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EX-31.1 - EXHIBIT 31.1 - MIDDLEBURG FINANCIAL CORPmbrg093015ex311.htm
EX-31.2 - EXHIBIT 31.2 - MIDDLEBURG FINANCIAL CORPmbrg093015ex-312.htm
EX-32.1 - EXHIBIT 32.1 - MIDDLEBURG FINANCIAL CORPmbrg093015ex-321.htm
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.  20549

FORM 10-Q

[X] Quarterly Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2015
or
[   ] Transition Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934

For the transition period from ____________ to _____________

Commission File Number:  0-24159
MIDDLEBURG FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
Virginia
(State or other jurisdiction of
incorporation or organization) 
54-1696103
(I.R.S. Employer
Identification No.)
111 West Washington Street
Middleburg, Virginia
(Address of principal executive offices)
 
20117
(Zip Code)
(703) 777-6327
(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
 
Yes  þ
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 definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer o
 
Accelerated filer þ
 
Non-accelerated filer  o (Do not check if a smaller reporting company)
 
Smaller reporting company  o
 

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.  7,162,716 shares of Common Stock as of November 6, 2015.
 
 




 MIDDLEBURG FINANCIAL CORPORATION

INDEX

Page No.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

2


ITEM 1.
FINANCIAL STATEMENTS

PART I

MIDDLEBURG FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except for share and per share data)
 
(Unaudited)
 
 
 
September 30,
 
December 31,
 
2015
 
2014
ASSETS
 
 
 
Cash and due from banks
$
6,498

 
$
7,396

Interest bearing deposits with other banks
33,281

 
47,626

Total cash and cash equivalents
39,779

 
55,022

Securities held to maturity, fair value of $1,375 and $1,397, respectively
1,500

 
1,500

Securities available for sale, at fair value
372,779

 
348,263

Restricted securities, at cost
5,349

 
5,279

Loans, net of allowance for loan losses of $11,400 and $11,786, respectively
769,467

 
743,060

Premises and equipment, net
19,787

 
18,104

Goodwill and identified intangibles, net
3,679

 
3,807

Other real estate owned, net of valuation allowance of $890 and $755, respectively
3,871

 
4,051

Bank owned life insurance
23,107

 
22,617

Accrued interest receivable and other assets
21,972

 
21,154

TOTAL ASSETS
$
1,261,290

 
$
1,222,857

LIABILITIES
 

 
 

Deposits:
 

 
 

Non-interest bearing demand deposits
$
242,890

 
$
216,912

Savings and interest bearing demand deposits
539,972

 
523,230

Time deposits
249,491

 
248,938

Total deposits
1,032,353

 
989,080

Securities sold under agreements to repurchase
24,468

 
38,551

Federal Home Loan Bank borrowings
60,000

 
55,000

Subordinated notes
5,155

 
5,155

Accrued interest payable and other liabilities
12,902

 
13,037

TOTAL LIABILITIES
1,134,878

 
1,100,823

Commitments and contingent liabilities

 

SHAREHOLDERS' EQUITY
 

 
 

Common stock ($2.50 par value; 20,000,000 shares authorized; 7,162,716 and 7,131,643 issued and outstanding, respectively)
17,522

 
17,494

Capital surplus
45,224

 
44,892

Retained earnings
60,542

 
55,854

Accumulated other comprehensive income
3,124

 
3,794

TOTAL SHAREHOLDERS' EQUITY
126,412

 
122,034

TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY
$
1,261,290

 
$
1,222,857

 
See accompanying notes to the consolidated financial statements.


3


MIDDLEBURG FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Dollars in thousands, except for per share data)
 
(Unaudited)
 
For the Three Months Ended
September 30,
 
For the Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
INTEREST INCOME
 
 
 
 
 
 
 
Interest and fees on loans
$
8,227

 
$
8,357

 
$
24,484

 
$
25,656

Interest and dividends on securities
 

 
 

 
 
 
 
Taxable
1,938

 
1,763

 
5,636

 
5,173

Tax-exempt
444

 
535

 
1,354

 
1,656

Dividends
71

 
84

 
196

 
230

Interest on deposits with other banks and federal funds sold
23

 
51

 
84

 
123

Total interest and dividend income
10,703

 
10,790

 
31,754

 
32,838

INTEREST EXPENSE
 

 
 

 
 
 
 
Interest on deposits
877

 
955

 
2,580

 
2,952

Interest on securities sold under agreements to repurchase
2

 
81

 
64

 
243

Interest on FHLB borrowings and other debt
165

 
209

 
507

 
876

Total interest expense
1,044

 
1,245

 
3,151

 
4,071

NET INTEREST INCOME
9,659

 
9,545

 
28,603

 
28,767

(Recovery of) provision for loan losses
(432
)
 
550

 
(407
)
 
1,510

NET INTEREST INCOME AFTER (RECOVERY OF) PROVISION FOR LOAN LOSSES
10,091

 
8,995

 
29,010

 
27,257

NON-INTEREST INCOME
 

 
 

 
 
 
 
Service charges on deposit accounts
622

 
635

 
1,792

 
1,815

Trust services income
1,168

 
1,119

 
3,629

 
3,224

Gains on sales of loans held for sale, net

 
1

 
3

 
4,859

Gains on sales of securities available for sale, net

 
12

 
138

 
141

Commissions on investment sales
132

 
193

 
415

 
479

Bank owned life insurance
166

 
168

 
489

 
494

Gain on sale of majority interest in consolidated subsidiary

 

 

 
24

Other operating income
266

 
152

 
1,331

 
1,399

Total non-interest income
2,354

 
2,280

 
7,797

 
12,435

NON-INTEREST EXPENSE
 

 
 

 
 
 
 
Salaries and employee benefits
4,834

 
4,441

 
14,664

 
17,467

Occupancy and equipment
1,248

 
1,262

 
3,813

 
4,841

Advertising
98

 
136

 
332

 
430

Computer operations
524

 
439

 
1,536

 
1,408

Other real estate owned
193

 
(33
)
 
285

 
145

Other taxes
230

 
220

 
684

 
637

Federal deposit insurance
188

 
220

 
583

 
687

Other operating expenses
1,959

 
1,706

 
5,355

 
6,042

Total non-interest expense
9,274

 
8,391

 
27,252

 
31,657

Income before income taxes
3,171

 
2,884

 
9,555

 
8,035

Income tax expense
850

 
763

 
2,506

 
2,179

NET INCOME
2,321

 
2,121

 
7,049

 
5,856

Net loss attributable to non-controlling interest

 

 

 
98

Net income attributable to Middleburg Financial Corporation
$
2,321

 
$
2,121

 
$
7,049

 
$
5,954

Earnings per share:
 
 
 
 
 
 
 
Basic
$
0.32

 
$
0.30

 
$
0.99

 
$
0.84

Diluted
$
0.32

 
$
0.30

 
$
0.98

 
$
0.84


See accompanying notes to the consolidated financial statements. 

4


MIDDLEBURG FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Dollars in thousands)
 
(Unaudited)
 
For the Three Months Ended
September 30,
 
For the Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
 
 
 
 
 
 
 
Net income
$
2,321

 
$
2,121

 
$
7,049

 
$
5,856

Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
Unrealized holding gains (losses) arising during the period, net of tax of ($102), ($89), $229 and ($1,911), respectively
198

 
173

 
(446
)
 
3,710

Reclassification adjustment for gains included in net income, net of tax of $0, $4, $47 and $48, respectively

 
(8
)
 
(91
)
 
(93
)
Unrealized gains (losses) on interest rate swaps, net of tax of $66, ($39), $66 and $14, respectively
(128
)
 
81

 
(129
)
 
(27
)
Reclassification adjustment for gain on interest rate swap ineffectiveness included in net income, net of tax of $0, $3, $2 and $0, respectively

 
(5
)
 
(4
)
 

Total other comprehensive income (loss)
70

 
241

 
(670
)
 
3,590

Total comprehensive income
2,391

 
2,362

 
6,379

 
9,446

Comprehensive loss attributable to non-controlling interest

 

 

 
98

Comprehensive income attributable to Middleburg Financial Corporation
$
2,391

 
$
2,362

 
$
6,379

 
$
9,544


See accompanying notes to the consolidated financial statements.




5


MIDDLEBURG FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(Dollars in thousands, except for share and per share data)
 (Unaudited)
 
 
 
For the Nine Months Ended September 30, 2015 and 2014
 
Common Stock
 
Capital Surplus
 
Retained Earnings
 
Accumulated Other Comprehensive Income
 
Non-Controlling Interest
 
Total
Balance December 31, 2013
$
17,403

 
$
44,251

 
$
50,689

 
$
232

 
$
2,498

 
$
115,073

 
 
 
 
 
 
 
 
 
 
 
 
Net income

 

 
5,954

 

 
(98
)
 
5,856

Other comprehensive income, net of tax

 

 

 
3,590

 

 
3,590

Cash dividends declared ($0.14 per share)

 

 
(1,706
)
 

 

 
(1,706
)
Sale of majority interest in consolidated subsidiary

 

 

 

 
(2,400
)
 
(2,400
)
Exercise of stock options (9,563 shares)
50

 
250

 

 

 

 
300

Restricted stock vesting (15,258 shares)
39

 
(39
)
 

 

 

 

Repurchase of restricted stock (4,693 shares)
(12
)
 
(76
)
 

 

 

 
(88
)
Share-based compensation

 
297

 

 

 

 
297

Balance September 30, 2014
$
17,480

 
$
44,683

 
$
54,937

 
$
3,822

 
$

 
$
120,922

 
 
 
 
 
 
 
 
 
 
 
 
Balance December 31, 2014
$
17,494

 
$
44,892

 
$
55,854

 
$
3,794

 
$

 
$
122,034

 
 

 
 

 
 

 
 

 
 

 
 

Net income

 

 
7,049

 

 

 
7,049

Other comprehensive loss, net of tax

 

 

 
(670
)
 

 
(670
)
Cash dividends ($0.33 per share)

 

 
(2,361
)
 

 

 
(2,361
)
Restricted stock vesting (15,692 shares)
39

 
(39
)
 

 

 

 

Repurchase of restricted stock (4,577 shares)
(11
)
 
(72
)
 

 

 

 
(83
)
Share-based compensation

 
443

 

 

 

 
443

Balance September 30, 2015
$
17,522

 
$
45,224

 
$
60,542

 
$
3,124

 
$

 
$
126,412

 
See accompanying notes to the consolidated financial statements.


6

MIDDLEBURG FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS


 
(Unaudited)
 
For the Nine Months Ended
 
September 30,
(Dollars in thousands)
2015
 
2014
Cash Flows From Operating Activities
 
 
 
Net income
$
7,049

 
$
5,856

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

Depreciation and amortization
1,736

 
1,536

(Recovery of) provision for loan losses
(407
)
 
1,510

Gain on sales of securities available for sale, net
(138
)
 
(141
)
Loss on disposal of assets, net
65

 
59

Premium amortization on securities, net
2,937

 
2,114

Decrease in loans held for sale, net

 
33,175

Share-based compensation
443

 
297

Gain on sale of majority interest in consolidated subsidiary

 
(24
)
Loss (gain) on sale of other real estate owned, net
46

 
(238
)
Valuation adjustment on other real estate owned
177

 
222

Valuation adjustment on property held for sale

 
200

Changes in assets and liabilities:
 
 
 
Increase in other assets
(1,854
)
 
(2,431
)
(Decrease) increase in other liabilities
(135
)
 
3,025

Net cash provided by operating activities
$
9,919

 
$
45,160

Cash Flows from Investing Activities
 
 
 

Proceeds from maturities, calls, principal repayments and sales of securities available for sale
$
82,336

 
$
102,344

Purchase of securities available for sale
(110,464
)
 
(105,448
)
(Purchase) redemption of restricted stock, net
(70
)
 
1,951

(Purchase) sale of bank premises and equipment, net
(2,756
)
 
988

Origination of loans, net
(27,847
)
 
(8,117
)
Proceeds from sale of loans
1,127

 


Proceeds from sale of majority interest in consolidated subsidiary, net

 
3,618

Proceeds from sale of other real estate owned and repossessed assets
766

 
1,680

Net cash used in investing activities
$
(56,908
)
 
$
(2,984
)
Cash Flows from Financing Activities
 

 
 

Increase in demand, interest-bearing demand and savings deposits
$
42,720

 
$
23,885

Increase (decrease) in time deposits
553

 
(19,715
)
Increase (decrease) in securities sold under agreements to repurchase
(14,083
)
 
1,930

Increase (decrease) in FHLB borrowings
5,000

 
(35,000
)
Payment of dividends on common stock
(2,361
)
 
(1,706
)
Proceeds from issuance of common stock, net

 
300

Repurchase of common stock
(83
)
 
(88
)
Net cash provided by (used in) financing activities
$
31,746

 
$
(30,394
)
Increase (decrease) in cash and and cash equivalents
(15,243
)
 
11,782

Cash and cash equivalents at beginning of the period
55,022

 
67,343

Cash and cash equivalents at end of the period
$
39,779

 
$
79,125

Supplemental Disclosures of Cash Flow Information
 
 
 

Interest paid
$
3,158

 
$
4,194

Income taxes
$
2,560

 
$
500

Supplemental Disclosure of Non-Cash Transactions
 
 
 

Unrealized (loss) gain on securities available for sale
$
(813
)
 
$
5,480

Change in market value of interest rate swap
$
(201
)
 
$
(41
)
Transfer of loans to other real estate owned and repossessed assets
$
720

 
$
4,438


See accompanying notes to the consolidated financial statements.

7


MIDDLEBURG FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements

Note 1.        General

In the opinion of management, the accompanying unaudited financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the financial position at September 30, 2015 and December 31, 2014, the results of operations, comprehensive income, for the three and nine month periods ending September 30, 2015 and 2014 and changes in shareholders' equity and cash flows for the nine months ended September 30, 2015 and 2014, in accordance with accounting principles generally accepted in the United States of America.  The statements should be read in conjunction with the Notes to Consolidated Financial Statements included in the Annual Report on Form 10-K for the year ended December 31, 2014 (the “2014 Form 10-K”) of Middleburg Financial Corporation (the “Company”).  The results of operations for the three and nine months ended September 30, 2015 are not necessarily indicative of the results to be expected for the full year.

In preparing these financial statements, management has evaluated subsequent events and transactions for potential recognition or disclosure through the date these financial statements were issued.  Management has concluded there were no additional material subsequent events to be disclosed.

Certain amounts in the 2014 consolidated financial statements have been reclassified to conform to the 2015 presentation. The amounts of these items are not considered to be material variations from the original classifications and presentations.

On May 15, 2014, the Company sold all of its interest in Southern Trust Mortgage to a consortium of banks and the President of Southern Trust Mortgage. While the Company no longer has a direct financial interest in Southern Trust Mortgage, the Company maintains a warehouse participation agreement with Southern Trust Mortgage in the amount of $19.0 million, which is reflected in loans, net of allowance for loan losses, on the Company's consolidated balance sheets.

Note 2.        Share-Based Compensation Plan

The Company sponsors one share-based compensation plan, the 2006 Equity Compensation Plan, which provides for the granting of stock options, stock appreciation rights, restricted stock awards, performance share awards, incentive awards, and stock units.  The 2006 Equity Compensation Plan was approved by the Company’s shareholders at the Annual Meeting held on April 26, 2006, and has succeeded the Company’s 1997 Stock Incentive Plan.  Under the plan, the Company may grant share-based compensation to its directors, officers, employees, and other persons the Company determines have contributed to the profits or growth of the Company.  The number of shares reserved for issuance total 430,000 shares.

For the nine months ended September 30, 2015, and 2014, the Company recorded $443,000 and $297,000, respectively, in share-based compensation expense. As of September 30, 2015, there was $1.6 million of total unrecognized compensation expense related to non-vested restricted awards under the 2006 Equity Compensation Plan. For the three and nine months ended September 30, 2015, the Company recorded no compensation expense related to option awards. As of September 30, 2015 all outstanding option awards were previously vested and, accordingly, there was no unrecognized compensation expense as of September 30, 2015.  

The aggregate intrinsic value, noted in the tables below, represents the amount by which the current market value of the underlying stock exceeds the exercise price as of September 30, 2015. Given there is no exercise price for restricted stock, the amount is equal to the current market value of the stock. This amount changes based on changes in the market value of the Company’s common stock.

The following table summarizes restricted stock awarded under the 2006 Equity Compensation Plan:
 
September 30, 2015
 
Shares
 
Weighted-Average Grant Date Fair Value
 
Aggregate Intrinsic Value
(in thousands)
Non-vested at December 31, 2014
134,108

 
$
16.66

 
 
Granted
36,150

 
18.50

 
 
Vested
(15,692
)
 
15.82

 
 
Forfeited
(500
)
 
18.07

 
 
Non-vested at September 30, 2015
154,066

 
$
17.17

 
$
2,713



8


The weighted-average remaining contractual term for non-vested service award grants at September 30, 2015, was 3.17 years. 

The following table summarizes options outstanding under the 2006 Equity Compensation Plan and remaining outstanding unexercised options under the 1997 Stock Incentive Plan.  
 
September 30, 2015
 
Shares
 
Weighted-Average Exercise Price
 
Aggregate Intrinsic Value
(in thousands)
Outstanding at December 31, 2014
30,012

 
$
14.00

 
$

Granted

 

 

Exercised

 

 

Forfeited

 

 

Outstanding at September 30, 2015
30,012

 
$
14.00

 
$
108

Options exercisable at September 30, 2015
30,012

 
$
14.00

 
$
108


As of September 30, 2015, options outstanding and exercisable are summarized as follows:
Exercise Prices
 
Options Outstanding
 
Weighted-Average Remaining Contractual Life (years)
 
Options Exercisable
$
14.00

 
25,012

 
3.45
 
25,012

$
14.00

 
5,000

 
4.09
 
5,000

$
14.00

 
30,012

 
3.56
 
30,012


Note 3.        Securities

Amortized costs and fair values of securities held to maturity are summarized as follows.
 
September 30, 2015
(Dollars in thousands)
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Held to Maturity
 
 
 
 
 
 
 
Obligations of states and political subdivisions
$
1,500

 
$

 
$
(125
)
 
$
1,375

Total
$
1,500

 
$

 
$
(125
)
 
$
1,375


 
December 31, 2014
(Dollars in thousands)
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Held to Maturity
 
 
 
 
 
 
 
Obligations of states and political subdivisions
$
1,500

 
$

 
$
(103
)
 
$
1,397

Total
$
1,500

 
$

 
$
(103
)
 
$
1,397


The amortized cost and fair value of securities held to maturity as of September 30, 2015, by contractual maturity are shown below. 
 
September 30, 2015
(Dollars in thousands)
Amortized
Cost
 
Fair
Value
Held to Maturity
 
 
 
Due after ten years
$
1,500

 
$
1,375

Total
$
1,500

 
$
1,375


9




Amortized costs and fair values of securities available for sale are summarized as follows:
 
September 30, 2015
(Dollars in thousands)
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Available for Sale
 
 
 
 
 
 
 
U.S. government agencies
$
67,119

 
$
656

 
$
(58
)
 
$
67,717

U.S. Treasury securities
50

 

 

 
50

Obligations of states and political subdivisions
75,131

 
1,908

 
(470
)
 
76,569

Mortgage-backed securities:
 
 
 
 
 
 
 
Agency
137,836

 
4,282

 
(434
)
 
141,684

Non-agency
14,914

 
28

 
(60
)
 
14,882

Other asset backed securities
54,958

 
505

 
(475
)
 
54,988

Corporate securities
17,554

 
2

 
(667
)
 
16,889

Total
$
367,562

 
$
7,381

 
$
(2,164
)
 
$
372,779


 
December 31, 2014
(Dollars in thousands)
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Available for Sale
 
 
 
 
 
 
 
U.S. government agencies
$
41,317

 
$
283

 
$
(203
)
 
$
41,397

Obligations of states and political subdivisions
55,541

 
2,408

 
(209
)
 
57,740

Mortgage-backed securities:
 
 
 
 
 
 
 

Agency
169,257

 
4,698

 
(742
)
 
173,213

Non-agency
28,235

 
115

 
(227
)
 
28,123

Other asset backed securities
31,338

 
433

 
(58
)
 
31,713

Corporate securities
16,545

 
131

 
(599
)
 
16,077

Total
$
342,233

 
$
8,068

 
$
(2,038
)
 
$
348,263


The amortized cost and fair value of securities available for sale as of September 30, 2015, by contractual maturity are shown below.  Maturities may differ from contractual maturities in corporate and mortgage-backed securities because the securities and mortgages underlying the securities may be called or repaid without any penalties.  Therefore, these securities are not included in the maturity categories in the following maturity summary.
 
September 30, 2015
(Dollars in thousands)
Amortized
Cost
 
Fair
Value
Due in one year or less
$
320

 
$
321

Due after one year through five years
10,639

 
11,067

Due after five years through ten years
25,868

 
25,675

Due after ten years
123,027

 
124,162

Mortgage-backed securities
152,750

 
156,566

Other asset backed securities
54,958

 
54,988

Total
$
367,562

 
$
372,779


Proceeds from maturities, calls, principal repayments and sales of securities available for sale during the nine months ended September 30, 2015, were $82.3 million.  Gross gains of $175,000 and gross losses of $37,000 were realized, respectively.  The tax expense applicable to these net realized gains amounted to $47,000.

The carrying value of securities pledged to qualify for fiduciary powers, to secure public monies and for other purposes as required by law amounted to $109.5 million and $125.7 million at September 30, 2015 and December 31, 2014, respectively.

10


Investments in an unrealized loss position that are temporarily impaired are as follows:

(Dollars in thousands)
 
Less than Twelve Months
 
Twelve Months or Greater
 
Total
September 30, 2015
 
Fair Value
 
Gross
Unrealized Losses
 
Fair Value
 
Gross
Unrealized Losses
 
Fair Value
 
Gross
Unrealized Losses
Held to Maturity
 
 
 
 
 
 
 
 
 
 
 
 
Obligations of states and political subdivisions
 
$
1,375

 
$
(125
)
 
$

 
$

 
$
1,375

 
$
(125
)
Total
 
$
1,375

 
$
(125
)
 
$

 
$

 
$
1,375

 
$
(125
)
 
 
 
 
 
 
 
 
 
 
 
 
 
Available for Sale
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government agencies
 
$
12,515

 
$
(24
)
 
$
2,481

 
$
(34
)
 
$
14,996

 
$
(58
)
Obligations of states and political subdivisions
 
18,340

 
(306
)
 
978

 
(164
)
 
19,318

 
(470
)
Mortgage-backed securities:
 
 

 
 

 
 

 
 

 
 

 
 

Agency
 
18,710

 
(148
)
 
9,372

 
(286
)
 
28,082

 
(434
)
Non-agency
 
9,370

 
(46
)
 
1,861

 
(14
)
 
11,231

 
(60
)
Other asset backed securities
 
21,564

 
(220
)
 
12,244

 
(255
)
 
33,808

 
(475
)
Corporate securities
 
13,193

 
(414
)
 
2,747

 
(253
)
 
15,940

 
(667
)
Total
 
$
93,692

 
$
(1,158
)
 
$
29,683

 
$
(1,006
)
 
$
123,375

 
$
(2,164
)

(Dollars in thousands)
 
Less than Twelve Months
 
Twelve Months or Greater
 
Total
December 31, 2014
 
Fair Value
 
Gross Unrealized Losses
 
Fair Value
 
Gross Unrealized Losses
 
Fair Value
 
Gross Unrealized Losses
Held to Maturity
 
 
 
 
 
 
 
 
 
 
 
 
Obligations of states and political subdivisions
 
$
1,397

 
$
(103
)
 
$

 
$

 
$
1,397

 
$
(103
)
Total
 
$
1,397

 
$
(103
)
 
$

 
$

 
$
1,397

 
$
(103
)
 
 
 
 
 
 
 
 
 
 
 
 
 
Available for Sale
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government agencies
 
$
15,331

 
$
(65
)
 
$
5,833

 
$
(138
)
 
$
21,164

 
$
(203
)
Obligations of states and political subdivisions
 
2,780

 
(14
)
 
3,456

 
(195
)
 
6,236

 
(209
)
Mortgage-backed securities:
 
 
 
 
 
 
 
 
 
 

 
 

Agency
 
28,065

 
(327
)
 
11,027

 
(415
)
 
39,092

 
(742
)
Non-agency
 
15,488

 
(167
)
 
4,730

 
(60
)
 
20,218

 
(227
)
Other asset backed securities
 
6,594

 
(45
)
 
1,077

 
(13
)
 
7,671

 
(58
)
Corporate securities
 
9,192

 
(391
)
 
792

 
(208
)
 
9,984

 
(599
)
Total
 
$
77,450

 
$
(1,009
)
 
$
26,915

 
$
(1,029
)
 
$
104,365

 
$
(2,038
)

A total of 145 securities have been identified by the Company as temporarily impaired at September 30, 2015.  Of the 145 securities, 143 are investment grade and two are speculative grade.  Mortgage-backed securities, municipal securities, other asset backed securities and corporate securities make up the majority of the gross unrealized losses for temporarily impaired securities at September 30, 2015.  Market prices change daily and are affected by conditions beyond the control of the Company.  Although the Company has the ability to hold these securities until the temporary loss is recovered, decisions by management may necessitate a sale before the loss is fully recovered.  No such sales were anticipated or required as of September 30, 2015.  Investment decisions reflect the strategic asset/liability objectives of the Company.  The investment portfolio is analyzed frequently by the Company and managed to provide an overall positive impact to the Company’s consolidated income statement and balance sheet.

Other-than-temporary impairment losses

At September 30, 2015, the Company evaluated the investment portfolio for possible other-than-temporary impairment losses and concluded that no adverse change in cash flows occurred and did not consider any portfolio securities to be other-than-temporarily impaired.  Based on this analysis and because the Company does not intend to sell securities prior to maturity and it is more likely

11


than not the Company will not be required to sell any securities before recovery of amortized cost basis, which may be at maturity. For debt securities related to corporate securities, the Company determined that there was no other adverse change in the cash flows as viewed by a market participant; therefore, the Company does not consider the investments in these assets to be other-than-temporarily impaired at September 30, 2015.  However, there is a risk that the Company’s continuing reviews could result in recognition of other-than-temporary impairment charges in the future. For the three and nine months ended September 30, 2015 and the year ended December 31, 2014, no credit related impairment losses were recognized by the Company.

The Company’s investment in FHLB stock totaled $3.6 million at September 30, 2015 and December 31, 2014.  FHLB stock is generally viewed as a long-term investment and as a restricted security which is carried at cost because there is no market for the stock other than the FHLB or member institutions.  Therefore, when evaluating FHLB stock for impairment, its value is based on the ultimate recoverability of the par value rather than by recognizing temporary declines in value.  The Company does not consider this investment to be other-than-temporarily impaired at September 30, 2015, and no impairment has been recognized.  FHLB stock is shown in restricted securities on the consolidated balance sheets.

The Company also has an investment in Federal Reserve Bank (“FRB”) stock which totaled $1.7 million at September 30, 2015 and December 31, 2014, respectively. The investment in FRB stock is a required investment and is carried at cost since there is no ready market. The Company does not consider this investment to be other-than-temporarily impaired at September 30, 2015 and no impairment has been recognized. FRB stock is shown in the restricted securities line item on the consolidated balance sheets.

Note 4.        Loans, Net

The Company segregates its loan portfolio into three primary loan segments:  Real Estate Loans, Commercial Loans, and Consumer Loans.  Real estate loans are further segregated into the following classes: construction loans, loans secured by farmland, loans secured by 1-4 family residential real estate, and other real estate loans.  Other real estate loans include commercial real estate loans.  The consolidated loan portfolio was composed of the following:
 
September 30, 2015
 
December 31, 2014
(Dollars in thousands)
Outstanding
Balance
 
Percent of
Total Portfolio
 
Outstanding
Balance
 
Percent of
Total Portfolio
Real estate loans:
 
 
 
 
 
 
 
Construction
$
33,381

 
4.3
%
 
$
33,050

 
4.4
%
Secured by farmland
19,391

 
2.5

 
19,708

 
2.6

Secured by 1-4 family residential
273,176

 
35.0

 
265,216

 
35.1

Other real estate loans
258,012

 
33.0

 
255,236

 
33.8

Commercial loans
179,907

 
23.0

 
163,269

 
21.6

Consumer loans
17,000

 
2.2

 
18,367

 
2.5

Total Gross Loans (1)
$
780,867

 
100.0
%
 
$
754,846

 
100.0
%
Less allowance for loan losses
11,400

 
 

 
11,786

 
 
Net loans
$
769,467

 
 

 
$
743,060

 
 

(1) 
Includes net deferred loan costs and premiums of $3.3 million and $3.0 million, respectively.

The following tables present a contractual aging of the recorded investment in past due loans by class of loans:
 
September 30, 2015
(Dollars in thousands)
30-59 Days Past Due
 
60-89 Days Past Due
 
90 Days Or Greater
 
Total Past Due
 
Current
 
Total Loans
Real estate loans:
 
 
 
 
 
 
 
 
 
 
 
Construction
$

 
$
54

 
$

 
$
54

 
$
33,327

 
$
33,381

Secured by farmland

 

 

 

 
19,391

 
19,391

Secured by 1-4 family residential
181

 
233

 
1,818

 
2,232

 
270,944

 
273,176

Other real estate loans
592

 

 

 
592

 
257,420

 
258,012

Commercial loans
130

 

 

 
130

 
179,777

 
179,907

Consumer loans
56

 
2

 
20

 
78

 
16,922

 
17,000

Total
$
959

 
$
289

 
$
1,838

 
$
3,086

 
$
777,781

 
$
780,867



12


 
December 31, 2014
(Dollars in thousands)
30-59 Days Past Due
 
60-89 Days Past Due
 
90 Days Or Greater
 
Total Past Due
 
Current
 
Total Loans
Real estate loans:
 
 
 
 
 
 
 
 
 
 
 
Construction
$

 
$

 
$

 
$

 
$
33,050

 
$
33,050

Secured by farmland

 

 

 

 
19,708

 
19,708

Secured by 1-4 family residential
819

 

 
548

 
1,367

 
263,849

 
265,216

Other real estate loans

 

 

 

 
255,236

 
255,236

Commercial loans
138

 

 
320

 
458

 
162,811

 
163,269

Consumer loans
16

 
1

 
3,003

 
3,020

 
15,347

 
18,367

Total
$
973

 
$
1

 
$
3,871

 
$
4,845

 
$
750,001

 
$
754,846


The following table presents the recorded investment in nonaccrual loans and loans past due 90 days or more and still accruing by class of loans:
 
September 30, 2015
 
December 31, 2014
(Dollars in thousands)
Nonaccrual
 
Past due 90 days or more and still accruing
 
Nonaccrual
 
Past due 90 days or more and still accruing
Real estate loans:
 
 
 
 
 
 
 
Construction
$
212

 
$

 
$
247

 
$

Secured by 1-4 family residential
5,058

 
224

 
4,932

 

Other real estate loans
1,187

 

 
1,472

 

Commercial loans
68

 

 
290

 
30

Consumer loans
2,302

 

 
3,003

 

Total
$
8,827

 
$
224

 
$
9,944

 
$
30


If interest on nonaccrual loans had been accrued, such income would have approximated $305,300 and $544,000 for the nine months ended September 30, 2015 and the year ended December 31, 2014, respectively.

The Company utilizes an internal asset classification system as a means of measuring and monitoring credit risk in the loan portfolio.  Under the Company’s classification system, problem and potential problem loans are classified as “Special Mention”, “Substandard”, and “Doubtful”.

Special Mention: Loans with potential weaknesses that deserve management’s close attention.  If left uncorrected, the potential weaknesses may result in the deterioration of the repayment prospects for the credit.

Substandard:  Loans with well-defined weakness that jeopardize the liquidation of the debt.  Either the paying capacity of the borrower or the value of the collateral may be inadequate to protect the Company from potential losses.

Doubtful:  Loans with a very high possibility of loss.  However, because of important and reasonably specific pending factors, classification as a loss is deferred until a more exact status may be determined.

Loss: Loans are deemed uncollectible and are charged off immediately.

The following tables present the recorded investment in loans by class of loan that have been classified according to the internal classification system:
September 30, 2015
(Dollars in thousands)
Real Estate Construction
 
Real Estate Secured by Farmland
 
Real Estate Secured by 1-4 Family Residential
 
Other Real Estate Loans
 
Commercial
 
Consumer
 
Total
Pass
$
27,034

 
$
10,892

 
$
264,332

 
$
243,540

 
$
178,301

 
$
14,644

 
$
738,743

Special Mention
5,800

 

 
1,078

 
6,223

 
1,410

 
16

 
14,527

Substandard
547

 
8,499

 
6,608

 
7,062

 
196

 
2,338

 
25,250

Doubtful

 

 
1,158

 
1,187

 

 

 
2,345

Loss

 

 

 

 

 
2

 
2

Ending Balance
$
33,381

 
$
19,391

 
$
273,176

 
$
258,012

 
$
179,907

 
$
17,000

 
$
780,867


13



December 31, 2014
(Dollars in thousands)
Real Estate Construction
 
Real Estate Secured by Farmland
 
Real Estate Secured by 1-4 Family Residential
 
Other Real Estate Loans
 
Commercial
 
Consumer
 
Total
Pass
$
25,637

 
$
11,203

 
$
255,898

 
$
232,169

 
$
159,595

 
$
15,310

 
$
699,812

Special Mention
6,764

 
7,903

 
1,518

 
15,687

 
3,059

 
18

 
34,949

Substandard
649

 
602

 
7,348

 
7,380

 
369

 
3,019

 
19,367

Doubtful

 

 
452

 

 
246

 
3

 
701

Loss

 

 

 

 

 
17

 
17

Ending Balance
$
33,050

 
$
19,708

 
$
265,216

 
$
255,236

 
$
163,269

 
$
18,367

 
$
754,846


The following tables present loans individually evaluated for impairment by class of loan:
 
September 30, 2015
(Dollars in thousands)
Recorded Investment
 
Unpaid Principal Balance
 
Related Allowance
 
Average Recorded Investment
 
Interest Income Recognized
With no related allowance recorded:
 
 
 
 
 
 
 
 
 
Real estate loans:
 
 
 
 
 
 
 
 
 
Construction
$
105

 
$
105

 
$

 
$
118

 
$

Secured by farmland
7,903

 
7,903

 

 
7,903

 
177

Secured by 1-4 family residential
1,083

 
1,083

 

 
1,094

 
2

Other real estate loans

 

 

 

 

Commercial loans
461

 
461

 

 
470

 
13

Consumer loans

 

 

 

 

Total with no related allowance
$
9,552

 
$
9,552

 
$

 
$
9,585

 
$
192

With an allowance recorded:
 

 
 

 
 

 
 

 
 

Real estate loans:
 

 
 

 
 

 
 

 
 

Construction
$
107

 
$
107

 
$
57

 
$
111

 
$

Secured by farmland

 

 

 

 

Secured by 1-4 family residential
4,445

 
4,496

 
1,376

 
4,480

 
9

Other real estate loans
4,220

 
4,220

 
463

 
4,236

 
118

Commercial loans
307

 
307

 
46

 
334

 
12

Consumer loans
2,302

 
2,302

 
1,020

 
2,662

 

Total with a related allowance
$
11,381

 
$
11,432

 
$
2,962

 
$
11,823

 
$
139

Total
$
20,933

 
$
20,984

 
$
2,962

 
$
21,408

 
$
331

 

14


 
December 31, 2014
(Dollars in thousands)
Recorded Investment
 
Unpaid Principal Balance
 
Related Allowance
 
Average Recorded Investment
 
Interest Income Recognized
With no related allowance recorded:
 
 
 
 
 
 
 
 
 
Real estate loans:
 
 
 
 
 
 
 
 
 
Construction
$
131

 
$
131

 
$

 
$
138

 
$

Secured by farmland
7,903

 
7,903

 

 
7,903

 
454

Secured by 1-4 family residential
1,919

 
2,047

 

 
2,032

 
16

Other real estate loans
3,289

 
3,289

 

 
3,352

 
104

Commercial loans
448

 
448

 

 
454

 
18

Consumer loans

 

 

 

 

Total with no related allowance
$
13,690

 
$
13,818

 
$

 
$
13,879

 
$
592

With an allowance recorded:
 

 
 

 
 

 
 

 
 

Real estate loans:
 

 
 

 
 

 
 

 
 

Construction
$
115

 
$
115

 
$
66

 
$
124

 
$

Secured by farmland

 

 

 

 

Secured by 1-4 family residential
3,694

 
3,746

 
1,370

 
3,704

 
11

Other real estate loans
1,242

 
1,242

 
294

 
1,260

 
69

Commercial loans
398

 
1,248

 
292

 
783

 
7

Consumer loans
3,019

 
3,019

 
647

 
3,021

 
2

Total with a related allowance
$
8,468

 
$
9,370

 
$
2,669

 
$
8,892

 
$
89

Total
$
22,158

 
$
23,188

 
$
2,669

 
$
22,771

 
$
681

 
The “Recorded Investment” amounts in the table above represent the outstanding principal balance net of charge-offs and nonaccrual payments to interest on each loan represented in the table.  The “Unpaid Principal Balance” represents the outstanding principal balance on each loan represented in the table plus any amounts that have been charged-off on each loan and nonaccrual payments applied to principal.
 
Included in certain loan categories of impaired loans are troubled debt restructurings (“TDRs”). The total balance of TDRs at September 30, 2015 was $15.9 million of which $3.8 million were included in the Company’s nonaccrual loan totals at that date and $12.1 million represented loans performing as agreed according to the restructured terms. This compares with $6.9 million in total restructured loans at December 31, 2014.  The amount of the valuation allowance related to TDRs was $1.62 million and $517,000 as of September 30, 2015 and December 31, 2014, respectively.
 
Loan modifications that were classified as TDRs during the three and nine months ended September 30, 2015 and 2014 were as follows:
 
 
Loans Modified as TDRs
 
 
For the Three Months Ended September 30,
(Dollars in thousands)
 
2015
 
2014
Class of Loan
 
Number of Contracts
 
Pre-Modification Outstanding Recorded Investment
 
Post-Modification Outstanding Recorded Investment
 
Number of Contracts
 
Pre-Modification Outstanding Recorded Investment
 
Post-Modification Outstanding Recorded Investment
Real estate loans:
 
 
 
 
 
 
 
 
 
 
 
 
   Construction
 

 
$

 
$

 

 
$

 
$

   Secured by farmland
 

 

 

 

 

 

   Secured by 1-4 family residential
 

 

 

 
1

 
409

 
409

   Other real estate loans
 

 

 

 

 

 

Total real estate loans
 

 
$

 
$

 
1

 
$
409

 
$
409

Commercial loans
 

 

 

 

 

 

Consumer loans
 

 

 

 

 

 

Total
 

 
$

 
$

 
1

 
$
409

 
$
409



15


 
 
Loans Modified as TDRs
 
 
For the Nine Months Ended September 30,
(Dollars in thousands)
 
2015
 
2014
Class of Loan
 
Number of Contracts
 
Pre-Modification Outstanding Recorded Investment
 
Post-Modification Outstanding Recorded Investment
 
Number of Contracts
 
Pre-Modification Outstanding Recorded Investment
 
Post-Modification Outstanding Recorded Investment
Real estate loans:
 
 
 
 
 
 
 
 
 
 
 
 
   Construction
 

 
$

 
$

 

 
$

 
$

   Secured by farmland
 
1

 
7,903

 
7,903

 

 

 

   Secured by 1-4 family residential
 

 

 

 
4

 
1,190

 
1,142

   Other real estate loans
 

 

 

 
1

 
200

 
173

Total real estate loans
 
1

 
$
7,903

 
$
7,903

 
5

 
$
1,390

 
$
1,315

Commercial loans
 

 

 

 

 

 

Consumer loans
 
1

 
3,000

 
2,282

 

 

 

Total
 
2

 
$
10,903

 
$
10,185

 
5

 
$
1,390

 
$
1,315


There were no outstanding commitments to lend additional amounts to troubled debt restructured borrowers at September 30, 2015.

TDR payment defaults during three and nine months ended September 30, 2015 and 2014 were as follows:

 
 
For the Three Months Ended September 30,
(Dollars in thousands)
 
2015
 
2014
Class of Loan
 
Number of Loans
 
Recorded Investment
 
Number of Loans
 
Recorded Investment
Real estate loans:
 
 
 
 
 
 
 
 
   Construction
 

 
$

 

 
$

   Secured by farmland
 

 

 

 

   Secured by 1-4 family residential
 

 

 
2

 
200

   Other real estate loans
 

 

 
1

 
94

Total real estate loans
 

 
$

 
3

 
$
294

Commercial loans
 

 

 
1

 
49

Consumer loans
 

 

 

 

Total
 

 
$

 
4

 
$
343


 
 
For the Nine Months Ended September 30,
(Dollars in thousands)
 
2015
 
2014
Class of Loan
 
Number of Loans
 
Recorded Investment
 
Number of Loans
 
Recorded Investment
Real estate loans:
 
 
 
 
 
 
 
 
   Construction
 

 
$

 

 
$

   Secured by farmland
 

 

 

 

   Secured by 1-4 family residential
 

 

 
4

 
376

   Other real estate loans
 

 

 
1

 
94

Total real estate loans
 

 
$

 
5

 
$
470

Commercial loans
 

 

 
1

 
49

Consumer loans
 

 

 

 

Total
 

 
$

 
6

 
$
519


For purposes of this disclosure, a TDR payment default occurs when, within 12 months of the original TDR modification, either a full or partial charge-off occurs or a TDR becomes 90 days or more past due.


16


Note 5.        Allowance for Loan Losses

The following table presents, the total allowance for loan losses, the allowance by impairment methodology (individually evaluated for impairment or collectively evaluated for impairment), the total loans and loans by impairment methodology (individually evaluated for impairment or collectively evaluated for impairment).
 
September 30, 2015
(Dollars in thousands)
Real Estate Construction
 
Real Estate Secured by Farmland
 
Real Estate Secured by 1-4 Family Residential
 
Other Real Estate Loans
 
Commercial
 
Consumer
 
Total
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2014
$
550

 
$
179

 
$
3,966

 
$
3,916

 
$
2,354

 
$
821

 
$
11,786

Charge-offs

 

 
(100
)
 
(9
)
 
(246
)
 
(46
)
 
(401
)
Recoveries
41

 

 
338

 
23

 
11

 
9

 
422

Provision (recovery)
189

 
12

 
(369
)
 
(200
)
 
(428
)
 
389

 
(407
)
Balance at September 30, 2015
$
780

 
$
191

 
$
3,835

 
$
3,730

 
$
1,691

 
$
1,173

 
$
11,400

Ending allowance:
 

 
 

 
 

 
 

 
 
 
 
 
 
Ending allowance balance attributable to loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
Individually evaluated for impairment
$
57

 
$

 
$
1,376

 
$
463

 
$
46

 
$
1,020

 
$
2,962

Collectively evaluated for impairment
723

 
191

 
2,459

 
3,267

 
1,645

 
153

 
8,438

Total ending allowance balance
$
780

 
$
191

 
$
3,835

 
$
3,730

 
$
1,691

 
$
1,173

 
$
11,400

Loans:
 

 
 

 
 

 
 

 
 

 
 

 
 

Individually evaluated for impairment
$
212

 
$
7,903

 
$
5,528

 
$
4,220

 
$
768

 
$
2,302

 
$
20,933

Collectively evaluated for impairment
33,169

 
11,488

 
267,648

 
253,792

 
179,139

 
14,698

 
759,934

Total ending loans balance
$
33,381

 
$
19,391

 
$
273,176

 
$
258,012

 
$
179,907

 
$
17,000

 
$
780,867


17


 
December 31, 2014
(Dollars in thousands)
Real Estate Construction
 
Real Estate Secured by Farmland
 
Real Estate Secured by 1-4 Family Residential
 
Other Real Estate Loans
 
Commercial
 
Consumer
 
Total
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2013
$
847

 
$
166

 
$
6,734

 
$
3,506

 
$
1,890

 
$
177

 
$
13,320

Adjustment for the sale of majority interest in consolidated subsidiary

 

 
(95
)
 

 

 

 
(95
)
Charge-offs
(1,186
)
 

 
(1,380
)
 
(747
)
 
(959
)
 
(36
)
 
(4,308
)
Recoveries
258

 

 
342

 
110

 
104

 
95

 
909

Provision
631

 
13

 
(1,635
)
 
1,047

 
1,319

 
585

 
1,960

Balance at December 31, 2014
$
550

 
$
179

 
$
3,966

 
$
3,916

 
$
2,354

 
$
821

 
$
11,786

Ending allowance:
 

 
 

 
 

 
 

 
 
 
 
 
 
Ending allowance balance attributable to loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
Individually evaluated for impairment
$
66

 
$

 
$
1,370

 
$
294

 
$
292

 
$
647

 
$
2,669

Collectively evaluated for impairment
484

 
179

 
2,596

 
3,622

 
2,062

 
174

 
9,117

Total ending allowance balance
$
550

 
$
179

 
$
3,966

 
$
3,916

 
$
2,354

 
$
821

 
$
11,786

Loans:
 

 
 

 
 

 
 

 
 

 
 

 
 

Individually evaluated for impairment
$
246

 
$
7,903

 
$
5,613

 
$
4,531

 
$
846

 
$
3,019

 
$
22,158

Collectively evaluated for impairment
32,804

 
11,805

 
259,603

 
250,705

 
162,423

 
15,348

 
732,688

Total ending loans balance
$
33,050

 
$
19,708

 
$
265,216

 
$
255,236

 
$
163,269

 
$
18,367

 
$
754,846


Note 6.        Earnings Per Share

The following shows the weighted-average number of shares used in computing earnings per share and the effect on weighted-average number of shares of diluted potential common stock. Nonvested restricted shares are included in basic earnings per share because of dividend participation rights. Potential dilutive common stock had no effect on income available to common stockholders.
 
For the Three Months Ended September 30,
 
2015
 
2014
 
Shares
 
Per Share Amount
 
Shares
 
Per Share Amount
Earnings per share, basic
7,162,930

 
$
0.32

 
7,108,450

 
$
0.30

Effect of dilutive securities:
 

 
 

 
 

 
 

Stock options
6,487

 
 
 
11,102

 
 
Warrant
11,716

 
 
 
14,710

 
 
Earnings per share, diluted
7,181,133

 
$
0.32

 
7,134,262

 
$
0.30



18


 
For the Nine Months Ended September 30,
 
2015
 
2014
 
Shares
 
Per Share Amount
 
Shares
 
Per Share Amount
Earnings per share, basic
7,146,495

 
$
0.99

 
7,099,506

 
$
0.84

Effect of dilutive securities:
 

 
 

 
 

 
 

Stock options
6,880

 
 
 
10,778

 
 
Warrant
13,167

 
 
 
13,891

 
 
Earnings per share, diluted
7,166,542

 
$
0.98

 
7,124,175

 
$
0.84


The warrant and none of the stock options were considered anti-dilutive as of September 30, 2015 and 2014.

Note 7.        Segment Reporting

The Company operates in a decentralized fashion in the following principal business activities: retail banking services; wealth management services; and mortgage banking services.  
Revenue from retail banking activity consists primarily of interest earned on loans and investment securities and service charges on deposit accounts.
Revenue from the wealth management activities is comprised of fees based upon the market value of the accounts under administration as well as commissions on investment transactions.
Revenue from the mortgage banking activities is comprised of interest earned on loans and fees received as a result of the mortgage origination process. The Company recognized gains on the sale of loans as part of other income. On May 15, 2014, the Company sold all of its majority interest in Southern Trust Mortgage and as a result, any mortgage banking activity for the Company subsequent to the sale date is included with the results of the retail banking segment. Any activity since the sale of Southern Trust Mortgage is considered to be immaterial and incidental to the Company's retail banking activities. The mortgage banking activities will continue to be evaluated and will be separately reported as a distinguishable segment if determined to be of significance to the reader of these financial statements or if the related operating results are believed to meet the quantitative tests for disclosure. Mortgage banking activities for the three and nine months ended September 30, 2014 are the result of Southern Trust Mortgage activity that was consolidated with the Company through the date of sale.
Middleburg Bank and the Company have assets in custody with Middleburg Trust Company and accordingly pay Middleburg Trust Company a monthly fee. Middleburg Bank also pays interest to Middleburg Trust Company on deposit accounts with Middleburg Bank. Middleburg Bank provided a warehouse line, office space, data processing and accounting services to Southern Trust Mortgage for which it received income. Transactions related to these relationships are eliminated to reach consolidated totals.

19


The following tables represent reportable segment information for the three and nine months ended September 30, 2015 and 2014, respectively:
 
For the Three Months Ended
 
For the Three Months Ended
 
September 30, 2015
 
September 30, 2014
(In Thousands)
Retail
Banking
Wealth
Management
Mortgage
Banking
Intercompany
Eliminations
Consolidated
 
Retail
Banking
Wealth
Management
Mortgage
Banking
Intercompany
Eliminations
Consolidated
Revenues:
 
 
 
 
 
 
 
 
 
 
 
Interest income
$
10,700

$
3

$

$

$
10,703

 
$
10,876

$
4

$

$
(90
)
$
10,790

Trust and investment fee income
132

1,209


(41
)
1,300

 
193

1,157


(38
)
1,312

Other income
1,054




1,054

 
989



(21
)
968

Total operating income
11,886

1,212


(41
)
13,057

 
12,058

1,161


(149
)
13,070

Expenses:
 
 
 
 
 
 
 
 
 
 
 
Interest expense
1,044




1,044

 
1,335



(90
)
1,245

Salaries and employee benefits
4,355

479



4,834

 
3,877

564



4,441

Provision for (recovery of) loan losses
(432
)



(432
)
 
550




550

Other
2,465

2,016


(41
)
4,440

 
3,722

287


(59
)
3,950

Total operating expenses
7,432

2,495


(41
)
9,886

 
9,484

851


(149
)
10,186

Income before income taxes and non-controlling interest
4,454

(1,283
)


3,171

 
2,574

310



2,884

Income tax expense
722

128



850

 
635

128



763

Net Income
3,732

(1,411
)


2,321

 
1,939

182



2,121

Non-controlling interest in income of consolidated subsidiary





 





Net income attributable to Middleburg Financial Corporation
$
3,732

$
(1,411
)
$

$

$
2,321

 
$
1,939

$
182

$

$

$
2,121

Total assets
$
1,259,205

$
6,615

$

$
(4,530
)
$
1,261,290

 
$
1,322,493

$
12,505

$

$
(127,271
)
$
1,207,727

Capital expenditures
$
285

$

$

$

$
285

 
$
307

$
1

$
3

$

$
311

Goodwill and other intangibles
$

$
3,679

$

$

$
3,679

 
$

$
3,850

$

$

$
3,850


20


 
For the Nine Months Ended
 
For the Nine Months Ended
 
September 30, 2015
 
September 30, 2014
(In Thousands)
Retail
Banking
Wealth
Management
Mortgage
Banking
Intercompany
Eliminations
Consolidated
 
Retail
Banking
Wealth
Management
Mortgage
Banking
Intercompany
Eliminations
Consolidated
Revenues:
 
 
 
 
 
 
 
 
 
 
 
Interest income
$
31,746

$
8

$

$

$
31,754

 
$
32,665

$
11

$
450

$
(288
)
$
32,838

Trust and investment fee income
415

3,752


(123
)
4,044

 
479

3,339


(115
)
3,703

Other income
3,753




3,753

 
3,657


5,121

(46
)
8,732

Total operating income
35,914

3,760


(123
)
39,551

 
36,801

3,350

5,571

(449
)
45,273

Expenses:
 
 
 
 
 
 
 
 
 
 
 
Interest expense
3,151




3,151

 
4,055


304

(288
)
4,071

Salaries and employee benefits
13,045

1,619



14,664

 
11,996

1,699

3,772


17,467

Provision for (recovery of) loan losses
(407
)



(407
)
 
1,476


34


1,510

Other
10,126

2,585


(123
)
12,588

 
11,792

837

1,722

(161
)
14,190

Total operating expenses
25,915

4,204


(123
)
29,996

 
29,319

2,536

5,832

(449
)
37,238

Income before income taxes and non-controlling interest
9,999

(444
)


9,555

 
7,482

814

(261
)

8,035

Income tax expense
2,063

443



2,506

 
1,847

332



2,179

Net Income
7,936

(887
)


7,049

 
5,635

482

(261
)

5,856

Non-controlling interest in (income) loss of consolidated subsidiary





 


98


98

Net income attributable to Middleburg Financial Corporation
$
7,936

$
(887
)
$

$

$
7,049

 
$
5,635

$
482

$
(163
)
$

$
5,954

Total assets
$
1,259,205

$
6,615

$

$
(4,530
)
$
1,261,290

 
$
1,322,493

$
12,505

$

$
(127,271
)
$
1,207,727

Capital expenditures
$
2,756

$

$

$

$
2,756

 
$
748

$
11

$
3

$

$
762

Goodwill and other intangibles
$

$
3,679

$

$

$
3,679

 
$

$
3,850

$

$

$
3,850


Note 8.        Capital Purchase Program

On January 30, 2009, as part of the Capital Purchase Program established by the U.S. Department of the Treasury (the “Treasury”) under the Emergency Economic Stabilization Act of 2008, the Company entered into a Letter Agreement and Securities Purchase Agreement—Standard Terms (collectively, the “Purchase Agreement”) with the Treasury, pursuant to which the Company sold (i) 22,000 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, par value $2.50 per share, having a liquidation preference of $1,000 per share (the “Preferred Stock”) and (ii) a warrant (the “Warrant”) to purchase 208,202 shares of the Company’s common stock, par value $2.50 per share, at an initial exercise price of $15.85 per share. As a result of the completion of a public stock offering in 2009, the number of shares of common stock underlying the Warrant was reduced by one-half to 104,101 and the Company redeemed all 22,000 shares of Preferred Stock pursuant to the Purchase Agreement. During 2011, the Warrant was sold by the U.S. Treasury at public auction and has not been exercised as of September 30, 2015.

Note 9.        Fair Value Measurements

The Company follows ASC 820, "Fair Value Measurements" to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures.  ASC 820 clarifies that fair value of certain assets and liabilities is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.

ASC 820 specifies a hierarchy of valuation techniques based on whether the inputs are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions.  The three levels of the fair value hierarchy under ASC 820 based on these two types of inputs are as follows:


21


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 pricing observability 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.

Measured on a recurring basis

The following describes the valuation techniques and inputs used by the Company in determining the fair value of certain assets recorded at fair value on a recurring basis in the financial statements.

Securities Available for Sale

The Company primarily values its investment portfolio using Level II fair value measurements, but may also use Level I or Level III measurements if required by the composition of the portfolio. If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level II). In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified as Level III of the valuation hierarchy.

Interest Rate Swaps and Interest Rate Cap

Interest rate swaps and caps are recorded at fair value based on third party vendors who compile prices from various sources and may determine fair value of identical or similar instruments by using pricing models that consider observable market data (Level II).

The following tables present the balances of assets and liabilities measured at fair value on a recurring basis as of September 30, 2015 and December 31, 2014.
(Dollars in thousands)
 
September 30, 2015
Description
 
Total
 
Level I
 
Level II
 
Level III
Assets:
 
 
 
 
 
 
 
 
U.S. government agencies
 
$
67,717

 
$

 
$
67,717

 
$

U.S. Treasury securities
 
50

 

 
50

 

Obligations of states and political subdivisions
 
76,569

 

 
76,569

 

Mortgage-backed securities:
 
 

 
 

 
 

 
 

Agency
 
141,684

 

 
141,684

 

Non-agency
 
14,882

 

 
14,882

 

Other asset backed securities
 
54,988

 

 
54,988

 

Corporate securities
 
16,889

 

 
16,889

 

Interest rate swaps
 
136

 

 
136

 

Interest rate cap
 
35

 

 
35

 

Liabilities:
 
 
 
 
 
 
 
 
Interest rate swaps
 
619

 

 
619

 

 

22


(Dollars in thousands)
 
December 31, 2014
Description
 
Total
 
Level I
 
Level II
 
Level III
Assets:
 
 
 
 
 
 
 
 
U.S. government agencies
 
$
41,397

 
$

 
$
41,397

 
$

Obligations of states and political subdivisions
 
57,740

 

 
57,740

 

Mortgage-backed securities:
 
 

 
 

 
 

 
 

Agency
 
173,213

 

 
173,213

 

Non-agency
 
28,123

 

 
28,123

 

Other asset backed securities
 
31,713

 

 
31,713

 

Corporate securities
 
16,077

 

 
16,077

 


Interest rate swaps
 
50

 

 
50

 

Liabilities:
 
 
 
 
 
 
 
 
Interest rate swaps
 
337

 

 
337

 


Measured on nonrecurring basis

The Company may be required, from time to time, to measure and recognize certain other assets at fair value on a nonrecurring basis in accordance with GAAP. The following describes the valuation techniques and inputs used by the Company in determining the fair value of certain assets recorded at fair value on a nonrecurring basis in the financial statements.

Impaired Loans

Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected when due.  The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral.  Fair value is measured based on the value of the collateral securing the loans.  Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable.  The vast majority of the collateral is real estate.  The value of real estate collateral is determined utilizing a market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level II).  However, if the collateral is a house or building in the process of construction or if an appraisal of the real estate property is over two years old, then the fair value is considered Level III.  The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable financial statements of the business if not considered significant using observable market data.  Likewise, values for inventory and accounts receivable collateral are based on financial statement balances or aging reports (Level III).  Impaired loans allocated to the Allowance for Loan Losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the consolidated statements of income.

When collateral-dependent loans are performing in accordance with the original terms of their contract, the Company continues to use the appraisal that was performed at origination as the basis for the collateral value. When loans become collateral-dependent and considered nonperforming, they are reviewed to determine the next appropriate course of action, either foreclosure or modification with forbearance agreement. The loans would then be reappraised prior to foreclosure or before a forbearance agreement is executed. This process does not vary by loan type.

The Company's procedure to monitor the value of collateral for collateral-dependent impaired loans between receipt of the original appraisal and an updated appraisal is to review annual tax assessment records. At this time, adjustments are made, if necessary. Information considered in the determination not to order an updated appraisal includes the availability and reliability of tax assessment records and significant changes in capitalization rates for income properties. Other facts and circumstances on a case-by-case basis may be considered relative to a decision not to order an updated appraisal. If, in the judgment of management, a reliable collateral value cannot be obtained by an alternative method, an updated appraisal would be obtained.

Circumstances that may warrant a reappraisal for nonperforming loans might include foreclosure proceedings or a material adverse change in the borrower's condition or that of the collateral underlying the loan. In some cases, management may decide that an updated appraisal for a nonperforming loan is not necessary, In such cases, an estimate of the fair value of the collateral would be made by management by reference to current tax assessments, the latest appraised value, and knowledge of collateral value fluctuations in a loan's market area. If, in management's judgment, a reliable collateral value cannot be obtained by an alternative method, an updated appraisal would be obtained.

For the purpose of evaluating the allowance for loan losses, new appraisals are discounted by 10% for estimated selling costs when determining the amount of specific reserves. Thereafter, for collateral-dependent impaired loans, we consider each loan on

23


a case-by-case basis to determine whether or not the recorded values are appropriate given current market conditions. When necessary, new appraisals are obtained. If an appraisal is less than 12 months old, the only adjustment made is the 10% discount for selling costs. If an appraisal is older than 12 months, management will use judgment based on knowledge of current market values and specific facts surrounding any particular property to determine if an additional valuation adjustment may be necessary.

Other Real Estate Owned
 
The value of other real estate owned (“OREO”) is determined utilizing a market valuation approach based on an appraisal conducted by an independent, licensed appraiser using observable market data (Level II).  For OREO properties that may be in construction, the Company’s policy is to obtain “as-is” appraisals on an annual basis as opposed to “as-completed” appraisals.  This approach provides current values without regard to completion of any construction or renovation that may be in process.  Accordingly, the Company considers the valuations to be Level II valuations even though some properties may be in process of renovation or construction. If the collateral value is significantly adjusted due to differences in the comparable properties, or is discounted by the Company because of marketability or other factors, then the fair value is considered Level III. Any initial fair value adjustment is charged against the Allowance for Loan Losses. Any subsequent fair value adjustments are recorded in the period incurred and included in other non-interest expense on the consolidated statements of income.

For the purpose of OREO valuations, appraisals are discounted 10% for selling costs and it is the policy of the Company to obtain annual appraisals for properties held in accordance with the bank's OREO policy. Any fair value adjustments are recorded in the period incurred as loss on other real estate owned on the consolidated statements of income.

Repossessed Assets
 
The value of repossessed assets is determined by the Company based on marketability and other factors and is considered Level III.
 
The following table summarizes the Company’s non-financial assets that were measured at fair value on a nonrecurring basis during the period.
(Dollars in thousands)
 
September 30, 2015
 
 
Total
 
Level I
 
Level II
 
Level III
Assets:
 
 
 
 
 
 
 
 
Impaired loans
 
$
8,419

 
$

 
$
4,351

 
$
4,068

Other real estate owned
 
$
3,871

 
$

 
$
3,871

 
$

Repossessed assets (1)
 
$
1,044

 
$

 
$

 
$
1,044

 
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
December 31, 2014
 
 
Total
 
Level I
 
Level II
 
Level III
Assets:
 
 

 
 

 
 

 
 

Impaired loans
 
$
5,799

 
$

 
$
1,289

 
$
4,510

Other real estate owned
 
$
4,051

 
$

 
$
4,051

 
$

Repossessed assets (1)
 
$
1,132

 
$

 
$

 
$
1,132

(1)    Included in other assets on the consolidated balance sheets.

The following table presents quantitative information as of September 30, 2015 and December 31, 2014 about Level III fair value measurements for assets measured at fair value on a nonrecurring basis:
September 30, 2015
 
Fair Value
(in thousands)
 
Valuation Technique
 
Unobservable Inputs
 
Range
(Weighted Average)
Impaired loans
 
$
4,068

 
Discounted appraised value
 
Discount for age of appraisals
 
0% - 100% (5%)
Repossessed assets
 
$
1,044

 
Market analysis
 
Historical sales activity
 
50%


24


December 31, 2014
 
Fair Value
(in thousands)
 
Valuation Technique
 
Unobservable Inputs
 
Range
(Weighted Average)
Impaired loans
 
$
4,510

 
Discounted appraised value
 
Discount for age of appraisals
 
0% - 100% (7%)
Repossessed assets
 
$
1,132

 
Market analysis
 
Historical sales activity
 
50%

The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation.  Fair value is best determined based upon quoted market prices.  However, in many instances, there are no quoted market prices for the Company’s various financial instruments.  In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques.  Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows.  Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.  U.S. generally accepted accounting principles excludes certain financial instruments and all non-financial instruments from its disclosure requirements.  Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.

The following methods and assumptions were used to estimate the fair value of each class of financial instruments (not previously described) for which it is practicable to estimate that value:

Cash and Cash Equivalents

For cash and cash equivalents, the carrying amount is a reasonable estimate of fair value.

Securities held to maturity

Certain debt securities that management has the positive intent and ability to hold until maturity are recorded at amortized cost. Fair values are determined in a manner that is consistent with securities available for sale.

Restricted securities

The restricted security category is comprised of FHLB and Federal Reserve Bank stock. These stocks are classified as restricted securities because their ownership is restricted to certain types of entities and they lack a market. When the FHLB or Federal Reserve Bank repurchases stock, they repurchase at the stock's book value. Therefore, the carrying amounts of restricted securities approximate fair value.

Loans, Net

For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values.  For fixed rate loans, the fair value is estimated by discounting future cash flows using current market inputs at which loans with similar terms and qualities would be made to borrowers of similar credit quality.  Where quoted market prices were available, primarily for certain residential mortgage loans, such market rates were utilized as estimates for fair value. Fair value for impaired loans is described above.

Bank Owned Life Insurance

The carrying amount of bank owned life insurance is a reasonable estimate of fair value.

Accrued Interest Receivable and Payable

The carrying amounts of accrued interest approximate fair values.

Deposits

The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date.  For all other deposits, the fair value is determined using the discounted cash flow method.  The discount rate is equal to the rate currently offered on similar products.



25


Securities Sold Under Agreements to Repurchase

The carrying amounts approximate fair values.

FHLB Borrowings and Subordinated Debt

For variable rate long-term debt, fair values are based on carrying values.  For fixed rate debt, fair values are estimated based on observable market prices and discounted cash flow analysis using interest rates for borrowings of similar remaining maturities and characteristics.  The fair values of the Company's Subordinated Debentures are estimated using discounted cash flow analysis based on the Company's current incremental borrowing rates for similar types of borrowing arrangements.

Off-Balance Sheet Financial Instruments

The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties.  For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates.  The fair value of standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date.  At September 30, 2015 and December 31, 2014, the fair values of loan commitments and standby letters of credit were deemed immaterial; therefore, they have not been included in the tables below.

Fair Value of Financial Instruments

The estimated fair values, and related carrying amounts, of the Company's financial instruments are as follows:
(Dollars in thousands)
September 30, 2015
 
 
 
 
 
Fair value measurements using:
 
Carrying
Amount
 
Total Fair Value
 
Level I
 
Level II
 
Level III
Financial assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
39,779

 
$
39,779

 
$
39,779

 
$

 
$

Securities held to maturity
1,500

 
1,375

 

 
1,375

 

Securities available for sale
372,779

 
372,779

 

 
372,779

 

Loans, net
769,467

 
781,466

 

 
4,351

 
777,115

Bank owned life insurance
23,107

 
23,107

 

 
23,107

 

Accrued interest receivable
5,007

 
5,007

 

 
5,007

 

Interest rate swaps
136

 
136

 

 
136

 

Interest rate cap
35

 
35

 

 
35

 

Financial liabilities:
 

 
 

 
 
 
 
 
 
Deposits
$
1,032,353

 
$
1,032,511

 
$

 
$
1,032,511

 
$

Securities sold under agreements to repurchase
24,468

 
24,468

 

 
24,468

 

FHLB borrowings
60,000

 
60,022

 

 
60,022

 

Subordinated debt
5,155

 
5,157

 

 
5,157

 

Accrued interest payable
396

 
396

 

 
396

 

Interest rate swaps
619

 
619

 

 
619

 



26


(Dollars in thousands)
December 31, 2014
 
 
 
 
 
Fair value measurements using:
 
Carrying
Amount
 
Total Fair Value
 
Level I
 
Level II
 
Level III
Financial assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
55,022

 
$
55,022

 
$
55,022

 
$

 
$

Securities held to maturity
1,500

 
1,397

 

 
1,397

 

Securities available for sale
348,263

 
348,263

 

 
348,263

 

Loans, net
743,060

 
751,572

 

 
1,289

 
750,283

Bank-owned life insurance
22,617

 
22,617

 

 
22,617

 

Accrued interest receivable
4,285

 
4,285

 

 
4,285

 

Interest rate swaps
50

 
50

 

 
50

 

Financial liabilities:
 
 
 
 
 
 
 
 
 
Deposits
$
989,080

 
$
989,563

 
$

 
$
989,563

 
$

Securities sold under agreements to repurchase
38,551

 
38,551

 

 
38,551

 

FHLB borrowings
55,000

 
55,042

 

 
55,042

 

Subordinated debt
5,155

 
5,159

 

 
5,159

 

Accrued interest payable
403

 
403

 

 
403

 

Interest rate swaps
337

 
337

 

 
337

 

 
The Company assumes interest rate risk as a result of its normal operations.  As a result, the fair values of the Company's financial instruments will change when interest rate levels change, which may be either favorable or unfavorable to the Company.  Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk.  However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment.  Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment.  Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company's overall interest rate risk.

Note 10.        Recent Accounting Pronouncements

In June 2014, the FASB issued ASU No. 2014-11, “Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures.” This ASU aligns the accounting for repurchase-to-maturity transactions and repurchase agreements executed as a repurchase financing with the accounting for other typical repurchase agreements. The new guidance eliminates sale accounting for repurchase-to-maturity transactions and supersedes the guidance under which a transfer of a financial asset and a contemporaneous repurchase financing could be accounted for on a combined basis as a forward agreement. The amendments in the ASU also require a new disclosure for transactions economically similar to repurchase agreements in which the transferor retains substantially all of the exposure to the economic return on the transferred financial assets throughout the term of the transaction. Additional disclosures will be required for the nature of collateral pledged in repurchase agreements and similar transactions accounted for as secured borrowings. The amendments in this ASU are effective for the first interim or annual period beginning after December 15, 2014; however, the disclosure for transactions accounted for as secured borrowings is required to be presented for annual periods beginning after December 15, 2014, and interim periods beginning after March 15, 2015. Early adoption is not permitted. The adoption of the new guidance did not have a material impact on our consolidated financial statements.

In June 2014, the FASB issued ASU No. 2014-12, “Compensation - Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period.” The new guidance applies to reporting entities that grant employees share-based payments in which the terms of the award allow a performance target to be achieved after the requisite service period. The amendments in the ASU require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. Existing guidance in “Compensation - Stock Compensation (Topic 718),” should be applied to account for these types of awards. The amendments in this ASU are effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. Early adoption is permitted and reporting entities may choose to apply the amendments in the ASU either on a prospective or retrospective basis. The Company is currently assessing the impact that ASU 2014-12 will have on its consolidated financial statements.

In August 2014, the FASB issued ASU No. 2014-15, “Presentation of Financial Statements - Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern.” This update is intended to provide guidance about management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going

27


concern and to provide related footnote disclosures. Management is required under the new guidance to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date the financial statements are issued when preparing financial statements for each interim and annual reporting period. If conditions or events are identified, the ASU specifies the process that must be followed by management and also clarifies the timing and content of going concern footnote disclosures in order to reduce diversity in practice. The amendments in this ASU are effective for annual periods and interim periods within those annual periods beginning after December 15, 2016. Early adoption is permitted. The Company does not expect the adoption of ASU 2014-15 to have a material impact on its consolidated financial statements.

In November 2014, the FASB issued ASU No. 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.” The amendments in ASU do not change the current criteria in U.S. GAAP for determining when separation of certain embedded derivative features in a hybrid financial instrument is required. The amendments clarify how current U.S. GAAP should be interpreted in evaluating the economic characteristics and risks of a host contract in a hybrid financial instrument that is issued in the form of a share. Specifically, the amendments clarify that an entity should consider all relevant terms and features, including the embedded derivative feature being evaluated for bifurcation, in evaluating the nature of the host contract. Furthermore, the amendments clarify that no single term or feature would necessarily determine the economic characteristics and risks of the host contract. Rather, the nature of the host contract depends upon the economic characteristics and risks of the entire hybrid financial instrument. The amendments in this ASU also clarify that, in evaluating the nature of a host contract, an entity should assess the substance of the relevant terms and features (i.e., the relative strength of the debt-like or equity-like terms and features given the facts and circumstances) when considering how to weight those terms and features. The amendments in this ASU are effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption, including adoption in an interim period, is permitted. The Company does not expect the adoption of ASU 2014-16 to have a material impact on its consolidated financial statements.

In January 2015, the FASB issued ASU No. 2015-01, “Income Statement-Extraordinary and Unusual Items (Subtopic 225-20): Simplifying Income Statement Presentation by Eliminating the Concept of Extraordinary Items.” The amendments in this ASU eliminate from U.S. GAAP the concept of extraordinary items. Subtopic 225-20, Income Statement - Extraordinary and Unusual Items, required that an entity separately classify, present, and disclose extraordinary events and transactions. Presently, an event or transaction is presumed to be an ordinary and usual activity of the reporting entity unless evidence clearly supports its classification as an extraordinary item. If an event or transaction meets the criteria for extraordinary classification, an entity is required to segregate the extraordinary item from the results of ordinary operations and show the item separately in the income statement, net of tax, after income from continuing operations. The entity also is required to disclose applicable income taxes and either present or disclose earnings-per-share data applicable to the extraordinary item. The amendments in this ASU are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted provided that the guidance is applied from the beginning of the fiscal year of adoption. The Company does not expect the adoption of ASU 2015-01 to have a material impact on its consolidated financial statements.

In February 2015, the FASB issued ASU No. 2015-02, “Consolidation (Topic 810): Amendments to the Consolidation Analysis.” The amendments in this ASU are intended to improve targeted areas of consolidation guidance for legal entities such as limited partnerships, limited liability corporations, and securitization structures (collateralized debt obligations, collateralized loan obligations, and mortgage-backed security transactions). In addition to reducing the number of consolidation models from four to two, the new standard simplifies the FASB Accounting Standards Codification™ and improves current GAAP by placing more emphasis on risk of loss when determining a controlling financial interest, reducing the frequency of the application of related-party guidance when determining a controlling financial interest in a variable interest entity (VIE), and changing consolidation conclusions for public and private companies in several industries that typically make use of limited partnerships or VIEs. The amendments in this ASU are effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted, including adoption in an interim period. ASU 2015-02 may be applied retrospectively in previously issued financial statements for one or more years with a cumulative-effect adjustment to retained earnings as of the beginning of the first year restated. The Company does not expect the adoption of ASU 2015-02 to have a material impact on its consolidated financial statements.

In April 2015, the FASB issued ASU No. 2015-03, “Interest - Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs.” The amendments in this ASU are intended to simplify the presentation of debt issuance costs. These amendments 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 ASU. The amendments in this ASU are effective for public business entities for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within

28


those fiscal years. Early adoption is permitted for financial statements that have not been previously issued. The Company does not expect the adoption of ASU 2015-03 to have a material impact on its consolidated financial statements.

In April 2015, the FASB issued ASU No. 2015-05, “Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement.” The amendments in this ASU 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. The amendments do not change the accounting for a customer’s accounting for service contracts. As a result of the amendments, all software licenses within the scope of Subtopic 350-40 will be accounted for consistent with other licenses of intangible assets. The amendments in this ASU are effective for public business entities for annual periods, including interim periods within those annual periods, beginning after December 15, 2015. Early adoption is permitted. An entity can elect to adopt the amendments either: (1) prospectively to all arrangements entered into or materially modified after the effective date; or (2) retrospectively. The Company is currently assessing the impact that ASU 2015-05 will have on its consolidated financial statements.

In May 2015, the FASB issued ASU No. 2015-08, “Business Combinations (Topic 805): Pushdown Accounting - Amendments to SEC Paragraphs Pursuant to Staff Accounting Bulletin No. 115.” The amendments in ASU 2015-08 amend various SEC paragraphs pursuant to the issuance of Staff Accounting Bulletin No. 115, Topic 5: Miscellaneous Accounting, regarding various pushdown accounting issues, and did not have a material impact on our consolidated financial statements.

In August 2015, the FASB issued ASU No. 2015-14, “Revenue from Contracts with Customers (Topic 606): Deferral of Effective Date.” The amendments in ASU 2015-14 defer the effective date of ASU 2014-09 for all entities by one year. Public business entities, certain not-for-profit entities, and certain employee benefit plans should apply the guidance in ASU 2014-09 to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. Earlier application is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. All other entities should apply the guidance in ASU 2014-09 to annual reporting periods beginning after December 15, 2018, and interim reporting periods within annual reporting periods beginning after December 15, 2019. All other entities may apply the guidance in ASU 2014-09 earlier as of an annual reporting period beginning after December 15, 2016, including interim reporting periods within that reporting period. All other entities also may apply the guidance in ASU 2014-09 earlier as of an annual reporting period beginning after December 15, 2016, and interim reporting periods within annual reporting periods beginning one year after the annual reporting period in which the entity first applies the guidance in ASU 2014-09. The Company does not expect the adoption of ASU 2015-14 (or ASU 2014-09) to have a material impact on its consolidated financial statements.

In August 2015, the FASB issued ASU 2015-15, “Interest - Imputation of Interest (Subtopic 835-30) - Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements (Amendments to SEC Paragraphs Pursuant to Staff Announcement at June 18, 2015 EITF Meeting).” On April 7, 2015, the FASB issued ASU 2015-03, Interest-Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs, which requires entities to present debt issuance costs related to a recognized debt liability as a direct deduction from the carrying amount of that debt liability. The guidance in ASU 2015-03 (see paragraph 835-30-45-1A) does not address presentation or subsequent measurement of debt issuance costs related to line-of-credit arrangements. Given the absence of authoritative guidance within ASU 2015-03 for debt issuance costs related to line-of-credit arrangements, the SEC staff stated that they would not object to an entity deferring and presenting debt issuance costs as an asset and subsequently amortizing the deferred debt issuance costs ratably over the term of the line-of-credit arrangement, regardless of whether there are any outstanding borrowings on the line-of-credit arrangement. ASU 2015-15 adds these SEC comments to the "S" section of the Codification. The Company does not expect the adoption of ASU 2015-15 to have a material impact on its consolidated financial statements.

In September 2015, the FASB issued ASU 2015-16, “Business Combinations (Topic 805): Simplifying the Accounting for Measurement-Period Adjustments.” The amendments in ASU 2015-16 require that an acquirer recognize adjustments to estimated amounts that are identified during the measurement period in the reporting period in which the adjustment amounts are determined. The amendments require that the acquirer record, in the same period’s financial statements, the effect on earnings of changes in depreciation, amortization, or other income effects, if any, as a result of the change to the estimated amounts, calculated as if the accounting had been completed at the acquisition date. The amendments also require an entity to present separately on the face of the income statement or disclose in the notes the portion of the amount recorded in current-period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the estimated amounts had been recognized as of the acquisition date. The amendments in this ASU are effective for public business entities for fiscal years beginning after December 15, 2015, including interim periods within those fiscal years. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2016, and interim periods within fiscal years beginning after December 15, 2017.

29


The amendments should be applied prospectively to adjustments to provisional amounts that occur after the effective date with earlier application permitted for financial statements that have not been issued. The Company does not expect the adoption of ASU 2015-16 to have a material impact on its consolidated financial statements.

Note 11.        Accumulated Other Comprehensive Income

Changes in accumulated other comprehensive income for the nine months ended September 30, 2015 and 2014 were:
(Dollars in thousands)
Unrealized Gains (Losses) on Securities
 
Cash Flow Hedges
 
Accumulated Other Comprehensive Income
Balance December 31, 2013
$
261

 
$
(29
)
 
$
232

Unrealized holding gains (net of tax, $1,911)
3,710

 

 
3,710

Reclassification adjustment (net of tax, $48)
(93
)
 

 
(93
)
Unrealized loss on interest rate swaps (net of tax, $14)

 
(27
)
 
(27
)
Reclassification adjustment (net of tax, $0)

 

 

Balance September 30, 2014
$
3,878

 
$
(56
)
 
$
3,822

 
 
 
 
 
 
Balance December 31, 2014
$
3,979

 
$
(185
)
 
$
3,794

Unrealized holding losses (net of tax of $229)
(446
)
 

 
(446
)
Reclassification adjustment (net of tax, $47)
(91
)
 

 
(91
)
Unrealized loss on interest rate swap (net of tax, $66)

 
(129
)
 
(129
)
Reclassification adjustment, (net of tax of $2)

 
(4
)
 
(4
)
Balance September 30, 2015
$
3,442

 
$
(318
)
 
$
3,124


The following table presents information related to reclassifications from accumulated other comprehensive income:

Details about Accumulated Other Comprehensive Income
Amount Reclassified from Accumulated Other Comprehensive Income
Affected Line Item in the Consolidated Statements of Income
 
For the Three Months Ended September 30,
 
 
(Dollars in thousands)
2015
 
2014
 
 
Securities available for sale (1):
 
 
 
 
 
Net securities gains reclassified into earnings
$

 
$
(12
)
 
Gain on securities available for sale
Related income tax expense

 
4

 
Income tax expense
Derivatives (2):
 
 
 
 
 
Loss on interest rate swap ineffectiveness

 
(8
)
 
Other operating expenses
Related income tax expense

 
3

 
Income tax expense
Net effect on accumulated other comprehensive income

 
(13
)
 
Net of tax
Total reclassifications
$

 
$
(13
)
 
Net of tax
(1)    For more information related to unrealized gains on securities available for sale, see Note 3, "Securities".
(2)    For more information related to unrealized losses on derivatives, see Note 12, "Derivatives".


30


Details about Accumulated Other Comprehensive Income
Amount Reclassified from Accumulated Other Comprehensive Income
Affected Line Item in the Consolidated Statements of Income
 
For the Nine Months Ended September 30,
 
 
(Dollars in thousands)
2015
 
2014
 
 
Securities available for sale (1):
 
 
 
 
 
Net securities gains reclassified into earnings
$
(138
)
 
$
(141
)
 
Gain on securities available for sale
Related income tax expense
47

 
48

 
Income tax expense
Derivatives (2):
 
 
 
 
 
(Gain) loss on interest rate swap ineffectiveness
(6
)
 

 
Other operating expenses
Related income tax expense
2

 

 
Income tax expense
Net effect on accumulated other comprehensive income
(95
)
 
(93
)
 
Net of tax
Total reclassifications
$
(95
)
 
$
(93
)
 
Net of tax
(1)    For more information related to unrealized gains on securities available for sale, see Note 3, "Securities".
(2)    For more information related to unrealized losses on derivatives, see Note 12, "Derivatives".


Note 12.        Derivatives

The Company utilizes derivative instruments as a part of its asset-liability management program to control fluctuation of market values and cash flows to changes in interest rates associated with certain financial instruments. The Company accounts for derivatives in accordance with ASC 815, "Derivatives and Hedging". Under current guidance, derivative transactions are classified as either cash flow hedges or fair value hedges or they are not designated as hedging instruments. The Company designates each derivative instrument at the inception of the derivative transaction in accordance with this guidance. Information concerning each of the Company's categories of derivatives as of September 30, 2015 and December 31, 2014 is presented below.

Derivatives designated as cash flow hedges

During 2010, the Company entered into an interest rate swap agreement as part of the interest rate risk management process.  The swap was designated as a cash flow hedge intended to hedge the variability of cash flows associated with the Company’s trust preferred capital securities. The swap hedges the cash flow associated with the trust preferred capital notes wherein the Company receives a floating rate based on LIBOR from a counterparty and pays a fixed rate of 2.59% to the same counterparty.  The swap is calculated on a notional amount of $5.2 million.  The term of the swap is 10 years and commenced on October 23, 2010.  The swap was entered into with a counterparty that met the Company’s credit standards and the agreement contains collateral provisions protecting the at-risk party.  The Company believes that the credit risk inherent in the contract is not significant.

During 2013, the Company entered into an interest rate swap agreement as part of the interest rate risk management process.  The swap has been designated as a cash flow hedge intended to hedge the variability of cash flows associated with the Company’s FHLB borrowings. The swap hedges the cash flows associated with the FHLB borrowings wherein the Company receives a floating rate based on LIBOR from a counterparty and pays a fixed rate of 1.43% to the same counterparty.  The swap is calculated on a notional amount of $10.0 million.  The term of the swap is 5 years and commenced on November 25, 2013.  The swap was entered into with a counterparty that met the Company’s credit standards and the agreement contains collateral provisions protecting the at-risk party.  The Company believes that the credit risk inherent in the contract is not significant.

Amounts receivable or payable are recognized as accrued under the terms of the agreement, with the effective portion of the derivative’s unrealized gain or loss recorded as a component of other comprehensive income.  The ineffective portion of the unrealized gain or loss, if any, would be recorded in other expense.  The Company has assessed the effectiveness of the hedging relationship by comparing the changes in cash flows on the designated hedged item.  As a result of this assessment, there was no hedge ineffectiveness identified for the three and nine months ended September 30, 2015 and 2014. At December 31, 2014 there was $6,000 of hedge ineffectiveness identified for this interest rate swap.
 
The amounts included in accumulated other comprehensive income (loss) as unrealized losses (market value net of tax) were $318,000 and $185,000 as of September 30, 2015 and December 31, 2014, respectively.

Information concerning the derivatives designated as a cash flow hedges at September 30, 2015 and December 31, 2014 is presented in the following tables:

31


 
September 30, 2015
 
Positions (#)
 
Notional Amount
(in thousands)
 
Asset
(in thousands)
 
Liability
(in thousands)
 
Receive Rate
 
Pay
Rate
 
Life (Years)
Pay fixed - receive floating interest rate swap
1
 
$
5,155

 
$

 
$
312

 
0.29
%
 
2.59
%
 
4.9
Pay fixed - receive floating interest rate swap
1
 
$
10,000

 
$

 
$
171

 
0.20
%
 
1.43
%
 
3.1

 
December 31, 2014
 
Positions (#)
 
Notional Amount
(in thousands)
 
Asset
(in thousands)
 
Liability
(in thousands)
 
Receive Rate
 
Pay
Rate
 
Life (Years)
Pay fixed - receive floating interest rate swap
1
 
$
5,155

 
$

 
$
213

 
0.23
%
 
2.59
%
 
5.8
Pay fixed - receive floating interest rate swap
1
 
$
10,000

 
$

 
$
74

 
0.16
%
 
1.43
%
 
4.0

Derivatives not designated as hedging instruments

Two-way client loan swaps

During the fourth quarter of 2014 and 2012, the Company entered into certain interest rate swap contracts that are not designated as hedging instruments. These derivative contracts relate to transactions in which we enter into an interest rate swap with a customer while at the same time entering into an offsetting interest rate swap with another financial institution. In connection with each swap transaction, the Company agrees to pay interest to the customer on a notional amount at a variable interest rate and receive interest from the customer on an identical notional amount at a fixed interest rate. At the same time, the Company agrees to pay the counterparty the same fixed interest rate on the same notional amount and receive the same variable interest rate on the same notional amount. The transaction allows our clients to effectively convert a variable rate loan into a fixed rate loan. Because the Company acts as an intermediary for our customers, changes in the fair value of the underlying derivatives contracts offset each other and do not significantly impact our results of operations. The Company had no undesignated interest rate swaps at September 30, 2015 and December 31, 2014.

Certain additional risks arise from interest rate swap contracts in that the counterparties to the contracts may not be able to meet the terms of the contracts. We do not expect any counterparty to fail to meet its obligations.

Information concerning two-way client interest rate swaps not designated as either fair value or cash flow hedges is presented in the following table:

32


 
September 30, 2015
 
Positions (#)
 
Notional Amount
(in thousands)
 
Asset
(in thousands)
 
Liability
(in thousands)
 
Receive Rate
 
Pay
Rate
 
Life (Years)
Pay fixed - receive floating interest rate swap
1
 
$
3,821

 
$

 
$
62

 
1 month
LIBOR
plus 200 BP

 
3.90
%
 
12.0
Pay fixed - receive floating interest rate swap
1
 
1,716

 

 
74

 
1 month
LIBOR
plus 180 BP

 
4.09
%
 
9.0
Pay floating - receive fixed interest rate swap
1
 
3,821

 
62

 

 
3.90
%
 
1 month
LIBOR
plus 200 BP

 
12.0
Pay floating - receive fixed interest rate swap
1
 
1,716

 
74

 

 
4.09
%
 
1 month
LIBOR
plus 180 BP

 
9.0
Total derivatives not designated
 
 
$
11,074

 
$
136

 
$
136

 
 
 
 
 
 

 
December 31, 2014
 
Positions (#)
 
Notional Amount
(in thousands)
 
Asset
(in thousands)
 
Liability
(in thousands)
 
Receive Rate
 
Pay
Rate
 
Life (Years)
Pay fixed - receive floating interest rate swap
1

 
$
4,002

 
$

 
$
19

 
1 month
LIBOR
plus 200 BP

 
3.90
%
 
12.9
Pay fixed - receive floating interest rate swap
1

 
1,747

 

 
31

 
1 month
LIBOR
plus 180 BP

 
4.09
%
 
9.9
Pay floating - receive fixed interest rate swap
1

 
4,002

 
19

 

 
3.90
%
 
1 month
LIBOR
plus 200 BP

 
12.9
Pay floating - receive fixed interest rate swap
1

 
1,747

 
31

 

 
4.09
%
 
1 month
LIBOR
plus 180 BP

 
9.9
Total derivatives not designated
 
 
$
11,498

 
$
50

 
$
50

 
 
 
 
 


Rate Cap Transaction

At September 30, 2015, the Company had one derivative instrument in the form of an interest rate cap agreement with a notional amount of $10.0 million. The notional amount of the financial derivative instrument does not represent exposure to credit loss. The Company is exposed to credit loss only to the extent the counter-party defaults in its responsibility to pay interest under the terms of the agreement. The credit risk in derivative instruments is mitigated by entering into transactions with highly-rated counterparties that management believes to be creditworthy and by limiting the amount of exposure to each counter-party. We do not expect any counterparty to fail to meet its obligations.

The details of the interest rate cap agreement as of September 30, 2015 is summarized below:


33


September 30, 2015
(Dollars in thousands)
Notional Amount
 
Termination Date
 
3-Month LIBOR Strike Rate
 
Premium Paid
 
Unamortized Premium at September 30, 2015
 
Fair Value
September 30, 2015
 
Cumulative Cash Flows Received
$
10,000

 
September 8, 2018
 
2.00
%
 
$
70

 
$
70

 
$
35

 
$


In the third quarter of 2015, the interest rate cap agreement was purchased to limit the Company's exposure to rising interest rates. Under the terms of the agreement, the Company paid a premium of $70,000 for the right to receive cash flow payments if 3-month LIBOR rises above the cap of 2.00%, thus effectively ensuring interest expense is capped at a maximum rate of 2.00% for the duration of the agreement. The interest rate cap agreement is a derivative not designated as a hedging instrument.

At September 30, 2015, the total fair value of the interest rate cap agreement was $35,000. The fair value of the interest rate cap agreement is included in other assets on the Company's consolidated balance sheets. Changes in fair value are recorded in earnings in other operating expenses. At September 30, 2015, $35,000 was recognized in other operating expenses.

The premium paid on the interest rate cap agreement is recognized as an increase in interest expense over the duration of the agreement using the caplet method. For the three and nine months ended September 30, 2015, no premium amortization was required.
 

Note 13.        Other Real Estate Owned (OREO)

At September 30, 2015 and December 31, 2014, OREO balances were $3.9 million and $4.1 million, respectively. OREO is primarily comprised of residential properties and non-residential properties, and are located primarily in the state of Virginia. Changes in the balance for OREO, net of valuation allowances, are as follows:
(Dollars in thousands)
September 30, 2015
 
December 31, 2014
Balance at the beginning of year, net
$
4,051

 
$
3,424

Transfers between loans and other real estate owned
720

 
3,301

Sales proceeds
(677
)
 
(2,663
)
Loss on disposition
(46
)
 
(14
)
Less valuation adjustments
(177
)
 
3

Balance at the end of year, net
$
3,871

 
$
4,051


Expenses applicable to OREO, were $193,000 and $(33,000) during the three months ended September 30, 2015 and 2014, respectively and $285,000 and $145,000 during the nine months ended September 30, 2015 and 2014, respectively.

The major classifications of OREO in the consolidated balance sheets at September 30, 2015 and December 31, 2014 were as follows:
(Dollars in thousands)
September 30, 2015
 
December 31, 2014
Real estate loans:
 
 
 
Construction
$
853

 
$
871

Secured by farmland

 

Secured by 1-4 family residential
1,598

 
1,035

Other real estate loans
1,420

 
2,145

Total real estate loans
$
3,871

 
$
4,051


At September 30, 2015, the Company had $817,000 in two consumer mortgage loans secured by residential real estate for which foreclosure was in process. At December 31, 2014, there were no consumer mortgage loans secured by residential real estate for which foreclosure was in process.



34


Note 14.        Low Income Housing Tax Credits

The Company has invested in three separate housing equity funds at September 30, 2015. The general purpose of these funds is to encourage and assist participants in investing in low-income residential rental properties located in the Commonwealth of Virginia, develop and implement strategies to maintain projects as low-income housing, deliver Federal Low Income Housing Credits to investors, allocate tax losses and other possible tax benefits to investors, and to preserve and protect project assets. The investments in these funds were recorded as other assets on the consolidated balance sheets and were $6.18 million and $6.36 million at September 30, 2015 and December 31, 2014, respectively. The expected terms of these investments and the related tax benefits run through 2032. Tax credits and other tax benefits recognized during the nine months ended September 30, 2015 and the year ended December 31, 2014, were $253,000 and $78,000, respectively, related to these investments. Total projected tax credits to be received for 2015 are $316,000, which is based on the most recent quarterly estimates received from the funds. Additional capital calls expected for the funds totaled $6.77 million and $7.00 million at September 30, 2015 and December 31, 2014, respectively, and are included in other liabilities on the consolidated balance sheets.

ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITON AND RESULTS OF OPERATIONS

The following discussion and analysis of the financial condition at September 30, 2015 and results of operations of the Company for the three and nine months ended September 30, 2015 should be read in conjunction with the Company’s Consolidated Financial Statements and the accompanying Notes to Consolidated Financial Statements included in this report and in the 2014 Form 10-K. It should also be read in conjunction with the “Caution About Forward Looking Statements” section at the end of this discussion.

Overview

The Company is headquartered in Middleburg, Virginia and conducts its primary operations through two wholly owned subsidiaries, Middleburg Bank and Middleburg Investment Group, Inc.  Middleburg Bank is a community bank serving the Virginia counties of Prince William, Loudoun, Fairfax, Fauquier, the Town of Williamsburg and the City of Richmond with twelve financial service centers and one limited service facility.  Middleburg Investment Group is a non-bank holding company with one wholly owned subsidiary, Middleburg Trust Company.  Middleburg Trust Company is a trust company headquartered in Richmond, Virginia, and maintains offices in Williamsburg, Virginia and in several of Middleburg Bank’s facilities.  On May 15, 2014, the Company sold its membership interests in Southern Trust Mortgage to a consortium of banks and the President of Southern Trust Mortgage.

The Company generates a significant amount of its income from the net interest income earned by Middleburg Bank.  Net interest income is the difference between interest income and interest expense.  Interest income depends on the amount of interest-earning assets outstanding during the period and the interest rates earned thereon.  Middleburg Bank’s cost of funds is a function of the average amount of deposits and borrowed money outstanding during the period and the interest rates paid thereon.  The quality of the assets further influences the amount of interest income lost on nonaccrual loans and the amount of additions to the allowance for loan losses or potential other-than-temporary impairment of securities.  Middleburg Investment Group’s subsidiary, Middleburg Trust Company, generates fee income by providing investment management and trust services to its clients.  Investment management and trust fees are generally based upon the value of assets under management, and, therefore can be significantly affected by fluctuations in the values of securities caused by changes in the capital markets.  

Net income attributable to Middleburg Financial Corporation for the quarter ended September 30, 2015 increased 9.43% to $2.32 million from $2.12 million over the same period in 2014. Earnings per diluted share for the quarter ended September 30, 2015 were $0.32 per share compared to $0.30 per share for the same period in 2014. Net income attributable to Middleburg Financial Corporation for the nine months ended September 30, 2015 increased 18.39% to $7.05 million from $5.95 million over the same period in 2014. Earnings per diluted share for the nine months ended September 30, 2015 were $0.98 per share compared to $0.84 per share for the same period in 2014.
 
Annualized return on average assets for the quarter ended September 30, 2015 was 0.73%, compared to 0.69% for the same period in 2014. Annualized return on average equity of Middleburg Financial Corporation for the quarter ended September 30, 2015 was 7.32%, compared to 7.00% for the same period in 2014. Annualized return on average assets for the nine months ended September 30, 2015 was 0.75%, compared to 0.65% for the same period in 2014. Annualized return on average equity of Middleburg Financial Corporation for the nine months ended September 30, 2015 was 7.54%, compared to 6.77% for the same period in 2014.

The net interest margin, a non-GAAP measure more fully described in the “Results of Operations” section below, decreased from 3.36% for the quarter ended September 30, 2014 to 3.28% for the quarter ended September 30, 2015.  The net interest margin decreased from 3.43% for the nine months ended September 30, 2014 to 3.31% for the nine months ended September 30, 2015.


35


The Company recorded a recovery of loan losses in the amount of $432,000 for the quarter ended September 30, 2015 compared to a provision of $550,000 for the same period in 2014. The recovery of loan losses was $407,000 for the nine months ended September 30, 2015 compared to a provision for loan losses of $1.51 million for the same period in 2014. These recoveries of provision resulted from an overall improvement in asset quality. Refer to the discussion of asset quality in the financial condition section for specific discussion in the movement of asset quality.
 
Non-interest income for the quarter and nine months ended September 30, 2015 increased by 3.25% compared to the quarter ended September 30, 2014 and decreased by 37.30% compared to the nine months ended September 30, 2014 . The primary reason for the decrease in non interest income for the nine months ended September 30, 2015 compared to the nine months ended September 30, 2014, is the decline in gains recorded on the sale of residential mortgage loans in the current period, stemming from the Company's sale of its majority interest in Southern Trust Mortgage during the second quarter of 2014.

Non-interest expense increased by 10.52% compared to the quarter ended September 30, 2014 and declined by 13.91% compared to the nine months ended September 30, 2014. The increase in non-interest expenses for the quarter was the result of an increase in salaries and employee benefits of 8.85% due to staffing changes related to the Bank's mortgage division, an increase in OREO expense which resulted from a valuation adjustment for one property based on an updated appraisal received during the quarter, and other non-recurring expenses that were incurred during the quarter related to fraud losses and advisory fees. Actions taken by the Company to reduce costs as well as the Company's sale of its interest in Southern Trust Mortgage during the second quarter of 2014 were the primary reasons for the decline in non-interest expense during the nine months ended September 30, 2015.

The Company’s capital ratios remain well above regulatory minimum capital ratios as of September 30, 2015:
Tier 1 Leverage ratio was 9.84%, 5.84% over the regulatory minimum of 4.00%.
Common Equity Tier 1 ratio was 16.31%, 9.31% over the regulatory minimum of 7.00%.
Tier 1 Risk-Based Capital Ratio was 16.99%, 8.49% over the regulatory minimum of 8.50%
Total Risk Based Capital Ratio was 18.25%, 7.75% over the regulatory minimum of 10.50%.

At September 30, 2015, total assets were $1.26 billion, an increase of 3.14% since December 31, 2014.  Net loans held-for-investment increased by $26.41 million to $769.47 million, an increase of 3.55% since December 31, 2014. Total deposits were $1.03 billion, an increase of 4.38% since December 31, 2014. Non-maturity deposits, including demand, NOW and savings deposits increased $42.72 million from December 31, 2014 to $782.86 million at September 30, 2015.  Time deposits increased by 0.22% or $553,000 from December 31, 2014 to $249.49 million at September 30, 2015.  

Critical Accounting Policies

General

The financial condition and results of operations presented in the Consolidated Financial Statements, the accompanying Notes to the Consolidated Financial Statements and this section are, to some degree, dependent upon the accounting policies of the Company.  The selection and application of these accounting policies involve judgments, estimates, and uncertainties that are susceptible to change.

Presented below is discussion of those accounting policies that management believes are the most important (“Critical Accounting Policies”) to the portrayal and understanding of Middleburg Financial Corporation’s financial condition and results of operations.  The Critical Accounting Policies require management’s most difficult, subjective and complex judgments about matters that are inherently uncertain.  In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood.

Allowance for Loan Losses

Middleburg Bank monitors and maintains an allowance for loan losses to absorb an estimate of probable losses inherent in the loan portfolio.  Middleburg Bank maintains policies and procedures that address the systems of controls over the following areas of maintenance of the allowance:  the systematic methodology used to determine the appropriate level of the allowance to provide assurance they are maintained in accordance with accounting principles generally accepted in the United States of America; the accounting policies for loan charge-offs and recoveries; the assessment and measurement of impairment in the loan portfolio; and the loan grading system.

Middleburg Bank evaluates various loans individually for impairment as required by applicable accounting standards.  Loans evaluated individually for impairment include nonperforming loans, such as loans on nonaccrual, loans past due 90 days or more, troubled debt restructurings and other loans selected by management.  The evaluations are based upon discounted cash flows or

36


collateral valuations.  If the evaluation shows that a loan is individually impaired, then a specific reserve is established for the amount of impairment.  If a loan evaluated individually is not impaired, then the loan is assessed for impairment with a group of loans that have similar characteristics.

For loans without individual measures of impairment, Middleburg Bank makes estimates of losses for groups of loans as required by applicable accounting standards.  Loans are grouped by similar characteristics, including the type of loan, the assigned loan grade and the general collateral type.  A loss rate reflecting the expected loss inherent in a group of loans is derived based upon estimates of default rates for a given loan grade, the predominant collateral type for the group and the terms of the loan.  The resulting estimate of losses for groups of loans are adjusted for relevant environmental factors and other conditions of the portfolio of loans, including:  borrower and industry concentrations; levels and trends in delinquencies, charge-offs and recoveries; changes in underwriting standards and risk selection; level of experience, ability and depth of lending management; and national and local economic conditions.

The amount of estimated impairment for individually evaluated loans and groups of unimpaired loans is added together for a total estimate of loans losses.  This estimate of losses is compared to the allowance for loan losses of Middleburg Bank as of the evaluation date and, if the estimate of losses is greater than the allowance, an additional provision to the allowance would be made.  If the estimate of losses is less than the allowance, the degree to which the allowance exceeds the estimate is evaluated to determine whether the allowance falls outside a range of estimates.  If the estimate of losses is below the range of reasonable estimates, the allowance would be reduced by way of a credit to the provision for loan losses.  Middleburg Bank recognizes the inherent imprecision in estimates of losses due to various uncertainties and variability related to the factors used, and therefore a reasonable range around the estimate of losses is derived and used to ascertain whether the allowance is too high.  If different assumptions or conditions were to prevail and it is determined that the allowance is not adequate to absorb the new estimate of probable losses, an additional provision for loan losses would be made, which may be material to the consolidated financial statements.
 
Goodwill and Intangibles

With the adoption of Accounting Standards Update 2011-08, "Intangible-Goodwill and Other-Testing Goodwill for Impairment", the Company is no longer required to perform a test for impairment unless, based on an assessment of qualitative factors related to goodwill, we determine that it is more likely than not that the fair value of each applicable reporting unit is less than its carrying amount. If the likelihood of impairment is more than 50%, the Company must perform a test for impairment and may be required to record impairment charges. The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value with its carrying amount, including goodwill. If the carrying amount is greater than zero and its fair value exceeds its carrying amount, goodwill is considered not impaired; thus, the second step of the impairment test is unnecessary. If the carrying amount exceeds its fair value, the second step of the goodwill impairment test shall be performed to measure the amount of impairment loss, if any. The second step of the goodwill impairment test, used to measure the amount of impairment loss, compares the implied fair value with the carrying amount of that goodwill. If the carrying amount exceeds the implied fair value of that goodwill, an impairment loss shall be recognized in an amount equal to that excess. The loss recognized cannot exceed the carrying amount of goodwill. After a goodwill impairment loss is recognized, the adjusted carrying amount of goodwill shall be its new accounting basis. Subsequent reversal of a previously recognized goodwill impairment loss is prohibited once the measurement of that loss is recognized.

Management estimates fair value utilizing multiple methodologies which include discounted cash flows, comparable companies, third-party sale and assets under management analysis. Determining the fair value requires management to make judgments and assumptions related to various items, including estimates of future operating results, allocations of indirect expenses, and discount rates.  Management believes its estimates and assumptions are reasonable; however, the fair value could be different in the future if actual results or market conditions differ from the estimates and assumptions used.

The Company’s forecasted cash flows assume a stable economic environment and consistent long-term growth in assets under management over the projected periods.  Additionally, expenses are assumed to be consistently correlated with projected asset and revenue growth over the time periods projected.  Although we believe the key assumptions underlying the financial forecasts to be reasonable, they are inherently uncertain and involve a number of risks and uncertainties that are beyond the control of the Company.  Accordingly, there can be no assurance that the forecasted results will be realized and variations from the forecast may be material.  If weak economic conditions continue or worsen for a prolonged period of time, or if the reporting unit loses key personnel, the fair value may be adversely affected which may result in impairment of goodwill or other intangible assets in the future.  Any changes in the key management estimates or judgments could result in an impairment charge, and such a charge could have an adverse effect on the Company’s financial condition and results of operations.


37


Middleburg Investment Group has intangible assets in the form of certain customer relationships that were acquired in 2002. We amortize those intangible assets on a straight line basis over their estimated useful life.

Other-Than-Temporary Impairment (OTTI) for Securities

Impairment of securities occurs when the fair value of a security is less than its amortized cost. For debt securities, impairment is considered other-than-temporary and recognized in its entirety in net income if either (i) we intend to sell the security or (ii) it is more-likely-than-not that we will be required to sell the security before recovery of its amortized cost basis. If, however, we do not intend to sell the security and it is not more-likely-than-not that we will be required to sell the security before recovery, we must determine what portion of the impairment is attributable to a credit loss, which occurs when the amortized cost basis of the security exceeds the present value of the cash flows expected to be collected from the security. If there is no credit loss, there is no other-than-temporary impairment. If there is a credit loss, other-than-temporary impairment exists, and the credit loss must be recognized in net income and the remaining portion of impairment must be recognized in other comprehensive income. For equity securities, impairment is considered to be other-than-temporary based on our ability and intent to hold the investment until a recovery of fair value. Other-than-temporary impairment of an equity security results in a write-down that must be included in net income. We regularly review each investment security for other-than-temporary impairment based on criteria that includes the extent to which cost exceeds market price, the duration of that market decline, the financial health of and specific prospects for the issuer, our best estimate of the present value of cash flows expected to be collected from debt securities, our intention with regard to holding the security to maturity and the likelihood that we would be required to sell the security before recovery.

Results of Operations

The Company's net income for the third quarter of 2015 was $2.32 million, an increase of $200,000 or 9.43% compared to the second quarter of 2014. For the third quarter of 2015, earnings per diluted share was $0.32 compared to earnings per diluted share of $0.30 for the third quarter of 2014.

The following tables reflect an analysis of the Company’s net interest income for the quarters ended September 30, 2015 and 2014 using the daily average balances of the Company’s assets and liabilities for the periods indicated. Nonaccrual loans are included in the loan balances.

38


 
Three Months Ended September 30,
 
2015
 
2014
 
Average
Balance
 
Income/
Expense
 
Yield/
Rate (2)
 
Average
Balance
 
Income/
Expense
 
Yield/
Rate (2)
 
(Dollars in thousands)
Assets:
 
 
 
 
 
 
 
 
 
 
 
Securities:
 
 
 
 
 
 
 
 
 
 
 
Taxable
$
320,684

 
$
2,009

 
2.49
%
 
$
282,860

 
$
1,847

 
2.59
%
Tax-exempt (1)
51,252

 
672

 
5.20
%
 
54,410

 
811

 
5.91
%
Total securities
$
371,936

 
$
2,681

 
2.86
%
 
$
337,270

 
$
2,658

 
3.13
%
Loans:
 
 
 
 
 
 
 
 
 
 
 
   Taxable
$
777,039

 
$
8,222

 
4.20
%
 
$
730,006

 
$
8,351

 
4.54
%
   Tax-exempt (1)
630

 
8

 
5.04
%
 
652

 
9

 
5.48
%
Total loans (3)
$
777,669

 
$
8,230

 
4.20
%
 
$
730,658

 
$
8,360

 
4.54
%
Interest on deposits with other banks and federal funds sold
46,671

 
23

 
0.20
%
 
90,463

 
51

 
0.22
%
Total earning assets
$
1,196,276

 
$
10,934

 
3.63
%
 
$
1,158,391

 
$
11,069

 
3.79
%
Less: allowances for loan losses
(11,870
)
 
 
 
 
 
(11,309
)
 
 
 
 
Total nonearning assets
77,155

 
 
 
 
 
74,477

 
 
 
 
Total assets
$
1,261,561

 
 

 
 
 
$
1,221,559

 
 

 
 
Liabilities:
 

 
 

 
 
 
 

 
 

 
 
Interest-bearing deposits:
 

 
 

 
 
 
 

 
 

 


Checking
$
343,584

 
$
176

 
0.20
%
 
$
354,080

 
$
163

 
0.18
%
Regular savings
120,104

 
56

 
0.18
%
 
113,607

 
53

 
0.19
%
Money market savings
66,144

 
32

 
0.19
%
 
72,034

 
34

 
0.19
%
Time deposits:
 
 
 
 
 
 
 
 
 
 
 
$100,000 and over
148,998

 
322

 
0.86
%
 
121,274

 
297

 
0.97
%
Under $100,000
103,897

 
291

 
1.11
%
 
129,578

 
408

 
1.25
%
Total interest-bearing deposits
$
782,727

 
$
877

 
0.45
%
 
$
790,573

 
$
955

 
0.48
%
Securities sold under agreements to repurchase
28,859

 
2

 
0.03
%
 
39,142

 
81

 
0.82
%
FHLB borrowings and other debt
68,416

 
165

 
0.96
%
 
60,372

 
209

 
1.37
%
Federal funds purchased

 

 
%
 
 
 
 
 
 
Total interest-bearing liabilities
$
880,002

 
$
1,044

 
0.47
%
 
$
890,087

 
$
1,245

 
0.55
%
Non-interest bearing liabilities:
 

 
 

 
 
 
 

 
 

 
 
Demand deposits
242,983

 
 
 
 
 
200,768

 
 
 
 
Other liabilities
12,815

 
 
 
 
 
10,539

 
 
 
 
Total liabilities
$
1,135,800

 
 

 
 
 
$
1,101,394

 
 

 
 
Shareholders' equity
125,761

 
 
 
 
 
120,165

 
 
 
 
Total liabilities and shareholders' equity
$
1,261,561

 
 

 
 
 
$
1,221,559

 
 

 
 
Net interest income
 

 
$
9,890

 
 
 
 

 
$
9,824

 
 
Interest rate spread
 

 
 

 
3.16
%
 
 

 
 

 
3.24
%
Cost of Funds
 

 
 

 
0.37
%
 
 

 
 

 
0.45
%
Interest expense as a percent of average earning assets
 

 
 

 
0.35
%
 
 

 
 

 
0.43
%
Net interest margin
 

 
 

 
3.28
%
 
 

 
 

 
3.36
%
(1) 
Income and yields are reported on a tax equivalent basis assuming a federal tax rate of 34%.
(2) 
All yields and rates have been annualized on a 365 day year.
(3) 
Total average loans include loans on non-accrual status.

The Company's net income for the nine months ended September 30, 2015 was $7.05 million, an increase of $1.10 million or 18.39% from the nine months ended September 30, 2014. For the nine months ended September 30, 2015, earnings per diluted share was $0.98 compared to earnings per diluted share of $0.84 for the nine months ended September 30, 2014.
 
The following tables reflect an analysis of the Company’s net interest income for the nine months ended September 30, 2015 and 2014 using the daily average balances of the Company’s assets and liabilities for the periods indicated. Nonaccrual loans are included in the loan balances.

39


 
Nine Months Ended September 30,
 
2015
 
2014
 
Average
Balance
 
Income/
Expense
 
Yield/
Rate (2)
 
Average
Balance
 
Income/
Expense
 
Yield/
Rate (2)
 
(Dollars in thousands)
Assets:
 
 
 
 
 
 
 
 
 
 
 
Securities:
 
 
 
 
 
 
 
 
 
 
 
Taxable
$
315,507

 
$
5,832

 
2.47
%
 
$
278,650

 
$
5,403

 
2.59
%
Tax-exempt (1)
51,680

 
2,051

 
5.31
%
 
57,556

 
2,509

 
5.83
%
Total securities
$
367,187

 
$
7,883

 
2.87
%
 
$
336,206

 
$
7,912

 
3.15
%
Loans:
 
 
 
 
 
 
 
 
 
 
 
   Taxable
$
764,337

 
$
24,468

 
4.28
%
 
$
743,703

 
$
25,639

 
4.61
%
   Tax-exempt (1)
620

 
25

 
5.39
%
 
652

 
26

 
5.33
%
Total loans (3)
$
764,957

 
$
24,493

 
4.28
%
 
$
744,355

 
$
25,665

 
4.61
%
Interest on deposits with other banks and federal funds sold
52,858

 
84

 
0.21
%
 
73,759

 
123

 
0.22
%
Total earning assets
$
1,185,002

 
$
32,460

 
3.66
%
 
$
1,154,320

 
$
33,700

 
3.90
%
Less: allowances for loan losses
(11,894
)
 
 
 
 
 
(12,497
)
 
 
 
 
Total nonearning assets
76,703

 
 
 
 
 
78,292

 
 
 
 
Total assets
$
1,249,811

 
 

 
 
 
$
1,220,115

 
 

 
 
Liabilities:
 

 
 

 
 
 
 

 
 

 
 
Interest-bearing deposits:
 

 
 

 
 
 
 

 
 

 
 
Checking
$
342,184

 
$
517

 
0.20
%
 
$
342,551

 
$
485

 
0.19
%
Regular savings
117,981

 
164

 
0.19
%
 
113,378

 
158

 
0.19
%
Money market savings
67,314

 
95

 
0.19
%
 
73,910

 
105

 
0.19
%
Time deposits:
 
 
 
 
 
 
 
 
 
 
 
$100,000 and over
136,980

 
900

 
0.88
%
 
125,036

 
937

 
1.00
%
Under $100,000
107,181

 
904

 
1.13
%
 
130,776

 
1,267

 
1.30
%
Total interest-bearing deposits
$
771,640

 
$
2,580

 
0.45
%
 
$
785,651

 
$
2,952

 
0.50
%
Securities sold under agreements to repurchase
30,578

 
64

 
0.28
%
 
36,682

 
243

 
0.88
%
FHLB borrowings and other debt
69,752

 
507

 
0.97
%
 
76,803

 
876

 
1.52
%
Federal funds purchased
2

 

 
%
 
1

 

 
%
Total interest-bearing liabilities
$
871,972

 
$
3,151

 
0.48
%
 
$
899,137

 
$
4,071

 
0.61
%
Non-interest bearing liabilities:
 

 
 

 
 
 
 

 
 

 
 
Demand deposits
239,791

 
 
 
 
 
193,501

 
 
 
 
Other liabilities
13,126

 
 
 
 
 
9,947

 
 
 
 
Total liabilities
$
1,124,889

 
 

 
 
 
$
1,102,585

 
 

 
 
Shareholders' equity
124,922

 
 
 
 
 
117,530

 
 
 
 
Total liabilities and shareholders' equity
$
1,249,811

 
 

 
 
 
$
1,220,115

 
 

 
 
Net interest income
 

 
$
29,309

 
 
 
 

 
$
29,629

 
 
Interest rate spread
 

 
 

 
3.18
%
 
 

 
 

 
3.29
%
Cost of Funds
 

 
 

 
0.38
%
 
 

 
 

 
0.50
%
Interest expense as a percent of average earning assets
 

 
 

 
0.36
%
 
 

 
 

 
0.47
%
Net interest margin
 

 
 

 
3.31
%
 
 

 
 

 
3.43
%

Net Interest Income

Net interest income represents the principal source of earnings of the Company.  Net interest income is the amount by which interest generated from earning assets exceeds the expense of funding those assets.  Changes in volume and mix of interest earning assets and interest bearing liabilities, as well as their respective yields and rates, have a significant impact on the level of net interest income.

Net interest income was $9.66 million for the quarter ended September 30, 2015.  This is an increase of 1.19% compared to net interest income for the same period in 2014.  The net interest margin for the quarter ended September 30, 2015 was 3.28% compared to 3.36% for the same period in 2014. Net interest income was $28.60 million for the nine months ended September 30, 2015. This is a decrease of 0.57% over net interest income reported for the same period for 2014. The net interest margin for the nine months ended September 30, 2015 was 3.31% compared to 3.43% for the same period for 2014.

40



The following factors contributed to the change in the net interest margin:

Yields on earning assets during the quarter ended September 30, 2015 declined by 16 basis points ("bp") compared to the same period in 2014. This included a 34 bp decrease in loan yields and a 27 bp decrease in yields on investment securities for the same period. Yields on earning assets during the nine month period ended September 30, 2015 declined by 24 bp compared to the same period in 2014. This included a 33 bp decrease in loan yields and a 28 bp decrease in yields on investment securities for the same period.
Cost of funds was 37 bp and 38 bp, for the three and nine months ended September 30, 2015. Cost of funds was 45 bp and 50 bp, for the three and nine months ended September 30, 2014.

Yields on investment securities were impacted by higher premium amortization stemming from faster prepayments on mortgage backed securities accompanied by lower book yields for securities that were added to the portfolio during the period. Loan yields declined due to refinancing of existing loans and new loan origination being booked at lower rates.

The net interest margin is calculated by dividing tax equivalent net interest income by total average earning assets.  Because a portion of interest income earned by the Company is nontaxable, the tax equivalent net interest income is considered in the calculation of this ratio.  The tax rate utilized in calculating the tax benefit for each of the reported periods is 34%.  The reconciliation of tax equivalent net interest income, which is not a measurement under accounting principles generally accepted in the United States, to net interest income is reflected in the table below.
 
For the
Three Months Ended
September 30,
 
For the
Nine Months Ended
September 30,
(Dollars in thousands)
2015
 
2014
 
2015
 
2014
GAAP measures:
 
 
 
 
 
 
 
Interest Income - Loans
$
8,227

 
$
8,357

 
$
24,484

 
$
25,656

Interest Income - Investments & Other
2,476

 
2,433

 
7,270

 
7,182

Interest Expense - Deposits
877

 
955

 
2,580

 
2,952

Interest Expense - Other Borrowings
167

 
290

 
571

 
1,119

Total Net Interest Income
$
9,659

 
$
9,545

 
$
28,603

 
$
28,767

Non-GAAP measures:
 
 
 

 
 
 
 

Tax Benefit Realized on:
 
 
 

 
 
 
 

Non-taxable interest income - municipal securities
228

 
276

 
697

 
853

Non-taxable interest income - loans
3

 
3

 
9

 
9

Total Tax Benefit Realized on Non-Taxable Interest Income
$
231

 
$
279

 
$
706

 
$
862

Total Tax Equivalent Net Interest Income
$
9,890

 
$
9,824

 
$
29,309

 
$
29,629


Based on our internal interest rate risk models and the assumption of a sustained low rate environment, the Company expects net interest income to trend downward throughout the next 12 months as loans and securities reprice lower and the decline in funding costs slows.  It is anticipated that targeted growth in earning assets and liability repricing opportunities will help mitigate the impact to the Company’s net interest margin.  The Asset/Liability Management Committee continues to focus on various strategies to maintain the net interest margin.

Non-Interest Income

Non-interest income has been and will continue to be an important factor for increasing profitability.  Management recognizes this and continues to review and consider areas where non-interest income can be increased.  Non-interest income includes fees generated by the commercial and retail banking segment and the wealth management segment.  Non-interest income for the quarter and nine months ended September 30, 2015 was higher by 3.25% and lower by 37.30% compared to the quarter and nine months ended September 30, 2014, respectively.  A more detailed discussion of non-interest income follows:
The primary reason for the increase in non-interest income for the quarter ended September 30, 2015 compared to the same period in 2014 was a 75.00% increase in other operating income stemmed from rental income received and prepayment penalties on certain investment securities. The primary reason for the decline in non-interest income during the nine months ended September 30, 2015, compared to the nine months ended September 30, 2014 was due to the decline of gains on the sales of residential mortgage loans in the current period, stemming primarily from the Company's sale of its majority interest in Southern Trust Mortgage during the second quarter of 2014.
Total revenue generated by our wealth management group, Middleburg Investment Group ("MIG") was $1.17 million for the quarter ended September 30, 2015, an increase of 4.38% compared to the quarter ended September 30, 2014 and

41


12.56% higher when comparing the nine months ended September 30, 2015 to September 30, 2014. Fee income is based primarily upon the market value of assets under administration which were $1.91 billion at September 30, 2015, $1.87 billion at December 31, 2014 and $1.78 billion at September 30, 2014.

The following table depicts the changes in non-interest income:
(Dollars in thousands)
For the
Three Months Ended September 30,
 
For the
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Service charges on deposit accounts
$
622

 
$
635

 
$
1,792

 
$
1,815

Trust services income
1,168

 
1,119

 
3,629

 
3,224

Gains on sales of loans held for sale, net

 
1

 
3

 
4,859

Gains on sales of securities available for sale, net

 
12

 
138

 
141

Commissions on investment sales
132

 
193

 
415

 
479

Bank owned life insurance
166

 
168

 
489

 
494

Gain on sale of majority interest in consolidated subsidiary

 

 

 
24

Other operating income
266

 
152

 
1,331

 
1,399

Total non-interest income
$
2,354

 
$
2,280

 
$
7,797

 
$
12,435


Non-Interest Expense

Non-interest expense for the quarter ended September 30, 2015, increased by 10.52% compared to the same period in 2014. Non-interest expense for the nine months ended September 30, 2015 fell by 13.91% compared to the nine months ended September 30, 2014. Principal reasons for the changes in non-interest expenses were the following:
Salaries and employee benefit expenses increased by 8.85% when compared to the quarter ended September 30, 2014. The increase in salary and benefit expenses compared to the third quarter of 2014 resulted from staffing changes related to our mortgage division. Salaries and employee benefit expenses for the nine months ended September 30, 2015, declined by 16.05% when compared to the nine months ended September 30, 2014. This decline was primarily due to the sale of the Company's majority interest in Southern Trust Mortgage in the second quarter of 2014.
Occupancy and equipment expense during 2015 declined by1.11% and 21.24% compared to the quarter and nine month periods ended September 30, 2014. The primary reasons for lower expenses in this category was management's overall expense control initiative and the sale of Southern Trust Mortgage in the second quarter of 2014.
Costs related to other real estate owned (OREO) increased, primarily driven by a valuation adjustment for one property resulting from an updated appraisal received during the current quarter.
Other operating expenses increased by 14.83% compared to the quarter ended September 30, 2014 and decreased by 11.37% compared to the nine month period ended September 30, 2014. Most of the increase in other expenses for the quarter ended September 30, 2015 was due to expenses related to an external fraud loss and advisory fees that were non-recurring in nature. The primary reason for lower expenses for the nine month period ended September 30, 2015 compared to 2014 was the sale of the Company's majority interest in Southern Trust Mortgage in the second quarter of 2014.

The following table depicts the changes in non-interest expense:
(Dollars in thousands)
For the
Three Months Ended September 30,
 
For the
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Salaries and employee benefits
$
4,834

 
$
4,441

 
$
14,664

 
$
17,467

Occupancy and equipment
1,248

 
1,262

 
3,813

 
4,841

Advertising
98

 
136

 
332

 
430

Computer operations
524

 
439

 
1,536

 
1,408

Other real estate owned
193

 
(33
)
 
285

 
145

Other taxes
230

 
220

 
684

 
637

Federal deposit insurance
188

 
220

 
583

 
687

Other operating expenses
1,959

 
1,706

 
5,355

 
6,042

Total non-interest expense
$
9,274

 
$
8,391

 
$
27,252

 
$
31,657



42


The adjusted efficiency ratio is not a measurement under accounting principles generally accepted in the United States. The Company calculates its efficiency ratio by dividing non-interest expense (adjusted for amortization of intangibles and other real estate expenses) by the sum of tax equivalent net interest income and non-interest income excluding gains and losses on the investment portfolio. The tax rate utilized in calculating tax equivalent amounts is 34%. The Company calculates and reviews this ratio as a means of evaluating operational efficiency.  The calculation of the adjusted efficiency ratio for the three and nine months ended September 30, 2015 and 2014 is as follows:
 
For the
Three Months Ended September 30,
 
For the
Nine Months Ended September 30,
(Dollars in thousands)
2015
 
2014
 
2015
 
2014
Summary of Operating Results:
 
 
 
 
 
 
 
Non-interest expense
$
9,274

 
$
8,391

 
$
27,252

 
$
31,657

Less: Amortization expense
43

 
43

 
128

 
129

Less: Other real estate owned expenses, net
193

 
(33
)
 
285

 
145

Adjusted non-interest expense
$
9,038

 
$
8,381

 
$
26,839

 
$
31,383

 
 
 
 
 
 
 
 
Net interest income
$
9,659

 
$
9,545

 
$
28,603

 
$
28,767

 
 
 
 
 
 
 
 
Non-interest income
2,354

 
2,280

 
7,797

 
12,435

Less: Gains on securities available for sale, net

 
12

 
138

 
141

Adjusted non-interest income
$
2,354

 
$
2,268

 
$
7,659

 
$
12,294

Tax equivalent adjustment
317

 
365

 
958

 
1,117

Total net interest income and non-interest income, adjusted
$
12,330

 
$
12,178

 
$
37,220

 
$
42,178

 
 
 
 
 
 
 
 
Efficiency ratio, adjusted
73.30
%
 
68.82
%
 
72.11
%
 
74.41
%
Efficiency ratio, GAAP (1)
77.20
%
 
70.96
%
 
74.87
%
 
76.83
%
(1) Computed by dividing non-interest expense by the sum of net interest income and non-interest income.

Income Taxes
 
Income taxes on earnings amounted to $850,000, resulting in an effective tax rate of 26.81% for the quarter ended September 30, 2015, compared with $763,000, or 26.46% for the quarter ended September 30, 2014. Income taxes on earnings amounted to $2.51 million, resulting in an effective tax rate of 26.23% for the nine months ended September 30, 2015, compared with $2.18 million, or 27.12% for the nine months ended September 30, 2014. The primary reason for the decline in the effective tax rate was the benefit from low income housing tax credits. For a further discussion of low income housing tax credits, see “Note 14. Low Income Housing Tax Credits".

Financial Condition

Assets, Liabilities and Shareholders’ Equity

Total consolidated assets at September 30, 2015 were $1.26 billion, an increase of 3.14% from December 31, 2014. Changes in major asset categories were as follows:
Cash balances and deposits with other banks decreased by $15.24 million compared to December 31, 2014.
The Company deployed some of its excess liquidity into growing its securities portfolio which increased by $24.52 million compared to December 31, 2014.
Loan momentum increased with loans held-for-investment growing to $780.87 million as of September 30, 2015 compared to $754.85 million on December 31, 2014, an increase of $26.02 million from December 31, 2014. The mortgage division contributed $4.66 million and $6.06 million to total loan growth during the three and nine month periods ended September 30, 2015, respectively.

Total consolidated liabilities at September 30, 2015 were $1.13 billion, an increase of 3.09% from December 31, 2014. Total deposits increased by $43.27 million from December 31, 2014 to $1.03 billion as of September 30, 2015. Federal Home Loan Bank borrowings increased by $5 million to $60 million.

Shareholders equity at September 30, 2015 was $126.41 million, compared to shareholders equity of $122.03 million at December 31, 2014. Retained earnings at September 30, 2015 were $60.54 million compared to retained earnings of $55.85

43


million at December 31, 2014. The book value of the Company’s common stock at September 30, 2015 was $17.65 per share versus $17.11 per share at December 31, 2014.

Loans

The Company’s loan portfolio at September 30, 2015 totaled 65.90% of average earning assets with a tax equivalent yield of 4.28% during the nine month period ended September 30, 2015.

The following table summarized total loans by category:
 
September 30,
 
Years Ended December 31,
(Dollars in thousands)
2015
 
2014
 
2013
 
2012
 
2011
Real estate loans:
 
 
 
 
 
 
 
 
 
Construction
$
33,381

 
$
33,050

 
$
36,025

 
$
50,218

 
$
42,208

Secured by farmland
19,391

 
19,708

 
16,578

 
11,876

 
10,047

Secured by 1-4 family residential
273,176

 
265,216

 
273,384

 
260,620

 
236,760

Other real estate loans
258,012

 
255,236

 
260,333

 
254,930

 
275,428

Commercial loans
179,907

 
163,269

 
129,554

 
118,573

 
94,427

Consumer loans
17,000

 
18,367

 
12,606

 
13,260

 
12,523

Total gross loans
780,867

 
754,846

 
728,480

 
709,477

 
671,393

Less allowance for loan losses
11,400

 
11,786

 
13,320

 
14,311

 
14,623

Net loans
$
769,467

 
$
743,060

 
$
715,160

 
$
695,166

 
$
656,770


Changes in the loan portfolio at September 30, 2015 compared to December 31, 2014 were as follows.
Real estate construction loans consist primarily of pre-sold 1-4 family residential loans along with a marginal amount of commercial construction loans.  These loans represented 4.30% of total loans, an increase of approximately $331,000 from $33.05 million.  
Loans secured by farmland decreased by $317,000 from $19.71 million.
Loans secured by 1-4 family residential real estate represented 35.00% of total loans, an increase of $7.96 million.  
Other real estate loans are typically non-farm, non-residential real estate loans which are, in most cases, owner-occupied commercial buildings.  Other real estate loans represented 33.00% of total loans, an increase of $2.78 million.
Commercial loans, which consist of secured and unsecured loans to small businesses, increased 10.19%.
Consumer loans decreased by $1.37 million or 7.44%.

Asset Quality

While total non performing assets increased in the first nine months of 2015, the increase was primarily due to the restructuring of two loans that are part of a single relationship. During the second quarter of 2015, two loans from a single relationship totaling $9.93 million underwent a restructuring and one of the loans was downgraded that quarter, which resulted in total nonperforming assets increasing to $26.07 million compared to $19.45 million at December 31, 2014. This also increased troubled debt restructurings ("TDR's") to $15.94 million at September 30, 2015 compared to $6.90 million at December 31, 2014. While this loan was restructured and downgraded during 2015, the Company had properly classified this loan as impaired at December 31, 2014 and no additional specific reserve was required. The loan is also an accruing TDR.

With the exception of the increase in TDR's discussed above, there were declines in past due, nonaccrual and loans risk rated as special mention, substandard, doubtful or loss during the nine months ended September 30, 2015.
Total past due loans have declined by 36.21% to $3.09 million as of September 30, 2015 from $4.85 million as of December 31, 2014.
Nonaccrual loans have declined by 11.23% to $8.83 million as of September 30, 2015 from $9.94 million as of December 31, 2014.
Loans that were risk rated as special mention, substandard, doubtful, and loss declined by 23.46% to $42.12 million as of September 30, 2015 from $55.03 million as of December 31, 2014.

In a continuing effort to enhance asset quality, the Company also sold $1.02 million of nonperforming loans in the second quarter of 2015.

The improvement in asset quality resulted in the allowance for loans losses declining to $11.40 million or 1.46% of total loans at September 30, 2015 compared to $11.79 million or 1.56% of total loans at December 31, 2014.


44




The table below summarizes nonperforming assets for the periods indicated.
 
September 30,
 
December 31,
(Dollars in thousands)
2015
 
2014
 
2013
 
2012
 
2011
Nonaccrual loans
$
8,827

 
$
9,944

 
$
19,752

 
$
21,664

 
$
25,346

Restructured loans (1)
12,106

 
4,295

 
4,674

 
5,132

 
3,853

Accruing loans greater than 90 days past due
224

 
30

 
808

 
1,044

 
1,233

Total nonperforming loans
$
21,157

 
$
14,269

 
$
25,234

 
$
27,840

 
$
30,432

Other real estate owned
3,871

 
4,051

 
3,424

 
9,929

 
8,535

Repossessed assets (2)
1,044

 
1,132

 

 

 

Total nonperforming assets
$
26,072

 
$
19,452

 
$
28,658

 
$
37,769

 
$
38,967

 
 
 
 
 
 
 
 
 
 
Allowance for loan losses
$
11,400

 
$
11,786

 
$
13,320

 
$
14,311

 
$
14,623

 
 
 
 
 
 
 
 
 
 
Nonperforming loans to total loans
2.71
%
 
1.89
%
 
3.46
%
 
3.92
%
 
4.53
%
Allowance for loan losses to nonperforming loans
53.88
%
 
82.60
%
 
52.79
%
 
51.40
%
 
48.05
%
Nonperforming assets to total assets
2.07
%
 
1.59
%
 
2.33
%
 
3.05
%
 
3.27
%
(1) Amount reflects restructured loans that are not included in nonaccrual loans.
(2) Included in other assets.
 
Included in nonperforming loans are troubled debt restructurings (“TDRs”). The total balance of TDRs at September 30, 2015 was $15.9 million of which $3.8 million were included in the Company’s nonaccrual loan totals at that date and $12.1 million represented loans performing as agreed to the restructured terms. This compares with $6.9 million in total TDRs at December 31, 2014. The increase in TDRs during the first six months of 2015 is primarily attributed to the restructuring of two loans to a single borrower described above.  The amount of the valuation allowance related to TDRs was $1.62 million and $517,000 as of September 30, 2015 and December 31, 2014, respectively.
 
The Company requires six timely consecutive monthly payments be made and future payments be reasonably assured, before a restructured loan that has been placed on nonaccrual can be returned to accrual status. The Company does not utilize formal modification programs or packages when loans are considered for restructuring.  Any loan restructuring is based on the borrower’s circumstances and may include modifications to more than one of the terms and conditions of the loan.

The Company has not performed any commercial real estate or other type of loan workout whereby the existing loan would have been structured into multiple new loans.

Allowance For Loan Losses

For a discussion of the Company’s accounting policies with respect to the allowance for loan losses, see “Critical Accounting Policies – Allowance for Loan Losses”.

The allowance for loans losses was $11.40 million or 1.46% of total loans at September 30, 2015 compared to $11.79 million or 1.56% of total loans at December 31, 2014 and $11.42 million or 1.57% of total loans at September 30, 2014.

The following table depicts the transactions, in summary form, related to the allowance for loan losses.

45


 
For the Nine Months Ended
 
For the Year Ended
(Dollars in thousands)
September 30, 2015
 
December 31, 2014
Balance, beginning of period
$
11,786

 
$
13,320

Add: Provision for (recovery of) loan losses 
(407
)
 
1,960

Adjustment for the sale of majority interest in consolidated subsidiary

 
(95
)
Less: Charge-offs: 
 
 
 

Real estate loans:
 
 
 

Construction 
$

 
$
(1,186
)
Secured by 1-4 family residential
(100
)
 
(1,380
)
Other real estate loans
(9
)
 
(747
)
Commercial loans
(246
)
 
(959
)
Consumer loans 
(46
)
 
(36
)
Total charge-offs  
$
(401
)
 
$
(4,308
)
Add: Recoveries:
 
 
 

Real estate loans:
 
 
 

Construction 
$
41

 
$
258

Secured by 1-4 family residential
338

 
342

Other real estate loans 
23

 
110

Commercial loans
11

 
104

Consumer loans 
9

 
95

Total recoveries
$
422

 
$
909

Net charge-offs
$
21

 
$
(3,399
)
Balance, end of period
$
11,400

 
$
11,786

 
 
 
 
Allowance for loan losses to total loans
1.46
 %
 
1.56
%
Net charge-offs (recoveries) to average loans
(0.0028
)%
 
0.46
%

The allocation of the allowance (dollars in thousands) at September 30, 2015 and December 31, 2014 were:
 
September 30, 2015
 
December 31, 2014
Real Estate Construction
$
780

 
$
550

Real Estate Secured by Farmland
191

 
179

1-4 Family Residential
3,835

 
3,966

Other Real Estate Loans
3,730

 
3,916

Commercial
1,691

 
2,354

Consumer
1,173

 
821

 
$
11,400

 
$
11,786


The Company has allocated the allowance according to the amount deemed reasonably necessary to provide for the possibility of losses being incurred within each loan category.  The allocation of the allowance should not be interpreted as an indication that loan losses in future years will occur in the same proportions that they may have in prior periods or that the allocation indicates future loan loss trends.  Additionally, the proportion allocated to each loan category is not the total amount that may be available for future losses that could occur within such categories since the total allowance is available to absorb losses on the total portfolio.

Securities

The carrying value of the securities portfolio was $374.28 million at September 30, 2015, an increase of $24.52 million compared to the carrying value of $349.76 million at December 31, 2014.  

Unrealized losses were $2.29 million and $2.14 million at September 30, 2015 and December 31, 2014, respectively. Unrealized gains were $7.38 million and $8.07 million at September 30, 2015 and December 31, 2014, respectively. At September 30, 2015, the Company evaluated the investment portfolio for possible other-than-temporary impairment and concluded that no adverse change in cash flows occurred and did not consider any securities to be other-than-temporarily impaired. 

The securities portfolio at September 30, 2015 and December 31, 2014 represented approximately 31.5% and 30.4% of the average earning assets of the Company during the nine and twelve month periods then ended.


46


Goodwill and Other Identified Intangibles

Goodwill and other identified intangibles decreased by $128,000 to $3.68 million at September 30, 2015. This decrease is attributable to amortization expense related to intangibles.

Deposits

Total deposits increased by $43.27 million from December 31, 2014 to $1.03 billion as of September 30, 2015, primarily due to strong deposit inflows, specifically in non-interest bearing business checking accounts, during the period.

Time deposits increased by $553,000 or 0.22% from December 31, 2014 to $249.49 million at September 30, 2015. Time deposits include brokered certificates of deposit and CDARS deposits. Securities sold under agreements to repurchase (“Repo Accounts”) decreased by $14.08 million from $38.55 million at December 31, 2014 to $24.47 million at September 30, 2015. The Repo Accounts include certain long-term commercial checking accounts with average balances that typically exceed $100,000. All repurchase agreement transactions entered into by the Company are accounted for as collateralized financings and not as sales.

FHLB Borrowings

The Company had no overnight advances from the Federal Home Loan Bank of Atlanta (“FHLB”) outstanding at September 30, 2015. FHLB term advances were $60.00 million at September 30, 2015, higher by $5.00 million compared to December 31, 2014.  We raised cash through short term advances maturing in three months or less in part to pay-off longer term wholesale borrowings that matured during the second quarter of 2015.  Additionally, since some of the deposit growth in the second quarter was deemed to be cyclical, the FHLB term advances enabled the Bank to manage liquidity without selling securities, which would have reduced the yield on earning assets.   

Capital Resources and Dividends

Shareholders' equity was $126.41 million at September 30, 2015 compared to $122.03 million at December 31, 2014. During the nine month period ended September 30, 2015, the Company declared common stock dividends of $0.33 per share, compared to $0.24 per share for the same period in 2014. The book value of common stock was $17.65 per share at September 30, 2015 and $17.11 at December 31, 2014.

The Company's capital ratios remain well above regulatory minimum capital ratios as of September 30, 2015 and December 31, 2014:
Total Risk Based Capital ratio of 18.25% and 16.95% at September 30, 2015 and December 31, 2014, respectively.  
Common Equity Tier 1 ratio of 16.31% at September 30, 2015. This is a new ratio under Basel III for 2015.
Tier 1 Capital ratio of 16.99% and 15.70% at September 30, 2015 and December 31, 2014, respectively. 
Leverage ratio of 9.84% at September 30, 2015 compared to 9.90% at December 31, 2014.

The Company’s Tier 1 capital and total capital include $5.0 million of trust preferred securities. Under the changes to the regulatory capital framework that were approved on July 9, 2013 by the federal banking agencies (Basel III Final Rule), the Company's trust preferred securities will continue to be included in Tier 1 capital and total capital until they mature, pursuant to a "grandfathering" provision that exempts Middleburg Financial Corporation's securities from the more stringent regulatory capital treatment contained in the Basel III Final Rule for trust preferred securities. In addition to "grandfathering" certain previously outstanding trust preferred securities for community banks, the Basel III Final Rule introduces a new Common Equity Tier 1 capital measure, increases the applicable minimum regulatory capital levels and certain prompt corrective action capital levels, and establishes a capital conservation buffer and new risk weights for certain types of assets. The implementation date of the Basel III capital rules was January 1, 2015 for all US banking organizations not subject to the advanced approaches capital rules and the date for banking organizations to meet the fully phased in Basel III capital ratios is January 1, 2019. The Company is not subject to the advanced approaches capital rules. An advanced approaches banking organization is one that has total assets of $250 billion or more or foreign asset exposure of $10 billion or more (or elects with approval from its primary federal regulator to use the advanced approaches methodology to calculate risk weights).

Liquidity

Liquidity represents an institution’s ability to meet present and future financial obligations through either the sale or maturity of existing assets or the acquisition of additional funds through liability management.  Liquid assets include cash, interest-bearing deposits with banks, federal funds sold, short-term investments, securities classified as available for sale and loans and securities maturing within one year.  As a result of the Company’s management of liquid assets and the ability to generate liquidity through

47


liability funding, management believes the Company maintains overall liquidity sufficient to satisfy its depositors’ requirements and meet its customers’ credit needs.

The Company also maintains additional sources of liquidity through a variety of borrowing arrangements.  Middleburg Bank maintains federal funds lines with large regional and money-center banking institutions.  These available lines total approximately $35.0 million, none of which had outstanding balancesnat September 30, 2015.  Middleburg Bank is also able to borrow from the discount window of the Federal Reserve Bank of Richmond.  At September 30, 2015, available borrowing capacity from this source was $41.23 million.  At September 30, 2015, Middleburg Bank had $24.47 million of outstanding borrowings pursuant to securities sold under agreements to repurchase transactions (“Repo Accounts”), with maturities of one day.  The Repo Accounts are long-term commercial checking accounts with average balances that typically exceed $100,000.  

The Company has a secured line of credit with the Federal Home Loan Bank of Atlanta. The credit available from this line depends on the total assets of the bank. As of September 30, 2015, the remaining credit availability from this line was up to $310.80 million, while the amount of eligible lendable collateral, in the form of qualifying real estate secured loans, was $124.91 million. The bank would have to post additional collateral, in the form of eligible securities, if it sought to borrow more than the amount of eligible lending collateral. The Company had $257.71 million of unencumbered securities as of September 30, 2015.

At September 30, 2015, cash, interest-bearing deposits with other banks, federal funds sold, short-term investments and unencumbered securities available for sale were 26.21% of total deposits and liabilities.

Off-Balance Sheet Arrangements
As of September 30, 2015, there have been no material changes to the off-balance sheet arrangements disclosed in “Management’s Discussion and Analysis” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014.

Caution About Forward Looking Statements

Certain information contained in this discussion may include “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended.  These forward-looking statements are generally identified by phrases such as “the Company expects,” “the Company believes” or words of similar import.

Such forward-looking statements involve known and unknown risks including, but not limited to, the following factors:
further adverse changes in general economic and business conditions in the Company’s market area;
changes in banking and other laws and regulations applicable to the Company;
maintaining asset qualities;
the ability to properly identify risks in our loan portfolio and calculate an adequate loan loss allowance;
risks inherent in making loans such as repayment risks and fluctuating collateral values;
concentration in loans secured by real estate;
changing trends in customer profiles and behavior;
changes in interest rates and interest rate policies;
maintaining cost controls as the Company opens or acquires new facilities;
competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;
the ability to continue to attract low cost core deposits to fund asset growth;
the ability to successfully manage the Company’s growth or implement its growth strategies if it is unable to identify attractive markets, locations or opportunities to expand in the future;
reliance on the Company’s management team, including its ability to attract and retain key personnel;
demand, development and acceptance of new products and services;
problems with technology utilized by the Company;
maintaining capital levels adequate to support the Company’s growth; and
other factors described in Item 1A, “Risk Factors,” discussed in more detail in the Company's Annual Report on Form 10-K for the year ended December 31, 2014.

Although the Company believes that its expectations with respect to the forward-looking statements are based upon reliable assumptions within the bounds of its knowledge of its business and operations, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements.


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ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates or prices such as interest rates, foreign currency exchange rates, commodity prices and equity prices.  The Company’s primary market risk exposure is interest rate risk, though it should be noted that the assets under management by Middleburg Trust Company are affected by equity price risk.  The ongoing monitoring and management of this risk is an important component of the Company’s asset/liability management process, which is governed by policies established by its Board of Directors that are reviewed and approved annually. The Board of Directors delegates responsibility for carrying out asset/liability management policies to the Asset/Liability Committee (“ALCO”) of Middleburg Bank.  In this capacity, ALCO develops guidelines and strategies that govern the Company’s asset/liability management related activities, based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends.

Interest rate risk represents the sensitivity of earnings to changes in market interest rates.  As interest rates change, the interest income and expense streams associated with the Company’s financial instruments also change, affecting net interest income, the primary component of the Company’s earnings.  ALCO uses the results of a detailed and dynamic simulation model to quantify the estimated exposure of net interest income to sustained interest rate changes.  While ALCO routinely monitors simulated net interest income sensitivity over a rolling two-year horizon, it also employs additional tools to monitor potential longer-term interest rate risk.  

The simulation model captures the impact of changing interest rates on the interest income received and interest expense paid on all assets and liabilities reflected on the Company’s balance sheet.  The simulation model is prepared and updated four times during each year.  This sensitivity analysis is compared to ALCO policy limits, which specify a maximum tolerance level for net interest income exposure over a one-year horizon, assuming no balance sheet growth, given a 200 basis point (bp) upward shift and a 200 basis point downward shift in interest rates.  The following reflects the range of the Company’s net interest income sensitivity analysis as of September 30, 2015 and December 31, 2014.
Estimated Net Interest Income Sensitivity
Rate Change
 
September 30, 2015
 
December 31, 2014
+ 200 bps
 
7.0%
 
4.3%
- 200 bps
 
(17.6)%
 
(14.8)%

At September 30, 2015, the Company’s interest rate risk model indicated that for an immediate 200 basis points increase in interest rates, net interest income was expected to increase by 7.00% over a 12-month period.  For the same time period, the interest rate risk model indicated that, for an immediate 200 basis points decrease in interest rates, net interest income was expected to decrease by 17.6% over a 12-month period.  While these numbers are subjective based upon the parameters used within the model, management believes the balance sheet is slightly asset sensitive.

The Company’s specific goal is to lower, where possible, the cost of its borrowed funds.

The preceding sensitivity analysis does not represent the Company's forecast and should not be relied upon as being indicative of expected operating results.  These hypothetical estimates are based upon numerous assumptions, including the nature and timing of interest rate levels including yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment or replacement of asset and liability cash flows.  While assumptions are developed based upon current economic and local market conditions, the Company cannot make any assurances about the predictive nature of these assumptions, including how customer preferences or competitor influences might change.

Also, as market conditions vary from those assumed in the sensitivity analysis, actual results will also differ due to factors such as prepayment and refinancing levels likely deviating from those assumed, the varying impact of interest rate change, caps or floors on adjustable rate assets, the potential effect of changing debt service levels on customers with adjustable rate loans, depositor early withdrawals and product preference changes, and other internal and external variables.  Furthermore, the sensitivity analysis does not reflect actions that the ALCO might take in response to or in anticipation of changes in interest rates.

ITEM 4.    CONTROLS AND PROCEDURES

As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e)

49


under the Securities Exchange Act of 1934, as amended.)  Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective.

The Company’s management is also responsible for establishing and maintaining adequate internal control over financial reporting.  There were no changes in the Company’s internal control over financial reporting identified in connection with the evaluation of it that occurred during the Company’s last fiscal quarter that materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

PART II

ITEM 1.    LEGAL PROCEEDINGS

There are no material pending legal proceedings to which the Company is a party or of which the property of the Company is subject.

ITEM 1A.    RISK FACTORS

Our operations are subject to many risks that could adversely affect our future financial condition and performance and, therefore, the market value of our securities. The risk factors that are applicable to us are outlined in our Annual Report on Form 10-K for the year ended December 31, 2014. There have been no material changes in our risk factors from those disclosed in this report.

ITEM 2.    UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
 
None.

ITEM 3.    DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4.MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5.    OTHER INFORMATION

None.

ITEM 6.    EXHIBITS
31.1

Rule 13a-14(a) Certification of Chief Executive Officer
31.2

Rule 13a-14(a) Certification of Chief Financial Officer
32.1

Statement of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. § 1350
101

The following materials from the Middleburg Financial Corporation Quarterly Report on Form 10-Q for the quarter ended September 30, 2015 formatted in Extensible Business reporting Language (XBRL):  (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Income, (iii) Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Changes in Shareholders’ Equity, (v) Consolidated Statements of Cash Flows, and (vi) Notes to Consolidated Financial Statements.


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SIGNATURES
 
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

MIDDLEBURG FINANCIAL CORPORATION
 
 
 
 
Date:
November 6, 2015
By:
/s/ Gary R. Shook
 
 
 
Gary R. Shook
 
 
 
Chief Executive Officer
 
 
 
 
 
 
 
 
Date:
November 6, 2015
By:
/s/ Raj Mehra
 
 
 
Raj Mehra
 
 
 
Chief Financial Officer
 
 
 
 



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EXHIBIT INDEX

Exhibits

31.1
Rule 13a-14(a) Certification of Chief Executive Officer
31.2
Rule 13a-14(a) Certification of Chief Financial Officer
32.1
Statement of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. § 1350
101
The following materials from the Middleburg Financial Corporation Quarterly Report on Form 10-Q for the quarter ended September 30, 2015 formatted in Extensible Business reporting Language (XBRL):  (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Income, (iii) Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Changes in Shareholders’ Equity, (v) Consolidated Statements of Cash Flows, and (vi) Notes to Consolidated Financial Statements.