UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

For the quarterly period ended September 30, 2016

or

For the transition period from                      to                     

Commission File Number: 0-20957

 

SUN BANCORP, INC.

(Exact name of registrant as specified in its charter)

 

 

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

(Address of principal executive offices) (Zip Code)

(856) 691-7700

(Registrant’s telephone number, including area code)

N/A

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

 

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ☒    No  ☐

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

 

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

Common Stock, $5.00 Par Value – 18,897,090 Shares Outstanding at November 4, 2016

 

 

 

 

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TABLE OF CONTENTS

 

 

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SUN BANCORP, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands, except par value amounts)

 

 

See Notes to Unaudited Condensed Consolidated Financial Statements.

 

 

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SUN BANCORP, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

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

 

 

See Notes to Unaudited Condensed Consolidated Financial Statements.

 

 

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SUN BANCORP, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Dollars in thousands)

 

 

 

 

See Notes to Unaudited Condensed Consolidated Financial Statements.

 

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SUN BANCORP, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(Dollars in thousands)

 

 

See Notes to Unaudited Condensed Consolidated Financial Statements.

 

 

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SUN BANCORP, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

 

 

See Notes to Unaudited Condensed Consolidated Financial Statements.

 

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SUN BANCORP, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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

 

 

(1) Organization

Sun Bancorp, Inc. (the “Company”) is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended. The Company is the parent company of Sun National Bank (the “Bank”), a national bank and the Company’s principal wholly owned subsidiary. The Bank’s wholly owned subsidiaries are Prosperis Financial Solutions, LLC (“Prosperis Financial Solutions”), 2020 Properties, L.L.C. and 4040 Properties, L.L.C.

The Company’s principal business is to serve as a holding company for the Bank. Through the Bank, the Company provides commercial and consumer banking services. The Bank is in the business of attracting customer deposits through its Community Banking Centers and investing these funds, together with borrowed funds and cash from operations, in loans, primarily commercial real estate and multifamily residential loans, as well as mortgage-backed and investment securities. The principal business of Prosperis Financial Solutions is to offer mutual funds, securities brokerage, annuities and investment advisory services through the Bank’s Community Banking Centers. The principal business of 2020 Properties, L.L.C. and 4040 Properties, L.L.C. is to acquire and thereafter liquidate certain real estate and other assets in satisfaction of debts previously contracted by the Bank. The Company’s five capital trusts, Sun Capital Trust V, Sun Capital Trust VI, Sun Capital Trust VII, Sun Statutory Trust VII and Sun Capital Trust VIII, collectively, the “Issuing Trusts,” are presented on a deconsolidated basis. The Issuing Trusts, consisting of four Delaware business trusts and one Connecticut business trust, hold junior subordinated debentures issued by the Company.

As of September 30, 2016, the Company had 37 locations primarily throughout New Jersey, including 31 branch offices. The Company also had one loan production office located in each of New York and Pennsylvania.

The Company’s outstanding common stock is traded on the NASDAQ Global Select Market under the symbol “SNBC.” The Company is subject to the reporting requirements of the Securities and Exchange Commission (“SEC”). The Company’s primary federal regulator is the Board of Governors of the Federal Reserve System (the “FRB”) and the Bank’s primary federal regulator is the Office of the Comptroller of the Currency (the “OCC”).

 

 

(2) Summary of Significant Accounting Policies

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

All normal recurring adjustments that, in the opinion of management, are necessary for a fair presentation of the unaudited condensed consolidated financial statements have been included. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the accompanying notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015 filed with the SEC. The results for the three and nine months ended September 30, 2016 are not necessarily indicative of the results that may be expected for the year ending December 31, 2016 or any other period. The preparation of the unaudited condensed consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expense during the reporting period. The significant estimates include the allowance for loan losses, other-than-temporary impairment (“OTTI”) on investment securities, goodwill, income taxes, stock-based compensation and the fair value of financial instruments. Actual results may differ from these estimates under different assumptions or conditions.

 

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

Segment Information. As defined in accordance with FASB ASC 280, Segment Reporting, the Company has one reportable and operating segment, “Community Banking.” All of the Company’s activities are interrelated, and each activity is dependent and assessed based on how each of the activities of the Company supports the others. For example, lending is dependent upon the

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ability of the Company to fund itself with deposits and other borrowings and manage interest rate and credit risk. In addition, the Company’s chief operating decision maker reviews the Company’s financial data on a consolidated basis when assessing financial performance. Accordingly, all significant operating decisions are based upon analysis of the Company as one segment or unit.

Investment Securities. The Company’s investment portfolio includes both held-to-maturity and available-for-sale securities. The purchase and sale of the Company’s investment securities are recorded based on trade date accounting.  At September 30, 2016 and December 31, 2015 the Company had no unsettled investment purchase or sale transactions. The following provides further information on the Company’s accounting for debt securities:

Held-to-Maturity – Investment securities that management has the positive intent and ability to hold until maturity are classified as held-to-maturity and carried at their remaining unpaid principal balance, net of unamortized premiums or unaccreted discounts. Premiums are amortized and discounts are accreted using the interest method over the estimated remaining term of the underlying security.

Available-for-Sale – Investment securities that will be held for indefinite periods of time, including securities that may be sold in response to changes in market interest or prepayment rates, needs for liquidity and changes in the availability and the yield of alternative investments, are classified as available-for-sale. These assets are carried at their estimated fair value. Fair values are based on quoted prices for identical assets in active markets, quoted prices for similar assets in markets that are either actively or not actively traded, or in some cases where there is limited activity or less transparency around inputs, internally developed discounted cash flow models. Unrealized gains and losses are excluded from earnings and are reported net of tax in accumulated other comprehensive income (loss) on the unaudited condensed consolidated statements of financial condition until realized, including those recognized through the non-credit component of an OTTI charge.

In accordance with FASB ASC 325-40, Beneficial Interests in Securitized Financial Assets (FASB ASC 325-40), and FASB ASC 320, Investment – Debt and Equity Securities (FASB ASC 320), the Company evaluates its securities portfolio for OTTI throughout the year. Each investment, which has a fair value less than the book value, is reviewed on a quarterly basis by management. Management considers, at a minimum, whether the following factors exist that, both individually or in combination, could indicate that the decline is other-than-temporary: (a) the Company has the intent to sell the security; (b) it is more likely than not that it will be required to sell the security before recovery; and (c) the Company does not expect to recover the entire amortized cost basis of the security. Among the factors that are considered in determining the Company’s intent is a review of capital adequacy, the interest rate risk profile and liquidity at the Company. An impairment charge is recorded against individual securities if the review described above concludes that the decline in value is other-than-temporary. During the nine months ended September 30, 2016 and 2015, it was determined there were no other-than-temporarily impaired investments. As a result, the Company did not record credit related OTTI charges through earnings during the nine months ended September 30, 2016 and 2015.

Loans Held-For-Sale. Loans held-for-sale totaled $1.5 million at September 30, 2016 and consists of one commercial loan and one consumer loan which are recorded at the lower of cost or market.  Loans held for sale totaled $0 at December 31, 2015.

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

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

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

Goodwill. Goodwill is the excess of the fair value of liabilities assumed over the fair value of tangible and identifiable intangible assets acquired in a business combination. Goodwill is not amortized but is tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. The Company tests goodwill for impairment annually as of December 31, unless circumstances indicate that a test is required at an earlier date. The Company elected to not apply the qualitative evaluation option permitted under Accounting Standards Update (“ASU”) 2011-8, Intangibles – Goodwill and Other (Topic 35): Testing Goodwill for Impairment issued in September 2011. Therefore, the Company utilizes the two-step goodwill impairment test outlined in FASB ASC 350, Intangibles – Goodwill and Other (“FASB ASC 350”). Step one, which is used to identify potential impairment, compares the fair value of the reporting unit with its carrying amount, including goodwill. A reporting unit is an operating segment, or one level below an operating segment, as defined in FASB ASC 280. The Company has one reportable operating segment, “Community Banking,” and there are no components to this operating segment. If the fair value of a reporting unit exceeds its carrying value, goodwill of the reporting unit is not considered impaired and step two is therefore unnecessary. If the carrying amount of the reporting unit exceeds its fair value, the second step is performed to measure the amount of the impairment loss, if any. At December 31, 2015, the Company performed its annual goodwill impairment test, and step one of the analysis indicated that the Company’s fair value was greater than its carrying value; therefore, the Company’s goodwill was not impaired at December 31, 2015. Since that time, no event has occurred nor have circumstances changed that would more likely than not reduce the fair value of the reporting unit below its carrying amount. The carrying amount of goodwill totaled $38.2 million at both September 30, 2016 and December 31, 2015.

Bank Owned Life Insurance (“BOLI”). The Company has purchased life insurance policies on certain key employees. These policies are recorded at their cash surrender value, or the amount that can be realized in accordance with FASB ASC 325-30, Investments in Insurance Contracts. At September 30, 2016, the Company had $28.4 million invested in a general account and $54.3 million in a separate account, for a total BOLI cash surrender value of $82.7 million. The BOLI separate account is invested in a mortgage-backed securities fund, which is managed by an independent investment firm. Pricing volatility of these underlying instruments may have an impact on investment income; however, the fluctuations would be partially mitigated by a

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stable value wrap agreement which is a component of the separate account. Income from these policies and changes in the cash surrender value are recorded in BOLI income in the unaudited condensed consolidated statements of operations.

Accounting for Income Taxes. The Company accounts for income taxes in accordance with FASB ASC 740, Income Taxes (“FASB ASC 740”). FASB ASC 740 requires the recording of deferred income taxes that reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Management exercises significant judgment in the evaluation of the amount and timing of the recognition of the resulting tax assets and liabilities. The judgments and estimates required for the evaluation are updated based upon changes in business factors and the tax laws. If actual results differ from the assumptions and other considerations used in estimating the amount and timing of tax recognized, there can be no assurance that additional expenses will not be required in future periods. The Company recognizes, when applicable, interest and penalties related to unrecognized tax benefits in the provision for income taxes in the unaudited condensed consolidated statements of operations. Assessment of uncertain tax positions under FASB ASC 740 requires careful consideration of the technical merits of a position based on management’s analysis of tax regulations and interpretations. Significant judgment is applied when addressing the requirements of FASB ASC 740.   At September 30, 2016, the Company had a valuation allowance of $128.0 million against its gross deferred tax asset. As the Company remained in a cumulative loss position, the deferred tax valuation allowance is still appropriate at September 30, 2016. The net deferred tax liability of $3.4 million in the unaudited condensed consolidated statements of financial condition at September 30, 2016 primarily represents the tax liability created from the goodwill amortization recorded for tax purposes and not for book purposes.

Accumulated Other Comprehensive Income (Loss). The Company classifies items of accumulated comprehensive income (loss) by their nature and displays the details of other comprehensive income (loss) in the unaudited condensed consolidated statements of comprehensive income. Amounts categorized as comprehensive income (loss) represent net unrealized gains or losses on investment securities available for sale, net of tax and the non-credit portion of any OTTI loss not recorded in earnings. Reclassifications are made to avoid double counting items which are displayed as part of net income (loss) for the period. These reclassifications for the three and nine months ended September 30, 2016 and 2015 were as follows:

 

 

 

 

 

Recent Accounting Principles.

 

In August 2016, the FASB issued ASU 2016-15: Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. The amendments in this Update address the following eight specific cash flow issues with the objective of reducing the existing diversity in practice: (1) debt prepayments or debt extinguishment cost (cash outflow-financing), (2) settlement of debt instruments with coupon interest rates insignificant to the effective interest rate, Interest payment (cash outflow-operating), principal payment (cash outflow-financing), (3) contingent consideration payments made soon after business combination (cash outflow-investing), (4) proceeds from settlement of insurance claims (classification on basis of the nature of each loss), (5) proceeds from corporate/bank-owned life insurance, proceeds (cash inflow-investing), payments (cash outflow-investing/operating), (6) distribution received from equity method investees, cumulative earnings approach (cash inflow-investing), nature of distribution approach (cash inflow-operating/investing), (7) beneficial interest in securitization transactions, assets (noncash transaction), cash receipts from trade receivable (cash inflow-investing), (8) separately identifiable cash flows (classified based on source-financing/investing/operating).  The amendments in this Update are effective for public business entities for the fiscal years beginning after December 15, 2017 and interim periods within those fiscal years.  Early

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adoption is permitted, including adoption in an interim period.  If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period.  An entity that elects early adoption must adopt all of the amendments in the same period.   The Company is currently evaluating the impact of the adoption of this accounting standards update on its financial statements.

 

In June 2016, the FASB issued ASU 2016-13: Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which applies to entities holding financial assets and net investment in leases that are not accounted for at fair value through net income.  The amendments affect loans, debt securities, trade receivables, net investments in leases, off-balance-sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash.  The amendments broaden the information that an entity must consider in developing its expected credit loss estimate for assets measured either collectively or individually.  The amendments in ASU 2016-13 for public business entities are effective for the fiscal years beginning after December 15, 2019.  Early adoption is permitted as of the fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.  The Company is currently evaluating the impact of the adoption of this accounting standards update on its financial statements.

 

In March 2016, the FASB issued ASU 2016-09: Compensation — Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, which applies to all entities that issue share-based payment awards to their employees. The amendments involve several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. The amendments are part of FASB's Simplification Initiative, the stated objective of which is to identify, evaluate, and improve areas of GAAP for which cost and complexity can be reduced while maintaining or improving the usefulness of the information provided to users of financial statements. The amendments in ASU 2016-09 for public business entities are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. Early adoption is permitted for any entity in any interim or annual period and if so elected, adjustments should be reflected as of the beginning of the fiscal year that includes the interim period. An entity that elects early adoption must adopt all of the amendments in the same period. The Company is currently evaluating the impact of the adoption of this accounting standards update on its financial statements.

 

In February 2016, the FASB issued ASU 2016-02: Leases (Topic 842). This ASU is intended to improve financial reporting about leasing transactions and affects all companies and other organizations that lease assets such as real estate, airplanes, and manufacturing equipment. The ASU will require organizations that lease assets to recognize on the balance sheet the assets and liabilities for the rights and obligations created by those leases with over twelve month terms. The accounting by organizations that own the assets leased by the lessee will remain largely unchanged from current requirements under GAAP. However, the ASU contains some targeted improvements that are intended to align, where necessary, lessor accounting with the lessee accounting model and with the updated revenue recognition guidance issued in 2014. The amendments in this ASU are effective for public business entities for fiscal years and interim periods beginning after December 15, 2018. The Company is currently evaluating the impact of the adoption of this accounting standards update on its financial statements.

In January 2016, the FASB issued ASU 2016-01: Financial Instruments- Overall (Subtopic 825-10). The amendments in this ASU affect all entities that hold financial assets or owe financial liabilities. The amendments in this ASU make targeted improvements to GAAP as follows: (1) Require certain equity investments to be measured at fair value with changes in fair value recognized in net income; (2) Simplify the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; (3) Eliminate the requirement to disclose the fair value of financial instruments measured at amortized cost for entities that are not public business entities; (4) Eliminate the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet; (5) Require public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; (6) Require an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments; (7) Require separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements; and (8) Clarify that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets. The amendments in this ASU are effective for public business entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company is currently evaluating the impact of the adoption of this accounting standards update on its financial statements.

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

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revenue to depict the transfer of promised goods or services to customers in an amount that reflects the considerations to which the entity expects to be entitled in exchange for those goods or services. The guidance in this Update affects any entity that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets, unless those contracts are within the scope of other standards. For a public entity, the amendments in this Update are effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. Early adoption is not permitted. The Company does not expect the adoption of this guidance to have a material impact on its financial condition or results of operations.

 

 

(3) Branch Sales

On August 28, 2015, the Company sold the Bank’s Hammonton branch assets, related deposits and loans (the “Hammonton Agreement”) to Cape Bancorp. Inc.  The Company sold $32.0 million of deposits, $4.8 million of loans, $354 thousand of fixed assets and $143 thousand of cash.  After transaction costs, the sale resulted in a net gain of $1.3 million in the three months ended September 30, 2015, recorded in gain on sale of bank branches in the unaudited condensed consolidated statements of operations.

On March 6, 2015, the Company sold seven branch offices to Sturdy Savings Bank.  In accordance with the sale, the Company sold $153.3 million of deposits, $63.8 million of loans, $4.0 million of fixed assets and $897 thousand of cash. The transaction resulted in a net cash payment of approximately $71.5 million by the Company to Sturdy Savings Bank. After transaction costs, the sale resulted in a net gain of $9.2 million which was recorded in the first quarter of 2015 and is reflected in the gain on sale of bank branches in the unaudited condensed consolidated statements of operations for the nine months ended September 30, 2015.

 

 

(4) Stock-Based Compensation

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

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

The Company’s stock-based incentive plan authorizes the issuance of shares of common stock pursuant to awards that may be granted in the form of stock options to purchase common stock (“Options”) and awards of shares of (or share units with respect to) common stock (“Stock Awards”). The purpose of the Company’s stock-based incentive plan is to give the Company a competitive advantage in attracting, retaining, and motivating officers, employees, directors, and consultants and to provide the Company and its subsidiaries and affiliates with a compensation plan providing incentives for future performance of services directly linked to the profitability of the Company’s businesses and increases in Company shareholder value. Under the Company’s stock-based incentive plan, Options expire 10 years after the date of grant, unless terminated earlier under the Option’s terms. For both Options and Stock Awards, a committee of independent directors has the authority to determine the conditions upon which the Options or Stock Awards granted will vest.

In March 2015, the Board of Directors of the Company approved the Sun Bancorp, Inc. 2015 Omnibus Stock Incentive Plan (the “2015 Plan”). The 2015 Plan, which was approved by shareholders in May 2015, at which time the Company ceased new grants under the 2014 Performance Equity Plan, the 2010 Stock-Based Incentive Plan, and the 2004 Stock-Based Incentive Plan (collectively, the “Prior Plans”). Any awards outstanding under the Prior Plans remain in full force and effect under such plans according to their respective terms. The 2015 Plan authorizes the issuance of 1,400,000 shares of common stock pursuant to awards that may be granted in the form of Options and Stock Awards. For the purpose of calculating the number of shares available for issuance under the 2015 Plan, each issued Option equals one share and each issued Stock Award equals two shares.

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Under the 2015 Plan, Options expire 10 years after the date of grant, unless terminated earlier under the option terms. For both Options and Stock Awards, a Committee of independent directors has the authority to determine the conditions upon which the Options or Stock Awards granted will vest. At September 30, 2016, there were 123,739 Options and 179,118 Stock Awards granted under the 2015 Plan.  

Activity in the Company’s stock option plans for the nine months ended September 30, 2016 and September 30, 2015 was as follows:

Summary of Options Activity

 

 

 

 

The weighted average remaining contractual term was approximately 7.3 years for Options outstanding and 5.4 years for Options exercisable as of September 30, 2016.

At September 30, 2016, the aggregate intrinsic value was $1.7 million for Options outstanding and $482 thousand for Options exercisable.

During the nine months ended September 30, 2016, the Company granted 123,739 Options pursuant to the 2015 Plan and during the nine months ended September 30, 2015, the Company granted 218,760 Options pursuant to the Company’s 2010 Stock-Based Incentive Plan.  In accordance with FASB ASC 718, the fair value of the Options granted are estimated on the date of grant using the Black-Scholes option pricing model which uses the assumptions in the table below. The expected term of an Option is estimated using historical exercise behavior of employees at a particular level of management who were granted Options with a comparable term. The Options have historically been granted with a 10 year term. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of the grant. The expected volatility is based on the historical volatility of the Company’s stock price.

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Significant weighted average assumptions used to calculate the fair value of the Options for the nine months ended September 30, 2016 and 2015 are as follows:

 

 

A summary of the Company’s nonvested Stock Award activity during the nine months ended September 30, 2016 and 2015 are presented in the following tables:

Summary of Nonvested Stock Award Activity

 

 

 

There were 118,549 shares of nonvested Stock Awards issued during the nine months ended September 30, 2016 and 50,864 nonvested Stock Awards issued during the nine months ended September 30, 2015. The value of these shares is based upon the closing price of the Company’s common stock on the date of grant. Compensation expense is recognized on a straight-line basis over the service period for all of the nonvested Stock Awards issued.

Total compensation expense recognized related to Options and nonvested Stock Awards, including that for non-employee directors, during the three and nine months ended September 30, 2016 was $633 thousand and $1.9 million, respectively, as compared to $527 thousand and $1.4 million, respectively, for the three and nine months ended September 30, 2015.  As of September 30, 2016, there was approximately $5.2 million of total unrecognized compensation cost related to Options and nonvested Stock Awards. The cost of the Options and Stock Awards is expected to be recognized over a weighted average period of 3.4 years and 2.5 years, respectively.

 

 

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(5) Investment Securities

The amortized cost of investment securities and the approximate fair value at September 30, 2016 and December 31, 2015 were as follows:

 

 

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During the nine months ended September 30, 2016, the Company had one security mature which had an aggregate par value of $248 thousand.  Additionally, the Bank had one security called with an aggregate par value of $5.0 million which resulted in income of $22 thousand. During the same period, six securities were sold prior to maturity for gross proceeds of $37.8 million, which resulted in gross realized gains of $328 thousand and gross realized losses of $290 thousand. In addition, the Company recorded a gain of $387 thousand related to the sale of Class B Visa shares which had no book value.  The following table provides the gross unrealized losses and fair value, aggregated by investment category and length of time the individual securities have been in a continuous unrealized loss position at September 30, 2016 and December 31, 2015:

Gross Unrealized Losses by Investment Category

 

 

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

FASB ASC 320-10 requires the Company to assess if an OTTI exists by considering whether the Company has the intent to sell the security or it is more likely than not that it will be required to sell the security before recovery. If either of these situations applies, the guidance requires the Company to record an OTTI charge to earnings on debt securities for the difference between the amortized cost basis of the security and the fair value of the security. If neither of these situations applies, the Company is required to assess whether it is expected to recover the entire amortized cost basis of the security. If the Company is not expected to recover the entire amortized cost basis of the security, the guidance requires the Company to bifurcate the identified OTTI into a credit loss component and a component representing loss related to other factors. A discount rate is applied which equals the effective yield of the security. The difference between the present value of the expected cash flows and the amortized book value is considered a credit loss. When a market price is not readily available, the market value of the security is determined using the same expected cash flows; the discount rate is a rate the Company determines from open market and other sources as appropriate for the security. The difference between the market value and the present value of cash flows expected to be collected is recognized in accumulated other comprehensive loss on the unaudited condensed consolidated statements of financial condition. Application of this guidance resulted in no OTTI charges during the nine months ended September 30, 2016 and 2015.

As of September 30, 2016, the Company’s cumulative OTTI balance was $1.2 million. There were no OTTI charges recognized in earnings as a result of credit losses on investments in the three and nine months ended September 30, 2016 and 2015.

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U.S. Government Agency Mortgage-Backed Securities. At September 30, 2016, the gross unrealized loss in the category of less than 12 months of $56 thousand consisted of four mortgage-backed securities with an estimated fair value of $30.9 million. The gross unrealized loss in the category of 12 months or longer of $203 thousand consisted of four mortgage-backed securities with an estimated fair value of $13.0 million issued and guaranteed by a U.S. Government sponsored agency. The Company monitors key credit metrics such as market rates and possible credit deterioration to determine if an OTTI exists. As of September 30, 2016, management concluded that an OTTI did not exist on any of the aforementioned securities based upon its assessment. Management also concluded that it does not intend nor will it be required to sell the securities, before their recovery, which may be maturity, and management expects to recover the entire amortized cost basis of these securities.

Collateralized Loan Obligations. At September 30, 2016, the gross unrealized loss in the category of collateralized loan obligations with a continuous loss position of less than 12 months was $19 thousand, which consisted of one AAA-rated security with a total estimated fair value of $10.0 million. The gross unrealized loss in the category of collateralized loan obligations with a continuous loss position of 12 months or longer was $222 thousand, which consisted of two AAA and two AA-rated collateralized loan obligation securities with a total estimated fair value of $25.3 million. The Company monitors key credit metrics such as delinquencies, defaults, cumulative losses and credit support levels to determine if an OTTI exists. As of September 30, 2016, management concluded that an OTTI did not exist on any of the aforementioned securities based upon its assessment. Management also concluded that it does not intend nor will it be required to sell the securities, before their recovery, which may be maturity, and management expects to recover the entire amortized cost basis of these securities.

Trust Preferred Securities. At September 30, 2016, the gross unrealized loss in the category of trust preferred securities with a continuous loss position of 12 months or longer was $2.3 million, which consisted of two trust preferred securities. The trust preferred securities are comprised of one non-rated single issuer security with an amortized cost of $3.2 million and an estimated fair value of $3.0 million and one investment grade rated pooled security with an amortized cost of $8.8 million and an estimated fair value of $6.8 million.

For the pooled security, the Company monitors each issuer in the collateral pool with respect to financial performance using data from the issuer’s most recent regulatory reports as well as information on issuer deferrals and defaults. Also, the security structure is monitored with respect to collateral coverage and current levels of subordination. Expected future cash flows are projected assuming additional defaults and deferrals based on the performance of the collateral pool. The pooled security is in a senior position in the capital structure. The security had a 3.3 times principal coverage. As of the most recent reporting date, interest has been paid in accordance with the terms of the security. The Company reviews projected cash flow analysis for adverse changes in the present value of projected future cash flows that may result in an other-than-temporary credit impairment to be recognized through earnings. The most recent valuations assumed no recovery on any defaulted collateral, no recovery on any deferring collateral and an additional 3.6% of defaults or deferrals’ every three years with no recovery rate. As of September 30, 2016, management concluded that an OTTI did not exist on the aforementioned security based upon its assessment. Management also concluded that it does not intend to sell the security, and that it is not more likely than not it will be required to sell the security, before its recovery, which may be maturity, and management expects to recover the entire amortized cost basis of this security.

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

During the nine months ended September 30, 2016, the Company did not record an OTTI credit-related charge related to this single issuer trust preferred security. Based on the Company’s most recent evaluation, and based upon the receipt of all scheduled dividend payments since September 2014, the Company does not expect the issuer to default on the security based primarily on the issuer’s subsidiary bank reporting that it meets the minimum regulatory requirements to be considered a “well capitalized” institution. The cumulative OTTI on this security as of September 30, 2016 was $1.2 million. Based upon the current capital position of the issuer and recent improvements in the financial performance of the issuer, the Company concluded that an additional impairment charge was not warranted at September 30, 2016.

On January 14, 2014, five federal agencies approved an interim final rule to permit banking entities to retain interests in certain collateralized debt obligations backed primarily by trust preferred securities as an exception to the investment prohibitions of the Volcker Rule. Under the interim final rule, the agencies permit the retention of an interest in or sponsorship of covered funds by banking entities if certain qualifications are met. In addition, the agencies released a non-exclusive list of issuers that meet the requirements of the interim final rule. The issuer of the pooled security was included in the non-exclusive list of issuers that meet the requirements of the interim final rule, and therefore, the pooled security will not be required to be sold by the Company. The single issuer security is not subject to the provisions of the Volcker rule. At September 30, 2016, the Company

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was in full compliance with the requirements of the Volcker Rule. See Note 13 of the notes to unaudited condensed consolidated financial statements for more information regarding the Volcker Rule.

The amortized cost and estimated fair value of the investment securities, by contractual maturity, at September 30, 2016 and December 31, 2015 are shown below. Actual maturities will differ from contractual maturities as borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

 

At September 30, 2016, the Company had $14.9 million, amortized cost, and $15.0 million estimated fair value of investment securities pledged to secure public deposits. As of September 30, 2016, the Company had $153.2 million amortized cost and $154.6 million estimated fair value of investment securities pledged as collateral on secured borrowings.

 

 

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(6) Loans

The components of loans as of September 30, 2016 and December 31, 2015 were as follows:

Loan Components

 

 

The following table is a comparison of the Company’s non-accrual loans as of September 30, 2016 and December 31, 2015:

Loans on Non-Accrual Status

 

 

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

As of September 30, 2016, the Company had $12.5 million outstanding on three commercial construction and land development relationships for which the agreements included interest reserves. As of December 31, 2015, the Company had $8.8 million outstanding on two residential construction, commercial construction and land development relationships for which the agreements included interest reserves. The total amount available in those reserves to fund interest payments was $363 thousand and $571 thousand at September 30, 2016 and December 31, 2015, respectively. There were no relationships with interest reserves which were on non-accrual status at September 30, 2016 and December 31, 2015. Construction projects are monitored throughout their lives by the Company through either internal resources or professional inspectors engaged by the Company. The budgets for loan advances and borrower equity injections are developed at the time of underwriting in conjunction with the review of the plans and specifications for the project being financed. Advances of the Company’s funds are based on the prepared budgets and will not be made unless the project has been inspected by the Company’s professional inspector who must

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certify that the work related to the advance is in place and properly complete. As it relates to construction project financing, the Company does not extend, renew or restructure terms unless its borrower posts cash collateral in an interest reserve.

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

 

 

(7) Allowance for Loan Losses

Changes in the allowance for loan losses were as follows:

Allowance for Loan Losses and Recorded Investment in Financing Receivables

 

 

 

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Risk Characteristics

 

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

Home Equity Loans. This segment consists of both home equity lines of credit and home equity term loans on single family residences. These loans rely on the personal income of the borrower for repayment which may be impacted by economic conditions, such as unemployment levels, interest rates and the housing market. These loans are primarily secured by second liens on the property, which serves as the secondary source of repayment. The secondary source of repayment may be impaired by the real estate market and local regulations. The Company ceased all origination activity on home equity lines of credit and all home equity term loans in the second half of 2014.

Residential Real Estate Loans. Included in this segment are residential mortgages on single family residences. These loans rely on the personal income of the borrower for repayment which may be impacted by economic conditions, such as unemployment levels, interest rates and the housing market. These loans are primarily secured by a lien on the underlying property, which serves as the secondary source of repayment. The secondary source of repayment may be impaired by the real estate market and local regulations. Beginning in the third quarter of 2014, the Company ceased all residential real estate origination activity for both its portfolio and for sale to the secondary market.

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

The allowance for loan losses was $15.8 million and $18.0 million at September 30, 2016 and December 31, 2015, respectively. The ratio of allowance for loan losses to gross loans held-for-investment was 1.01% at September 30, 2016 and 1.16% at December 31, 2015.

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

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

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

 

 

 

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In accordance with FASB ASC 310, those impaired loans for which the collateral is sufficient to support the outstanding principal do not result in a specific allowance for loan losses. Included in impaired loans at September 30, 2016 were eleven TDRs, totaling $3.4 million, for which the collateral is sufficient to support the outstanding principal, one of which was in accruing status. There were no TDRs at September 30, 2016 that included a commitment to lend additional funds as of September 30, 2016.

There were three and six TDR agreements entered into during the three and nine months ended September 30, 2016, respectively. The following table presents a summary of the Company’s TDR agreements entered into during the three and nine months ended September 30, 2016:

 

 

There were zero and three TDR agreements entered into during the three and nine months ended September 30, 2015, respectively.  The following table presents a summary of the Company’s TDR agreements entered into during the nine months ended September 30, 2015.

 

 

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The following table presents information regarding the types of concessions granted on loans that were restructured during the three and nine months ended September 30, 2016 and 2015:

 

 

 

During the nine month periods ended September 30, 2016 and 2015, the Company did not have any TDR agreements that had subsequently defaulted that were entered into within the respective preceding twelve months.  

The following table presents the Company’s distribution of risk ratings within the Company’s held-for-investment loan portfolio, segregated by class, as of September 30, 2016 and December 31, 2015:

Credit Quality Indicators by Internally Assigned Grade

 

 

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

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

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

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

The following table presents the Company’s analysis of past due loans, segregated by class of loans, as of September 30, 2016 and December 31, 2015:

Aging of Receivables

 

 

 

(8) Derivative Financial Instruments and Hedging Activities

Derivative financial instruments involve, to varying degrees, interest rate, market and credit risk. The Company manages these risks as part of its asset and liability management process and through credit policies and procedures. The Company seeks to minimize counterparty credit risk by establishing credit limits and collateral agreements. The Company utilizes certain

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derivative financial instruments to enhance its ability to manage interest rate risk that exists as part of its ongoing business operations. In general, the derivative transactions entered into by the Company fall into one of two types: a fair value hedge of a specific fixed-rate loan agreement and an economic hedge of a derivative offering to a Bank customer. The Company does not use derivative financial instruments for trading purposes.

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

The Company previously entered into interest rate swaps with a counterparty whereby the Company makes payments based on a fixed interest rate and receives payments from the counterparty based on a floating interest rate, both calculated based on the principal amount of the underlying subordinated note, without the exchange of the underlying principal. The Company no longer enters into these interest rate swap transactions, the last of which occurred in August 2007. The interest rate swaps are designated as fair value hedges under FASB ASC 815, Derivatives and Hedging (“FASB ASC 815”). The critical terms assessed by the Company for each hedge of subordinated notes include the notional amounts of the swap compared to the principal amount of the notes, expiration/maturity dates, benchmark interest rate, prepayment terms and cash payment dates. At September 30, 2016 and December 31, 2015, the total outstanding notional amount of these swaps was $2.6 million and $5.6 million, respectively. For each of these swap agreements, the floating rate is based on the one-month London Interbank Offered Rate (“LIBOR”) paid on the first day of the month which matches the interest payment date on each subordinated note. The expiration dates for these swap agreements range from December 1, 2016 to August 1, 2022 and are consistent with the underlying subordinated note maturities and the swaps had a fair value of $0 at inception. At hedge inception and on an ongoing basis, conditions supporting hedge effectiveness are evaluated. The Company believes that all conditions required in FASB ASC 815-20-25-104 have been met, as all terms of the subordinated note and the interest rate swap match. Because the Company’s evaluations have concluded that the critical terms of the subordinated notes and the interest rate swaps meet the criteria outlined in FASB ASC 815-20-25-104, the “short-cut” method of accounting is applied, which assumes there is no ineffectiveness of a hedging arrangement’s ability to hedge risk as changes in the interest rate component of the swaps’ fair value are expected to exactly offset the corresponding changes in the fair value of the underlying subordinated notes, as described above. Because the hedging arrangement is considered perfectly effective, changes to the underlying benchmark interest rates considered in the valuation of these instruments do not result in a net impact to earnings; however, there may be fair value adjustments related to credit quality variations between counterparties, which may impact earnings as required by FASB ASC 820, Fair Value Measurements and Disclosures (“FASB ASC 820”). The fair value adjustments related to credit quality were not material as of September 30, 2016 and December 31, 2015.

The following tables provide information pertaining to interest rate swaps designated as fair value hedges under FASB ASC 815 at September 30, 2016 and December 31, 2015:

Summary of Interest Rate Swaps Designated As Fair Value Hedges

 

 

Summary of Interest Rate Swap Components

 

 

Customer Derivatives – Interest Rate Swaps. The Company enters into interest rate swaps that allow our commercial loan customers to effectively convert a variable-rate commercial loan agreement to a fixed-rate commercial loan agreement. Under these agreements, the Company enters into a variable-rate loan agreement with a customer in addition to an interest rate swap agreement, which serves to effectively swap the customer’s variable-rate loan into a fixed-rate loan. The Company then enters

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into a corresponding swap agreement with a third party in order to economically hedge its exposure through the customer agreement. The interest rate swaps with both the customers and third parties are not designated as hedges under FASB ASC 815 and are marked to market through earnings. As the interest rate swaps are structured to offset each other, changes to the underlying benchmark interest rates considered in the valuation of these instruments do not result in an impact to earnings; however, there may be fair value adjustments related to credit quality variations between counterparties, which may impact earnings as required by FASB ASC 820. The Company recognized $87 thousand and $70 thousand in expense resulting from fair value adjustments during the nine months ended September 30, 2016 and 2015, respectively, which were included in other income in the unaudited condensed consolidated statements of operations.

 

 

The Company has an International Swaps and Derivatives Association agreement with a third party that requires a minimum dollar transfer amount upon a margin call. This requirement is dependent on certain specified credit measures. The amount of collateral posted with the third party at September 30, 2016 and December 31, 2015 was $15.3 million and $19.2 million, respectively. The amount of collateral posted with the third party is deemed to be sufficient to collateralize both the fair market value change as well as any additional amounts that may be required as a result of a change in the specified credit measures. The aggregate fair value of all derivative financial instruments in a liability position with credit measure contingencies and entered into with the third party was $3.9 million and $6.0 million at September 30, 2016 and December 31, 2015, respectively.

 

 

(9) Deposits

Deposits consist of the following major classifications:

 

 

 

(10) Earnings Per Share

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

Earnings Per Share Computation

 

 

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(11) Commitments and Contingent Liabilities

Letters of Credit

In the normal course of business, the Company has various commitments and contingent liabilities, such as customers’ letters of credit (including standby letters of credit of $8.6 million and $13.3 million at September 30, 2016 and December 31, 2015, respectively) which are not reflected in the accompanying unaudited condensed consolidated financial statements. Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

Reserve for Unfunded Commitments

The Company maintains a reserve for unfunded loan commitments and letters of credit which is reported in other liabilities in the unaudited condensed consolidated statements of financial condition consistent with FASB ASC 825, Financial Instruments. As of September 30, 2016, the Company recorded estimated losses inherent with unfunded loan commitments in accordance with FASB ASC 450, Contingencies, and estimated future obligations under letters of credit in accordance with FASB ASC 460, Guarantees. The methodology used to determine the adequacy of this reserve is integrated in the Company’s process for establishing the allowance for loan losses and considers the probability of future losses and obligations that may be incurred under these off-balance sheet agreements. The reserve for unfunded loan commitments and letters of credit at September 30, 2016 and December 31, 2015 was $614 thousand and $628 thousand, respectively. Management believes this reserve level is sufficient to absorb estimated probable losses related to these commitments.

Reserves for Loans Sold with Recourse

The Company maintains reserves for residential mortgage loans and small business loans sold with recourse to third-party purchasers which are reported in other liabilities in the unaudited condensed consolidated statements of financial condition. The Company records estimated losses inherent with residential mortgage loans sold with recourse in accordance with FASB ASC 450, Contingencies. This reserve is determined based upon the probability of future losses which is calculated using historical Company and industry loss data. The recourse reserves for these loans were $1.5 million and $1.4 million at September 30, 2016 and December 31, 2015, respectively. Management believes this reserve level is sufficient to address potential recourse exposure.

 

 

(12) Fair Value of Financial Instruments

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

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

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

 

 

Level 1 Valuation Techniques and Inputs

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

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

Level 2 Valuation Techniques and Inputs

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

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

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

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

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

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

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

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

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

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

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Level 3 Valuation Techniques and Inputs

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

The cash flow model for the pooled issue owned by the Company at September 30, 2016 assumes no recovery on defaulted collateral, no recovery on securities in deferral and an additional 3.6% future default rate assumption on the remaining performing collateral every three years with no recovery rate.

For trust preferred securities, projected cash flows are discounted at a rate based on a trading group of similar securities quoted on the New York Stock Exchange or over-the-counter markets which is reviewed for market data points such as credit rating, maturity, price and liquidity. The Company indexes the securities to a comparable maturity interest rate swap to determine the market spread, which is then used as the discount rate in the cash flow models. As of the reporting date, the market spreads were 2.50% for the pooled security and 5.5% for the single issuer. An increase or decrease of three percentage points in the discount rate on the pooled issue would result in a decrease of $2.3 million or an increase of $3.1 million in the security fair value, respectively. An increase or decrease of three percentage points in the discount on the single issuer would result in a decrease of $1.5 million or an increase of $1.5 million in the security fair value, respectively.

The following provides details of the Level 3 fair value measurement activity for the three and nine months ended September 30, 2016 and 2015:

Fair Value Measurements Using Significant Unobservable Inputs-Level 3

Investment Securities

 

 

 

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There were no transfers between the three levels for the nine months ended September 30, 2016 and 2015. The Company evaluates its hierarchy on a quarterly basis to ensure proper classification.

Certain assets are measured at fair value on a nonrecurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). The Company measures impaired loans, loans held-for-sale, bank properties and equipment and bank properties transferred to other real estate owned at fair value on a non-recurring basis. At September 30, 2016 and 2015, these assets were valued in accordance with GAAP and, except for impaired loans and loans held-for-sale included in the following table, did not require fair value disclosure under the provisions of FASB ASC 820. The related changes in fair value for the nine months ended September 30, 2016 and 2015 are as follows:

 

 

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

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

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

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

 

 

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

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

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

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

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

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

Impaired loan fair value measurements are based upon unobservable inputs, and therefore, are categorized as a Level 3 measurement. There were no impaired loans with specific reserves at both September 30, 2016 and 2015. There were no charge-offs recorded on impaired loans with a specific reserve during both the nine months ended September 30, 2016, and 2015. Impaired loans held-for-investment with an aggregate carrying amount of $6.6 million and $1.2 million at September 30, 2016 and 2015, respectively, did not include specific reserves as the value of the underlying collateral was not below the carrying amount. However, these loans did include charge-offs of $585 thousand, of which $117 thousand related to loans that were fully

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charged off at September 30, 2016 and $821 thousand, of which $336 thousand related to loans that were fully charged off at September 30, 2015.

Once a loan is determined to be uncollectible, the underlying collateral is repossessed and reclassified as other real estate owned. The balance of other real estate owned can also include bank properties transferred from operations. These assets are carried at the lower of cost or fair value of the collateral, less cost to sell. In some cases, adjustments are made to the appraised values for various factors including age of the appraisal, age of comparable properties included in the appraisal, and known changes in the market and the collateral. During the nine months ended September 30, 2016 and 2015, the Company did not record a decrease in fair value on either commercial or consumer properties.                    

 In accordance with ASC 825-10-50-10, Fair Value of Financial Instruments, the Company is required to disclose the fair value of its financial instruments. The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a distressed sale. Fair value is best determined using observable market prices; however, for many of the Company’s financial instruments, no quoted market prices are readily available. In instances where quoted market prices are not readily available, fair value is determined using cash flow models or other techniques appropriate for the particular instrument. These techniques involve some degree of judgment and, as a result, are not necessarily indicative of the amounts the Company would realize in a current market exchange. Utilizing different assumptions or estimation techniques may have a material effect on the estimated fair value.

Carrying Amounts and Estimated Fair Values of Financial Assets and Liabilities

 

 

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

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

Investment securities. For investment securities, fair values are based on a combination of quoted prices for identical assets in active markets, quoted prices for similar assets in markets that are either actively or not actively traded and price models, discounted cash flow methodologies, or similar techniques that may contain unobservable inputs that are supported by little or

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no market activity and require significant judgment. The fair value of available-for-sale securities is measured utilizing Level 1, Level 2, and Level 3 inputs. The fair value of held-to-maturity securities is measured utilizing Level 2 inputs.

 

Loans receivable, net. The fair value of loans receivable is estimated using discounted cash flow analysis. Projected future cash flows are calculated using loan characteristics, and assumptions of voluntary and involuntary prepayment speeds. For performing loans, Level 2 inputs are utilized as the cash flow analysis is performed using available market data on the performance of similar loans. Projected cash flows are prepared using discount rates believed to represent current market rates. In the second quarter of 2016, an assumption change was made by the Company to the cash flow analysis to utilize loan spreads on loans for comparable banks in its local market as compared to national markets which was used previously. For non-performing loans, the cash flow assumptions are considered Level 3 inputs as market data is not readily available.

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

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

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

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

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

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

The fair value estimates presented herein are based on pertinent information available to management as of September 30, 2016 and December 31, 2015. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these condensed consolidated financial statements since those dates and, therefore, current estimates of fair value may differ significantly from the amount presented herein.

 

 

(13) Regulatory Matters

The Company is subject to risk-based capital guidelines adopted by the FRB for bank holding companies. The Bank is also subject to similar capital requirements adopted by the OCC. Under these requirements, the federal bank regulatory agencies have established quantitative measures to ensure that minimum capital thresholds are maintained. Failure to meet minimum capital requirements can result in certain mandatory, and possibly additional discretionary, actions by the regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s consolidated financial statements.

Pursuant to the Dodd-Frank Act, the federal bank regulatory agencies issued rules that subject many national banks and bank holding companies, including the Bank and the Company, to consolidated capital requirements, effective January 1, 2015 (the “Final Capital Rules”). The Final Capital Rules also revised the quantity and quality of capital required by (1) establishing a new minimum common equity Tier 1 capital ratio of 4.5% of risk-weighted assets; (2) raising the minimum capital ratio from

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4.0% to 6.0% of risk-weighted assets; (3) maintaining the minimum total capital ratio of 8.0% of risk-weighted assets; and (4) maintaining a minimum Tier 1 leverage capital ratio of 4.0%.

Furthermore, the Final Capital Rules added a requirement for a minimum common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets, (“Conservation Buffer”) to be applied to the common equity Tier 1 capital ratio, the Tier 1 capital ratio and the total capital ratio. The required minimum Conservation Buffer will be phased in incrementally between 2016 and 2019. The Conservation Buffer requirement was phased in beginning on January 1, 2016 at 0.625% of risk-weighted assets and will increase by that amount each year until fully implemented in January 2019. If a bank’s or bank holding company’s Conservation Buffer is less than the required minimum and its net income for the four calendar quarters preceding the applicable calendar quarter, net of any capital distributions and associated tax effects not already reflected in net income (“Eligible Retained Income”) is negative, it would be prohibited from making capital distributions or certain discretionary cash bonus payments to executive officers. As a result, under the Final Capital Rules, should the Company fail to maintain the Conservation Buffer, it would be subject to limits on, and in the event the Company has negative Eligible Retained Income for any four consecutive calendar quarters, it would be prohibited in, the Company’s ability to obtain capital distributions from the Bank.

At September 30, 2016, the Bank exceeded all regulatory capital requirements to be considered “well capitalized”, including the Conservation Buffer of 0.625%.

 

The following table provides both the Company’s and the Bank’s risk-based capital ratios as of September 30, 2016 and December 31, 2015.

Regulatory Capital Levels

 

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On April 15, 2010, the Bank entered into a written agreement with the OCC (the “OCC Agreement”) which contained requirements to develop and implement a profitability and capital plan that would provide for the maintenance of adequate capital to support the Bank’s risk profile.  

The OCC had also imposed an individual minimum capital requirement on the Bank. An individual minimum capital requirement requires a bank to establish and maintain levels of capital greater than those generally required for a bank to be “well capitalized.”  At December 31, 2015, the Bank was in compliance with its individual minimum capital requirement.

Effective January 21, 2016, the OCC Agreement and the individual minimum capital requirement to which the Bank was subject were terminated.

Separately, on January 21 2016, without admitting or denying any wrongdoing, the Bank entered into a  Consent Order with the OCC to pay a $25,000 civil money penalty in connection with various deficiencies identified by the OCC in the mortgage banking practices of Sun Home Loans, a former division of the Bank which was closed in July 2014 when the Bank exited the residential mortgage lending business as part of a comprehensive strategic restructuring.  The identified deficiencies occurred from July 2011 through September 2013.

In addition, the Company was required to seek the prior approval of the Federal Reserve Bank before paying interest, principal or other sums on trust preferred securities or any related subordinated debentures, declaring or paying cash dividends or receiving dividends from the Bank, repurchasing outstanding stock or incurring indebtedness. The Company also was required to submit, and periodically update, a capital plan, a profit plan and cash flow projections, as well as other progress reports to the Federal Reserve Bank.  The foregoing requirements were terminated be the Federal Reserve Bank in October 2016.

The Bank is subject to various statutory and regulatory restrictions on its ability to pay dividends to the Company. All national banks are limited in the payment of dividends without the approval of the OCC of a total amount not to exceed the net income for that year to date plus the retained income for the preceding two years. Federal law also prohibits national banks from paying dividends that would be greater than the bank’s undivided profits after deducting statutory bad debt in excess of the bank’s allowance for loan losses. Due to the Bank’s history of losses, any proposed dividends from the Bank to the Company will be subject to regulatory approval until such time as net income for the current year combined with the prior two years is sufficient. Under the Federal Deposit Insurance Corporation Improvement Act (“FDICIA”), an insured depository institution such as the Bank is prohibited from making capital distributions, including the payment of dividends, if, after making such distribution, the institution would become “undercapitalized” (as such term is used in the FDICIA). Payment of dividends by the Bank also may be restricted at any time at the discretion of the OCC if it deems the payment to constitute an unsafe and unsound banking practice. The Bank did not seek OCC approval to pay a dividend during the first nine months of 2016.

Federal Deposit Insurance Corporation (“FDIC”) assessment expense of $173 thousand and $763 thousand was recognized during the three months ended September 30, 2016 and 2015, respectively, and $872 thousand and $2.3 million was recognized during the nine months ended September 30, 2016 and 2015, respectively.  The Company’s FDIC assessment rates were reduced, effective July 1, 2016.

The Company’s capital securities qualify as Tier 1 capital under federal regulatory guidelines. These instruments are subject to a 25% capital limitation under risk-based capital guidelines developed by the FRB. Under FRB rules, restricted core capital elements, which are qualifying trust preferred securities, qualifying cumulative perpetual preferred stock (and related surplus) and certain minority interests in consolidated subsidiaries, are limited in the aggregate to no more than 25% of a bank holding company’s core capital elements (including restricted core capital elements), net of goodwill less any associated deferred tax liability. However, under the Dodd-Frank Act, bank holding companies are prohibited from including in their Tier 1 capital hybrid debt and equity securities, including trust preferred securities, issued on or after May 19, 2010. Any such instruments issued before May 19, 2010 by a bank holding company, such as the Company, with total consolidated assets of less than $15 billion as of December 31, 2009, may continue to be included as Tier 1 capital (subject to the 25% limitation). The portion that exceeds the 25 percent capital limitation qualifies as Tier 2, or supplementary capital of the Company. At September 30, 2016, $56.5 million of a total of $90.0 million in capital securities qualified as Tier 1 with $33.5 million qualifying as Tier 2 capital.

On December 10, 2013, the FRB, the OCC, the FDIC, the Commodity Futures Trading Commission (the “CFTC”) and the SEC issued final rules to implement the Volcker Rule contained in Section 619 of the Dodd-Frank Act. The Dodd-Frank Act

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provided that banks and bank holding companies were required to conform their activities and investments by July 21, 2014, however, the FRB has extended the conformance period until July 21, 2017.  

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

On January 14, 2014, the five federal agencies, including the FRB and OCC, approved an interim final rule to permit banking entities to retain interests in certain collateralized debt obligations backed primarily by trust preferred securities from the investment prohibitions of the Volcker Rule. Under the interim final rule, the agencies permit the retention of an interest in or sponsorship of covered funds by banking entities if certain qualifications are met. In addition, the agencies released a non-exclusive list of issuers that meet the requirements of the interim final rule. At September 30, 2016, the Company had an investment in one pool of trust preferred securities with an amortized cost of $8.8 million and estimated fair value of $6.8 million. This pool was included in the list of non-exclusive issuers that meet requirements of the interim final rule release by the agencies and therefore was not required to be sold by the Company.

At September 30, 2016, the Company was in full compliance with the requirements of the Volcker Rule.

 

 

(14) Dividends:

On October 27, 2016, the Company’s Board of Directors declared a quarterly cash dividend of $0.01 per share payable on December 12, 2016 to shareholders on record as of November 28, 2016.

On July 25, 2016, the Company’s Board of Directors declared a quarterly cash dividend of $0.01 per share which was paid on September 6, 2016 to shareholders on record as of August 23, 2016.

 

 

 

Forward-Looking Statements

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

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

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Some of these and other factors are discussed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2015 under “Item 1A Risk Factors” and “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” as such sections may be amended or supplemented herein or in other filings pursuant to the Exchange Act. The development of any or all of these factors could have an adverse impact on our financial position and results of operations.

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

NON-GAAP FINANCIAL MEASURES

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

Tax Equivalent Net Interest Income:

This Quarterly Report on Form 10-Q references tax-equivalent interest income. Tax-equivalent interest income is a non-GAAP financial measure. Tax-equivalent interest income assumes a 35% marginal federal tax rate for all periods. The fully taxable equivalent adjustments for the three months ended September 30, 2016 and 2015 were $0 and $125 thousand, respectively. The fully taxable equivalent adjustments for the nine months ended September 30, 2016 and 2015 were $0 and $456 thousand, respectively. Tax-equivalent net interest income is net interest income plus the taxes that would have been paid had tax-exempt securities been taxable. This number attempts to enhance the comparability of the performance of assets that have different tax liabilities. The following table provides a reconciliation of tax equivalent net interest income to GAAP net interest income using a 35% tax rate:

For the Three Months Ended:

 

    

For the Nine Months Ended:

 

 

Core Deposits:

Core deposits are calculated by excluding time deposits and brokered deposits from total deposits. The following table provides a reconciliation of core deposits to GAAP total deposits at September 30, 2016 and December 31, 2015:

 

 

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

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

General Overview

The Company is a bank holding company headquartered in Mount Laurel, New Jersey, with its principal subsidiary being Sun National Bank. The Company’s principal business is to serve as a holding company for the Bank. At September 30, 2016, the Company had total assets of $2.19 billion, total liabilities of $1.92 billion and total shareholders’ equity of $265.9 million. The Company reported net income available to common shareholders of $1.6 million, or $0.09 per diluted share, and $5.4 million, or $0.29 per diluted share, for the three and nine months ended September 30, 2016, respectively.

Through the Bank, the Company provides an array of community banking services to consumers, small businesses and mid-sized companies. The Company’s lending services to businesses include term loans, lines of credit and commercial mortgages. The Company’s commercial deposit services include business checking and money market accounts and cash management solutions such as online banking, electronic bill payment and wire transfer services, lockbox services, remote deposit and controlled disbursement services. The Company’s consumer deposit services include checking accounts, savings accounts, money market accounts, certificates of deposit, individual retirement accounts and online banking. The Company’s lending services to consumers consist primarily of lines of credit for overdraft sweeps. In addition, the Company, through a subsidiary of the Bank, Prosperis Financial Solutions, LLC, offers clients access to mutual funds, securities brokerage, annuities and investment advisory services.

The Company funds its lending activities primarily through retail and brokered deposits, the scheduled maturities of its investment portfolio and other wholesale funding sources. As a financial institution with a primary focus on traditional banking activities, the Company generates the majority of its revenue through net interest income, which is the difference between interest income earned on loans and investments and interest paid on deposits and borrowings. Growth in net interest income is dependent upon the Company’s ability to prudently manage the balance sheet for growth, combined with how successfully it maintains or increases net interest margin, which is net interest income as a percentage of average interest-earning assets. The Company generates additional revenue through fees earned on the various services and products offered to its customers. Offsetting these revenue sources are provisions for credit losses on loans, operating expenses and income taxes.

In June 2014, the Company adopted a comprehensive strategic restructuring plan (the “Restructuring Plan”) to refocus on serving commercial borrowers in the communities in which the Bank operates. Pursuant to the Restructuring Plan, during 2014 and 2015, the Bank exited Sun Home Loans, its residential mortgage banking origination business and its healthcare and asset-based lending businesses, it sold seven branch locations in the Cape May County area to Sturdy Savings Bank, sold its Hammonton branch to Cape Bank, consolidated nine branch locations, significantly reduced classified assets and operating expenses and declared a 1-for-5 reverse stock split. Upon finalization of the branch consolidations in the third quarter of 2015, the Company’s Restructuring Plan was completed.

As a result of the implementation and completion of the Restructuring Plan, the Company’s primary lending focus is now centered around commercial relationships, specifically commercial real estate and commercial and industrial originations, as well as both originations and participations in multi-family loans. With the Bank’s branch network rationalized, the Company is focusing on enhancing its brand and building a relationship-based deposit gathering strategy which the Company anticipates will generate additional fee income.

On April 15, 2010, the Board of Directors of the Bank entered into the OCC Agreement. Pursuant to the OCC Agreement, the Bank was required to, among other things, develop and implement a profitability and capital plan that would provide for the maintenance of adequate capital to support the Bank’s risk profile.  The OCC had also imposed an individual minimum capital requirement on the Bank. An individual minimum capital requirement requires a bank to establish and maintain levels of capital greater than those generally required for a bank to be “well capitalized.” During 2015, the Bank successfully remediated the various financial, process and compliance issues necessary for the termination of the OCC Agreement.  Effective January 21, 2016, the OCC terminated the OCC Agreement and the individual minimum capital requirement to which the Bank was subject.  Additionally, effective October 2016, the Federal Reserve Bank terminated its requirement that the Company seek prior approval before paying interest, principal or other sums on thrust preferred securities or any related subordinated debenture, declaring or paying cash dividends from the Bank, repurchasing outstanding stock or incurring indebtedness.

The U.S. economy has grown slowly with suggestions of inflationary pressure through the first nine months of 2016. The labor markets have continued to tighten and wages are accelerating. Interest rates have remained near historical lows with a growing market expectation for an increase in the near future. The unemployment rate in the U.S. was 4.9% in October 2016, which is unchanged from June 2016. Based upon initial estimates, the U.S. gross domestic product for the third quarter of 2016 increased at an annual rate of 2.9% as compared to a revised 1.4% increase in the second quarter of 2016. This was the fastest economic growth in two years and consumer confidence reached a nine-year high. Increases in personal consumption spending, exports, private inventory investment,

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federal government spending and nonresidential fixed investments were partially offset by reductions in residential fixed investment and state and local government spending. Uncertainty over global demand and the upcoming U.S. presidential election have also resulted in caution on business spending. At the state level, according to the latest South Jersey Business Survey produced by the Federal Reserve Bank, growth in business activity increased in the third quarter of 2016.  Business expectations remain positive and employment forecasts are marginally stronger. In Northern New Jersey, business activity is expected to continue to increase at a modest pace. New Jersey’s unemployment rate increased to 5.3% as of September 2016 from 5.1% as of June 2016.

At its latest meeting in November 2016, the Federal Open Market Committee (the “FOMC”) kept the Federal Funds target rate at 0.25% to 0.50%.  The FOMC signaled that it could potentially increase the target rate in December as the economy gains momentum and inflation increases modestly. The FOMC stated that the labor market has continued to strengthen and, economic activity has been expanding since June 2016. In addition, the payrolls and other labor market indicators have pointed to a recent increase in labor utilization.  In determining whether to raise the target rate in the future, the FOMC will assess realized and expected economic conditions relative to its objectives of maximum employment and 2% inflation.  

The economy continues to experience uncertainty in some sectors, and, together with the challenging regulatory environment and the upcoming presidential election, it will continue to affect the Company and the markets in which it does business and may adversely impact the Company’s results in the future. The following discussion provides further detail on the financial condition and results of operations of the Company at and for the three and nine months ended September 30, 2016.

Critical Accounting Policies, Judgments and Estimates

The Company’s significant accounting policies are described in Note 2 to the consolidated financial statements included in the Company’s 2015 Form 10-K and in Note 2 to the unaudited condensed consolidated financial statements included in Item 1 of this report. The discussion and analysis of the financial condition and results of operations are based on the unaudited condensed consolidated financial statements, which are prepared in conformity with GAAP. The preparation of these financial statements requires management to make estimates and assumptions affecting the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities, and the reported amounts of income and expenses. Management evaluates these estimates and assumptions on an ongoing basis, including those related to the allowance for loan losses, goodwill, intangible assets, income taxes and the fair value of financial instruments. Management bases its estimates on historical experience and various other factors and assumptions that are believed to be reasonable under the circumstances. These form the basis for making judgments on the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

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

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

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Additionally, for the commercial loan portfolio, historic loss and recovery experience over a two-year horizon, based on a rolling 28-quarter migration analysis, is taken into account for the quantitative factor component. The Company previously used a 12-quarter commercial loan migration analysis, however during the fourth quarter of 2015, the Company began to use a 28-quarter analysis to better align its allowance model with the Company’s credit cycle. This methodology change was completed in conjunction with the completion of the Company’s comprehensive restructuring plan and resulted in a corresponding reduction in qualitative factor assumptions. Prior to the second quarter of 2016, the Company utilized a loss horizon of three years. This period was reduced to two years as of June 30, 2016 as a result of the Company’s analysis of its recent loss experience. For the non-commercial loan quantitative component, the average one-year loss history and recovery experience over a 12-quarter time period is utilized for the allowance calculation.

Values assigned to the qualitative factors and those developed from historic loss and recovery experience provide a dynamic basis for the calculation of reserve factors for both pass-rated loans and those criticized and classified loans through the use of both a general pooled allowance and a specific allowance. In determining the appropriate level of the general pooled allowance, management makes estimates based on internal risk ratings, which take into account such factors as debt service coverage, loan-to-value ratios and external factors. Estimates are periodically measured against actual loss experience. When a loan is determined to be non-performing, the Company typically performs an impairment analysis utilizing a current appraisal value discounted for an estimated cost of disposal. In certain cases, a discounted cash flow analysis may be performed to determine whether an impairment exists. A specific allowance may be calculated on individually identified impaired loans. Loans not individually reviewed are evaluated as a group using reserve factor percentages based on historic loss and recovery experience and the qualitative factors described above.

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

Although the Company maintains its allowance for loan losses at levels considered adequate to provide for the inherent risk of loss in its loan portfolio, if economic conditions differ substantially from the assumptions used in making the evaluations, there can be no assurance that future losses will not exceed estimated amounts or that additional provisions for loan losses will not be required in future periods. Accordingly, the current state of the national economy and local economies of the areas in which the loans are concentrated and their slow recovery from a severe recession could result in an increase in loan delinquencies, foreclosures or repossessions resulting in increased charge-off amounts and the need for additional loan loss allowances in future periods.

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

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

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Financial Condition

Total assets declined to $2.19 billion at September 30, 2016 as compared to $2.21 billion at December 31, 2015, mainly due to a decrease in cash and cash equivalents, partially offset by increases in investment securities and total loans.  Cash and cash equivalents decreased by $48.0 million, or 23.5%, to $156.3 million at September 30, 2016 as compared to $204.3 million at December 31, 2015, primarily due to the use of excess cash to purchase investment securities, fund new loans and a reduction in total deposits during the nine months ended September 30, 2016. Total loans, net of allowance for loan losses, increased by $20.3 million to $1.55 billion at September 30, 2016 as compared to $1.53 billion at December 31, 2015, as the Bank funded organic commercial loan originations of $261.1 million during the nine months ended September 30, 2016, partially offset by pay downs. As a result, commercial loans increased by $61.0 million compared to December 31, 2015. Non-owner occupied commercial real estate loan growth totaled $50.6 million year-to-date, land and development loan growth totaled $16.6 million, while owner occupied commercial real estate loans declined by $2.0 million and commercial and industrial loans decreased by $4.2 million. Consumer loans fell by $42.9 million compared to the fourth quarter of 2015, in accordance with the Company’s strategic plan.

Investment securities available for sale increased by $9.0 million, or 3.2%, from $282.9 million at December 31, 2015 to $291.9 million at September 30, 2016 due primarily to the purchase of $58.1 million of mortgage backed securities and $20.1 million of collateralized mortgage obligations, partially offset by sales of $30.4 million, principal paydowns of $37.6 million and a called agency security of $5.0 million.

Other assets decreased by $4.5 million or 28.3%, to $11.5 million at September 30, 2016 from $16.0 million at December 31, 2015. This decrease was primarily the result of the collection of a $1.9 million miscellaneous receivable during the nine months ended September 30, 2016 and paydowns on swap transactions.

Total liabilities decreased by $30.7 million, or 1.6%, to $1.92 billion at September 30, 2016, compared to $1.95 billion at December 31, 2015. The decrease in total liabilities is primarily attributable to a decrease of $28.5 million in total deposits to $1.72 billion as a result of the re-pricing of certain non-relationship retail deposits initiated in 2015 as well as continued reductions in municipal deposits. The Company’s deposit mix has repositioned during 2016 as single-service money market and DDA accounts were replaced with certificates of deposit. The Company’s borrowings were relatively unchanged with FHLBNY advances of $85.5 million at September 30, 2016 as compared to $85.6 million at December 31, 2015.

 

The Company’s allowance for loan losses was $15.8 million, or 1.01% of gross loans held-for-investment, at September 30, 2016 and $18.0 million, or 1.16% of gross loans held-for-investment, at December 31, 2015.  The decrease in reserve balances is due to net charge-offs of $499 thousand and a reduction in the provision for loan losses of $1.7 million recorded during the nine months ended September 30, 2016.  The reduction in the provision for loan losses was driven by the overall stability in the Company’s asset quality and credit metrics at significantly improved levels, despite recent increases in the Company’s non-performing assets which continue to be at low levels.  The Company’s continued stability has resulted in continued improvement in the Company’s historical loss severity.  Across the commercial and consumer loan portfolio, the Company continues to closely monitor areas of weakness and take expedient and appropriate action as necessary to ensure adequate reserves are in place to absorb losses inherent in the loan portfolio.

Shareholders’ equity increased by $9.5 million to $265.9 million at September 30, 2016 as compared to $256.4 million at December 31, 2015 primarily due to net income of $5.4 million, a decrease in treasury stock of $3.2 million and an increase in accumulated other comprehensive income of $1.5 million, partially offset by a reduction in additional paid-in capital of $1.2 million from restricted stock vestings and grants of new Stock Awards.

Table 1 provides detail regarding the Company’s non-performing assets and TDRs at September 30, 2016 and December 31, 2015.

Table 1: Summary of Non-performing Assets and TDRs

 

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Total non-performing assets increased by $3.4 million to $6.8 million at September 30, 2016 from $3.4 million at December 31, 2015 due to the troubled debt restructuring of one commercial loan and industrial relationship, and four residential mortgage loans during the nine months ended September 30, 2016.  Also, two commercial real estate loans and two residential mortgage loans entered non-accrual status during the third quarter of 2016.

Real estate owned, net, decreased to zero at September 30, 2016, from $281 thousand at December 31, 2015.  During the nine months ended September 30, 2016, one remaining Bank-owned property with a carrying value of $281 thousand was sold for a loss of $15 thousand. The Company did not transfer any balances from loans into real estate owned during the same period.

The net deferred tax liability increased by $1.9 million from $1.5 million at December 31, 2015 to $3.4 million at September 30, 2016. This increase was due primarily to an increase in tax amortization of goodwill. The Company maintains a valuation allowance of $128.0 million against the remaining portion of its gross deferred tax asset at September 30, 2016. Upon consideration of several quantitative and qualitative factors, the Company determined that it is more likely than not that the full deferred tax asset will not be realized as of September 30, 2016. The Company will continue to assess the potential for reversal of the valuation allowance on a quarterly basis.

Comparison of Operating Results for the Three Months Ended September 30, 2016 and 2015

Overview. The Company’s net income available to shareholders for the three months ended September 30, 2016 was $1.6 million, or $0.09 per diluted share, compared to net income of $3.2 million, or $0.17 per diluted share, for the corresponding period in 2015. The Company’s results in the third quarter of 2016 continue to reflect the benefit of its expense management and branch rationalization strategies. During the three months ended September 30, 2016, the Company did not record a provision for loan losses compared to a negative provision of $1.8 million recorded during the same period in 2015.  During the three months ended September 30, 2015, the Company recorded a $1.3 million gain on the sale of its Hammonton bank branch and $1.4 million in net gains on the sale of investment securities.

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

Net interest income, on a tax-equivalent basis, decreased by $629 thousand to $14.7 million for the three months ended September 30, 2016, from $15.3 million for the corresponding period in 2015. The decrease in net interest income is primarily due to the overall decline in the Company’s balance sheet, particularly in the average balance of investment securities and the average balances of the Company’s home equity and residential real estate portfolios, despite increases in the interest rate spread and net interest margin reflecting the continued shift in balance sheet composition toward higher yielding commercial loans.

Tax equivalent interest income decreased by $255 thousand, or 1.4%, from $17.7 million for the three months ended September 30, 2015, to $17.5 million for the three months ended September 30, 2016 primarily due to a decrease in the average balance of investment securities and the continued decline in the average balances of the Company’s consumer portfolio. The average balance of investment securities decreased by $32.1 million, or 9.3%, for the three months ended September 30, 2016 as compared to the three months ended September 30, 2015 and the average yield on investment securities decreased by 17 basis points during the same time period, which resulted in a decrease in interest income on investment securities of $327 thousand. Significant pressure on commercial loan yields continued through the third quarter of 2016 due to the competitive lending environment and the Bank’s strategic decision to maintain a very selective approach to new loan relationships. Interest income on loans increased by $103 thousand for the three months ended September 30, 2016 as compared to the three months ended September 30, 2015.  This was due primarily to an increase in interest income of $599 thousand due to growth in the Company’s commercial portfolio. This increase was partially offset by a decrease of $496 thousand in interest income on consumer loans as a result of the continuing planned decline in the Company’s consumer loan portfolio.

Interest expense increased by $374 thousand for the three months ended September 30, 2016, as compared to the corresponding period in 2015. Interest expense on interest-bearing deposits increased by $294 thousand for the three months ended September 30, 2016, as compared to the corresponding period in 2015, mainly due to an increase in the average rate of interest bearing deposits of 11 basis points during this time period.  This was partially offset by a decline in the average balances of interest-bearing deposits of $46.3 million. The declines in the average balances of interest-bearing deposits reflect the impact of the branch sales completed in 2015 as

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well as a managed reduction in higher rate deposit balances.  Additionally, interest expense on borrowings increased by $80 thousand for the three months ended September 30, 2016, as compared to the corresponding period in 2015. The average borrowings decreased by $548 thousand for the three months ended September 30, 2016 to $184.7 million, from $185.3 million for the quarter ended September 30, 2015, due to a decrease in the average FHLBNY balance of $154 thousand and a decrease in the average capital lease obligations of $394 thousand. In addition, interest expense on junior subordinated debentures increased by $91 thousand from the three months ended September 30, 2015 as compared to the three months ended September 30, 2016 due to increased interest rates.

The interest rate spread and net interest margin for the three months ended September 30, 2016 were 2.75% and 2.94%, respectively, compared to 2.62% and 2.81%, respectively, for the corresponding period in 2015. The increase in net interest margin is due primarily to the increase in the average yield on interest-earning assets of 25 basis points, partially offset by an increase in the cost of interest-bearing liabilities of 12 basis points. Table 2 provides detail regarding the Company’s average daily balances with corresponding interest income (on a tax-equivalent basis) and interest expense as well as yield and cost information for the three months ended September 30, 2016 and 2015. Average balances are derived from daily balances.

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Table 2: Average Balance Sheets

SUN BANCORP, INC. AND SUBSIDIARIES

AVERAGE BALANCE SHEETS (Unaudited)

(Dollars in thousands)

 

 

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Table 3: Rate/Volume⁽¹⁾

 

 

Provision for Loan Losses. The Company did not record a provision for loan losses during the three months ended September 30, 2016 compared to a negative provision for loan losses of $1.8 million during the three months ended September 30, 2015.  The ratio of allowance for loan losses to gross loans held-for-investment was 1.01% at September 30, 2016, as compared to 1.24% at September 30, 2015, reflecting the improved risk profile of the Company’s loan portfolio.  Net charge-offs for the three months ended September 30, 2016 were $65 thousand as compared to net recoveries of $344 thousand during the corresponding period in 2015. See “Financial Condition” above.

The provision recorded is the amount deemed appropriate by management based on the current risk profile of the portfolio to absorb losses existing at the balance sheet date. At least monthly, management performs an analysis to identify the inherent risk of loss in the Company’s loan portfolio. This analysis includes a qualitative evaluation of concentrations of credit, past loss experience, current economic conditions, amount and composition of the loan portfolio (including loans being specifically monitored by management), estimated fair value of underlying collateral, delinquencies, and other factors.   Additionally, management updates the migration analysis and historic loss and recovery experience on a quarterly basis.  As the charge-off levels continue to decline, the loss severity in the Company’s allowance for loan losses calculation has declined accordingly, thereby resulting in provision reductions in prior periods and no provision on the third quarter of 2016.

Non-Interest Income. Non-interest income decreased by $3.3 million to $3.1 million for the three months ended September 30, 2016, as compared to $6.5 million for the corresponding period in 2015. This decrease was primarily attributable to $1.5 million of gains recognized on the sale of investment securities and a $1.3 million gain on the sale of bank branches recognized during the three months ended September 30, 2015.  

Non-Interest Expense. Non-interest expense decreased by $3.9 million to $15.9 million for the three months ended September 30, 2016 as compared to $19.9 million for the three months ended September 30, 2015. This decrease was primarily due to decreases in occupancy expense of $1.0 million, salaries and employee benefits of $840 thousand, equipment expense of $705 thousand, and

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insurance expense of $686 thousand.  The decrease in occupancy and equipment expense was mainly a result of a decrease in branch locations during 2015, while the reduction in insurance expense was attributed to a reduction in the Bank’s FDIC assessment rate in 2016.  The decline in salaries and employee benefits is attributed to a reduction in workforce attributed to the Bank’s strategic initiatives, including branch sales as well as other efficiency based reductions. In addition, other expense declined by $468 thousand during the three months ended September 30, 2016 as compared to the three months ended September 30, 2015, reflecting a variety of expenses incurred in the prior year which are not expected to recur.

Income Tax Expense. Income tax expense decreased by $96 thousand for the three months ended September 30, 2016 from $383 thousand for the three months ended September 30, 2015. The income tax expense in the third quarter of 2016 relates primarily to the tax amortization of the Company’s indefinite-lived intangible assets that is not available to offset existing deferred tax assets which was first recorded in the first quarter of 2013. The income tax expense will decline as individual intangible assets are fully amortized for tax purposes. The reduction in income tax expense from the prior year is due to a corresponding decrease in alternative minimum tax expense.  As the Company remained in a cumulative loss position at September 30, 2016, a full deferred tax valuation allowance is still considered appropriate. The deferred tax asset balance and the related valuation allowance will decrease as the Company generates net income.

The Company assesses the need for a valuation allowance against its deferred tax asset each quarter through the review of all available positive and negative evidence. If the Company continues to generate positive pre-tax net income, it is reasonably possible that it will release a portion of its valuation allowance in the next twelve months. A reduction of the valuation allowance, in whole or in part, would result in a non-cash income tax benefit during the period of reduction. The Company performs an analysis to determine the amount and timing of the valuation allowance release which is highly dependent upon historical and future projected earnings, among other factors. The potential timing and amount of any future valuation allowance release has yet to be determined. Any such adjustment could have a material impact on the Company’s financial position and results of operations.

Comparison of Operating Results for the Nine Months Ended September 30, 2016 and 2015

Overview. The Company’s net income available to shareholders for the nine months ended September 30, 2016 was $5.4 million, or $0.29 per diluted share, compared to net income of $8.8 million, or $0.47 per diluted share, for the corresponding period in 2015. The Company’s results in 2016 continue to reflect the impact of its expense management and branch rationalization strategies. During the nine months ended September 30, 2016 and 2015, the Company recorded a negative loan loss provision of $1.7 million and $3.0 million, respectively.  

Net Interest Income.  Net interest income, on a tax-equivalent basis, decreased by $2.2 million to $44.1 million for the nine months ended September 30, 2016, from $46.2 million for the same period in 2015.

Tax equivalent interest income decreased by $1.6 million, or 3.0%, from $53.5 million for the nine months ended September 30, 2015, to $51.9 million for the nine months ended September 30, 2016.  Average loans receivable increased by $26.9 million for the nine months ended September 30, 2016 as compared to the nine months ended September 30, 2015 and the yield on total loans decreased by five basis points during the same time period which resulted in an increase in interest income on loans of $252 thousand.  Interest income from investments decreased by $1.7 million primarily due to a decrease in average investment balances of $67.5 million from the nine months ended September 30, 2015.      

Interest expense increased by $563 thousand, or 7.76%, for the nine months ended September 30, 2016, as compared to the same period in 2015.  The average balance of interest-bearing liabilities decreased $149.5 million, or 9.1%, for the nine months ended September 30, 2016 as compared to the nine months ended September 30, 2015, primarily due to a decrease in average interest-bearing deposits.  The cost of interest-bearing liabilities increased by eleven basis points during the same period, to 70 basis points, which drove the overall increase in interest expense.

The interest rate spread and net interest margin for the nine months ended September 30, 2016 were 2.76% and 2.94% respectively, compared to 2.55% and 2.71%, respectively, for the same period in 2015.  

Table 4 provides detail regarding the Company’s average daily balances with corresponding interest income (on a tax-equivalent basis) and interest expense as well as yield and cost information for the nine months ended September 30, 2016 and 2015.  Average balances are derived from daily balances.

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Table 4: Average Balance Sheets

SUN BANCORP, INC. AND SUBSIDIARIES

AVERAGE BALANCE SHEETS (Unaudited)

(Dollars in thousands)

 

 

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Table 5: Rate/Volume⁽¹⁾

 

 

Provision for Loan Losses. The Company recorded a negative provision for loan losses of $1.7 million during the nine months ended September 30, 2016, as compared to a negative provision for loan losses of $3.0 million for the same period in 2015.  The ratio of allowance for loan losses to gross loans held-for-investment was 1.01% at September 30, 2016, as compared to 1.24% at September 30, 2015, reflecting the improved risk profile of the Company’s loan portfolio.  Net charge-offs for the nine months ended September 30, 2016 were $499 thousand as compared to net charge-offs of $1.4 million during the corresponding period in 2015. See “Financial Condition” above.

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

Non-Interest Income. Non-interest income decreased by $14.3 million to $10.1 million for the nine months ended September 30, 2016, as compared to $24.4 million for the corresponding period in 2015. This decrease was primarily attributable to $10.6 million of gains recognized on the sale of seven branch locations to Sturdy Savings Bank and a $1.5 million gain on the sale of investment securities during the nine months ended September 30, 2015 as well as a $1.4 million reduction in gain on sale of loans from the prior year nine month period.  Additionally, deposit service charges and fees decreased by $827 thousand during the nine months ended September 30, 2016 from the nine months ended September 30, 2015. The decline in deposit service charges and fees is due primarily to declining transaction volume resulting from the reduced branch count.

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Non-Interest Expense. Non-interest expense decreased by $13.9 million to $49.5 million for the nine months ended September 30, 2016 as compared to $63.5 million for the corresponding period in 2015. This decrease was primarily due to decreases in occupancy expense of $4.5 million, equipment expense of $3.6 million, salaries and employee benefits expense of $2.2 million, insurance expense of $1.7 million, and problem loan expense of $742 thousand.  The decrease in occupancy and equipment expense was mainly attributed to the sale of eight branch locations and the closure of nine other branch locations during 2015. The reduction in salaries and employee benefits expense is attributed to the branch sales and closures, as well as a general reduction in employee headcount over 2015. The reduction in insurance expense is attributed to the decline in the Bank’s FDIC assessment rate during 2016, while the decline in problem loan costs was driven by a reduction in legal expense associated with the monitoring and management of distressed loans, as well as costs associated with distressed loan sales.

Income Tax Expense. Income tax expense decreased by $66 thousand to $885 thousand for the nine months ended September 30, 2016 from $951 thousand for the nine months ended September 30, 2015. The tax expense in the third quarter of 2016 relates primarily to the tax amortization of the Company’s indefinite-lived intangible assets that is not available to offset existing deferred tax assets which was first recorded in the first quarter of 2013. The income tax expense will decline as individual intangible assets are fully amortized for tax purposes. The reduction in income tax expense from the prior year is due to a corresponding decrease in alternative minimum tax expense.  As the Company remained in a cumulative loss position at September 30, 2016, a full deferred tax valuation allowance is still considered appropriate. The deferred tax asset balance and the related valuation allowance will decrease as the Company generates net income.

The Company assesses the need for a valuation allowance against its deferred tax asset each quarter through the review of all available positive and negative evidence. If the Company continues to generate positive pre-tax net income, it is reasonably possible that it will release a portion of its valuation allowance in the next twelve months. A reduction of the valuation allowance, in whole or in part, would result in a non-cash income tax benefit during the period of reduction. The Company performs an analysis to determine the amount and timing of the valuation allowance release which is highly dependent upon historical and future projected earnings, among other factors. The potential timing and amount of any future valuation allowance release has yet to be determined. Any such adjustment could have a material impact on the Company’s financial position and results of operations.

Liquidity and Capital Resources

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

The major source of the Company’s funding on a consolidated basis is deposits, which management believes will be sufficient to meet the Company’s daily and long-term operating liquidity needs. The ability of the Company to retain and attract new deposits is dependent upon the variety and effectiveness of its customer account products, customer service and convenience, and rates paid to customers. The Company also obtains funds from the repayment and maturities of loans, loan sales or participations and maturities or calls of investment securities. Additional liquidity can be obtained in a variety of wholesale funding sources as well, including, but not limited to, federal funds purchased, FHLBNY advances, securities sold under agreements to repurchase, and other securities and unsecured borrowings. Through the Bank, the Company also purchases brokered deposits for funding purposes. In a continued effort to balance deposit growth and net interest margin, especially in the current interest rate environment and with competitive local deposit pricing, the Company continually evaluates these other funding sources for funding cost efficiencies. Throughout 2015, the Company continued to lower deposit rates to align itself with the market and continued to manage its excess cash position while undergoing the implementation of its Restructuring Plan.

Core deposits, which exclude all certificates of deposit, decreased by $83.5 million to $1.32 billion, or 77.1% of total deposits, at September 30, 2016, as compared to $1.41 billion, or 80.6% of total deposits, at December 31, 2015.  The Company’s deposit mix has repositioned during 2016 as single-service money market and DDA accounts were replaced with certificates of deposit. The Company has secured borrowing capacity with the Federal Reserve Bank of approximately $90.7 million, of which none was utilized as of September 30, 2016, and the FHLBNY of approximately $204.6 million, of which $85.5 million was utilized as of September 30, 2016. In addition to secured borrowings, the Company also has unsecured borrowing capacity through lines of credit with other financial institutions of $35.0 million, of which none were utilized as of September 30, 2016. Management continues to monitor the Company’s liquidity and has taken measures to increase its borrowing capacity by providing additional collateral through the pledging of loans. As of September 30, 2016, the Company had a par value of $225.4 million and $153.3 million in loans and securities, respectively, pledged as collateral on secured borrowings.

The Company’s primary uses of funds are loan originations, the funding of the Company’s maturing certificates of deposit, deposit withdrawals, the repayment of borrowings and general operating expenses. Certificates of deposit scheduled to mature during

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the twelve months ended September 30, 2017 totaled $259.5 million, or approximately 66.0% of total certificates of deposit. The Company continues to operate with a core deposit relationship strategy that values a long-term stable customer relationship. This strategy employs a pricing strategy that rewards customers that establish core accounts and maintain a certain minimum threshold account balance. Based on market conditions and other liquidity considerations, the Company may also avail itself to the secondary borrowings discussed above.

The Company anticipates that deposits, cash and cash equivalents on hand, the cash flow from assets, as well as other sources of funds will provide adequate liquidity for the Company’s future operating, investing and financing needs. At September 30, 2016, the Company had $128.7 million of cash held at the FRB, as compared to $182.5 million at December 31, 2015. The significant reduction in excess liquidity reflects the Company’s efforts to strategically deploy its excess liquidity, which the Company expects to continue into 2017.

On April 15, 2010, the Bank entered into the OCC Agreement which required the Bank to develop and implement a profitability and capital plan which provides for the maintenance of adequate capital to support the Bank’s risk profile. Pursuant to the OCC Agreement the Bank also agreed to: (a) adopt and implement a program to protect the Bank’s interest in criticized or classified assets; (b) review and revise the Bank’s loan review program; (c) adopt and implement a program for the maintenance of an adequate allowance for loan losses; and (d) revise the Bank’s credit administration policies. The Bank also agreed that its brokered deposits would not exceed 6.0% of its total liabilities unless approved by the OCC.

The OCC had also imposed an individual minimum capital requirement on the Bank. An individual minimum capital requirement requires a bank to establish and maintain levels of capital greater than those generally required for a bank to be “well capitalized.” In accordance with the individual minimum capital requirement, the Bank was required to maintain Tier 1 Capital at least equal to 8.50% of adjusted total assets, Tier 1 Capital at least equal to 9.50% of risk-weighted assets and Total Capital at least equal to 11.50% of risk-weighted assets. At December 31, 2015, the Bank was in compliance with its individual minimum capital requirement.

Effective January 21, 2016 the OCC terminated the OCC Agreement and the individual minimum capital requirement to which the Bank was subject.

In addition, the Company is required to seek the prior approval of the Federal Reserve Bank before paying interest, principal or other sums on trust preferred securities or any related subordinated debentures, declaring or paying cash dividends or taking dividends from the Bank, repurchasing outstanding stock or incurring indebtedness. The foregoing requirements were terminated by the Federal Reserve Bank in October, 2016.

Final Capital Rules

Pursuant to the Dodd-Frank Act, the federal bank regulatory agencies issued the Final Capital Rules that subject many national banks and their holding companies, including the Bank and the Company, to consolidated capital requirements. The Final Capital Rules also revised the quantity and quality of required minimum risk-based and leverage capital requirements applicable to the Bank, consistent with the Dodd-Frank Act and the Basel III capital standards. The Final Capital Rules revised the quantity and quality of capital required by (1) establishing a new minimum common equity Tier 1 ratio of 4.5% of risk-weighted assets; (2) raising the minimum capital ratio from 4.0% to 6.0% of risk-weighted assets; (3) maintaining the minimum total capital ratio of 8.0% of risk-weighted assets; and (4) maintaining a minimum Tier 1 leverage capital ratio of 4.0%.

The Final Capital Rules further require that certain items be deducted from the common equity Tier 1 capital, including (1) goodwill and other intangible assets, other than mortgage servicing rights, net of deferred tax liabilities (“DTLs”): (2) deferred tax assets that arise from operating losses and tax credit carryforwards, net of valuation allowances and DTLs: (3) after-tax gain-on-dale associated with a securitization exposure: and (4) defined benefit pension fund assets held by a depository institution holding company, net of DTLs.  In addition, banking organizations must deduct from common equity Tier 1 capital, the amount of certain assets, including mortgage servicing assets that exceed certain thresholds.  The Final Capital Rules also allow all but the largest banking organizations to make a one-time election not to recognize unrealized gains and losses on available-for-sale debt securities in regulatory capital, as under prior capital rules.

Furthermore, the Final Capital Rules added a requirement for a minimum common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets, (the “Conservation Buffer”), to be applied to the common equity Tier 1 capital ratio, the Tier 1 capital ratio and the total capital ratio.  The required minimum Conservation Buffer will be phased in incrementally between 2016 and 2019.  If a bank’s or bank holding company’s Conservation Buffer is less than the required minimum and its net income for the four calendar quarters preceding the applicable calendar quarter, net of any capital distributions and associated tax effects not already reflected in net income (“Eligible Retained Income”), is negative, it would be prohibited from making capital distributions or certain discretionary cash bonus payments to executive officers.  As a result, under the Final Capital Rules, should the Company fail to maintain the

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Conservation Buffer, it would be subject to limits on, and in the event the Company has negative Eligible Retained Income for any four consecutive calendar quarters, the Company would be prohibited in, its ability to obtain capital distributions from the Bank.

The chart below sets forth the new regulatory capital levels including the Conservation Buffer, during the applicable transition period:

 

 

The Bank’s Total risk-based capital ratio, Tier 1 common equity capital risk-based capital ratio, Tier 1 risk-based capital ratio and leverage capital ratio were 19.34%, 18.29%, 18.29% and 13.42%, respectively at September 30, 2016. The Company’s Total risk-based capital ratio, Tier 1 common equity capital risk-based capital ratio, Tier 1 risk-based capital ratio and leverage capital ratio were 21.19%, 14.45%, 18.06% and 13.26%, respectively at September 30, 2016. At September 30, 2016, the Bank exceeded all regulatory capital requirements, including the Conservation Buffer of 0.625%. If the fully phased in conservation buffer of 2.5% were in effect at September 30, 2016, the Company would be in compliance.

The Final Capital Rules also revised the “Prompt Corrective Action” regulations of FDICIA. To be deemed “well capitalized” a national bank must maintain a Total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 8.0% or greater, a common equity Tier 1 risk-based capital ratio of 6.5% or greater and a Tier 1 leverage capital ratio of 5.0% or greater and not be subject to any order or directive by the OCC to meet a specific capital level.

The following table provides both the Company’s and the Bank’s regulatory capital ratios as of September 30, 2016:

Table 6: Regulatory Capital Levels

 

 

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

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holding company, such as the Company, with total consolidated assets of less than $15 billion as of December 31, 2009, may continue to be included as Tier 1 capital (subject to the 25% limitation). The portion that exceeds the 25 percent capital limitation qualifies as Tier 2, or supplementary capital of the Company.  At September 30, 2016, $57.0 million of a total of $90.0 million in capital securities qualified as Tier 1 with $33.0 million qualifying as Tier 2.

Dividend Restrictions

The Bank is subject to various statutory and regulatory restrictions on its ability to pay dividends to the Company. All national banks are limited in the payment of dividends without the approval of the OCC of a total amount not to exceed the net income for that year to date plus the retained net income for the preceding two years. Federal law also prohibits national banks from paying dividends that would be greater than the bank’s undivided profits after deducting statutory bad debt in excess of the bank’s allowance for loan losses. Due to the Bank’s history of losses, any proposed dividends from the Bank to the Company will be subject to regulatory approval until such time as net income for the current year combined with the prior two years is sufficient. Under FDICIA, an insured depository institution such as the Bank is prohibited from making capital distributions, including the payment of dividends, if, after making such distribution, the institution would become “undercapitalized” (as such term is used in the FDICIA). Payment of dividends by the Bank also may be restricted at any time at the discretion of the OCC if it deems the payment to constitute an unsafe and unsound banking practice. The Bank did not seek OCC approval to pay a dividend the first nine months of 2016.

Volcker Rule

On December 10, 2013, the FRB, the OCC, the FDIC, the CFTC and the SEC issued final rules to implement the Volcker Rule contained in Section 619 of the Dodd-Frank Act. The Dodd-Frank Act provided that banks and bank holding companies were required to conform their activities and investments by July 21, 2014, however, the FRB has extended the conformance period until July 21, 2017.

On January 14, 2014, the five federal agencies, including the FRB and OCC, approved an interim final rule to permit banking entities to retain interests in certain collateralized debt obligations backed primarily by trust preferred securities from the investment prohibitions of the Volcker Rule. Under the interim final rule, the agencies permit the retention of an interest in or sponsorship of covered funds by banking entities if certain qualifications are met. In addition, the agencies released a non-exclusive list of issuers that meet the requirements of the interim final rule. At September 30, 2016, the Company had an investment in one pool of trust preferred securities with an amortized cost of $8.8 million and estimated fair value of $6.8 million. This pool was included in the list of non-exclusive issuers that meet the requirements of the interim final rule released by the agencies and therefore was not required to be sold by the Company.

At September 30, 2016, the Bank had no collateralized loan obligation securities or other securities which are not compliant with the provisions of the Volcker Rule.

At September 30, 2016, the Bank had one non-rated single issuer security with an amortized cost of $3.2 million and an estimated fair value of $3.0 million. This security is not subject to the provisions of the Volcker Rule.

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

Disclosures about Commitments

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The guarantees are primarily issued to support private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. In the event of a draw by the beneficiary that complies with the terms of the letter of credit, the Company would be required to honor the commitment. The Company takes various forms of collateral, such as real estate assets and customer business assets, to secure the commitment. Additionally, all letters of credit are supported by indemnification agreements executed by the customer. The maximum undiscounted exposure related to these commitments at September 30, 2016 was $8.6 million and the portion of the exposure not covered by collateral was approximately $105 thousand. The Company believes that the utilization rate of these letters of credit will continue to be substantially less than the amount of these commitments, as has been our experience to date.

The Company maintains a reserve for unfunded loan commitments and letters of credit, which is reported in other liabilities in the unaudited condensed consolidated statements of financial condition, consistent with FASB ASC 825. As of the balance sheet date, the Company records estimated losses inherent with unfunded loan commitments in accordance with FASB ASC 450, Contingencies, and estimated future obligations under letters of credit in accordance with FASB ASC 460, Guarantees. The methodology used to

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determine the adequacy of this reserve is integrated in the Company’s process for establishing the allowance for loan losses and considers the probability of future losses and obligations that may be incurred under these off-balance sheet agreements. The reserve for unfunded loan commitments and letters of credit at September 30, 2016 and December 31, 2015 was $614 thousand and $628 thousand, respectively. Management believes this reserve level is sufficient to absorb estimated probable losses related to these commitments.

The Company maintains reserves for residential mortgage loans and small business loans sold with recourse to third-party purchasers which are reported in other liabilities in the unaudited condensed consolidated statements of financial condition. The Company records estimated losses inherent with residential mortgage loans sold with recourse in accordance with FASB ASC 450, Contingencies. This reserve is determined based upon the probability of future losses which is calculated using historical Company and industry loss data. The recourse reserves for these loans were $1.5 million and $1.4 million at September 30, 2016 and December 31, 2015, respectively. Management believes this reserve level is sufficient to address potential recourse exposure.

 

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Asset and Liability Management

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

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

At September 30, 2016, the Company’s gap analysis showed an asset sensitive position with total interest-earning assets maturing or re-pricing within one year exceeding interest-bearing liabilities maturing or re-pricing during the same time period by $64.1 million representing a positive one-year gap ratio of 2.9%. This is a decrease from 14.3% at December 31, 2015 as the cumulative gap decreased from $316.1 million at December 31, 2015, reflecting the continued deployment of excess liquidity into long-term assets. All amounts are categorized by their actual maturity or anticipated call or re-pricing date with the exception of interest-bearing demand deposits and savings deposits. Though the rates on interest-bearing demand and savings deposits generally trend with open market rates, they often do not fully adjust to open market rates and frequently adjust with a time lag. As a result of prior experience during periods of rate volatility and management’s estimate of future rate sensitivities, the Company allocates the interest-bearing demand deposits and savings deposits based on an estimated decay rate for those deposits.

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

Net interest income simulation analysis at September 30, 2016 shows a position that is asset sensitive and will benefit from a rise in interest rates. This position is lower than the position at December 31, 2015 for all scenarios as the Company has been deploying its excess cash. A large factor causing this asset sensitive position is the higher levels of cash on the Company’s balance sheet, which the Company intends to continue to strategically deploy the remainder of 2016. After this excess liquidity is deployed, the Company expects that its interest rate risk profile will be more neutral. The net income simulation results are impacted by higher cash levels, an expected continuation of deposit pricing competition which may limit deposit pricing flexibility in both increasing and decreasing rate environments, floating-rate loan floors initially limiting loan rate increases and a relatively short liability maturity structure including retail certificates of deposit.

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Actual results may differ from the simulated results due to such factors as the timing, magnitude and frequency of interest rate changes, changes in market conditions, management strategies and differences in actual versus forecasted balance sheet composition and activity. Table 7 provides the Company’s estimated earnings sensitivity profile as of September 30, 2016. The Company anticipates that strong deposit pricing competition will continue to limit deposit pricing flexibility in an increasing and a decreasing rate environment.

Table 7: Sensitivity Profile

 

 

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

Item 4. Controls and Procedures

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

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

 

 

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PART II – OTHER INFORMATION

Item 1. Legal Proceedings

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

Item 1A. Risk Factors

Management of the Company does not believe there have been any material changes to the Risk Factors previously disclosed under Item 1A of the Company’s Form 10-K for the year ended December 31, 2015 and Part II, Item 1A, “Risk Factors”, of the Company’s Form 10-Q for the quarter ended June 30, 2016, each as previously filed with the Securities and Exchange Commission.

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

Not applicable

Item 3. Defaults Upon Senior Securities

Not applicable

Item 4. Mine Safety Disclosures.

Not applicable

Item 5. Other Information

Not Applicable

Item 6. Exhibits

 

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SIGNATURES

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

 

 

 

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