UNITED STATES SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

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

 

For the quarterly period ended     September 30, 2016     

OR

 

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

 

For the transition period from __________________________ to __________________________

 

 

ENB Financial Corp

(Exact name of registrant as specified in its charter)

 

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

 

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

 

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

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x           No o

 

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

Yes x           No o

 

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

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

 

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

Yes o           No x

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. As of November 7, 2016, the registrant had 2,846,838 shares of $0.20 (par) Common Stock outstanding.

 

ENB FINANCIAL CORP

INDEX TO FORM 10-Q

September 30, 2016

 

 

Part I – FINANCIAL INFORMATION
	Item 1.	Financial Statements
	Consolidated Balance Sheets at September 30, 2016 and 2015 and December 31, 2015 (Unaudited)		3
	Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2016 and 2015 (Unaudited)		4
	Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2016 and 2015 (Unaudited)		5
	Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2016 and 2015 (Unaudited)		6
	Notes to the Unaudited Consolidated Interim Financial Statements		7-30
	Item 2.	Management’s Discussion and Analysis of Results of Operations and Financial Condition	31-66
	Item 3.	Quantitative and Qualitative Disclosures about Market Risk	67-72
	Item 4.	Controls and Procedures	73
Part II – OTHER INFORMATION			74
	Item 1.	Legal Proceedings	74
	Item 1A.	Risk Factors	74
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	74
	Item 3.	Defaults Upon Senior Securities	74
	Item 4.	Mine Safety Disclosures	74
	Item 5.	Other Information	74
	Item 6.	Exhibits	75
SIGNATURE PAGE			76
EXHIBIT INDEX			77

 

 

Part I - Financial Information

Item 1. Financial Statements

 

CONSOLIDATED BALANCE SHEETS (UNAUDITED)

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

 

		September 30,				December 31,				September 30,
		2016				2015				2015
		$				$				$
ASSETS
Cash and due from banks			16,055				15,426				15,668
Interest-bearing deposits in other banks			33,812				28,801				24,139
Total cash and cash equivalents			49,867				44,227				39,807
Securities available for sale (at fair value)			298,139				289,423				278,470
Loans held for sale			4,525				1,126				1,020
Loans (net of unearned income)			565,968				520,283				495,039
Less: Allowance for loan losses			7,435				7,078				7,106
Net loans			558,533				513,205				487,933
Premises and equipment			22,776				21,696				21,953
Regulatory stock			5,218				4,314				4,296
Bank owned life insurance			24,489				23,869				23,659
Other assets			7,140				7,741				7,128
Total assets			970,687				905,601				864,266
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Deposits:
Noninterest-bearing			260,873				236,214				208,678
Interest-bearing			531,787				503,848				484,011
Total deposits			792,660				740,062				692,689
Short-term borrowings			12,053				8,736				9,951
Long-term debt			63,757				59,594				64,594
Other liabilities			2,264				2,107				2,269
Total liabilities			870,734				810,499				769,503
Stockholders' equity:
Common stock, par value $0.20;
Shares:  Authorized 12,000,000
Issued 2,869,557 and Outstanding 2,851,338
(Issued 2,869,557 and Outstanding 2,849,524 as of 12/31/15)
(Issued 2,869,557 and Outstanding  2,854,312 as of 9/30/15)			574				574				574
Capital surplus			4,398				4,395				4,392
Retained earnings			94,353				91,029				89,804
Accumulated other comprehensive income (loss) net of tax			1,221				(252	)			475
Less: Treasury stock cost on 18,219 shares (20,033 shares
as of 12/31/15 and 15,245 shares as of 9/30/15)			(593	)			(644	)			(482	)
Total stockholders' equity			99,953				95,102				94,763
Total liabilities and stockholders' equity			970,687				905,601				864,266

 

See Notes to the Unaudited Consolidated Interim Financial Statements  

CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

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

 

		Three Months ended September 30,								Nine Months ended September 30,
		2016				2015				2016				2015
		$				$				$				$
Interest and dividend income:
Interest and fees on loans			5,721				5,060				16,716				15,035
Interest on securities available for sale
Taxable			581				761				729				2,566
Tax-exempt			966				843				2,788				2,413
Interest on deposits at other banks			38				18				94				51
Dividend income			87				79				246				286
Total interest and dividend income			7,393				6,761				20,573				20,351
Interest expense:
Interest on deposits			509				614				1,568				1,898
Interest on borrowings			242				314				751				995
Total interest expense			751				928				2,319				2,893
Net interest income			6,642				5,833				18,254				17,458
Provision (credit) for loan losses			200				(150	)			200				150
Net interest income after provision (credit) for loan losses			6,442				5,983				18,054				17,308
Other income:
Trust and investment services income			344				250				1,104				921
Service fees			589				533				1,644				1,419
Commissions			552				520				1,611				1,488
Gains on securities transactions, net			464				529				2,130				1,690
Gains on sale of mortgages			557				226				1,109				615
Earnings on bank-owned life insurance			210				196				604				530
Other income			112				88				364				274
Total other income			2,828				2,342				8,566				6,937
Operating expenses:
Salaries and employee benefits			4,219				3,679				12,230				11,055
Occupancy			555				508				1,584				1,586
Equipment			276				283				811				849
Advertising & marketing			120				96				422				412
Computer software & data processing			471				407				1,345				1,165
Shares tax			227				195				680				586
Professional services			380				322				1,207				1,077
Other expense			500				600				1,663				1,697
Total operating expenses			6,748				6,090				19,942				18,427
Income before income taxes			2,522				2,235				6,678				5,818
Provision for federal income taxes			445				382				1,045				903
Net income			2,077				1,853				5,633				4,915
Earnings per share of common stock			0.73				0.65				1.98				1.72
Cash dividends paid per share			0.27				0.27				0.81				0.81
Weighted average shares outstanding			2,851,939				2,851,893				2,851,184				2,853,823

 

See Notes to the Unaudited Consolidated Interim Financial Statements

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)

(DOLLARS IN THOUSANDS)

 

		Three Months ended September 30,								Nine Months ended September 30,
		2016				2015				2016				2015
		$				$				$				$
Net income			2,077				1,853				5,633				4,915
Other comprehensive income (loss), net of tax:
Securities available for sale not other-than-temporarily impaired:
Unrealized gains (losses) arising during the period			(650	)			1,978				4,362				892
Income tax effect			221				(672	)			(1,483	)			(303	)
			(429	)			1,306				2,879				589
Gains recognized in earnings			(464	)			(529	)			(2,130	)			(1,690	)
Income tax effect			158				179				724				574
			(306	)			(350	)			(1,406	)			(1,116	)
Other comprehensive income (loss), net of tax			(735	)			956				1,473				(527	)
Comprehensive Income			1,342				2,809				7,106				4,388

 

See Notes to the Unaudited Consolidated Interim Financial Statements

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(DOLLARS IN THOUSANDS)

		Nine Months Ended September 30,
		2016				2015
		$				$
Cash flows from operating activities:
Net income			5,633				4,915
Adjustments to reconcile net income to net cash
provided by operating activities:
Net amortization of securities premiums and discounts and loan fees			5,393				4,429
Decrease in interest receivable			452				196
Decrease in interest payable			(41	)			(90	)
Provision for loan losses			200				150
Gains on securities transactions, net			(2,130	)			(1,690	)
Gains on sale of mortgages			(1,109	)			(615	)
Loans originated for sale			(36,127	)			(19,927	)
Proceeds from sales of loans			33,837				20,028
Earnings on bank-owned life insurance			(604	)			(530	)
Loss on sale of other real estate owned			—				30
Depreciation of premises and equipment and amortization of software			1,209				1,160
Net (increase) decrease in deferred income tax			(314	)			285
Other assets and other liabilities, net			45				(276	)
Net cash provided by operating activities			6,444				8,065
Cash flows from investing activities:
Securities available for sale:
Proceeds from maturities, calls, and repayments			51,739				37,005
Proceeds from sales			142,095				123,335
Purchases			(203,307	)			(146,374	)
Proceeds from sale of other real estate owned			—				176
Purchase of regulatory bank stock			(1,894	)			(1,288	)
Redemptions of regulatory bank stock			990				219
Purchase of bank-owned life insurance			(16	)			(2,526	)
Net increase in loans			(45,803	)			(24,346	)
Purchases of premises and equipment, net			(2,136	)			(588	)
Purchase of computer software			(295	)			(174	)
Net cash used for investing activities			(58,627	)			(14,561	)
Cash flows from financing activities:
Net increase in demand, NOW, and savings accounts			68,433				7,346
Net decrease in time deposits			(15,835	)			(14,308	)
Net increase in short-term borrowings			3,317				9,951
Proceeds from long-term debt			17,163				12,794
Repayments of long-term debt			(13,000	)			(10,500	)
Dividends paid			(2,309	)			(2,311	)
Treasury stock sold			368				392
Treasury stock purchased			(314	)			(473	)
Net cash provided by financing activities			57,823				2,891
Increase (decrease) in cash and cash equivalents			5,640				(3,605	)
Cash and cash equivalents at beginning of period			44,227				43,412
Cash and cash equivalents at end of period			49,867				39,807
Supplemental disclosures of cash flow information:
Interest paid			2,360				2,982
Income taxes paid			1,340				640
Supplemental disclosure of non-cash investing and financing activities:
Net transfer of other real estate owned from loans			—				137
Fair value adjustments for securities available for sale			(2,231	)			(800	)

 

See Notes to the Unaudited Consolidated Interim Financial Statements  

1.       Basis of Presentation

 

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

 

ENB Financial Corp (“the Corporation”) is the bank holding company for its wholly-owned subsidiary Ephrata National Bank (the “Bank”). This Form 10-Q, for the third quarter of 2016, is reporting on the results of operations and financial condition of ENB Financial Corp.

 

Operating 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 ended December 31, 2016. For further information, refer to the consolidated financial statements and footnotes thereto included in ENB Financial Corp’s Annual Report on Form 10-K for the year ended December 31, 2015.

 

 

2.       Securities Available for Sale

 

The amortized cost, gross unrealized gains and losses, and fair value of securities held at September 30, 2016,

and December 31, 2015, are as follows:        

 

						Gross				Gross
(DOLLARS IN THOUSANDS)		Amortized				Unrealized				Unrealized				Fair
		Cost				Gains				Losses				Value
		$				$				$				$
September 30, 2016
U.S. government agencies			33,088				28				(39	)			33,077
U.S. agency mortgage-backed securities			50,160				239				(208	)			50,191
U.S. agency collateralized mortgage obligations			34,940				139				(41	)			35,038
Corporate bonds			53,751				241				(83	)			53,909
Obligations of states and political subdivisions			118,515				1,885				(433	)			119,967
Total debt securities			290,454				2,532				(804	)			292,182
Marketable equity securities			5,835				125				(3	)			5,957
Total securities available for sale			296,289				2,657				(807	)			298,139
December 31, 2015
U.S. government agencies			29,829				3				(141	)			29,691
U.S. agency mortgage-backed securities			42,288				39				(347	)			41,980
U.S. agency collateralized mortgage obligations			48,140				125				(934	)			47,331
Corporate bonds			63,825				29				(549	)			63,305
Obligations of states and political subdivisions			100,208				1,780				(405	)			101,583
Total debt securities			284,290				1,976				(2,376	)			283,890
Marketable equity securities			5,515				23				(5	)			5,533
Total securities available for sale			289,805				1,999				(2,381	)			289,423

 

The amortized cost and fair value of debt securities available for sale at September 30, 2016, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities due to certain call or prepayment provisions.

 

CONTRACTUAL MATURITY OF DEBT SECURITIES

(DOLLARS IN THOUSANDS)      

 

		Amortized
		Cost				Fair Value
		$				$
Due in one year or less			20,701				20,755
Due after one year through five years			89,220				89,649
Due after five years through ten years			68,847				69,021
Due after ten years			111,686				112,757
Total debt securities			290,454				292,182

 

 

Securities available for sale with a par value of $67,271,000 and $60,295,000 at September 30, 2016, and December 31, 2015, respectively, were pledged or restricted for public funds, borrowings, or other purposes as required by law. The fair value of these pledged securities was $71,066,000 at September 30, 2016, and $65,137,000 at December 31, 2015.

 

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

 

PROCEEDS FROM SALES OF SECURITIES AVAILABLE FOR SALE

(DOLLARS IN THOUSANDS)

           

		Three Months Ended September 30,								Nine Months Ended September 30,
		2016				2015				2016				2015
		$				$				$				$
Proceeds from sales			38,592				46,797				142,095				123,335
Gross realized gains			468				531				2,186				1,784
Gross realized losses			4				2				56				94

 

 

Management evaluates all of the Corporation’s securities for other than temporary impairment (OTTI) on a periodic basis. No securities in the portfolio had other-than-temporary impairment recorded in the first nine months of 2016 or 2015.

 

Information pertaining to securities with gross unrealized losses at September 30, 2016, and December 31, 2015, aggregated by investment category and length of time that individual securities have been in a continuous loss position follows:

TEMPORARY IMPAIRMENTS OF SECURITIES

(DOLLARS IN THOUSANDS)  

		Less than 12 months								More than 12 months								Total
						Gross								Gross								Gross
		Fair				Unrealized				Fair				Unrealized				Fair				Unrealized
		Value				Losses				Value				Losses				Value				Losses
		$				$				$				$				$				$
As of September 30, 2016
U.S. government agencies			15,955				(39	)			—				—				15,955				(39	)
U.S. agency mortgage-backed securities			17,118				(128	)			4,246				(80	)			21,364				(208	)
U.S. agency collateralized mortgage obligations			9,492				(41	)			—				—				9,492				(41	)
Corporate bonds			18,877				(78	)			2,014				(5	)			20,891				(83	)
Obligations of states & political subdivisions			28,209				(258	)			9,187				(175	)			37,396				(433	)
Total debt securities			89,651				(544	)			15,447				(260	)			105,098				(804	)
Marketable equity securities			107				(3	)			—				—				107				(3	)
Total temporarily impaired securities			89,758				(547	)			15,447				(260	)			105,205				(807	)
As of December 31, 2015
U.S. government agencies			24,968				(106	)			1,965				(35	)			26,933				(141	)
U.S. agency mortgage-backed securities			24,613				(235	)			4,827				(112	)			29,440				(347	)
U.S. agency collateralized mortgage obligations			26,563				(827	)			4,652				(107	)			31,215				(934	)
Corporate bonds			50,530				(532	)			2,002				(17	)			52,532				(549	)
Obligations of states & political subdivisions			21,913				(252	)			7,435				(153	)			29,348				(405	)
Total debt securities			148,587				(1,952	)			20,881				(424	)			169,468				(2,376	)
Marketable equity securities			142				(5	)			—				—				142				(5	)
Total temporarily impaired securities			148,729				(1,957	)			20,881				(424	)			169,610				(2,381	)

 

 

In the debt security portfolio there were 75 positions that were carrying unrealized losses as of September 30, 2016. In the equity security portfolio there were two positions that were carrying unrealized losses as of September 30, 2016. There were no instruments considered to be other-than-temporarily impaired at September 30, 2016.

 

The Corporation evaluates both equity and fixed maturity positions for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic and market concerns warrant such evaluation. U.S. generally accepted accounting principles provide for the bifurcation of OTTI into two categories: (a) the amount of the total OTTI related to a decrease in cash flows expected to be collected from the debt security (the credit loss), which is recognized in earnings, and (b) the amount of total OTTI related to all other factors, which is recognized, net of taxes, as a component of accumulated other comprehensive income.

 

As part of management’s normal monthly securities review, instruments are examined for known or expected calls that would impact the value of the bonds by causing accelerated amortization. If a security was purchased at a high premium, or dollar price above par, the remaining premium has to be amortized on a straight line basis to the known call date. Calls can occur in a majority of the securities the Corporation purchases but they are dependent on the structure of the instrument, and can also be dependent on certain conditions. The Corporation experienced a clean-up call on a Ginnie Mae U.S. agency mortgage-backed security in the fourth quarter of 2015, which required $385,000 of remaining premium to be amortized. Subsequent to this event, all other high coupon and/or high premium U.S. agency mortgage-backed securities and collateralized mortgage obligations were reviewed to determine if there was any other current material exposure to clean-up call provisions. No other securities were identified with impending clean-up calls.

 

On March 15, 2016, management was made aware of a regulatory call provision on a CoBank bond held by the Corporation. CoBank is a sub-U.S. agency and cooperative of the Farm Credit Association (FCA), a U.S. government sponsored enterprise (GSE). The bond is classified as a corporate bond for disclosure purposes. The regulatory call was not anticipated and the high coupon bond was purchased at a high premium. The call required accelerated amortization to the April 15, 2016 call date, resulting in an additional $479,000 of amortization through September 30, 2016. This regulatory call specifically involved the CoBank issue maturing on April 16, 2018.

 

On April 26, 2016, management became aware of an AgriBank bond call. AgriBank is another cooperative of the FCA. The Corporation owned $6.4 million par of the AgriBank issue maturing on July 15, 2019. AgriBank went public with this call, stating they intended to call the bonds on July 15, 2016. As a result of this par call notice, management accelerated the amortization of the remaining premium on the AgriBank bond, beginning in April and running until the call date of July 15, 2016. As of September 30, 2016, $1,202,000 of accelerated amortization was recorded on this bond.

 

In both the CoBank and AgriBank matters investors, including the Corporation, have contested the ability of both CoBank and AgriBank to conduct these regulatory calls. Presently, management is pursuing litigation against CoBank and AgriBank to contest the process that was undertaken to exercise these regulatory calls. Management cannot make any prediction or draw any conclusion as to the outcome of any negotiations and/or litigation in connection with these matters.

 

3.        Loans and Allowance for Loan Losses

 

The following table presents the Corporation’s loan portfolio by category of loans as of September 30, 2016, and December 31, 2015:

 

LOAN PORTFOLIO

(DOLLARS IN THOUSANDS)    

 

		September 30,				December 31,
		2016				2015
		$				$
Commercial real estate
Commercial mortgages			87,676				87,613
Agriculture mortgages			167,531				158,321
Construction			28,796				14,966
Total commercial real estate			284,003				260,900
Consumer real estate (a)
1-4 family residential mortgages			143,066				133,538
Home equity loans			10,537				10,288
Home equity lines of credit			50,251				37,374
Total consumer real estate			203,854				181,200
Commercial and industrial
Commercial and industrial			41,705				36,189
Tax-free loans			11,485				19,083
Agriculture loans			19,363				18,305
Total commercial and industrial			72,553				73,577
Consumer			4,663				3,892
Gross loans prior to deferred fees			565,073				519,569
Less:
Deferred loan costs, net			(895	)			(714	)
Allowance for loan losses			7,435				7,078
Total net loans			558,533				513,205

 

(a)	Real estate loans serviced for others, which are not included in the Consolidated Balance Sheets, totaled $59,506,000 and $38,024,000 as of September 30, 2016, and December 31, 2015, respectively.

 

   

The Corporation grades commercial credits differently than consumer credits. The following tables represent all of the Corporation’s commercial credit exposures by internally assigned grades as of September 30, 2016 and December 31, 2015. The grading analysis estimates the capability of the borrower to repay the contractual obligations under the loan agreements as scheduled. The Corporation's internal commercial credit risk grading system is based on experiences with similarly graded loans.

 

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

 

·

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

 

·

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

 

·

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

 

·

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

 

·

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

 

 

COMMERCIAL CREDIT EXPOSURE

CREDIT RISK PROFILE BY INTERNALLY ASSIGNED GRADE

(DOLLARS IN THOUSANDS)

 

September 30, 2016		Commercial Mortgages				Agriculture Mortgages				Construction				Commercial and Industrial				Tax-free Loans				Agriculture Loans				Total
		$				$				$				$				$				$				$
Grade:
Pass			83,351				161,428				27,796				37,969				11,485				18,262				340,291
Special Mention			996				3,761				—				294				—				366				5,417
Substandard			3,329				2,342				1,000				3,442				—				735				10,848
Doubtful			—				—				—				—				—				—				—
Loss			—				—				—				—				—				—				—
Total			87,676				167,531				28,796				41,705				11,485				19,363				356,556

 

 

December 31, 2015		Commercial Mortgages				Agriculture Mortgages				Construction				Commercial and Industrial				Tax-free Loans				Agriculture Loans				Total
		$				$				$				$				$				$				$
Grade:
Pass			81,865				154,507				13,822				35,416				19,083				17,860				322,553
Special Mention			511				623				—				—				—				125				1,259
Substandard			5,237				3,191				1,144				773				—				320				10,665
Doubtful			—				—				—				—				—				—				—
Loss			—				—				—				—				—				—				—
Total			87,613				158,321				14,966				36,189				19,083				18,305				334,477

 

For consumer loans, the Corporation evaluates credit quality based on whether the loan is considered performing or non-performing. Non-performing loans consist of those loans greater than 90 days delinquent and nonaccrual loans. The following tables present the balances of consumer loans by classes of the loan portfolio based on payment performance as of September 30, 2016 and December 31, 2015:

 

CONSUMER CREDIT EXPOSURE

CREDIT RISK PROFILE BY PAYMENT PERFORMANCE

(DOLLARS IN THOUSANDS)          

 

September 30, 2016		1-4 Family Residential Mortgages				Home Equity Loans				Home Equity Lines of Credit				Consumer				Total
Payment performance:		$				$				$				$				$
Performing			142,570				10,482				50,251				4,656				207,959
Non-performing			496				55				—				7				558
Total			143,066				10,537				50,251				4,663				208,517

 

December 31, 2015		1-4 Family Residential Mortgages				Home Equity Loans				Home Equity Lines of Credit				Consumer				Total
Payment performance:		$				$				$				$				$
Performing			133,220				10,278				37,327				3,889				184,714
Non-performing			318				10				47				3				378
Total			133,538				10,288				37,374				3,892				185,092

 

The following tables present an age analysis of the Corporation’s past due loans, segregated by loan portfolio class, as of September 30, 2016 and December 31, 2015:

 

AGING OF LOANS RECEIVABLE

(DOLLARS IN THOUSANDS)

               

																										Loans
										Greater																Receivable >
		30-59 Days				60-89 Days				than 90				Total Past								Total Loans				90 Days and
September 30, 2016		Past Due				Past Due				Days				Due				Current				Receivable				Accruing
		$				$				$				$				$				$				$
Commercial real estate
Commercial mortgages			350				—				586				936				86,740				87,676				161
Agriculture mortgages			—				—				—				—				167,531				167,531				—
Construction			—				—				—				—				28,796				28,796				—
Consumer real estate
1-4 family residential mortgages			465				198				496				1,159				141,907				143,066				496
Home equity loans			41				5				55				101				10,436				10,537				2
Home equity lines of credit			—				—				—				—				50,251				50,251				—
Commercial and industrial
Commercial and industrial			5				—				75				80				41,625				41,705				—
Tax-free loans			—				—				—				—				11,485				11,485				—
Agriculture loans			—				—				—				—				19,363				19,363				—
Consumer			16				5				7				28				4,635				4,663				7
Total			877				208				1,219				2,304				562,769				565,073				666

 

               

 

																										Loans
										Greater																Receivable >
		30-59 Days				60-89 Days				than 90				Total Past								Total Loans				90 Days and
December 31, 2015		Past Due				Past Due				Days				Due				Current				Receivable				Accruing
		$				$				$				$				$				$				$
Commercial real estate
Commercial mortgages			—				601				—				601				87,012				87,613				—
Agriculture mortgages			—				—				—				—				158,321				158,321				—
Construction			—				—				—				—				14,966				14,966				—
Consumer real estate
1-4 family residential mortgages			1,264				123				318				1,705				131,833				133,538				318
Home equity loans			27				59				10				96				10,192				10,288				10
Home equity lines of credit			35				—				47				82				37,292				37,374				47
Commercial and industrial
Commercial and industrial			20				9				—				29				36,160				36,189				—
Tax-free loans			—				—				—				—				19,083				19,083				—
Agriculture loans			—				—				—				—				18,305				18,305				—
Consumer			17				17				3				37				3,855				3,892				3
Total			1,363				809				378				2,550				517,019				519,569				378

 

The following table presents nonaccrual loans by classes of the loan portfolio as of September 30, 2016 and December 31, 2015:

NONACCRUAL LOANS BY LOAN CLASS

(DOLLARS IN THOUSANDS)  

		September 30,				December 31,
		2016				2015
		$				$
Commercial real estate
Commercial mortgages			677				380
Agriculture mortgages			—				—
Construction			—				—
Consumer real estate
1-4 family residential mortgages			—				—
Home equity loans			53				—
Home equity lines of credit			—				—
Commercial and industrial
Commercial and industrial			75				—
Tax-free loans			—				—
Agriculture loans			—				—
Consumer			—				—
Total			805				380

 

As of September 30, 2016 and December 31, 2015, all of the Corporation’s commercial loans on nonaccrual status were also considered impaired. Information with respect to impaired loans for the three and nine months ended September 30, 2016 and September 30, 2015, is as follows:

 

IMPAIRED LOANS

(DOLLARS IN THOUSANDS)          

 

		Three months ended September 30,								Nine months ended September 30,
		2016				2015				2016				2015
		$				$				$				$
Average recorded balance of impaired loans			1,830				1,820				1,894				1,997
Interest income recognized on impaired loans			14				23				42				68

 

Interest income on impaired loans would have increased by approximately $9,000 and $16,000 for the three and nine months ended September 30, 2016, compared to $3,000 and $17,000 for the three and nine months ended September 30, 2015, had these loans performed in accordance with their original terms.

 

During the nine months ended September 30, 2016 and 2015, there were no loan modifications made that would cause a loan to be considered a troubled debt restructuring (TDR). A TDR is a loan where management has granted a concession to the borrower from the original terms. A concession is generally defined as more favorable payment or credit terms granted to a borrower in an effort to improve the likelihood of the lender collecting principal in its entirety. Concessions usually are in the form of interest only for a period of time, or a lower interest rate offered in an effort to enable the borrower to continue to make normally scheduled payments.

 

The following tables summarize information in regards to impaired loans by loan portfolio class as of September 30, 2016, December 31, 2015, and September 30, 2015:

 

IMPAIRED LOAN ANALYSIS
(DOLLARS IN THOUSANDS)
September 30, 2016		Recorded Investment				Unpaid Principal Balance				Related Allowance				Average Recorded Investment				Interest Income Recognized
		$				$				$				$				$
With no related allowance recorded:
Commercial real estate
Commercial mortgages			730				827				—				561				—
Agriculture mortgages			1,267				1,267				—				1,295				42
Construction			—				—				—				—				—
Total commercial real estate			1,997				2,094				—				1,856				42
Commercial and industrial
Commercial and industrial			75				75				—				38				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			75				75				—				38				—
Total with no related allowance			2,072				2,169				—				1,894				42
With an allowance recorded:
Commercial real estate
Commercial mortgages			—				—				—				—				—
Agriculture mortgages			—				—				—				—				—
Construction			—				—				—				—				—
Total commercial real estate			—				—				—				—				—
Commercial and industrial
Commercial and industrial			—				—				—				—				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			—				—				—				—				—
Total with a related allowance			—				—				—				—				—
Total by loan class:
Commercial real estate
Commercial mortgages			730				827				—				561				—
Agriculture mortgages			1,267				1,267				—				1,295				42
Construction			—				—				—				—				—
Total commercial real estate			1,997				2,094				—				1,856				42
Commercial and industrial
Commercial and industrial			75				75				—				38				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			75				75				—				38				—
Total			2,072				2,169				—				1,894				42

IMPAIRED LOAN ANALYSIS
(DOLLARS IN THOUSANDS)
December 31, 2015		Recorded Investment				Unpaid Principal Balance				Related Allowance				Average Recorded Investment				Interest Income Recognized
		$				$				$				$				$
With no related allowance recorded:
Commercial real estate
Commercial mortgages			380				952				—				544				—
Agriculture mortgages			1,325				1,325				—				1,359				83
Construction			—				—				—				—				—
Total commercial real estate			1,705				2,277				—				1,903				83
Commercial and industrial
Commercial and industrial			—				49				—				54				3
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			—				49				—				54				3
Total with no related allowance			1,705				2,326				—				1,957				86
With an allowance recorded:
Commercial real estate
Commercial mortgages			—				—				—				—				—
Agriculture mortgages			—				—				—				—				—
Construction			—				—				—				—				—
Total commercial real estate			—				—				—				—				—
Commercial and industrial
Commercial and industrial			—				—				—				—				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			—				—				—				—				—
Total with a related allowance			—				—				—				—				—
Total by loan class:
Commercial real estate
Commercial mortgages			380				952				—				544				—
Agriculture mortgages			1,325				1,325				—				1,359				83
Construction			—				—				—				—				—
Total commercial real estate			1,705				2,277				—				1,903				83
Commercial and industrial
Commercial and industrial			—				49				—				54				3
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			—				49				—				54				3
Total			1,705				2,326				—				1,957				86

IMPAIRED LOAN ANALYSIS
(DOLLARS IN THOUSANDS)
September 30, 2015		Recorded Investment				Unpaid Principal Balance				Related Allowance				Average Recorded Investment				Interest Income Recognized
		$				$				$				$				$
With no related allowance recorded:
Commercial real estate
Commercial mortgages			423				995				—				572				—
Agriculture mortgages			1,345				1,345				—				1,367				65
Construction			—				—				—				—				—
Total commercial real estate			1,768				2,340				—				1,939				65
Commercial and industrial
Commercial and industrial			46				53				—				58				3
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			46				53				—				58				3
Total with no related allowance			1,814				2,393				—				1,997				68
With an allowance recorded:
Commercial real estate
Commercial mortgages			—				—				—				—				—
Agriculture mortgages			—				—				—				—				—
Construction			—				—				—				—				—
Total commercial real estate			—				—				—				—				—
Commercial and industrial
Commercial and industrial			—				—				—				—				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			—				—				—				—				—
Total with a related allowance			—				—				—				—				—
Total by loan class:
Commercial real estate
Commercial mortgages			423				995				—				572				—
Agriculture mortgages			1,345				1,345				—				1,367				65
Construction			—				—				—				—				—
Total commercial real estate			1,768				2,340				—				1,939				65
Commercial and industrial
Commercial and industrial			46				53				—				58				3
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			46				53				—				58				3
Total			1,814				2,393				—				1,997				68

The following table details activity in the allowance for loan losses by portfolio segment for the nine months ended September 30, 2016:

 

ALLOWANCE FOR CREDIT LOSSES

(DOLLARS IN THOUSANDS)

 

		Commercial Real Estate				Consumer Real Estate				Commercial and Industrial				Consumer				Unallocated				Total
		$				$				$				$				$				$
Allowance for credit losses:
Beginning balance - December 31, 2015			3,831				1,403				1,314				62				468				7,078
Charge-offs			—				—				(4	)			(12	)			—				(16	)
Recoveries			—				10				16				2				—				28
Provision			(303	)			(45	)			47				15				236				(50	)
Balance - March 31, 2016			3,528				1,368				1,373				67				704				7,040
Charge-offs			—				—				—				(2	)			—				(2	)
Recoveries			—				—				159				—				—				159
Provision			255				105				(271	)			6				(45	)			50
Ending Balance - June 30, 2016			3,783				1,473				1,261				71				659				7,247
Charge-offs			—				—				(19	)			(10	)			—				(29	)
Recoveries			—				1				9				7				—				17
Provision			95				95				101				20				(111	)			200
Ending Balance - September 30, 2016			3,878				1,569				1,352				88				548				7,435

 

During the nine months ended September 30, 2016, a credit provision was recorded for the commercial and industrial segment with provision expense recorded in all other loan categories. For the entire portfolio, $200,000 of additional provision expense was needed for the first nine months of 2016. Delinquency rates among most loan pools remain very low with the total amount of delinquent loans lower on September 30, 2016 than on December 31, 2015, even with larger loan balances. The Corporation received $157,000 more recoveries than charge-offs for the nine months ended September 30, 2016. These favorable results acted to offset higher levels of classified loans and non-accruals resulting in $200,000 of additional provision being sufficient to cover the growth in the loan portfolio. Changes in qualitative factors were minimal during the third quarter and the provision expense recorded was mostly to account for significant loan growth during the year-to-date period.  

The following table details activity in the allowance for loan losses by portfolio segment for the nine months ended September 30, 2015:

 

ALLOWANCE FOR CREDIT LOSSES

(DOLLARS IN THOUSANDS)

 

		Commercial Real Estate				Consumer Real Estate				Commercial and Industrial				Consumer				Unallocated				Total
		$				$				$				$				$				$
Allowance for credit losses:
Beginning balance - December 31, 2014			3,834				1,367				1,301				66				573				7,141
Charge-offs			(272	)			—				—				(1	)			—				(273	)
Recoveries			2				—				70				—				—				72
Provision			623				(283	)			(147	)			(11	)			18				200
Balance - March 31, 2015			4,187				1,084				1,224				54				591				7,140
Charge-offs			—				—				(2	)			(3	)			—				(5	)
Recoveries			1				—				11				2				—				14
Provision			(29	)			(20	)			157				22				(30	)			100
Ending Balance - June 30, 2015			4,159				1,064				1,390				75				561				7,249
Charge-offs			—				—				—				(4	)			—				(4	)
Recoveries			—				—				10				1				—				11
Provision			(63	)			94				(195	)			(26	)			40				(150	)
Ending Balance - September 30, 2015			4,096				1,158				1,205				46				601				7,106

 

During the nine months ended September 30, 2015, provision expense was recorded for the commercial real estate segment with credit provisions recorded in all other loan categories. There were $272,000 of commercial real estate loan charge-offs during the first quarter of 2015, which increased the historical loss rates and ultimately resulted in a higher required reserve amount for the commercial real estate category as of March 31, 2015. However, since the first quarter, charge-offs had been at a minimum, economic conditions continued to improve, and the qualitative factors impacting commercial real estate had declined, resulting in a lower allocation. The majority of the Corporation’s total allowance is devoted to commercial real estate as this is the largest element of the portfolio and generally carries a higher element of credit risk. With charge-offs and recoveries running at minimal levels for the second and third quarters of 2015, it had been the qualitative factor movements that were primarily responsible for adjusting the allocations shown above for the four main loan categories.

The following tables present the balance in the allowance for credit losses and the recorded investment in loans receivable by portfolio segment based on impairment method as of September 30, 2016 and December 31, 2015:

 

ALLOWANCE FOR CREDIT LOSSES AND RECORDED INVESTMENT IN LOANS RECEIVABLE

(DOLLARS IN THOUSANDS)

 

As of September 30, 2016:		Commercial Real Estate				Consumer Real Estate				Commercial and Industrial				Consumer				Unallocated				Total
		$				$				$				$				$				$
Allowance for credit losses:
Ending balance: individually evaluated
for impairment			—				—				—				—				—				—
Ending balance: collectively evaluated
for impairment			3,878				1,569				1,352				88				548				7,435
Loans receivable:
Ending balance			284,003				203,854				72,553				4,663								565,073
Ending balance: individually evaluated
for impairment			1,997				—				75				—								2,072
Ending balance: collectively evaluated
for impairment			282,006				203,854				72,478				4,663								563,001

 

As of December 31, 2015:		Commercial Real Estate				Consumer Real Estate				Commercial and Industrial				Consumer				Unallocated				Total
		$				$				$				$				$				$
Allowance for credit losses:
Ending balance: individually evaluated
for impairment			—				—				—				—				—				—
Ending balance: collectively evaluated
for impairment			3,831				1,403				1,314				62				468				7,078
Loans receivable:
Ending balance			260,900				181,200				73,577				3,892								519,569
Ending balance: individually evaluated
for impairment			1,705				—				—				—								1,705
Ending balance: collectively evaluated
for impairment			259,195				181,200				73,577				3,892								517,864

 

4. Fair Value Presentation

 

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

 

Level I:

Quoted prices are available in active markets for identical assets or liabilities as of the reported date.

 

Level II:

Pricing inputs are other than the quoted prices in active markets, which are either directly or indirectly observable as of the reported date. The nature of these assets and liabilities includes items for which quoted prices are available but traded less frequently and items that are fair-valued using other financial instruments, the parameters of which can be directly observed.

 

Level III:

Assets and liabilities that have little to no observable pricing as of the reported date. These items do not have two-way markets and are measured using management’s best estimate of fair value, where the inputs into the determination of fair value require significant management judgment or estimation.

 

The following tables present the assets reported on the consolidated balance sheets at their fair value as of September 30, 2016, and December 31, 2015, by level within the fair value hierarchy. As required by U.S. generally accepted accounting principles, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

 

 

Fair Value Measurements:

ASSETS MEASURED ON A RECURRING BASIS

(DOLLARS IN THOUSANDS)    

 

		September 30, 2016
		Level I				Level II				Level III				Total
		$				$				$				$
U.S. government agencies			—				33,077				—				33,077
U.S. agency mortgage-backed securities			—				50,191				—				50,191
U.S. agency collateralized mortgage obligations			—				35,038				—				35,038
Corporate bonds			—				53,909				—				53,909
Obligations of states & political subdivisions			—				119,967				—				119,967
Marketable equity securities			5,957				—				—				5,957
Total securities			5,957				292,182				—				298,139

 

 

On September 30, 2016, the Corporation held no securities valued using level III inputs. All of the Corporation’s debt instruments were valued using level II inputs, where quoted prices are available and observable, but not necessarily quotes on identical securities traded in active markets on a daily basis. The Corporation’s CRA fund investments and bank stocks are fair valued utilizing level I inputs because the funds have their own quoted prices in an active market. As of September 30, 2016, the CRA fund investments had a $5,000,000 book and fair market value and the bank stock portfolio had a book value of $835,000, and fair market value of $957,000.

 

Fair Value Measurements:

ASSETS MEASURED ON A RECURRING BASIS

(DOLLARS IN THOUSANDS)    

		December 31, 2015
		Level I				Level II				Level III				Total
		$				$				$				$
U.S. government agencies			—				29,691				—				29,691
U.S. agency mortgage-backed securities			—				41,980				—				41,980
U.S. agency collateralized mortgage obligations			—				47,331				—				47,331
Corporate bonds			—				63,305				—				63,305
Obligations of states & political subdivisions			—				101,583				—				101,583
Marketable equity securities			5,533				—				—				5,533
Total securities			5,533				283,890				—				289,423

 

 

On December 31, 2015, the Corporation held no securities valued using level III inputs. All of the Corporation’s debt instruments were valued using level II inputs, where quoted prices are available and observable but not necessarily quotes on identical securities traded in active markets on a daily basis. As of December 31, 2015, the Corporation’s CRA fund investments had a book and fair market value of $5,000,000 and the bank stock portfolio had a book value of $515,000 and a market value of $533,000 utilizing level I pricing.

 

Financial instruments are considered level III when their values are determined using pricing models, discounted cash flow methodologies, or similar techniques, and at least one significant model assumption or input is unobservable. In addition to these unobservable inputs, the valuation models for level III financial instruments typically also rely on a number of inputs that are readily observable either directly or indirectly. Level III financial instruments also include those for which the determination of fair value requires significant management judgment or estimation. There were no level III securities as of September 30, 2016 or December 31, 2015.

 

The following tables present the assets measured on a nonrecurring basis on the Consolidated Balance Sheets at their fair value as of September 30, 2016 and December 31, 2015, by level within the fair value hierarchy:

 

ASSETS MEASURED ON A NONRECURRING BASIS

(Dollars in Thousands)

		September 30, 2016
		Level I $				Level II $				Level III $				Total $
Assets:
Impaired Loans			—				—				2,072				2,072
Total			—				—				2,072				2,072

 

 

		December 31, 2015
		Level I $				Level II $				Level III $				Total $
Assets:
Impaired Loans			—				—				1,705				1,705
Total			—				—				1,705				1,705

 

 

The Corporation had a total of $2,072,000 of impaired loans as of September 30, 2016, with no specific allocation against these loans and $1,705,000 of impaired loans as of December 31, 2015, with no specific allocation against these loans. The value of impaired loans is generally determined through independent appraisals of the underlying collateral.

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

 

QUANTITATIVE INFORMATION ABOUT LEVEL III FAIR VALUE MEASUREMENTS

(DOLLARS IN THOUSANDS)      

 

	September 30, 2016
	Fair Value	Valuation	Unobservable	Range
	Estimate	Techniques	Input	(Weighted Avg)
Impaired loans	2,072	Appraisal of	Appraisal	-20% (-20%)
		collateral (1)	adjustments (2)
			Liquidation	-10% (-10%)
			expenses (2)

 

	December 31, 2015
	Fair Value	Valuation	Unobservable	Range
	Estimate	Techniques	Input	(Weighted Avg)
Impaired loans	1,705	Appraisal of	Appraisal	-20% (-20%)
		collateral (1)	adjustments (2)
			Liquidation	-10% (-10%)
			expenses (2)

 

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

 

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

 

5. Interim Disclosures about Fair Value of Financial Instruments

 

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

 

Cash and Cash Equivalents

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

 

Securities Available for Sale

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

 

Regulatory Stock

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

 

Loans Held for Sale

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

 

Loans

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

 

Accrued Interest Receivable

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

 

Bank Owned Life Insurance

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

 

Deposits

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

 

Borrowings

The carrying amount of short-term borrowing is a reasonable estimate of fair value. The fair value of long-term borrowing is estimated by comparing the rate currently offered for the same type of borrowing instrument with a matching remaining term.

 

Accrued Interest Payable

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

 

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

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

 

Fair Value of Financial Instruments

 

The carrying amounts and estimated fair values of the Corporation's financial instruments at September 30, 2016 and December 31, 2015, are summarized as follows:

 

FAIR VALUE OF FINANCIAL INSTRUMENTS

(DOLLARS IN THOUSANDS)

		September 30, 2016
										Quoted Prices in
										Active Markets				Significant Other				Significant
										for Identical				Observable				Unobservable
		Carrying								Assets				Inputs				Inputs
		Amount				Fair Value				(Level 1)				(Level II)				(Level III)
		$				$				$				$				$
Financial Assets:
Cash and cash equivalents			49,867				49,867				49,867				—				—
Securities available for sale			298,139				298,139				5,957				292,182				—
Regulatory stock			5,218				5,218				5,218				—				—
Loans held for sale			4,525				4,525				4,525				—				—
Loans, net of allowance			558,533				556,457				—				—				556,457
Accrued interest receivable			3,148				3,148				3,148				—				—
Bank owned life insurance			24,489				24,489				24,489				—				—
Financial Liabilities:
Demand deposits			260,873				260,873				260,873				—				—
Interest-bearing demand deposits			21,799				21,799				21,799				—				—
NOW accounts			91,719				91,719				91,719				—				—
Money market deposit accounts			86,096				86,096				86,096				—				—
Savings accounts			166,904				166,904				166,904				—				—
Time deposits			165,269				166,851				—				—				166,851
Total deposits			792,660				794,242				627,391				—				166,851
Short-term borrowings			12,053				12,053				12,053				—				—
Long-term debt			63,757				64,379				—				—				64,379
Accrued interest payable			415				415				415				—				—

 

FAIR VALUE OF FINANCIAL INSTRUMENTS

(DOLLARS IN THOUSANDS)

 

		December 31, 2015
										Quoted Prices in
										Active Markets				Significant Other				Significant
										for Identical				Observable				Unobservable
		Carrying								Assets				Inputs				Inputs
		Amount				Fair Value				(Level 1)				(Level II)				(Level III)
		$				$				$				$				$
Financial Assets:
Cash and cash equivalents			44,227				44,227				44,227				—				—
Securities available for sale			289,423				289,423				5,533				283,890				—
Regulatory stock			4,314				4,314				4,314				—				—
Loans held for sale			1,126				1,126				1,126				—				—
Loans, net of allowance			513,205				512,481				—				—				512,481
Accrued interest receivable			3,600				3,600				3,600				—				—
Bank owned life insurance			23,869				23,869				23,869				—				—
Financial Liabilities:
Demand deposits			236,214				236,214				236,214				—				—
Interest-bearing demand deposits			14,737				14,737				14,737				—				—
NOW accounts			77,180				77,180				77,180				—				—
Money market deposit accounts			82,507				82,507				82,507				—				—
Savings accounts			148,320				148,320				148,320				—				—
Time deposits			181,104				182,887				—				—				182,887
Total deposits			740,062				741,845				558,958				—				182,887
Short-term borrowings			8,736				8,736				8,736				—				—
Long-term debt			59,594				59,805				—				—				59,805
Accrued interest payable			456				456				456				—				—

 

 

6.       Commitments and Contingent Liabilities

 

In order to meet the financing needs of its customers in the normal course of business, the Corporation makes various commitments that are not reflected in the accompanying consolidated financial statements. These commitments include firm commitments to extend credit, unused lines of credit, and open letters of credit. As of September 30, 2016, firm loan commitments were $39.3 million, unused lines of credit were $178.7 million, and open letters of credit were $10.4 million. The total of these commitments was $228.4 million, which represents the Corporation’s exposure to credit loss in the event of nonperformance by its customers with respect to these financial instruments. The actual credit losses that may arise from these commitments are expected to compare favorably with the Corporation’s loan loss experience on its loan portfolio taken as a whole. The Corporation uses the same credit policies in making commitments and conditional obligations as it does for balance sheet financial instruments.

 

7. Accumulated Other Comprehensive Income (Loss)

 

The activity in accumulated other comprehensive income (loss) for the three and nine months ended September 30, 2016 and 2015 is as follows:

 

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

(DOLLARS IN THOUSANDS)  

		Unrealized
		Gains (Losses)
		on Securities
		Available-for-Sale
		$
Balance at December 31, 2015			(252	)
Other comprehensive income before reclassifications			1,050
Amount reclassified from accumulated other comprehensive income			(480	)
Period change			570
Balance at March 31, 2016			318
Other comprehensive income before reclassifications			2,258
Amount reclassified from accumulated other comprehensive income			(620	)
Period change			1,638
Balance at June 30, 2016			1,956
Other comprehensive loss before reclassifications			(429	)
Amount reclassified from accumulated other comprehensive loss			(306	)
Period change			(735	)
Balance at September 30, 2016			1,221
Balance at December 31, 2014			1,002
Other comprehensive income before reclassifications			1,529
Amount reclassified from accumulated other comprehensive income			(370	)
Period change			1,159
Balance at March 31, 2015			2,161
Other comprehensive loss before reclassifications			(2,246	)
Amount reclassified from accumulated other comprehensive loss			(396	)
Period change			(2,642	)
Balance at June 30, 2015			(481	)
Other comprehensive income before reclassifications			1,306
Amount reclassified from accumulated other comprehensive income			(350	)
Period change			956
Balance at September 30, 2015			475

 

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

(2)	Amounts in parentheses indicate debits.

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

(DOLLARS IN THOUSANDS)      

 

		Amount Reclassified from
		Accumulated Other Comprehensive
		Income (Loss)
		For the Three Months
		Ended September 30,
		2016				2015				Affected Line Item in the
		$				$				Consolidated Statements of Income
Securities available-for-sale:
Net securities gains reclassified into earnings			464				529			Gains on securities transactions, net
Related income tax expense			(158	)			(179	)		Provision for federal income taxes
Net effect on accumulated other comprehensive
income for the period			306				350

 

(1) Amounts in parentheses indicate debits.

       

 

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

(DOLLARS IN THOUSANDS)      

 

		Amount Reclassified from
		Accumulated Other Comprehensive
		Income (Loss)
		For the Nine Months
		Ended September 30,
		2016				2015				Affected Line Item in the
		$				$				Consolidated Statements of Income
Securities available-for-sale:
Net securities gains reclassified into earnings			2,130				1,690			Gains on securities transactions, net
Related income tax expense			(724	)			(574	)		Provision for federal income taxes
Net effect on accumulated other comprehensive
income for the period			1,406				1,116

 

(1) Amounts in parentheses indicate debits.      

 

 

8. Recently Issued Accounting Standards

 

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

 

In August 2015, the FASB issued ASU 2015-14, Revenue from Contract with Customers (Topic 606). The amendments in this Update defer the effective date of ASU 2014-09 for all entities by one year. Public business entities, certain not-for-profit entities, and certain employee benefit plans should apply the guidance in ASU 2014-09 to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. All other entities should apply the guidance in ASU 2014-09 to annual reporting periods beginning after December 15, 2018, and interim reporting periods within annual reporting periods beginning after December 15, 2019. The Corporation is evaluating the effect of adopting this new accounting Update.

 

In January 2016, the FASB issued ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. This Update applies to all entities that hold financial assets or owe financial liabilities and is intended to provide more useful information on the recognition, measurement, presentation, and disclosure of financial instruments. Among other things, this Update (a) requires equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income; (b) simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; (c) eliminates the requirement to disclose the fair value of financial instruments measured at amortized cost for entities that are not public business entities; (d) eliminates 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; (e) requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; (f) requires 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; (g) requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (that is, securities or loans and receivables) on the balance sheet or the accompanying notes to the financial statements; and (h) clarifies 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. For public business entities, the amendments in this Update are effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. For all other entities, including not-for-profit entities and employee benefit plans within the scope of Topics 960 through 965 on plan accounting, the amendments in this Update are effective for fiscal years beginning after December 15, 2018, and interim periods within fiscal years beginning after December 15, 2019. All entities that are not public business entities may adopt the amendments in this Update earlier as of the fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Corporation is currently evaluating the impact the adoption of the standard will have on the Corporation’s financial position or results of operations.

 

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The standard requires lessees to recognize the assets and liabilities that arise from leases on the balance sheet.  A lessee should recognize in the statement of financial position a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term.  A short-term lease is defined as one in which (a) the lease term is 12 months or less and (b) there is not an option to purchase the underlying asset that the lessee is reasonably certain to exercise. For short-term leases, lessees may elect to recognize lease payments over the lease term on a straight-line basis. For public business entities, the amendments in this Update are effective for fiscal years beginning after December 15, 2018, and interim periods within those years. For all other entities, the amendments in this Update are effective for fiscal years beginning after December 15, 2019, and for interim periods within fiscal years beginning after December 15, 2020. The amendments should be applied at the beginning of the earliest period presented using a modified retrospective approach with earlier application permitted as of the beginning of an interim or annual reporting period. This Update is not expected to have a significant impact on the Corporation’s financial statements.

 

In March 2016, the FASB issued ASU 2016-08, Revenue from Contracts with Customers (Topic 606). The amendments in this Update affect entities with transactions included within the scope of Topic 606, which includes entities that enter into contracts with customers to transfer goods or services (that are an output of the entity’s ordinary activities) in exchange for consideration. The amendments in this Update do not change the core principle of the guidance in Topic 606; they simply clarify the implementation guidance on principal versus agent considerations. The amendments in this Update are intended to improve the operability and understandability of the implementation guidance on principal versus agent considerations. The amendments in this Update affect the guidance in ASU 2014-09, Revenue from Contracts with Customers (Topic 606), which is not yet effective. The effective date and transition requirements for the amendments in this Update are the same as the effective date and transition requirements of Update 2014-09. ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date, defers the effective date of Update 2014-09 by one year. The Corporation is currently evaluating the impact the adoption of the standard will have on the Corporation’s financial position or results of operations.

 

In April 2016, the FASB issued ASU 2016-10, Revenue from Contracts with Customers (Topic 606). The amendments in this Update affect entities with transactions included within the scope of Topic 606, which includes entities that enter into contracts with customers to transfer goods or services in exchange for consideration. The amendments in this Update do not change the core principle for revenue recognition in Topic 606. Instead, the amendments provide (1) more detailed guidance in a few areas and (2) additional implementation guidance and examples based on feedback the FASB received from its stakeholders. The amendments are expected to reduce the degree of judgment necessary to comply with Topic 606, which the FASB expects will reduce the potential for diversity arising in practice and reduce the cost and complexity of applying the guidance. The amendments in this Update affect the guidance in ASU 2014-09, Revenue from Contracts with Customers (Topic 606), which is not yet effective. The effective date and transition requirements for the amendments in this Update are the same as the effective date and transition requirements in Topic 606 (and any other Topic amended by Update 2014-09). ASU 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date, defers the effective date of Update 2014-09 by one year. The Corporation is currently evaluating the impact the adoption of the standard will have on the Corporation’s financial position or results of operations.

 

In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which changes the impairment model for most financial assets. This Update is intended to improve financial reporting by requiring timelier recording of credit losses on loans and other financial instruments held by financial institutions and other organizations. The underlying premise of the Update is that financial assets measured at amortized cost should be presented at the net amount expected to be collected, through an allowance for credit losses that is deducted from the amortized cost basis. The allowance for credit losses should reflect management’s current estimate of credit losses that are expected to occur over the remaining life of a financial asset. The income statement will be effected for the measurement of credit losses for newly recognized financial assets, as well as the expected increases or decreases of expected credit losses that have taken place during the period. ASU 2016-13 is effective for annual and interim periods beginning after December 15, 2019, and early adoption is permitted for annual and interim periods beginning after December 15, 2018. With certain exceptions, transition to the new requirements will be through a cumulative effect adjustment to opening retained earnings as of the beginning of the first reporting period in which the guidance is adopted. The Corporation is currently evaluating the impact the adoption of the standard will have on the Corporation’s financial position or results of operations.

 

In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (“ASU 2016-15”), which addresses eight specific cash flow issues with the objective of reducing diversity in practice. Among these include recognizing cash payments for debt prepayment or debt extinguishment as cash outflows for financing activities; cash proceeds received from the settlement of insurance claims should be classified on the basis of the related insurance coverage; and cash proceeds received from the settlement of bank-owned life insurance policies should be classified as cash inflows from investing activities while the cash payments for premiums on bank-owned policies may be classified as cash outflows for investing activities, operating activities, or a combination of investing and operating activities. The amendments in this Update are effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2018, and interim periods within fiscal years beginning after December 15, 2019. Early 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 amendments in this Update should be applied using a retrospective transition method to each period presented. If it is impracticable to apply the amendments retrospectively for some of the issues, the amendments for those issues would be applied prospectively as of the earliest date practicable. The Corporation is currently evaluating the impact the adoption of the standard will have on the Corporation’s statement of cash flows. 

 

 

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

 

The following discussion and analysis represents management’s view of the financial condition and results of operations of the Corporation. This discussion and analysis should be read in conjunction with the consolidated financial statements and other financial schedules included in this quarterly report, and in conjunction with the 2015 Annual Report to Shareholders of the Corporation. The financial condition and results of operations presented are not indicative of future performance.

 

Forward-Looking Statements

 

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

 

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

 

·

National and local economic conditions

·

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

·

Health of the housing market

·

Real estate valuations and its impact on the loan portfolio

·

Interest rate and monetary policies of the Federal Reserve Board

·

Volatility of the securities markets including the valuation of securities

·

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

·

Political changes and their impact on new laws and regulations

·

Competitive forces

·

Impact of mergers and acquisition activity in the local market and the effects thereof

·

Potential impact from continually evolving cybersecurity and other technological risks and attacks, including additional costs, reputational damage, regulatory penalties, and financial losses

·

Changes in customer behavior impacting deposit levels and loan demand

·

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

·

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

·

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

·

Operation, legal, and reputation risk

·

Results of the regulatory examination and supervision process

·

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

·

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

·

Disruptions due to flooding, severe weather, or other natural disasters

·

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

 

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

 

Results of Operations

 

Overview

The Corporation recorded net income of $2,077,000 and $5,633,000 for the three and nine-month periods ended September 30, 2016, a 12.1% and 14.6% increase respectively, from the $1,853,000 and $4,915,000 earned during the same periods in 2015. The earnings per share, basic and diluted, were $0.73 and $1.98 for the three and nine months ended September 30, 2016, compared to $0.65 and $1.72 for the same periods in 2015.

 

The primary reasons for the increase in earnings were an increase in net interest income and an increase in other income. The Corporation’s net interest income for the three and nine months ended September 30, 2016, increased from the same periods in 2015. Net interest income was $6,642,000 for the third quarter of 2016, compared to $5,833,000 for the same quarter in 2015, an $809,000, or 13.9% increase. The Corporation’s net interest income for the nine months ended September 30, 2016, was $18,254,000, compared to $17,458,000 for the same period in 2015, a $796,000, or 4.6% increase. The Corporation’s net interest margin was 3.22% for the third quarter of 2016, compared to 3.09% for the third quarter of 2015, compared to 3.04% and 3.10% for the respective year-to-date periods. Net interest margin was negatively affected by non-recurring accelerated amortization on called U.S. Sub-Agency bonds, which are discussed in more detail under the Net Interest Income section below.

 

Other operating income increased by $486,000, or 20.8%, and $1,629,000, or 23.5%, for the three and nine months ended September 30, 2016, compared to the same periods in the prior year. The increase for the three-month period ended September 30, 2016, was driven largely by an increase in mortgage gains, while both security and mortgage gains contributed to higher other operating income for the nine-month period ended September 30, 2016. Net gains on securities decreased by $65,000, or 12.3%, for the quarter-to-date period, but increased by $440,000, or 26.0%, for the nine-month period ended September 30, 2016, compared to the same period in 2015. Gains on the sale of mortgages increased by $331,000, or 146.5%, and $494,000, or 80.3%, for the three and nine months ended September 30, 2016, compared to the same periods in the prior year, primarily driven higher by increased volume in the second and third quarters of 2016. More detail is provided under the Other Income section under Results of Operations.

 

Partially offsetting the increased income mentioned above, operating expenses increased by $658,000, or 10.8%, and $1,515,000, or 8.2%, for the three and nine months ended September 30, 2016, compared to the same periods in the prior year. Personnel costs increased by $540,000, or 14.7%, and $1,175,000, or 10.6%, for each respective period due to new staff positions as well as higher benefit costs associated with new and existing staff. Salary and benefit costs were driven higher due to new hires for two new branch offices opened in 2016.

 

The financial services industry uses two primary performance measurements to gauge performance: return on average assets (ROA) and return on average equity (ROE). ROA measures how efficiently a bank generates income based on the amount of assets or size of a company. ROE measures the efficiency of a company in generating income based on the amount of equity or capital utilized. The latter measurement typically receives more attention from shareholders. The ROA and ROE increased for the three and nine months ended September 30, 2016, due to the increase in the Corporation’s income compared to the same periods in the prior year.

 

Key Ratios		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2016				2015				2016				2015
Return on Average Assets			0.87%				0.84%				0.81%				0.76%
Return on Average Equity			8.31%				7.90%				7.71%				7.05%

 

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

 

·

Net interest income

·

Provision for loan losses

·

Other income

·

Operating expenses

·

Provision for income taxes

 

The following discussion analyzes each of these five components.

 

Net Interest Income

 

Net interest income (NII) represents the largest portion of the Corporation’s operating income. In the first nine months of 2016, NII generated 68.1% of the Corporation’s gross revenue stream, which consists of net interest income and non-interest income, compared to 71.6% in the first nine months of 2015. The overall performance of the Corporation is highly dependent on the changes in net interest income since it comprises such a significant portion of operating income. Without the impact of the accelerated amortization on the U.S. Sub-Agency bonds, the Corporation’s NII would have accounted for 69.9% of the gross revenue stream for the first nine months of 2016.

 

The following table shows a summary analysis of net interest income on a fully taxable equivalent (FTE) basis. For analytical purposes and throughout this discussion, yields, rates, and measurements such as NII, net interest spread, and net yield on interest earning assets are presented on an FTE basis. The FTE NII shown in both tables below will exceed the NII reported on the consolidated statements of income, which is not shown on an FTE basis. The amount of FTE adjustment totaled $524,000 and $1,570,000 for the three and nine months ended September 30, 2016, compared to $480,000 and $1,379,000 for the same periods in 2015.

 

NET INTEREST INCOME

(DOLLARS IN THOUSANDS)          

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2016				2015				2016				2015
		$				$				$				$
Total interest income			7,393				6,761				20,573				20,351
Total interest expense			751				928				2,319				2,893
Net interest income			6,642				5,833				18,254				17,458
Tax equivalent adjustment			524				480				1,570				1,379
Net interest income (fully taxable equivalent)			7,166				6,313				19,824				18,837

 

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

 

·

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

·

The average balance of interest earning assets and interest bearing liabilities

 

The Federal funds rate, the Prime rate, the shape of the U.S. Treasury curve, and other wholesale funding curves, all affect NII. The Federal Reserve controls the Federal funds rate, which is one of a number of tools available to the Federal Reserve to conduct monetary policy. The Federal funds rate, and guidance on when the rate might be changed, is often the focal point of discussion regarding the direction of interest rates. Until December 16, 2015, the Federal funds rate had not changed since December 16, 2008. On December 16, 2015, the Federal funds rate was increased 25 basis points to 0.50%, from 0.25%. This period of seven years with extremely low and unchanged overnight rates was the lowest and longest in U.S. history. The impact has been lower margin to the Corporation and generally across the financial industry. The increase in December resulted in higher short-term U.S. Treasury rates, but the long-term rates have actually decreased since the Federal Reserve’s decision to increase rates, resulting in a flattening of the yield curve. This low rate environment continued through the third quarter of 2016, although there is a possibility that the Federal Reserve could increase overnight rates again later in 2016 or early in 2017. In anticipation of the next Fed rate increase, U.S. Treasury rates could increase throughout the next few months. Alternatively, the rate curve could flatten with higher short-term rates and no increase in the mid to long-term rates.

 

The Prime rate is generally used by commercial banks to extend variable rate loans to business and commercial customers. For many years, the Prime rate has been set at 300 basis points, or 3.00% higher, than the Federal funds rate and typically moves when the Federal funds rate changes. As such, the Prime rate increased from 3.25% to 3.50% on December 16, 2015. Depending on the loan instrument, the Corporation’s Prime-based loans would reprice either a day after the Federal Reserve rate movement or after a 45-day notification period. Commercial rates generally reprice the next business day while some consumer loans require the 45-day notification period.

 

The fact that the Federal funds rate and the Prime rate had remained at these very low levels for seven years and only increased by 25 basis points in December of 2015 had made it difficult to grow the NII of the Corporation as a large portion of the Corporation’s loans are priced off of the Prime rate. Prime-based loans accounted for 34.3% of the loan portfolio as of September 30, 2016, and 31.0% as of December 31, 2015. The Corporation has grown interest earning assets at a fast pace in the first nine months of 2016, which has helped to grow interest income, but the non-recurring U.S. Sub-Agency accelerated amortization partially offset this growth, having a negative impact on margin. For the three months ended September 30, 2016, NII on a tax equivalent basis increased by $853,000, or 13.5%, and the Corporation’s margin showed an increase from 3.09% in 2015, to 3.22% in 2016. For the nine months ended September 30, 2016, NII on a tax equivalent basis increased by $987,000, or 5.2%, but the Corporation’s year-to-date margin showed a decline from 3.10% in 2015 to 3.04% in 2016. Factoring out the non-recurring Sub-Agency amortization, the quarterly margin as of September 30, 2016 would have been 3.30%, and the year-to-date margin would have been 3.30% both significant improvements over the prior year.

 

The prolonged extremely low short-term rates have enabled management to reduce the cost of funds on borrowings and allowed lower interest rates paid on deposits, reducing the Corporation’s interest expense, while the increase in the Prime rate in December of 2015 has increased the yield on the Corporation’s Prime-based loans. However, in this environment the Corporation’s fixed-rate loans and securities have generally repriced to lower rates as they mature or reach the end of their fixed rate period. This has occurred over the past seven years and continues to cause lower yields on the Corporation’s assets. Due to the increasing number of variable rate loans in the Corporation’s loan portfolio, the 25 basis-point increase in the Prime rate in December 2015 did have a positive effect on the loan interest income in the first nine months of 2016. If the Fed increases rates again in the latter part of the year, NII will see another increase.

 

Security yields fluctuate more rapidly than loan yields based primarily on the changes to the U.S. Treasury rates and yield curve. With lower U.S. Treasury rates on average in the first nine months of 2016 compared to 2015, most of the security reinvesting was occurring at lower rates. As the volume of securities sold at gains continued at a higher level, this also resulted in more reinvestment at lower rates. Management did generally direct a large portion of the security sale proceeds into loan growth particularly in the fourth quarter of 2015 and the first quarter of 2016 when loan growth was significant. The Corporation’s loan yield has continued to decline slightly as new loans are occurring at among the lowest loan rates of this interest rate cycle. Partially offsetting these lower rates on new loans, the increased rate on Prime-based loans is having a positive impact on yield. Management does price above the Prime rate on variable rate loans, which helps with loan yield, however, these rates on average are still lower than the typical fixed rate loan. An element of the Corporation’s Prime-based commercial loans is priced above the Prime rate based on the level of credit risk of the borrower. Additionally, a minority of the Corporation’s variable-rate consumer loans are currently priced above Prime. Nearly all of the Corporation’s variable rate consumer loans are in the form of home equity lines of credit where nearly 40% of these lines are priced above the Prime rate. This has been a growing product for the Corporation, with balances of $50.3 million as of September 30, 2016, compared to balances of $37.4 million as of December 31, 2015. Both commercial and consumer Prime-based pricing continues to be driven largely by local competition.

 

Mid-term and long-term interest rates on average were lower in the first nine months of 2016 compared to 2015. The average rate of the 10-year U.S. Treasury was 1.74% in the first nine months of 2016 compared to 2.12% in the first nine months of 2015, and it stood at 1.60% on September 30, 2016, compared to 2.06% at September 30, 2015. The slope of the yield curve was already compressed, but with the Fed rate increase in December of 2015, there was even less slope between the short end and long end of the curve. There was only a difference of 110 basis points between overnight rates and the 10-year U.S. Treasury as of September 30, 2016, compared to 181 basis points as of September 30, 2015. With a flatter yield curve and lower mid and long-term interest rates, management was not able to increase loan rates to improve yield although the 25 basis point increase in the Prime rate did act to increase the yield on Prime-based variable rate loans. Additionally, with lower rates, security amortization increased and yields on new purchases were low resulting in a lower overall securities yield. As a result, the Corporation’s asset yield continued to decline.

 

While it is becoming increasingly difficult to achieve savings on the Corporation’s overall cost of funds, management was still achieving savings on select long-term CDs and repricing FHLB borrowings through the third quarter of 2016. It is not anticipated that interest rates on interest bearing core deposits can be reduced further in 2016 as these rates have already been reduced significantly over the course of the past few years. While CD rate reductions are also limited, there are still small savings to be achieved in CDs repricing down from higher rates five years ago. Borrowing costs and the wholesale borrowing curves that they are based on generally follow the direction and slope of the U.S. Treasury curve. However, these curves can be quicker to rise and slower to fall as the providers of these funds seek to protect themselves from rate movements. The Corporation was able to refinance most borrowings at lower rates in 2015 and in the first nine months of 2016.

 

Management currently anticipates that the overnight interest rate and Prime rate could be increased in the fourth quarter of 2016 although the next interest rate increase may not occur until early 2017. It is likely that the mid and long-term Treasury rates could increase throughout the remainder of the year in anticipation of additional Federal Reserve rate movements. This would allow management to achieve higher earnings on assets if the opportunity for higher yielding securities and the ability to price new loans at higher market rates occurred. If the Federal Reserve would act to increase overnight rates, it is also possible that the yield curve could flatten more, making it more difficult for management to lend out or reinvest at higher interest rates out further on the yield curve. Should another Federal Reserve rate increase occur in late 2016, management would likely have to begin increasing deposit rates to remain competitive in the market. To protect funding costs, management would desire to defer on any deposit rate increases after a Federal Reserve rate increase until competitive forces make that necessary.

 

Generally, a flatter yield curve is not conducive to increasing net interest margin and net interest income. However, the Corporation has benefited from a gradual increase in the amount of variable rate loans. Over 34% of the Corporation’s loans are variable rate, which would reprice to a higher rate based on the Prime rate with any Federal Reserve increase. Higher amounts of variable rate loans would help in the event of a flatter yield curve, but would likely not be sufficient alone to offset higher funding costs if short-term rates were to increase materially and deposit rates had to be increased.

 

The Corporation’s margin was 3.22% for the third quarter of 2016, a 13 basis-point increase from the 3.09% for the third quarter of 2015. For the year-to-date period, the Corporation’s margin was 3.04%, compared to 3.10% in the prior year, a decline of 6 basis points. The margin decline for the year-to-date period was due to $1,681,000 of non-recurring accelerated amortization on U.S. Sub-Agency bonds that reduced interest income on securities. Without this event, NIM would have been 3.30% for the third quarter of 2016, and 3.30% for the nine months ended September 30, 2016.

 

In the first quarter of 2016, CoBank, a farm Credit System Bank, regulated by the Farm Credit Administration (FCA), a U.S. Government Sponsored Enterprise (GSE), announced on March 11, 2016, they were prematurely calling their 7.875% notes maturing April 16, 2018, on April 15, 2016, using an extra ordinary redemption provision. CoBank based their call on a regulatory event occurring. This event caught the Corporation, specifically, and many in the investment community generally by surprise as the holders viewed the instruments as not generally callable and this marked the first instance that such a call was conducted on these securities. This call required that the Corporation accelerate the amortization on these bonds causing an additional $479,000 of amortization in the nine months ended September 30, 2016.

 

The Corporation was also made aware on April 26, 2016 of AgriBank’s intention to conduct a regulatory par call on their 9.125% notes maturing on July 15, 2019, with the call date of July 15, 2016. Similar to CoBank, AgriBank is a co-operative of the FCA and a U.S. GSE. The Corporation owned $6.4 million par value of the AgriBank issue maturing on July 15, 2019, with a book value of $7.7 million. As a result of this par call notice, management had accelerated amortization of $1,202,000 of premium on the AgriBank bond in the nine months ended September 30, 2016. The Corporation’s net interest income and margin were negatively impacted to a significant degree as a result of these two U.S. Sub-Agency calls.

 

Although loan growth is occurring, it has been a challenge to increase loan pricing to the point where it is contributing to an increase in overall asset yield. As cost of funds savings become harder to achieve, the only way to materially increase net interest margin going forward will be through increases in asset yield. Any significant improvement in asset yields would be dependent on either additional Prime rate increases or on mid-term and longer-term market interest rates increasing. This would assist with increased loan pricing and higher securities yields as a result of reduced amortization and higher yields being available at the time of purchase.

 

As shown in the tables that follow, interest income, on an FTE basis increased by $676,000, or 9.3%, and $413,000, or 1.9%, for the three and nine months ended September 30, 2016, compared to the same periods in 2015. Interest expense decreased by $177,000, or 19.1%, and $574,000, or 19.8%, for the three and nine-month periods when comparing both years, resulting in an $853,000, or 13.5% increase, and $987,000, or 5.2% increase, in net interest income on an FTE basis for both periods.

 

The following tables show a more detailed comparative analysis of net interest income on an FTE basis for both the three-month and nine-month periods ended September 30, 2016. They are shown with all the major elements of the Corporation’s balance sheet, which consists of interest earning and non-interest earning assets and interest bearing and non-interest bearing liabilities. Additionally, the analysis provides the net interest spread and the net yield on interest earning assets. The net interest spread is the difference between the yield on interest earning assets and the interest rate paid on interest bearing liabilities. The net interest spread has the deficiency of not giving credit for the non-interest bearing funds and capital used to fund a portion of the total interest earning assets. For this reason, Management emphasizes the net yield on interest earning assets, also referred to as the net interest margin (NIM). The NIM is calculated by dividing net interest income on an FTE basis into total average interest earning assets. The NIM is generally the benchmark used by analysts to measure how efficiently a bank generates NII.

 

COMPARATIVE AVERAGE BALANCE SHEETS AND NET INTEREST INCOME

(DOLLARS IN THOUSANDS)    

		For the Three Months Ended September 30,
		2016												2015
										(c)												(c)
		Average								Annualized				Average								Annualized
		Balance				Interest				Yield/Rate				Balance				Interest				Yield/Rate
		$				$				%				$				$				%
ASSETS
Interest earning assets:
Federal funds sold and interest
on deposits at other banks			25,973				39				0.60				23,619				18				0.31
Securities available for sale:
Taxable			183,607				608				1.32				200,276				782				1.56
Tax-exempt			113,566				1,444				5.09				100,121				1,265				5.05
Total securities (d)