UNITED STATES SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

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

 

For the quarterly period ended       March 31, 2017    

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, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

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

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

 

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

Yes o          No x

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. As of May 1, 2017, the registrant had 2,848,741 shares of $0.20 (par) Common Stock outstanding.

 

ENB FINANCIAL CORP

INDEX TO FORM 10-Q

March 31, 2017

 

 

Part I – FINANCIAL INFORMATION
	Item 1.	Financial Statements
	Consolidated Balance Sheets at March 31, 2017 and 2016 and December 31, 2016 (Unaudited)		3
	Consolidated Statements of Income for the Three Months Ended March 31, 2017 and 2016 (Unaudited)		4
	Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2017 and 2016 (Unaudited)		5
	Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2017 and 2016 (Unaudited)		6
	Notes to the Unaudited Consolidated Interim Financial Statements		7-30
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	31-62
	Item 3.	Quantitative and Qualitative Disclosures about Market Risk	63-67
	Item 4.	Controls and Procedures	68
Part II – OTHER INFORMATION			69
	Item 1.	Legal Proceedings	69
	Item 1A.	Risk Factors	69
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	69
	Item 3.	Defaults Upon Senior Securities	69
	Item 4.	Mine Safety Disclosures	69
	Item 5.	Other Information	69
	Item 6.	Exhibits	70
SIGNATURE PAGE			71
EXHIBIT INDEX			72

 

Part I - Financial Information

Item 1. Financial Statements

 

CONSOLIDATED BALANCE SHEETS (UNAUDITED)

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

 

		March 31,				December 31,				March 31,
		2017				2016				2016
		$				$				$
ASSETS
Cash and due from banks			16,161				19,852				11,989
Interest-bearing deposits in other banks			43,127				25,780				28,689
Total cash and cash equivalents			59,288				45,632				40,678
Securities available for sale (at fair value)			315,176				308,111				287,270
Loans held for sale			3,127				2,552				804
Loans (net of unearned income)			572,876				571,567				544,784
Less: Allowance for loan losses			7,672				7,562				7,040
Net loans			565,204				564,005				537,744
Premises and equipment			23,881				22,568				21,466
Regulatory stock			5,455				5,372				4,675
Bank owned life insurance			24,856				24,687				24,082
Other assets			10,836				11,326				8,102
Total assets			1,007,823				984,253				924,821
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Deposits:
Noninterest-bearing			287,799				280,543				243,647
Interest-bearing			547,831				536,948				506,084
Total deposits			835,630				817,491				749,731
Short-term borrowings			14,774				8,329				11,467
Long-term debt			58,819				61,257				64,883
Other liabilities			2,188				2,237				1,866
Total liabilities			911,411				889,314				827,947
Stockholders' equity:
Common stock, par value $0.20;
Shares:  Authorized 12,000,000
Issued 2,869,557 and Outstanding  2,853,741
(Issued 2,869,557 and Outstanding 2,850,382 as of 12/31/16)
(Issued 2,869,557 and Outstanding  2,851,394 as of 3/31/16)			574				574				574
Capital surplus			4,411				4,403				4,395
Retained earnings			96,504				95,475				92,172
Accumulated other comprehensive income (loss) net of tax			(4,559	)			(4,885	)			318
Less: Treasury stock cost on 15,816 shares (19,175 shares
as of 12/31/16 and 18,163 shares as of 3/31/16)			(518	)			(628	)			(585	)
Total stockholders' equity			96,412				94,939				96,874
Total liabilities and stockholders' equity			1,007,823				984,253				924,821

 

See Notes to the Unaudited Consolidated Interim Financial Statements      

 

CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

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

 

		Three Months ended March 31,
		2017				2016
		$				$
Interest and dividend income:
Interest and fees on loans			5,832				5,439
Interest on securities available for sale
Taxable			888				473
Tax-exempt			1,120				867
Interest on deposits at other banks			54				26
Dividend income			88				81
Total interest and dividend income			7,982				6,886
Interest expense:
Interest on deposits			467				546
Interest on borrowings			235				265
Total interest expense			702				811
Net interest income			7,280				6,075
Provision (credit) for loan losses			90				(50	)
Net interest income after provision (credit) for loan losses			7,190				6,125
Other income:
Trust and investment services income			482				387
Service fees			562				478
Commissions			547				515
Gains on securities transactions, net			140				728
Gains on sale of mortgages			355				155
Earnings on bank-owned life insurance			173				194
Other income			153				194
Total other income			2,412				2,651
Operating expenses:
Salaries and employee benefits			4,719				3,971
Occupancy			599				514
Equipment			282				263
Advertising & marketing			237				135
Computer software & data processing			530				420
Shares tax			215				227
Professional services			389				377
Other expense			547				575
Total operating expenses			7,518				6,482
Income before income taxes			2,084				2,294
Provision for federal income taxes			257				382
Net income			1,827				1,912
Earnings per share of common stock			0.64				0.67
Cash dividends paid per share			0.28				0.27
Weighted average shares outstanding			2,850,689				2,849,954

 

See Notes to the Unaudited Consolidated Interim Financial Statements      

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)

(DOLLARS IN THOUSANDS)

 

		Three Months ended March 31,
		2017				2016
		$				$
Net income			1,827				1,912
Other comprehensive income, net of tax:
Securities available for sale not other-than-temporarily impaired:
Unrealized gains arising during the period			633				1,591
Income tax effect			(215	)			(541	)
			418				1,050
Gains recognized in earnings			(140	)			(728	)
Income tax effect			48				248
			(92	)			(480	)
Other comprehensive income, net of tax			326				570
Comprehensive Income			2,153				2,482

 

See Notes to the Unaudited Consolidated Interim Financial Statements        

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(DOLLARS IN THOUSANDS)

 

		Three Months Ended March 31,
		2017				2016
		$				$
Cash flows from operating activities:
Net income			1,827				1,912
Adjustments to reconcile net income to net cash
provided by operating activities:
Net amortization of securities premiums and discounts and loan fees			1,015				1,758
Decrease in interest receivable			508				105
Decrease in interest payable			(2	)			(13	)
Provision (credit) for loan losses			90				(50	)
Gains on securities transactions, net			(140	)			(728	)
Gains on sale of mortgages			(355	)			(155	)
Loans originated for sale			(5,221	)			(5,120	)
Proceeds from sales of loans			5,001				5,597
Earnings on bank-owned life insurance			(173	)			(194	)
Depreciation of premises and equipment and amortization of software			406				404
Deferred income tax			55				238
Other assets and other liabilities, net			(343	)			(1,076	)
Net cash provided by operating activities			2,668				2,678
Cash flows from investing activities:
Securities available for sale:
Proceeds from maturities, calls, and repayments			5,391				19,915
Proceeds from sales			13,687				48,099
Purchases			(26,416	)			(65,953	)
Purchase of regulatory bank stock			(873	)			(670	)
Redemptions of regulatory bank stock			790				309
Purchase of bank-owned life insurance			—				(19	)
Net increase in loans			(1,397	)			(24,564	)
Purchases of premises and equipment, net			(1,657	)			(129	)
Purchase of computer software			(3	)			(194	)
Net cash used for investing activities			(10,478	)			(23,206	)
Cash flows from financing activities:
Net increase in demand, NOW, and savings accounts			21,789				20,881
Net decrease in time deposits			(3,650	)			(11,212	)
Net increase in short-term borrowings			6,445				2,731
Proceeds from long-term debt			5,062				10,289
Repayments of long-term debt			(7,500	)			(5,000	)
Dividends paid			(798	)			(769	)
Proceeds from sale of treasury stock			118				124
Treasury stock purchased			—				(65	)
Net cash provided by financing activities			21,466				16,979
Increase (decrease) in cash and cash equivalents			13,656				(3,549	)
Cash and cash equivalents at beginning of period			45,632				44,227
Cash and cash equivalents at end of period			59,288				40,678
Supplemental disclosures of cash flow information:
Interest paid			704				823
Income taxes paid			—				625
Supplemental disclosure of non-cash investing and financing activities:
Fair value adjustments for securities available for sale			493				863

 

See Notes to the Unaudited Consolidated Interim Financial Statements

1.       Basis of Presentation

 

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

 

ENB Financial Corp (“the Corporation”) is the bank holding company for its wholly-owned subsidiary Ephrata National Bank (the “Bank”). This Form 10-Q, for the first quarter of 2017, is reporting on the results of operations and financial condition of ENB Financial Corp.

 

Operating results for the three months ended March 31, 2017, are not necessarily indicative of the results that may be expected for the year ended December 31, 2017. 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, 2016.

 

2.       Securities Available for Sale

 

The amortized cost, gross unrealized gains and losses, and fair value of securities held at March 31, 2017, and December 31, 2016, are as follows:        

 

						Gross				Gross
(DOLLARS IN THOUSANDS)		Amortized				Unrealized				Unrealized				Fair
		Cost				Gains				Losses				Value
		$				$				$				$
March 31, 2017
U.S. government agencies			33,119				—				(847	)			32,272
U.S. agency mortgage-backed securities			59,782				12				(927	)			58,867
U.S. agency collateralized mortgage obligations			43,437				93				(774	)			42,756
Corporate bonds			53,046				14				(640	)			52,420
Obligations of states and political subdivisions			127,183				254				(4,144	)			123,293
Total debt securities			316,567				373				(7,332	)			309,608
Marketable equity securities			5,517				51				—				5,568
Total securities available for sale			322,084				424				(7,332	)			315,176
December 31, 2016
U.S. government agencies			33,124				—				(863	)			32,261
U.S. agency mortgage-backed securities			56,826				22				(979	)			55,869
U.S. agency collateralized mortgage obligations			38,737				41				(842	)			37,936
Corporate bonds			52,928				8				(845	)			52,091
Obligations of states and political subdivisions			128,428				346				(4,344	)			124,430
Total debt securities			310,043				417				(7,873	)			302,587
Marketable equity securities			5,469				55				—				5,524
Total securities available for sale			315,512				472				(7,873	)			308,111

 

The amortized cost and fair value of debt securities available for sale at March 31, 2017, 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			17,333				17,145
Due after one year through five years			102,411				101,140
Due after five years through ten years			72,919				71,403
Due after ten years			123,904				119,920
Total debt securities			316,567				309,608

 

Securities available for sale with a par value of $63,945,000 and $63,726,000 at March 31, 2017, and December 31, 2016, respectively, were pledged or restricted for public funds, borrowings, or other purposes as required by law. The fair value of these pledged securities was $65,816,000 at March 31, 2017, and $65,770,000 at December 31, 2016.

 

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 March 31,
		2017				2016
		$				$
Proceeds from sales			13,687				48,099
Gross realized gains			172				730
Gross realized losses			32				2

 

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 three months of 2017 or 2016.

 

Information pertaining to securities with gross unrealized losses at March 31, 2017, and December 31, 2016, aggregated by investment category and length of time that individual securities have been in a continuous loss position follows:

 

TEMPORARY IMPAIRMENTS OF SECURITIES

(DOLLARS IN THOUSANDS)    

		Less than 12 months								More than 12 months								Total
						Gross								Gross								Gross
		Fair				Unrealized				Fair				Unrealized				Fair				Unrealized
		Value				Losses				Value				Losses				Value				Losses
		$				$				$				$				$				$
As of March 31, 2017
U.S. government agencies			32,272				(847	)			—				—				32,272				(847	)
U.S. agency mortgage-backed securities			49,382				(784	)			3,658				(143	)			53,040				(927	)
U.S. agency collateralized mortgage obligations			33,111				(774	)			—				—				33,111				(774	)
Corporate bonds			42,451				(634	)			2,009				(6	)			44,460				(640	)
Obligations of states & political subdivisions			99,061				(3,840	)			9,006				(304	)			108,067				(4,144	)
Total debt securities			256,277				(6,879	)			14,673				(453	)			270,950				(7,332	)
Marketable equity securities			—				—				—				—				—				—
Total temporarily impaired securities			256,277				(6,879	)			14,673				(453	)			270,950				(7,332	)
As of December 31, 2016
U.S. government agencies			32,261				(863	)			—				—				32,261				(863	)
U.S. agency mortgage-backed securities			47,418				(856	)			3,989				(123	)			51,407				(979	)
U.S. agency collateralized mortgage obligations			33,206				(842	)			—				—				33,206				(842	)
Corporate bonds			45,335				(830	)			2,002				(15	)			47,337				(845	)
Obligations of states & political subdivisions			101,229				(4,063	)			8,041				(281	)			109,270				(4,344	)
Total debt securities			259,449				(7,454	)			14,032				(419	)			273,481				(7,873	)
Marketable equity securities			—				—				—				—				—				—
Total temporarily impaired securities			259,449				(7,454	)			14,032				(419	)			273,481				(7,873	)

 

In the debt security portfolio there were 201 positions that were carrying unrealized losses as of March 31, 2017. In the equity security portfolio there were no positions that were carrying unrealized losses as of March 31, 2017. There were no instruments considered to be other-than-temporarily impaired at March 31, 2017.

 

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.

 

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 was 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 in 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. This resulted in $1,202,000 of accelerated amortization recorded on this bond in 2016.

 

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 March 31, 2017, and December 31, 2016:

 

LOAN PORTFOLIO

(DOLLARS IN THOUSANDS)      

		March 31,				December 31,
		2017				2016
		$				$
Commercial real estate
Commercial mortgages			86,008				86,434
Agriculture mortgages			158,190				163,753
Construction			20,381				24,880
Total commercial real estate			264,579				275,067
Consumer real estate (a)
1-4 family residential mortgages			157,509				150,253
Home equity loans			11,287				10,391
Home equity lines of credit			54,944				53,127
Total consumer real estate			223,740				213,771
Commercial and industrial
Commercial and industrial			43,890				42,471
Tax-free loans			14,089				13,091
Agriculture loans			20,773				21,630
Total commercial and industrial			78,752				77,192
Consumer			4,773				4,537
Gross loans prior to deferred fees			571,844				570,567
Less:
Deferred loan costs, net			(1,032	)			(1,000	)
Allowance for loan losses			7,672				7,562
Total net loans			565,204				564,005

 

(a)	Real estate loans serviced for others, which are not included in the Consolidated Balance Sheets, totaled $73,161,000 and $66,767,000 as of March 31, 2017, and December 31, 2016, respectively.

The Corporation grades commercial credits differently than consumer credits. The following tables represent all of the Corporation’s commercial credit exposures by internally assigned grades as of March 31, 2017 and December 31, 2016. The grading analysis estimates the capability of the borrower to repay the contractual obligations under the loan agreements as scheduled. The Corporation's internal commercial credit risk grading system is based on experiences with similarly graded loans.

 

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

 

·

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

 

·

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

 

·

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

 

·

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

 

·

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

 

 

COMMERCIAL CREDIT EXPOSURE

CREDIT RISK PROFILE BY INTERNALLY ASSIGNED GRADE

(DOLLARS IN THOUSANDS)

 

March 31, 2017		Commercial Mortgages				Agriculture Mortgages				Construction				Commercial and Industrial				Tax-free Loans				Agriculture Loans				Total
		$				$				$				$				$				$				$
Grade:
Pass			79,359				149,357				19,381				38,497				14,089				19,182				319,865
Special Mention			1,228				4,617				—				252				—				514				6,611
Substandard			5,421				4,216				1,000				5,141				—				1,077				16,855
Doubtful			—				—				—				—				—				—				—
Loss			—				—				—				—				—				—				—
Total			86,008				158,190				20,381				43,890				14,089				20,773				343,331

 

December 31, 2016		Commercial Mortgages				Agriculture Mortgages				Construction				Commercial and Industrial				Tax-free Loans				Agriculture Loans				Total
		$				$				$				$				$				$				$
Grade:
Pass			81,945				155,820				23,880				36,887				13,091				20,245				331,868
Special Mention			1,282				5,360				—				1,955				—				653				9,250
Substandard			3,207				2,573				1,000				3,629				—				732				11,141
Doubtful			—				—				—				—				—				—				—
Loss			—				—				—				—				—				—				—
Total			86,434				163,753				24,880				42,471				13,091				21,630				352,259

For consumer loans, the Corporation evaluates credit quality based on whether the loan is considered performing or non-performing. Non-performing loans consist of those loans greater than 90 days delinquent and nonaccrual loans. The following tables present the balances of consumer loans by classes of the loan portfolio based on payment performance as of March 31, 2017 and December 31, 2016:

 

CONSUMER CREDIT EXPOSURE

CREDIT RISK PROFILE BY PAYMENT PERFORMANCE

(DOLLARS IN THOUSANDS)          

March 31, 2017		1-4 Family Residential Mortgages				Home Equity Loans				Home Equity Lines of Credit				Consumer				Total
Payment performance:		$				$				$				$				$
Performing			156,918				11,287				54,944				4,773				227,922
Non-performing			591				—				—				—				591
Total			157,509				11,287				54,944				4,773				228,513

 

December 31, 2016		1-4 Family Residential Mortgages				Home Equity Loans				Home Equity Lines of Credit				Consumer				Total
Payment performance:		$				$				$				$				$
Performing			149,873				10,388				53,127				4,536				217,924
Non-performing			380				3				—				1				384
Total			150,253				10,391				53,127				4,537				218,308

 

The following tables present an age analysis of the Corporation’s past due loans, segregated by loan portfolio class, as of March 31, 2017 and December 31, 2016:

 

AGING OF LOANS RECEIVABLE

(DOLLARS IN THOUSANDS)

																										Loans
										Greater																Receivable >
		30-59 Days				60-89 Days				than 90				Total Past								Total Loans				90 Days and
March 31, 2017		Past Due				Past Due				Days				Due				Current				Receivable				Accruing
		$				$				$				$				$				$				$
Commercial real estate
Commercial mortgages			258				130				572				960				85,048				86,008				—
Agriculture mortgages			—				—				—				—				158,190				158,190				—
Construction			—				—				—				—				20,381				20,381				—
Consumer real estate
1-4 family residential mortgages			519				—				591				1,110				156,399				157,509				591
Home equity loans			40				—				—				40				11,247				11,287				—
Home equity lines of credit			—				—				—				—				54,944				54,944				—
Commercial and industrial
Commercial and industrial			217				3				75				295				43,595				43,890				—
Tax-free loans			67				—				—				67				14,022				14,089				—
Agriculture loans			—				—				—				—				20,773				20,773				—
Consumer			3				—				—				3				4,770				4,773				—
Total			1,104				133				1,238				2,475				569,369				571,844				591

 

 

																										Loans
										Greater																Receivable >
		30-59 Days				60-89 Days				than 90				Total Past								Total Loans				90 Days and
December 31, 2016		Past Due				Past Due				Days				Due				Current				Receivable				Accruing
		$				$				$				$				$				$				$
Commercial real estate
Commercial mortgages			—				419				417				836				85,598				86,434				—
Agriculture mortgages			165				—				—				165				163,588				163,753				—
Construction			—				—				—				—				24,880				24,880				—
Consumer real estate
1-4 family residential mortgages			572				662				380				1,614				148,639				150,253				380
Home equity loans			81				—				3				84				10,307				10,391				3
Home equity lines of credit			90				—				—				90				53,037				53,127				—
Commercial and industrial
Commercial and industrial			266				—				75				341				42,130				42,471				—
Tax-free loans			—				—				—				—				13,091				13,091				—
Agriculture loans			—				—				—				—				21,630				21,630				—
Consumer			16				4				1				21				4,516				4,537				1
Total			1,190				1,085				876				3,151				567,416				570,567				384

 

The following table presents nonaccrual loans by classes of the loan portfolio as of March 31, 2017 and December 31, 2016:

 

NONACCRUAL LOANS BY LOAN CLASS

(DOLLARS IN THOUSANDS)  

		March 31				December 31,
		2017				2016
		$				$
Commercial real estate
Commercial mortgages			760				646
Agriculture mortgages			—				—
Construction			—				—
Consumer real estate
1-4 family residential mortgages			—				—
Home equity loans			—				—
Home equity lines of credit			—				—
Commercial and industrial
Commercial and industrial			75				75
Tax-free loans			—				—
Agriculture loans			—				—
Consumer			—				—
Total			835				721

 

As of March 31, 2017 and December 31, 2016, all of the Corporation’s commercial loans on nonaccrual status were also considered impaired. Information with respect to impaired loans for the three months ended March 31, 2017 and March 31, 2016 is as follows:

 

IMPAIRED LOANS

(DOLLARS IN THOUSANDS)      

		Three months ended March 31,
		2017				2016
		$				$
Average recorded balance of impaired loans			1,957				1,672
Interest income recognized on impaired loans			14				14

 

Interest income on impaired loans would have increased by approximately $7,000 for the three months ended March 31, 2017, compared to $4,000 for the three months ended March 31, 2016, had these loans performed in accordance with their original terms.

 

During the three months ended March 31, 2017 and 2016, 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 March 31, 2017, December 31, 2016, and March 31, 2016:

 

IMPAIRED LOAN ANALYSIS

(DOLLARS IN THOUSANDS)      

March 31, 2017		Recorded Investment				Unpaid Principal Balance				Related Allowance				Average Recorded Investment				Interest Income Recognized
		$				$				$				$				$
With no related allowance recorded:
Commercial real estate
Commercial mortgages			760				857				—				644				3
Agriculture mortgages			1,229				1,229				—				1,238				11
Construction			—				—				—				—				—
Total commercial real estate			1,989				2,086				—				1,882				14
Commercial and industrial
Commercial and industrial			75				75				—				75				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			75				75				—				75				—
Total with no related allowance			2,064				2,161				—				1,957				14
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			760				857				—				644				3
Agriculture mortgages			1,229				1,229				—				1,238				11
Construction			—				—				—				—				—
Total commercial real estate			1,989				2,086				—				1,882				14
Commercial and industrial
Commercial and industrial			75				75				—				75				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			75				75				—				75				—
Total			2,064				2,161				—				1,957				14

 

IMPAIRED LOAN ANALYSIS

(DOLLARS IN THOUSANDS)    

December 31, 2016		Recorded Investment				Unpaid Principal Balance				Related Allowance				Average Recorded Investment				Interest Income Recognized
		$				$				$				$				$
With no related allowance recorded:
Commercial real estate
Commercial mortgages			646				743				—				768				2
Agriculture mortgages			1,248				1,248				—				1,285				55
Construction			—				—				—				—				—
Total commercial real estate			1,894				1,991				—				2,053				57
Commercial and industrial
Commercial and industrial			75				75				—				76				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			75				75				—				76				—
Total with no related allowance			1,969				2,066				—				2,129				57
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			646				743				—				768				2
Agriculture mortgages			1,248				1,248				—				1,285				55
Construction			—				—				—				—				—
Total commercial real estate			1,894				1,991				—				2,053				57
Commercial and industrial
Commercial and industrial			75				75				—				76				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			75				75				—				76				—
Total			1,969				2,066				—				2,129				57

 

IMPAIRED LOAN ANALYSIS

(DOLLARS IN THOUSANDS)      

March 31, 2016		Recorded Investment				Unpaid Principal Balance				Related Allowance				Average Recorded Investment				Interest Income Recognized
		$				$				$				$				$
With no related allowance recorded:
Commercial real estate
Commercial mortgages			337				434				—				358				—
Agriculture mortgages			1,304				1,304				—				1,314				14
Construction			—				—				—				—				—
Total commercial real estate			1,641				1,738				—				1,672				14
Commercial and industrial
Commercial and industrial			—				—				—				—				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			—				—				—				—				—
Total with no related allowance			1,641				1,738				—				1,672				14
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			337				434				—				358				—
Agriculture mortgages			1,304				1,304				—				1,314				14
Construction			—				—				—				—				—
Total commercial real estate			1,641				1,738				—				1,672				14
Commercial and industrial
Commercial and industrial			—				—				—				—				—
Tax-free loans			—				—				—				—				—
Agriculture loans			—				—				—				—				—
Total commercial and industrial			—				—				—				—				—
Total			1,641				1,738				—				1,672				14

 

The following table details activity in the allowance for loan losses by portfolio segment for the three months ended March 31, 2017:

 

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, 2016			3,795				1,652				1,552				82				481				7,562
Charge-offs			—				—				(7	)			(4	)			—				(11	)
Recoveries			—				20				9				2				—				31
Provision (credit)			(275	)			163				95				3				104				90
Ending Balance - March 31, 2017			3,520				1,835				1,649				83				585				7,672

 

During the three months ended March 31, 2017, a credit provision was recorded for the commercial real estate segment with provision expense recorded in all other loan categories. For the entire portfolio, $90,000 of additional provision expense was recorded for the first three months of 2017. Delinquency rates among most loan pools remain very low with the total amount of delinquent loans lower on March 31, 2017 than on December 31, 2016. The Corporation received $20,000 more recoveries than charge-offs for the three months ended March 31, 2017. These favorable results acted to offset higher levels of classified loans and non-accruals resulting in $90,000 of additional provision being sufficient to cover projected losses inherent in the loan portfolio and still retain a sufficient unallocated portion of the allowance. Changes in qualitative factors were minimal during the first quarter and the provision expense recorded was primarily the result of higher levels of classified loans.  

The following table details activity in the allowance for loan losses by portfolio segment for the three months ended March 31, 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 (credit)			(303	)			(45	)			47				15				236				(50	)
Balance - March 31, 2016			3,528				1,368				1,373				67				704				7,040

 

During the first quarter of 2016, credit provisions were recorded for the commercial real estate and consumer real estate segments with provision expenses recorded in all other loan categories. Delinquency rates in the real estate secured segment of loans were extremely low requiring fewer reserves. Qualitative factors continued to shift, with net declines in non-dairy agriculture and home equity loans. Our three-year historical loss rate was declining in our business mortgage pool, as the twelve-month charge-off rate fell from 4.43% of loans in the fourth quarter of 2015, to 2.69% of loans in the first quarter of 2016. A substantial paydown of a substandard loan with potential impairment also supported a reduced allowance balance, despite an increase in loan balances.

The following tables present the balance in the allowance for credit losses and the recorded investment in loans receivable by portfolio segment based on impairment method as of March 31, 2017 and December 31, 2016:

 

ALLOWANCE FOR CREDIT LOSSES AND RECORDED INVESTMENT IN LOANS RECEIVABLE

(DOLLARS IN THOUSANDS)

 

As of March 31, 2017:		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			3,520				1,835				1,649				83				585				7,672
Loans receivable:
Ending balance			264,579				223,740				78,752				4,773								571,844
Ending balance: individually evaluated
for impairment			1,989				—				75				—								2,064
Ending balance: collectively evaluated
for impairment			262,590				223,740				78,677				4,773								569,780

 

As of December 31, 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			3,795				1,652				1,552				82				481				7,562
Loans receivable:
Ending balance			275,067				213,771				77,192				4,537								570,567
Ending balance: individually evaluated
for impairment			1,894				—				75				—								1,969
Ending balance: collectively evaluated
for impairment			273,173				213,771				77,117				4,537								568,598

4. Fair Value Presentation

 

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

 

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

 

The following tables present the assets reported on the Consolidated Balance Sheets at their fair value as of March 31, 2017, and December 31, 2016, by level within the fair value hierarchy. As required by U.S. generally accepted accounting principles, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

 

Fair Value Measurements:

ASSETS MEASURED ON A RECURRING BASIS

(DOLLARS IN THOUSANDS)    

		March 31, 2017
		Level I				Level II				Level III				Total
		$				$				$				$
U.S. government agencies			—				32,272				—				32,272
U.S. agency mortgage-backed securities			—				58,867				—				58,867
U.S. agency collateralized mortgage obligations			—				42,756				—				42,756
Corporate bonds			—				52,420				—				52,420
Obligations of states & political subdivisions			—				123,293				—				123,293
Marketable equity securities			5,568				—				—				5,568
Total securities			5,568				309,608				—				315,176

 

On March 31, 2017, the Corporation held no securities valued using level III inputs. All of the Corporation’s debt instruments were valued using level II inputs, where quoted prices are available and observable, but not necessarily quotes on identical securities traded in active markets on a daily basis. The Corporation’s CRA fund investments and bank stocks are fair valued utilizing level I inputs because the funds have their own quoted prices in an active market. As of March 31, 2017, the CRA fund investments had a $5,273,000 book and fair market value and the bank stock portfolio had an amortized cost of $244,000, and fair market value of $295,000.

 

Fair Value Measurements:

  

ASSETS MEASURED ON A RECURRING BASIS

(DOLLARS IN THOUSANDS)        

		December 31, 2016
		Level I				Level II				Level III				Total
		$				$				$				$
U.S. government agencies			—				32,261				—				32,261
U.S. agency mortgage-backed securities			—				55,869				—				55,869
U.S. agency collateralized mortgage obligations			—				37,936				—				37,936
Corporate bonds			—				52,091				—				52,091
Obligations of states & political subdivisions			—				124,430				—				124,430
Marketable equity securities			5,524				—				—				5,524
Total securities			5,524				302,587				—				308,111

 

On December 31, 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 December 31, 2016, the CRA fund investments had a $5,250,000 book and market value and the bank stocks had an amortized cost of $219,000 and a market value of $274,000.

 

Financial instruments are considered level III when their values are determined using pricing models, discounted cash flow methodologies, or similar techniques, and at least one significant model assumption or input is unobservable. In addition to these unobservable inputs, the valuation models for level III financial instruments typically also rely on a number of inputs that are readily observable either directly or indirectly. Level III financial instruments also include those for which the determination of fair value requires significant management judgment or estimation. There were no level III securities as of March 31, 2017 or December 31, 2016.

 

The following tables present the assets measured on a nonrecurring basis on the Consolidated Balance Sheets at their fair value as of March 31, 2017 and December 31, 2016, by level within the fair value hierarchy:

 

ASSETS MEASURED ON A NONRECURRING BASIS

(Dollars in Thousands)

		March 31, 2017
		Level I $				Level II $				Level III $				Total $
Assets:
Impaired Loans			—				—				2,064				2,064
Total			—				—				2,064				2,064

 

 

		December 31, 2016
		Level I $				Level II $				Level III $				Total $
Assets:
Impaired Loans			—				—				1,969				1,969
Total			—				—				1,969				1,969

 

The Corporation had a total of $2,064,000 of impaired loans as of March 31, 2017, with no specific allocation against these loans and $1,969,000 of impaired loans as of December 31, 2016, 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)      

	March 31, 2017
	Fair Value	Valuation	Unobservable	Range
	Estimate	Techniques	Input	(Weighted Avg)
Impaired loans	2,064	Appraisal of	Appraisal	-20% (-20%)
		collateral (1)	adjustments (2)
			Liquidation	-10% (-10%)
			expenses (2)

 

	December 31, 2016
	Fair Value	Valuation	Unobservable	Range
	Estimate	Techniques	Input	(Weighted Avg)
Impaired loans	1,969	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 March 31, 2017 and December 31, 2016, are summarized as follows:

 

FAIR VALUE OF FINANCIAL INSTRUMENTS

(DOLLARS IN THOUSANDS)

		March 31, 2017
										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			59,288				59,288				59,288				—				—
Securities available for sale			315,176				315,176				5,568				309,608				—
Regulatory stock			5,455				5,455				5,455				—				—
Loans held for sale			3,127				3,127				3,127				—				—
Loans, net of allowance			565,204				562,923				—				—				562,923
Accrued interest receivable			3,242				3,242				3,242				—				—
Bank owned life insurance			24,856				24,856				24,856				—				—
Financial Liabilities:
Demand deposits			287,799				287,799				287,799				—				—
Interest-bearing demand deposits			18,614				18,614				18,614				—				—
NOW accounts			86,147				86,147				86,147				—				—
Money market deposit accounts			98,431				98,431				98,431				—				—
Savings accounts			186,686				186,686				186,686				—				—
Time deposits			157,953				159,272				—				—				159,272
Total deposits			835,630				836,949				677,677				—				159,272
Short-term borrowings			14,774				14,774				14,774				—				—
Long-term debt			58,819				58,928				—				—				58,928
Accrued interest payable			382				382				382				—				—

 

FAIR VALUE OF FINANCIAL INSTRUMENTS

(DOLLARS IN THOUSANDS)

		December 31, 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			45,632				45,632				45,632				—				—
Securities available for sale			308,111				308,111				5,524				302,587				—
Regulatory stock			5,372				5,372				5,372				—				—
Loans held for sale			2,552				2,552				2,552				—				—
Loans, net of allowance			564,005				563,418				—				—				563,418
Accrued interest receivable			3,750				3,750				3,750				—				—
Bank owned life insurance			24,687				24,687				24,687				—				—
Financial Liabilities:
Demand deposits			280,543				280,543				280,543				—				—
Interest-bearing demand deposits			20,108				20,108				20,108				—				—
NOW accounts			85,540				85,540				85,540				—				—
Money market deposit accounts			93,943				93,943				93,943				—				—
Savings accounts			175,753				175,753				175,753				—				—
Time deposits			161,604				163,464				—				—				163,464
Total deposits			817,491				819,351				655,887				—				163,464
Short-term borrowings			8,329				8,329				8,329				—				—
Long-term debt			61,257				61,372				—				—				61,372
Accrued interest payable			384				384				384				—				—

 

 

6.       Commitments and Contingent Liabilities

 

In order to meet the financing needs of its customers in the normal course of business, the Corporation makes various commitments that are not reflected in the accompanying consolidated financial statements. These commitments include firm commitments to extend credit, unused lines of credit, and open letters of credit. As of March 31, 2017, firm loan commitments were $38.6 million, unused lines of credit were $192.8 million, and open letters of credit were $10.2 million. The total of these commitments was $241.6 million, which represents the Corporation’s exposure to credit loss in the event of nonperformance by its customers with respect to these financial instruments. The actual credit losses that may arise from these commitments are expected to compare favorably with the Corporation’s loan loss experience on its loan portfolio taken as a whole. The Corporation uses the same credit policies in making commitments and conditional obligations as it does for balance sheet financial instruments.

 

7. Accumulated Other Comprehensive Income (Loss)

 

The activity in accumulated other comprehensive income (loss) for the three months ended March 31, 2017 and 2016 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, 2016			(4,885	)
Other comprehensive income before reclassifications			418
Amount reclassified from accumulated other comprehensive income (loss)			(92	)
Period change			326
Balance at March 31, 2017			(4,559	)
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

 

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

(2)	Amounts in parentheses indicate debits.

 

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

(DOLLARS IN THOUSANDS)      

 

		Amount Reclassified from
		Accumulated Other Comprehensive
		Income (Loss)
		For the Three Months
		Ended March 31,
		2017				2016				Affected Line Item in the
		$				$				Consolidated Statements of Income
Securities available-for-sale:
Net securities gains reclassified into earnings			140				728			Gains on securities transactions, net
Related income tax expense			(48	)			(248	)		Provision for federal income taxes
Net effect on accumulated other comprehensive
income for the period			92				480

 

(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. Because the guidance does not apply to revenue associated with financial instruments, including loans and securities, we do not expect the new standard, or an of the amendments, to result in a material change from our current accounting for revenue because the majority of the Corporation’s financial instruments are not within the scope of Topic 606. However, we do expect that the standard will result in new disclosure requirements, which are currently being evaluated.

 

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. The Corporation is currently assessing the practical expedients it may elect at adoption, but does not anticipate the amendments will have a significant impact to the financial statements. Based on the Corporation’s preliminary analysis of its current portfolio, the impact to the Corporation’s balance sheet is estimated to result in less than a 1% increase in assets and liabilities. The Corporation also anticipates additional disclosures to be provided at adoption.

 

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. We expect to recognize a one-time cumulative effect adjustment to the allowance for loan losses as of the beginning of the first reporting period in which the new standard is effective, but cannot yet determine the magnitude of any such one-time adjustment or the overall impact of the new guidance on the consolidated financial statements.

 

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.

 

In October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740), which requires recognition of current and deferred income taxes resulting from an intra-entity transfer of any asset (excluding inventory) when the transfer occurs. Consequently, the amendments in this Update eliminate the exception for an intra-entity transfer of an asset other than inventory. The amendments in this Update are effective for public business entities for fiscal years beginning after December 15, 2017, including interim periods within those annual reporting periods. For all other entities, the amendments are effective for annual reporting periods beginning after December 15, 2018, and interim reporting periods within annual periods beginning after December 15, 2019. Early adoption is permitted for all entities as of the beginning of an annual reporting period for which financial statements (interim or annual) have not been issued or made available for issuance. That is, earlier adoption should be in the first interim period if an entity issues interim financial statements. The amendments in this Update should be applied on a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. This Update is not expected to have a significant impact on the Corporation’s financial statements.

 

In October 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230), which requires that a statement of cash flows explains the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Therefore, amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. 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. The amendments in this Update should be applied using a retrospective transition method to each period presented. The Corporation is currently evaluating the impact the adoption of the standard will have on the Corporation’s statement of cash flows.

 

In December 2016, the FASB issued ASU 2016-19, Technical Corrections and Improvements, which represents changes to clarify, correct errors, or make minor improvements to the Accounting Standards Codification. The amendments make the Accounting Standards Codification easier to understand and easier to apply by eliminating inconsistencies and providing clarifications. Most of the amendments in this Update do not require transition guidance and are effective upon issuance of this Update. This Update is not expected to have a significant impact on the Corporation’s financial statements.

 

In December 2016, the FASB issued ASU 2016-20, Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers. This Update, among others things, clarifies that guarantee fees within the scope of Topic 460, Guarantees, (other than product or service warranties) are not within the scope of Topic 606. The effective date and transition requirements for ASU 2016-20 are the same as the effective date and transition requirements for the new revenue recognition guidance. For public entities with a calendar year-end, the new guidance is effective in the quarter and year beginning January 1, 2018. For all other entities with a calendar year-end, the new guidance is effective in the year ending December 31, 2019, and interim periods in 2020. The Corporation is currently evaluating the impact the adoption of the standard will have on the Corporation’s financial position or results of operations.

 

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 2016 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 $1,827,000 for the three-month period ended March 31, 2017, a 4.4% decrease from the $1,912,000 earned during the same period in 2016. The earnings per share, basic and diluted, were $0.64 for the three months ended March 31, 2017, compared to $0.67 for the same period in 2016.

 

The primary reasons for the decrease in earnings were a decrease in gains on securities and a significant increase in operating expenses, offset by an increase in net interest income. Net interest income increased by $1,205,000, or 19.8%, for the three months ended March 31, 2017, compared to the same period in 2016. The Corporation recorded a provision for loan losses of $90,000 for the three months ended March 31, 2017, compared to a credit provision of $50,000 for the three months ended March 31, 2016, representing an aggregate decrease in income of $140,000. The Corporation’s net interest margin was 3.41% for the first quarter of 2017, compared to 3.09% for the first quarter of 2016. Net interest margin was positively affected by the Federal Reserve Bank raising the overnight interest rates by 0.25% in December of 2016 and again in March of 2017. Increases in NII are discussed further under the Net Interest Income section below.

 

Other operating income decreased by $239,000, or 9.0% for the three months ended March 31, 2017, compared to the same period in the prior year. The decrease was primarily related to a decline in securities gains, which were $140,000 in the first quarter of 2017, compared to $728,000 in the first quarter of 2016. The gains the Corporation was able to generate in the first quarter of 2016 were much higher primarily due to the low interest rate environment resulting in opportunities to sell securities to generate gains and reposition assets to support the financial performance of the Corporation. Interest rates began to rise beginning in the fourth quarter of 2016, resulting in fewer gains taken in the first quarter of 2017. Mortgage gains contributed to higher other operating income for the three-month period ended March 31, 2017. The gain on the sale of mortgages increased by $200,000, or 129.0%, for the three-month period ended March 31, 2017, compared to the prior year’s period. Both mortgage production and margins made on sold mortgages were higher in the first quarter of 2017. More detail is provided under the Other Income section under Results of Operations.

 

Partially offsetting the increased income mentioned above, operating expenses increased by $1,036,000, or 16.0%, for the three months ended March 31, 2017, compared to the same period in the prior year. Personnel costs increased by $748,000, or 18.8%, driven higher in the first quarter of 2017 due to the hiring of staff to support new branch offices as well as commercial sales positions and back office support. In addition, benefit costs increased as a result of higher health insurance premiums.

 

The financial services industry uses two primary performance measurements to gauge performance: return on average assets (ROA) and return on average equity (ROE). ROA measures how efficiently a bank generates income based on the amount of assets or size of a company. ROE measures the efficiency of a company in generating income based on the amount of equity or capital utilized. The latter measurement typically receives more attention from shareholders. The ROA and ROE decreased for the three months ended March 31, 2017, due to a decrease in earnings as well as an increase in the Corporation’s assets and equity compared to the prior year.

 

Key Ratios		Three Months Ended
		March 31,
		2017				2016
Return on Average Assets			0.75%				0.84%
Return on Average Equity			7.81%				8.01%

 

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

 

·

Net interest income

·

Provision for loan losses

·

Other income

·

Operating expenses

·

Provision for income taxes

 

The following discussion analyzes each of these five components.

 

 

Net Interest Income

 

Net interest income (NII) represents the largest portion of the Corporation’s operating income. In the first three months of 2017, NII generated 75.1% of the Corporation’s gross revenue stream, which consists of net interest income and non-interest income, compared to 69.6% in the first three months of 2016. 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. With the increases in overnight rates occurring December 14, 2016 and March 15, 2017, and with no unusual security amortization events in the first quarter of 2017, the Corporation’s NII has significantly increased compared to the three months ended March 31, 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 $606,000 for the three months ended March 31, 2017, compared to $511,000 for the same period in 2016.

 

NET INTEREST INCOME
(DOLLARS IN THOUSANDS)
		Three Months Ended
		March 31,
		2017				2016
		$				$
Total interest income			7,982				6,886
Total interest expense			702				811
Net interest income			7,280				6,075
Tax equivalent adjustment			606				511
Net interest income (fully taxable equivalent)			7,886				6,586

 

 

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%. On December 14, 2016, the Federal funds rate was increased 25 basis points to 0.75% and on March 15, 2017, the Federal funds rate was again increased 25 basis points to 1.00%. Prior to December of 2015, the period of seven years with extremely low and unchanged overnight rates was the lowest and longest in U.S. history. The impact has been a lower net interest margin to the Corporation and generally across the financial industry. The increase in December of 2015, December of 2016, and March of 2017 resulted in higher short-term U.S. Treasury rates, but the long-term rates initially decreased after the Federal Reserve’s decision to increase rates in December of 2015, resulting in a flattening of the yield curve. It was only during the fourth quarter of 2016 that long-term rates saw an increase but they then declined slightly throughout the first quarter of 2017. Long-term rates like the ten-year U.S. Treasury were 160 basis points under the 4.00% Prime rate as of March 31, 2017. It appears that the general conditions of a flatter yield curve with low long-term U.S. Treasury rates, significantly below the Prime rate, will continue for 2017. Management anticipates the next 0.25% Federal Reserve rate increase could occur as early as June 2017, with at least one more 0.25% Federal Reserve rate increase in the remainder of 2017. It remains to be seen whether mid and long-term U.S. Treasury rates will also increase to the same degree that the Federal Reserve will move the overnight Federal funds rate. If they do not, the yield curve would further flatten making it harder for the Corporation to increase asset yield.

 

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, from 3.50% to 3.75% on December 14, 2016, and from 3.75% to 4.00% on March 15, 2017. 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 vast majority of the Corporation’s Prime-based consumer loans reprice the day after the Federal Reserve rate action.

 

As a result of the December 2015 Federal Reserve rate increase the Corporation’s NII on a tax equivalent basis began to increase in 2016 with the Corporation’s margin increasing to 3.12% for the year, compared to 3.07% in 2015. The December 2016 Federal Reserve rate increase again came too late in the year to significantly impact the 2016 margin but did have a positive impact to first quarter of 2017 margin. The Corporation’s, NII for the first quarter of 2017 increased substantially over the first quarter of 2016, by $1,205,000, or 19.8%, with the margin increasing to 3.41%. Management’s asset liability sensitivity measurements continue to show a benefit to both margin and NII given further Federal Reserve rate increases. Actual results over the past five quarters have confirmed the asset sensitivity of the Corporation’s balance sheet. Management expects that any additional Federal Reserve rate increases in 2017 would further improve both margin and NII.

 

The extended extremely low Federal funds rate has enabled management to reduce the cost of funds on overnight borrowings and allowed lower interest rates paid on deposits, reducing the Corporation’s interest expense. It was only after the third 25-basis point Fed rate increase in March of 2017 that the Corporation raised some deposit rates minimally. While the low Prime rate reduced the yield on the Corporation’s loans for many years, the rate increases through March of 2017 did act to boost interest income and help improve the Corporation’s margin. With a higher Prime rate and elevated Treasury rates, higher asset yields should be possible throughout the remainder of 2017. Due to the increasing number of variable rate loans in the Corporation’s loan portfolio, the 25 basis point increase in the Prime rate at the end of 2015, 2016, and in March of 2017 did cause higher NII in the month of December 2015, and for the entire year of 2016. The full impact of all of these increases will be experienced in the second quarter of 2017. Additionally, with one or two more anticipated Fed rate increases in 2017, the Corporation should see even more benefit due to the near immediate repricing of the Prime-based variable loans.

 

Security yields fluctuate more rapidly than loan yields based primarily on the changes to the U.S. Treasury rates and yield curve. During 2016, management did generally direct a large portion of the security sale proceeds into loan growth resulting in higher overall asset yields. With higher Treasury rates in the first quarter of 2017 compared to the first quarter of 2016, security reinvestment has been occurring at slightly higher yields and amortization has slowed resulting in higher yields. The Corporation’s loan yield has continued to decline as new loans are going on at among the lowest loan rates of this interest rate cycle. 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. Therefore, any increases in total variable rate loans will generally reduce overall loan portfolio yield. An element of the Corporation’s Prime-based commercial loans is priced above the Prime rate based on the level of credit risk of the borrower. Additionally, certain variable rate consumer loans are priced above Prime. Prime-based pricing continues to be driven largely by local competition.

 

Mid-term and long-term interest rates on average were higher in 2017 compared to 2016. The average rate of the 10-year U.S. Treasury was 2.45% in the first quarter of 2017 compared to 1.91% in the first quarter of 2016, and it stood at 2.40% on March 31, 2017, compared to 1.78% at March 31, 2016. The slope of the yield curve has been compressed throughout most of 2016 and through the first quarter of 2017, but with the Fed rate increase in March of 2017, there was slightly more slope between the short end and long end of the curve compared to the prior year. There was a difference of 140 basis points between overnight rates and the 10-year U.S. Treasury as of March 31, 2017, compared to 103 basis points as of March 31, 2016. The slope of the yield curve has fluctuated many times in the past two years with the 10-year U.S. Treasury yield as high as 2.60% in 2016 and 2.62% in 2017, and as low as 1.37% in 2016 and 2.31% in 2017. Although the yield curve is still relatively flat, the slightly higher slope in the curve allowed for security reinvestment during the first quarter of 2017 at slightly higher rates but management was not able to increase loan rates to improve yield. The non-recurring sub-agency amortization of $1,681,000 during 2016 negatively affected security yield resulting in artificially low yields during 2016 and higher yields during 2017. With higher long-term rates in 2017 and the likelihood of further Fed rate increases, the Corporation’s asset yield is projected to increase throughout 2017.

 

While it is becoming increasingly difficult to achieve savings on the Corporation’s overall cost of funds, management was able to selectively reprice time deposits and borrowings to lower levels during the first quarter of 2017 resulting in savings on these instruments. Generally, it was longer-term CDs repricing at lower rates that helped to achieve interest expense savings on deposits. It is anticipated that interest rates on interest bearing core deposits will need to be increased during the remainder of 2017 if the Federal Reserve does act to raise interest rates. Management selectively repriced some CD rates higher after the March Fed increase. 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 some borrowings at lower rates in 2016 but it will be difficult to do this going forward as rates are higher now and most borrowings are already at lower interest rates relative to their term.

 

Management currently anticipates that the overnight interest rate and Prime rate will remain at the current levels until June of 2017 with the possibility of at least one 0.25% rate increase by mid-year and another 0.25% increase before year-end. It is likely that mid and long-term U.S. Treasury rates will increase throughout 2017 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. However, it is also possible that even after Federal Reserve rate increases the yield curve could flatten, making it more difficult for management to lend out or reinvest at higher interest rates out further on the yield curve. Additionally, Federal Reserve rate increases would continue to affect the repricing of the Corporation’s liabilities. Management would expect to have to increase deposit rates further to remain competitive in the market and maturing borrowings would likely begin to reprice to higher rates.

 

The Corporation has benefited from a gradual increase in the amount of variable rate loans. Over 35% 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 3.41% for the first quarter of 2017, a 32 basis-point increase from the 3.09% for the first quarter of 2016. The margin increase for the quarter-to-date period was partially due to non-recurring accelerated amortization on U.S. Sub-Agency bonds during the first quarter of 2016 that reduced interest income on securities. Without this event, NIM would have been 3.28% (Non-GAAP) for the first quarter of 2016. Aside from the non-recurring amortization, the Corporation’s NIM improvement was primarily due to higher balances of earning assets at similar or slightly better yields compared to the prior year’s quarter as well as lower costs on interest-bearing liabilities.

 

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 because of reduced amortization and higher yields being available at the time of purchase.

 

As shown in the table that follows, interest income, on an FTE basis increased by $1,191,000, or 16.1%, for the three months ended March 31, 2017, compared to the same period in 2016. Interest expense decreased by $109,000, or 13.4%, for the three-month period when comparing both years, resulting in a $1,300,000, or 19.7% increase in net interest income on an FTE basis for both periods.

 

The following table shows a more detailed comparative analysis of net interest income on an FTE basis for the three-month period ended March 31, 2017. It is 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 March 31,
		2017												2016
										(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			23,387				54				0.92				19,127				26				0.55
Securities available for sale:
Taxable			191,403				913				1.91				192,712				496				1.03
Tax-exempt			130,175				1,672				5.14				102,371				1,299				5.08
Total securities (d)			321,578				2,585				3.22				295,083				1,795				2.43
Loans (a)			575,169				5,886				4.09				534,226				5,517				4.14
Regulatory stock			5,445				63				4.63				4,644				59				5.08
Total interest earning assets			925,579				8,588				3.72				853,080				7,397				3.47
Non-interest earning assets (d)			59,724												59,950
Total assets			985,303												913,030
LIABILITIES &
STOCKHOLDERS' EQUITY
Interest bearing liabilities:
Demand deposits			203,064				73				0.15				176,288				65				0.15
Savings deposits			181,189				23				0.05				153,203				20				0.05
Time deposits			160,040				371				0.94				175,065				461				1.06
Borrowed funds			73,879				235				1.29				78,531				265				1.36
Total interest bearing liabilities			618,172				702				0.46				583,087				811				0.56
Non-interest bearing liabilities:
Demand deposits			269,617												231,048
Other			2,626												2,920
Total liabilities			890,415												817,055
Stockholders' equity			94,888												95,975
Total liabilities & stockholders' equity			985,303												913,030
Net interest income (FTE)							7,886												6,586
Net interest spread (b)											3.26												2.91
Effect of non-interest
bearing deposits											0.15												0.18
Net yield on interest earning assets (c)											3.41												3.09

 

(a) Includes balances of nonaccrual loans and the recognition of any related interest income.  The quarter-to-date average balances include net deferred loan costs of $1,012,000 as of March 31, 2017, and $728,000 as of March 31, 2016.  Such fees and costs recognized through income and included in the interest amounts totaled ($108,000) in 2017, and ($75,000) in 2016.

(b) Net interest spread is the arithmetic difference between the yield on interest earning assets and the rate paid on interest bearing liabilities.

(c) Net yield, also referred to as net interest margin, is computed by dividing net interest income (FTE) by total interest earning assets.

(d) Securities recorded at amortized cost.  Unrealized holding gains and losses are included in non-interest earning assets.

The Corporation’s interest income increased and interest expense decreased for the quarter-to-date period in 2017 compared to 2016 resulting in a higher NIM of 3.41% for the first quarter of 2017, compared to 3.09% for the first quarter of 2016. The yield earned on assets increased by 25 basis points for the quarter while the rate paid on liabilities dropped 10 basis points. Management does anticipate further improvements in NIM during the remainder of 2017 with higher short-term rates and the possibility of further Fed rate increases. Loan yields were at historically low levels during 2016 and in the first three months of 2017 due to the extended low-rate environment as well as extremely competitive pricing for the loan opportunities in the market. It is anticipated that these yields will improve slightly throughout the remainder of 2017 as the economy improves and loan demand increases, reducing pricing pressures and intense competition for loans. The Corporation’s loan yield decreased five basis points in the first quarter of 2017 compared to the first quarter of 2016. Despite the lower yields, the growth in the loan portfolio resulted in fully tax equivalent interest income on loans increasing by $369,000, or 6.7%, for the three months ended March 31, 2017, compared to the same period in 2016.

 

Loan pricing was a challenge in 2016, and continues to be in 2017 as a result of intense competition resulting in fixed-rate loans being priced at very low levels and variable-rate loans priced at the Prime rate or below. The Prime rate is generally lower than typical fixed-rate business and commercial loans, which typically range between 4.50% and 6.50%, depending on term and credit risk. Management is able to price loan customers with higher levels of credit risk at Prime plus pricing, such as Prime plus 0.75%, currently 4.75%. However, there are relatively few of these higher rate loans in the commercial and agricultural portfolios due to the strong credit quality of the Corporation’s borrowers. These rates are actually above some shorter-term commercial fixed rates, which are still around 4.00%. Competition in the immediate market area is keeping commercial and agricultural lending rates below 4.00% for the better loan credits. This current market environment is preventing the Corporation from gaining yield on fixed rate commercial and agricultural loans. The Asset Liability Committee (ALCO) carefully monitors the NIM because it indicates trends in net interest income, the Corporation’s largest source of revenue. For more information on the plans and strategies in place to protect the NIM and moderate the impact of rising rates, please refer to Item 7A. Quantitative and Qualitative Disclosures about Market Risk.

 

Earnings and yields on the Corporation’s securities increased by 79 basis points for the three months ended March 31, 2017, compared to the same period in 2016. The Corporation’s securities portfolio consists of nearly all fixed income debt instruments. The Corporation’s taxable securities experienced an 88 basis-point increase in yield for the three months ended March 31, 2017, compared to the same period in 2016. This was largely due to accelerated amortization that caused significantly lower interest income for the first three months of 2016. Additionally, some security reinvestment in the first quarter of 2017 has been occurring at higher rates and regular amortization has been lower due to the slightly higher interest rate environment. These variables have caused taxable security yields to increase significantly. The yield on tax-exempt securities increased by six basis points for the first quarter of 2017, compared to the same period in 2016. As the 10-year U.S. Treasury rates increased, the spreads available on these securities increased, resulting in higher yields. Management was also selling out of lower yielding municipal bonds in an effort to improve overall municipal bond yield.

 

Prior to 2017, with short-term rates extremely low and with small rate differences for longer-term deposits, the consumer generally elected to stay short and maintain funds in accessible deposit instruments. During the first quarter of 2017, with higher short-term rates but still low longer-term rates, the customer still prefers keeping balances in both non-interest and interest bearing checking products and savings accounts. In addition to the consumer staying liquid with their available funds, there has been a general trend of funds flowing from time deposit accounts into both non-interest checking, NOW and savings accounts. The average balance of the Corporation’s interest bearing liabilities increased during the three months ended March 31, 2017. The average balance of time deposits declined during this period compared to 2016, but the other areas of NOW, MMDA, and savings grew sufficiently enough to compensate for the decline in time deposits, causing total interest bearing funds to increase. However, with more of the interest bearing funds in the form of NOW, MMDA, and savings accounts the average interest rate paid on these instruments is significantly less than what is paid on time deposits, resulting in less interest expense.

 

Interest expense on deposits declined by $79,000, or 14.5%, for the three months ended March 31, 2017, compared to the same period in 2016. Demand and savings deposits reprice in entirety whenever the offering rates are changed. This allows management to reduce interest costs rapidly; however, it becomes difficult to continue to gain cost savings once offering rates decline to these historically low levels. For the first quarter of 2017, the average balances of interest bearing demand deposits increased by $26.8 million, or 15.2%, over the same period in 2016, while the average balance of savings accounts increased by $28.0 million, or 18.3%. This increase in balances of lower cost accounts has helped to reduce the Corporation’s overall interest expense in 2017 compared to 2016.

 

Time deposits reprice over time according to their maturity schedule. This enables management to both reduce and increase rates slowly over time. During the three months ended March 31, 2017, time deposit balances decreased compared to balances at March 31, 2016. The decrease can be attributed to the lowest rates paid historically on time deposits, which has caused the differential between time deposit rates and rates on non-maturity deposits to be minimal. As a result, customers have elected to keep more of their funds in non-maturity deposits and less funds in time deposits. Because time deposits are the most expensive deposit product for the Corporation and the largest dollar expense from a funding standpoint, the reduction in time deposits, along with the increases in interest-bearing checking, savings, and non-interest bearing checking, has allowed the Corporation to achieve a lower cost and more balanced deposit funding position. The Corporation was able to reduce interest expense on time deposits by $90,000, or 19.5%, for the first quarter of 2017, compared to the same period in 2016. Average balances of time deposits decreased by $15.0 million, or 8.6%, for the three months ended March 31, 2017, compared to the same period in 2016. The average annualized interest rate paid on time deposits decreased by 12 basis points for the three-month period when comparing both years.

 

The Corporation historically uses both short-term and long-term borrowings to supplement liquidity generated by deposit growth. Average short-term advances of $15,139,000 were utilized in the three months ended March 31, 2017, while average short-term advances of $12,755,000 were utilized in the three months ended March 31, 2016. Management has used long-term borrowings as part of an asset liability strategy to lengthen liabilities rather than as a source of liquidity. Average total borrowings decreased by $4.7 million, or 5.9%, for the three months ended March 31, 2017, compared to the same period in 2016. Interest expense on borrowed funds was $30,000, or 11.3% lower, for the three-month period when comparing 2017 to 2016, as a result of management refinancing maturing long-term advances to lower rates.

 

For the quarter ended March 31, 2017, the net interest spread increased 35 basis points to 3.26%, from 2.91% for the first quarter of 2016. The effect of non-interest bearing funds dropped three basis points for the three-month period compared to the same period in the prior year. The effect of non-interest bearing funds refers to the benefit gained from deposits on which the Corporation does not pay interest. As rates go lower, the benefit of non-interest bearing deposits is reduced because there is less difference between non-interest bearing funds and interest bearing liabilities. For example, if an interest checking account with $10,000 earns 1%, the benefit for $10,000 of non-interest bearing deposits is equivalent to $100; but if the interest-checking rate is reduced to 0.20%, then the benefit of the non-interest bearing funds is only $20. This assumes dollar-for-dollar replacement, which is not realistic, but demonstrates the way the lower cost of funds affects the benefit to non-interest bearing deposits.

 

The Asset Liability Committee (ALCO) carefully monitors the NIM because it indicates trends in net interest income, the Corporation’s largest source of revenue. For more information on the plans and strategies in place to protect the NIM and moderate the impact of rising rates, refer to Item 7A: Quantitative and Qualitative Disclosures about Market Risk.

 

 

Provision for Loan Losses

 

The allowance for loan losses (ALLL) provides for losses inherent in the loan portfolio as determined by a quarterly analysis and calculation of various factors related to the loan portfolio. The amount of the provision reflects the adjustment management determines necessary to ensure the ALLL is adequate to cover any losses inherent in the loan portfolio. The Corporation recorded a provision expense of $90,000 for the three months ended March 31, 2017, compared to a credit provision of $50,000 for the three months ended March 31, 2016. The analysis of the ALLL takes into consideration, among other things, the following factors: