,880				5,587				-				120,569
Farmland			21,001				1,878				47				-				22,926
Total real estate			367,183				22,200				16,276				-				405,659
Consumer/Finance			34,692				74				21				-				34,787
Less deferred fees			-				-				-				-				(1,179	)
Total loans		$	505,948			$	28,922			$	18,449			$	-			$	552,140

 

December 31, 2013						Other Loans
						Especially
		Pass				Mentioned				Substandard				Doubtful				Total
Commercial and agricultural		$	100,262			$	2,858			$	991			$	-			$	104,111
Real estate:
Construction and development			26,587				1,101				1,408				-				29,096
Residential 1-4 family			84,407				554				2,801				-				87,762
Multi-family			17,520				0				0				-				17,520
Commercial real estate — owner occupied			100,612				1,019				3,963				-				105,594
Commercial real estate — non owner occupied			98,044				16,752				2,498				-				117,294
Farmland			20,228				2,464				1,006				-				23,698
Total real estate			347,398				21,890				11,676				-				380,964
Consumer/Finance			20,570				62				96				-				20,728
Less deferred fees			-				-				-				-				(1,137	)
Total loans		$	468,230			$	24,810			$	12,763			$	-			$	504,666

 

 

Impaired Loans

 

Impaired loans by type as of September 30, 2014, and interest income recognized for the three and nine months ended September 30, 2014, were as follows:

 

(Dollars in Thousands)														3 Month				9 Month				3 Month				9 Month
		Unpaid												Average				Average				Interest				Interest
		Principal				Recorded				Related				Recorded				Recorded				Income				Income
		Balance				Investment				Allowance				Investment				Investment				Recognized				Recognized
September 30, 2014
With no Related Allowance:
Commercial		$	440			$	402			$	-			$	407			$	455			$	4			$	15
Consumer											-				26				53				-				-
Residential real estate			1,425				1,089				-				932				815				18				43
Commercial real estate:
CRE — owner occupied			1,640				1,640				-				1,650				1,732				-				-
CRE — non owner occupied			3,589				3,217				-				3,557				4,064				17				28
Farmland											-				478				716				-				225
Construction and development			3,139				1,081				-				1,177				1,260				15				48
Total		$	10,233			$	7,429			$	-			$	8,227			$	9,095			$	54			$	359
With a Related Allowance:
Consumer/Finance		$	-			$	-			$	-			$	-			$	-			$	-			$	-
Residential real estate			-				-				-				-				-				-				-
Total		$	-			$	-			$	-			$	-			$	-			$	-			$	-
Total Impaired Loans:
Commercial		$	440			$	402			$	-			$	407			$	455			$	4			$	15
Consumer											-				26				53				-				-
Residential real estate			1,425				1,089				-				932				815				18				43
Commercial real estate:
CRE — owner occupied			1,640				1,640				-				1,650				1,732				-				-
CRE — non owner occupied			3,589				3,217				-				3,557				4,064				17				28
Farmland											-				478				716				-				225
Construction and development			3,139				1,081				-				1,177				1,260				15				48
Total Impaired Loans		$	10,233			$	7,429			$	-			$	8,227			$	9,095			$	54			$	359

 

 

Impaired loans by type as of September 30, 2013, and interest income recognized for the three and nine months ended September 30, 2013, were as follows:

 

(Dollars in Thousands)														3 Month				9 Month				3 Month				9 Month
		Unpaid												Average				Average				Interest				Interest
		Principal				Recorded				Related				Recorded				Recorded				Income				Income
		Balance				Investment				Allowance				Investment				Investment				Recognized				Recognized
September 30, 2013
With no Related Allowance:
Commercial		$	766			$	766			$	-			$	984			$	1,440			$	1			$	6
Consumer			-				-				-				-				-				-				-
Residential real estate			1,102				871				-				1,233				1,150				9				19
Commercial real estate:
CRE — owner occupied			1,787				1,787				-				2,327				2,674				-				24
CRE — non owner occupied			6,791				4,591				-				4,584				5,349				9				32
Farmland			955				955				-				955				960				20				60
Construction and development			3,685				1,413				-				1,435				1,626				-				-
Total		$	15,086			$	10,383			$	-			$	11,518			$	13,199			$	39			$	141
With a Related Allowance:
Consumer		$	-			$	-			$	-			$	5			$	2			$	-			$	-
Residential real estate			-				-				-				100				50				-				1
Total		$				$				$				$	105			$	52			$				$	1
Total Impaired Loans:
Commercial		$	766			$	766			$	-			$	984			$	1,440			$	1			$	6
Consumer															5				2				-				-
Residential real estate			1,102				871								1,333				1,200				9				20
Commercial real estate:
CRE — owner occupied			1,787				1,787				-				2,327				2,674								24
CRE — non owner occupied			6,791				4,591				-				4,584				5,349				9				32
Farmland			955				955				-				955				960				20				60
Construction and development			3,685				1,413				-				1,435				1,626				-				-
Total Impaired Loans		$	15,086			$	10,383			$	-			$	11,623			$	13,251			$	39			$	142

 

 

Aging Analysis

 

The following tables summarize the Company’s loans past due, both accruing and nonaccruing, by type as of September 30, 2014 and December 31, 2013:

 

(Dollars in Thousands)
										Greater
		30-59 Days				60-89 Days				Than				Total Past				Non-accrual								Total
		Past Due				Past Due				90 Days				Due				Loans				Current				Loans
September 30, 2014:
Commercial and agricultural		$	7			$	-			$	-			$	7			$	113			$	112,753			$	112,873
Real estate:
Construction and development			-				-				-				-				1,081				24,338				25,419
Residential 1-4 family			251				-				-				251				714				93,136				94,101
Multi-family			-				-				-								-				20,554				20,554
Commercial real estate — owner occupied			-				-				409				409				1,586				120,095				122,090
Commercial real estate — non owner occupied			2,612				-				-				2,612				1,163				116,794				120,569
Farmland			-				-				-				-				-				22,926				22,926
Total real estate			2,863								409				3,272				4,544				397,843				405,659
Consumer/Finance			2				-				-				2				154				34, 631				34,787
Less deferred fees			-				-				-				-				-				(1,179	)			(1,179	)
Total		$	2,872							$		$409		$	3,281			$	4,811			$	544,048			$	552,140
December 31, 2013:
Commercial and agricultural		$	14			$	-			$	-			$	14			$	286			$	103,811			$	104,111
Real estate:
Construction and development			-				-				-				-				1,408				27,688				29,096
Residential 1-4 family			333				-				-				333				400				87,029				87,762
Multi-family			-				-				-				-				-				17,520				17,520
Commercial real estate — owner occupied			-				-				-				-				1,659				103,935				105,594
Commercial real estate — non owner occupied			-				-				-				-				2,482				114,812				117,294
Farmland			875				-				-				875				955				21,868				23,698
Total real estate			1,208				-				-				1,208				6,904				372,852				380,964
Consumer/Finance			165				3				-				168				53				20,507				20,728
Less deferred fees			-				-				-				-				-				(1,137	)			(1,137	)
Total		$	1,387			$	3			$	-			$	1,390			$	7,243			$	496,033			$	504,666

 

Modifications

 

A modification of a loan constitutes a troubled debt restructuring (“TDR”) when a borrower is experiencing financial difficulty and the modification constitutes a concession.  There are various types of concessions when modifying a loan, however, forgiveness of principal is rarely granted by the Company.  Commercial and industrial loans modified in a TDR may involve term extensions, below market interest rates and/or interest-only payments wherein the delay in the repayment of principal is determined to be significant when all elements of the loan and circumstances are considered.  Additional collateral, a co-borrower, or a guarantor is often required. Commercial mortgage and construction loans modified in a TDR often involve reducing the interest rate for the remaining term of the loan, extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, or substituting or adding a new borrower or guarantor.  Construction loans modified in a TDR may also involve extending the interest-only payment period.  Residential mortgage loans modified in a TDR are primarily comprised of loans where monthly payments are lowered to accommodate the borrowers’ financial needs. Land loans are typically structured as interest-only monthly payments with a balloon payment due at maturity.  Land loans modified in a TDR typically involve extending the balloon payment by one to three years, and providing an interest rate concession. Home equity modifications are made infrequently and are uniquely designed to meet the specific needs of each borrower.

 

Loans modified in a TDR are considered impaired loans and typically already on non-accrual status. Partial charge-offs have in some cases already been taken against the outstanding loan balance.  Loans modified in a TDR for the Company may have the financial effect of increasing the specific allowance associated with the loan.  An allowance for impaired loans that have been modified in a TDR is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the estimated fair value of the collateral, less any selling costs, if the loan is collateral dependent.  The Company’s practice is to re-appraise collateral dependent loans every six to nine months. During the nine months ended September 30, 2014, there was no impact on the allowance from TDRs during the period, as the loans classified as TDRs during the period did not have a specific reserve and were already considered impaired loans at the time of modification and no further impairment was required upon modification. The Company had no commitments to lend additional funds for loans classified as TDRs at September 30, 2014.

 

 

The Company closely monitors the performance of modified loans for delinquency, as delinquency is considered an early indicator of possible future default. The allowance may be increased, adjustments may be made in the allocation of the allowance, or partial charge-offs may be taken to further write-down the carrying value of the loan.

 

The following table presents TDRs for the nine months ended September 30, 2014 and 2013, all of which were modified due to financial stress of the borrower.

 

Restructured loans by type current and subsequently defaulted

(Dollars in Thousands)

 

		September 30, 2014
		Current Restructured Loans												Subsequently Defaulted Restructured Loans
		Number of Loans				Pre-TDR Outstanding Recorded Investment				Post-TDR Outstanding Recorded Investment				Number of Loans				Pre-TDR Outstanding Recorded Investment				Post-TDR Outstanding Recorded Investment
Commercial and agriculture			1			$	335			$	288				-			$	-			$	-
Construction and development			2				2,764				1,081				-				-				-
Residential real estate			2				272				221				-				-				-
CRE — owner occupied			1				59				54				-				-				-
CRE — non owner occupied			1				2,180				2,054				-				-				-
Total restructured loans (1)			7			$	5,610			$	3,698				-			$	-			$	-

 

		September 30, 2013
		Current Restructured Loans												Subsequently Defaulted Restructured Loans
		Number of Loans				Pre-TDR Outstanding Recorded Investment				Post-TDR Outstanding Recorded Investment				Number of Loans				Pre-TDR Outstanding Recorded Investment				Post-TDR Outstanding Recorded Investment
Commercial and agriculture			1			$	335			$	306				-			$	-			$	-
Construction and development			3				2,972				1,413				-				-				-
Residential real estate			2				272				227				-				-				-
CRE — owner occupied			1				59				56				-				-				-
CRE — non owner occupied			1				2,180				2,110				-				-				-
Total restructured loans (1)			8			$	5,818			$	4,112				-			$	-			$	-

 

(1) The period end balances are inclusive of all partial paydowns and charge-offs since the modification date.

 

The following table summarizes the Company’s troubled debt restructured loans by type and geographic region as of September 30, 2014:

 

Restructured loans by type and geographic region

(Dollars in Thousands)

 

		September 30, 2014
		Restructured Loans
		Central Western Washington				Southwestern Washington				Northern Washington				Oregon				Totals				Number of Loans
Commercial and agriculture		$	-			$	-			$	288			$	-			$	288				1
Construction and development											841				240				1,081				2
Residential real estate			-				-				-				221				221				2
CRE — owner occupied			54				-				-				-				54				1
CRE — non owner occupied			-				-				2,054				-				2,054				1
Total restructured loans		$	54			$	-			$	3,183			$	461			$	3,698				7

 

 

The following table presents troubled debt restructurings by accrual or nonaccrual status as of September 30, 2014 and 2013:

 

Restructured loans by accrual or nonaccrual status

(Dollars in Thousands)

 

		September 30, 2014
		Restructured loans
		Accrual Status				Non-accrual Status				Total Modifications
Commercial and agriculture		$	288			$	-			$	288
Construction and development			-				1,081				1,081
Residential real estate			221				-				221
CRE — owner occupied			54				-				54
CRE — non owner occupied			2,054				-				2,054
Total restructured loans		$	2,617			$	1,081			$	3,698

 

		September 30, 2013
		Restructured loans
		Accrual Status				Non-accrual Status				Total Modifications
Commercial and agriculture		$	306			$	-			$	306
Construction and development			-				1,413				1,413
Residential real estate			227				-				227
CRE — owner occupied			56				-				56
CRE — non owner occupied			2,110				-				2,110
Total restructured loans		$	2,699			$	1,413			$	4,112

 

 

NOTE 5 – ACCUMULATED OTHER COMPREHENSIVE INCOME/(LOSS)

 

The following table presents the changes in each component of accumulated other comprehensive income/(loss), net of tax, for the nine months ended September 30, 2014 and 2013:

 

(Dollars in Thousands)		Net Unrealized
		Gains and Losses
		On Investment				Defined Benefit
		Securities				Plans				Total
Balance, January 1, 2014		$	(919	)		$	(450	)		$	(1,369	)
Other comprehensive gain before reclassifications			946				87				1,033
Amounts reclassified from AOCI			(26	)			-				(26	)
Net Current period other comprehensive income (loss)			920				87				1,007
Balance, September 30, 2014		$	1			$	(363	)		$	(362	)

 

		Net Unrealized
		Gains and Losses
		On Investment				Defined Benefit
		Securities				Plans				Total
Balance, January 1, 2013		$	956			$	(535	)		$	421
Other comprehensive gain before reclassifications			(1,254	)			84				(1,170	)
Amounts reclassified from AOCI			(240	)			-				(240	)
Net Current period other comprehensive income (loss)			(1,494	)			84				(1,410	)
Balance, September 30, 2013		$	(538	)		$	(451	)		$	(989	)

 

 

The following table presents the amounts reclassified out of each component of accumulated other comprehensive income (“AOCI”) for the three and nine months ended September 30, 2014 and 2013:

 

(Dollars in Thousands)
Details about Accumulated Other Comprehensive Income Components		Amounts Reclassified from AOCI								Affected Line Item in the Statement Where Net Income is Presented
		Three Months				Nine Months
		Ended September				Ended September
		30, 2014				30, 2014
Net Unrealized Gains and Losses		$	(38	)		$	(88	)		(Gain)/loss on sales of investments available for sale
on Investment Securities			-				48			Net OTTI losses
			13				14			Income tax expense
		$	(25	)		$	(26	)		Unrealized gain on investment securities net of tax

 

(Dollars in Thousands)
Details about Accumulated Other Comprehensive Income Components		Amounts Reclassified from AOCI								Affected Line Item in the Statement Where Net Income is Presented
		Three Months				Nine Months
		Ended September				Ended September
		30, 2013				30, 2013
Net Unrealized Gains and Losses		$	(14	)		$	(401	)		(Gain) on sales of investments available for sale
on Investment Securities			4				38			Net OTTI losses
			3				123			Income tax expense
		$	(7	)		$	(240	)		Unrealized gain on investment securities net of tax

 

 

The following table presents the components of other comprehensive income (loss) for the three and nine months ended September 30, 2014 and 2013:

 

(Dollars in Thousands)
		Before Tax				Tax Effect				Net of Tax
Three months ended September 30, 2014
Net unrealized losses on investment securities:
Net unrealized gains arising during the period		$	(26	)		$	(9	)		$	(17	)
Less: reclassification adjustments for net gains realized in net income			(38	)		$	(13	)			(25	)
Net unrealized losses on investment securities		$	(64	)		$	(22	)		$	(42	)
Net unrealized losses on investment securities:
Amortization of unrecognized prior service costs and net  actuarial gains/losses		$	44			$	15			$	29
Other Comprehensive Income (Loss)		$	(20	)		$	(7	)		$	(13	)
Nine months ended September 30, 2014
Net unrealized losses on investment securities:
Net unrealized gains arising during the period		$	1,433			$	487			$	946
Less: reclassification adjustments for net gains realized in net income			(40	)		$	(14	)			(26	)
Net unrealized losses on investment securities		$	1,393			$	473			$	920
Net unrealized losses on investment securities:
Amortization of unrecognized prior service costs and net actuarial gains/losses		$	132			$	45			$	87
Other Comprehensive Income (Loss)		$	1,525			$	518			$	1,007

 

 

(Dollars in Thousands)
		Before Tax				Tax Effect				Net of Tax
Three months ended September 30, 2013
Net unrealized losses on investment securities:
Net unrealized losses arising during the period		$	781			$	265			$	516
Less: reclassification adjustments for net gains realized in net income			(10	)		$	(3	)			(7	)
Net unrealized losses on investment securities		$	771			$	262			$	509
Net unrealized losses on investment securities:
Amortization of unrecognized prior service costs and net  actuarial gains/losses		$	43			$	15			$	28
Other Comprehensive Income (Loss)		$	814			$	277			$	537
Nine months ended September 30, 2013
Net unrealized losses on investment securities:
Net unrealized losses arising during the period		$	(1,901	)		$	(647	)		$	(1,254	)
Less: reclassification adjustments for net gains realized in net income			(363	)			(123	)			(240	)
Net unrealized losses on investment securities		$	(2,264	)		$	(770	)		$	(1,494	)
Net unrealized losses on investment securities:
Amortization of unrecognized prior service costs and net actuarial gains/losses		$	128			$	44			$	84
Other Comprehensive Income (Loss)		$	(2,136	)		$	(726	)		$	(1,410	)

 

NOTE 6 – STOCK BASED COMPENSATION

 

The Company’s 2011 Equity Incentive Plan, as amended (the “2011 Plan”), provides for the issuance of up to 900,000 shares in connection with incentive and nonqualified stock options, restricted stock, restricted stock units and other equity-based awards. Prior to adoption of the 2011 Plan, the Company made equity-based awards under the Company’s 2000 Stock Incentive Plan, which expired January 1, 2011.

 

Stock Options

 

The 2011 Plan authorizes the issuance of incentive and non-qualified stock options, as defined under current tax laws, to key personnel. Options granted under the 2011 Plan either become exercisable ratably over five years or in a single installment five years from the date of grant.

 

The Company uses the Black-Scholes option pricing model to calculate the fair value of stock option awards based on assumptions in the following table. Expected volatility is based on historical volatility of the Company’s common stock. The expected term of stock options granted is based on the simplified method, which is the simple average between contractual term and vesting period. The risk-free rate is based on the expected term of stock options and the applicable U.S. Treasury yield in effect at the time of grant.

 

Grant period ended		Expected Life		Risk Free Interest Rate				Expected Volatility				Dividend Yield				Average Fair Value
September 30, 2014		6.5 years			2.11	%			23.24	%			3.27	%		$	1.02
September 30, 2013		6.5 years			1.35	%			23.04	%			4.14	%		$	0.57

 

 

A summary of stock option activity as of September 30, 2014 and 2013, and changes during the nine months then ended are presented below:

 

		Shares				Weighted Average Exercise Price				Weighted Average Remaining Contractual Term (Years)				Aggregate Intrinsic Value
September 30, 2014
Outstanding beginning of period			625,495			$	9.53
Granted			22,500				6.13
Exercised			-				-
Forfeited			-				-
Expired			(70,400	)			15.17
Outstanding end of period			577,595			$	8.71				5.2			$	227,900
Exercisable end of period			295,495			$	11.43				3.3			$	42,875

 

		Shares				Weighted Average Exercise Price				Weighted Average Remaining Contractual Term (Years)				Aggregate Intrinsic Value
September 30, 2013
Outstanding beginning of period			537,107			$	11.28
Granted			183,500				5.03
Exercised			-				-
Forfeited			(33,275	)			9.25
Expired			(64,337	)			11.36
Outstanding end of period			622,995			$	9.54				5.4			$	114,450
Exercisable end of period			313,245			$	13.25				2.7			$	4,443

 

A summary of the status of the Company’s non-vested options as of September 30, 2014 and 2013 and changes during the nine months then ended, are presented below:

 

		September 30, 2014								September 30, 2013
		Shares				Weighted Average Fair Value				Shares				Weighted Average Fair Value
Non-vested beginning of period			296,650			$	0.47				147,280			$	0.31
Granted			22,500				1.02				183,500				0.57
Vested			(37,050	)			0.59				(2,275	)			0.65
Forfeited			-				-				(18,755	)			0.40
Non-vested end of period			282,100			$	0.50				309,750			$	0.45

 

  

The Company accounts for stock based compensation in accordance with GAAP, which requires measurement of compensation cost for all stock-based awards based on grant date fair value and recognition of compensation cost over the service period of each award.

 

Stock-based compensation expense
(Unaudited)
(Dollars in Thousands)
Nine months ended September 30, 2014		Before Tax				Tax Effect				Net of Tax
Recognized compensation expense		$	32			$	11			$	21

 

Nine months ended September 30, 2013		Before Tax				Tax Effect				Net of Tax
Recognized compensation expense		$	38			$	13			$	25

 

		September 30, 2014				September 30, 2013
Future compensation expense  (1)		$	70			$	90
Weighted Average Remaining Contractual Term (Years)			1.7				1.8

 

(1) related to non-vested stock options

 

  

Restricted Stock Units

 

The Company grants restricted stock units (“RSU”) to employees qualifying for awards under the Company’s Annual Incentive Compensation Plan. Recipients of RSUs will be issued a specified number of shares of common stock under the 2011 Plan upon the lapse of applicable restrictions. Outstanding RSUs are subject to forfeiture if the recipient’s employment terminates prior to the expiration of three years from the date of grant.

 

The following table summarizes RSU activity during the nine months ended September 30, 2014 and 2013:

 

		September 30, 2014
		Shares				Weighted Average Grant Price				Weighted Average Remaining Contractual terms (in years)
Outstanding, January 1, 2014			50,024
Granted			11,673			$	6.45
Exercised			(476	)			-
Forfeited			(944	)		$	5.27
Non-vested end of period			60,277								1.7

 

		September 30, 2013
		Shares				Weighted Average Grant Price				Weighted Average Remaining Contractual terms (in years)
Outstanding, January 1, 2013			16,059
Granted			35,476			$	4.93
Exercised			-
Forfeited			(1,511	)		$	-
Non-vested end of period			50,024								2.2

 

  

The following table summarizes RSU compensation expense during the nine months ended September 30, 2014 and 2013:

 

RSU compensation expense
(Unaudited)
(Dollars in Thousands)
Nine months ended September 30, 2014		Before Tax				Tax Effect				Net of Tax
RSU recognized compensation expense		$	74			$	25			$	49

 

Nine months ended September 30, 2013		Before Tax				Tax Effect				Net of Tax
RSU recognized compensation expense		$	46			$	16			$	30

 

		September 30, 2014				September 30, 2013
Future compensation expense  (1)		$	174			$	193

 

(1) related to non-vested RSU's

 

NOTE 7 – COMMITMENTS AND CONTINGENCIES

 

The Bank is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit, and involve, to varying degrees, elements of credit risk in excess of the amount recognized on the consolidated balance sheets.

 

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as they do for on-balance-sheet instruments. A summary of the Bank’s off-balance sheet commitments at September 30, 2014 and December 31, 2013 is as follows:

 

(Dollars in Thousands)
		September 30, 2014				December 31, 2013
Commitments to extend credit		$	96,817			$	106,017
Standby letters of credit		$	1,351			$	1,733

 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Many of the commitments expire without being drawn upon; therefore total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on management’s credit evaluation of the customer. Collateral held varies, but may include accounts receivable, inventory, property and equipment, residential real estate, and income-producing commercial properties.

 

Standby letters of credit are conditional commitments issued by the Bank 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.

 

In connection with certain loans held for sale, the Bank typically makes representations and warranties that the underlying loans conform to specified guidelines. If the underlying loans do not conform to the specifications, the Bank may have an obligation to repurchase the loans or indemnify the purchaser against loss. The Bank believes that the potential for loss under these arrangements is remote. Accordingly, no contingent liability is recorded in the condensed consolidated financial statements.

 

  

The Company is currently not party to any material pending litigation. However, because of the nature of its activities, the Company may be subject to or threatened with legal actions in the ordinary course of business. In the opinion of management, liabilities arising from these claims, if any, will not have a material effect on the results of operations or financial condition of the Company.

 

NOTE 8 – FAIR VALUE MEASUREMENTS

 

Fair Value Hierarchy

 

The Company uses an established hierarchy for measuring fair value that is intended to maximize the use of observable inputs and minimize the use of unobservable inputs. This hierarchy uses three levels of inputs to measure the fair value of assets and liabilities as follows:

 

Level 1 – Valuations based on quoted prices in active exchange markets for identical assets or liabilities; also includes certain corporate debt securities actively traded in over-the-counter markets.

 

Level 2 – Valuations of assets and liabilities traded in less active dealer or broker markets. Valuations include quoted prices for similar assets and liabilities traded in the same market; quoted prices for identical or similar instruments in markets that are not active; and model–derived valuations whose inputs are observable or whose significant value drivers are observable. Valuations may be obtained from, or corroborated by, third-party pricing services. This category generally includes certain U.S. Government, agency and non-agency securities, state and municipal securities, mortgage-backed securities, corporate securities, and residential mortgage loans held for sale.

 

Level 3 – Valuation based on unobservable inputs supported by little or no market activity for financial instruments whose value is determined using pricing models, discounted cash flow methodologies, yield curves and similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities, but in all cases are corroborated by external data, which may include third-party pricing services.

 

Investment Securities Available-for-Sale

 

The Company uses an independent pricing service to assist management in determining fair values of investment securities available-for-sale. This service provides pricing information by utilizing evaluated pricing models supported with market based information. Standard inputs include benchmark yields, reported trades, broker/dealer quotes, credit ratings, bids and offers, relative credit information and reference data from market research publications. Investment securities that are deemed to have been trading in illiquid or inactive markets may require the use of significant unobservable inputs.

 

The pricing service provides quoted market prices when available. Quoted prices are not always available due to bond market inactivity. For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows. Discounted cash flows are calculated using spread to swap and LIBOR curves that are updated to incorporate loss severities, volatility, credit spread and optionality. Additionally, the pricing service may obtain a broker quote when sufficient information is not available to produce a valuation. Valuations and broker quotes are non-binding and do not represent quotes on which one may execute the disposition of the assets.

 

The Company generally obtains one value from its primary external third-party pricing service. The Company’s third-party pricing service has established processes for us to submit inquiries regarding quoted prices. The Company’s third-party pricing service will review the inputs to the evaluation in light of any new market data presented by us. The Company’s third-party pricing service may then affirm the original quoted price or may update the evaluation on a going forward basis.

 

On a quarterly basis, management reviews the pricing information received from the third party-pricing service through a combination of procedures that include an evaluation of methodologies used by the pricing service, analytical reviews and performance analyses of the prices against statistics and trends and maintenance of an investment watch list. Based on this review, management determines whether the current placement of the security in the fair value hierarchy is appropriate or whether transfers may be warranted. As necessary, the Company compares prices received from the pricing service to discounted cash flow models or through performing independent valuations of inputs and assumptions similar to those used by the pricing service in order to ensure prices represent a reasonable estimate of fair value. Although the Company does identify differences from time to time as a result of these validation procedures, the Company did not make any significant adjustments as of September 30, 2014 or December 31, 2013.

 

  

The following table presents the balances of assets measured at fair value on a recurring basis at September 30, 2014 and December 31, 2013.

 

(Dollars in Thousands)		Fair Value Measurements
		At September 30, 2014
Description		Fair Value 09/30/2014				Quoted Prices in Active Markets for Identical Assets (Level 1)				Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Available-for-sale securities:
Collateralized mortgage obligations: agency issued		$	40,039			$	-			$	40,039			$	-
Collateralized mortgage obligations: non agency			579				-				579				-
Mortgage-backed securities: agency issued			12,499				-				12,499				-
U.S. Government agency securities			8,655				-				8,655				-
State and municipal securities			27,556				-				26,198				1,358
Total assets measured at fair value		$	89,328			$				$	87,970			$	1,358

 

		Fair Value Measurements
		At December 31, 2013
Description		Fair Value 12/31/2013				Quoted Prices in Active Markets for Identical Assets (Level 1)				Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Available-for-sale securities:
Collateralized mortgage obligations: agency issued		$	38,791			$	-			$	38,791			$	-
Collateralized mortgage obligations: non agency			2,011				-				2,011				-
Mortgage-backed securities: agency issued			13,389				-				13,389				-
U.S. Government agency securities			8,811				-				8,811				-
State and municipal securities			32,160				-				30,741				1,419
Corporate bonds			982				-				982				-
Total assets measured at fair value		$	96,144			$				$	94,725			$	1,419

 

As of September 30, 2014 and December 31, 2013, the Company had three investments classified as Level 3 investments which consist of local non-rated municipal bonds for which the Company is the sole owner of the entire bond issue. The valuation of these securities is supported by analysis prepared by an independent third party. Their approach to determining fair value involves using recently executed transactions and market quotations for similar securities. As these securities are not rated by the rating agencies and there is no trading volume, management determined that these securities should be classified as Level 3 within the fair value hierarchy. Additionally, these securities are considered sensitive to changes in credit given the unobserved assumed credit ratings.

 

The following table presents a reconciliation of assets that are measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the three and nine months ended September 30, 2014 and 2013, respectively. There were no transfers of assets into or out of Level 1, 2 or 3 for the three and nine months ended September 30, 2014.

 

(Dollars in Thousands)		Three months ended September 30,								Nine months ended September 30,
		2014				2013				2014				2013
Balance beginning of period		$	1,394			$	1,491				1,419			$	1,614
Principal paydowns			(61	)			(61	)			(92	)			(90	)
Change in FV (included in other comprehensive income)			25				(3	)			31				(97	)
Balance end of period		$	1,358			$	1,427				1,358			$	1,427

 

  

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

 

Certain assets and liabilities are measured at fair value on a nonrecurring basis after initial recognition such as loans measured for impairment and other real estate owned (“OREO”). The following methods were used to estimate the fair value of each such class of financial instrument:

 

Impaired loans – A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due (both interest and principal) according to the contractual terms of the loan agreement. Impaired loans are classified as Level 3 in the fair value hierarchy and are measured based on the present value of expected future cash flows or by the net realizable value of the collateral if the loan is collateral dependent. In determining the net realizable value of the underlying collateral, we consider third party appraisals by qualified licensed appraisers, less estimated costs to sell. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach.

 

Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available and include consideration for variations in location, size, and income production capacity of the property. The income approach commonly utilizes a discount or cap rate to determine the present value of expected future cash flows. Additionally, the appraisals are periodically further adjusted by the Company in consideration of charges that may be incurred in the event of foreclosure and are based on management’s historical knowledge, changes in business factors and changes in market conditions. Such discounts are typically significant, and may range from 10% to 30%.

 

Impaired loans are reviewed and evaluated quarterly for additional impairment and adjusted accordingly, based on the same factors identified above. Because of the high degree of judgment required in estimating the fair value of collateral underlying impaired loans and because of the relationship between fair value and general economic conditions, we consider the fair value of impaired loans to be highly sensitive to changes in market conditions.

 

Other real estate owned – OREO is initially recorded at the fair value of the property less estimated costs to sell. This amount becomes the property’s new basis. Management considers third party appraisals in determining the fair value of particular properties. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach.

 

Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available and include consideration for variations in location, size, and income production capacity of the property. Additionally, the appraisals are periodically further adjusted by the Company based on management’s historical knowledge, changes in business factors and changes in market conditions. Such adjustments are typically downward, and may range from 10% to 25%.

 

Any write-downs based on the property fair value less estimated costs to sell at the date of acquisition are charged to the allowance for credit losses. Management periodically reviews OREO to ensure the property is carried at the lower of its new basis or fair value, net of estimated costs to sell. Any additional write-downs based on re-evaluation of the property fair value are charged to non-interest expense. Because of the high degree of judgment required in estimating the fair value of OREO and because of the relationship between fair value and general economic conditions, we consider the fair value of OREO to be highly sensitive to changes in market conditions.

 

  

The following table presents the Company’s assets that were held at the end of each period that were measured at fair value on a nonrecurring basis during the nine months ended September 30, 2014 and year ended December 31, 2013:

 

(Dollars in Thousands)		Fair Value Measurements
		As of September 30, 2014
Description		Fair Value 09/30/2014				Quoted Prices in Active Markets for Identical Assets (Level 1)				Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Other real estate owned and foreclosed assets		$	291			$				$				$	291
Loans measured for impairment, net of specific reserves			441												441
Total impaired assets measured at fair value		$	732			$				$				$	732

 

		Fair Value Measurements
		As of December 31, 2013
Description		Fair Value 12/31/2013				Quoted Prices in Active Markets for Identical Assets (Level 1)				Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Other real estate owned and foreclosed assets		$	1,960			$				$				$	1,960
Loans measured for impairment, net of specific reserves			162												162
Total impaired assets measured at fair value		$	2,122			$				$				$	2,122

 

Other real estate owned with a pre-foreclosure loan balance of $652,000 was acquired during the nine months ended September 30, 2014. Upon foreclosure, write downs totaling $127,000 were applied to the allowance for credit losses during the period related to these assets.

 

The following table presents quantitative information about Level 3 inputs for financial instruments measured at fair value on a nonrecurring basis at September 30, 2014:

 

(Dollars in Thousands)

Description

Fair Value 09/30/2014

Valuation Technique

Significant Unobservable Inputs

Range (Weighted Average)

Other real estate owned and foreclosed assets

$

291

Appraised value

Adjustment for

0-10% (1.6%)

market conditions

Loans measured for impairment, net of specific reserves

$

441

Appraised value

Adjustment for  market conditions

0-20% (2.8%)

 

Fair Value of Financial Instruments

 

The following methods and assumptions were used by the Company in estimating the fair values of financial instruments disclosed in these consolidated financial statements:

 

Cash and due from banks, interest bearing deposits in banks, and certificates held for investment

The carrying amounts of cash, interest bearing deposits at other financial institutions approximate their fair value.

 

Investment securities available-for-sale and held-to-maturity

The fair value of all investment securities are based upon the assumptions market participants would use in pricing the security. Such assumptions include observable and unobservable inputs such as quoted market prices, dealer quotes and analysis of discounted cash flows.

 

  

Federal Home Loan Bank Stock

FHLB stock is carried at cost which approximates fair value and equals its par value because the shares can only be redeemed with the FHLB at par.

 

Pacific Coast Bankers’ Bancshares Stock

PCBB stock is carried at cost which approximates fair value and equals its par value based on the price per share paid at the capital offering concluded during the current quarter.

 

Loans, net and loans held for sale

The fair value of loans is estimated based on comparable market statistics for loans with similar credit ratings. An additional liquidity discount is also incorporated to more closely align the fair value with observed market prices. Fair values of loans held for sale are based on a discounted cash flow calculation using interest rates currently available on similar loans. The fair value was based on an aggregate loan basis.

 

Deposits

The fair value of deposits with no stated maturity date is included at the amount payable on demand. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flow calculation based on interest rates currently offered on similar certificates.

 

Borrowings

The fair values of the Company’s long-term borrowings is estimated using discounted cash flow analysis based on the Company’s incremental borrowing rates for similar types of borrowing arrangements.

 

Junior subordinated debentures

The fair value of the junior subordinated debentures and trust preferred securities is estimated using discounted cash flow analysis based on interest rates currently available for junior subordinated debentures.

 

Off-Balance-Sheet Instruments

The fair value of commitments to extend credit and standby letters of credit was estimated using the rates currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the customers. Since the majority of the Company’s off-balance-sheet instruments consist of non-fee producing, variable-rate commitments, the Company has determined they do not have a material fair value.

 

  

The estimated fair value of the Company’s financial instruments at September 30, 2014 and December 31, 2013 is as follows:

 

(Dollars in Thousands)
		As of September 30, 2014
		Carrying Value				Quoted Prices in Active Markets for Identical Assets (Level 1)				Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)				Total Fair Value
Financial assets:
Cash and cash equivalents		$	40,781			$	40,781			$	-			$	-			$	40,781
Interest-bearing certificates of deposit (original maturities greater than 90 days)			2,727				2,727				-				-				2,727
Investment securities available-for-sale			89,328				-				87,970				1,358				89,328
Investment securities held-to-maturity			1,857				-				1,874				-				1,874
Federal Home Loan Bank stock			2,926				-				2,926				-				2,926
Loans held-for-sale			8,161				-				8,161				-				8,161
Loans			543,885				-				-				517,498				517,498
Financial liabilities:
Deposits		$	644,004			$				$	644,518			$	-			$	644,518
Short-term borrowings			-				-				-				-				-
Long-term borrowings			11,491				-				10,145				-				10,145
Junior subordinated debentures			13,403				-				-				7,541				7,541

 

		As of December 31, 2013
		Carrying Value				Quoted Prices in Active Markets for Identical Assets (Level 1)				Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)				Total Fair Value
Financial assets:
Cash and cash equivalents		$	35,948			$	35,948			$	-			$	-			$	35,948
Interest-bearing certificates of deposit (original maturities greater than 90 days)			2,727				2,727				-				-				2,727
Investment securities available-for-sale			96,144				-				94,725				1,419				96,144
Investment securities held-to-maturity			2,132				-				2,158				-				2,158
Federal Home Loan Bank stock			3,013				-				3,013				-				3,013
Loans held-for-sale			7,765				-				7,765				-				7,765
Loans			496,307				-				-				473,224				473,224
Financial liabilities:
Deposits		$	607,347			$				$	606,654			$	-			$	606,654
Short-term borrowings			-				-				-				-				-
Long-term borrowings			10,000				-				10,195				-				10,195
Junior subordinated debentures			13,403				-				-				7,646				7,646

 

NOTE 9 – JUNIOR SUBORDINATED DEBENTURES

 

At September 30, 2014, two wholly-owned subsidiary grantor trusts established by the Company had outstanding $13.0 million of Trust Preferred Securities (“trust preferred securities”). Trust preferred securities accrue and pay distributions periodically at specified annual rates as provided in the indentures. The trusts used the net proceeds from the offering of trust preferred securities to purchase a like amount of Junior Subordinated Debentures (the “Debentures”) of the Company. The Debentures are the sole assets of the trusts. The Company’s obligations under the Debentures and the related documents, taken together, constitute a full and unconditional guarantee by the Company of the obligations of the trusts. The trust preferred securities are mandatorily redeemable upon the maturity of the Debentures, or upon earlier redemption as provided in the indentures. The Company has the right to redeem the Debentures in whole or in part, at a redemption price specified in the indentures plus any accrued but unpaid interest to the redemption date.

 

  

The Debentures issued by the Company to the grantor trusts totaling $13.0 million are reflected in the consolidated balance sheet in the liabilities section under the caption “junior subordinated debentures.” The Company records interest expense on the corresponding junior subordinated debentures in the consolidated statements of income. The Company recorded $403,000 in the consolidated balance sheet at September 30, 2014 for the common capital securities issued by the issuer trusts.

 

As of September 30, 2014, regular accrued interest on junior subordinated debentures totaled $40,000 and is included in accrued interest payable on the balance sheet. Following are the terms of the junior subordinated debentures as of September 30, 2014.

  

(Dollars in Thousands)
				Issued						Maturity
Trust Name		Issue Date		Amount				Rate		Date
Pacific Financial Corporation		December								March
Statutory Trust I		2005		$	5,000			LIBOR + 1.45% (1)		2036
Pacific Financial Corporation		June								July
Statutory Trust II		2006			8,000			LIBOR + 1.60% (2)		2036
				$	13,000

 

(1)

Pacific Financial Corporation Statutory Trust I securities incurred interest at the fixed rate of 6.39% until mid March 2011, at which the rate changed to a variable rate of 3-month LIBOR (0.234% at September 11, 2014) plus 1.45% or 1.68%, adjusted quarterly, through the final maturity date in March 2036.

(2)

Pacific Financial Corporation Statutory Trust II securities incur interest at a variable rate of 3-month LIBOR (0.234% at July 11, 2014) plus 1.60% or 1.83%, adjusted quarterly, through the final maturity date in July 2036.

 

NOTE 10 – RECENTLY ISSUED ACCOUNTING STANDARDS

 

In June 2014, the FASB issued ASU No. 2014-11, Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures. ASU 2014-11 changes the accounting for repurchase-to-maturity transactions and repurchase financing arrangements. It also requires additional disclosures about repurchase agreements and other similar transactions. The new guidance aligns the accounting for repurchase-to-maturity transactions and repurchase agreements executed as a repurchase financing with the accounting for other typical repurchase agreements. Going forward, these transactions would all be accounted for as secured borrowings. The ASU also requires new and expanded disclosures. This ASU is effective for the first interim or annual period beginning after December 15, 2014. The adoption of ASU No. 2014-11 is not expected to have a material impact on the Company's consolidated financial statements.

 

In June 2014, the FASB issued ASU No. 2014-12, Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period. ASU 2014-12 requires that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. A reporting entity should apply existing guidance in Topic 718, Compensation - Stock Compensation, as it relates to awards with performance conditions that affect vesting to account for such awards. The performance target should not be reflected in estimating the grant-date fair value of the award. Compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered. The amendments in this ASU can be applied prospectively or retrospectively and are effective for annual periods and interim periods within those annual periods beginning after December 15, 2015 with early adoption permitted. The Company is currently reviewing the requirements of ASU No. 2014-12, but does not expect the ASU to have a material impact on the Company's consolidated financial statements.

 

In May 2014, the FASB issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (ASU 2014-09), which supersedes nearly all existing revenue recognition guidance under U.S. GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing U.S. GAAP. The standard is effective for annual periods beginning after December 15, 2016, and interim periods therein, using either of the following transition methods: (i) a full retrospective approach reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients, or (ii) a retrospective approach with the cumulative effect of initially adopting ASU 2014-09 recognized at the date of adoption (which includes additional footnote disclosures). We are currently evaluating the impact of our pending adoption of ASU 2014-09 on our consolidated financial statements and have not yet determined the method by which we will adopt the standard in 2017.

 

  

In July 2013, FASB issued ASU No. 2013-11, "Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists." The provisions of ASU No. 2013-11 require an entity to present an unrecognized tax benefit, or portion thereof, in the statement of financial position as a reduction to a deferred tax asset for a net operating loss carryforward or a tax credit carryforward, with certain exceptions related to availability. ASU No. 2013-11 is effective for interim and annual reporting periods beginning after December 15, 2013. The adoption of ASU No. 2013-11 has not had a material impact on the Company's Consolidated Financial Statements.

 

NOTE 11 – BUSINESS COMBINATION

 

On January 28, 2013, the Bank and Sterling Savings Bank, a Washington state-chartered bank (“Sterling”), entered into a Purchase and Assumption Agreement (the “Agreement”) pursuant to which the Bank agreed to purchase from Sterling three branches located in Aberdeen, Washington; Astoria, Oregon; and Seaside, Oregon; including certain deposit liabilities, loans and other assets and liabilities associated with such branch locations.  The actual amount of loans and deposits, the value of other assets and liabilities transferred to the Bank and the actual price paid were determined at the time of the closing of the transaction on September 1, 2013, in accordance with the terms of the Agreement.  The purchase price was $976,000 and exceeded the estimated fair value of tangible net assets acquired by approximately $1.1 million, which was recorded as goodwill and intangible assets.

 

Cash flow information relative to the agreement is as follows (in thousands):

 

Fair value of tangible net assets acquired		$	37,533
Cash paid for deposit premium			(976	)
Liabilities assumed			(37,684	)
Goodwill and intangible assets recorded		$	1,127

 

The primary purposes of the acquisition are to expand the Company’s market share in the northern Oregon coast, to provide existing customers with added convenience and service, and to provide our new customers with the opportunity to enjoy the outstanding personalized service and commitment of our community-based bank.

 

Fair value adjustments and related goodwill were recorded in the statement of financial condition of the Company.  The following is a condensed balance sheet disclosing the estimated fair value amounts of the acquired branches of Sterling assigned to the major consolidated asset and liability captions at the acquisition date (in thousands):

 

Cash and cash equivalents		$	31,941
Loans receivable			3,989
Premises and equipment			604
Goodwill and intangible assets			1,127
Other assets			23
Total assets		$	37,684
Deposits and accrued interest payable		$	37,636
Deferred tax liability			47
Other liabilities			1
Total liabilities and shareholders’ equity		$	37,684

 

The core deposit intangible asset that was recognized as part of the business combination was $242,000 and will be amortized over its estimated useful life of approximately ten years utilizing an accelerated method. The goodwill of $885,000 will not be amortized for financial statement purposes; instead, it will be reviewed annually for impairment.

 

  

The fair value of savings and transaction deposit accounts acquired from Sterling was assumed to approximate the carrying value as these accounts have no stated maturity and are payable on demand.  Certificates of deposit were valued by comparing the contractual cost of the portfolio to an identical portfolio bearing current market rates.  The projected cash flows from maturing certificates were calculated based on contractual rates.  The fair value of certificates of deposit was calculated by discounting their contractual cash flows at a market rate for a certificate of deposit with a corresponding maturity.

 

Direct costs related to the Sterling acquisition were expensed as incurred in the year ended December 31, 2013.  These acquisition and integration expenses included salaries and benefits, technology and communications, occupancy and equipment, professional services and other noninterest expenses.  For the year ended December 31, 2013, the Company incurred $615,000 of expenses related to acquisition costs.

 

NOTE 12 – GOODWILL

 

The majority of goodwill and intangibles generally arise from business combinations accounted for under the purchase method.  Goodwill and other intangibles deemed to have indefinite lives generated from purchase business combinations are not subject to amortization and are instead tested for impairment no less than annually.

 

During the second quarter of 2014, the Company initiated its annual goodwill impairment test to determine whether an impairment of its goodwill asset exists. The test was completed during the current quarter. The goodwill impairment test involves a two-step process.  The first step is a comparison of the reporting unit’s fair value to its carrying value. If the reporting unit’s fair value is less than its carrying value, the Company is required to progress to the second step. In the second step the Company calculates the implied fair value of its reporting unit and, in accordance with applicable GAAP standards, compares the implied fair value of goodwill to the carrying amount of goodwill on the Company’s balance sheet.  If the carrying amount of the goodwill is greater than the implied fair value of that goodwill, an impairment loss must be recognized in an amount equal to that excess.  The implied fair value of goodwill is determined in the same manner as goodwill recognized in a business combination.  The estimated fair value of the Company is allocated to all of the Company’s individual assets and liabilities, including any unrecognized identifiable intangible assets, as if the Company had been acquired in a business combination and the estimated fair value of the Company is the price paid to acquire it. The allocation process is performed only for purposes of determining whether a goodwill impairment exists and the amount of any such impairment. No assets or liabilities are written up or down, nor are any additional unrecognized identifiable intangible assets recorded as a part of this process.

 

The Company estimates fair value using the best information available, including market information and a discounted cash flow analysis, which is also referred to as the income approach. The income approach uses a reporting unit’s projection of estimated operating results and cash flows that is discounted using a rate that reflects current market conditions. The projection uses management’s best estimates of economic and market conditions over the projected period including growth rates in loans and deposits, estimates of future expected changes in net interest margins and cash expenditures. The market approach estimates fair value by applying cash flow multiples to the reporting unit’s operating performance. The multiples are derived from comparable publicly traded companies with similar operating and investment characteristics of the reporting unit. We validate our estimated fair value by comparing the fair value estimates using the income approach to the fair value estimates using the market approach.

 

As part of our process for performing the step one impairment test of goodwill, the Company estimated the fair value of the reporting unit utilizing the income approach and the market approach in order to derive an enterprise value of the Company. In determining the discount rate for the discounted cash flow model, the Company used a modified capital asset pricing model that develops a rate of return utilizing a risk-free rate and equity risk premium resulting in a discount rate of 12.0%. This approach also includes adjustments for the industry the Company operates in and size of the Company. In addition, assumptions used by the Company in its discounted cash flow model (income approach) included an average annual revenue growth rate that approximated 23%; an asset growth of 4.4% in years one through five; net interest margin ranging from 4.02% in the base year to 4.24% in year five; and a return on assets that ranged from 0.62% to 1.24%.

 

In applying the market approach method, the Company considered all banks that announced a sale between January 1, 2013 and September 30, 2014, with total assets under $5 billion and a return on assets greater than zero. This resulted in selecting 24 institutions which fit these criteria.  After selecting these institutions, the Company derived the fair value of the reporting unit by completing a comparative analysis of the relationship between their financial metrics listed above and their market values utilizing various market multiples.  Focus was placed on the price to tangible book value of equity multiple as this multiple generally reflects returns on the capital employed within the industry and is generally correlated with the profitability of each individual company.

 

  

The Company concluded its reporting unit had a fair value of $8.50 per share, or $86.6 million, after giving similar consideration to the values derived from 1) the market approach of $8.20 per share weighted at 80%, and 2) the income approach of $9.67 per share million weighted at 20%. This estimate compares to a carrying value of its reporting unit of $70.9 million. Accordingly, following step one of the Company’s goodwill impairment test, the Company concluded that its reporting unit’s fair value exceeded its carrying value and no goodwill impairment existed.

 

Even though the Company determined that there was no goodwill impairment, a future impairment charge may be necessary if our stock price declines, market values of others in the financial industry decrease, the Bank’s revenue falls, or there are significant adverse changes in the operating environment for the financial industry. It is also possible that changes in circumstances existing now or in the future, or in the numerous estimates, judgments, and assumptions made by management in assessing the fair value of our goodwill, could result in a future goodwill impairment. If the Company records an impairment charge, its financial position and results of operations would be adversely affected; however, such an impairment charge would have no impact on liquidity, day-to-day operations or regulatory capital.

 

NOTE 13 – INCOME TAXES

 

The Company recorded an income tax provision for the three months ended September 30, 2014, June 31, 2014 and September 30, 2013. The amount of the provision for each period was commensurate with the estimated tax liability associated with the net income earned during the period. As of September 30, 2014, the Company maintained a deferred tax asset balance of $4.1 million. The Company believes it will be fully utilized in the normal course of business, thus no valuation allowance is maintained against this asset.

 

The Company's provision for income taxes includes both federal and state income taxes and reflects the application of federal and state statutory rates to the Company's income before taxes. The principal difference between statutory tax rates and the Company's effective tax rate is the benefit derived from investing in tax-exempt securities and bank owned life insurance.

 

Income taxes are accounted for using the asset and liability method. Under this method a deferred tax asset or liability is determined based on the enacted tax rates which will be in effect when the differences between the financial statement carrying amounts and tax basis of existing assets and liabilities are expected to be reported in the Company’s income tax returns. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are established to reduce the net carrying amount of deferred tax assets if it is determined to be more likely than not, that all or some portion of the potential deferred tax asset will not be realized.

 

The Company applies the provisions of FASB ASC 740, Income Taxes, relating to the accounting for uncertainty in income taxes. The Company periodically reviews its income tax positions based on tax laws and regulations, and financial reporting considerations, and records adjustments as appropriate. This review takes into consideration the status of current taxing authorities’ examinations of the Company’s tax returns, recent positions taken by the taxing authorities on similar transactions, if any, and the overall tax environment. The Company’s uncertain tax positions were nominal in amount as of September 30, 2014.

 

  

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion should be read in conjunction with the audited consolidated financial statements and related notes to those statements of Pacific Financial Corporation (“Company”) that appear under the heading “Financial Statements and Supplementary Data” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013 (“2013 10-K”), as well as the unaudited consolidated financial statements for the current quarter found under Item 1 above.

 

DISCLOSURE REGARDING FORWARD LOOKING STATEMENTS

 

This document contains forward-looking statements that are subject to risks and uncertainties. These statements are based on the present beliefs and assumptions of our management, and on information currently available to them. Forward-looking statements include the information concerning our possible future results of operations set forth under "Management's Discussion and Analysis of Financial Condition and Results of Operations" and statements preceded by, followed by or that include the words "believes," “will”, "expects," "anticipates," "intends," "plans," "estimates" or similar expressions.

 

Any forward-looking statements in this document are subject to the risks of our business, including risk factors described in our 2013 10-K, as well as risks relating to, among other things, the following:

 

·

changing laws, regulations, standards, and government programs that may limit our revenue sources, significantly increase our costs, including compliance and insurance costs, limit our opportunities to generate noninterest income, and place additional burdens on our limited management resources;

 

·

economic or business conditions, nationally and in the regions in which we do business that may result in, among other things, reduced demand for credit and other banking services, lower credit quality and additional workout and other real estate owned (“OREO”) expenses;

 

·

decreases in real estate and other asset prices, whether or not due to economic conditions, that may reduce the value of the assets that serve as collateral for many of our loans;

 

·

competitive pressures among depository and other financial institutions that may impede our ability to attract and retain depositors, borrowers and other customers, maintain and improve our net interest income and margin and non-interest income, such as fee income, and/or retain our key employees;

 

·

a lack of liquidity in the market for our common stock that may make it difficult or impossible for you to liquidate your investment in our stock or lead to distortions in the market price of our stock; and

 

·

integration of three bank branches and related assets acquired from Sterling that may cost more or be less beneficial to us than expected.

 

Our management believes the forward-looking statements in this report are reasonable; however, you should not place undue reliance on them. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Many of the factors that will determine our future results and share value are beyond our ability to control or predict. We undertake no obligation to update forward-looking statements.

 

Third Quarter 2014 Highlights (as of, or for the period ended September 30, 2014, except as noted):

 

•

Earnings per share (“EPS”) declined by 7% to $0.13, compared to $0.14 in second quarter 2014, primarily due more shares outstanding reflecting the exercise of warrants during the quarter. EPS grew 44% from $0.09 in third quarter 2013. Year-to-date, EPS increased 28% to $0.37, from $0.29 for the same period in 2013.

 

•

Net interest income increased $86,000, or 1%, to $6.9 million, compared to $6.8 million in second quarter 2014, and grew $867,000, or 14%, from $6.0 million in third quarter 2013. For the first nine months of 2014, net interest income increased $2.7 million, or 15%, to $20.2 million, from $17.5 million for the like period in 2013.

   

 

•

Net interest margin (NIM) was 4.13%, compared to 4.28% for the preceding quarter, and 3.88% for third quarter 2013. Year-to-date, net interest margin expanded 23 basis points to 4.22%, compared to 3.99% for the first nine months of 2013.

 

•

Gross loans grew to $552.1 million, an increase of $4.8 million, or 1% from $547.3 million at June 30, 2014, and up 13% from $486.7 million at September 30, 2013.

 

•

Nonperforming assets declined to $6.4 million, or 0.86% of total assets, down from $7.4 million, or 1.03% of total assets, at June 30, 2014 and $12.4 million, or 1.73% of total assets at September 30, 2013.

 

•

Classified loans increased to $18.4 million, or 3.33% of gross loans, up from $16.0 million, or 2.91% of gross loans, at June 30, 2014, and $13.7 million, or 2.82% of gross loans at September 30, 2013.

 

•

Net charge-offs totaled $160,000, compared to $73,000 in second quarter 2014 and $156,000 for third quarter 2013. Year-to-date, net charge-offs were $304,000, compared to $102,000 for the first nine months of 2013.

 

•

Capital levels exceeded regulatory requirements for a well-capitalized financial institution, with a total risk-based capital ratio of 14.06% and a leverage ratio of 10.09% at quarter end.

 

OPERATING RESULTS

 

Net Interest Income

Net interest income for the quarter and nine months ended September 30, 2014, increased from the quarter and nine months ended September 30, 2013. This increase was primarily due to the growth in earning assets, along with changes in the balance sheet mix. Loan balances increased due to the production generated predominately in Western Washington. Investment securities and federal funds sold decreased as a proportion of the balance sheet due to the strong loan demand during the past several quarters. Funding costs remained low due to the shift in mix toward non-interest bearing and lower-cost deposits, and continued historically low interest rates.

 

Net interest income for the current quarter increased from the second quarter of 2014, reflecting higher loan balances and lower levels of investments. While funding costs declined slightly when comparing the periods, given the lengthy period of very low interest rates over the past several years, additional reductions in funding costs are becoming more difficult to achieve as renewing certificates of deposit are receiving rates that are similar to those granted at previous renewals.

 

Certain reclassifications have been made to the June 31, 2014 and September 30, 2013 financial table presentations to conform to current year presentations. These reclassifications have no effect on previously reported net income per share.

 

  

INCOME STATEMENT OVERVIEW

 

(Unaudited)

(Dollars in Thousands, Except for Income per Share Data)

		For the Three Months Ended September 30, 2014				For the Three Months Ended June 30, 2014				$ Change				% Change				For the Three Months Ended September 30, 2013				$ Change				% Change
Interest and dividend income		$	7,400			$	7,337			$	63				1	%		$	6,605			$	795				12	%
Interest expense			518				541				(23	)			-4	%			590				(72	)			-12	%
Net interest income			6,882				6,796				86				1	%			6,015				867				14	%
Loan loss provision			100				100				-				0	%			-				100				100	%
Non-interest income			2,274				2,176				98				5	%			2,232				42				2	%
Non-interest expense			7,133				7,066				67				1	%			7,089				44				1	%
INCOME BEFORE PROVISION FOR INCOME TAXES			1,923				1,806				117				6	%			1,158				765				66	%
PROVISION FOR INCOME TAXES			549				403				146				36	%			249				300				120	%
NET INCOME		$	1,374			$	1,403			$	(29	)			-2	%		$	909			$	465				51	%
INCOME PER COMMON SHARE:
BASIC (1)		$	0.13			$	0.14			$	(0.01	)			-7	%		$	0.09			$	0.04				44	%
DILUTED (2)		$	0.13			$	0.14			$	(0.01	)			-7	%		$	0.09			$	0.04				44	%
Average common shares outstanding - basic (1)			10,281,745				10,189,386				92,359				1	%			10,121,853				159,892				2	%
Average common shares outstanding - diluted (2)			10,379,166				10,275,628				103,538				1	%			10,194,826				184,340				2	%

 

		For the Nine Months Ended September 30, 2014				For the Nine Months Ended September 30, 2013				$ Change				% Change
Interest and dividend income		$	21,821				19,476				2,345				12	%
Interest expense			1,589				1,927				(338	)			-18	%
Net interest income			20,232				17,549				2,683				15	%
Loan loss provision			200				(450	)			650				-144	%
Non-interest income			6,058				8,033				(1,975	)			-25	%
Non-interest expense			21,028				22,380				(1,352	)			-6	%
INCOME BEFORE PROVISION FOR INCOME TAXES			5,062				3,652				1,410				39	%
PROVISION FOR INCOME TAXES			1,257				710				547				77	%
NET INCOME		$	3,805				2,942				863				29	%
INCOME PER COMMON SHARE:
BASIC (1)		$	0.37				0.29				0.08				28	%
DILUTED (2)		$	0.37				0.29				0.08				28	%
Average common shares outstanding - basic (1)			10,218,103				10,121,853				96,250				1	%
Average common shares outstanding - diluted (2)			10,309,436				10,179,928				129,508				1	%

 

The following tables provide reconciliations of net income to pre-tax, pre-credit cost operating income and to tax equivalent pretax income (each non-GAAP financial measures) for the periods presented:

 

Reconciliation of Non-GAAP Measure:
Non-GAAP Operating Income
(Dollars in Thousands)
For The Three Months Ended		September 30, 2014				June 30, 2014				$ Change				% Change				September 30, 2013				$ Change				% Change
Net income		$	1,374			$	1,403			$	(29	)			-2	%		$	909			$	465				51	%
Provision for loan losses			100				100				0				0	%			-				100				100	%
Other real estate owned write-downs			1				54				(53	)			-98	%			176				(175	)			-99	%
Other real estate owned operating costs			100				30				70				233	%			67				33				49	%
Provision for income taxes			549				403				146				36	%			249				300				120	%
Pre-tax, pre-credit cost operating income*		$	2,124			$	1,990			$	134				7	%		$	1,401			$	723				52	%

 

For The Nine Months Ended		September 30, 2014				September 30, 2013				$ Change				% Change
Net income		$	3,805			$	2,942			$	863				29	%
Provision for loan losses			200				(450	)			650				-144	%
Other real estate owned write-downs			67				636				(569	)			-89	%
Other real estate owned operating costs			191				276				(85	)			-31	%
Provision for income taxes			1,257				710				547				77	%
Pre-tax, pre-credit cost operating income*		$	5,520			$	4,114			$	1,406				34	%

 

  

Reconciliation of Non-GAAP Measure:

Tax Equivalent Income

(Dollars in Thousands)

For the Three Months ended		September 30, 2014				June 30, 2014				$ Change				% Change				September 30, 2013				$ Change				% Change
Net interest income		$	6,882			$	6,796			$	86				1	%		$	6,015			$	867				14	%
Tax equivalent adjustment for municipal loan interest			45				46				(1	)			-2	%			46				(1	)			-2	%
Tax equivalent adjustment for municipal bond interest			94				120				(26	)			-22	%			121				(27	)			-22	%
Tax equivalent net interest income			7,021				6,962				59				1	%			6,182				839				14	%
Provision for loan losses			100				100				-				0	%			-				100				100	%
Non-interest income			2,274				2,176				98				5	%			2,232				42				2	%
Non-interest expense			7,133				7,066				67				1	%			7,089				44				1	%
Tax equivalent income before income taxes*			2,062				1,972				90				5	%			1,325				737				56	%
Provision for income taxes			549				403				146				36	%			249				300				120	%
Accumulative tax adjustment			(139	)			(166	)			27				-16	%			(167	)			28				-17	%
Common stock dividends			-				-				-				0	%			-				-				0	%
Net income		$	1,374			$	1,403			$	(29	)			-2	%		$	909			$	465				51	%

 

For the Nine Months ended		September 30, 2014				September 30, 2013				$ Change				% Change
Net interest income		$	20,232			$	17,549			$	2,683				15	%
Tax equivalent adjustment for municipal loan interest			138				163				(25	)			-15	%
Tax equivalent adjustment for municipal bond interest			332				392				(60	)			-15	%
Tax equivalent net interest income			20,702				18,104				2,598				14	%
Provision for loan losses			200				(450	)			650				-144	%
Non-interest income			6,058				8,033				(1,975	)			-25	%
Non-interest expense			21,028				22,380				(1,352	)			-6	%
Tax equivalent income before income taxes*			5,532				4,207				1,325				31	%
Provision for income taxes			1,257				710				547				77	%
Accumulative tax adjustment			(470	)			(555	)			85				-15	%
Common stock dividends			-				-				-				0	%
Net income		$	3,805			$	2,942			$	863				29	%

 

*Pre-tax, pre-credit cost operating income and tax equivalent income before income taxes are non-GAAP financial measures. Non-GAAP financial measures have inherent limitations and are not required to be uniformly applied. Management believes that presentation of these non-GAAP financial measures provides useful information that is frequently used by shareholders and analysts in the evaluation of financial institutions. Non-GAAP financial measures have limitations as analytical tools and should not be considered in isolation or as a substitute for information reported in accordance with GAAP.

 

Noninterest Income

Noninterest income for third quarter 2014 grew compared to both the preceding and year ago quarters, reflecting increases in gains from sales of loans over the preceding quarter. Gains on sale of residential mortgage loans and related fee income rose in third quarter 2014 compared to second quarter 2014, and was similar to that earned in third quarter 2013. The recent rebound in home purchases throughout many of our markets is fueling new residential mortgage originations. In addition, fee income from annuity sales increased in the current quarter compared to the second quarter of 2013, but was down slightly from the prior quarter due to seasonal factors. Losses on sale of other real estate owned (“OREO”) were higher in the current period as compared to the prior quarter and were in contrast to a small gain in third quarter in 2013, reflecting a more aggressive approach to pricing in order to reduce the levels of OREO. In addition, gains on our securities available for sale portfolio in third quarter 2014 and third quarter 2013 were taken to improve the credit quality of securities in the portfolio and to reduce interest rate risk.

 

Noninterest income for the first nine months of 2014 was down from the same period in 2013, reflecting the declines in gains on sale of residential mortgage loans due to the slowdown in refinancing activity that occurred in the second half of 2013 and higher losses on sale of OREO.

 

  

Noninterest income

(Unaudited)

(Dollars in Thousands)

 

For The Three Months Ended
		September 30, 2014				June 30, 2014				$ Change				% Change				September 30, 2013				$ Change				% Change
Service charges on deposit accounts		$	450			$	474			$	(24	)			-5	%		$	440			$	10				2	%
Net (loss) on sale of other real estate owned			(85	)			(57	)			(28	)			49	%			18				(103	)			-572	%
Net gains from sales of loans			1,120				968				152				16	%			1,128				(8	)			-1	%
Net gains on sales of securities available for sale			38				(2	)			40				-2000	%			14				24				171	%
Net other-than-temporary impairment (net of $0, $0, and $7, respectively recognized other comprehensive income before taxes)			-				(3	)			3				-100	%			(4	)			4				-100	%
Earnings on bank owned life insurance			127				140				(13	)			-9	%			105				22				21	%
Other operating income
Fee income			498				442				56				13	%			421				77				18	%
Income from other real estate owned			6				17				(11	)			-65	%			22				(16	)			-73	%
Other non-interest income			120				197				(77	)			-39	%			88				32				36	%
Total non-interest income		$	2,274			$	2,176			$	98				5	%		$	2,232			$	42				2	%

 

For The Nine Months Ended
		September 30, 2014				September 30, 2013				$ Change				% Change
Service charges on deposit accounts		$	1,359			$	1,281			$	78				6	%
Net (loss) on sale of other real estate owned			(179	)			43				(222	)			-516	%
Net gains from sales of loans			2,717				4,306				(1,589	)			-37	%
Net gains on sales of securities available for sale			88				401				(313	)			-78	%
Net other-than-temporary impairment (net of $15, and $2, respectively recognized other comprehensive income before taxes)			(48	)			(38	)			(10	)			26	%
Earnings on bank owned life insurance			378				342				36				11	%
Other operating income
Fee income			1,304				1,392				(88	)			-6	%
Income from other real estate owned			34				51				(17	)			-33	%
Other non-interest income			405				255				150				59	%
Total non-interest income		$	6,058			$	8,033			$	(1,975	)			-25	%

 

Noninterest Expense

Noninterest expense for third quarter of 2014 was virtually unchanged as compared to the second quarter of 2014. Decreases in OREO write-downs were offset by increased operating costs associated with acquisitions into OREO during the current quarter.

 

Noninterest expense for third quarter 2014 was virtually unchanged compared to the year ago quarter. Salary and benefits expense increased with the addition of loan production personnel and branch staff for the new branch that opened in the fourth quarter of 2013. Total costs associated with OREO and related third-party loan expenses decreased due to the decline in OREO balances and stabilization of valuations. Other non-interest expenses also declined primarily due to a decrease in loan origination and appraisal expense associated with a decline in mortgage origination activity.

 

Noninterest expense for the first nine months of 2014 was down as compared to the same period in 2013, because of the $471,000 savings generated from reduction in mortgage lending staff initiated in first quarter 2014 prompted by the decline in residential mortgage loan refinance activity. Also, in second quarter 2013 the Bank incurred one-time expenses of $395,000 in data processing conversion costs relating to three branches acquired from Sterling Savings Bank in June 2013. In addition, OREO write-downs and expenses and loan origination and appraisal expense were down as compared to the prior period for reasons noted above.

 

  

Noninterest expense

(Unaudited)

(Dollars in Thousands)

 

For The Three Months Ended
		September 30, 2014				June 30, 2014				$ Change				% Change				September 30, 2013				$ Change				% Change
Salaries and employee benefits		$	4,286			$	4,283			$	3				0	%		$	4,098			$	188				5	%
Occupancy			483				504				(21	)			-4	%			473				10				2	%
Equipment			261				263				(2	)			-1	%			233				28				12	%
Data processing			492				462				30				6	%			449				43				10	%
Professional services			220				201				19				9	%			198				22				11	%
Other real estate owned write-downs			1				54				(53	)			-98	%			176				(175	)			-99	%
Other real estate owned operating costs			100				30				70				233	%			67				33				49	%
State taxes			110				107				3				3	%			110				0				0	%
FDIC and state assessments			119				129				(10	)			-8	%			129				(10	)			-8	%
Other non-interest expense:
Director fees			80				72				8				11	%			48				32				67	%
Communication			65				53				12				23	%			42				23				55	%
Advertising			73				76				(3	)			-4	%			76				(3	)			-4	%
Professional liability insurance			24				19				5				26	%			21				3				14	%
Amortization			99				98				1				1	%			116				(17	)			-15	%
Other non-interest expense			720				715				5				1	%			853				(133	)			-16	%
Total non-interest expense		$	7,133			$	7,066			$	67				1	%		$	7,089			$	44				1	%

 

For The Nine Months Ended
		September 30, 2014				September 30, 2013				$ Change				% Change
Salaries and employee benefits		$	12,624			$	12,983			$	(359	)			-3	%
Occupancy			1,494				1,338				156				12	%
Equipment			775				619				156				25	%
Data processing			1,387				1,688				(301	)			-18	%
Professional services			606				696				(90	)			-13	%
Other real estate owned write-downs			67				636				(569	)			-89	%
Other real estate owned operating costs			191				276				(85	)			-31	%
State taxes			314				360				(46	)			-13	%
FDIC and state assessments			381				395				(14	)			-4	%
Other non-interest expense:
Director fees			208				164				44				27	%
Communication			155				130				25				19	%
Advertising			227				222				5				2	%
Professional liability insurance			65				67				(2	)			-3	%
Amortization			291				311				(20	)			-6	%
Other non-interest expense			2,243				2,495				(252	)			-10	%
Total non-interest expense		$	21,028			$	22,380			$	(1,352	)			-6	%

 

 

SUMMARY BALANCE SHEET OVERVIEW

 

(Unaudited)

(Dollars in Thousands)

 

		September				June								%				September								%
		30, 2014				30, 2014				$ Change				Change				30, 2013				$ Change				Change
Assets:
Cash and cash equivalents		$	40,781			$	17,694			$	23,087				130	%		$	69,657			$	(28,876	)			-41	%
Interest-bearing certificates of deposit			2,727				2,727				0				0	%			1,735				992				57	%
Federal Home Loan Bank stock, at cost			2,926				2,956				(30	)			-1	%			3,041				(115	)			-4	%
Pacific Coast Bankers' Bank stock, at cost			1,000				0				1,000				-				0				1,000				-
Investment securities			91,185				90,583				602				1	%			94,129				(2,944	)			-3	%
Loans held-for-sale			8,161				7,632				529				7	%			7,266				895				12	%
Gross loans, net of deferred fees			552,140				547,283				4,857				1	%			486,700				65,440				13	%
Allowance for loan losses			(8,255	)			(8,315	)			60				-1	%			(8,806	)			551				-6	%
Net loans			543,885				538,968				4,917				1	%			477,894				65,991				14	%
Other assets			58,382				58,912				(530	)			-1	%			62,026				(3,644	)			-6	%
Total assets		$	749,047			$	719,472			$	29,575				4	%		$	715,748			$	33,299				5	%
Liabilities and shareholders' equity
Total deposits		$	644,004			$	619,301			$	24,703				4	%		$	618,918			$	25,086				4	%
Accrued interest payable			141				151				(10	)			-7	%			182				(41	)			-23	%
Borrowings			24,894				23,743				1,151				5	%			23,403				1,491				6	%
Other liabilities			6,751				5,417				1,334				25	%			4,909				1,842				38	%
Shareholders' equity			73,257				70,860				2,397				3	%			68,336				4,921				7	%
Total liabilities and shareholders' equity		$	749,047			$	719,472			$	29,575				4	%		$	715,748			$	33,299				5	%

  

Cash and Cash Equivalents and Investment Securities

(Unaudited)

(Dollars in Thousands)

		September 30, 2014				% of Total				June 30, 2014				% of Total				$ Change				% Change				September 30, 2013				% of Total				$ Change				% Change
Cash and due from banks		$	15,284				11	%		$	17,455				15	%		$	(2,171	)			-12	%		$	15,494				9	%		$	(210	)			-1	%
Cash equivalents:
Interest-bearing deposits			25,497				18	%			239				0	%			25,258				10568	%			54,163				32	%			(28,666	)			-53	%
Interest-bearing certificates of deposit			2,727				2	%			2,727				2	%			-				0	%			1,735				1	%			992				57	%
Total cash equivalents and certificate of deposits			43,508				31	%			20,421				18	%			23,087				113	%			71,392				42	%			(27,884	)			-39	%
Investment securities:
Collateralized mortgage obligations: agency issued			40,039				29	%			38,822				34	%			1,217				3	%			34,482				20	%			5,557				16	%
Collateralized mortgage obligations: non-agency issued			579				0	%			604				1	%			(25	)			-4	%			2,179				1	%			(1,600	)			-73	%
Mortgage-backed securities: agency issued			12,630				9	%			12,059				11	%			571				5	%			12,972				8	%			(342	)			-3	%
U.S. Government and agency securities			8,655				6	%			8,721				8	%			(66	)			-1	%			8,859				5	%			(204	)			-2	%
State and municipal securities			29,282				21	%			30,377				27	%			(1,095	)			-4	%			35,042				21	%			(5,760	)			-16	%
Corporate bonds			-				0	%			-				0	%			-				0	%			595				0	%			(595	)			-100	%
FHLB Stock			2,926				2	%			2,956				3	%			(30	)			-1	%			3,041				2	%			(115	)			-4	%
Pacific Coast Bankers' Bank stock, at cost			1,000				1	%			-				0	%			1,000				100	%			-				0	%			1,000				100	%
Total investment securities			95,111				69	%			93,539				82	%			1,572				2	%			97,170				58	%			(2,059	)			-2	%
Total cash equivalents and investment securities		$	138,619				100	%		$	113,960				100	%		$	24,659				22	%		$	168,562				100	%		$	(29,943	)			-18	%
Total cash equivalents and investment securities as a % of total assets							19	%							16	%															24	%

 

  

Investment securities and interest-bearing certificates of deposit

(Unaudited)
(Dollars in Thousands)
For the Three Months Ended		September 30, 2014				June 30, 2014				$ Change				% Change				September 30, 2013				$ Change				% Change
Balance beginning of period		$	96,266			$	102,951			$	(6,685	)			-6	%		$	94,855			$	1,411				1	%
Principal purchases			7,482				3,806				3,676				97	%			10,772				(3,290	)			-31	%
Proceeds from sales			(3,927	)			(8,979	)			5,052				-56	%			(3,067	)			(860	)			28	%
Principal paydowns, maturities, and calls			(1,673	)			(2,144	)			471				-22	%			(4,266	)			2,593				-61	%
Gains on sales of securities			94				159				(65	)			-41	%			57				37				65	%
Losses on sales of securities			(56	)			(161	)			105				-65	%			(43	)			(13	)			30	%
OTTI loss writedown			-				(3	)			3				-100	%			13				(13	)			-100	%
Change in unrealized gains (loss) before tax			(64	)			903				(967	)			-107	%			770				(834	)			-108	%
Amortization and accretion of discounts and premiums			(284	)			(266	)			(18	)			7	%			(186	)			(98	)			53	%
Total investment portfolio		$	97,838			$	96,266			$	1,572				2	%		$	98,905			$	(1,067	)			-1	%

 

Liquidity remains strong based on the current levels of cash equivalents and investment securities. The Company maintains unsecured lines of credit totaling $16.0 million with correspondent banks, all of which are currently available. In addition, it has a secured borrowing facility with the Federal Home Loan Bank of Seattle of $143.8 million, of which $11.5 million is currently outstanding. In an effort to fund pending loan demand, cash equivalents were increased during the current quarter. In addition, some restructuring of the investment portfolio was conducted to reduce the impact of interest rate risk on securities valuation, resulting in a lowering of portfolio yields. The expected modified duration (adjusted for calls, consensus pre-payment speeds and rate adjustment dates) of the investment portfolio was 4.3 years at September 30, 2014, 4.5 years at June 30, 2014 and 4.4 years at September 30, 2013.

 

LOANS

Loan portfolio growth continues to be well diversified and generated predominately within our Washington and Oregon markets. This is despite a payoff of a $5.7 million non-owner occupied commercial real estate relationship during the current quarter. The portfolio includes $36.3 million in purchased government-guaranteed commercial and commercial real estate loans. In addition, the loan portfolio contains $25.3 million in indirect consumer loans to individuals with high credit scores to finance luxury and classic cars as a part of a strategy to diversify the loan portfolio.

 

Our ability to continue loan growth will be dependent on many factors, including the effects of competition, economic conditions in our markets, retention of key personnel and valued customers, and our ability to close loans in the pipeline. The Company manages new loan origination volume using concentration limits that establish maximum exposure levels by designated industry segment, real estate product types, geography, and single borrower limits.

 

Loans by category

(Unaudited)		September 30,				% of				June 30,				% of				$								September				% of				$
(Dollars in Thousands)		2014				Gross Loans				2014				Gross Loans				Change				% Change				30, 2013				Gross Loans				Change				% Change
Commercial and agricultural		$	112,873				20	%		$	109,368				20	%		$	3,505				3	%		$	94,471				19	%		$	18,402				19	%
Real estate:
Construction and development			25,419				5	%			32,071				6	%			(6,652	)			-21	%			29,538				6	%			(4,119	)			-14	%
Residential 1-4 family			94,101				17	%			90,549				17	%			3,552				4	%			85,625				18	%			8,476				10	%
Multi-family			20,554				4	%			20,110				4	%			444				2	%			13,846				3	%			6,708				48	%
Commercial real estate — owner occupied			122,090				22	%			117,203				21	%			4,887				4	%			106,670				22	%			15,420				14	%
Commercial real estate — non owner occupied			120,569				22	%			124,929				23	%			(4,360	)			-3	%			115,290				24	%			5,279				5	%
Farmland			22,926				4	%			23,900				4	%			(974	)			-4	%			24,002				5	%			(1,076	)			-4	%
Consumer			34,787				6	%			30,241				6	%			4,546				15	%			18,366				4	%			16,421				89	%
Gross loans			553,319				100	%			548,371				100	%			4,948				1	%			487,808				100	%			65,511				13	%
Less: allowance for loan losses			(8,255	)							(8,315	)							60								(8,806	)							551
Less: deferred fees			(1,179	)							(1,088	)							(91	)							(1,108	)							(71	)
Loans, net		$	543,885							$	538,968							$	4,917							$	477,894							$	65,991

 

The table provided below summarizes the Bank’s level of concentrations in commercial real estate as of September 30, 2014, December 31, 2013 and September 30, 2013, respectively, as defined in the Interagency Guidelines for Real Estate Lending and the Commercial Real Estate Lending Joint Guidance policy. The results displayed support the Company’s efforts to manage CRE concentrations in the loan portfolio.

 

  

Commercial Real Estate ("CRE")
Portfolio Policy Concentrations
		September 30, 2014				December 31, 2013				September 30, 2013				Guideline
Total Regulatory CRE1			224	%			231	%			226	%			300	%
Construction & Land Development CRE2			39	%			44	%			39	%			100	%

 

As a percent of total risk based capital ("TRBC")

 

¹Consists of CRE Const, CRE Residential SFR 1-4 Const, CRE Land Dev & Other Land, CRE NOO Term, C&I Loans not RE Secured to Finance CRE Activities

²Consists of CRE Const, CRE Residential SFR 1-4 Const, CRE Land Dev & Other Land

 

Commercial real estate markets continue to be vulnerable to financial and valuation pressures that may limit refinance options and negatively impact borrowers’ ability to perform under existing loan agreements. Declines in the value of commercial real estate or higher market interest rates may have a further adverse impact on the ability of borrowers with maturing loans to satisfy loan to value ratios required to renew such loans.

 

At September 30, 2014, the Bank had outstanding loan advances of $3.7 million to persons serving as directors, executive officers, principal stockholders and their related interests. This compares to $66,000 and $254,000 at December 31, 2013 and September 30, 2013, respectively. These loans were made in the ordinary course of business on substantially the same terms, including interest rates, maturities and collateral, as comparable loans made to customers not related to the Bank. None of these loans were on nonaccrual, past due or restructured as of September 30, 2014.

 

DEPOSITS

Total deposits were up at September 30, 2014, compared to the second quarter of this year and the third quarter a year ago. Non-interest bearing deposits grew due to seasonal inflows associated with increased business activity in our local markets with economies focused on summer tourism. Recent success in acquiring business deposit relationships in conjunction with the growth in lending achieved over the past year has also contributed to deposit growth. The combination of our efforts to reduce higher-cost time deposits through lowering interest rates paid and offering non-insured deposit products, when appropriate, reduced the average rate paid on total deposits in third quarter 2014 from third quarter 2013.

 

Total brokered deposits were $22.6 million at September 30, 2014, which included $2.5 million via reciprocal deposit arrangements. This compares to $22.9 million and $24.1 million at June 30, 2014 and September 30, 2013, respectively. In addition, the Company’s funding structure contains $11.5 million in borrowings from the Federal Home Loan Bank. The Company views the prudent use of brokered deposits and borrowings to be an appropriate funding tool to support interest rate risk mitigation strategies.

 

Deposits
(Unaudited)
(Dollars in Thousands)		September 30, 2014				Percent of Total				June 30, 2014				Percent of Total				$ Change				September 30, 2013				Percent of Total				$ Change
Interest-bearing demand and money market		$	266,863				41	%		$	268,480				43	%		$	(1,617	)		$	253,895				41	%		$	12,968
Savings			76,661				12	%			74,336				12	%			2,325				72,880				12	%			3,781
Time deposits			118,221				18	%			119,531				19	%			(1,310	)			135,979				22	%			(17,758	)
Total interest-bearing deposits			461,745				72	%			462,347				75	%			(602	)			462,754				75	%			(1,009	)
Non-interest bearing demand			182,259				28	%			156,954				25	%			25,305				156,164				25	%			26,095
Total deposits		$	644,004				100	%		$	619,301				100	%		$	24,703			$	618,918				100	%		$	25,086

 

  

Deposits and Borrowings

 

The following table summarizes the quarterly average dollar amount in each of the deposit and borrowing categories during the three months ended September 30, 2014, June 31, 2014 and September 30, 2013 as well as the nine months ended September 30, 2014 and 2013:

 

AVERAGE DEPOSITS AND BORROWINGS

(Unaudited)
(Dollars in Thousands)
Averages for the Three Months Ended		September 30, 2014				% of Total				June 30, 2014				% of Total				$ Change				% Change				September 30, 2013				% of Total				$ Change				% Change
Non-interest bearing demand deposits		$	170,560				26	%		$	150,776				24	%		$	19,784				2	%		$	138,875				22	%		$	31,685				4	%
Interest bearing demand			268,922				41	%			270,702				42	%			(1,780	)			-1	%			251,400				40	%			17,522				1	%
Savings			74,282				11	%			74,414				12	%			(132	)			-1	%			71,206				11	%			3,076				0	%
Time deposits			120,515				18	%			122,134				19	%			(1,619	)			-1	%			138,762				22	%			(18,247	)			-4	%
Total average interest bearing deposits			463,719				70	%			467,250				73	%			(3,531	)			-3	%			461,368				74	%			2,351				-4	%
Total average deposits		$	634,279							$	618,026							$	16,253							$	600,243							$	34,036
Average rate on total average deposits
Federal Home Loan Bank borrowings		$	10,878				2	%		$	10,000				2	%		$	878				0	%		$	10,000				2	%		$	878				0	%
Short term borrowings			587				0	%			6				0	%			581				0	%			-				0	%			587				0	%
Junior subordinated debentures			13,403				2	%			13,403				2	%			-				0	%			13,403				2	%			-				0	%
Total average borrowings		$	24,868				4	%		$	23,409				4	%		$	1,459							$	23,403				4	%		$	1,465				0	%
Total average interest-bearing liabilities		$	488,587							$	490,659							$	(2,072	)						$	484,771							$	3,816
Total average deposits and borrowings		$	659,147				100	%		$	641,435				100	%		$	17,712							$	623,646				100	%		$	35,501

 

Averages for the Nine Months Ended		September 30, 2014				% of Total				September 30, 2013				% of Total				$ Change				% Change
Non-interest bearing demand deposits		$	154,213				24	%		$	123,868				21	%		$	30,345				3	%
Interest bearing demand			267,060				42	%			244,141				41	%			22,919				1	%
Savings			74,473				12	%			67,651				11	%			6,822				1	%
Time deposits			123,140				19	%			136,863				23	%			(13,723	)			-4	%
Total average interest bearing deposits			464,673				72	%			448,655				75	%			16,018				-3	%
Total average deposits		$	618,886							$	572,523							$	46,363
Average rate on total average deposits
Federal Home Loan Bank borrowings		$	10,296				2	%		$	10,066				2	%		$	230				0	%
Short term borrowings			200				0	%			-				0	%			200				0	%
Junior subordinated debentures			13,403				2	%			13,403				2	%			-				0	%
Total average borrowings		$	23,899				4	%		$	23,469				4	%		$	430
Total average interest-bearing liabilities		$	488,572							$	472,124							$	16,448
Total average deposits and borrowings		$	642,785				100	%		$	595,992				100	%		$	46,793

 

Two wholly-owned subsidiary grantor trusts established by the Company had issued and outstanding $13.4 million of trust preferred securities and accrued interest. For additional information regarding these securities see the discussion under the subheadings “Junior Subordinated Debentures” included in Note 10 of the Company’s audited financial statements as presented in its 2013 Form10-K.

 

CAPITAL

Pacific Financial Corporation, and its subsidiary Bank of the Pacific, continue to meet the thresholds to be considered “well-capitalized” under regulatory requirements. Capital ratios increased slightly as compared to the prior quarter primarily due to earnings retention. Also, $1.2 million of additional capital was supplied via the exercise at a price of $6.50 per share of warrants to purchase 185,000 shares of common stock originally issued in conjunction with a private capital raise conducted in 2009. In general, capital ratios declined from September 30, 2013 due to the successful execution of the Company’s growth strategy and shift in the balance sheet mix to higher risk-weighted loan assets. However, the tangible common equity ratio grew due to the additional capital supplied via exercise of warrants, as previously mentioned.

 

 

The Board of Governors of the Federal Reserve System (“Federal Reserve”) and the FDIC have established minimum requirements for capital adequacy for bank holding companies and state non-member banks. For more information on these topics, see the discussions under the subheading “Capital Adequacy” in the section “Business” included in Item 1, of the Company’s 2013 Form 10-K. The following table summarizes the capital measures of the Company and the Bank, respectively, at the dates listed below.

 

The total risk based capital ratios of the Company include $13.4 million of junior subordinated debentures, all of which qualified as Tier 1 capital at September 30, 2014, under guidance issued by the Federal Reserve. The Company expects to continue to rely on these junior subordinated debentures as part of its regulatory capital.

 

		September 30, 2014				June 30, 2014				Change				September 30, 2013				Change				Regulatory Minimum to be "Well Capitalized"
																						greater than or equal to
Pacific Financial Corporation
Total risk-based capital ratio			14.09	%			13.76	%			0.33				14.84	%			(0.75	)			10	%
Tier 1 risk-based capital ratio			12.83	%			12.51	%			0.32				13.59	%			(0.76	)			6	%
Leverage ratio			10.09	%			10.04	%			0.05				10.04	%			0.05				5	%
Tangible common equity ratio			8.11	%			8.11	%			-				7.79	%			0.32				n/a
Bank of the Pacific
Total risk-based capital ratio			13.87	%			13.73	%			0.14				14.85	%			(0.98	)			10	%
Tier 1 risk-based capital ratio			12.61	%			12.48	%			0.13				13.59	%			(0.98	)			6	%
Leverage ratio			9.91	%			10.01	%			(0.10	)			10.04	%			(0.13	)			5	%

 

  

FINANCIAL PERFORMANCE OVERVIEW
(Unaudited)
(Dollars in Thousands, Except per Share Data)
For The Three Months Ended
		September 30, 2014				June 30, 2014				Change				September 30, 2013				Change
Selective quarterly performance ratios
Return on average assets, annualized			0.74	%			0.79	%			(0.05	)			0.52	%			0.22
Return on average equity, annualized			7.55	%			8.04	%			(0.49	)			5.33	%			2.22
Efficiency ratio (1)			77.91	%			78.76	%			(0.85	)			85.96	%			(8.05	)
Share and per share information
Average common shares outstanding - basic			10,281,745				10,189,386				92,359				10,121,853				159,892
Average common shares outstanding - diluted			10,379,166				10,275,628				103,538				10,194,826				184,340
Basic income per common share			0.13				0.14				(0.01	)			0.09				0.04
Diluted income per common share			0.13				0.14				(0.01	)			0.09				0.04
Book value per common share (2)			7.07				6.94				0.13				6.75				0.32
Tangible book value per common share (3)			5.75				5.60				0.15				5.46				0.29

 

For The Nine Months Ended
		September 30, 2014				September 30, 2013				Change
Selective quarterly performance ratios
Return on average assets, annualized			0.71	%			0.59	%			0.12
Return on average equity, annualized			7.26	%			5.81	%			1.45
Efficiency ratio (1)			79.98	%			87.48	%			(7.50	)
Share and per share information
Average common shares outstanding - basic			10,218,103				10,121,853				96,250
Average common shares outstanding - diluted			10,309,436				10,179,928				129,508
Basic income per common share			0.37				0.29				0.08
Diluted income per common share			0.37				0.29				0.08

 

(1)

Non-interest expense divided by net interest income plus non-interest income.

(2)

Book value is calculated as the total common equity divided by the period ending number of common shares outstanding.

(3)

Tangible book value is calculated as the total common equity less total intangible assets and liabilities divided by the period ending number of common shares outstanding.

 

Net Interest Margin

Net interest margin declined compared to second quarter of 2014, as reductions in investment securities and loan yields offset declines in deposit costs. Declines in yields on investment securities were primarily due to portfolio restructuring. Loan yield declines resulted from increased competition for high quality borrowing relationships in the marketplace. Net interest margin improved when compared to third quarter of 2013, predominantly due to a shift in the mix of earning assets toward higher-yielding loans and the lower cost of interest bearing liabilities. The growth in the proportion of noninterest bearing deposits over the past several quarters has supported the improvement in net interest margin as well. In second quarter 2014, loan yields and net interest margin were enhanced by 9 and 7 basis points, respectively, due to the collection of $115,000 in non-accrual interest during the period. There was no similar collection of non-accrual interest during the third quarter of 2014 or 2013.

 

The improvement in yields on investment securities also enhanced net interest margin between the nine months ending September 30, 2014 and the same period in 2013. This was primarily the result of reducing the proportion of lower yielding cash-equivalent investments to fund loan growth and increasing the proportion of relatively higher-yielding federal government guaranteed mortgage-backed securities.

 

  

NET INTEREST MARGIN

 

(Annualized, tax-equivalent basis)
(Unaudited)
For The Three Months Ended
		September 30, 2014				June 30, 2014				Change				September 30, 2013				Change
Selective quarterly performance ratios
Yield on average gross loans (1)			4.95	%			5.04	%			(0.09	)			4.99	%			(0.04	)
Yield on average investment securities (1)			2.02	%			2.54	%			(0.52	)			1.70	%			0.32
Cost of average interest bearing deposits			0.34	%			0.37	%			(0.03	)			0.41	%			(0.07	)
Cost of average borrowings			1.83	%			1.90	%			(0.07	)			1.97	%			(0.14	)
Cost of average total deposits and borrowings			0.31	%			0.34	%			(0.03	)			0.38	%			(0.07	)
Cost of average interest-bearing liabilities			0.42	%			0.44	%			(0.02	)			0.48	%			(0.06	)
Yield on average interest-earning assets			4.44	%			4.61	%			(0.17	)			4.25	%			0.19
Cost of average interest-bearing liabilities			0.42	%			0.44	%			(0.02	)			0.48	%			(0.06	)
Net interest spread			4.02	%			4.17	%			(0.15	)			3.77	%			0.25
Net interest margin (1)			4.13	%			4.28	%			(0.15	)			3.88	%			0.25

 

For The Nine Months Ended
		September 30, 2014				September 30, 2013				Change
Selective quarterly performance ratios
Yield on average gross loans (1)			5.04	%			5.09	%			(0.05	)
Yield on average investment securities (1)			2.30	%			1.83	%			0.47
Cost of average interest bearing deposits			0.36	%			0.47	%			(0.11	)
Cost of average borrowings			1.90	%			2.02	%			(0.12	)
Cost of average total deposits and borrowings			0.33	%			0.43	%			(0.10	)
Cost of average interest-bearing liabilities			0.43	%			0.55	%			(0.12	)
Yield on average interest-earning assets			4.55	%			4.42	%			0.13
Cost of average interest-bearing liabilities			0.43	%			0.55	%			(0.12	)
Net interest spread			4.12	%			3.87	%			0.25
Net interest margin (1)			4.22	%			3.99	%			0.23

 

⁽¹⁾ Tax-exempt income has been adjusted to a tax equivalent basis at a 34% rate.

 

The following tables set forth information with regard to average balances of interest earning assets and interest bearing liabilities and the resultant yields or cost, net interest income, and the net interest margin on a tax equivalent basis. Loans held for sale and non-accrual loans are included in total loans.

 

 

 

Average Interest Earning Balances:		For the Three Months Ended
		September 30, 2014												June 30, 2014												September 30, 2013
		Average Balance				Interest Income or Expense				Average Yields or Rates				Average Balance				Interest Income or Expense				Average Yields or Rates				Average Balance				Interest Income or Expense				Average Yields or Rates
(Dollars in Thousands)
ASSETS:
Interest bearing certificate of deposit		$	2,727			$	11				1.60	%		$	2,727			$	10				1.47	%		$	1,871			$	6				1.27	%
Interest bearing deposits in banks			23,928				14				0.23	%			12,552				9				0.29	%			46,665				29				0.25	%
Investments - taxable			63,751				298				1.85	%			65,964				343				2.09	%			61,924				221				1.42	%
Investments - nontaxable			27,646				277				3.98	%			31,607				352				4.47	%			32,058				355				4.39	%
Gross loans (1)			549,280				6,870				4.96	%			532,490				6,718				5.06	%			483,459				6,090				5.00	%
Loans held for sale			7,068				69				3.87	%			7,685				71				3.71	%			6,642				72				4.30	%
Total interest earning assets			674,400				7,539				4.44	%			653,025				7,503				4.61	%			632,619				6,773				4.25	%
Cash and due from banks			14,169												13,135												12,362
Bank premises and equipment (net)			16,615												16,703												16,167
Other real estate owned			940												2,088												4,070
Deferred fees			(1,113	)											(1,068	)											(1,045	)
Allowance for loan losses			(8,342	)											(8,271	)											(8,917	)
Other assets			40,757												40,705												40,955
Total assets		$	737,426											$	716,317											$	696,211
LIABILITIES AND SHAREHOLDERS' EQUITY:
Interest-bearing deposits		$	343,204				134				0.15	%		$	345,116				140				0.16	%		$	322,606				167				0.21	%
Time deposits			120,515				269				0.89	%			122,134				290				0.95	%			138,762				307				0.88	%
FHLB borrowings			10,878				61				2.22	%			10,000				60				2.41	%			10,000				62				2.46	%
Short term borrowings			587				-				0.00	%			6				-				0.00	%			-				-				0.00	%
Junior subordinated debentures			13,403				54				1.60	%			13,403				51				1.53	%			13,403				54				1.60	%
Total interest bearing liabilities			488,587				518				0.42	%			490,659				541				0.44	%			484,771				590				0.48	%
Non-interest-bearing deposits			170,560												150,776												138,875
Other liabilities			6,055												4,928												4,957
Equity			72,224												69,954												67,608
Total liabilities and shareholders' equity		$	737,426											$	716,317											$	696,211
Net interest income (3)						$	7,021											$	6,962											$	6,183
Net interest spread											4.02	%											4.17	%											3.77	%
Average yield on investments											2.02	%											2.54	%											1.70	%
Average yield on earning assets (2) (3)											4.44	%											4.61	%											4.25	%
Interest expense to earning assets											0.31	%											0.33	%											0.37	%
Net interest income to earning assets (2) (3)											4.13	%											4.28	%											3.88	%
Reconciliation of Non-GAAP measure:
Tax Equivalent Net Interest Income
Net interest income						$	6,882											$	6,796											$	6,015
Tax equivalent adjustment for municipal loan interest							45												46												46
Tax equivalent adjustment for municipal bond interest							94												120												121
Tax equivalent net interest income						$	7,021											$	6,962											$	6,182

 

Non-GAAP financial measures have inherent limitations, are not required to be uniformly applied, and are not audited.

Management believes that presentation of this non-GAAP measure provides useful information frequently used by shareholders in the evaluation of a company.

Non-GAAP financial measures have limitations as analytical tools and should not be considered in isolation or as a substitute for analyses of results as reported under GAAP.

(1) Non-accrual loans of approximately $4.8 million at 09/30/14, $6.4 million at 06/30/2014, and $7.8 million for 09/30/2013 are included in the average loan balances.

(2) Loan interest income includes loan fee income of $152,000, $180,000, and $169,000 for the three months ended 09/30/2014, 06/30/2014, and 09/30/2013, respectively.

(3) Tax-exempt income has been adjusted to a tax equivalent basis at a 34% effective rate. The amount of such adjustment was an addition to recorded pre-tax income of $139,000, $166,000, and $167,000 for the three months ended September 30, 2014, June 30, 2014, and September 30, 2013, respectively.

 

  

		For the Three Months Ended												For the Three Months Ended
		September 30, 2014 vs. June 30, 2014												September 30, 2014 vs. September 30, 2013
		Increase (Decrease) Due To												Increase (Decrease) Due To
(Dollars in Thousands)										Net												Net
		Volume				Rate				Change				Volume				Rate				Change
ASSETS:
Interest bearing certificate of deposit		$	-			$	1			$	1			$	3			$	2			$	5
Interest bearing deposits in banks			8				(3	)			5				(14	)			(1	)			(15	)
Investments - taxable			(12	)			(33	)			(45	)			6				71				77
Investments - nontaxable			(44	)			(31	)			(75	)			(48	)			(30	)			(78	)
Gross loans			212				(60	)			152				821				(41	)			780
Loans held for sale			(6	)			4				(2	)			5				(8	)			(3	)
Total interest earning assets		$	158			$	(122	)		$	36			$	773			$	(7	)		$	766
LIABILITIES AND SHAREHOLDERS' EQUITY:
Interest-bearing deposits		$	(1	)		$	(5	)		$	(6	)		$	11			$	(44	)		$	(33	)
Time deposits			(4	)			(17	)			(21	)			(40	)			2				(38	)
FHLB borrowings			5				(4	)			1				5				(6	)			(1	)
Short-term borrowings			-				-				-				-				-				-
Long-term borrowings			-				3				3				-				-				-
Total interest bearing liabilities			0				(23	)			(23	)			(24	)			(48	)			(72	)
Net increase (decrease) in net interest income		$	158			$	(99	)		$	59			$	797			$	41			$	838

 

  

Average Interest Earning Balances:		For the Nine Months Ended
		September 30, 2014												September 30, 2013
		Average Balance				Interest Income or Expense				Average Yields or Rates				Average Balance				Interest Income or Expense				Average Yields or Rates
(Dollars in Thousands)
ASSETS:
Interest bearing certificate of deposit		$	2,727			$	31				1.52	%		$	2,312			$	20				1.16	%
Interest bearing deposits in banks			18,167				33				0.24	%			37,359				66				0.24	%
Investments - taxable			65,789				980				1.99	%			51,861				472				1.22	%
Investments - nontaxable			30,656				977				4.26	%			33,557				1,153				4.59	%
Gross loans (1)			531,517				20,081				5.05	%			471,702				18,071				5.12	%
Loans held for sale			6,348				189				3.98	%			9,709				249				3.43	%
Total interest earning assets			655,204				22,291				4.55	%			606,500				20,031				4.42	%
Cash and due from banks			13,106												11,478
Bank premises and equipment (net)			16,707												15,547
Other real estate owned			1,858												4,086
Deferred fees			(1,106	)											(1,008	)
Allowance for loan losses			(8,334	)											(9,218	)
Other assets			40,862												40,925
Total assets		$	718,297											$	668,310
LIABILITIES AND SHAREHOLDERS' EQUITY:
Interest-bearing deposits		$	341,533				415				0.16	%		$	311,792				547				0.23	%
Time deposits			123,140				835				0.91	%			136,863				1,026				1.00	%
FHLB borrowings			10,296				181				2.35	%			10,066				186				2.47	%
Short term borrowings			200				-				0.00	%			-				-				0.00	%
Junior subordinated debentures			13,403				158				1.58	%			13,403				168				1.68	%
Total interest bearing liabilities			488,572				1,589				0.43	%			472,124				1,927				0.55	%
Non-interest-bearing deposits			154,213												123,868
Other liabilities			5,396												4,596
Equity			70,116												67,722
Total liabilities and shareholders' equity		$	718,297											$	668,310
Net interest income (3)						$	20,702											$	18,104
Net interest spread											4.12	%											3.87	%
Average yield on investments											2.30	%											1.83	%
Average yield on earning assets (2) (3)											4.55	%											4.42	%
Interest expense to earning assets											0.33	%											0.43	%
Net interest income to earning assets (2) (3)											4.22	%											3.99	%
Reconciliation of Non-GAAP measure:
Tax Equivalent Net Interest Income
Net interest income						$	20,232											$	17,549
Tax equivalent adjustment for municipal loan interest							138												163
Tax equivalent adjustment for municipal bond interest							332												392
Tax equivalent net interest income						$	20,702											$	18,104

 

Non-GAAP financial measures have inherent limitations, are not required to be uniformly applied, and are not audited.

Management believes that presentation of this non-GAAP measure provides useful information frequently used by shareholders in the evaluation of a company.

Non-GAAP financial measures have limitations as analytical tools and should not be considered in isolation or as a substitute for analyses of results as reported under GAAP.

(1) Non-accrual loans of approximately $4.8 million at 09/30/14 and $7.8 million for 09/30/2013 are included in the average loan balances.

(2) Loan interest income includes loan fee income of $482,000 and $396,000 for the nine months ended 09/30/2014 and 09/30/2013, respectively.

(3) Tax-exempt income has been adjusted to a tax equivalent basis at a 34% effective rate. The amount of such adjustment was an addition to recorded pre-tax income of $470,000 and $555,000 for the nine months ended September 30, 2014 and September 30, 2013, respectively.

 

  

		For the Nine Months Ended
		September 30, 2014 vs. September 30, 2013
		Increase (Decrease) Due To
(Dollars in Thousands)										Net
		Volume				Rate				Change
ASSETS:
Interest bearing certificate of deposit		$	2			$	9			$	11
Interest bearing deposits in banks			(23	)			(10	)			(33	)
Investments - taxable			84				424				508
Investments - nontaxable			(66	)			(110	)			(176	)
Gross loans			1,519				491				2,010
Loans held for sale			(57	)			(3	)			(60	)
Total interest earning assets		$	1,459			$	801			$	2,260
LIABILITIES AND SHAREHOLDERS' EQUITY:
Interest-bearing deposits		$	34			$	(166	)		$	(132	)
Time deposits			(68	)			(123	)			(191	)
FHLB borrowings			3				(8	)			(5	)
Short-term borrowings			-				-				-
Long-term borrowings			-				(10	)			(10	)
Total interest bearing liabilities			(31	)			(307	)			(338	)
Net increase (decrease) in net interest income		$	1,490			$	1,108			$	2,598

 

  

SUMMARY AVERAGE BALANCE SHEETS

 

(Unaudited)
(Dollars in Thousands)
Averages for the Three Months Ended		September 30,				June 30,												September 30,
		2014				2014				$ Change				% Change				2013				$ Change				% Change
Assets:
Cash and due from banks		$	14,169			$	13,135			$	1,034				8	%		$	12,362			$	1,807				15	%
Interest-bearing deposits in banks			23,928				12,552				11,376				91	%			46,665				(22,737	)			-49	%
Interest bearing certificate of deposit			2,727				2,727				0				0	%			1,871				856				46	%
Investment securities			91,397				97,571				(6,174	)			-6	%			93,982				(2,585	)			-3	%
Loans, net of deferred loan fees			555,235				539,106				16,129				3	%			489,056				66,179				14	%
Allowance for loan losses			(8,342	)			(8,271	)			(71	)			1	%			(8,917	)			575				-6	%
Net loans			546,893				530,835				16,058				3	%			480,139				66,754				14	%
Other assets			58,312				59,497				(1,185	)			-2	%			61,191				(2,879	)			-5	%
Total assets		$	737,426			$	716,317			$	21,109				3	%		$	696,210			$	41,216				6	%
Liabilities:
Total deposits		$	634,279			$	618,026			$	16,253				3	%		$	600,242			$	34,037				6	%
Borrowings			24,868				23,409				1,459				6	%			23,403				1,465				6	%
Other liabilities			6,055				4,928				1,127				23	%			4,957				1,098				22	%
Total liabilities			665,202				646,363				18,839				3	%			628,602				36,600				6	%
Equity:
Common equity			72,224				69,954				2,270				3	%			67,608				4,616				7	%
Total equity			72,224				69,954				2,270				3	%			67,608				4,616				7	%
Total liabilities and shareholders' equity		$	737,426			$	716,317			$	21,109				3	%		$	696,210			$	41,216				6	%

 

Averages for the Nine Months Ended		September 30,				September 30,
		2014				2013				$ Change				% Change
Assets:
Cash and due from banks		$	13,106			$	11,478			$	1,628				14	%
Interest-bearing deposits in banks			18,167				37,359				(19,192	)			-51	%
Interest bearing certificate of deposit			2,727				2,312				415				18	%
Investment securities			96,445				85,418				11,027				13	%
Loans, net of deferred loan fees			536,759				480,404				56,355				12	%
Allowance for loan losses			(8,334	)			(9,218	)			884				-10	%
Net loans			528,425				471,186				57,239				12	%
Other assets			59,427				60,557				(1,130	)			-2	%
Total assets		$	718,297			$	668,310			$	49,987				7	%
Liabilities:
Total deposits		$	618,886			$	572,523			$	46,363				8	%
Borrowings			23,899				23,469				430				2	%
Other liabilities			5,396				4,596				800				17	%
Total liabilities			648,181				600,588				47,593				8	%
Equity:
Common equity			70,116				67,722				2,394				4	%
Total equity			70,116				67,722				2,394				4	%
Total liabilities and shareholders' equity		$	718,297			$	668,310			$	49,987				7	%

 

AVERAGE INTEREST EARNING ASSETS

 

(Unaudited)
(Dollars in Thousands)						% of								% of				$				%								% of				$				%
Averages for the Three Months Ended		September 30, 2014				Total				June 30, 2014				Total				Change				Change				September 30, 2013				Total				Change				Change
Interest-bearing certificate of deposits		$	2,727				0	%		$	2,727				0	%		$	0				0	%		$	1,871				0	%		$	856				0	%
Interest-bearing deposits in banks			23,928				4	%			12,552				2	%			11,376				2	%			46,665				7	%			(22,737	)			-3	%
Investments			91,397				14	%			97,571				15	%			(6,174	)			-1	%			93,982				15	%			(2,585	)			-1	%
Gross loans			549,280				81	%			532,490				82	%			16,790				-1	%			483,459				76	%			65,821				5	%
Loans held for sale			7,068				1	%			7,685				1	%			(617	)			0	%			6,642				1	%			426				0	%
Total average interest-earning assets		$	674,400				100	%		$	653,025				100	%		$	21,375							$	632,619				100	%		$	41,781

 

						% of								% of				$				%
Averages for the Nine Months Ended		September 30, 2014				Total				September 30, 2013				Total				Change				Change
Interest-bearing certificate of deposits		$	2,727				0	%		$	2,312				0	%		$	415				0	%
Interest-bearing deposits in banks			18,167				3	%			37,359				6	%			(19,192	)			-3	%
Investments			96,445				15	%			85,418				14	%			11,027				1	%
Gross loans			531,517				81	%			471,702				78	%			59,815				3	%
Loans held for sale			6,348				1	%			9,709				2	%			(3,361	)			-1	%
Total average interest-earning assets		$	655,204				100	%		$	606,500				100	%		$	48,704

 

  

ASSET QUALITY

At September 30, 2014, total adversely classified loans increased in dollars and as a percentage of gross loans from the preceding and year ago quarters. This is the result of designating a $4.7 million commercial and commercial real estate relationship as adversely classified during the current quarter. Total loans on accruing status 30-89 days past due continue to remain below 1.00% of gross loans, mirroring the improvement in overall credit quality noted previously. Past due loans increased in the current period primarily from a $2.6 million commercial real estate relationship scheduled to be paid off. We monitor delinquencies, defined as loans on accruing status 30-89 days past due, as an indicator of future adversely classified loans.

 

At September 30, 2014, total nonperforming loans were down compared to June 30, 2014 and September 30, 2013. Nonperforming assets also declined during this period as a percentage of total assets, despite the increase in OREO during the current quarter. This was primarily due to the payoff of a $1.0 million non-accrual commercial real estate loan during the current quarter. Nonperforming loans consist primarily of commercial real estate loans.

 

Adversely classified loans

(Unaudited)

(Dollars in Thousands)

 

		September 30, 2014				June 30, 2014				$ Change				% Change				September 30, 2013				$ Change				% Change
Rated substandard or worse, but not impaired		$	11,020			$	6,938			$	4,082				59	%		$	3,365			$	7,655				227	%
Impaired			7,429				9,025				(1,596	)			-18	%			10,383				(2,954	)			-28	%
Total adversely classified loans*		$	18,449			$	15,963			$	2,486				16	%		$	13,748			$	4,701				34	%
Gross loans		$	553,319			$	548,371			$	4,948				1	%		$	487,808			$	65,511				13	%
Adversely classified loans to gross loans			3.33	%			2.91	%			0.42	%							2.82	%			0.51	%
Allowance for loan losses		$	8,255			$	8,315			$	(60	)			-1	%		$	8,806			$	(551	)			-6	%
Allowance for loan losses as a percentage of adversely classified loans			44.74	%			52.09	%			-7.35	%							64.05	%			-19.31	%
Allowance for loan losses to total impaired loans			111.12	%			92.13	%			18.99	%							84.81	%			26.31	%

 

* Adversely classified loans are defined as loans having a well-defined weakness or weaknesses related to the borrower's financial capacity or to pledged collateral that may jeopardize the repayment of the debt. They are characterized by the possibility that the Bank may sustain some loss if the deficiencies giving rise to the substandard classification are not corrected. Note that any loans internally rated worse than substandard are included in the impaired loan totals.

 

30-89 Days Past Due by type

(Unaudited)

(Dollars in Thousands)

 

		September 30, 2014				% of Category				June 30, 2014				% of Category				$ Change				% Change				September 30, 2013				% of Category				$ Change				% Change
Commercial and agricultural		$	7				0.2	%		$	23				16.5	%		$	(16	)			-70	%		$	52				6.7	%		$	(45	)			-87	%
Real estate:
Construction and development							0.0	%			-				0.0	%			-				0	%			-				0.0	%			-				0	%
Residential 1-4 family			251				8.7	%			53				38.1	%			198				374	%			590				76.5	%			(339	)			-57	%
Multi-family							0.0	%			-				0.0	%			-				0	%			-				0.0	%			-				0	%
Commercial real estate — owner occupied							0.0	%			0				0.0	%			0				0	%			87				11.3	%			(87	)			-100	%
Commercial real estate — non owner occupied			2,612				90.9	%			0				0.0	%			2,612				100	%			-				0.0	%			2,612				100	%
Farmland											-				0.0	%			-				0	%			37				4.8	%			(37	)			-100	%
Total real estate		$	2,863							$	53							$	2,810				5302	%		$	714							$	2,149
																			-
Consumer			2				0.1	%			63				45.3	%			(61	)			-97	%			5				0.6	%			(3	)			-60	%
Total loans 30-89 days past due, not in nonaccrual status		$	2,872				100.0	%		$	139				100.0	%		$	2,733				1966	%		$	771				100.0	%		$	2,101				273	%
Delinquent loans to total loans, not in nonaccrual status			0.60	%							0.03	%															0.17	%

 

  

Non-performing assets

(Unaudited)

 

(Dollars in Thousands)		September 30, 2014				June 30, 2014				$ Change				% Change				September 30, 2013				$ Change				% Change
Loans on nonaccrual status		$	4,811			$	6,388			$	(1,577	)			-25	%		$	7,829			$	(3,018	)			-39	%
Loans past due greater than 90 days but not on nonaccrual status			409				-				409				100	%			221				188				85	%
Total non-performing loans			5,220				6,388				(1,168	)			-18	%			8,050				(2,830	)			-35	%
Other real estate owned and foreclosed assets			1,210				991				219				22	%			4,334				(3,124	)			-72	%
Total nonperforming assets		$	6,430			$	7,379			$	(949	)			-13	%		$	12,384			$	(5,954	)			-48	%
Percentage of nonperforming assets to total assets			0.86	%			1.03	%											1.73	%

 

OREO increased during third quarter 2014, but declined significantly year-over-year. One commercial income property was taken into the OREO portfolio during the quarter. OREO valuation adjustments continued to be minimal. At September 30, 2014, the OREO portfolio consisted of 7 properties, down from both second quarter 2014 and third quarter 2013. The largest balances in the OREO portfolio at the end of the quarter were attributable to commercial properties, followed by residential properties, all of which are located within our market area.

 

Other real estate owned and foreclosed assets

(Unaudited)

(Dollars in Thousands)

 

For the Three Months Ended		September 30, 2014				% of Category				June 30, 2014				% of Category				$ Change				% Change				September 30, 2013				% of Category				$ Change				% Change
Other real estate owned, beginning of period		$	991				82	%		$	2,386				241	%		$	(1,395	)			-58	%		$	3,451				80	%		$	(2,460	)			-71	%
Transfers from outstanding loans			525				43	%			206				21	%			319				155	%			1,382				32	%			(857	)			-62	%
Improvements and other additions			-				0	%			-				0	%			-				0	%			-				0	%			-				0	%
Proceeds from sales			(219	)			-18	%			(1,490	)			-150	%			1,271				-85	%			(341	)			-8	%			122				-36	%
Net gain (loss) on sales			(86	)			-7	%			(57	)			-6	%			(29	)			51	%			18				0	%			(104	)			-578	%
Impairment charges			(1	)			0	%			(54	)			-5	%			53				-98	%			(176	)			-4	%			175				-99	%
Total other real estate owned		$	1,210				100	%		$	991				100	%		$	219				22	%		$	4,334				100	%		$	(3,124	)			-72	%

 

For the Nine Months Ended		September 30, 2014				% of Category				September 30, 2013				% of Category				$ Change				% Change
Other real estate owned, beginning of period		$	2,771				229	%		$	4,678				108	%		$	(1,907	)			-41	%
Transfers from outstanding loans			842				70	%			1,591				37	%			(749	)			-47	%
Improvements and other additions			-				0	%			-				0	%			-				0	%
Proceeds from sales			(2,157	)			-178	%			(1,342	)			-31	%			(815	)			61	%
Net gain (loss) on sales			(179	)			-15	%			43				1	%			(222	)			-516	%
Impairment charges			(67	)			-6	%			(636	)			-15	%			569				-89	%
Total other real estate owned		$	1,210				100	%		$	4,334				100	%		$	(3,124	)			-72	%

 

Other real estate owned and foreclosed assets by type

(Unaudited)

(Dollars in Thousands)

 

		September 30, 2014				# of Properties				June 30, 2014				# of Properties				$ Change				% Change				September 30, 2013				# of Properties				$ Change				% Change
Construction, Land Dev & Other Land		$	35				1			$	46				2			$	(11	)			-24	%		$	787				7			$	(752	)			-96	%
1-4 Family Residential Properties			86				2				317				4				(231	)			-73	%			868				6				(782	)			-90	%
Nonfarm Nonresidential Properties			1,089				4				628				4				461				73	%			2,679				13				(1,590	)			-59	%
Total OREO by type		$	1,210				7			$	991				10			$	219				22	%		$	4,334				26			$	(3,124	)			-72	%

 

ALLOWANCE FOR LOAN LOSSES

The allowance for loan losses continues to decline in relation to total loans in concert with the general trend of improvement in relevant credit metrics. As such, loss factors used in estimates to establish reserve levels have declined commensurately. A provision was made to the allowance for loan losses in the current and prior quarter, corresponding to recent growth in the loan portfolio. No provision was made in third quarter 2013.

 

  

For the quarter ended September 30, 2014, total net loan charge-offs were up compared to the quarter ended June 30, 2014, but virtually unchanged versus the quarter ended September 30, 2013. The charge-offs incurred in the third quarter 2014 were primarily centered in one commercial real estate loan, which was written down $127,000 prior to transfer to OREO. The ratio of net loan charge-offs to average gross loans (annualized) for the current quarter was up compared to the prior quarter, but unchanged from the third quarter one year ago.

 

The overall risk profile of the loan portfolio continues to improve, as stated above, but more slowly than in recent periods. However, the trend of future provision for loan losses will depend primarily on economic conditions, growth in the loan portfolio, level of adversely-classified assets, and changes in collateral values.

 

  

Allowance for Loan Losses

(Unaudited)

(Dollars in Thousands)

 

For the Three Months Ended		September 30, 2014				June 30, 2014				$ Change				% Change				September 30, 2013				$ Change				% Change
Gross loans outstanding at end of period		$	553,319			$	548,371			$	4,948				1	%		$	487,808			$	65,511				13	%
Average loans outstanding, gross		$	549,280			$	532,490			$	16,790				3	%		$	483,459			$	65,821				14	%
Allowance for loan losses, beginning of period		$	8,315			$	8,288			$	27				0	%		$	8,962			$	(647	)			-7	%
Commercial			0				(9	)			9				-100	%			(40	)			40				-100	%
Commercial Real Estate			(127	)			(389	)			262				-67	%			(37	)			(89	)			241	%
Residential Real Estate			(61	)			(4	)			(57	)			1425	%			(29	)			(32	)			110	%
Consumer			(12	)			(29	)			17				-59	%			(79	)			67				-85	%
Total charge-offs			(200	)			(431	)			231				-54	%			(185	)			(14	)			8	%
Commercial			7				1				6				600	%			20				(13	)			-65	%
Commercial Real Estate			29				347				(318	)			-92	%			5				23				460	%
Residential Real Estate			4				9				(5	)			-56	%			3				0				0	%
Consumer			-				1				1				100	%			1				0				0	%
Total recoveries			40				358				(318	)			-89	%			29				10				34	%
Net charge-offs			(160	)			(73	)			(87	)			119	%			(156	)			(4	)			3	%
Provision charged to income			100				100				-				0	%			-				100				100	%
Allowance for loan losses, end of period		$	8,255			$	8,315			$	(60	)			-1	%		$	8,806			$	(551	)			-6	%
Ratio of net loans charged-off to average gross loans outstanding, annualized			0.12	%			0.05	%			0.07	%			140	%			0.13	%			-0.01	%			-8	%
Ratio of allowance for loan losses to  gross loans outstanding			1.49	%			1.52	%			-0.03	%			-2	%			1.81	%			-0.32	%			-18	%

 

For the Nine Months Ended		September 30, 2014				September 30, 2013				$  Change				% Change
Gross loans outstanding at end of period		$	553,319			$	487,808			$	65,511				13	%
Average loans outstanding, gross		$	531,517			$	471,702			$	59,815				13	%
Allowance for loan losses, beginning of period		$	8,359			$	9,358			$	(999	)			-11	%
Commercial			(26	)			(40	)			14				-35	%
Commercial Real Estate			(523	)			(83	)			(440	)			530	%
Residential Real Estate			(105	)			(95	)			(10	)			11	%
Consumer			(59	)			(145	)			86				-59	%
Total charge-offs			(713	)			(363	)			(349	)			96	%
Commercial			9				35				(26	)			-74	%
Commercial Real Estate			381				220				161				73	%
Residential Real Estate			17				4				13				325	%
Consumer			2				2				-				0	%
Total recoveries			409				261				148				57	%
Net charge-offs			(304	)			(102	)			(202	)			198	%
Provision charged to income			200				(450	)			650				-144	%
Allowance for loan losses, end of period		$	8,255			$	8,806			$	(551	)			-6	%
Ratio of net loans charged-off to average gross loans outstanding, annualized			0.08	%			0.03	%			0.05	%			167	%
Ratio of allowance for loan losses to gross loans outstanding			1.49	%			1.81	%			-0.32	%			-18	%

 

An allowance for loan losses has been established based on management’s best estimate, as of the balance sheet date, of probable losses inherent in the loan portfolio. For more information regarding the Company’s allowance for loan losses and net loan charge-offs, see the discussion under the subheadings “Loans Receivable” and “Allowance for Credit Losses” included in Note 1 – Summary of Significant Accounting Policies and “Loans” included in Note 4 of the Company’s interim financials as presented in this Form 10-Q and audited financial statements as presented in its 2013 10-K.

 

  

Overall, we believe that the allowance for loan losses is adequate to absorb probable losses in the loan portfolio at September 30, 2014. there can be no assurance that future loan losses will not exceed our current estimates. The process for determining the adequacy of the allowance for loan losses is significant to our financial results. Please refer to Item 1A “Risk Factors”, together with our discussion of our critical accounting policies in our 2013 Form 10-K for further information.

 

Liquidity and Sources of Funds

 

The Bank’s sources of funds include core deposits, loan repayments, advances from the FHLB or the Federal Reserve Bank discount window, brokered deposits, maturities of investment securities, sales of “Available-for-Sale” securities, loan and OREO sales, net income and the use of Federal Funds markets. Stated maturities of investment securities, loan repayments from maturities and core deposits are a relatively stable source of funds, while brokered deposit inflows, unscheduled loan prepayments, and loan and OREO sales are not. Deposit inflows, sales of securities, loan and OREO properties, and unscheduled loan prepayments may, amongst other factors, be influenced by general interest rate levels, interest rates available on other investments, competition, pricing considerations, and general economic conditions.

 

Deposits are our primary source of funds. Our loan to deposit ratio has increased as a result of loan demand due to the improvement of economic conditions in our region and customer dissatisfaction at other financial institutions from recent merger activity. The increase in loan balances has resulted in increased demands on our liquidity. As such, our current approach to managing our liquidity is directed toward increasing non-interest bearing core deposits from businesses and consumers. We continued to reduce higher cost time deposits during the most recent quarter.

 

The following table summarizes the primary (on-balance sheet) liquidity, short-term funds availability, net non-core funding dependency, and loan to deposit ratios of the Bank. The primary liquidity ratio represents the sum of net interest-bearing cash/federal funds sold, short-term and readily marketable assets divided by total assets. The short-term funds availability ratio consists of the sum of net interest-bearing cash/federal funds sold, short-term and readily marketable assets and available capacity under borrowing facilities divided by assets. The net non-core funding dependency ratio is non-core liabilities less short-term investments divided by long-term assets. Despite the increase in the loan to deposit ratio due to the loan growth, as previously discussed, the Bank’s primary liquidity, short-term funds availability, and net non-core funding dependency ratios remained strong at quarter end.

 

		September				December				September
		30, 2014				31, 2013				30, 2013
Primary liquidity			12.8	%			16.3	%			22.1	%
Short term funds availability			25.0	%			29.4	%			30.7	%
Net non-core funding dependency			3.4	%			3.2	%			6.4	%
Gross loans to deposits			85.9	%			80.7	%			78.8	%

 

An analysis of liquidity should encompass a review of the changes that appear in the consolidated statements of cash flow for the nine months ended September 30, 2014 and 2013. The statement of cash flows includes operating, investing, and financing categories.

 

At September 30, 2014, the Bank had $11.5 million in outstanding borrowings against its $143.8 million in established borrowing capacity with the FHLB. The Bank had $10.0 million outstanding in borrowings at December 31, 2013 and September 30, 2013. The borrowing capacity at the FHLB was $143.1 million and $137.2 million at December 31, 2013 and September 30, 2013, respectively. The Bank’s borrowing facility with the FHLB is subject to collateral and stock ownership requirements. The Bank also had an available discount window primary credit line with the Federal Reserve Bank of San Francisco of approximately $53.6 million, subject to collateral requirements, and $16.0 million from correspondent banks with no balance outstanding on any of these facilities.

 

Off-Balance Sheet Arrangements

 

At September 30, 2014, the Bank had commitments to extend credit and standby letters related to extensions of credit of $97.9 million compared to $107.7 million at December 31, 2013 and $102.1 million at September 30, 2013. Such commitments represented 17.7%, 21.3% and 21.9% of total net loans as of September 30, 2014, December 31, 2013 and September 30, 2013, respectively. Please refer to Note 7 – “Commitments and Contingencies” in the accompanying financial statements for further information.

 

  

Critical Accounting Policies

 

Management has identified the calculation of our allowance for loan losses, goodwill, investment valuation and Other-Than-Temporary-Impairment (OTTI), valuation of OREO, and estimates relating to income taxes as critical accounting policies. Each of these policies are discussed in our 2013 10-K under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operation – Critical Accounting Policies.”

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Market risk is the risk of loss from adverse changes in market prices and rates. The Company’s market risk arises principally from interest rate risk in its lending, deposit and borrowing activities. Management actively monitors and manages its interest rate risk exposure. Although the Company manages other risks, such as credit quality and liquidity risk, in the normal course of business, Management considers interest rate risk to be a significant market risk, which could have a material effect on the Company’s financial condition and results of operations. Other types of market risks, such as foreign currency exchange rate risk and commodity price risk, do not arise in the normal course of the Company’s business activities. The Company did not experience a significant change in market risk at September 30, 2014, as compared to December 31, 2013.

 

The Company attempts to monitor interest rate risk from the perspective of changes in the economic value of equity, also referred to as net portfolio value (NPV), and changes in net interest income. Changes to the NPV and net interest income are simulated using instant and permanent rates up and down shocks of various increments. It is the Company’s policy to manage interest rate risk to maximize long-term profitability under the range of likely interest-rate scenarios. For additional information, refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Asset and Liability Management” in the Company’s 2013 10-K.

 

ITEM 4. CONTROLS AND PROCEDURES

 

EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES

 

As of the end of the period covered by this report, Pacific Financial Corporation’s Management, with the participation of our Chief Executive Officer and Chief Financial Officer, carried out an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934). Based upon that evaluation, Management, including our Chief Executive Officer and Chief Financial Officer, has concluded that our disclosure controls and procedures were effective, including in timely alerting them to information relating to us that is required to be included in our periodic SEC filings.

 

CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING

 

There have not been any changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934) during our most recent quarter ended September 30, 2014, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

PART II – OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

 

From time to time, in the normal course of business, Pacific Financial may become party to various legal actions. Management is unaware of any existing legal actions against the Company or its subsidiaries that Management believes will have a materially adverse impact on our business, financial condition or results of operations.

 

ITEM 1A. RISK FACTORS

 

There were no material changes in the risk factors presented in the Company’s 2013 10-K.

 

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

 

(a) Between August 4 and September 30, 2014, the Company sold 139,000 shares of common stock at a price of $6.50 per share upon exercise of certain warrants originally issued in a private placement transaction completed in 2009.  Total proceeds from the exercise of warrants were $903,500, all of which will be used for general working capital purposes.  The Company completed the sales pursuant to the exemption from the registration requirements of the Securities Act of 1933, as amended, provided by Section 4(a)(2) of the Securities Act.

 

(b) [Not applicable.]

 

(c) [None.]

 

  

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

 

(a) [Not applicable.]

 

(b) [Not applicable.]

 

ITEM 4. MINE SAFETY DISCLOSURES

 

(a) [Not applicable.]

 

ITEM 5. OTHER INFORMATION

 

(a) [None.]

 

  

ITEM 6. EXHIBITS

 

EXHIBIT NO.		EXHIBIT
31.1		Certification of CEO under Rule 13a – 14(a) of the Exchange Act.
31.2		Certification of CFO under Rule 13a – 14(a) of the Exchange Act.
32.1		Certification of CEO under 18 U.S.C. Section 1350.
32.2		Certification of CFO under 18 U.S.C. Section 1350.
101.		INS XBRL Instance Document
101.		SCH XBRL Taxonomy Extension Schema Document
101.		CAL XBRL Taxonomy Extension Calculation Linkbase Document
101.		DEF XBRL Taxonomy Extension Definition Linkbase Document
101.		LAB XBRL Taxonomy Extension Label Linkbase Document
101.		PRE XBRL Taxonomy Extension Presentation Linkbase Document

 

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.

 

DATED: November 14, 2014

 

Pacific Financial Corporation

 

/s/ Dennis A. Long
Dennis A. Long, President and Chief Executive Officer

 

/s/ Douglas N. Biddle
Douglas N. Biddle, Executive Vice President and Chief Financial Officer