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EX-32.2 - EXHIBIT 32.2 - FIRST KEYSTONE CORPtv477754_ex32-2.htm
EX-32.1 - EXHIBIT 32.1 - FIRST KEYSTONE CORPtv477754_ex32-1.htm
EX-31.2 - EXHIBIT 31.2 - FIRST KEYSTONE CORPtv477754_ex31-2.htm
EX-31.1 - EXHIBIT 31.1 - FIRST KEYSTONE CORPtv477754_ex31-1.htm

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C. 20549

 

FORM 10Q

 

xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2017

 

or

 

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

 

For the transition period from ________ to ________

 

Commission File Number: 2-88927

 

FIRST KEYSTONE CORPORATION
(Exact name of registrant as specified in its charter)

 

Pennsylvania   23-2249083
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification No.)
     
111 West Front Street, Berwick, PA   18603
(Address of principal executive offices)   (Zip Code)

 

Registrant’s telephone number, including area code: (570) 752-3671

 

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 ¨

 

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

Yes x No ¨

 

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

 

  Large accelerated filer ¨ Accelerated filer x
  Non-accelerated filer ¨ Smaller reporting company ¨
  Emerging growth company ¨    

 

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. ¨

 

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

Yes ¨ No x

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical date:

 

Common Stock, $2 Par Value, 5,706,241 shares as of November 3, 2017

 

 

 

 

 

 

PART I - FINANCIAL INFORMATION

 

Item 1. Financial Statements

FIRST KEYSTONE CORPORATION AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

(Unaudited)

  

(Dollars in thousands, except per share data)  September 30,   December 31, 
   2017   2016 
ASSETS          
Cash and due from banks  $9,371   $8,338 
Interest-bearing deposits in other banks   1,744    790 
Total cash and cash equivalents   11,115    9,128 
Time deposits with other banks   1,482    1,482 
Investment securities available-for-sale   361,092    379,637 
Investment securities held-to-maturity (fair value 2017- $0; 2016 - $4)       4 
Restricted investment in bank stocks   4,472    5,477 
Loans   542,785    522,382 
Allowance for loan losses   (7,448)   (7,357)
Net loans   535,337    515,025 
Premises and equipment, net   18,506    19,237 
Accrued interest receivable   4,034    3,917 
Cash surrender value of bank owned life insurance   22,196    21,718 
Investments in low-income housing partnerships   2,673    2,555 
Goodwill   19,133    19,133 
Foreclosed assets held for resale   1,078    1,273 
Deferred income taxes   1,163    2,760 
Other assets   2,827    2,937 
TOTAL ASSETS  $985,108   $984,283 
LIABILITIES          
Deposits:          
Non-interest bearing  $125,131   $110,314 
Interest bearing   634,585    615,668 
Total deposits   759,716    725,982 
Short-term borrowings   41,209    69,290 
Long-term borrowings   65,022    75,116 
Accrued interest payable   505    427 
Other liabilities   3,347    3,783 
TOTAL LIABILITIES   869,799    874,598 
STOCKHOLDERS’ EQUITY          
Preferred stock, par value $2.00 per share; authorized 1,000,000 shares as of September 30, 2017 and December 31, 2016;   issued 0 in 2017 and 2016        
Common stock, par value $2.00 per share; authorized 20,000,000 shares as of September 30, 2017 and December 31, 2016;  issued 5,939,353 as of September 30, 2017 and 5,904,563 as of December 31, 2016; outstanding 5,706,241 as of  September 30, 2017 and 5,671,451 as of December 31, 2016   11,879    11,809 
Surplus   35,909    35,047 
Retained earnings   71,662    70,004 
Accumulated other comprehensive income (loss)   1,615    (1,419)
Treasury stock, at cost, 233,112 shares in 2017 and 2016   (5,756)   (5,756)
TOTAL STOCKHOLDERS’ EQUITY   115,309    109,685 
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY  $985,108   $984,283 

 

See accompanying notes to consolidated financial statements.

 

 2 

 

 

FIRST KEYSTONE CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2017 AND 2016

(Unaudited)

 

(Dollars in thousands, except per share data)  Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
   2017   2016   2017   2016 
INTEREST INCOME                    
Interest and fees on loans  $5,662   $5,509   $16,718   $16,433 
Interest and dividend income on investment securities:                    
Taxable   1,103    1,362    3,317    4,306 
Tax-exempt   1,290    957    3,733    2,819 
Dividends   11    16    33    47 
Dividend income on restricted investment in bank stocks   89    73    244    197 
Interest on interest-bearing deposits in other banks   9    9    26    25 
Total interest income   8,164    7,926    24,071    23,827 
INTEREST EXPENSE                    
Interest on deposits   1,055    803    2,955    2,482 
Interest on short-term borrowings   369    113    767    274 
Interest on long-term borrowings   363    393    1,111    1,148 
Total interest expense   1,787    1,309    4,833    3,904 
Net interest income   6,377    6,617    19,238    19,923 
Provision for loan losses   84    1,133    167    1,700 
Net interest income after provision for loan losses   6,293    5,484    19,071    18,223 
NON-INTEREST INCOME                    
Trust department   203    208    660    638 
Service charges and fees   460    475    1,357    1,336 
Bank owned life insurance income   160    161    478    490 
ATM fees and debit card income   351    323    1,034    966 
Gains on sales of mortgage loans   81    101    205    258 
Net investment securities gains   414    395    886    789 
Gains from life insurance proceeds       458        458 
Other   44    37    126    189 
Total non-interest income   1,713    2,158    4,746    5,124 
NON-INTEREST EXPENSE                    
Salaries and employee benefits   3,050    2,606    8,823    7,979 
Occupancy, net   423    512    1,340    1,301 
Furniture and equipment   146    146    422    410 
Computer expense   252    248    765    718 
Professional services   201    140    634    442 
Pennsylvania shares tax   157    189    568    566 
FDIC insurance   81    85    241    402 
ATM and debit card fees   184    184    509    490 
Data processing fees   148    149    442    417 
Foreclosed assets held for resale expense   13    89    119    201 
Advertising   146    93    408    256 
Other   880    637    2,339    2,050 
Total non-interest expense   5,681    5,078    16,610    15,232 
Income before income tax expense   2,325    2,564    7,207    8,115 
Income tax expense   269    420    946    1,304 
NET INCOME  $2,056   $2,144   $6,261   $6,811 
PER SHARE DATA                    
Net income per share:                    
Basic  $0.36   $0.38   $1.10   $1.21 
Diluted   0.36    0.38    1.10    1.21 
Dividends per share   0.27    0.27    0.81    0.81 

 

See accompanying notes to consolidated financial statements.

 

 3 

 

  

FIRST KEYSTONE CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

 

(Dollars in thousands)  Three Months Ended 
   September 30, 
   2017   2016 
Net Income  $2,056   $2,144 
           
Other comprehensive loss:          
Unrealized net holding gains (losses) on available-for-sale investment securities  arising during the period, net of income taxes of $134 and $(836), respectively   251    (1,642)
           
Less reclassification adjustment for net gains included in net income,  net of income taxes of $(140) and $(134), respectively (a) (b)   (274)   (261)
           
Total other comprehensive loss   (23)   (1,903)
           
Total Comprehensive Income  $2,033   $241 

 

 

(a) Gross amounts are included in net investment securities gains on the Consolidated Statements of Income in non-interest income.

(b) Income tax amounts are included in income tax expense on the Consolidated Statements of Income.

 

(Dollars in thousands)  Nine Months Ended 
   September 30, 
   2017   2016 
Net Income  $6,261   $6,811 
           
Other comprehensive income:          
Unrealized net holding gains on available-for-sale investment securities  arising during the period, net of income taxes of $1,874 and $2,700, respectively   3,619    5,216 
           
Less reclassification adjustment for net gains included in net income,  net of income taxes of $(301) and $(268), respectively (a) (b)   (585)   (521)
           
Total other comprehensive income   3,034    4,695 
           
Total Comprehensive Income  $9,295   $11,506 

 

 

(a) Gross amounts are included in net investment securities gains on the Consolidated Statements of Income in non-interest income.

(b) Income tax amounts are included in income tax expense on the Consolidated Statements of Income.

 

See accompanying notes to consolidated financial statements.

 

 4 

 

  

FIRST KEYSTONE CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

NINE MONTHS ENDED SEPTEMBER 30, 2017 AND 2016

(Unaudited)

 

(Dollars in thousands, except per share data)                            
                   Accumulated         
                   Other       Total 
   Common Stock       Retained   Comprehensive   Treasury   Stockholders’ 
   Shares   Amount   Surplus   Earnings   (Loss) Income   Stock   Equity 
                             
Balance at January 1, 2017   5,904,563   $11,809   $35,047   $70,004   $(1,419)  $(5,756)  $109,685 
Net Income                6,261              6,261 
Other comprehensive income, net of taxes                     3,034         3,034 
Issuance of common stock under dividend reinvestment plan   34,790    70    862                   932 
Dividends - $0.81 per share              (4,603)             (4,603)
Balance at September 30, 2017   5,939,353   $11,879   $35,909   $71,662   $1,615   $(5,756)  $115,309 
                                   
Balance at January 1, 2016   5,853,317   $11,707   $33,830   $66,622   $2,035   $(5,756)  $108,438 
Net Income                6,811              6,811 
Other comprehensive income, net of taxes                     4,695         4,695 
Issuance of common stock under dividend reinvestment plan   39,604    79    941                   1,020 
Dividends - $0.81 per share              (4,562)             (4,562)
Balance at September 30, 2016   5,892,921   $11,786   $34,771   $68,871   $6,730   $(5,756)  $116,402 

 

See accompanying notes to consolidated financial statements.

 

 5 

 

 

FIRST KEYSTONE CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2017 AND 2016

(Unaudited)

 

(Dollars in thousands)        
   2017   2016 
OPERATING ACTIVITIES          
Net income  $6,261   $6,811 
Adjustments to reconcile net income to net cash provided by operating activities:          
Provision for loan losses   167    1,700 
Depreciation and amortization   841    885 
Net premium amortization on investment securities   3,544    2,896 
Deferred income tax expense   25    124 
Gains on sales of mortgage loans   (205)   (258)
Proceeds from sales of mortgage loans originated for resale   6,749    7,088 
Originations of mortgage loans originated for resale   (7,846)   (9,594)
Gains on sales of investment securities   (886)   (789)
Net (gains) losses on sales of foreclosed real estate held for resale, including write-downs   (26)   110 
(Increase) decrease in accrued interest receivable   (117)   352 
Earnings on investment in bank owned life insurance   (478)   (490)
Gain from bank-owned life insurance proceeds       (458)
Decrease (increase) in other assets   110    (761)
Amortization of investment in real estate ventures   121    132 
Increase in accrued interest payable   78    8 
(Decrease) increase in other liabilities   (436)   17 
NET CASH PROVIDED BY OPERATING ACTIVITIES   7,902    7,773 
INVESTING ACTIVITIES          
Proceeds from sales of investment securities available-for-sale   77,710    66,814 
Proceeds from maturities and redemptions of investment securities available-for-sale   15,518    13,108 
Purchases of investment securities available-for-sale   (72,735)   (48,345)
Proceeds from maturities and redemptions of investment securities held-to-maturity   4    9 
Net change in restricted investment in bank stocks   1,005    137 
Net (increase) decrease in loans   (19,291)   3,788 
Proceeds from bank-owned life insurance       1,290 
Purchases of premises and equipment   (173)   (243)
Purchase of investment in real estate venture   (239)   (1,178)
Proceeds from sales of foreclosed assets held for resale   398    232 
NET CASH PROVIDED BY INVESTING ACTIVITIES   2,197    35,612 
FINANCING ACTIVITIES          
Net increase in deposits   33,734    29,271 
Net decrease in short-term borrowings   (28,081)   (60,895)
Proceeds from long-term borrowings       10,000 
Repayment of long-term borrowings   (10,094)   (5,086)
Common stock issued   932    984 
Dividends paid   (4,603)   (4,562)
NET CASH USED IN FINANCING ACTIVITIES   (8,112)   (30,288)
INCREASE IN CASH AND CASH EQUIVALENTS   1,987    13,097 
CASH AND CASH EQUIVALENTS, BEGINNING   9,128    9,008 
CASH AND CASH EQUIVALENTS, ENDING  $11,115   $22,105 
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION          
Interest paid  $4,755   $3,896 
Income taxes paid   1,200    873 
SUPPLEMENTAL DISCLOSURE OF NON-CASH ACTIVITIES          
Purchased securities settling after quarter end       1,262 
Loans transferred to foreclosed assets held for resale   177    200 
Loans transferred (from) to held for sale portfolio       (171)
Common stock subscription receivable       36 

 

See accompanying notes to consolidated financial statements.

 

 6 

 

  

FIRST KEYSTONE CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

NOTE 1 ― BASIS OF PRESENTATION AND ACCOUNTING POLICIES

 

The consolidated financial statements include the accounts of First Keystone Corporation (the “Corporation”) and its wholly owned subsidiary, First Keystone Community Bank (the “Bank”). All significant intercompany accounts and transactions have been eliminated.

 

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial information. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete consolidated financial statements. In the opinion of management, all adjustments considered necessary for fair presentation have been included. Operating results for the three and nine month periods ended September 30, 2017, are not necessarily indicative of the results for the year ending December 31, 2017. For further information, refer to the consolidated financial statements and notes thereto included in First Keystone Corporation’s Annual Report on Form 10-K for the year ended December 31, 2016.

 

For comparative purposes, the September 30, 2016 balances have been reclassified to conform to the September 30, 2017 presentation. Such reclassifications had no impact on net income.

 

The Corporation has evaluated events and transactions occurring subsequent to the consolidated balance sheet date of September 30, 2017 for items that should potentially be recognized or disclosed in these consolidated financial statements. The evaluation was conducted through the date these consolidated financial statements were issued. In October 2017, the Corporation purchased a property at a cost of $2,387,000 which the Corporation has been operating as a banking branch in Stroudsburg, Pennsylvania since 2007. Previous to the purchase settlement date, the property was leased and accounted for under the guidelines of a capital lease in the total assets of the Corporation.

 

NOTE 2 ― RECENT ACCOUNTING STANDARDS UPDATES (“ASU”)

 

Except as disclosed below, there were no new accounting pronouncements affecting the Corporation during the nine months ended September 30, 2017 that were not already adopted by the Corporation.

 

In May 2014, the Financial Accounting Standards Board (“FASB”) issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606), which supersedes the revenue requirements in Revenue Recognition (Topic 605). This ASU requires entities to recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services. The ASU is effective for annual reporting periods beginning after December 31, 2016, including interim periods within the reporting period. Early application is not permitted. In August 2015, the FASB issued an update ASU 2015-14 which approved a one-year delay of the effective date of this standard. The deferral would require public entities to apply the standard for annual reporting periods beginning after December 15, 2017. In March 2016, the FASB issued an update ASU 2016-08 which updates the new revenue standard by clarifying the principal versus agent implementation guidance, but does not change the core principle of the new standard. In April 2016, the FASB issued an update ASU 2016-10, that updates the standard by identifying performance obligations and licenses of intellectual property, which clarifies the guidance surrounding licensing arrangements and the identification of performance obligations. In May 2016, the FASB issued an update ASU 2016-12 which articulates narrow-scope improvements and practical expedients. In December, the FASB issued an update ASU 2016-20. The amendments affect narrow aspects of the guidance issued in ASU 2014-09 including Loan Guarantee Fees, Contract Costs, Provisions for Losses on Construction-Type and Production-Type Contracts, Disclosure of Remaining Performance Obligations, Disclosure of Prior Period Performance Obligations, Contract Modifications, Contract Asset vs. Receivable, Refund Liability, Advertising Costs, Fixed Odds Wagering Contracts in the Casino Industry, and Costs Capitalized for Advisors to Private Funds and Public Funds. In February 2017, the FASB issued an update ASU 2017-05 with amendments to clarify that a financial asset is within the scope of Subtopic 610.20 if it meets the definition of an in substance nonfinancial asset. The Corporation’s revenue has been more significantly weighted towards net interest income on financial assets and liabilities, which is explicitly excluded from the scope of the new standard. The Corporation is continuing to assess its revenue streams and reviewing its contracts with customers that are potentially affected by the new guidance including wealth and asset management revenue, fees on deposits, gains and losses on the sale of other real estate owned, credit and debit card interchange fees. The Corporation will adopt the requirements of the new standard on January 1, 2018, utilizing the modified retrospective transition method. Upon adoption, the Corporation will recognize the cumulative effect of adopting this ASU as an adjustment to the opening balance of retained earnings. Prior periods will not be retrospectively adjusted. The Corporation will also be subject to expanded disclosure requirements upon adoption for which the Corporation is still in the process of evaluating.

 

 7 

 

 

In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments – Overall (Subtopic 825-10) – Recognition and Measurement of Financial Assets and Financial Liabilities. The guidance addresses certain aspects of recognition, measurement, presentation and disclosure of financial instruments. In particular, the guidance revises an entity’s accounting related to (1) the classification and measurement of investments in equity securities and (2) the presentation of certain fair value changes for financial liabilities measured at fair value. The guidance also amends certain disclosure requirements associated with fair value of financial instruments. For public business entities, the guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Entities should apply the amendments by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. The adoption of this update is not expected to have a material impact on the Company’s consolidated financial position or results of operations.

 

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). Under the new guidance, lessees will be required to recognize the following for all leases (with the exception of short-term leases) at the commencement date: (i) a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and (ii) a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. Under the new guidance, lessor accounting is largely unchanged. Public business entities should apply the amendments in ASU 2016-02 for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early application is permitted for all public business entities upon issuance. Lessees (for capital and operating leases) and lessors (for sales-type, direct financing, and operating leases) must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The adoption of this ASU will result in an increase to the Consolidated Balance Sheets for right-of-use assets and associated lease liabilities for operating leases in which the Corporation is the lessee. The Corporation has not yet determined the impact ASU 2016-02 will have on its consolidated financial statements.

 

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The ASU requires 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. This is in contrast to existing guidance whereby credit losses generally are not recognized until they are incurred. For public companies, this update will be effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early application will be permitted for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. While the Corporation is currently evaluating the provisions of the ASU to determine the potential impact of the new standard will have on the Corporation’s consolidated financial statements, it has taken steps to prepare for the implementation when it becomes effective, such as forming an internal committee, gathering pertinent data, consulting with outside professionals, and begun evaluating its current IT systems.

 

In August 2016, the Financial Accounting Standards Board (“FASB”) issued ASU 2016-15, Classification of Certain Cash Receipts and Cash Payments. The amendments are intended to reduce diversity in practice. The guidance clarifies the classification of various business activities as financing, operating or investing activity. The ASU contains additional guidance clarifying when an entity should separate cash receipts and cash payments and classify them into more than one class of cash flows (including when reasonable judgment is required to estimate and allocate cash flows) versus when an entity should classify the aggregate amount into one class of cash flows on the basis of predominance. The amendments are effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. Early adoption is permitted. 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 Corporation is currently assessing the impact that this guidance will have on its consolidated financial statements and related disclosures.

 

 8 

 

 

In January 2017, the Financial Accounting Standards Board (“FASB”) issued ASU 2017-04, Intangibles – Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. The ASU simplifies the subsequent measurement of goodwill by eliminating Step 2 from the goodwill impairment test. Instead, under the amendments, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value with its carrying amount. Additionally, an entity should consider income tax effects from any tax deductible goodwill on the carrying amount when measuring the goodwill impairment loss, if applicable. The update also eliminated the requirements for zero or negative carrying amount to perform a qualitative assessment and, if it fails that qualitative test, to perform Step 2 of the goodwill impairment test. The amendments are effective for public business entities for its annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The adoption of this update is not expected to have a material impact on the Company’s consolidated financial position or results of operations.

 

In March 2017, the Financial Accounting Standards Board (“FASB”) issued ASU 2017-07, Compensation - Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. The amendments apply to all entities that offer employees defined benefit pension plans, other postretirement benefit plans, or other types of benefits accounted for under Topic 715, Compensation — Retirement Benefits. The amendments require that an employer report the service cost component in the same line item or items as other compensation costs arising from services rendered by the pertinent employees during the period. The other components of net benefit cost are required to be presented in the income statement separately from the service cost component and outside a subtotal of income from operations, if one is presented. The amendments also allow only the service cost component to be eligible for capitalization when applicable (e.g., as a cost of internally manufactured inventory or a self-constructed asset). The ASU is effective for public business entities for annual periods beginning after December 15, 2017, including interim periods within those annual periods. Early adoption is permitted as of the beginning of an annual period for which financial statements (interim or annual) have not been issued or made available for issuance. The adoption of this update is not expected to have a material impact on the Company’s consolidated financial position or results of operations.

 

In March 2017, the Financial Accounting Standards Board (“FASB”) issued ASU 2017-08, Receivables- Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities. The ASU shortens the amortization period for certain callable debt securities held at a premium. Specifically, the amendments require the premium to be amortized to the earliest call date. The amendments do not require an accounting change for securities held at a discount; the discount continues to be amortized to maturity. The amendments are effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. Early adoption is permitted, including adoption in an interim period. If an entity early adopts in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. The amendments should be applied on a modified retrospective basis, with a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. The Corporation is currently assessing the impact that this guidance will have on its consolidated financial statements and related disclosures.

 

NOTE 3INVESTMENT SECURITIES

 

The Corporation classifies its investment securities as either “Held-to-Maturity” or “Available-for-Sale” at the time of purchase. Investment securities are accounted for on a trade date basis. Debt securities are classified as Held-to-Maturity when the Corporation has the ability and positive intent to hold the securities to maturity. Investment securities classified as Held-to-Maturity are carried at cost adjusted for amortization of premium and accretion of discount to maturity.

 

Debt securities not classified as Held-to-Maturity and equity securities are included in the Available-for-Sale category and are carried at fair value. The amount of any unrealized gain or loss, net of the effect of deferred income taxes, is reported as accumulated other comprehensive income (loss) in the Consolidated Balance Sheets and Consolidated Statements of Changes in Stockholders’ Equity. Management’s decision to sell Available-for-Sale securities is based on changes in economic conditions, controlling the sources and applications of funds, terms, availability of and yield of alternative investments, interest rate risk and the need for liquidity.

 

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The cost of debt securities classified as Held-to-Maturity or Available-for-Sale is adjusted for amortization of premiums and accretion of discounts to expected maturity. Such amortization and accretion, as well as interest and dividends, are included in interest and dividend income from investment securities. Realized gains and losses are included in net investment securities gains and losses. The cost of investment securities sold, redeemed or matured is based on the specific identification method.

 

The amortized cost, related estimated fair value, and unrealized gains and losses for investment securities classified as “Available-For-Sale” or “Held-to-Maturity” were as follows at September 30, 2017 and December 31, 2016:

 

   Available-for-Sale Securities 
(Dollars in thousands)      Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
September 30, 2017:  Cost   Gains   Losses   Value 
U.S. Treasury securities  $   $   $   $ 
Obligations of U.S. Government Corporations and Agencies:                    
Mortgage-backed   87,287    239    (987)   86,539 
Other   23,092    201    (253)   23,040 
Obligations of state and political subdivisions   217,639    4,448    (1,376)   220,711 
Corporate debt securities   29,724    73    (727)   29,070 
Marketable equity securities   809    923        1,732 
Total  $358,551   $5,884   $(3,343)  $361,092 

 

   Held-to-Maturity Securities 
(Dollars in thousands)      Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
September 30, 2017:  Cost   Gains   Losses   Value 
Obligations of U.S. Government Corporations and Agencies:                
Mortgage-backed  $   $   $   $ 
Total  $   $   $   $ 

 

   Available-for-Sale Securities 
(Dollars in thousands)      Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
December 31, 2016:  Cost   Gains   Losses   Value 
U.S. Treasury securities  $1,008   $2   $   $1,010 
Obligations of U.S. Government Corporations and Agencies:                    
Mortgage-backed   112,155    83    (1,331)   110,907 
Other   21,399    82    (511)   20,970 
Obligations of state and political subdivisions   211,154    2,776    (2,796)   211,134 
Corporate debt securities   35,178    4    (1,206)   33,976 
Marketable equity securities   810    830        1,640 
Total  $381,704   $3,777   $(5,844)  $379,637 

 

   Held-to-Maturity Securities 
(Dollars in thousands)      Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
December 31, 2016:  Cost   Gains   Losses   Value 
Obligations of U.S. Government Corporations and Agencies:                    
Mortgage-backed  $4   $   $   $4 
Total  $4   $   $   $4 

 

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Securities Available-for-Sale with an aggregate fair value of $302,579,000 at September 30, 2017 and $320,319,000 at December 31, 2016, and securities Held-to-Maturity with an aggregate book value of $0 at September 30, 2017 and $4,000 at December 31, 2016, were pledged to secure public funds, trust funds, securities sold under agreements to repurchase, debtor in possession funds and the Federal Discount Window aggregating $226,380,000 at September 30, 2017 and $221,818,000 at December 31, 2016.

 

The amortized cost, estimated fair value and weighted average yield of debt and equity securities, by contractual maturity, are shown below at September 30, 2017. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

  

(Dollars in thousands)    
   September 30, 2017 
   Available-For-Sale   Held-To-Maturity 
       U.S. Government   Obligations           U.S. Government 
       Corporations &   of State   Corporate   Marketable   Corporations & 
   U.S. Treasury   Agencies   & Political   Debt   Equity   Agencies 
   Securities   Obligations1   Subdivisions2   Securities   Securities3   Obligations1 
Within 1 Year:                              
Amortized cost  $   $   $1,642   $533   $   $ 
Fair value           1,657    520         
Weighted average yield           2.55%   2.32%        
                               
1 - 5 Years:                              
Amortized cost       6,858    28,807    6,391         
Fair value       6,831    29,091    6,365         
Weighted average yield       2.09%   2.76%   2.35%        
                               
5 - 10 Years:                              
Amortized cost       40,792    71,628    22,800         
Fair value       40,012    72,657    22,185         
Weighted average yield       2.10%   3.29%   2.68%        
                               
After 10 Years:                              
Amortized cost       62,729    115,562        809     
Fair value       62,736    117,306        1,732     
Weighted average yield       2.23%   3.51%       5.46%    
                               
Total:                              
Amortized cost  $   $110,379   $217,639   $29,724   $809   $ 
Fair value       109,579    220,711    29,070    1,732     
Weighted average yield       2.18%   3.33%   2.60%   5.46%    

 

 

1Mortgage-backed securities are allocated for maturity reporting at their original maturity date.

2Average yields on tax-exempt obligations of state and political subdivisions have been computed on a tax-equivalent basis using a 34% tax rate.

3Marketable equity securities are not considered to have defined maturities and are included in the after ten year category.

 

There were no aggregate investments with a single issuer (excluding the U.S. Government and U.S. Government Agencies and Corporations) which exceeded ten percent of consolidated stockholders’ equity at September 30, 2017. The quality rating of the obligations of state and political subdivisions are generally investment grade, as rated by Moody’s, Standard and Poor’s or Fitch. The typical exceptions are local issues which are not rated, but are secured by the full faith and credit obligations of the communities that issued these securities.

 

Proceeds from sales of investments in Available-for-Sale debt and equity securities for the three months ended September 30, 2017 and 2016 were $25,718,000 and $39,406,000, respectively. Gross gains realized on these sales were $414,000 and $497,000, respectively. Gross losses realized on these sales were $0 and $102,000, respectively. There were no impairment losses realized on Available-for-Sale equity securities for the three months ended September 30, 2017 and 2016.

 

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Proceeds from sales of investments in Available-for-Sale debt and equity securities for the nine months ended September 30, 2017 and 2016 were $77,710,000 and $66,814,000, respectively. Gross gains realized on these sales were $949,000 and $932,000, respectively. Gross losses realized on these sales were $63,000 and $143,000, respectively. There were no impairment losses realized on Available-for-Sale equity securities for the nine months ended September 30, 2017 and 2016.

 

There were no proceeds from sales of investments in Held-to-Maturity debt securities during the three or nine month periods ended September 30, 2017 or 2016. Therefore, there were no gains or losses realized during these periods.

 

Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. Investment securities classified as Available-for-Sale or Held-to-Maturity are generally evaluated for OTTI under FASB ASC 320, Investments - Debt and Equity Securities. In determining OTTI under the FASB ASC 320 model, management considers many factors, including (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.

 

When other-than-temporary impairment occurs on debt securities, the amount of the other-than-temporary impairment recognized in earnings depends on whether an entity intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss. If an entity intends to sell or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the other-than-temporary impairment shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis less any current-period loss, the other-than-temporary impairment shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total other-than-temporary impairment related to the credit loss is determined based on the present value of cash flows expected to be collected, and the realized loss is recognized as impairment charges on securities on the Consolidated Statements of Income. The amount of the total other-than-temporary impairment related to the other factors shall be recognized in other comprehensive income (loss), net of applicable taxes. The previous amortized cost basis less the other-than-temporary impairment recognized in earnings becomes the new amortized cost basis of the investment.

 

The fair market value of the equity securities tends to fluctuate with the overall equity markets as well as the trends specific to each institution. The equity securities portfolio is reviewed in a similar manner as that of the debt securities with greater emphasis placed on the length of time the market value has been less than the carrying value and the financial sector outlook. The Corporation also reviews dividend payment activities, levels of non-performing assets and loan loss reserves. The starting point for the equity analysis is the length and severity of market value decline. The realized loss is recognized as impairment charges on securities on the Consolidated Statements of Income. The amount of the total other-than-temporary impairment is recognized in other comprehensive income (loss), net of applicable taxes. The previous cost basis less the other-than-temporary impairment recognized in earnings becomes the new cost basis of the investment.

 

The Corporation and its investment advisors monitor the entire portfolio monthly with particular attention given to securities in a continuous loss position of at least ten percent for over twelve months. Based on the factors described above, management did not consider any securities to be other-than-temporarily impaired at September 30, 2017 or December 31, 2016.

 

 

 12 

 

 

In accordance with disclosures required by FASB ASC 320-10-50, Investments - Debt and Equity Securities, the summary below shows the gross unrealized losses and fair value of the Corporation’s investments, aggregated by investment category, that individual securities have been in a continuous unrealized loss position for less than 12 months or 12 months or more as of September 30, 2017 and December 31, 2016:

 

September 30, 2017

 

(Dollars in thousands)  Less Than 12 Months   12 Months or More   Total 
   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
   Value   Loss   Value   Loss   Value   Loss 
Available-for-Sale:                              
U.S. Treasury securities  $   $   $   $   $   $ 
Obligations of U.S. Government Corporations and Agencies:                              
Mortgage-backed   41,978    (576)   20,092    (411)   62,070    (987)
Other   7,230    (253)           7,230    (253)
Obligations of state and political subdivisions   41,993    (863)   15,667    (513)   57,660    (1,376)
Corporate debt securities   3,316    (182)   18,570    (545)   21,886    (727)
Marketable equity securities                        
   $94,517   $(1,874)  $54,329   $(1,469)  $148,846   $(3,343)

 

December 31, 2016

 

(Dollars in thousands)  Less Than 12 Months   12 Months or More   Total 
   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
   Value   Loss   Value   Loss   Value   Loss 
Available-for-Sale:                              
U.S. Treasury securities  $   $   $   $   $   $ 
Obligations of U.S. Government Corporations and Agencies:                              
Mortgage-backed   89,444    (1,216)   8,783    (115)   98,227    (1,331)
Other   10,340    (500)   1,741    (11)   12,081    (511)
Obligations of state and political subdivisions   95,481    (2,796)           95,481    (2,796)
Corporate debt securities   21,656    (749)   10,298    (457)   31,954    (1,206)
Marketable equity securities                        
   $216,921   $(5,261)  $20,822   $(583)  $237,743   $(5,844)

 

The Corporation invests in various forms of agency debt including mortgage-backed securities and callable debt. The mortgage-backed securities are issued by FHLMC (“Federal Home Loan Mortgage Corporation”), FNMA (“Federal National Mortgage Association”) or GNMA (“Government National Mortgage Association”). The municipal securities consist of general obligations and revenue bonds. The marketable equity securities consist of stocks in other bank holding companies. The fair market value of the above securities is influenced by market interest rates, prepayment speeds on mortgage securities, bid-offer spreads in the market place and credit premiums for various types of agency debt. These factors change continuously and therefore the market value of these securities may be higher or lower than the Corporation’s carrying value at any measurement date. Management does not believe any of their 62 securities with a one year or less unrealized loss position or any of their 34 securities with a greater than one year unrealized loss position as of September 30, 2017, represent an other-than-temporary impairment, as these unrealized losses relate principally to changes in interest rates subsequent to the acquisition of the specific securities.

 

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NOTE 4LOANS AND ALLOWANCE FOR LOAN LOSSES

 

Loans

 

Net loans are stated at their outstanding recorded investment, net of deferred fees and costs, unearned income and the allowance for loan losses. Interest on loans is recognized as income over the term of each loan, generally, by the accrual method. Loan origination fees and certain direct loan origination costs have been deferred with the net amount amortized using the straight line method or the interest method over the contractual life of the related loans as an interest yield adjustment.

 

Residential mortgage loans held for sale are carried at the lower of cost or market on an aggregate basis determined by independent pricing from appropriate federal or state agency investors. These loans are sold without recourse. Loans held for sale amounted to $1,399,000 and $100,000 at September 30, 2017 and December 31, 2016, respectively.

 

The loans receivable portfolio is segmented into commercial, residential and consumer loans. Commercial loans consist of the following classes: Commercial and Industrial and Commercial Real Estate.

 

Commercial and Industrial Lending

 

The Corporation originates commercial and industrial loans primarily to businesses located in its primary market area and surrounding areas. These loans are used for various business purposes, which include short-term loans and lines of credit to finance machinery and equipment, inventory and accounts receivable. Generally, the maximum term for loans extended on machinery and equipment is based on the projected useful life of such machinery and equipment. Most business lines of credit are written on demand and are reviewed annually.

 

Commercial and industrial loans are generally secured with short-term assets; however, in many cases, additional collateral such as real estate is provided as additional security for the loan. Loan-to-value maximum thresholds have been established by the Corporation and are specific to the type of collateral. Collateral values may be determined using invoices, inventory reports, accounts receivable aging reports, business financial statements, collateral appraisals, etc. Commercial and industrial loans are typically secured by personal guarantees of the borrower.

 

In underwriting commercial and industrial loans, an analysis is performed to evaluate the borrower's character and capacity to repay the loan, the adequacy of the borrower's capital and collateral, as well as the conditions affecting the borrower. Evaluation of the borrower's past, present and future cash flows is also an important aspect of the Corporation's analysis of the borrower’s ability to repay.

 

Commercial and industrial loans generally present a higher level of risk than other types of loans due primarily to the effect of general economic conditions. Commercial and industrial loans are typically made on the basis of the borrower’s ability to make repayment from cash flows from the borrower’s primary business activities. As a result, the availability of funds for the repayment of commercial and industrial loans is dependent on the success of the business itself, which in turn, is likely to be dependent upon the general economic environment.

 

Commercial Real Estate Lending

 

The Corporation engages in commercial real estate lending in its primary market area and surrounding areas. The Corporation’s commercial real estate portfolio is secured primarily by commercial retail space, commercial office buildings, residential housing and hotels. Generally, commercial real estate loans have terms that do not exceed twenty years, have loan-to-value ratios of up to eighty percent of the value of the collateral property, and are typically secured by personal guarantees of the borrowers.

 

In underwriting these loans, the Corporation performs a thorough analysis of the financial condition of the borrower, the borrower’s credit history, and the reliability and predictability of the cash flow generated by the property securing the loan. The value of the property is determined by either independent appraisers or internal evaluations by Bank officers.

 

Commercial real estate loans generally present a higher level of risk than residential real estate secured loans. Repayment of loans secured by commercial real estate is typically dependent upon the successful operation of the related real estate project and/or the effect of the general economic conditions on income producing properties.

 

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Residential Real Estate Lending (Including Home Equity)

 

The Corporation’s residential real estate portfolio is comprised of one-to-four family residential mortgage loan originations, home equity term loans and home equity lines of credit. These loans are generated by the Corporation’s marketing efforts, its present customers, walk-in customers and referrals. These loans originate primarily within or with customers from the Corporation’s market area.

 

The Corporation’s one-to-four family residential mortgage originations are secured primarily by properties located in its primary market area and surrounding areas. The Corporation offers fixed-rate mortgage loans with terms up to a maximum of thirty years for both permanent structures and those under construction. Loans with terms of thirty years are normally held for sale and sold without recourse; most of the residential mortgages held in the Corporation’s residential real estate portfolio have maximum terms of twenty years. Generally, the majority of the Corporation’s residential mortgage loans originate with a loan-to-value of eighty percent or less, or those with primary mortgage insurance at ninety-five percent or less. Home equity term loans are secured by the borrower’s primary residence and typically have a maximum loan-to-value of eighty percent and a maximum term of fifteen years. In general, home equity lines of credit are secured by the borrower’s primary residence with a maximum loan-to-value of eighty percent and a maximum term of twenty years.

 

In underwriting one-to-four family residential mortgage loans, the Corporation evaluates the borrower’s ability to make monthly payments, the borrower’s repayment history and the value of the property securing the loan. The ability and willingness to repay is determined by the borrower’s employment history, current financial conditions and credit background. A majority of the properties securing residential real estate loans made by the Corporation are appraised by independent appraisers. The Corporation generally requires mortgage loan borrowers to obtain an attorney’s title opinion or title insurance and fire and property insurance, including flood insurance, if applicable.

 

Residential mortgage loans, home equity term loans and home equity lines of credit generally present a lower level of risk than consumer loans because they are secured by the borrower’s primary residence. Risk is increased when the Corporation is in a subordinate position, especially to another lender, for the loan collateral.

 

Consumer Lending

 

The Corporation offers a variety of secured and unsecured consumer loans, including vehicle loans, stock loans and loans secured by financial institution deposits. These loans originate primarily within or with customers from the market area.

 

Consumer loan terms vary according to the type and value of collateral and creditworthiness of the borrower. In underwriting personal loans, a thorough analysis is performed regarding the borrower’s willingness and financial ability to repay the loan as agreed. The ability to repay is determined by the borrower’s employment history, current financial condition and credit background.

 

Consumer loans may entail greater credit risk than residential real estate loans, particularly in the case of personal loans which are unsecured or are secured by rapidly depreciable assets, such as automobiles or recreational equipment. In such cases, repossessed collateral for a defaulted personal loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. In addition, personal loan collections are dependent on the borrower’s continuing financial stability and therefore, are more likely to be affected by adverse personal circumstances. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.

 

Delinquent Loans

 

Generally, a loan is considered to be past-due when scheduled loan payments are in arrears 10 days or more. Delinquent notices are generated automatically when a loan is 10 or 15 days past-due, depending on loan type. Collection efforts continue on past-due loans that have not been brought current, when it is believed that some chance exists for improvement in the status of the loan. Past-due loans are continually evaluated with the determination for charge-off being made when no reasonable chance remains that the status of the loan can be improved.

 

Commercial and Industrial and Commercial Real Estate loans are charged off in whole or in part when they become sufficiently delinquent based upon the terms of the underlying loan contract and when a collateral deficiency exists. Because all or part of the contractual cash flows are not expected to be collected, the loan is considered to be impaired, and the Bank estimates the impairment based on its analysis of the cash flows or collateral estimated at fair value less cost to sell.

 

 15 

 

 

Residential Real Estate and Consumer loans are charged off when they become sufficiently delinquent based upon the terms of the underlying loan contract and when the value of the underlying collateral is not sufficient to support the loan balance and a loss is expected. At that time, the amount of estimated collateral deficiency, if any, is charged off for loans secured by collateral, and all other loans are charged off in full. Loans with collateral are charged down to the estimated fair value of the collateral less cost to sell.

 

Loans in which the borrower is in bankruptcy are considered on a case by case basis and are either charged off or reaffirmed by the borrower.

 

Generally, a loan is classified as non-accrual and the accrual of interest on such a loan is discontinued when the contractual payment of principal or interest has become 90 days past due or management has serious doubts about further collectability of principal or interest, even though the loan may currently be performing. A loan may remain on accrual status if it is well secured (or supported by a strong guarantee) and in the process of collection. When a loan is placed on non-accrual status, unpaid interest credited to income in the current year is reversed and unpaid interest accrued in prior years is charged against interest income. Certain non-accrual loans may continue to perform; that is, payments are still being received. Generally, the payments are applied to principal. These loans remain under constant scrutiny, and if performance continues, interest income may be recorded on a cash basis based on management's judgment as to collectability of principal.

 

Allowance for Loan Losses

 

The allowance for loan losses is established through provisions for loan losses charged against income. Loans deemed to be uncollectible are charged against the allowance for loan losses and subsequent recoveries, if any, are credited to the allowance.

 

The allowance for loan losses is maintained at a level estimated by management to be adequate to absorb potential loan losses. Management’s periodic evaluation of the adequacy of the allowance for loan losses is based on the Corporation’s past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay (including the timing of future payments), the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions, and other relevant factors. This evaluation is inherently subjective as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change.

 

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are individually classified as impaired. Select loans are not aggregated for collective impairment evaluation, as such; all loans are subject to individual impairment evaluation should the facts and circumstances pertinent to a particular loan suggest that such evaluation is necessary. Factors considered by management in determining impairment include payment status and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. If a loan is impaired, a portion of the allowance may be allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from collateral. Troubled debt restructurings are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a troubled debt restructuring is considered to be a collateral dependent loan, the loans may be reported, net, at the fair value of the collateral. For troubled debt restructurings that subsequently default, the Corporation determines the amount of reserve in accordance with the accounting policy for the allowance for loan losses.

 

The general component covers all other loans not identified as impaired and is based on historical losses and qualitative factors. The historical loss component of the allowance is determined by losses recognized by portfolio segment over a time period that management has determined represents the current credit cycle. Qualitative factors impacting each portfolio segment may include: delinquency trends, loan volume trends, Bank policy changes, management processes and oversight, economic trends (including change in consumer and business disposable incomes, unemployment and under-employment levels, and other conditions), concentrations by industry or product, internal and external loan review processes, collateral value and market conditions, and external factors including regulatory issues and competition.

 

 16 

 

 

The unallocated component of the allowance is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

 

A reserve for unfunded lending commitments is provided for possible credit losses on off-balance sheet credit exposures. The reserve for unfunded lending commitments represents management’s estimate of losses inherent in its unfunded loan commitments and, if necessary, is recorded in other liabilities on the Consolidated Balance Sheets. As of September 30, 2017 and December 31, 2016, the amount of the reserve for unfunded lending commitments was $145,000 and $202,000, respectively.

 

The Corporation is subject to periodic examination by its federal and state examiners, and may be required by such regulators to recognize additions to the allowance for loan losses based on their assessment of credit information available to them at the time of their examinations.

 

A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect all amounts due according to the contractual terms of the original loan agreement. Under current accounting standards, the allowance for loan losses related to impaired loans is based on discounted cash flows using the loan’s effective interest rate at inception or the fair value of the collateral for certain collateral dependent loans.

 

The restructuring of a loan is considered a “troubled debt restructuring” if both the following conditions are met: (i) the borrower is experiencing financial difficulties, and (ii) the Bank has granted a concession. The most common concessions granted include one or more modifications to the terms of the debt, such as (a) a reduction in the interest rate for the remaining life of the debt, (b) an extension of the maturity date at an interest rate lower than the current market rate for new debt with similar risk, (c) a temporary period of interest-only payments, and (d) a reduction in the contractual payment amount for either a short period or remaining term of the loan. A less common concession is the forgiveness of a portion of the principal.

 

The determination of whether a borrower is experiencing financial difficulties takes into account not only the current financial condition of the borrower, but also the potential financial condition of the borrower were a concession not granted. Similarly, the determination of whether a concession has been granted is very subjective in nature. For example, simply extending the term of a loan at its original interest rate or even at a higher interest rate could be interpreted as a concession unless the borrower could readily obtain similar credit terms from a different lender.

 

Loans modified in a troubled debt restructuring are considered impaired and may or may not be placed on non-accrual status until the Bank determines the future collection of principal and interest is reasonably assured, which generally requires that the borrower demonstrates a period of performance according to the restructured terms of six months.

 

The Bank utilizes a risk grading matrix as a tool for managing credit risk in the loan portfolio and assigns an asset quality rating (risk grade) to all Commercial and Industrial, Commercial Real Estate, Residential Real Estate and Consumer borrowings. An asset quality rating is assigned using the guidance provided in the Bank’s loan policy. Primary responsibility for assigning the asset quality rating rests with the lender. The asset quality rating is validated periodically by both an internal and external loan review process.

 

The commercial loan grading system focuses on a borrower’s financial strength and performance, experience and depth of management, primary and secondary sources of repayment, the nature of the business and the outlook for the particular industry. Primary emphasis is placed on financial condition and trends. The grade also reflects current economic and industry conditions; as well as other variables such as liquidity, cash flow, revenue/earnings trends, management strengths or weaknesses, quality of financial information, and credit history.

 

The loan grading system for Residential Real Estate and Consumer loans focuses on the borrower’s credit score and credit history, debt-to-income ratio and income sources, collateral position and loan-to-value ratio, as well as other variables such as current economic conditions, and individual strengths and weaknesses.

 

 17 

 

 

Risk grade characteristics are as follows:

 

Risk Grade 1 – MINIMAL RISK through Risk Grade 6 – MANAGEMENT ATTENTION (Pass Grade Categories)

 

Risk is evaluated via examination of several attributes including but not limited to financial trends, strengths and weaknesses, likelihood of repayment when considering both cash flow and collateral, sources of repayment, leverage position, management expertise, and repayment history.

 

At the low-risk end of the rating scale, a risk grade of 1 – Minimal Risk is the grade reserved for loans with exceptional credit fundamentals and virtually no risk of default or loss. Loan grades then progress through escalating ratings of 2 through 6 based upon risk. Risk Grade 2 – Modest Risk are loans with sufficient cash flows; Risk Grade 3 – Average Risk are loans with key balance sheet ratios slightly above the borrower’s peers; Risk Grade 4 – Acceptable Risk are loans with key balance sheet ratios usually near the borrower’s peers, but one or more ratios may be higher; and Risk Grade 5 – Marginally Acceptable are loans with strained cash flow, increasing leverage and/or weakening markets. Risk Grade 6 – Management Attention are loans with weaknesses resulting from declining performance trends and the borrower’s cash flows may be temporarily strained. Loans in this category are performing according to terms, but present some type of potential concern.

 

Risk Grade 7 − SPECIAL MENTION (Non-Pass Category)

 

Generally, these loans or assets are currently protected, but are “potentially weak.” They constitute an undue and unwarranted credit risk but not to the point of justifying a classification of substandard.

 

Assets in this category are currently protected but have potential weakness which may, if not checked or corrected, weaken the asset or inadequately protect the Bank’s credit position at some future date. No loss of principal or interest is envisioned; however, they constitute an undue credit risk that may be minor but is unwarranted in light of the circumstances surrounding a specific asset. Risk is increasing beyond that at which the loan originally would have been granted. Historically, cash flows are inconsistent; financial trends show some deterioration. Liquidity and leverage are above industry averages. Financial information could be incomplete or inadequate. A Special Mention asset has potential weaknesses that deserve management’s close attention.

 

Risk Grade 8 − SUBSTANDARD (Non-Pass Category)

 

Generally, these assets are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified must have “well-defined” weaknesses that jeopardize the full liquidation of the debt.

 

These loans are characterized by the distinct possibility that the Bank will sustain some loss if the aggregate amount of substandard assets is not fully covered by the liquidation of the collateral used as security. Substandard loans have a high probability of payment default and require more intensive supervision by Bank management.

 

Risk Grade 9 − DOUBTFUL (Non-Pass Category)

 

Generally, loans graded doubtful have all the weaknesses inherent in a substandard loan with the added factor that the weaknesses are pronounced to a point whereby the basis of current information, conditions, and values, collection or liquidation in full is deemed to be highly improbable. The possibility of loss is extremely high, but because of certain important and reasonably specific pending factors that may work to strengthen the asset, its classification is deferred until, for example, a proposed merger, acquisition, liquidation procedure, capital injection, perfection of liens on additional collateral and/or refinancing plan is completed. Loans are graded doubtful if they contain weaknesses so serious that collection or liquidation in full is questionable.

 

 18 

 

 

The following table presents the classes of the loan portfolio summarized by risk rating as of September 30, 2017 and December 31, 2016:

 

   Commercial and         
(Dollars in thousands)  Industrial   Commercial Real Estate 
   September 30,   December 31,   September 30,   December 31, 
   2017   2016   2017   2016 
Grade:                    
1-6    Pass  $91,704   $78,319   $259,331   $243,023 
7       Special Mention   12    4,425    2,355    6,224 
8       Substandard   1,352    684    14,614    13,817 
9       Doubtful                
Add (deduct):   Unearned discount and                
Net deferred loan fees and costs   168    145    549    455 
Total loans  $93,236   $83,573   $276,849   $263,519 

 

   Residential Real Estate     
   Including Home Equity   Consumer 
   September 30,   December 31,   September 30,   December 31, 
   2017   2016   2017   2016 
Grade:                    
1-6    Pass  $164,111   $165,862   $6,122   $6,073 
7        Special Mention   788    1,664    1    71 
8        Substandard   1,601    1,523    25    9 
9        Doubtful                
Add (deduct):   Unearned discount and   (2)   (6)        
Net deferred loan fees and costs   (40)   (8)   94    102 
Total loans  $166,458   $169,035   $6,242   $6,255 

 

   Total Loans 
   September 30,   December 31, 
   2017   2016 
Grade:        
1-6    Pass  $521,268   $493,277 
7       Special Mention   3,156    12,384 
8       Substandard   17,592    16,033 
9       Doubtful        
Add (deduct):   Unearned discount and   (2)   (6)
Net deferred loan fees and costs   771    694 
Total loans  $542,785   $522,382 

 

Commercial and Industrial and Commercial Real Estate include loans categorized as tax-free in the amounts of $45,954,000 and $2,351,000 at September 30, 2017 and $36,289,000 and $2,780,000 at December 31, 2016. Loans held for sale amounted to $1,399,000 at September 30, 2017 and $100,000 at December 31, 2016.

 

 19 

 

 

The activity in the allowance for loan losses, by loan class, is summarized below for the periods indicated.

 

(Dollars in thousands)  Commercial   Commercial   Residential             
   and Industrial   Real Estate   Real Estate   Consumer   Unallocated   Total 
As of and for the three month period ended September 30, 2017:                              
Allowance for Loan Losses:                              
Beginning balance  $845   $4,582   $1,712   $103   $111   $7,353 
Charge-offs               (25)       (25)
Recoveries   1    25    9    1        36 
Provision   55    (35)   30    35    (1)   84 
Ending Balance  $901   $4,572   $1,751   $114   $110   $7,448 

 

(Dollars in thousands)  Commercial   Commercial   Residential             
   and Industrial   Real Estate   Real Estate   Consumer   Unallocated   Total 
As of and for the nine month period ended September 30, 2017:                              
Allowance for Loan Losses:                              
Beginning balance  $836   $4,421   $1,777   $95   $228   $7,357 
Charge-offs       (97)   (61)   (59)       (217)
Recoveries   74    52    9    6        141 
Provision   (9)   196    26    72    (118)   167 
Ending Balance  $901   $4,572   $1,751   $114   $110    7,448 
Ending balance: individually evaluated for impairment  $   $161   $16   $   $   $177 
Ending balance: collectively evaluated for impairment  $901   $4,411   $1,735   $114   $110   $7,271 
                               
Loans Receivable:                              
Ending Balance  $93,236   $276,849   $166,458   $6,242   $   $542,785 
Ending balance: individually evaluated for impairment  $1,218   $13,992   $976   $   $   $16,186 
Ending balance: collectively evaluated for impairment  $92,018   $262,857   $165,482   $6,242   $   $526,599 

 

(Dollars in thousands)  Commercial   Commercial   Residential             
   and Industrial   Real Estate   Real Estate   Consumer   Unallocated   Total 
As of and for the three month period ended September 30, 2016:                              
Allowance for Loan Losses:                              
Beginning balance  $702   $4,014   $1,697   $106   $700   $7,219 
Charge-offs   (193)   (1,133)   (20)   (9)       (1,355)
Recoveries   2            1        3 
Provision   272    1,393    35    2    (569)   1,133 
Ending Balance  $783   $4,274   $1,712   $100   $131   $7,000 

 

 20 

 

 

(Dollars in thousands)  Commercial   Commercial   Residential             
   and Industrial   Real Estate   Real Estate   Consumer   Unallocated   Total 
As of and for the nine month period ended September 30, 2016:                              
Allowance for Loan Losses:                              
Beginning balance  $725   $3,983   $1,777   $96   $158   $6,739 
Charge-offs   (195)   (1,190)   (45)   (32)       (1,462)
Recoveries   6        12    5        23 
Provision   247    1,481    (32)   31    (27)   1,700 
Ending Balance  $783   $4,274   $1,712   $100   $131   $7,000 
Ending balance: individually evaluated for impairment  $   $150   $19   $   $   $169 
Ending balance: collectively evaluated for impairment  $783   $4,124   $1,693   $100   $131   $6,831 
                               
Loans Receivable:                              
Ending Balance  $80,328   $258,762   $168,546   $6,375   $   $514,011 
Ending balance: individually evaluated for impairment  $418   $13,014   $836   $   $   $14,268 
Ending balance: collectively evaluated for impairment  $79,910   $245,748   $167,710   $6,375   $   $499,743 

 

(Dollars in thousands)  Commercial   Commercial   Residential             
   and Industrial   Real Estate   Real Estate   Consumer   Unallocated   Total 
As of and for the year ended December 31, 2016                              
Allowance for Loan Losses:                              
Beginning balance  $725   $3,983   $1,777   $96   $158   $6,739 
Charge-offs   (195)   (1,200)   (61)   (38)       (1,494)
Recoveries   9        12    8        29 
Provision   297    1,638    49    29    70    2,083 
Ending Balance  $836   $4,421   $1,777   $95   $228   $7,357 
Ending balance: individually evaluated for impairment  $   $200   $19   $   $   $219 
Ending balance: collectively evaluated for impairment  $836   $4,221   $1,758   $95   $228   $7,138 
                               
Loans Receivable:                              
Ending Balance  $83,573   $263,519   $169,035   $6,255   $   $522,382 
Ending balance: individually evaluated for impairment  $416   $12,873   $1,008   $   $   $14,297 
Ending balance: collectively evaluated for impairment  $83,157   $250,646   $168,027   $6,255   $   $508,085 

 

Of the $1,078,000 in foreclosed assets held for resale at September 30, 2017, $22,000 was secured by residential real estate, $50,000 was secured by land, and $1,006,000 was secured by commercial real estate. Of the $1,273,000 in foreclosed assets held for resale at December 31, 2016, $50,000 was secured by residential real estate, $50,000 was secured by land, and $1,173,000 was secured by commercial real estate. At September 30, 2017 and December 31, 2016, all foreclosed assets were held as the result of obtaining physical possession. Consumer mortgage loans secured by residential real estate for which the Bank has entered into formal foreclosure proceedings but for which physical possession of the property has yet to be obtained amounted to $498,000 at September 30, 2017 and $649,000 at December 31, 2016. These balances were not included in foreclosed assets held for resale at September 30, 2017 or December 31, 2016.

 

 21 

 

 

From time to time, the Bank may agree to modify the contractual terms of a borrower’s loan. In cases where the modifications represent a concession to a borrower experiencing financial difficulty, the modification is considered a troubled debt restructuring (“TDR”).

 

The outstanding recorded investment of TDRs as of September 30, 2017 and December 31, 2016 was $10,851,000 and $11,629,000, respectively. The decrease in TDRs at September 30, 2017 as compared to December 31, 2016 is attributable to large principal payments and paydowns made on existing TDRs net against smaller loans modified as TDRs during the nine months ended September 30, 2017. There was $2,000 in unfunded commitments on TDRs at September 30, 2017 and December 31, 2016.

 

During the three months ended September 30, 2017, no loans were modified as TDRs as compared to the same period in 2016, when two loans with a combined post modification balance of $1,860,000 were classified as TDRs. The loan modifications for the three months ended September 30, 2016 consisted of one term modification and one payment modification.

 

During the nine months ended September 30, 2017, two loans with a combined post modification balance of $107,000 were classified as TDRs, as compared to the same period in 2016, when nine loans with a combined post modification balance of $2,402,000 were classified as TDRs. The loan modifications for the nine months ended September 30, 2017 consisted of two payment modifications. The loan modifications for the nine months ended September 30, 2016 consisted of six term modifications and three payment modifications.

 

The following table presents the outstanding recorded investment of TDRs at the dates indicated:

 

(Dollars in thousands)        
   September 30,   December 31, 
   2017   2016 
Non-accrual TDRs  $280   $267 
Accruing TDRs   10,571    11,362 
Total  $10,851   $11,629 

 

At September 30, 2017, eight Commercial Real Estate loans classified as TDRs with a combined recorded investment of $469,000 and one Commercial and Industrial loan with a recorded investment of $12,000 were not in compliance with the terms of their restructure, compared to September 30, 2016 when nine Commercial Real Estate loans classified as TDRs with a combined recorded investment of $781,000 were not in compliance with the terms of their restructure.

 

During the three months ended September 30, 2017, no loans that were modified as TDRs within the preceding twelve months had experienced payment defaults, as compared to the same period in 2016 when one Commercial and Industrial loan in the amount of $15,000 that was modified as a TDR within the preceding twelve months had experienced a payment default. During the nine months ended September 30, 2017, no loans that were modified as TDRs within the preceding twelve months had experienced payment defaults, as compared to the same period in 2016 when one Commercial and Industrial loan in the amount of $15,000 that was modified as a TDR within the preceding twelve months had experienced a payment default.

 

The following table presents information regarding the loan modifications categorized as TDRs during the nine months ended September 30, 2017 and the three and nine months ended September 30, 2016. No loans were modified as TDRs during the three months ended September 30, 2017.

 

(Dollars in thousands)  Three Months Ended September 30, 2016 
       Pre-Modification   Post-Modification     
   Number   Outstanding Recorded   Outstanding Recorded   Recorded 
   of Contracts   Investment   Investment   Investment 
Commercial and Industrial      $   $   $ 
Commercial Real Estate   2    1,860    1,860    1,858 
Total   2   $1,860   $1,860   $1,858 

 

 22 

 

 

(Dollars in thousands)  Nine Months Ended September 30, 2017 
       Pre-Modification   Post-Modification     
   Number   Outstanding Recorded   Outstanding Recorded   Recorded 
   of Contracts   Investment   Investment   Investment 
Commercial and Industrial   1   $38   $38   $37 
Commercial Real Estate   1    72    72    70 
Total   2   $110   $110   $107 

 

(Dollars in thousands)  Nine Months Ended September 30, 2016 
       Pre-Modification   Post-Modification     
   Number   Outstanding Recorded   Outstanding Recorded   Recorded 
   of Contracts   Investment   Investment   Investment 
Commercial and Industrial   4   $86   $86   $22 
Commercial Real Estate   5    2,316    2,316    2,064 
Total   9   $2,402   $2,402   $2,086 

 

The following table provides detail regarding the types of loan modifications made for loans categorized as TDRs during the nine months ended September 30, 2017 and the three and nine months ended September 30, 2016 with the total number of each type of modification performed. No loans were modified as TDRs during the three months ended September 30, 2017.

 

   Nine Months Ended September 30, 2017 
   Rate   Term   Payment   Number 
   Modification   Modification   Modification   Modified 
Commercial and Industrial           1    1 
Commercial Real Estate           1    1 
Total           2    2 

 

   Three Months Ended September 30, 2016   Nine Months Ended September 30, 2016 
   Rate   Term   Payment   Number   Rate   Term   Payment   Number 
   Modification   Modification   Modification   Modified   Modification   Modification   Modification   Modified 
Commercial and Industrial                       3    1    4 
Commercial Real Estate       1    1    2        3    2    5 
Total       1    1    2        6    3    9 

 

During the nine months ended September 30, 2017, two existing TDRs experienced subsequent modifications. An existing Commercial and Industrial TDR to the owner of a greenhouse in the amount of $309,000 was subsequently modified during the nine months ended September 30, 2017 to extend the maturity date of the loan and change payments to interest-only with all other accrued interest and principal to be due in full at maturity. An existing Commercial Real Estate TDR to a travel agency in the amount of $38,000 was subsequently modified during the nine months ended September 30, 2017 to allow interest only payments through April 2018, after which time regular principal and interest payments will commence. Both TDRs retain their original classification as “payment” modifications as of September 30, 2017.

 

 23 

 

 

The recorded investment, unpaid principal balance, and the related allowance of the Corporation’s impaired loans are summarized below for the periods ended September 30, 2017 and December 31, 2016.

 

(Dollars in thousands)  September 30, 2017   December 31, 2016 
       Unpaid           Unpaid     
   Recorded   Principal   Related   Recorded   Principal   Related 
   Investment   Balance   Allowance   Investment   Balance   Allowance 
With no related allowance recorded:                              
Commercial and Industrial  $1,218   $1,218   $   $416   $416   $ 
Commercial Real Estate   11,279    13,528        11,905    14,352     
Residential Real Estate   804    950        584    745     
                               
With an allowance recorded:                              
Commercial and Industrial                        
Commercial Real Estate   2,713    4,128    161    968    2,383    200 
Residential Real Estate   172    172    16    424    424    19 
Total  $16,186   $19,996   $177   $14,297   $18,320   $219 
                               
Total consists of:                              
Commercial and Industrial  $1,218   $1,218   $   $416   $416   $ 
Commercial Real Estate  $13,992   $17,656   $161   $12,873   $16,735   $200 
Residential Real Estate  $976   $1,122   $16   $1,008   $1,169   $19 

 

 

At September 30, 2017 and December 31, 2016, $10,851,000 and $11,629,000 of loans classified as TDRs were included in impaired loans with a total allocated allowance of $7,000 and $0, respectively. The recorded investment represents the loan balance reflected on the Consolidated Balance Sheets net of any charge-offs. The unpaid principal balance is equal to the gross amount due on the loan.

 

The average recorded investment and interest income recognized for the Corporation’s impaired loans are summarized below for the three and nine months ended September 30, 2017 and 2016.

 

(Dollars in thousands)  For the Three Months Ended   For the Three Months Ended 
   September 30, 2017   September 30, 2016 
   Average   Interest   Average   Interest 
   Recorded   Income   Recorded   Income 
   Investment   Recognized   Investment   Recognized 
With no related allowance recorded:                    
Commercial and Industrial  $1,225   $5   $455   $2 
Commercial Real Estate   11,353    127    12,132    160 
Residential Real Estate   813    1    415     
                     
With an allowance recorded:                    
Commercial and Industrial                
Commercial Real Estate   2,271    2    958     
Residential Real Estate   163        424     
Total  $15,825   $135   $14,384   $162 
                     
Total consists of:                    
Commercial and Industrial  $1,225   $5   $455   $2 
Commercial Real Estate  $13,624   $129   $13,090   $160 
Residential Real Estate  $976   $1   $839   $ 

 

 

Of the $135,000 and $162,000 in interest income recognized on impaired loans for the three months ended September 30, 2017 and 2016, respectively, $1,000 and $5,000 in interest income was recognized with respect to non-accrual loans.

 

 24 

 

 

(Dollars in thousands)  For the Nine Months Ended   For the Nine Months Ended 
   September 30, 2017   September 30, 2016 
   Average   Interest   Average   Interest 
   Recorded   Income   Recorded   Income 
   Investment   Recognized   Investment   Recognized 
With no related allowance recorded:                    
Commercial and Industrial  $1,240   $21   $473   $12 
Commercial Real Estate   11,730    376    10,396    331 
Residential Real Estate   910    2    417     
                     
With an allowance recorded:                    
Commercial and Industrial                
Commercial Real Estate   1,498    2    3,350    74 
Residential Real Estate   229        427     
Total  $15,607   $401   $15,063   $417 
                     
Total consists of:                    
Commercial and Industrial  $1,240   $21   $473   $12 
Commercial Real Estate  $13,228   $378   $13,746   $405 
Residential Real Estate  $1,139   $2   $844   $ 

 

 

Of the $401,000 and $417,000 in interest income recognized on impaired loans for the nine months ended September 30, 2017 and 2016, respectively, $18,000 and $5,000 in interest income was recognized with respect to non-accrual loans.

 

Total non-performing assets (which includes loans receivable on non-accrual status, foreclosed assets held for resale and loans past-due 90 days or more and still accruing interest) as of September 30, 2017 and December 31, 2016 were as follows:

 

(Dollars in thousands)        
   September 30,   December 31, 
   2017   2016 
Commercial and Industrial  $811   $ 
Commercial Real Estate   3,828    1,927 
Residential Real Estate   976    1,008 
Total non-accrual loans   5,615    2,935 
Foreclosed assets held for resale   1,078    1,273 
Loans past-due 90 days or more and still accruing interest   119    34 
Total non-performing assets  $6,812   $4,242 

 

The following tables present the classes of the loan portfolio summarized by past-due status at September 30, 2017 and December 31, 2016:

 

(Dollars in thousands)                          90 Days 
                           Or Greater 
                           Past Due 
           90 Days               and Still 
   30-59 Days   60-89 Days   or Greater   Total       Total   Accruing 
   Past Due   Past Due   Past Due   Past Due   Current   Loans   Interest 
September 30, 2017:                                   
Commercial and Industrial  $54   $13   $   $67   $93,169   $93,236   $ 
Commercial Real Estate   892    372    834    2,098    274,751    276,849    97 
Residential Real Estate   2,099    247    465    2,811    163,647    166,458    22 
Consumer   25    10        35    6,207    6,242     
Total  $3,070   $642   $1,299   $5,011   $537,774   $542,785   $119 

 

 25 

 

 

(Dollars in thousands)                          90 Days 
                           Or Greater 
                           Past Due 
           90 Days               and Still 
   30-59 Days   60-89 Days   or Greater   Total       Total   Accruing 
   Past Due   Past Due   Past Due   Past Due   Current   Loans   Interest 
December 31, 2016:                                   
Commercial and Industrial  $130   $   $   $130   $83,443   $83,573   $ 
Commercial Real Estate   1,019    273    1,927    3,219    260,300    263,519     
Residential Real Estate   1,750    542    1,020    3,312    165,723    169,035    34 
Consumer   28    8        36    6,219    6,255     
Total  $2,927   $823   $2,947   $6,697   $515,685   $522,382   $34 

 

At September 30, 2017 and December 31, 2016, commitments to lend additional funds with respect to impaired loans consisted of three irrevocable letters of credit totaling $1,268,000. One irrevocable letter of credit in the amount of $1,249,000 was associated with a loan to a developer of a residential sub-division. Two irrevocable letters of credit totaling $19,000 were associated with a loan to a non-profit community recreation facility.

 

NOTE 5BORROWINGS

 

Short-Term Borrowings

 

Short-term borrowings include federal funds purchased, securities sold under agreements to repurchase, the Federal Discount Window, and Federal Home Loan Bank (“FHLB”) advances, which generally represent overnight or less than 30-day borrowings.

 

Securities Sold Under Agreements to Repurchase (“Repurchase Agreements”)

 

The Corporation enters into agreements under which it sells securities subject to an obligation to repurchase the same or similar securities. Under these arrangements, the Corporation may transfer legal control over the assets but still retain effective control through an agreement that both entitles and obligates the Corporation to repurchase the assets.

 

As a result, these repurchase agreements are accounted for as collateralized financing agreements (i.e., secured borrowings) and not as a sale and subsequent repurchase of securities. The obligation to repurchase the securities is reflected as a liability on the Corporation’s Consolidated Balance Sheets, while the securities underlying the repurchase agreements remain in the respective investment securities asset accounts. In other words, there is not offsetting or netting of the investment securities assets with the repurchase agreement liabilities. In addition, as the Corporation does not enter into reverse repurchase agreements, there is no such offsetting to be done with the repurchase agreements.

 

The right of setoff for a repurchase agreement resembles a secured borrowing, whereby the collateral would be used to settle the fair value of the repurchase agreement should the Corporation be in default (e.g., fails to make an interest payment to the counterparty). The collateral is held by a correspondent bank in the counterparty’s custodial account. The counterparty has the right to sell or repledge the investment securities.

 

 26 

 

 

The following table presents the short-term borrowings subject to an enforceable master netting arrangement or repurchase agreements as of September 30, 2017 and December 31, 2016.

 

(Dollars in thousands)      Gross   Net Amounts             
       Amounts   of Liabilities             
       Offset   Presented             
   Gross   in the   in the             
   Amounts of   Consolidated   Consolidated       Cash     
   Recognized   Balance   Balance   Financial   Collateral   Net 
   Liabilities   Sheet   Sheet   Instruments   Pledge   Amount 
September 30, 2017                              
Repurchase agreements (a)  $20,397   $   $20,397   $(20,397)  $   $ 
                               
December 31, 2016                              
Repurchase agreements (a)  $18,490   $   $18,490   $(18,490)  $   $ 

 

 

(a) As of September 30, 2017 and December 31, 2016, the fair value of securities pledged in connection with repurchase agreements was $24,764,000 and $25,298,000, respectively.

 

The following table presents the remaining contractual maturity of the master netting arrangement or repurchase agreements as of September 30, 2017:

 

(Dollars in thousands)  Remaining Contractual Maturity of the Agreements 
   Overnight           Greater     
   and   Up to   30 -90   than     
   Continuous   30 days   Days   90 Days   Total 
September 30, 2017:                    
Repurchase agreements and repurchase-to-maturity transactions:                         
U.S. Treasury and/or agency securities  $20,397   $   $   $   $20,397 
Total  $20,397   $   $   $   $20,397 

 

Long-Term Borrowings

 

Long-term borrowings are comprised of advances from FHLB and a capital lease assumed as a result of the acquisition of Pocono Community Bank. Under terms of a blanket agreement, collateral for the FHLB loans is certain qualifying assets of the Corporation’s banking subsidiary. The principal assets are real estate mortgages and certain investment securities.

 

NOTE 6COMMITMENTS AND CONTINGENCIES

 

In the normal course of business, there are various pending legal actions and proceedings that are not reflected in the consolidated financial statements. Management does not believe the outcome of these actions and proceedings will have a material effect on the consolidated financial position or results of operations of the Corporation.

 

NOTE 7 — FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND CONCENTRATIONS OF CREDIT RISK

 

Financial Instruments with Off Balance Sheet Risk

 

The Corporation is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Consolidated Balance Sheets. The contract or notional amounts of those instruments reflect the extent of involvement the Corporation has in particular classes of financial instruments. The Corporation does not engage in trading activities with respect to any of its financial instruments with off-balance sheet risk.

 

 27 

 

 

The Corporation’s exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments.

 

The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

 

The Corporation may require collateral or other security to support financial instruments with off-balance sheet credit risk.

 

The contract or notional amounts at September 30, 2017 and December 31, 2016, were as follows:

 

(Dollars in thousands)        
   September 30, 2017   December 31, 2016 
Financial instruments whose contract amounts represent credit risk:          
Commitments to extend credit  $96,567   $84,519 
Financial standby letters of credit  $440   $453 
Performance standby letters of credit  $2,994   $5,341 

 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses that may require payment of a fee. Since some of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Corporation evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation upon extension of credit, is based on management’s credit evaluation of the borrower. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, owner-occupied income-producing commercial properties, and residential real estate.

 

Standby letters of credit are conditional commitments issued by the Corporation to guarantee payment to a third party when a customer either fails to repay an obligation or fails to perform some non-financial obligation. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Corporation may hold collateral (similar to the items held as collateral for commitments to extend credit) to support standby letters of credit for which collateral is deemed necessary.

 

Financial Instruments with Concentrations of Credit Risk

 

The Corporation originates primarily commercial and residential real estate loans to customers in northeastern Pennsylvania. The ability of the majority of the Corporation’s customers to honor their contractual loan obligations is dependent on the economy and real estate market in this area. At September 30, 2017, the Corporation had $443,307,000 in loans secured by real estate, which represented 81.7% of total loans. The real estate loan portfolio is largely secured by lessors of residential buildings and dwellings, lessors of non-residential buildings, and lessors of hotels/motels. As of September 30, 2017 and December 31, 2016, management is of the opinion that there were no concentrations exceeding 10% of total loans with regard to loans to borrowers who were engaged in similar activities that were similarly impacted by economic or other conditions.

 

As all financial instruments are subject to some level of credit risk, the Corporation requires collateral and/or guarantees for all loans. Collateral may include, but is not limited to property, plant, and equipment, commercial and/or residential real estate property, land, and pledge of securities. In the event of a borrower’s default, the collateral supporting the loan may be seized in order to recoup losses associated with the loan. The Corporation also establishes an allowance for loan losses that constitutes the amount available to absorb losses within the loan portfolio that may exist due to deficiencies in collateral values.

 

NOTE 8FAIR VALUE MEASUREMENTS

 

Fair value measurement and disclosure guidance defines fair value as the price that would be received to sell the asset or transfer the liability in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. This guidance provides additional information on determining when the volume and level of activity for the asset or liability has significantly decreased. The guidance also includes information on identifying circumstances when a transaction may not be considered orderly.

 

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Fair value measurement and disclosure guidance provides a list of factors that a reporting entity should evaluate to determine whether there has been a significant decrease in the volume and level of activity for the asset or liability in relation to normal market activity for the asset or liability. When the reporting entity concludes there has been a significant decrease in the volume and level of activity for the asset or liability, further analysis of the information from that market is needed and significant adjustments to the related prices may be necessary to estimate fair value in accordance with the fair value measurement and disclosure guidance.

 

This guidance clarifies that when there has been a significant decrease in the volume and level of activity for the asset or liability, some transactions may not be orderly. In those situations, the entity must evaluate the weight of the evidence to determine whether the transaction is orderly. The guidance provides a list of circumstances that may indicate that a transaction is not orderly. A transaction price that is not associated with an orderly transaction is given little, if any, weight when estimating fair value.

 

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from independent sources, or unobservable, meaning those that reflect the reporting entity’s own belief about the assumptions market participants would use in pricing the asset or liability based upon the best information available in the circumstances. Fair value measurement and disclosure guidance establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

 

Level 1 Inputs: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;

 

Level 2 Inputs: Quoted prices in markets that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability;

 

Level 3 Inputs: Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity).

 

A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth as follows.

 

Financial Assets Measured at Fair Value on a Recurring Basis

 

At September 30, 2017 and December 31, 2016, investments measured at fair value on a recurring basis and the valuation methods used are as follows:

 

(Dollars in thousands)                
                 
   Level 1   Level 2   Level 3   Total 
September 30, 2017                    
Available-for-Sale Securities:                    
U.S. Treasury securities  $   $   $   $ 
Obligations of U.S. Government Corporations and Agencies:                    
Mortgage-backed       86,539        86,539 
Other       23,040        23,040 
Obligations of state and political subdivisions       220,711        220,711 
Corporate debt securities       29,070        29,070 
Marketable equity securities   1,732            1,732 
Total  $1,732   $359,360   $   $361,092 

 

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(Dollars in thousands)                
                 
  Level 1   Level 2   Level 3   Total 
December 31, 2016                    
Available-for-Sale Securities:                    
U.S. Treasury securities  $   $1,010   $   $1,010 
Obligations of U.S. Government Corporations and Agencies:                    
Mortgaged-backed       110,907        110,907 
Other       20,970        20,970 
Obligations of state and political subdivisions       211,134        211,134 
Corporate debt securities       33,976        33,976 
Marketable equity securities   1,640            1,640 
Total  $1,640   $377,997   $   $379,637 

 

The estimated fair values of equity securities classified as Level 1 are derived from quoted market prices in active markets; these assets consist mainly of stocks held in other banks. The estimated fair values of all debt securities classified as Level 2 are obtained from nationally-recognized third-party pricing agencies. The estimated fair values are derived primarily from cash flow models, which include assumptions for interest rates, credit losses, and prepayment speeds. The significant inputs utilized in the cash flow models are based on market data obtained from sources independent of the Corporation (observable inputs), and are therefore classified as Level 2 within the fair value hierarchy. The Corporation does not have any Level 3 inputs for investments. There were no transfers between Level 1 and Level 2 during 2017 or 2016.

 

Financial Assets Measured at Fair Value on a Nonrecurring Basis

 

At September 30, 2017 and December 31, 2016, impaired loans measured at fair value on a nonrecurring basis and the valuation methods used are as follows:

 

(Dollars in thousands)                
   Level 1   Level 2   Level 3   Total 
Assets at September 30, 2017                    
Impaired loans:                    
Commercial Real Estate  $   $   $6,402   $6,402 
Residential Real Estate           260    260 
Total impaired loans  $   $   $6,662   $6,662 

 

(Dollars in thousands)                
   Level 1   Level 2   Level 3   Total 
Assets at December 31, 2016                    
Impaired loans:                    
Commercial Real Estate  $   $   $4,763   $4,763 
Residential Real Estate           524    524 
Total impaired loans  $   $   $5,287   $5,287 

 

The Bank’s impaired loan valuation procedure for any loans greater than $250,000 requires an appraisal to be obtained and reviewed annually at year end. A quarterly collateral evaluation is performed which may include a site visit, property pictures and discussions with realtors and other similar business professionals to ascertain current values. For impaired loans less than $250,000 upon classification and annually at year end, the Bank completes a Certificate of Inspection, which includes an onsite inspection, insured values, tax assessed values, recent sales comparisons and a review of the previous evaluations. These assets are included as Level 3 fair values, based upon the lowest level that is significant to the fair value measurements. The fair value consists of the impaired loan balances less the valuation allowance and/or charge-offs. There were no transfers between valuation levels in 2017 and 2016.

 

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Nonfinancial Assets Measured at Fair Value on a Nonrecurring Basis

 

At September 30, 2017 and December 31, 2016, foreclosed assets held for resale measured at fair value on a nonrecurring basis and the valuation methods used are as follows:

 

(Dollars in thousands)  Level 1   Level 2   Level 3   Total 
Assets at September 30, 2017                    
Foreclosed assets held for resale:                    
Commercial Real Estate  $   $   $81   $81 
Total foreclosed assets held for resale  $   $   $81   $81 

 

(Dollars in thousands)  Level 1   Level 2   Level 3   Total 
Assets at December 31, 2016                    
Other foreclosed assets held for resale:                    
Commercial Real Estate  $   $   $248   $248 
Total foreclosed assets held for resale  $   $   $248   $248 

 

The Bank’s foreclosed asset valuation procedure requires an appraisal, which considers the sales prices of similar properties in the proximate vicinity, to be completed periodically with the exception of those cases which the Bank has obtained a sales agreement. These assets are included as Level 3 fair values, based upon the lowest level that is significant to the fair value measurements. There were no transfers between valuation levels in 2017 and 2016.

 

The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis and for which the Bank has utilized Level 3 inputs to determine the fair value:

 

   Quantitative Information about Level 3 Fair Value Measurements 
   Fair Value            Weighted 
(Dollars in thousands)  Estimate   Valuation Technique  Unobservable Input  Range  Average 
September 30, 2017                   
Impaired loans  $3,389   Appraisal of collateral1,3  Appraisal adjustments2  (10%) – (57%)   (17%)
Impaired loans  $3,273   Discounted cash flow  Discount rate  (7%) – (8%)   (7%)
Foreclosed assets held for resale  $81   Appraisal of collateral1,3  Appraisal adjustments2  (35%) – (35%)   (35%)
                    
December 31, 2016                   
Impaired loans  $2,119   Appraisal of collateral1,3  Appraisal adjustments2  (10%) – (79%)   (21%)
Impaired loans  $3,168   Discounted cash flow  Discount rate  (7%) – (7%)   (7%)
Foreclosed assets held for resale  $248   Appraisal of collateral1,3  Appraisal adjustments2  (23%) – (37%)   (32%)

 

 

1Fair value is generally determined through independent appraisals of the underlying collateral, as defined by Bank regulators.

2Appraisals may be adjusted downward by management for qualitative factors such as economic conditions and estimated liquidation expenses. The typical range of appraisal adjustments are presented as a percent of the appraisal value.

3Includes qualitative adjustments by management and estimated liquidation expenses.

 

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Fair Value of Financial Instruments

 

   Carrying   Fair Value Measurements at September 30, 2017 
(Dollars in thousands)  Amount   Level 1   Level 2   Level 3   Total 
FINANCIAL ASSETS:                         
Cash and due from banks  $9,371   $9,371   $   $   $9,371 
Interest-bearing deposits in other banks   1,744        1,744        1,744 
Time deposits with other banks   1,482        1,482        1,482 
Investment securities available-for-sale   361,092    1,732    359,360        361,092 
Investment securities held-to-maturity                    
Restricted investment in bank stocks   4,472        4,472        4,472 
Net loans   535,337            537,800    537,800 
Mortgage servicing rights   381            381    381 
Accrued interest receivable   4,034        4,034        4,034 
                          
FINANCIAL LIABILITIES:                         
Core Deposits   562,839        562,839        562,839 
Time Deposits   196,877        196,357        196,357 
Short-term borrowings   41,209        41,209        41,209 
Long-term borrowings   65,022        65,549        65,549 
Accrued interest payable   505        505        505 
                          
OFF-BALANCE SHEET FINANCIAL INSTRUMENTS                    

 

   Carrying   Fair Value Measurements at December 31, 2016 
(Dollars in thousands)  Amount   Level 1   Level 2   Level 3   Total 
FINANCIAL ASSETS:                         
Cash and due from banks  $8,338   $8,338   $   $   $8,338 
Interest-bearing deposits in other banks   790        790        790 
Time deposits with other banks   1,482        1,482        1,482 
Investment securities available-for-sale   379,637    1,640    377,997        379,637 
Investment securities held-to-maturity   4        4        4 
Restricted investment in bank stocks   5,477        5,477        5,477 
Net loans   515,025            504,206    504,206 
Mortgage servicing rights   431            431    431 
Accrued interest receivable   3,917        3,917        3,917 
                          
FINANCIAL LIABILITIES:                         
Core Deposits   532,661        532,661        532,661 
Time Deposits   193,321        192,812        192,812 
Short-term borrowings   69,290        69,290        69,290 
Long-term borrowings   75,116        75,718        75,718 
Accrued interest payable   427        427        427 
                          
OFF-BALANCE SHEET FINANCIAL INSTRUMENTS                    

 

The following information should not be interpreted as an estimate of the fair value of the entire Corporation since a fair value calculation is only provided for a limited portion of the Corporation’s assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between the Corporation’s disclosures and those of other companies may not be meaningful. The following methods and assumptions were used to estimate the fair values of the Corporation’s financial instruments at September 30, 2017 and December 31, 2016:

 

 32 

 

 

Cash and Due From Banks, Interest-Bearing Deposits in Other Banks, Time Deposits with Other Banks, Restricted Investment in Bank Stocks, Accrued Interest Receivable and Accrued Interest Payable

 

The fair values are equal to the current carrying values.

 

Investment Securities

 

The fair values of investment securities are determined by obtaining quoted market prices on nationally recognized securities exchanges (Level 1) or matrix pricing (Level 2), which is a mathematical technique used widely in the industry to value debt securities without relying on the securities’ relationship to other benchmark quoted prices.

 

Loans

 

Fair values are estimated for categories of loans with similar financial characteristics. Loans are segregated by type such as Commercial and Industrial, Commercial and Residential Real Estate mortgages and Consumer. For estimation purposes, each loan category is further segmented into fixed and adjustable rate interest terms.

 

The fair value of each category of performing loans is calculated by discounting future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.

 

Fair value for impaired loans is based on management’s estimate of future cash flows discounted using a rate commensurate with the risk associated with the estimated future cash flows or based on the value of the collateral if repayment is expected solely from collateral. The assumptions used by management are judgmentally determined using information regarding each specific borrower.

 

Mortgage Servicing Rights

 

Servicing rights are carried at cost. The carrying amount approximates fair value.

 

Deposits

 

The fair value of deposits with no stated maturity, such as demand deposits, savings accounts and money market accounts, is equal to the amount payable on demand at September 30, 2017 and December 31, 2016.

 

Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on similar term borrowings, to a schedule of aggregated expected monthly maturities on time deposits.

 

Short-Term and Long-Term Borrowings

 

The fair values of short-term borrowings are equal to the current carrying values, and long-term borrowings are estimated using discounted cash flow analyses based on the Corporation’s incremental borrowing rate for similar instruments.

 

Off-Balance Sheet Financial Instruments

 

The fair values for the Corporation’s off-balance sheet financial instruments (lending commitments and letters of credit) are based on fees currently charged in the market to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.

 

 33 

 

 

NOTE 9EARNINGS PER SHARE

 

Basic earnings per share (“EPS”) is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Corporation. Potential common shares that may be issued by the Corporation relate solely to outstanding stock options and are determined using the treasury stock method. The following table sets forth the computation of basic and diluted earnings per share.

 

   Three Months Ended 
   September 30, 
(In thousands, except earnings per share)  2017   2016 
Net income  $2,056   $2,144 
Weighted-average common shares outstanding   5,695    5,646 
Basic earnings per share  $0.36   $0.38 
          
Weighted-average common shares outstanding   5,695    5,646 
Common stock equivalents due to effect of stock options   2    2 
Total weighted-average common shares and equivalents   5,697    5,648 
Diluted earnings per share  $0.36   $0.38 

 

   Nine Months Ended 
   September 30, 
(In thousands, except earnings per share)  2017   2016 
Net income  $6,261   $6,811 
Weighted-average common shares outstanding   5,683    5,633 
Basic earnings per share  $1.10   $1.21 
           
Weighted-average common shares outstanding   5,683    5,633 
Common stock equivalents due to effect of stock options   2    2 
Total weighted-average common shares and equivalents   5,685    5,635 
Diluted earnings per share  $1.10   $1.21 

 

 34 

 

 

Item 2. First Keystone Corporation Management’s Discussion and Analysis of Financial Condition and Results of Operation

 

This quarterly report contains certain forward-looking statements, which are included pursuant to the “safeharbor” provisions of the Private Securities Litigation Reform Act of 1995, and reflect management’s beliefs and expectations based on information currently available. These forward-looking statements are inherently subject to significant risks and uncertainties, including changes in general economic and financial market conditions, the Corporation’s ability to effectively carry out its business plans and changes in regulatory or legislative requirements. Other factors that could cause or contribute to such differences are changes in competitive conditions, and pending or threatened litigation. Although management believes the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially.

 

CRITICAL ACCOUNTING ESTIMATES

 

The Corporation has chosen accounting policies that it believes are appropriate to accurately and fairly report its operating results and financial position, and the Corporation applies those accounting policies in a consistent manner. The Significant Accounting Policies are summarized in Note 1 to the consolidated financial statements included in the 2016 Annual Report on Form 10-K. There have been no changes to the Critical Accounting Estimates since the Corporation filed its Annual Report on Form 10-K for the year ended December 31, 2016.

 

RESULTS OF OPERATIONS

 

Quarter ended September 30, 2017 compared to quarter ended September 30, 2016

 

First Keystone Corporation realized earnings for the three months ended September 30, 2017 of $2,056,000, a decrease of $88,000, or 4.1% from the third quarter of 2016. The decrease in net income for the three months ended September 30, 2017 was primarily due to an increase in salaries and employee benefits as well as an increase in interest expense on deposits and short-term borrowings, as compared to the three months ended September 30, 2016.

 

On a per share basis, net income was $0.36 for the three months ended September 30, 2017 versus $0.38 for the three months ended September 30, 2016. Cash dividends amounted to $0.27 per share for the three months ended September 30, 2017 and 2016.

 

NET INTEREST INCOME

 

The major source of operating income for the Corporation is net interest income, defined as interest income less interest expense. For the three months ended September 30, 2017, interest income amounted to $8,164,000, an increase of $238,000 or 3.0% from the three months ended September 30, 2016, while interest expense amounted to $1,787,000 for the three months ended September 30, 2017, an increase of $478,000 or 36.5% from the three months ended September 30, 2016. As a result, net interest income decreased $240,000 or 3.6% to $6,377,000 from $6,617,000 for the same period in 2016.

 

The Corporation’s net interest margin for the three months ended September 30, 2017 was 3.05% compared to 3.19% for the same period in 2016. The decrease in net interest margin was a result of the unprecedented continuing low interest rate environment.

 

PROVISION FOR LOAN LOSSES

 

The provision for loan losses for the three months ended September 30, 2017 and September 30, 2016 was $84,000 and $1,133,000, respectively. The decrease in the provision for loan losses resulted from the Corporation’s analysis of the current loan portfolio, including historic losses, past-due trends, current economic conditions, and other relevant factors. Charge-off and recovery activity resulted in net recoveries of $11,000 and net charge-offs of $1,352,000 for the three months ended September 30, 2017 and 2016, respectively. See Allowance for Loan Losses on page 41 for further discussion.

 

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NON-INTEREST INCOME

 

Total non-interest income was $1,713,000 for the three months ended September 30, 2017, as compared to $2,158,000 for the same period in 2016, a decrease of $445,000, or 20.6%. The decrease was mainly the result of a decrease in gains from life insurance proceeds. During the third quarter of 2016, the Corporation received $458,000 in tax-free claims income from life insurance proceeds as the result of a death benefit paid on a life insurance policy covering one of its former employees that remained an insured person by the Corporation’s bank-owned life insurance program following her separation of employment. ATM fees and debit card income increased $28,000 or 8.7% to $351,000 for the three months ended September 30, 2017. Gains on sales of mortgage loans decreased $20,000 or 19.8% due to a decrease in loans originated with the intent to sell and volume of loans sold. Net gains on sales of investment securities increased $19,000 to $414,000 for the three months ended September 30, 2017 as compared to the three months ended September 30, 2016. The Bank has taken gains and losses in the portfolio to reduce market risk and protect from further changes in value in the face of increases in long-term interest rates. The net effect of gains on sales of mortgage loans and net investment securities gains was $495,000 in the third quarter of 2017, a decrease of $1,000 or 0.2% from the third quarter of 2016.

 

NON-INTEREST EXPENSE

 

Total non-interest expense was $5,681,000 for the three months ended September 30, 2017, as compared to $5,078,000 for the three months ended September 30, 2016. Non-interest expense increased $603,000 or 11.9%.

 

Expenses associated with employees (salaries and employee benefits) continue to be the largest category of non-interest expense. Salaries and benefits amounted to $3,050,000 or 53.7% of total non-interest expense for the three months ended September 30, 2017, as compared to $2,606,000 or 51.3% for the same three months of 2016. The increase was due to the bank adding new sales positions and additional staff, as well as increased costs associated with employee health care.

 

Net occupancy, furniture and equipment, and computer expense amounted to $821,000 for the three months ended September 30, 2017, a decrease of $85,000 or 9.3%. Professional services increased $61,000 or 43.6% to $201,000 as of September 30, 2017. The increase was due to pricing increases associated with audit and tax services and additional fees incurred for financial services department analysis and consulting. Pennsylvania shares tax expense amounted to $157,000 for the three months ended September 30, 2017, a decrease of $32,000 or 16.9% as compared to the three months ended September 30, 2016.

 

FDIC insurance expense decreased $4,000 or 4.7% from the third quarter of 2016. FDIC insurance expense varies with changes in net asset size, risk ratings, and FDIC derived assessment rates. ATM and debit card fees expense amounted to $184,000 for the three months ended September 30, 2017 and 2016. Data processing expenses decreased $1,000 or 0.7% to $148,000 for the three months ended September 30, 2017 as compared to the same three months of 2016. Foreclosed assets held for resale expense decreased $76,000 in the third quarter of 2017 as the result of normal costs related to foreclosed assets and the net effect of gains on sold foreclosed asset properties during the three months ended September 30, 2017. Advertising expense increased $53,000 or 57.0% during the three months ended September 30, 2017 as compared to the same three months of 2016. The increase was primarily due to increased media advertising for the rollout of new rewards checking and savings products.

 

Other non-interest expense amounted to $880,000 for the three months ended September 30, 2017, an increase of $243,000 or 38.1% as compared to the three months ended September 30, 2016. The increase was due to an increase in collections fees attributable to increased legal costs.

 

INCOME TAXES

 

Income tax expense amounted to $269,000 for the three months ended September 30, 2017, as compared to $420,000 for the three months ended September 30, 2016, a decrease of $151,000. The effective total income tax rate was 11.6% for the third quarter of 2017 as compared to 16.4% for the third quarter of 2016. The decrease in the effective tax rate was due to a net increase in tax-exempt interest earned from investments in state and local units of government.

 

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Nine months ended September 30, 2017 compared to nine months ended September 30, 2016

 

First Keystone Corporation realized earnings for the nine months ended September 30, 2017 of $6,261,000, a decrease of $550,000, or 8.1% from the same period in 2016. The decrease in net income for the nine months ended September 30, 2017 was primarily due to an increase in salaries and employee benefits as well as an increase in interest expense on deposits and short-term borrowings.

 

On a per share basis, for the nine months ended September 30, 2017, net income was $1.10 versus $1.21 for the nine months ended September 30, 2016. Cash dividends amounted to $0.81 per share for the nine months ended September 30, 2017 and 2016.

 

NET INTEREST INCOME

 

The major source of operating income for the Corporation is net interest income, defined as interest income less interest expense. For the nine months ended September 30, 2017, interest income amounted to $24,071,000, an increase of $244,000 or 1.0% from the first nine months of 2016, while interest expense amounted to $4,833,000 for the nine months ended September 30, 2017, an increase of $929,000, or 23.8% from the nine months ended September 30, 2016. As a result, net interest income decreased $685,000 or 3.4% to $19,238,000 from $19,923,000 for the same period in 2016.

 

The Corporation’s net interest margin for the nine months ended September 30, 2017 was 3.06% compared to 3.18% for the same period in 2016. The decrease in net interest margin was a result of the unprecedented continuing low interest rate environment.

 

PROVISION FOR LOAN LOSSES

 

The provision for loan losses for the nine months ended September 30, 2017 and September 30, 2016 was $167,000 and $1,700,000, respectively. The decrease in the provision for loan losses resulted from the Corporation’s analysis of the current loan portfolio, including historic losses, past-due trends, current economic conditions, and other relevant factors. Net charge-offs for the nine months ended September 30, 2017 and 2016 were $76,000 and $1,439,000, respectively. See Allowance for Loan Losses on page 41 for further discussion.

 

NON-INTEREST INCOME

 

Total non-interest income was $4,746,000 for the nine months ended September 30, 2017, as compared to $5,124,000 for the same period in 2016, a decrease of $378,000, or 7.4%. ATM fees and debit card income increased by $68,000 or 7.0% to $1,034,000 for the nine months ended September 30, 2017. Gains on sales of mortgage loans decreased $53,000 or 20.5% due to a decrease in loans originated with the intent to sell and volume of loans sold. Net gains on sales of investment securities increased $97,000 to $886,000 for the nine months ended September 30, 2017 as compared to the nine months ended September 30, 2016. The Bank has taken gains and losses in the portfolio to reduce market risk and protect from further changes in value in the face of increases in long-term interest rates. Gains from life insurance proceeds decreased $458,000. In the third quarter of 2016, the Corporation received tax-free claims income from life insurance proceeds as the result of a death benefit paid on a life insurance policy covering one of its former employees that remained an insured person by the Corporation’s bank-owned life insurance program following her separation of employment. The net effect of gains on sales of mortgage loans and net investment securities gains was $1,091,000 in the nine months ended September 30, 2017, an increase of $44,000 or 4.2% from the nine months ended September 30, 2016.

 

NON-INTEREST EXPENSE

 

Total non-interest expense was $16,610,000 for the nine months ended September 30, 2017, as compared to $15,232,000 for the nine months ended September 30, 2016. Non-interest expense increased $1,378,000 or 9.0%.

 

Expenses associated with employees (salaries and employee benefits) continue to be the largest category of non-interest expense. Salaries and benefits amounted to $8,823,000 or 53.1% of total non-interest expense for the nine months ended September 30, 2017, as compared to $7,979,000 or 52.4% for the same nine months of 2016. The increase was due to the bank adding new sales positions in the commercial and residential mortgage lending areas and additional staff, as well as increased costs associated with employee health care.

 

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Net occupancy, furniture and equipment, and computer expense amounted to $2,527,000 for the nine months ended September 30, 2017, an increase of $98,000 or 4.0%. Professional services increased $192,000 or 43.4% to $634,000 as of September 30, 2017. The increase was due to pricing increases associated with audit and tax services, out of scope audit work associated with the 2016 annual report and additional fees incurred for financial services department analysis and consulting. Pennsylvania shares tax expense amounted to $568,000 for the nine months ended September 30, 2017, an increase of $2,000 or 0.4% as compared to the nine months ended September 30, 2016.

 

FDIC insurance expense decreased $161,000 or 40.0% from the same nine months of 2016. The decrease was due to changes in assessment methodologies implemented by the FDIC in the second half of 2016. FDIC insurance expense varies with changes in net asset size, risk ratings, and FDIC derived assessment rates. ATM and debit card fees expense increased $19,000 or 3.9% to $509,000 for the nine months ended September 30, 2017. Data processing expenses increased $25,000 or 6.0% to $442,000 for the nine months ended September 30, 2017. Foreclosed assets held for resale expense decreased $82,000 in the nine months ended September 30, 2017. The decrease was due to lower maintenance costs and sales expenses in the early part of 2017 and the net effect of gains on sold foreclosed asset properties during the third quarter of 2017. Advertising expense increased $152,000 or 59.4% during the nine months ended September 30, 2017 as compared to the same nine months of 2016. The increase was primarily due to increased media advertising for the rollout of new rewards checking and savings products.

 

Other non-interest expense amounted to $2,339,000 for the nine months ended September 30, 2017, an increase of $289,000 or 14.1% as compared to the nine months ended September 30, 2016. The increase was due to an increase in Kasasa brand product fees incurred as a result of discontinued services, an increase in collections fees attributable to increased legal costs, promotional expenses related to the mortgage servicing department and closing costs associated with the sale of a property.

 

INCOME TAXES

 

Income tax expense amounted to $946,000 for the nine months ended September 30, 2017, as compared to $1,304,000 for the nine months ended September 30, 2016, a decrease of $358,000. The effective total income tax rate was 13.1% for the nine months ended September 30, 2017 as compared to 16.1% for the nine months ended September 30, 2016. The decrease in the effective tax rate was due to a net increase in tax-exempt interest from investments in state and local units of government.

 

FINANCIAL CONDITION

 

SUMMARY

 

Total assets increased to $985,108,000 as of September 30, 2017, an increase of $825,000 from year-end 2016. Total assets as of December 31, 2016 amounted to $984,283,000.

 

Total investments decreased $18,549,000 or 4.9% to $361,092,000 as of September 30, 2017.

 

Total loans increased $20,403,000 or 3.9%. Loan demand grew in the nine months ended September 30, 2017 as the Bank has seen an increase in loan originations, primarily in the commercial real estate and commercial and industrial portfolios.

 

Total deposits increased $33,734,000 or 4.6% to $759,716,000 as of September 30, 2017.

 

The Corporation continues to maintain and manage its asset growth. The Corporation’s strong equity capital position provides an opportunity to further leverage its asset growth. Total borrowings decreased in the first nine months of 2017 by $38,175,000 to $106,231,000 from $144,406,000 as of December 31, 2016. Borrowings decreased due to increased deposit balances.

 

Total stockholders’ equity increased to $115,309,000 at September 30, 2017, an increase of $5,624,000 or 5.1% from December 31, 2016.

 

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SEGMENT REPORTING

 

Currently, management measures the performance and allocates the resources of the Corporation as a single segment.

 

EARNING ASSETS

 

Earning assets are defined as those assets that produce interest income. By maintaining a healthy asset utilization rate, i.e., the volume of earning assets as a percentage of total assets, the Corporation maximizes income. The earning asset ratio (average interest earning assets divided by average total assets) equaled 92.5% at September 30, 2017, compared to 92.4% at September 30, 2016. This indicates that the management of earning assets is a priority and non-earning assets, primarily cash and due from banks, fixed assets and other assets, are maintained at minimal levels. The primary earning assets are loans and investment securities.

 

Our primary earning asset, total loans, increased to $542,785,000 as of September 30, 2017, up $20,403,000, or 3.9% since year-end 2016. The loan portfolio continues to be well diversified. Non-performing assets increased since year-end 2016, and overall asset quality has remained consistent. Total non-performing assets were $6,812,000 as of September 30, 2017, an increase of $2,570,000, or 60.6% from $4,242,000 reported in non-performing assets as of December 31, 2016. Total allowance for loan losses to total non-performing assets was 109.3% as of September 30, 2017 and 173.5% at December 31, 2016.

 

In addition to loans, another primary earning asset is our overall investment portfolio, which decreased in size from December 31, 2016 to September 30, 2017. Available-for-sale securities amounted to $361,092,000 as of September 30, 2017, a decrease of $18,545,000 from year-end 2016.

 

Interest-bearing deposits in other banks increased as of September 30, 2017, to $1,744,000 from $790,000 at year-end 2016. Time deposits with other banks were $1,482,000 at September 30, 2017 and December 31, 2016.

 

LOANS

 

Total loans increased to $542,785,000 as of September 30, 2017 as compared to $522,382,000 as of December 31, 2016. The table on page 19 provides data relating to the composition of the Corporation’s loan portfolio on the dates indicated. Total loans increased by $20,403,000 or 3.9%.

 

Steady demand for borrowing by both individuals and businesses accounted for the 3.9% increase in the loan portfolio from December 31, 2016 to September 30, 2017. The Commercial and Industrial portfolio increased $9,663,000 to $93,236,000 as of September 30, 2017, as compared to $83,573,000 at December 31, 2016. The increase in the Commercial and Industrial portfolio (which includes tax-free Commercial and Industrial loans) was attributed to new loan originations totaling $24,183,000 offset by loan payoffs of $15,809,000, as well as regular principal payments and other typical fluctuations and activity in the Commercial and Industrial portfolio including utilization of existing lines of credit. The Commercial Real Estate portfolio (which includes tax-free Commercial Real Estate loans) increased $13,330,000 to $276,849,000 at September 30, 2017, as compared to $263,519,000 at December 31, 2016. The increase was mainly the result of $48,570,000 in new loan originations, offset by $22,187,000 in loan payoffs in addition to regular principal payments and other typical amortizations in the Commercial Real Estate portfolio. Residential Real Estate loans decreased $2,577,000 to $166,458,000 at September 30, 2017, as compared to $169,035,000 at December 31, 2016. The decrease was the result of $12,324,000 in new loan originations offset by loan payoffs of $11,237,000, net loans sold of $1,340,000, and regular principal payments. Net loans sold in the Residential Real Estate portfolio for the nine months ended September 30, 2017 consisted of total loans sold during the nine months ended September 30, 2017 of $6,545,000, offset with loans opened and sold in the same quarter during any quarter of 2017 which amounted to $5,205,000. The Corporation continues to originate and sell certain long-term fixed rate residential mortgage loans which conform to secondary market requirements. The Corporation derives ongoing income from the servicing of mortgages sold in the secondary market. The Corporation continues its efforts to lend to creditworthy borrowers despite the continued slow economic conditions.

 

Management believes that the loan portfolio is well diversified. The total commercial portfolio was $370,085,000 at September 30, 2017. Of total loans, $276,849,000 or 51.0% were secured by commercial real estate, primarily lessors of residential buildings and dwellings and lessors of non-residential buildings. The Corporation continues to monitor these portfolios.

 

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The largest relationship is comprised of various real estate entities with a mutual owner who is a related party of the bank and began real estate investment and development activities in 1989. The relationship had outstanding loan balances and unused commitments of $14,725,000 at September 30, 2017. The individual owns a diverse mix of real estate entities which specialize in construction/development projects, leasing of commercial office space, and rental of multi-tenant residential units. This relationship is comprised of $13,625,000 in term debt and two lines of credit totaling $1,100,000. The relationship is well secured by first lien mortgages on income producing commercial and residential real estate, plus assignment of governmental leases and collateral pledge of cash accounts and marketable securities.

 

The second largest relationship is comprised of multiple first and second lien mortgages relating to the purchase and improvements of several existing hotels. The principal and related owners/guarantors have extensive experience in the hotel industry, owning and operating hotels in various states for over twenty-five years. At September 30, 2017, the relationship had outstanding loan balances and unused commitments of $10,140,000. The debt is comprised of $10,085,000 in term debt and two lines of credit totaling $55,000. The loans are secured by commercial real estate and business assets.

 

The third largest relationship consists of a large, suburban/rural public school district that provides educational services to over 5,000 students and employs approximately 750 individuals as administrative, professional, and support staff. At September 30, 2017, the relationship had outstanding balances totaling $9,665,000 which consisted entirely of tax-free commercial term debt. The relationship is secured by business assets and the full faith, credit, and taxing power of the district.

 

The fourth largest relationship consists of a real estate development/holding company that was established in 2006 to construct a multi-tenant medical complex, as well as the medical-related entities that operate out of the complex. The relationship had outstanding loan balances and unused commitments of $8,286,000 at September 30, 2017. The debt is comprised of $7,836,000 in term debt and $450,000 in lines of credit. The relationship is secured by commercial real estate and business assets, as well as the assignment of leases and a life insurance policy.

 

The fifth largest relationship consists of a city incorporated in 1870, encompassing approximately 2.7 square miles, with a population of over 9,000. In 2016, the city undertook to refinance existing general obligation notes and bonds, to obtain interim financing (pending receipt of grants) to complete construction of a new wastewater treatment plant, and to fund an easement acquisition and obstruction removal project pertaining to the city’s municipal airport. At September 30, 2017, the relationship had outstanding loan balances and unused commitments of $8,085,000, which was comprised of $5,913,000 in term debt and $2,172,000 in available credit on three tax-free commercial loans. The relationship is secured by the full faith, credit, and taxing power of the city.

 

Each of the five relationships is located within the Corporation’s market area.

 

All of the above mentioned loans are performing as agreed and all are graded pass. The property securing each of the loans was appraised at the time the loan was originated. Appraisals are ordered independently of the loan approval process from appraisers on an approved list. All appraisals are reviewed internally for conformity with accepted standards of the Bank.

 

Overall, the portfolio risk profile as measured by loan grade is considered low risk, as $521,268,000 or 96.2% of gross loans are graded Pass; $3,156,000 or 0.6% are graded Special Mention; $17,592,000 or 3.2% are graded Substandard; and $0 are graded Doubtful. The rating is intended to represent the best assessment of risk available at a given point in time, based upon a review of the borrower’s financial statements, credit analysis, payment history with the Bank, credit history and lender knowledge of the borrower. See Note 4 — Loans and Allowance for Loan Losses for risk grading tables.

 

Overall, non-pass grades decreased to $20,748,000 at September 30, 2017, as compared to $28,417,000 at December 31, 2016. Commercial and Industrial non-pass grades decreased to $1,364,000 as of September 30, 2017 as compared to $5,109,000 as of December 31, 2016. Commercial Real Estate non-pass grades decreased to $16,969,000 as of September 30, 2017 as compared to $20,041,000 as of December 31, 2016. The Residential Real Estate and Consumer loan non-pass grades decreased to $2,415,000 as of September 30, 2017 as compared to $3,267,000 as of December 31, 2016.

 

The $3,745,000 decrease in Commercial and Industrial non-pass grades was mainly the result of the upgrade of nine loans totaling $4,411,000 net against the downgrade of four loans totaling $810,000, combined with typical amortization and other fluctuations in the Commercial and Industrial non-pass grade portfolio. Four of the upgraded loans totaling $3,946,000 are to a manufacturer that produces parts for various industries. The loans were upgraded from Special Mention to pass-grade status during the second quarter of 2017 due to the borrower’s improved financial performance and debt service capacity. Five of the upgraded loans totaling $465,000 are to a contractor specializing in concrete projects. The loans were upgraded from Special Mention to pass-grade status during the three months ended September 30, 2017 due to improved financial performance as reflected by increased sales and improved cash flow and debt service capacity. The four downgraded loans are to a plastic processing company focused on non-post-consumer recycling. The loans were downgraded to Substandard and moved to non-accrual status during the first quarter of 2017 due to a downturn in revenues resulting from lower commodity prices for new plastic produced from petroleum and natural gas liquids.

 

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The $3,072,000 decrease in the Commercial Real Estate non-pass grade portfolio was the result of several fluctuations including large upgrades to pass-grade status and significant payments, pay-downs, and pay-offs net against loans transferred to (or originated at) non-pass grade status and the repurchase of a portion of a non-pass grade participation loan, combined with other normal activity in the Commercial Real Estate non-pass grade portfolio during the nine months ended September 30, 2017. A repurchase of one participant’s portion of a non-pass grade participation loan to a student housing holding company was completed during the three months ended September 30, 2017; the repurchased portion totaled $1,350,000. One loan in the amount of $1,086,000 to the owner of a golf course and related facilities was upgraded from Special Mention to pass-grade status during the second quarter of 2017, and one loan in the amount of $536,000 to a contractor specializing in concrete projects was upgraded from Special Mention to pass-grade status during the three months ended September 30, 2017. Payments and principal pay-downs totaling $330,000 were made on a purchased participation loan to the owner of a recreation facility during the nine month period ended September 30, 2017. Two loans totaling $654,000 to a plastic processing company focused on non-post-consumer recycling were downgraded to Substandard and moved to non-accrual status during the first quarter of 2017 due to a downturn in revenues resulting from lower commodity prices for new plastic produced from petroleum and natural gas liquids.

 

Activity associated with four loans to the developer of a residential sub-division resulted in a net decrease of $2,568,000 in the Commercial Real Estate non-pass grade portfolio during the nine months ended September 30, 2017. Two loans totaling $2,220,000 were paid off and a $500,000 pay-down was made on one of the guarantor’s existing loans during the first quarter of 2017. A loan with an outstanding recorded investment of $152,000 at September 30, 2017 was originated at substandard status during the second quarter of 2017 to allow for the construction of an additional single family spec home in light of a perceived increase in interest on the part of prospective purchasers and to support sales momentum and provide available inventory of homes for sale in the aftermath of the successful sale of an existing spec home. The Bank granted the loan based on the borrower’s excellent loan payment history with the Bank and taking into account the existence of other viable sources of repayment, but inadequate debt service capability based on historical income led to the loan’s substandard risk rating.

 

The Corporation continues to internally underwrite each of its loans to comply with prescribed policies and approval levels established by its Board of Directors.

 

Total Loans

 

   September 30,   December 31, 
(Dollars in thousands)  2017