UNITED STATES SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

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

 

For the quarterly period ended March 31, 2015 

OR

 

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

 

For the transition period from ____________________________ to ____________________________

 

 

ENB Financial Corp

(Exact name of registrant as specified in its charter)

 

Pennsylvania		000-53297		51-0661129
(State or Other Jurisdiction of Incorporation)		(Commission File Number)		(IRS Employer Identification No)
31 E. Main St., Ephrata, PA		17522-0457
(Address of principal executive offices)		(Zip Code)

 

Registrant’s telephone number, including area code (717) 733-4181

 

Former name, former address, and former fiscal year, if changed since last report Not Applicable

 

 

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 o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Date 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 o

 

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

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

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o              No x

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. As of May 4, 2015, the registrant had 2,850,013 shares of $0.20 (par) Common Stock outstanding.

 

ENB FINANCIAL CORP

INDEX TO FORM 10-Q

March 31, 2015

 

 

 

Part I – FINANCIAL INFORMATION
Item 1.	Financial Statements
	Consolidated Balance Sheets at March 31, 2015 and 2014 and December 31, 2014 (Unaudited)	3
	Consolidated Statements of Income for the Three Months Ended March 31, 2015 and 2014 (Unaudited)	4
	Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2015 and 2014 (Unaudited)	5
	Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2015 and 2014 (Unaudited)	6
	Notes to the Unaudited Consolidated Interim Financial Statements	7-30
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	31-61
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	62-66
Item 4.	Controls and Procedures	67
Part II – OTHER INFORMATION		68
Item 1.	Legal Proceedings	68
Item 1A.	Risk Factors	68
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	68
Item 3.	Defaults Upon Senior Securities	68
Item 4.	Mine Safety Disclosures	68
Item 5.	Other Information	68
Item 6.	Exhibits	69
SIGNATURE PAGE		70
EXHIBIT INDEX		71

 

CONSOLIDATED BALANCE SHEETS (UNAUDITED)

(DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

 

		March 31,				December 31,				March 31,
		2015				2014				2014
		$				$				$
ASSETS
Cash and due from banks			13,423				16,727				14,620
Interest-bearing deposits in other banks			26,933				26,685				22,893
Total cash and cash equivalents			40,356				43,412				37,513
Securities available for sale (at fair value)			292,808				295,822				293,265
Loans held for sale			648				506				—
Loans (net of unearned income)			482,626				471,168				446,165
Less: Allowance for loan losses			7,140				7,141				7,056
Net loans			475,486				464,027				439,109
Premises and equipment			22,305				22,447				22,788
Regulatory stock			3,595				3,227				3,615
Bank owned life insurance			20,765				20,603				20,089
Other assets			6,752				7,164				8,742
Total assets			862,715				857,208				825,121
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Deposits:
Noninterest-bearing			205,830				210,444				182,420
Interest-bearing			489,777				489,207				485,213
Total deposits			695,607				699,651				667,633
Short-term borrowings			4,930				—				3,080
Long-term debt			65,548				62,300				65,000
Other liabilities			2,024				2,490				2,397
Total liabilities			768,109				764,441				738,110
Stockholders' equity:
Common stock, par value $0.20;
Shares:  Authorized 12,000,000
Issued 2,869,557 and Outstanding 2,856,413
(Issued 2,869,557 and Outstanding 2,856,836 as of 12-31-14)
(Issued 2,869,557 and Outstanding  2,855,034 as of 3-31-14)			574				574				574
Capital surplus			4,383				4,375				4,359
Retained earnings			87,895				87,200				84,260
Accumulated other comprehensive income (loss), net of tax			2,161				1,002				(1,767	)
Less: Treasury stock cost on 13,144 shares (12,721 shares
as of 12-31-14 and 14,523 shares as of 3-31-14)			(407	)			(384	)			(415	)
Total stockholders' equity			94,606				92,767				87,011
Total liabilities and stockholders' equity			862,715				857,208				825,121

 

See Notes to the Unaudited Consolidated Interim Financial Statements

 

CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

(DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

 

		Three Months ended March 31,
		2015				2014
		$				$
Interest and dividend income:
Interest and fees on loans			4,949				4,779
Interest on securities available for sale
Taxable			1,000				1,159
Tax-exempt			766				871
Interest on deposits at other banks			14				8
Dividend income			143				55
Total interest and dividend income			6,872				6,872
Interest expense:
Interest on deposits			674				789
Interest on borrowings			340				428
Total interest expense			1,014				1,217
Net interest income			5,858				5,655
Provision (credit) for loan losses			200				(200	)
Net interest income after provision (credit) for loan losses			5,658				5,855
Other income:
Trust and investment services income			355				365
Service fees			401				390
Commissions			465				466
Gains on securities transactions, net			561				685
Impairment losses on securities:
Impairment gains on investment securities			—				15
Non-credit related losses on securities not expected
to be sold in other comprehensive income before tax			—				(37	)
Net impairment losses on investment securities			—				(22	)
Gains on sale of mortgages			153				38
Earnings on bank-owned life insurance			160				155
Other income			106				103
Total other income			2,201				2,180
Operating expenses:
Salaries and employee benefits			3,702				3,430
Occupancy			554				516
Equipment			268				260
Advertising & marketing			155				129
Computer software & data processing			374				400
Shares tax			195				183
Professional services			318				327
Other expense			584				553
Total operating expenses			6,150				5,798
Income before income taxes			1,709				2,237
Provision for federal income taxes			243				399
Net income			1,466				1,838
Earnings per share of common stock			0.51				0.64
Cash dividends paid per share			0.27				0.26
Weighted average shares outstanding			2,857,282				2,854,113

 

See Notes to the Unaudited Consolidated Interim Financial Statements

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)

(DOLLARS IN THOUSANDS)

 

		Three Months ended March 31,
		2015				2014
		$				$
Net income			1,466				1,838
Other comprehensive income, net of tax:
Net change in unrealized gains:
Other-than-temporarily impaired securities available for sale:
Gains arising during the period			—				15
Income tax effect			—				(5	)
			—				10
Losses recognized in earnings			—				22
Income tax effect			—				(7	)
			—				15
Unrealized holding gains on other-than-temporarily impaired
securities available for sale, net of tax			—				25
Securities available for sale not other-than-temporarily impaired:
Gains arising during the period			2,317				3,939
Income tax effect			(788	)			(1,339	)
			1,529				2,600
Gains recognized in earnings			(561	)			(685	)
Income tax effect			191				233
			(370	)			(452	)
Unrealized holding gains on securities available for sale not
other-than-temporarily impaired, net of tax			1,159				2,148
Other comprehensive income, net of tax			1,159				2,173
Comprehensive Income			2,625				4,011

 

See Notes to the Unaudited Consolidated Interim Financial Statements    

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(DOLLARS IN THOUSANDS)

		Three Months Ended March 31,
		2015				2014
		$				$
Cash flows from operating activities:
Net income			1,466				1,838
Adjustments to reconcile net income to net cash
provided by operating activities:
Net amortization of securities premiums and discounts and loan fees			1,327				992
Decrease in interest receivable			336				266
Decrease in interest payable			(47	)			(49	)
Provision (credit) for loan losses			200				(200	)
Gains on securities transactions, net			(561	)			(685	)
Impairment losses on securities			—				22
Gains on sale of mortgages			(153	)			(38	)
Loans originated for sale			(5,139	)			(1,077	)
Proceeds from sales of loans			5,150				1,174
Earnings on bank-owned life insurance			(160	)			(155	)
Loss on sale of other real estate owned			21				—
Depreciation of premises and equipment and amortization of software			378				357
Deferred income tax			25				226
Other assets and other liabilities, net			(885	)			(1,096	)
Net cash provided by operating activities			1,958				1,575
Cash flows from investing activities:
Securities available for sale:
Proceeds from maturities, calls, and repayments			16,564				6,768
Proceeds from sales			40,235				41,261
Purchases			(52,754	)			(37,977	)
Proceeds from sale of other real estate owned			77				—
Purchase of regulatory bank stock			(491	)			(266	)
Redemptions of regulatory bank stock			123				311
Purchase of bank-owned life insurance			(2	)			(23	)
Net increase in loans			(11,837	)			(7,934	)
Purchases of premises and equipment			(215	)			(108	)
Purchase of computer software			(62	)			(82	)
Net cash provided by (used for) investing activities			(8,362	)			1,950
Cash flows from financing activities:
Net increase (decrease) in demand, NOW, and savings accounts			(1,187	)			15,233
Net decrease in time deposits			(2,857	)			(4,226	)
Net increase (decrease) in short-term borrowings			4,930				(820	)
Proceeds from long-term debt			6,248				2,500
Repayments of long-term debt			(3,000	)			(2,500	)
Dividends paid			(771	)			(743	)
Treasury stock sold			130				123
Treasury stock purchased			(145	)			(156	)
Net cash provided by financing activities			3,348				9,411
Increase (decrease) in cash and cash equivalents			(3,056	)			12,936
Cash and cash equivalents at beginning of period			43,412				24,577
Cash and cash equivalents at end of period			40,356				37,513
Supplemental disclosures of cash flow information:
Interest paid			1,061				1,266
Income taxes paid			250				550
Supplemental disclosure of non-cash investing and financing activities:
Net transfer of other real estate owned from loans			137				—
Fair value adjustments for securities available for sale			1,756				(3,292	)

 

See Notes to the Unaudited Consolidated Interim Financial Statements

1.	Basis of Presentation

 

The accompanying unaudited consolidated interim financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and to general practices within the banking industry. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all significant adjustments considered necessary for fair presentation have been included. Certain items previously reported have been reclassified to conform to the current period’s reporting format. Such reclassifications did not affect net income or stockholders’ equity.

 

ENB Financial Corp (“the Corporation”) is the bank holding company for its wholly-owned subsidiary Ephrata National Bank (the “Bank”). This Form 10-Q, for the first quarter of 2015, is reporting on the results of operations and financial condition of ENB Financial Corp.

 

Operating results for the three months ended March 31, 2015, are not necessarily indicative of the results that may be expected for the year ended December 31, 2015. For further information, refer to the consolidated financial statements and footnotes thereto included in ENB Financial Corp’s Annual Report on Form 10-K for the year ended December 31, 2014.

 

 

2.	Securities Available for Sale

 

The amortized cost and fair value of securities held at March 31, 2015, and December 31, 2014, are as follows:

 

						Gross				Gross
(DOLLARS IN THOUSANDS)		Amortized				Unrealized				Unrealized				Fair
		Cost				Gains				Losses				Value
		$				$				$				$
March 31, 2015
U.S. government agencies			37,721				184				(77	)			37,828
U.S. agency mortgage-backed securities			37,477				248				(141	)			37,584
U.S. agency collateralized mortgage obligations			55,667				252				(300	)			55,619
Corporate bonds			62,847				508				(50	)			63,305
Obligations of states and political subdivisions			90,461				2,969				(337	)			93,093
Total debt securities			284,173				4,161				(905	)			287,429
Marketable equity securities			5,362				20				(3	)			5,379
Total securities available for sale			289,535				4,181				(908	)			292,808
December 31, 2014
U.S. government agencies			46,577				110				(528	)			46,159
U.S. agency mortgage-backed securities			37,946				138				(134	)			37,950
U.S. agency collateralized mortgage obligations			48,690				55				(679	)			48,066
Corporate bonds			65,274				145				(311	)			65,108
Obligations of states and political subdivisions			90,628				2,961				(258	)			93,331
Total debt securities			289,115				3,409				(1,910	)			290,614
Marketable equity securities			5,189				19				—				5,208
Total securities available for sale			294,304				3,428				(1,910	)			295,822

The amortized cost and fair value of debt securities available for sale at March 31, 2015, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities due to certain call or prepayment provisions.

 

CONTRACTUAL MATURITY OF DEBT SECURITIES

(DOLLARS IN THOUSANDS)

		Amortized
		Cost				Fair Value
		$				$
Due in one year or less			24,135				24,193
Due after one year through five years			103,408				103,940
Due after five years through ten years			67,168				67,727
Due after ten years			89,462				91,569
Total debt securities			284,173				287,429

 

Securities available for sale with a par value of $74,426,000 and $75,013,000 at March 31, 2015, and December 31, 2014, respectively, were pledged or restricted for public funds, borrowings, or other purposes as required by law. The fair value of these pledged securities was $78,558,000 at March 31, 2015, and $78,269,000 at December 31, 2014.

 

Proceeds from active sales of debt securities available for sale, along with the associated gross realized gains and gross realized losses, are shown below. Realized gains and losses are computed on the basis of specific identification.

 

PROCEEDS FROM SALES OF SECURITIES AVAILABLE FOR SALE

(DOLLARS IN THOUSANDS)

		Three Months Ended March 31,
		2015				2014
		$				$
Proceeds from sales			40,235				41,261
Gross realized gains			607				974
Gross realized losses			46				289

 

SUMMARY OF GAINS AND LOSSES ON SECURITIES AVAILABLE FOR SALE

(DOLLARS IN THOUSANDS)  

		Three Months Ended March 31,
		2015				2014
		$				$
Gross realized gains			607				974
Gross realized losses			46				289
Impairment on securities			—				22
Total gross realized losses			46				311
Net gains on securities			561				663

 

The bottom portion of the above table shows the net gains on security transactions, including any impairment taken on securities held by the Corporation. The net gain or loss from security transactions is also reflected on the Corporation’s Consolidated Statements of Income and Consolidated Statements of Cash Flows.

Management evaluates all of the Corporation’s securities for other than temporary impairment (OTTI) on a periodic basis. Prior to June 30, 2014, the Corporation had a small number of private collateralized mortgage obligations (PCMOs) of which all but one had impairment recorded at some point in the past. During the second quarter of 2014, the three PCMOs remaining in the Corporation’s securities portfolio were sold. No other securities in the portfolio had other-than-temporary impairment recorded in 2014.

 

Information pertaining to securities with gross unrealized losses at March 31, 2015, and December 31, 2014, aggregated by investment category and length of time that individual securities have been in a continuous loss position follows:

 

TEMPORARY IMPAIRMENTS OF SECURITIES

(DOLLARS IN THOUSANDS)

		Less than 12 months								More than 12 months								Total
						Gross								Gross								Gross
		Fair				Unrealized				Fair				Unrealized				Fair				Unrealized
		Value				Losses				Value				Losses				Value				Losses
		$				$				$				$				$				$
As of March 31, 2015
U.S. government agencies			5,491				(17	)			6,972				(60	)			12,463				(77	)
U.S. agency mortgage-backed securities			4,797				(49	)			5,168				(92	)			9,965				(141	)
U.S. agency collateralized mortgage obligations			23,950				(179	)			5,125				(121	)			29,075				(300	)
Corporate bonds			8,356				(25	)			4,352				(25	)			12,708				(50	)
Obligations of states & political subdivisions			14,954				(186	)			8,629				(151	)			23,583				(337	)
Total debt securities			57,548				(456	)			30,246				(449	)			87,794				(905	)
Marketable equity securities			83				(3	)			—				—				83				(3	)
Total temporarily impaired securities			57,631				(459	)			30,246				(449	)			87,877				(908	)
As of December 31, 2014
U.S. government agencies			9,676				(30	)			19,689				(498	)			29,365				(528	)
U.S. agency mortgage-backed securities			7,412				(18	)			5,412				(116	)			12,824				(134	)
U.S. agency collateralized mortgage obligations			25,314				(403	)			11,222				(276	)			36,536				(679	)
Corporate bonds			33,413				(227	)			9,855				(84	)			43,268				(311	)
Obligations of states & political subdivisions			2,710				(29	)			16,720				(229	)			19,430				(258	)
Total temporarily impaired securities			78,525				(707	)			62,898				(1,203	)			141,423				(1,910	)

 

In the debt security portfolio, there are 68 positions that were carrying unrealized losses as of March 31, 2015. There were no instruments considered to be other-than-temporarily impaired at March 31, 2015.

 

The Corporation evaluates both equity and fixed maturity positions for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic and market concerns warrant such evaluation. U.S. generally accepted accounting principles provide for the bifurcation of OTTI into two categories: (a) the amount of the total OTTI related to a decrease in cash flows expected to be collected from the debt security (the credit loss), which is recognized in earnings, and (b) the amount of total OTTI related to all other factors, which is recognized, net of taxes, as a component of accumulated other comprehensive income. This accounting treatment was only applicable to two of the Corporation’s PCMOs in the first quarter of 2014, but both of those securities were sold in the second quarter of 2014, resulting in no further impairment charges.

 

The prior impairment on the PCMOs was a result of a deterioration of expected cash flows on those securities due to higher projected credit losses than the amount of credit protection carried by those securities. Specifically, the foreclosure and severity rates had been running at levels where expected principal losses were in excess of the remaining credit protection on those instruments. The projected principal losses were based on prepayment speeds that were equal to or slower than the actual last twelve-month prepayment speeds the particular securities had experienced. Every quarter prior to the second quarter of 2014, management evaluated third-party reporting that showed projected principal losses based on various prepayment speed and severity rate scenarios. Based on the assumption that all loans over 60 days delinquent would default and at a severity rate equal to or above that previously experienced, and based on historical and expected prepayment speeds, management determined that it was appropriate to take an additional $22,000 of impairment on one PCMO in the first quarter of 2014. Because all of the remaining PCMOs were sold in the second quarter of 2014, no further impairment was recorded on these bonds in 2014 and future impairment analysis will cease for this segment since it was completely sold off.

The following tables reflect the amortized cost, market value, and unrealized loss as of March 31, 2014, on the PCMO securities held which had impairment taken in the year. There were no impairment charges in 2015 since all of the PCMO securities were sold during 2014. In 2014, there was one PCMO that had impairment taken during the first quarter prior to the sale of the remaining PCMO portfolio. The values shown below are after the Corporation recorded year-to-date impairment charges of $22,000 through March 31, 2014. The $22,000 was deemed to be a credit loss and was the amount that management expected the principal losses would be by the time the securities matured. The remaining $23,000 of unrealized losses as of March 31, 2014, was deemed to be market value losses that were considered temporary. Because all of the remaining PCMO securities were sold during the second quarter of 2014, there are no temporary market value losses remaining at March 31, 2015.

 

SECURITY IMPAIRMENT CHARGES

(DOLLARS IN THOUSANDS)   

		As of March 31, 2014
		Book				Market				Unrealized				Impairment
		Value				Value				Loss				Charge
		$				$				$				$
Impaired private collateralized mortgage obligations			1,389				1,366				(23	)			(22	)

 

The following table provides a cumulative roll forward of credit losses recognized in earnings for debt securities held:

 

CREDIT LOSSES RECOGNIZED IN EARNINGS ON DEBT SECURITIES

(DOLLARS IN THOUSANDS)      

		Three Months Ended March 31,
		2015				2014
		$				$
Beginning balance			—				1,148
Credit losses on debt securities for which other-than-
temporary impairment has not been previously recognized			—				—
Additional credit losses on debt securities for which other-
than-temporary impairment was previously recognized			—				22
Sale of debt securities with previously recognized impairment			—				—
Ending balance			—				1,170

 

With the sale of the remaining PCMO portfolio during the second quarter of 2014, there are no remaining impairment balances as of March 31, 2015.

3.	Loans and Allowance for Loan Losses

 

The following table presents the Corporation’s loan portfolio by category of loans as of March 31, 2015, and December 31, 2014:

 

LOAN PORTFOLIO

(DOLLARS IN THOUSANDS)

		March 31,				December 31,
		2015				2014
		$				$
Commercial real estate
Commercial mortgages			94,783				95,914
Agriculture mortgages			150,005				140,322
Construction			8,416				7,387
Total commercial real estate			253,204				243,623
Consumer real estate (a)
1-4 family residential mortgages			122,048				123,395
Home equity loans			12,466				12,563
Home equity lines of credit			28,774				27,308
Total consumer real estate			163,288				163,266
Commercial and industrial
Commercial and industrial			32,971				31,998
Tax-free loans			12,759				11,806
Agriculture loans			16,612				16,496
Total commercial and industrial			62,342				60,300
Consumer			3,326				3,517
Gross loans prior to deferred fees			482,160				470,706
Less:
Deferred loan costs, net			(466	)			(462	)
Allowance for loan losses			7,140				7,141
Total net loans			475,486				464,027

 

(a)	Real estate loans serviced for others, which are not included in the Consolidated Balance Sheets, totaled $19,845,000 and $16,670,000 as of March 31, 2015, and December 31, 2014, respectively.

The Corporation grades commercial credits differently than consumer credits. The following tables represent all of the Corporation’s commercial credit exposures by internally assigned grades as of March 31, 2015 and December 31, 2014. The grading analysis estimates the capability of the borrower to repay the contractual obligations under the loan agreements as scheduled. The Corporation's internal commercial credit risk grading system is based on experiences with similarly graded loans.

 

The Corporation's internally assigned grades for commercial credits are as follows:

 

·

Pass – loans which are protected by the current net worth and paying capacity of the obligor or by the value of the underlying collateral.

 

·

Special Mention – loans where a potential weakness or risk exists, which could cause a more serious problem if not corrected.

 

·

Substandard – loans that have a well-defined weakness based on objective evidence and characterized by the distinct possibility that the Corporation will sustain some loss if the deficiencies are not corrected.

 

·

Doubtful – loans classified as doubtful have all the weaknesses inherent in a substandard asset.  In addition, these weaknesses make collection or liquidation in full highly questionable and improbable, based on existing circumstances.

 

·

Loss – loans classified as a loss are considered uncollectible, or of such value that continuance as an asset is not warranted.

 

COMMERCIAL CREDIT EXPOSURE

CREDIT RISK PROFILE BY INTERNALLY ASSIGNED GRADE

(DOLLARS IN THOUSANDS)

 

March 31, 2015		Commercial Mortgages				Agriculture Mortgages				Construction				Commercial and Industrial				Tax-free Loans				Agriculture Loans				Total
		$				$				$				$				$				$				$
Grade:
Pass			81,545				144,516				5,851				32,108				10,273				16,279				290,572
Special Mention			2,661				3,198				—				28				2,486				28				8,401
Substandard			10,577				2,291				2,565				835				—				305				16,573
Doubtful			—				—				—				—				—				—				—
Loss			—				—				—				—				—				—				—
Total			94,783				150,005				8,416				32,971				12,759				16,612				315,546

 

 

December 31, 2014		Commercial Mortgages				Agriculture Mortgages				Construction				Commercial and Industrial				Tax-free Loans				Agriculture Loans				Total
		$				$				$				$				$				$				$
Grade:
Pass			82,478				135,298				5,350				31,006				11,806				16,255				282,193
Special Mention			2,649				3,237				—				29				—				29				5,944
Substandard			10,787				1,787				2,037				963				—				212				15,786
Doubtful			—				—				—				—				—				—				—
Loss			—				—				—				—				—				—				—
Total			95,914				140,322				7,387				31,998				11,806				16,496				303,923

 

For consumer loans, the Corporation evaluates credit quality based on whether the loan is considered performing or non-performing. Non-performing loans consist of those loans greater than 90 days delinquent and nonaccrual loans. The following tables present the balances of consumer loans by classes of the loan portfolio based on payment performance as of March 31, 2015 and December 31, 2014:

CONSUMER CREDIT EXPOSURE

CREDIT RISK PROFILE BY PAYMENT PERFORMANCE

(DOLLARS IN THOUSANDS)

March 31, 2015		1-4 Family Residential Mortgages				Home Equity Loans				Home Equity Lines of Credit				Consumer				Total
Payment performance:		$				$				$				$				$
Performing			121,644				12,466				28,774				3,323				166,207
Non-performing			404				—				—				3				407
Total			122,048				12,466				28,774				3,326				166,614

 

December 31, 2014		1-4 Family Residential Mortgages				Home Equity Loans				Home Equity Lines of Credit				Consumer				Total
Payment performance:		$				$				$				$				$
Performing			123,023				12,551				27,308				3,517				166,399
Non-performing			372				12				—				—				384
Total			123,395				12,563				27,308				3,517				166,783

The following tables present an age analysis of the Corporation’s past due loans, segregated by loan portfolio class, as of March 31, 2015 and December 31, 2014:

 

AGING OF LOANS RECEIVABLE

(DOLLARS IN THOUSANDS)

 

																										Loans
										Greater																Receivable >
		30-59 Days				60-89 Days				than 90				Total Past								Total Loans				90 Days and
March 31, 2015		Past Due				Past Due				Days				Due				Current				Receivable				Accruing
		$				$				$				$				$				$				$
Commercial real estate
Commercial mortgages			102				185				—				287				94,496				94,783				—
Agriculture mortgages			—				—				—				—				150,005				150,005				—
Construction			—				—				—				—				8,416				8,416				—
Consumer real estate
1-4 family residential mortgages			538				230				404				1,172				120,876				122,048				404
Home equity loans			67				—				—				67				12,399				12,466				—
Home equity lines of credit			14				—				—				14				28,760				28,774				—
Commercial and industrial
Commercial and industrial			93				32				—				125				32,846				32,971				—
Tax-free loans			—				—				—				—				12,759				12,759				—
Agriculture loans			3				—				—				3				16,609				16,612				—
Consumer			23				11				3				37				3,289				3,326				3
Total			840				458				407				1,705				480,455				482,160				407

 

																										Loans
										Greater																Receivable >
		30-59 Days				60-89 Days				than 90				Total Past								Total Loans				90 Days and
December 31, 2014		Past Due				Past Due				Days				Due				Current				Receivable				Accruing
		$				$				$				$				$				$				$
Commercial real estate
Commercial mortgages			—				189				266				455				95,459				95,914				—
Agriculture mortgages			—				—				—				—				140,322				140,322				—
Construction			—				—				—				—				7,387				7,387				—
Consumer real estate
1-4 family residential mortgages			665				349				372				1,386				122,009				123,395				372
Home equity loans			78				14				12				104				12,459				12,563				12
Home equity lines of credit			13				—				—				13				27,295				27,308				—
Commercial and industrial
Commercial and industrial			21				73				—				94				31,904				31,998				—
Tax-free loans			—				—				—				—				11,806				11,806				—
Agriculture loans			—				—				—				—				16,496				16,496				—
Consumer			23				1				—				24				3,493				3,517				—
Total			800				626				650				2,076				468,630				470,706				384

The following table presents nonaccrual loans by classes of the loan portfolio as of March 31, 2015 and December 31, 2014:

 

NONACCRUAL LOANS BY LOAN CLASS

(DOLLARS IN THOUSANDS)  

		March 31,				December 31,
		2015				2014
		$				$
Commercial real estate
Commercial mortgages			585				894
Agriculture mortgages			—				—
Construction			—				—
Consumer real estate
1-4 family residential mortgages			—				—
Home equity loans			—				—
Home equity lines of credit			—				—
Commercial and industrial
Commercial and industrial			60				73
Tax-free loans			—				—
Agriculture loans			—				—
Consumer			—				—
Total			645				967

 

As of March 31, 2015 and December 31, 2014, all of the Corporation’s commercial loans on nonaccrual status were also considered impaired. Information with respect to impaired loans for the three months ended March 31, 2015 and March 31, 2014, is as follows:

  

IMPAIRED LOANS

(DOLLARS IN THOUSANDS)  

 

		Three months ended March 31,
		2015				2014
		$				$
Average recorded balance of impaired loans			2,111				2,655
Interest income recognized on impaired loans			24				27

 

Interest income on impaired loans would have increased by approximately $7,000 for the three months ended March 31, 2015, compared to $12,000 for the three months ended March 31, 2014, had these loans performed in accordance with their original terms.

 

During the three months ended March 31, 2015 and 2014, there were no loan modifications made that would cause a loan to be considered a troubled debt restructuring (TDR). A TDR is a loan where management has granted a concession to the borrower from the original terms. A concession is generally granted in order to improve the financial condition of the borrower and improve the likelihood of full collection by the lender. A concession is generally defined as more favorable payment or credit terms granted to a borrower in an effort to improve the likelihood of the lender collecting principal in its entirety. Concessions usually are in the form of interest only for a period of time, or a lower interest rate offered in an effort to enable the borrower to continue to make normally scheduled payments.

 

The following tables summarize information in regards to impaired loans by loan portfolio class as of March 31, 2015, December 31, 2014, and March 31, 2014:

 

IMPAIRED LOAN ANALYSIS

(DOLLARS IN THOUSANDS)

 

March 31, 2015

		Recorded Investment				Unpaid Principal Balance				Related Allowance				Average Recorded Investment				Interest Income Recognized
		$				$				$				$				$
With no related allowance recorded:
Commercial real estate
Commercial mortgages			585				1,157				—				665				—
Agriculture mortgages			1,372				1,372				—				1,383				23
Construction			—				—				—				—				—
Total commercial real estate			1,957				2,529				—				2,048				23
Commercial and industrial
Commercial and industrial			60				67				—				63				1
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			60				67				—				63				1
Total with no related allowance			2,017				2,596				—				2,111				24
With an allowance recorded:
Commercial real estate
Commercial mortgages			—				—				—				—				—
Agriculture mortgages			—				—				—				—				—
Construction			—				—				—				—				—
Total commercial real estate			—				—				—				—				—
Commercial and industrial
Commercial and industrial			—				—				—				—				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			—				—				—				—				—
Total with a related allowance			—				—				—				—				—
Total by loan class:
Commercial real estate
Commercial mortgages			585				1,157				—				665				—
Agriculture mortgages			1,372				1,372				—				1,383				23
Construction			—				—				—				—				—
Total commercial real estate			1,957				2,529				—				2,048				23
Commercial and industrial
Commercial and industrial			60				67				—				63				1
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			60				67				—				63				1
Total			2,017				2,596				—				2,111				24

 

IMPAIRED LOAN ANALYSIS

(DOLLARS IN THOUSANDS)

 

December 31, 2014

		Recorded Investment				Unpaid Principal Balance				Related Allowance				Average Recorded Investment				Interest Income Recognized
		$				$				$				$				$
With no related allowance recorded:
Commercial real estate
Commercial mortgages			745				931				—				931				—
Agriculture mortgages			1,391				1,391				—				1,539				104
Construction			—				—				—				—				—
Total commercial real estate			2,136				2,322				—				2,470				104
Commercial and industrial
Commercial and industrial			73				73				—				86				6
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			73				73				—				86				6
Total with no related allowance			2,209				2,395				—				2,556				110
With an allowance recorded:
Commercial real estate
Commercial mortgages			149				264				1				68				—
Agriculture mortgages			—				—				—				—				—
Construction			—				—				—				—				—
Total commercial real estate			149				264				1				68				—
Commercial and industrial
Commercial and industrial			—				—				—				—				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			—				—				—				—				—
Total with a related allowance			149				264				1				68				—
Total by loan class:
Commercial real estate
Commercial mortgages			894				1,195				1				999				—
Agriculture mortgages			1,391				1,391				—				1,539				104
Construction			—				—				—				—				—
Total commercial real estate			2,285				2,586				1				2,538				104
Commercial and industrial
Commercial and industrial			73				73				—				86				6
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			73				73				—				86				6
Total			2,358				2,659				1				2,624				110

 

IMPAIRED LOAN ANALYSIS

(DOLLARS IN THOUSANDS)

 

March 31, 2014

		Recorded Investment				Unpaid Principal Balance				Related Allowance				Average Recorded Investment				Interest Income Recognized
		$				$				$				$				$
With no related allowance recorded:
Commercial real estate
Commercial mortgages			939				1,036				—				966				—
Agriculture mortgages			1,580				1,580				—				1,586				27
Construction			—				—				—				—				—
Total commercial real estate			2,519				2,616				—				2,552				27
Commercial and industrial
Commercial and industrial			97				97				—				103				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			97				97				—				103				—
Total with no related allowance			2,616				2,713				—				2,655				27
With an allowance recorded:
Commercial real estate
Commercial mortgages			—				—				—				—				—
Agriculture mortgages			—				—				—				—				—
Construction			—				—				—				—				—
Total commercial real estate			—				—				—				—				—
Commercial and industrial
Commercial and industrial			—				—				—				—				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			—				—				—				—				—
Total with a related allowance			—				—				—				—				—
Total by loan class:
Commercial real estate
Commercial mortgages			939				1,036				—				966				—
Agriculture mortgages			1,580				1,580				—				1,586				27
Construction			—				—				—				—				—
Total commercial real estate			2,519				2,616				—				2,552				27
Commercial and industrial
Commercial and industrial			97				97				—				103				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			97				97				—				103				—
Total			2,616				2,713				—				2,655				27

The following table details activity in the allowance for loan losses by portfolio segment for the three months ended March 31, 2015:

 

ALLOWANCE FOR CREDIT LOSSES

(DOLLARS IN THOUSANDS)

 

		Commercial Real Estate				Consumer Real Estate				Commercial and Industrial				Consumer				Unallocated				Total
		$				$				$				$				$				$
Allowance for credit losses:
Beginning balance - December 31, 2014			3,834				1,367				1,301				66				573				7,141
Charge-offs			(272	)			—				—				(1	)			—				(273	)
Recoveries			2				—				70				—				—				72
Provision			623				(283	)			(147	)			(11	)			18				200
Balance - March 31, 2015			4,187				1,084				1,224				54				591				7,140

 

During the first quarter of 2015, provision expense was recorded for the commercial real estate segment with credit provisions recorded in all other loan categories. There were $272,000 of commercial real estate loan charge-offs during the first quarter of 2015, which increased the historical loss rates and ultimately resulted in a higher required reserve amount for the commercial real estate category. Qualitative factors have been shifting, with more factors declining than increasing. The consumer real estate area had declines in five of nine qualitative factors resulting in a lower required provision. To a lesser degree, the historic loss experience on commercial and industrial loans has been very favorable with more recoveries than charge-offs and one qualitative factor was reduced, resulting in a lower required provision. The consumer loan area saw three qualitative factors reduced with one increased, resulting in a lower required provision on a much smaller loan amount. The higher commercial loan charge-offs and loan growth during the first quarter of 2015 overshadowed the reduction in provisions in the other areas, resulting in a higher total provision.

 

The following table details activity in the allowance for loan losses by portfolio segment for the three months ended March 31, 2014:

 

ALLOWANCE FOR CREDIT LOSSES

(DOLLARS IN THOUSANDS)

         

		Commercial Real Estate				Consumer Real Estate				Commercial and Industrial				Consumer				Unallocated				Total
		$				$				$				$				$				$
Allowance for credit losses:
Beginning balance - December 31, 2013			3,657				1,346				1,416				102				698				7,219
Charge-offs			—				—				—				(15	)			—				(15	)
Recoveries			4				5				43				—				—				52
Provision			(150	)			51				(117	)			17				(1	)			(200	)(1)
Balance - March 31, 2014			3,511				1,402				1,342				104				697				7,056

 

(1)	The Corporation recognized a $200,000 credit provision in the first quarter of 2014 as a result of lower levels of total classified loans, impaired loans, non-accrual loans, recoveries in excess of charge-offs, continuing declines in historic loss ratios, and improving qualitative factors.

 

During the first quarter of 2014, credit provisions were recorded for the commercial real estate and commercial and industrial loan categories while there was provision expense required for the consumer real estate loan category. There were no commercial loan charge-offs since the prior year, which reduced the three-year weighted average charge-off ratio and ultimately resulted in a lower required reserve amount for the commercial loan categories. Conversely, factors in the allowance calculation related to consumer real estate were increased in the first quarter of 2014 as a result of the mortgage initiative and focus on increasing volume in this area.

The following tables present the balance in the allowance for credit losses and the recorded investment in loans receivable by portfolio segment based on impairment method as of March 31, 2015 and December 31, 2014:

 

ALLOWANCE FOR CREDIT LOSSES AND RECORDED INVESTMENT IN LOANS RECEIVABLE

(DOLLARS IN THOUSANDS)

 

As of March 31, 2015:		Commercial Real Estate				Consumer Real Estate				Commercial and Industrial				Consumer				Unallocated				Total
		$				$				$				$				$				$
Allowance for credit losses:
Ending balance: individually evaluated
for impairment			—				—				—				—				—				—
Ending balance: collectively evaluated
for impairment			4,187				1,084				1,224				54				591				7,140
Loans receivable:
Ending balance			253,204				163,288				62,342				3,326								482,160
Ending balance: individually evaluated
for impairment			1,957				—				60				—								2,017
Ending balance: collectively evaluated
for impairment			251,247				163,288				62,282				3,326								480,143

 

As of December 31, 2014:		Commercial Real Estate				Consumer Real Estate				Commercial and Industrial				Consumer				Unallocated				Total
		$				$				$				$				$				$
Allowance for credit losses:
Ending balance: individually evaluated
for impairment			1				—				—				—				—				1
Ending balance: collectively evaluated
for impairment			3,833				1,367				1,301				66				573				7,140
Loans receivable:
Ending balance			243,623				163,266				60,300				3,517								470,706
Ending balance: individually evaluated
for impairment			2,285				—				73				—								2,358
Ending balance: collectively evaluated
for impairment			241,338				163,266				60,227				3,517								468,348

 

4. Fair Value Presentation

 

U.S. generally accepted accounting principles establish a hierarchal disclosure framework associated with the level of observable pricing utilized in measuring assets and liabilities at fair value. The three broad levels defined by the hierarchy are as follows:

 

	Level I:	Quoted prices are available in active markets for identical assets or liabilities as of the reported date.
	Level II:	Pricing inputs are other than the quoted prices in active markets, which are either directly or indirectly observable as of the reported date.  The nature of these assets and liabilities includes items for which quoted prices are available but traded less frequently and items that are fair-valued using other financial instruments, the parameters of which can be directly observed.
	Level III:	Assets and liabilities that have little to no observable pricing as of the reported date.  These items do not have two-way markets and are measured using management’s best estimate of fair value, where the inputs into the determination of fair value require significant management judgment or estimation.

 

The following tables present the assets reported on the consolidated balance sheets at their fair value as of March 31, 2015, and December 31, 2014, by level within the fair value hierarchy. As required by U.S. generally accepted accounting principles, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

 

 

Fair Value Measurements:

ASSETS MEASURED ON A RECURRING BASIS

(DOLLARS IN THOUSANDS)  

		March 31, 2015
		Level I				Level II				Level III				Total
		$				$				$				$
U.S. government agencies			—				37,828				—				37,828
U.S. agency mortgage-backed securities			—				37,584				—				37,584
U.S. agency collateralized mortgage obligations			—				55,619				—				55,619
Corporate bonds			—				63,305				—				63,305
Obligations of states & political subdivisions			—				93,093				—				93,093
Marketable equity securities			5,379				—				—				5,379
Total securities			5,379				287,429				—				292,808

 

On March 31, 2015, the Corporation held no securities valued using level III inputs. All of the Corporation’s debt instruments were valued using level II inputs, where quoted prices are available and observable, but not necessarily quotes on identical securities traded in active markets on a daily basis. The Corporation’s CRA fund investments and bank stocks are fair valued utilizing level I inputs because the funds have their own quoted prices in an active market. As of March 31, 2015, the CRA fund investments had a $5,000,000 book and fair market value and the bank stock portfolio had a book value of $362,000, and fair market value of $379,000.

Fair Value Measurements:

ASSETS MEASURED ON A RECURRING BASIS

(DOLLARS IN THOUSANDS)      

		December 31, 2014
		Level I				Level II				Level III				Total
		$				$				$				$
U.S. government agencies			—				46,159				—				46,159
U.S. agency mortgage-backed securities			—				37,950				—				37,950
U.S. agency collateralized mortgage obligations			—				48,066				—				48,066
Corporate bonds			—				65,108				—				65,108
Obligations of states & political subdivisions			—				93,331				—				93,331
Marketable equity securities			5,208				—				—				5,208
Total securities			5,208				290,614				—				295,822

 

On December 31, 2014, the Corporation held no securities valued using level III inputs. All of the Corporation’s debt instruments were valued using level II inputs, where quoted prices are available and observable but not necessarily quotes on identical securities traded in active markets on a daily basis. As of December 31, 2014, the Corporation’s CRA fund investments had a book and fair market value of $5,000,000 and the bank stock portfolio had a book value of $189,000 and a market value of $208,000 utilizing level I pricing.

 

Financial instruments are considered level III when their values are determined using pricing models, discounted cash flow methodologies, or similar techniques, and at least one significant model assumption or input is unobservable. In addition to these unobservable inputs, the valuation models for level III financial instruments typically also rely on a number of inputs that are readily observable either directly or indirectly. Level III financial instruments also include those for which the determination of fair value requires significant management judgment or estimation. There were no level III securities as of March 31, 2015 or December 31, 2014.

 

The following tables present the assets measured on a nonrecurring basis on the Consolidated Balance Sheets at their fair value as of March 31, 2015 and December 31, 2014, by level within the fair value hierarchy:

 

ASSETS MEASURED ON A NONRECURRING BASIS

(Dollars in Thousands)

		March 31, 2015
		Level I $				Level II $				Level III $				Total $
Assets:
Impaired Loans			—				—				2,017				2,017
OREO			—				—				108				108
Total			—				—				2,125				2,125

 

 

		December 31, 2014
		Level I $				Level II $				Level III $				Total $
Assets:
Impaired Loans			—				—				2,357				2,357
OREO			—				—				69				69
Total			—				—				2,426				2,426

 

The Corporation had a total of $2,017,000 of impaired loans as of March 31, 2015, with no specific allocation against these loans and $2,358,000 of impaired loans as of December 31, 2014, with $1,000 of specifically allocated allowance against these loans. The value of impaired loans is generally determined through independent appraisals of the underlying collateral.

Other real estate owned (OREO) is measured at fair value, less estimated costs to sell at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management. The Corporation’s OREO balance consisted of two residential properties that were classified as OREO as of March 31, 2015, and a different residential property that was classified as OREO as of December 31, 2014, and sold prior to March 31, 2015. Management has estimated the current value of the OREO properties held at March 31, 2015, at $108,000 utilizing level III pricing. Income and expenses from operations and changes in valuation allowance are included in the net expenses from OREO.

 

The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis for which the Corporation has utilized level III inputs to determine fair value:

 

QUANTITATIVE INFORMATION ABOUT LEVEL III FAIR VALUE MEASUREMENTS

(DOLLARS IN THOUSANDS)    

 

		March 31, 2015
		Fair Value				Valuation		Unobservable		Range
		Estimate				Techniques		Input		(Weighted Avg)
Impaired loans			2,017			Appraisal of		Appraisal		-20%  (-20%)
						collateral (1)		adjustments (2)
								Liquidation		-10%  (-10%)
								expenses (2)
OREO			108			Appraisal of		Appraisal
						collateral (1),(3)		adjustments (2)		-40%  (-40%)
								Liquidation
								expenses (2)		-1%  (-1%)

 

		December 31, 2014
		Fair Value				Valuation		Unobservable		Range
		Estimate				Techniques		Input		(Weighted Avg)
Impaired loans			2,357			Appraisal of		Appraisal		-20%  (-20%)
						collateral (1)		adjustments (2)
								Liquidation		-10%  (-10%)
								expenses (2)
OREO			69			Appraisal of		Appraisal
						collateral (1),(3)		adjustments (2)		-40%  (-40%)
								Liquidation
								expenses (2)		-1%  (-1%)

 

(1) Fair value is generally determined through independent appraisals of the underlying collateral, which generally include various level III inputs which are not identifiable.

 

(2) Appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated liquidation expenses.  The range and weighted average of liquidation expenses and other appraisal adjustments are presented as a percent of the appraisal.

 

(3) Includes qualitative adjustments by management and estimated liquidation expenses.

 

 

5.

Interim Disclosures about Fair Value of Financial Instruments

 

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

 

Cash and Cash Equivalents

For these short-term instruments, the carrying amount is a reasonable estimate of fair value.

Securities Available for Sale

Management utilizes quoted market pricing for the fair value of the Corporation's securities that are available for sale, if available. If a quoted market rate is not available, fair value is estimated using quoted market prices for similar securities.

 

Regulatory Stock

Regulatory stock is valued at a stable dollar price, which is the price used to purchase or liquidate shares; therefore, the carrying amount is a reasonable estimate of fair value.

 

Loans Held for Sale

Loans held for sale are individual loans for which the Corporation has a firm sales commitment; therefore, the carrying value is a reasonable estimate of the fair value.

 

Loans

The fair value of fixed and variable rate loans is estimated by discounting back the scheduled future cash flows of the particular loan product, using the market interest rates of comparable loan products in the Corporation’s greater market area, with the same general structure, comparable credit ratings, and for the same remaining maturities.

 

Accrued Interest Receivable

The carrying amount of accrued interest receivable is a reasonable estimate of fair value.

 

Bank Owned Life Insurance

Fair value is equal to the cash surrender value of the life insurance policies.

 

Deposits

The fair value of non-interest bearing demand deposit accounts and interest bearing demand, savings, and money market deposit accounts is based on the amount payable on demand at the reporting date. The fair value of fixed-maturity time deposits is estimated by discounting back the expected cash flows of the time deposit using market interest rates from the Corporation’s greater market area currently offered for similar time deposits with similar remaining maturities.

 

Borrowings

The fair value of a term borrowing is estimated by comparing the rate currently offered for the same type of borrowing instrument with a matching remaining term.

 

Accrued Interest Payable

The carrying amount of accrued interest payable is a reasonable estimate of fair value.

 

Firm Commitments to Extend Credit, Lines of Credit, and Open Letters of Credit

These financial instruments are generally not subject to sale and estimated fair values are not readily available. The carrying value, represented by the net deferred fee arising from the unrecognized commitment or letter of credit, and the fair value, determined by discounting the remaining contractual fee over the term of the commitment, using fees currently charged to enter into similar agreements with similar credit risk, is not considered material for disclosure purposes. The contractual amounts of unfunded commitments are presented in Note 6.

 

Fair Value of Financial Instruments

 

The carrying amounts and estimated fair values of the Corporation's financial instruments at March 31, 2015 and December 31, 2014, are summarized as follows:

 

FAIR VALUE OF FINANCIAL INSTRUMENTS

(DOLLARS IN THOUSANDS)

		March 31, 2015
										Quoted Prices in
										Active Markets				Significant Other				Significant
										for Identical				Observable				Unobservable
		Carrying								Assets				Inputs				Inputs
		Amount				Fair Value				(Level 1)				(Level II)				(Level III)
		$				$				$				$				$
Financial Assets:
Cash and cash equivalents			40,356				40,356				40,356				—				—
Securities available for sale			292,808				292,808				5,379				287,429				—
Regulatory stock			3,595				3,595				3,595				—				—
Loans held for sale			648				648				648				—				—
Loans, net of allowance			475,486				473,518				—				—				473,518
Accrued interest receivable			3,370				3,370				3,370				—				—
Bank owned life insurance			20,765				20,765				20,765				—				—
Financial Liabilities:
Demand deposits			205,830				205,830				205,830				—				—
Interest-bearing demand deposits			11,799				11,799				11,799				—				—
NOW accounts			69,319				69,319				69,319				—				—
Money market deposit accounts			69,886				69,886				69,886				—				—
Savings accounts			140,062				140,062				140,062				—				—
Time deposits			198,711				199,939				—				—				199,939
Total deposits			695,607				696,835				496,896				—				199,939
Short-term borrowings			4,930				4,930				4,930				—				—
Long-term debt			65,548				66,372				—				—				66,372
Accrued interest payable			539				539				539				—				—

 

FAIR VALUE OF FINANCIAL INSTRUMENTS

(DOLLARS IN THOUSANDS)

		December 31, 2014
										Quoted Prices in
										Active Markets				Significant Other				Significant
										for Identical				Observable				Unobservable
		Carrying								Assets				Inputs				Inputs
		Amount				Fair Value				(Level 1)				(Level II)				(Level III)
		$				$				$				$				$
Financial Assets:
Cash and cash equivalents			43,412				43,412				43,412				—				—
Securities available for sale			295,822				295,822				5,208				290,614				—
Regulatory stock			3,227				3,227				3,227				—				—
Loans held for sale			506				506				506				—				—
Loans, net of allowance			464,027				463,197				—				—				463,197
Accrued interest receivable			3,706				3,706				3,706				—				—
Bank owned life insurance			20,603				20,603				20,603				—				—
Financial Liabilities:
Demand deposits			210,444				210,444				210,444				—				—
Interest-bearing demand deposits			14,039				14,039				14,039				—				—
NOW accounts			72,951				72,951				72,951				—				—
Money market deposit accounts			69,442				69,442				69,442				—				—
Savings accounts			131,206				131,206				131,206				—				—
Time deposits			201,569				203,787				—				—				203,787
Total deposits			699,651				701,869				498,082				—				203,787
Long-term debt			62,300				63,058				—				—				63,058
Accrued interest payable			586				586				586				—				—

 

6.	Commitments and Contingent Liabilities

 

In order to meet the financing needs of its customers in the normal course of business, the Corporation makes various commitments that are not reflected in the accompanying consolidated financial statements. These commitments include firm commitments to extend credit, unused lines of credit, and open letters of credit. As of March 31, 2015, firm loan commitments were $22.6 million, unused lines of credit were $144.4 million, and open letters of credit were $10.3 million. The total of these commitments was $177.3 million, which represents the Corporation’s exposure to credit loss in the event of nonperformance by its customers with respect to these financial instruments. The actual credit losses that may arise from these commitments are expected to compare favorably with the Corporation’s loan loss experience on its loan portfolio taken as a whole. The Corporation uses the same credit policies in making commitments and conditional obligations as it does for balance sheet financial instruments.

 

7. Accumulated Other Comprehensive Income (Loss)

 

The activity in accumulated other comprehensive income (loss) for the three months ended March 31, 2015 and 2014 is as follows:

 

ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) (1) (2)

(DOLLARS IN THOUSANDS)  

 

		Unrealized
		Gains (Losses)
		on Securities
		Available-for-Sale
		$
Balance at December 31, 2014			1,002
Other comprehensive income before reclassifications			1,529
Amount reclassified from accumulated other comprehensive income			(370	)
Period change			1,159
Balance at March 31, 2015			2,161
Balance at December 31, 2013			(3,940	)
Other comprehensive loss before reclassifications			2,610
Amount reclassified from accumulated other comprehensive loss			(437	)
Period change			2,173
Balance at March 31, 2014			(1,767	)

 

(1) All amounts are net of tax.  Related income tax expense or benefit is calculated using a Federal income tax rate of 34%.

(2) Amounts in parentheses indicate debits.  

 

 

DETAILS ABOUT ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) COMPONENTS (1)

(DOLLARS IN THOUSANDS)

 

		Amount Reclassified from
		Accumulated Other Comprehensive
		Income (Loss)
		For the Three Months
		Ended March 31,
		2015				2014				Affected Line Item in the
		$				$				Statements of Income
Securities available-for-sale:
Net securities gains reclassified into earnings			561				685			Gains on securities transactions, net
Related income tax expense			(191	)			(233	)		Provision for federal income taxes
Net effect on accumulated other comprehensive
income for the period			370				452
Net impairment losses reclassified into earnings			—				(22	)		Net impairment losses on investment securities
Related income tax expense			—				7			Provision for federal income taxes
Net effect on accumulated other comprehensive
income for the period			—				(15	)
Total reclassifications for the period			370				437

 

(1) Amounts in parentheses indicate debits.

 

8. Recently Issued Accounting Standards

 

In January 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-01, Investments – Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects. The amendments in this Update permit reporting entities to make an accounting policy election to account for their investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance in the income statement as a component of income tax expense (benefit). The amendments in this Update should be applied retrospectively to all periods presented. A reporting entity that uses the effective yield method to account for its investments in qualified affordable housing projects before the date of adoption may continue to apply the effective yield method for those preexisting investments. The amendments in this Update are effective for public business entities for annual periods and interim reporting periods within those annual periods, beginning after December 15, 2014. Early adoption is permitted. This Update did not have a significant impact on the Corporation’s financial statements.

 

In January 2014, the FASB issued ASU 2014-04, Receivables – Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure. The amendments in this Update clarify that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additionally, the amendments require interim and annual disclosure of both (1) the amount of foreclosed residential real estate property held by the creditor and (2) the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. The amendments in this Update are effective for public business entities for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. An entity can elect to adopt the amendments in this Update using either a modified retrospective transition method or a prospective transition method. This Update did not have a significant impact on the Corporation’s financial statements.

 

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (a new revenue recognition standard). The Update’s core principle is that a company will recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In addition, this update specifies the accounting for certain costs to obtain or fulfill a contract with a customer and expands disclosure requirements for revenue recognition. This Update is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. The Corporation is evaluating the effect of adopting this new accounting Update.

 

In June 2014, the FASB issued ASU 2014-10, Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures. The amendments in this Update change the accounting for repurchase-to-maturity transactions to secured borrowing accounting. For repurchase financing arrangements, the amendments require separate accounting for a transfer of a financial asset executed contemporaneously with a repurchase agreement with the same counterparty, which will result in secured borrowing accounting for the repurchase agreement. The amendments also require enhanced disclosures. The accounting changes in this Update are effective for the first interim or annual period beginning after December 15, 2014. An entity is required to present changes in accounting for transactions outstanding on the effective date as a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption. Earlier application is prohibited. The disclosure for certain transactions accounted for as a sale is required to be presented for interim and annual periods beginning after December 15, 2014, and the disclosure for repurchase agreements, securities lending transactions, and repurchase-to-maturity transactions accounted for as secured borrowings is required to be presented for annual periods beginning after December 15, 2014, and for interim periods beginning after March 15, 2015. The disclosures are not required to be presented for comparative periods before the effective date. This Update did not have a significant impact on the Corporation’s financial statements.

 

In June 2014, the FASB issued ASU 2014-12, Compensation-Stock Compensation (Topic 718): Accounting for Share-Based Payments when the Terms of an Award Provide that a Performance Target Could Be Achieved After the Requisite Service Period. The amendments require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. The amendments in this Update are effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. Earlier adoption is permitted. Entities may apply the amendments in this Update either (a) prospectively to all awards granted or modified after the effective date or (b) retrospectively to all awards with performance targets that are outstanding as of the beginning of the earliest annual period presented in the financial statements and to all new or modified awards thereafter. If retrospective transition is adopted, the cumulative effect of applying this Update as of the beginning of the earliest annual period presented in the financial statements should be recognized as an adjustment to the opening retained earnings balance at that date. Additionally, if retrospective transition is adopted, an entity may use hindsight in measuring and recognizing the compensation cost. This Update is not expected to have a significant impact on the Corporation’s financial statements.

 

In August 2014, the FASB issued ASU 2014-14, Receivables – Troubled Debt Restructurings by Creditors (Subtopic 310-40). The amendments in this Update require that a mortgage loan be derecognized and that a separate other receivable be recognized upon foreclosure if the following conditions are met: (1) the loan has a government guarantee that is not separable from the loan before foreclosure, (2) at the time of foreclosure, the creditor has the intent to convey the real estate property to the guarantor and make a claim on the guarantee, and the creditor has the ability to recover under that claim, and (3) at the time of foreclosure, any amount of the claim that is determined on the basis of the fair value of the real estate is fixed. Upon foreclosure, the separate other receivable should be measured based on the amount of the loan balance (principal and interest) expected to be recovered from the guarantor. The amendments in this Update are effective for public business entities for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. This Update did not have a significant impact on the Corporation’s financial statements.

 

In August 2014, the FASB issued ASU 2014-15, Presentation of Financial Statements - Going Concern (Subtopic 205-40). The amendments in this Update provide guidance in accounting principles generally accepted in the United States of America about management's responsibility to evaluate whether there is substantial doubt about an entity's ability to continue as a going concern and to provide related footnote disclosures. The amendments in this Update are effective for the annual periods ending after December 15, 2016, and for annual periods and interim periods thereafter. Early application is permitted. This Update is not expected to have a significant impact on the Corporation’s financial statements.

 

In November 2014, the FASB issued ASU 2014-16, Derivatives and Hedging (Topic 815): Determining Whether the Host Contract in a Hybrid Financial Instrument Issued in the Form of a Share Is More Akin to Debt or to Equity (a consensus of the FASB Emerging Issues Task Force). This ASU clarifies how current U.S. GAAP should be interpreted in subjectively evaluating the economic characteristics and risks of a host contract in a hybrid financial instrument that is issued in the form of a share. Public business entities are required to implement the new requirements in fiscal years and interim periods within those fiscal years beginning after December 15, 2015. This Update is not expected to have a significant impact on the Corporation’s financial statements.

 

In November 2014, the FASB issued ASU 2014-17, Business Combinations (Topic 805): Pushdown Accounting. The amendments in this Update apply to the separate financial statements of an acquired entity and its subsidiaries that are a business or nonprofit activity (either public or nonpublic) upon the occurrence of an event in which an acquirer (an individual or an entity) obtains control of the acquired entity. An acquired entity may elect the option to apply pushdown accounting in the reporting period in which the change-in-control event occurs. If pushdown accounting is not applied in the reporting period in which the change-in-control event occurs, an acquired entity will have the option to elect to apply pushdown accounting in a subsequent reporting period to the acquired entity's most recent change-in-control event. The amendments in this Update are effective on November 18, 2014. After the effective date, an acquired entity can make an election to apply the guidance to future change-in-control events or to its most recent change-in-control event. This Update is not expected to have a significant impact on the Corporation’s financial statements.

 

In January 2015, the FASB issued ASU 2015-01, Income Statement – Extraordinary and Unusual Items, as part of its initiative to reduce complexity in accounting standards. This Update eliminates from GAAP the concept of extraordinary items. The amendments in this Update are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. A reporting entity may apply the amendments prospectively. A reporting entity also may apply the amendments retrospectively to all prior periods presented in the financial statements. Early adoption is permitted provided that the guidance is applied from the beginning of the fiscal year of adoption. This Update is not expected to have a significant impact on the Corporation’s financial statements.

In February 2015, the FASB issued ASU 2015-02, Consolidation (Topic 810). The amendments in this Update affect reporting entities that are required to evaluate whether they should consolidate certain legal entities. All legal entities are subject to reevaluation under the revised consolidation model. Specifically, the amendments (1) Modify the evaluation of whether limited partnerships and similar legal entities are variable interest entities (VIEs) or voting interest entities; (2) Eliminate the presumption that a general partner should consolidate a limited partnership; (3) Affect the consolidation analysis of reporting entities that are involved with VIEs, particularly those that have fee arrangements and related party relationships; (4) Provide a scope exception from consolidation guidance for reporting entities with interests in legal entities that are required to comply with or operate in accordance with requirements that are similar to those in Rule 2a-7 of the Investment Company Act of 1940 for registered money market funds. The amendments in this Update are effective for public business entities for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2015. For all other entities, the amendments in this Update are effective for fiscal years beginning after December 15, 2016, and for interim periods within fiscal years beginning after December 15, 2017. This Update is not expected to have a significant impact on the Corporation’s financial statements.

 

In April 2015, the FASB issued ASU 2015-03, Interest-Imputation of Interest (Subtopic 835-30), as part of its initiative to reduce complexity in accounting standards. To simplify presentation of debt issuance costs, the amendments in this Update require that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The recognition and measurement guidance for debt issuance costs are not affected by the amendments in this Update. For public business entities, the amendments in this Update are effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. For all other entities, the amendments in this Update are effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within fiscal years beginning after December 15, 2016. An entity should apply the new guidance on a retrospective basis, wherein the balance sheet of each individual period presented should be adjusted to reflect the period-specific effects of applying the new guidance. This Update is not expected to have a significant impact on the Corporation’s financial statements.

 

In April 2015, the FASB issued ASU 2015-04, Compensation-Retirement Benefits (Topic 715), as part of its initiative to reduce complexity in accounting standards. For an entity with a fiscal year-end that does not coincide with a month-end, the amendments in this Update provide a practical expedient that permits the entity to measure defined benefit plan assets and obligations using the month-end that is closest to the entity's fiscal year-end and apply that practical expedient consistently from year to year. The practical expedient should be applied consistently to all plans if an entity has more than one plan. The amendments in this Update are effective for public business entities for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. For all other entities, the amendments in this Update are effective for financial statements issued for fiscal years beginning after December 15, 2016, and interim periods within fiscal years beginning after December 15, 2017. Earlier application is permitted. This Update is not expected to have a significant impact on the Corporation’s financial statements.

 

In April 2015, the FASB issued ASU 2015-05, Intangible – Goodwill and Other Internal Use Software (Topic 350-40), as part of its initiative to reduce complexity in accounting standards. This guidance will help entities evaluate the accounting for fees paid by a customer in a cloud computing arrangement. The amendments in this Update provide guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. For public business entities, the Board decided that the amendments will be effective for annual periods, including interim periods within those annual periods, beginning after December 15, 2015. For all other entities, the amendments will be effective for annual periods beginning after December 15, 2015, and interim periods in annual periods beginning after December 15, 2016. Early adoption is permitted for all entities. This Update is not expected to have a significant impact on the Corporation’s financial statements.

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

 

The following discussion and analysis represents management’s view of the financial condition and results of operations of the Corporation. This discussion and analysis should be read in conjunction with the consolidated financial statements and other financial schedules included in this quarterly report, and in conjunction with the 2014 Annual Report to Shareholders of the Corporation. The financial condition and results of operations presented are not indicative of future performance.

 

Forward-Looking Statements

 

The U.S. Private Securities Litigation Reform Act of 1995 provides safe harbor in regards to the inclusion of forward-looking statements in this document and documents incorporated by reference. Forward-looking statements pertain to possible or assumed future results that are made using current information. These forward-looking statements are generally identified when terms such as: “believe,” “estimate,” “anticipate,” “expect,” “project,” “forecast,” and other similar wordings are used. The readers of this report should take into consideration that these forward-looking statements represent management’s expectations as to future forecasts of financial performance, or the likelihood that certain events will or will not occur. Due to the very nature of estimates or predications, these forward-looking statements should not be construed to be indicative of actual future results. Additionally, management may change estimates of future performance, or the likelihood of future events, as additional information is obtained. This document may also address targets, guidelines, or strategic goals that management is striving to reach but may not be indicative of actual results.

 

Readers should note that many factors affect this forward-looking information, some of which are discussed elsewhere in this document and in the documents that are incorporated by reference into this document. These factors include, but are not limited to, the following:

 

·

National and local economic conditions

·

Real estate market and its impact on the loan portfolio

·

Monetary and interest rate policies of the Federal Reserve Board

·

Volatility of the securities markets including the valuation of securities

·

Future actions or inactions of the United States government, including a failure to increase the government debt limit or a prolonged shutdown of the federal government

·

Effects of slow economic conditions and the prolonged economic weakness, specifically the effect on loan customers to repay loans

·

Political changes and their impact on new laws and regulations

·

Competitive forces

·

Changes in customer behavior impacting deposit levels and loan demand

·

Changes in accounting principles, policies, or guidelines as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board, and other accounting standards setters

·

Ineffective business strategy due to current or future market and competitive conditions

·

Management’s ability to manage credit risk, liquidity risk, interest rate risk, and fair value risk

·

Operation, legal, and reputation risk

·

Results of the regulatory examination and supervision process

·

The risk that our analyses of these risks and forces could be incorrect and/or that the strategies developed to address them could be unsuccessful

·

The impact of new laws and regulations, including the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and the regulations issued thereunder

·

Possible impacts of the capital and liquidity requirements of the Basel III standards and other regulatory pronouncements, regulations and rules

·

Disruptions due to flooding, severe weather, or other natural disasters or Acts of God.

 

Readers should be aware if any of the above factors change significantly, the statements regarding future performance could also change materially. The safe harbor provision provides that the Corporation is not required to publicly update or revise forward-looking statements to reflect events or circumstances that arise after the date of this report. Readers should review any changes in risk factors in documents filed by the Corporation periodically with the Securities and Exchange Commission, including Item 1A of Part II of this Quarterly Report on Form 10-Q, Annual Reports on Form 10-K, and Current Reports on Form 8-K.

 

Results of Operations

 

Overview

The Corporation recorded net income of $1,466,000 for the three-month period ended March 31, 2015, a 20.2% decrease, from the $1,838,000 earned during the same period in 2014. The earnings per share, basic and diluted, were $0.51 for the three months ended March 31, 2015, compared to $0.64 for the same period in 2014.

 

The two primary reasons for the decline in earnings were an increase in the provision for loans losses and an increase in operational expenses for the year-to-date period. The Corporation recorded $200,000 of expense related to the provision for loan losses for the three months ended March 31, 2015, compared to a credit provision of $200,000 for the three months ended March 31, 2014. The increase in provision expense was primarily due to charge-offs recorded in the first quarter of 2015, as well as loan portfolio growth. The increase in charge-offs recorded in 2015 resulted in higher historical loss factors, which caused the higher required provision. Low levels of delinquent, non-performing, and classified loans, as well as minimal charge-offs over the past years resulted in the need to reduce the allowance for loan losses by recording a credit provision in the prior year. The allowance as a percentage of total loans was 1.48% as of March 31, 2015, compared to 1.58% as of March 31, 2014. More detail is provided in the Provision for Loan Losses section that follows and the Allowance for Loan Losses section under Financial Condition.

 

Operating expenses increased by $352,000, or 6.1%, for the three months ended March 31, 2015, compared to the same period in the prior year. Personnel costs increased by $272,000, or 7.9%, compared to the first quarter of 2014, due to new staff positions as well as higher benefit costs associated with new and existing staff. The personnel costs increase was largely the result of additional staffing in the mortgage department, but there was also a new information system position and three position upgrades in the operations, loans, and legal areas. The mortgage area is undergoing an expansion while the added and upgraded positions are largely to cover new requirements of the Dodd-Frank Act.

 

In the other income area, net gains on securities decreased by $102,000, or 14.4%, for the three-month period ended March 31, 2015, compared to the same period in 2014 while net gains on the sale of mortgages increased by $115,000, or 302.6%. More detail is provided under the Other Income and Operating Expense sections under Results of Operations.

 

The Corporation’s net interest income for the three months ended March 31, 2015, increased from the same period in 2014. Net interest income was $5,858,000 for the first quarter of 2015, compared to $5,655,000 for the same quarter of 2014, a $203,000, or 3.6% increase. The Corporation’s net interest margin was 3.13% for the first quarter of 2015, compared to 3.23% for the first quarter of 2014. Net interest margin did increase by nine basis points on a sequential basis from 3.04% in the fourth quarter of 2014.

 

The financial services industry uses two primary performance measurements to gauge performance: return on average assets (ROA) and return on average equity (ROE). ROA measures how efficiently a bank generates income based on the amount of assets or size of a company. ROE measures the efficiency of a company in generating income based on the amount of equity or capital utilized. The latter measurement typically receives more attention from shareholders. The ROA and ROE decreased for the three-month period ended March 31, 2015, compared to the same period in the prior year due to the decrease in the Corporation’s income and an increase in asset and capital levels.

 

Key Ratios		Three Months Ended March 31,
		2015				2014
Return on Average Assets			0.69%				0.92%
Return on Average Equity			6.38%				8.74%

 

The results of the Corporation’s operations are best explained by addressing, in further detail, the five major sections of the income statement, which are as follows:

 

·

Net interest income

·

Provision for loan losses

·

Other income

·

Operating expenses

·

Provision for income taxes

The following discussion analyzes each of these five components.

 

Net Interest Income

 

Net interest income (NII) represents the largest portion of the Corporation’s operating income. In the first three months of 2015, NII generated 72.7% of the Corporation’s gross revenue stream, which consists of net interest income and non-interest income, compared to 72.2% in the first three months of 2014. The overall performance of the Corporation is highly dependent on the changes in net interest income since it comprises such a significant portion of operating income.

 

The following table shows a summary analysis of net interest income on a fully taxable equivalent (FTE) basis. For analytical purposes and throughout this discussion, yields, rates, and measurements such as NII, net interest spread, and net yield on interest earning assets are presented on an FTE basis. The FTE net interest income shown in both tables below will exceed the NII reported on the consolidated statements of income, which is not shown on an FTE basis. The amount of FTE adjustment totaled $438,000 for the three months ended March 31, 2015, compared to $475,000 for the same period in 2014.

 

NET INTEREST INCOME

(DOLLARS IN THOUSANDS)    

 

		Three Months Ended
		March 31,
		2015				2014
		$				$
Total interest income			6,872				6,872
Total interest expense			1,014				1,217
Net interest income			5,858				5,655
Tax equivalent adjustment			438				475
Net interest income (fully taxable equivalent)			6,296				6,130

 

NII is the difference between interest income earned on assets and interest expense incurred on liabilities. Accordingly, two factors affect net interest income:

 

·

The rates earned on interest earning assets and paid on interest bearing liabilities

·

The average balance of interest earning assets and interest bearing liabilities

 

The Federal funds rate, the Prime rate, the shape of the U.S. Treasury curve, and other wholesale funding curves, all affect NII. The Federal Reserve controls the Federal funds rate, which is one of a number of tools available to the Federal Reserve to conduct monetary policy. The Federal funds rate, and guidance on when the rate might be changed, is often the focal point of discussion regarding the direction of interest rates. The Federal funds rate has not changed since December of 2008. While the Federal Reserve has not changed the Federal funds rate over the past six years, it has been utilizing a number of other granted powers to help stimulate the economy while managing monetary policy, including maintaining low levels of inflation. This period of over six years with extremely low overnight rates is the lowest and longest in U.S. history. It appears this low interest rate environment will continue well into 2015, although there is a possibility that the Federal Reserve could increase overnight rates later in the year.

 

The Prime rate is generally used by commercial banks to extend variable rate loans to business and commercial customers. For many years, the Prime rate has been set at 300 basis points, or 3.00% higher, than the Federal funds rate and typically moves when the Federal funds rate changes. As such, the Prime rate has also not moved from its historic low of 3.25% since December 31, 2008.

 

The fact that the Federal funds rate and the Prime rate have remained at these very low levels for over six years has made it difficult to grow the NII of the Corporation as the net interest margin has declined. During the first quarter of 2015, management was able to grow interest-earning assets 5.8% over the first quarter of 2014. Net interest income on a tax equivalent basis increased by $166,000, or 2.7%, but the Corporation’s margin still showed a decline from the prior year’s period. This is typical in a prolonged low rate environment when additional savings on interest expense are limited, while yields on the Corporation’s longer assets continue to reprice to lower levels. This causes a decline in the Corporation’s margin, but the impact of the decrease in margin can be offset by sufficient increases in interest earning assets, causing an increase in NII. On a sequential basis, both the Corporation’s first quarter margin and net interest income increased from the fourth quarter of 2014.

 

The extended extremely low Federal funds rate has enabled management to reduce the cost of funds on overnight borrowings and allowed lower interest rates paid on deposits, reducing the Corporation’s interest expense, while the decrease in the Prime rate has reduced the yield on the Corporation’s Prime-based loans. In this environment the Corporation’s fixed rate loans and securities have generally repriced to lower rates as they mature or reach the end of their fixed rate period. This has occurred over the past six years and continues to cause lower yields on the Corporation’s assets.

 

Security yields fluctuate more rapidly than loan yields based primarily on the changes to the U.S. Treasury rates and yield curve. With lower U.S. Treasury rates on average in the first quarter of 2015 compared to 2014, most of the security reinvesting was occurring at lower rates. As the volume of securities sold at gains continued at a higher level, this also resulted in more reinvestment at lower rates. Management did generally direct a portion of the security sale proceeds into loan growth. Additionally, management repositioned within the security portfolio and purchased shorter assets, which affected security yield. Meanwhile, the Corporation’s loan yield has continued to decline as new loans are going on at lower rates in 2015 and previous years. Management does price a minority portion of business and consumer loans above the Prime rate on variable rate loans, which helps with loan yield, however, these rates on average are still lower than the typical fixed rate loan. Therefore, any increases in total variable rate loans will generally reduce overall loan portfolio yield. An element of the Corporation’s Prime-based commercial loans is priced above the Prime rate based on the level of credit risk of the borrower. Additionally, certain variable rate consumer loans are priced above Prime. Prime-based pricing continues to be driven largely by local competition.

 

Mid-term and long-term interest rates generally declined throughout the first quarter of 2015 with little moves up and down, but ultimately ending lower than they were at the end of 2014 or during the first quarter of 2014. The 10-year U.S. Treasury yield stood at 1.94% on March 31, 2015, compared to 2.17% at December 31, 2014 and 2.73% at March 31, 2014. This had the impact of decreasing the U.S. Treasury curve slope with only 169 basis points of spread between the 10-year and overnight funds as of March 31, 2015. This provided opportunities during the first quarter to sell securities at higher gains. However, the materially lower U.S. Treasury rates had a negative impact to the yield on securities. Additionally, with a flatter yield curve and lower mid and long-term interest rates, management was not able to increase loan rates to improve yield. As a result, the Corporation’s asset yield continued to decline.

 

While it is becoming increasingly difficult to achieve savings on the Corporation’s overall cost of funds, management was able to selectively reprice longer-term time deposits and borrowings to lower levels during the first quarter of 2015 resulting in continued savings. Only time deposit terms three years or longer are repricing at lower rates helping to achieve interest expense savings on deposits. It is not anticipated that interest rates on interest bearing core deposits can be reduced further in 2015 as these rates have already been reduced significantly over the course of the past few years. Borrowing costs, and the wholesale borrowing curves that they are based on, generally follow the direction and slope of the U.S. Treasury curve, however these curves can be quicker to rise and slower to fall as the providers of these funds seek to protect themselves from rate movements. The Corporation was able to refinance longer-term borrowings at lower rates in the first quarter of 2015 and expects this trend to continue throughout the year as some advances at higher rates mature and are replaced by lower cost borrowings.

 

Management currently anticipates that the overnight interest rate and Prime rate will remain at these historically low levels through the first half of 2015, with the possibility of a small rate increase in the second half of the year. It is likely that the mid and long-term Treasury rates could increase throughout the course of the year in anticipation of a Federal Reserve rate movement. This would allow management to achieve higher earnings on assets given higher yielding securities and the ability to price new loans at higher market rates. If the Federal Reserve would act to increase overnight rates it is also possible that the yield curve could flatten, making it more difficult for management to increase the yield on earning assets and net interest margin, as generally the Corporation will lend out or reinvest out further on the yield curve such as five-year instruments.

 

Generally, a flatter yield curve is not conducive to increasing net interest margin and net interest income. However, the Corporation has benefited from a gradual increase in the amount of variable rate loans. Approximately 25% of the Corporation’s loans are variable rate, which would reprice to a higher rate based on the Prime rate with any Federal Reserve increase. Higher amounts of variable rate loans would help in the event of a flatter yield curve but would likely not be sufficient alone to offset higher funding costs if short term rates were to increase materially, therefore a lower margin would occur.

 

The Corporation’s margin was 3.13% for the first quarter of 2015, a ten basis-point decline from the 3.23% for the first quarter of 2014. On a sequential basis, margin did improve from the 3.04% for the fourth quarter of 2014. The sequential improvement was aided by a special one-time FHLB stock dividend of $89,000, accounting for half of the margin improvement. Without the special FHLB dividend, the Corporation’s first quarter 2015 margin would have been 3.09%, a 5 basis-point improvement from the fourth quarter of 2014. This marked the second consecutive quarter of margin improvement; however, the margin remained 10 basis points below the year-earlier period. Although loan growth is occurring, it has been a challenge to increase loan pricing to the point where it is contributing to an increase in overall asset yield. As cost of funds savings become harder to achieve, the only way to materially increase net interest margin going forward will be through increases in asset yield. This was a challenge in the first quarter of 2015, and will likely remain a challenge in the foreseeable future. Any improvement in asset yields would be dependent on mid-term and longer-term interest rates increasing. This would assist with increased loan pricing and higher securities yields as a result of reduced amortization and higher yields being available at the time of purchase.