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EX-32.1 - SECTION 906 CEO CERTIFICATION - TOWER BANCORP INCdex321.htm
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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

 

FORM 10-Q

 

 

 

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

For the quarterly period ended: September 30, 2010

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: 001-34277

 

 

LOGO

(Exact name of registrant as specified in its charter)

 

 

 

Pennsylvania   25-1445946
(State or other jurisdiction of incorporation)   (IRS Employer Identification Number)

 

112 Market Street, Harrisburg, Pennsylvania   17101
(Address of principal executive office)   (Zip Code)

(717) 231-2700

(Registrant’s telephone number, including area code)

 

 

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

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

 

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

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

 

 

 


Table of Contents

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

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

7,183,800 shares of common stock outstanding at October  31, 2010

TABLE OF CONTENTS

 

    Description    Page  
PART I   FINANCIAL INFORMATION   
Item 1.   Financial Statement      3   
 

Consolidated Balance Sheets

     3   
 

Consolidated Statements of Operations

     4   
 

Consolidated Statements of Shareholders’ Equity and Comprehensive Income

     5   
 

Consolidated Statements of Cash Flows

     6   
Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations      29   
Item 3.   Quantitative and Qualitative Disclosures About Market Risk      50   
Item 4.   Controls and Procedures      56   
PART II   OTHER INFORMATION   
Item 1.   Legal Proceedings      57   
Item 1A.   Risk Factors      57   
Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds      60   
Item 3.   Defaults Upon Senior Securities      60   
Item 4.   (Removed and Reserved)      60   
Item 5.   Other Information      60   
Item 6.   Exhibits      61   
  Signatures      63   
  Exhibit Index      64   

 

2


Table of Contents

 

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Tower Bancorp, Inc. and Subsidiary

Consolidated Balance Sheets

September 30, 2010 and December 31, 2009

(Amounts in thousands, except share data)

 

     September 30,
2010
    December 31,
2009
 
     (unaudited)        

Assets

    

Cash and due from banks

   $ 28,434      $ 33,955   

Federal funds sold

     17,831        16,645   
                

Cash and cash equivalents

     46,265        50,600   

Securities available for sale

     145,428        189,853   

Restricted investments

     6,254        6,254   

Loans held for sale

     12,851        8,034   

Loans, net of allowance for loan losses of $12,717, and $9,695

     1,308,820        1,128,576   

Premises and equipment, net of accumulated depreciation of $5,238 and $3,324

     29,006        29,810   

Premises and equipment held for sale, net of accumulated depreciation of $27

     549        —     

Accrued interest receivable

     5,220        4,974   

Deferred tax asset, net

     1,488        1,742   

Bank owned life insurance

     37,906        24,606   

Goodwill

     11,935        11,935   

Other intangible assets, net

     2,871        3,367   

Other assets

     10,248        10,832   
                

Total Assets

   $ 1,618,841      $ 1,470,583   
                

Liabilities and Stockholders’ Equity

    

Liabilities

    

Deposits:

    

Non-interest bearing

   $ 125,174      $ 119,116   

Interest bearing

     1,230,543        1,097,353   
                

Total deposits

     1,355,717        1,216,469   

Securities sold under agreements to repurchase

     7,102        6,892   

Short-term borrowings

     5,037        5,292   

Long-term debt

     72,398        65,689   

Accrued interest payable

     1,084        1,090   

Other liabilities

     11,709        11,274   
                

Total Liabilities

     1,453,047        1,306,706   
                

Stockholders’ Equity

    

Common stock, no par value; 50,000,000 shares authorized; 7,287,158 issued and 7,183,800 outstanding at September 30, 2010, 7,226,041 shares issued and 7,122,683 outstanding at December 31, 2009

     —          —     

Additional paid-in capital

     173,175        172,409   

Accumulated deficit

     (4,431     (4,025

Accumulated other comprehensive income (loss)

     1,143        (414

Less: cost of treasury stock, 103,358 shares at September 30, 2010 and December 31, 2009

     (4,093     (4,093
                

Total Stockholders’ Equity

     165,794        163,877   
                

Total Liabilities and Stockholders’ Equity

   $ 1,618,841      $ 1,470,583   
                

See Notes to the Consolidated Financial Statements

 

3


Table of Contents

 

Tower Bancorp, Inc. and Subsidiary

Consolidated Statements of Operations

For the Three and Nine Months Ended September 30 2010 and 2009

(Amounts in thousands, except share data)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2010      2009     2010      2009  
     (unaudited)     (unaudited)  

Interest Income

    

Loans, including fees

   $ 17,852       $ 15,249      $ 51,632       $ 38,789   

Securities

     1,020         419        3,223         935   

Federal funds sold and other

     24         56        98         83   
                                  

Total Interest Income

     18,896         15,724        54,953         39,807   

Interest Expense

          

Deposits

     4,492         4,725        13,645         13,382   

Short-term borrowings

     177         102        482         304   

Long-term debt

     856         693        2,503         1,430   
                                  

Total Interest Expense

     5,525         5,520        16,630         15,116   
                                  

Net Interest Income

     13,371         10,204        38,323         24,691   

Provision for Loan Losses

     1,600         800        4,950         3,816   
                                  

Net Interest Income after Provision for Loan Losses

     11,771         9,404        33,373         20,875   

Non-Interest Income

          

Service charges on deposit accounts

     832         625        2,377         1,506   

Other service charges, commissions and fees

     581         566        1,788         1,475   

Gain on sale of mortgage loans originated for sale

     656         334        1,250         1,182   

Gain (loss) on sale of other interest earning assets

     265         (113     260         156   

Income from bank owned life insurance

     599         283        1,390         725   

Other income

     148         115        512         431   
                                  

Total Non-Interest Income

     3,081         1,810        7,577         5,475   

Non-Interest Expenses

          

Salaries and employee benefits

     5,554         4,237        15,996         11,523   

Occupancy and equipment

     1,805         1,462        5,236         3,664   

Amortization of intangible assets

     160         177        496         354   

FDIC insurance premiums

     564         409        1,500         1,320   

Advertising and promotion

     231         204        740         422   

Data processing

     740         627        1,894         1,414   

Professional service fees

     385         305        1,197         843   

Impairment of long-lived assets

     —           —          920         —     

Other operating expenses

     1,519         963        4,436         2,858   

Merger related expenses

     117         310        304         1,722   
                                  

Total Non-Interest Expenses

     11,075         8,694        32,719         24,120   
                                  

Net Income Before Income Tax Expense

     3,777         2,520        8,231         2,230   
                                  

Income Tax Expense

     1,275         820        2,647         577   
                                  

Net Income

   $ 2,502       $ 1,700      $ 5,584       $ 1,653   
                                  

Net Income Per Common Share

          

Basic

   $ 0.35       $ 0.30      $ 0.78       $ 0.37   

Diluted

   $ 0.35       $ 0.30      $ 0.78       $ 0.37   

Dividends Declared Per Common Share

   $ 0.28       $ 0.28      $ 0.84       $ 0.56   

Weighted Average Common Shares Outstanding

          

Basic

     7,144,685         5,638,851        7,134,611         4,495,962   

Diluted

     7,144,721         5,652,292        7,137,508         4,502,396   

See Notes to the Consolidated Financial Statements

 

4


Table of Contents

 

Tower Bancorp, Inc. and Subsidiary

Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income

For the Nine Months Ended September 30, 2010 and 2009

(Amounts in thousands, except share data)

 

     Common
Stock
     Additional
Paid-in
Capital
     Accumulated
Deficit
    Accumulated
Other
Comprehensive
Income (Loss)
    Treasury
Stock
    Total  

Balance—December 31, 2008

   $ —         $ 57,547       $ (2,909   $ 147      $ —        $ 54,785   

Restricted common stock awards earned

        295               295   

Stock option expense

        551               551   

Fair value of consideration exchanged in Merger

        61,946             (4,093     57,853   

Dividends declared

           (2,834         (2,834

Proceeds from stock purchase plans

        263               263   

Proceeds from Common Stock Offering, net of expenses

        51,661               51,661   

Comprehensive Income:

              

Net income

           1,653            1,653   

Unrealized gain on securities available for sale, net of taxes of $169

             329          329   
                    

Total Comprehensive Loss

                 1,982   
                                                  

Balance—September 30, 2009 (unaudited)

   $ —         $ 172,263       $ (4,090   $ 476      $ (4,093   $ 164,556   
                                                  

Balance—December 31, 2009

   $ —         $ 172,409       $ (4,025   $ (414   $ (4,093   $ 163,877   

Stock issued as investment in Dellinger, Dolan, McCurdy and Phillips Investment Advisors, LLC (“DDMP”)

        51               51   

Stock option expense

        84               84   

Proceeds from stock purchase plans

        631               631   

Dividends declared

           (5,990         (5,990

Comprehensive Income:

              

Net income

           5,584            5,584   

Unrealized gain on securities available for sale, net of taxes of $829

             1,557          1,557   
                    

Total Comprehensive Income

                 7,141   
                                                  

Balance—September 30, 2010 (unaudited)

   $ —         $ 173,175       $ (4,431   $ 1,143      $ (4,093   $ 165,794   
                                                  

See Notes to the Consolidated Financial Statements

 

5


Table of Contents

 

Tower Bancorp, Inc. and Subsidiary

Consolidated Statements of Cash Flows

For the Nine Months Ended September 30, 2010 and 2009

(Amounts in thousands, except share data)

 

     2010     2009  
     (unaudited)     (unaudited)  

Cash Flows from Operating Activities

    

Net income

   $ 5,584      $ 1,653   

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

    

Provision for loan losses

     4,950        3,816   

Net amortization on securities and loans

     1,829        42   

Depreciation and amortization

     1,981        1,232   

Amortization of intangible assets

     496        354   

Amortization of unearned compensation on restricted stock

     —          295   

Stock option expense

     84        551   

Deferred tax benefit

     (575     (119

Increase in accrued interest receivable

     (246     (382

Decrease in accrued interest payable

     (6     (303

Net increase in the cash surrender value of life insurance

     (1,300     (695

Decrease (increase) in other assets

     654        (1,794

Increase (decrease) in other liabilities

     435        (3,039

Impairment of premises and equipment

     920        —     

Gain on sale of loans originated for sale and other assets, net

     (1,403     (1,338

Loans originated for sale

     (96,052     (105,353

Sale of loans

     92,485        109,928   
                

Net Cash Provided by Operating Activities

     9,836        4,848   
                

Cash Flows from Investing Activities

    

Proceeds from maturities and sales of securities available for sale

     119,638        61,779   

Purchases of securities available for sale

     (73,801     (142,525

Purchases of bank owned life insurance

     (12,000     —     

Net increase in loans

     (185,928     (32,650

Decrease of investment in restricted investments

     —          1,024   

Purchases of premises and equipment

     (2,657     (1,116

Net proceeds from the sale of premises and equipment

     24        —     

Net cash received in Merger

     —          9,017   
                

Net Cash Used in Investing Activities

     (154,724     (104,471
                

Cash Flows from Financing Activities

    

Proceeds from advances on long-term debt

     6,709        2,282   

Net decrease in short-term borrowings

     (255     (39,751

Net increase (decrease) in securities sold under agreements to repurchase

     210        (1,001

Net increase in deposits

     139,248        190,609   

Proceeds from the sale of common stock

     631        51,924   

Dividends paid

     (5,990     (2,625
                

Net Cash Provided by Financing Activities

     140,553        201,438   
                

Net Increase in Cash and Cash Equivalents

     (4,335     101,815   

Cash and Cash Equivalents - Beginning

     50,600        32,022   
                

Cash and Cash Equivalents - Ending

   $ 46,265      $ 133,837   
                

Supplemental disclosure of information:

    

Interest paid

   $ 16,636      $ 14,721   

Income taxes paid

   $ 3,550      $ 225   

Supplemental schedule of noncash investing and financing activities

    

Other real estate (sold) acquired in settlement of loan

   $ (48   $ 933   

Unrealized gain on investments securities available for sale, net of tax

   $ 1,557      $ 329   

Reclassification of long-term debt to short-term borrowings

   $ 5,000      $ 5,250   

See Notes to the Consolidated Financial Statements

 

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Table of Contents

 

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

September 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

Note 1 - Summary of Significant Accounting Policies

Organization and Nature of Operations

Tower Bancorp, Inc. (the “Company”) is a registered bank holding company that was incorporated in 1983 under the Bank Holding Company Act of 1956, as amended. On March 31, 2009, the Company merged with Graystone Financial Corp. (“Graystone”), a privately held, non-reporting corporation and a registered bank holding company under the Bank Holding Company Act of 1956, as amended (the “Merger”). Pursuant to an Agreement and Plan of Merger between the Company and Graystone (the “Merger Agreement”), the Company remains the surviving bank holding company and the First National Bank of Greencastle has merged with and into Graystone Bank, the wholly-owned subsidiary of Graystone, with Graystone Bank as the surviving institution under the name “Graystone Tower Bank” (the “Bank Merger”). Graystone Tower Bank (the “Bank”) operates as the sole subsidiary of the Company through two divisions – “Graystone Bank, a division of Graystone Tower Bank”, consisting of the former Graystone Bank branches, and “Tower Bank, a division of Graystone Tower Bank,” consisting of the former branches of The First National Bank of Greencastle. On April 22, 2010, Tower Bancorp, Inc. became a financial holding company pursuant to the Gramm-Leach-Bliley Act of 1999.

On December 27, 2009, Tower Bancorp, Inc. and First Chester County Corporation (“First Chester”) entered into an Agreement and Plan of Merger (the “FCEC Acquisition Agreement”) pursuant to which Tower will acquire First Chester in an all-stock transaction valued at approximately $65 million or $10.22 per share based on the closing price of Tower common stock at the announcement of this acquisition. As described in the definitive agreement, the exchange ratio is subject to upward or downward adjustment if loan delinquencies at First Chester increase or decrease beyond specified amounts, which would ultimately affect the total value of the acquisition.

As part of the definitive agreement, Tower’s subsidiary bank, Graystone Tower Bank, agreed to increase its lending facility with First Chester to up to $26 million as well as to purchase up to $100 million of residential mortgage and commercial loans from First National Bank of Chester County (“FNB”) in order for the bank to satisfy the regulatory capital requirements of the Office of the Comptroller of the Currency (the “OCC”). As of September 30, 2010, the Bank has loaned $26 million to First Chester. The Bank had also purchased approximately $52 million in performing commercial loans from First National Bank of Chester County during the fourth quarter of 2009.

Following the transaction, based on the 0.453 exchange ratio announced in the FCEC Acquisition Agreement, current Tower shareholders will own approximately 71% and First Chester shareholders will own approximately 29% of the combined company’s common stock. The Company has received all necessary regulatory approvals and pending the approvals of shareholder of both entities, the acquisition is expected to be completed before the end of 2010.

On March 4, 2010, the FCEC Acquisition Agreement was amended between Tower and First Chester. As part of the amended agreement, First Chester shall use its best efforts to sell at or prior to the effective date of the acquisition, the American Home Bank Division of FNB (“AHB Division”) to one or more purchasers on terms and conditions acceptable to both First Chester and Tower. The AHB Division engages in mortgage-banking activities on a nation-wide basis. Additionally, the Company extended a $2 million non-revolving line of credit to First Chester, which permits draws from time to time for the sole purpose of contributing additional capital to FNB in the event that, as a result of the attempt to sell the AHB Division, the actual sale thereof, or the effects on FNB of such sale, FNB’s regulatory capital ratios, as reported in FNB’s quarterly call report, fall below the minimum regulatory capital ratios applicable to FNB. Through September 30, 2010, the Company has not advanced any funds to First Chester under this facility. As of September 30, 2010, First Chester has not sold the AHB Division.

On October 28, 2010, The FCEC Acquisition Agreement was amended between Tower and Fitrst Chester. As part of the amended agreement, the closing deadline has been extended from November 20, 2010 to December 31, 2010 and provided increased clarity to the definition of “First Chester Delinquent Loans.”

Basis of Presentation

The merger between the Company and Graystone was considered a “merger of equals” and was accounted for as a reverse merger using the acquisition method of accounting with Graystone as the accounting acquirer. As a result, any historical financial information included in the Company’s financial statements and related footnotes as reported in this Form 10-Q related to periods prior to March 31, 2009 is that of Graystone.

 

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Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

September 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

 

The accompanying unaudited consolidated financial statements of the Company have been prepared in conformity with U.S. generally accepted accounting principles (U.S. GAAP), the instructions for Form 10-Q, and Article 10 of Regulation S-X. Accordingly, they do not include all information and footnotes required by U.S. GAAP for a complete presentation of consolidated financial statements. In the opinion of management, all adjustments, consisting of normal recurring adjustments, considered necessary for fair presentation are included. The operating results for the three month and nine month periods ended September 30, 2010 are not necessarily indicative of results that may be expected for any other period or for the full year ending December 31, 2010. The accounting policies discussed within the notes to the unaudited consolidated financial statements are followed consistently by the Company. These policies are in accordance with U.S. GAAP and conform to common practices in the banking industry.

The accompanying unaudited consolidated financial statements include the accounts of Tower Bancorp, Inc. and its wholly-owned subsidiary, Graystone Tower Bank and the Bank’s 90% owned mortgage subsidiary, Graystone Mortgage, LLC. All intercompany accounts and transactions are eliminated from the unaudited consolidated financial statements.

Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the potential other-than-temporary impairment of investments, the valuation of long-lived assets, and the valuation of deferred tax assets.

Significant Group Concentrations of Credit Risk

Most of the Company’s activities are with customers located within Central Pennsylvania and Washington County, Maryland. Note 3 discusses the types of securities in which the Company invests. Note 4 discusses the types of lending in which the Company engages. The Company does not have any significant concentrations to any one industry or customer.

Recent Accounting Pronouncements

In July 2010, the FASB issued Accounting Standard Codification Update No. 2010-20 concerning disclosures about the credit quality of financing receivables and the allowance for credit losses. Update No. 2010-20 is intended to provide additional information to assist financial statement users in assessing an entity’s credit risk exposures and evaluating the adequacy of its allowance for credit losses. Update No. 2010-20 requires companies to (1) provide enhanced disclosures around the nature of credit risk inherent in the entity’s portfolio of financing receivables; (2) explain how that risk is analyzed and assessed in arriving at the allowance for credit losses; and (3) explain the changes and reasons for changes in the allowance for credit losses. The provisions of Update No. 2010-20 concerning disclosures for the end of a period are effective for interim and annual periods ending on or after December 15, 2010, or December 31, 2010 for the Company. The provisions of Update No. 2010-20 concerning disclosures about activity that occurs during a reporting period are applicable to the Company for interim and annual periods beginning on or after December 15, 2010, the interim period ending on March 31, 2011. The adoption of Update No. 2010-20 is expected to provide the reader of the Company’s financial statements with expanded and enhanced disclosure surrounding the allowance for credit losses.

In January 2010, the FASB issued Accounting Standard Codification Update No. 2010-06 for improving disclosures about fair value measurements. Update No. 2010-06 requires companies to disclose, and provide the reasons for, all transfers of assets and liabilities between the Level 1 and 2 fair value categories. It also clarifies that companies should provide fair value measurement disclosures for classes of assets and liabilities which are subsets of line items within the balance sheet, if necessary. In addition, Update No. 2010-06 clarifies that companies provide disclosures about the fair value techniques and inputs for assets and liabilities classified within Level 2 or 3 categories. The disclosure requirements prescribed by Update No. 2010-06 are effective for fiscal years beginning after December 15, 2009, and for interim periods within those fiscal years, or March 31, 2010 for the Company. The Company has implemented the disclosure requirements of Update No. 2010-06 within this Form 10-Q which can be found in Note 12 of the Notes to the Unaudited Consolidated Financial Statements. Update No. 2010-06 also requires companies to reconcile changes in Level 3 assets and liabilities by separately providing information about Level 3 purchases, sales, issuances and settlements on a gross basis. This provision of Update No. 2010-06 is effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years, or March 31, 2011 for the Company. The adoption of Update No. 2010-06 is not expected to materially impact the Company’s fair value measurement disclosures.

 

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Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

September 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

 

In June 2009, the FASB issued a pronouncement that amends the derecognition guidance in U.S. GAAP and eliminates the concept of qualifying special-purpose entities (“QSPE”s). This pronouncement is effective for fiscal years and interim periods beginning after November 15, 2009 and early adoption is prohibited. We have adopted this pronouncement on January 1, 2010, which did not have a material effect on the consolidated financial statements for the period ended September 30, 2010.

In June 2009, the FASB issued a pronouncement, which amends the consolidation guidance applicable to variable interest entities (“VIE”s). An entity would consolidate a VIE, as the primary beneficiary, when the entity has both of the following characteristics: (a) the power to direct the activities of a VIE that most significantly impact the entity’s economic performance and (b) the obligation to absorb losses of the entity that could potentially be significant to the VIE or the right to receive benefits from the entity that could potentially be significant to the VIE. Ongoing reassessment of whether an enterprise is the primary beneficiary of a VIE is required. This pronouncement eliminates the quantitative approach previously required for determining the primary beneficiary of a VIE. The pronouncement is effective for fiscal years and interim periods beginning after November 15, 2009. We have adopted this pronouncement on January 1, 2010, which did not have a material effect on the consolidated financial statements for the period ended September 30, 2010.

In December 2007, the FASB issued a pronouncement that establishes accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. The guidance became effective as of January 1, 2009. The adoption of this pronouncement did not have a material impact to our consolidated financial statements. In January 2010, the FASB issued updated guidance relating to the decrease in ownership of a subsidiary. The updated guidance is effective at the beginning of the first interim or annual reporting period ending on or after December 15, 2009 and should be applied retrospectively. We have adopted this pronouncement on January 1, 2010, which did not have a material effect on the consolidated financial statements for the period ended September 30, 2010.

Note 2 - Merger Accounting

On November 13, 2008, Graystone and the Company announced the execution of an agreement of merger, providing for the merger of Graystone with and into the Company. The Merger became effective prior to the start of business on March 31, 2009. The Merger has been accounted for as a reverse merger using the acquisition method of accounting. For accounting purposes, Graystone is considered to be acquiring Tower in this transaction with the surviving legal entity operating under Tower Bancorp, Inc.’s articles of incorporation. Immediately following the holding company merger, the Company’s wholly-owned subsidiary, The First National Bank of Greencastle, merged with and into Graystone Bank, the wholly-owned subsidiary of Graystone, under the name “Graystone Tower Bank.” Graystone Tower Bank is, therefore, the wholly owned subsidiary of Tower Bancorp, Inc. and operates under the prior Graystone Bank charter.

The Merger generated goodwill of $11,935, consisting of synergies and increased economies of scale such as the ability to offer more diverse and more profitable products, added diversity to the branch system to achieve lower cost deposits, an increased legal lending limit, etc. Management expects that no goodwill recognized as a result of the Merger will be deductible for income tax purposes. Goodwill totaled $11,935 as of both September 30, 2010 and December 31, 2009. The Company tests goodwill for impairment annually as of October 31 and intermittently as events occur that would indicate that a potential impairment of goodwill had occurred. The Company experienced no events during the first nine months of 2010 that required the completion of a goodwill impairment test.

The following table shows the pro forma financial results for the Company and Graystone for the nine months ended September 30, 2009, assuming that the Merger occurred on January 1, 2009:

 

     Pro-forma
September 30, 2009
 

Net interest income

   $ 30,004   

Pre-tax net income

     1,823   

Income tax expense

     363   

Net income

     1,460   

Pro-forma earnings per share:

  

Basic

   $ 0.32   

Diluted

   $ 0.32   

 

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Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

September 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

 

Note 3 - Securities Available for Sale

The amortized cost of securities and their approximate fair values at September 30, 2010 and December 31, 2009 are as follows:

 

     Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Fair Value  
     September 30, 2010  

Equity securities

   $ 120       $ —         $ —        $ 120   

U.S. Government sponsored agency securities

     27,040         39         —          27,079   

U.S. Government sponsored agency mortgage-backed securities

     11,830         101         —          11,931   

Collateralized mortgage obligations

     73,626         1,057         —          74,683   

Municipal bonds

     10,929         412         —          11,341   

Municipal bonds – taxable

     10,360         116         (102     10,374   

SBA loan pool investments

     9,765         135         —          9,900   
                                  

Total securities available for sale

   $ 143,670       $ 1,860       $ (102   $ 145,428   
                                  
     December 31, 2009  

Equity securities

   $ 1,156       $ 20       $ (44   $ 1,132   

U.S. Government sponsored agency securities

     56,437         12         (65     56,384   

U.S. Government sponsored agency mortgage-backed securities

     9,109         37         (30     9,116   

Collateralized mortgage obligations

     93,058         81         (654     92,485   

Municipal bonds

     7,093         95         —          7,188   

Municipal bonds – taxable

     12,917         64         (71     12,910   

SBA loan pool investments

     10,710         —           (72     10,638   
                                  

Total securities available for sale

   $ 190,480       $ 309       $ (936   $ 189,853   
                                  

Included with the Company’s securities available for sale are pledged securities with a fair market value of $50,801 and $34,999 at September 30, 2010 and December 31, 2009, respectively. The securities were pledged to secure public deposits and securities sold under agreements to repurchase.

The amortized cost and fair value of available for sale securities as of September 30, 2010 by contractual maturity are shown below. Expected maturities may differ from contractual maturities due to the issuer’s rights to call or prepay the obligation without penalty.

 

     September 30, 2010  
     Amortized Cost      Fair Value  

Due in one year or less

   $ 5,684       $ 5,693   

Due after one year through five years

     20,986         21,054   

Due after five years through ten years

     11,885         11,945   

Due after ten years

     9,774         10,102   
                 
     48,329         48,794   
                 

Mortgage-backed securities (1)

     95,221         96,514   

Equity securities

     120         120   
                 
   $ 143,670       $ 145,428   
                 

 

(1) Mortgage-backed securities include agency mortgage-backed securities, Government National Mortgage Association collateralized mortgage obligations and Small Business Agency Loan pool investments.

 

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Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

September 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

The following table presents information related to the Company’s gains and losses on the sales of equity and debt securities, and losses recognized for other-than-temporary impairment of investments for the three and nine month periods ending September 30, 2010 and 2009.

 

     Three Months Ended September 30,  
     Gross Realized
Gains
     Gross Realized
Losses
    Other-than-
temporary
Impairment
Losses
    Net (Losses)/
Gains
 

2010

         

Equity securities

   $ 10       $ —        $ (70   $ (60

Debt securities

     239         (1     —          238   
                                 

Total

   $ 249       $ (1   $ (70   $ 178   
                                 

2009

         

Equity securities

   $ 160       $ (272   $ —        $ (112

Debt securities

     1         (2     —          (1
                                 

Total

   $ 161       $ (274   $ —        $ (113
                                 
     Nine Months Ended September 30,  
     Gross Realized
Gains
     Gross Realized
Losses
    Other-than-
temporary
Impairment
Losses
    Net (Losses)/
Gains
 

2010

         

Equity securities

   $ 48       $ (3   $ (139   $ (94

Debt securities

     243         (1     —          242   
                                 

Total

   $ 291       $ (4   $ (139   $ 148   
                                 

2009

         

Equity securities

   $ 701       $ (512   $ (29   $ 160   

Debt securities

     5         (9     —          (4
                                 

Total

   $ 706       $ (521   $ (29   $ 156   
                                 

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

September 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

The following table shows gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2010 and December 31, 2009:

 

     Less Than 12 Months      12 Months or More      Total  
     Fair Value      Unrealized
Losses
     Fair Value      Unrealized
Losses
     Fair Value      Unrealized
Losses
 
     September 30, 2010  

Equity securities

   $ —         $ —         $ —         $ —         $ —         $ —     

U.S. Government sponsored agency securities

     —           —           —           —           —           —     

U.S. Government sponsored agency mortgage-backed securities

     —           —           —           —           —           —     

Collateralized mortgage obligations

     —           —           —           —           —           —     

Municipal bonds

     —           —           —           —           —           —     

Municipal bonds – taxable

     4,261         102         —           —           4,261         102   

SBA loan pool investments

     —           —           —           —           —           —     
                                                     
   $ 4,261       $ 102       $ —         $ —         $ 4,261       $ 102   
                                                     
     December 31, 2009  

Equity securities

   $ 417       $ 44       $ —         $ —         $ 417       $ 44   

U.S. Government sponsored agency securities

     47,101         65         —           —           47,101         65   

U.S. Government sponsored agency mortgage-backed securities

     7,275         30         —           —           7,275         30   

Collateralized mortgage obligations

     70,991         654         —           —           70,991         654   

Municipal bonds

     —           —           —           —           —           —     

Municipal bonds – taxable

     6,955         71         —           —           6,955         71   

SBA loan pool investments

     10,710         72         —           —           10,710         72   
                                                     
   $ 143,449       $ 936       $ —         $ —         $ 143,449       $ 936   
                                                     

The previous table includes 5 investment securities at September 30, 2010 where the current fair value is less than the related amortized cost. There were 36 investment securities at December 31, 2009 that had a current fair value less than the related amortized cost. Management evaluates all securities for other-than-temporary impairment on at least a quarterly basis. Consideration is given to (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, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. At September 30, 2010, Management identified equity securities with unrealized losses that were deemed to be other-than-temporary in nature and resulting in an impairment charge for the three and nine months period ending September 30, 2010 of $70 and $139, respectively. The impairment charge for both the three and nine months period ending September 30, 2009 was $29. Management does not have the intent to sell the investments available for sale carrying an unrealized loss and believes it is more likely than not, that it will not be required to sell these securities prior to the recovery of their cost basis or maturity, with the exception of the securities for which an impairment charge was recognized this quarter. As a result, the Company has determined that, excluding the securities related to the impairment charge, no investments trading below cost had declined on an other-than-temporary basis during the first nine months of 2010.

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

September 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

 

Note 4 - Loans

The following table presents a summary of the loan portfolio at September 30, 2010 and December 31, 2009:

 

     September 30,
2010
    December 31,
2009
 

Commercial:

    

Industrial

   $ 707,114      $ 599,708   

Real estate

     179,064        159,947   

Construction

     138,863        102,018   

Consumer:

    

Home equity line

     85,921        49,239   

Other

     34,100        36,271   

Residential mortgage

     176,555        191,277   
                

Total Loans

     1,321,617        1,138,460   

Deferred costs (fees)

     (80     (189

Allowance for loan losses

     (12,717     (9,695
                

Net Loans

   $ 1,308,820      $ 1,128,576   
                

The Company serviced $104,797 and $111,649 of participation loans for unrelated parties at September 30, 2010 and December 31, 2009, respectively.

The Company sold $92,485 and $104,010 of residential mortgage loans into the secondary market during the nine months ended September 30, 2010 and 2009, respectively. A gain of $656 and $334 was recognized on the sale of these loans for the three month periods ended September 30, 2010 and 2009, respectively. A gain of $1,250 and $1,182 was recognized on the sale of these loans for the nine month periods ended September 30, 2010 and 2009, respectively.

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

September 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

Changes in the allowance for loan losses were as follows for the three months and nine months ended September 30, 2010 and 2009:

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2010     2009     2010     2009  

Balance at beginning of period

   $ 11,619      $ 7,965      $ 9,695      $ 6,017   

Provision for loan losses

     1,600        800        4,950        3,816   

Charge-offs

        

Commercial:

        

Industrial

     (113     (270     (915     (1,102

Real estate

     —          (65     (266     (65

Construction

     —          (37     —          (150

Consumer:

        

Home equity line

     (65     —          (265     (7

Other

     (62     (8     (291     (148

Residential mortgage

     (271     (7     (271     (7
                                

Total charge-offs

     (511     (387     (2,008     (1,479

Recoveries

        

Commercial

        

Industrial

     6        11        75        28   

Real estate

     —          —          —          —     

Construction

     —          1        2        1   

Consumer

        

Home equity line

     —          —          —          7   

Other

     1        —          1        —     

Residential mortgage

     2        —          2        —     
                                

Total recoveries

     9        12        80        36   
                                

Net charge-offs

     (502     (375     (1,928     (1.443
                                

Balance at end of period

   $ 12,717      $ 8,390      $ 12,717      $ 8,390   
                                

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

September 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

The following table presents non-performing assets as of September 30, 2010 and December 31, 2009:

 

     September 30,
2010
     December 31,
2009
 

Non-accrual loans

     

Commercial:

     

Industrial

   $ 4,697       $ 2,646   

Real estate

     1,643         464   

Construction

     5,235         298   

Consumer:

     

Home equity line

     54         —     

Other

     70         242   

Residential mortgage

     2,058         1,068   
                 

Total non-accrual loans

     13,757         4,718   
                 

Accruing loans greater than 90 days past due

     

Commercial:

     

Industrial

     —           356   

Real estate

     —           277   

Construction

     —           —     

Consumer:

     

Home equity line

     293         303   

Other

     264         51   

Residential mortgage

     972         1,119   
                 

Total accruing loans greater than 90 days past due

     1,529         2,106   
                 

Non-performing loans

     15,286         6,824   

Other real estate owned

     879         927   
                 

Non-performing assets

   $ 16,165       $ 7,751   
                 

The Company had total impaired loans of $18,095 and $10,917 as of September 30, 2010 and December 31, 2009, respectively. Management performed an evaluation of expected future cash flows, including the anticipated cash flow from the sale of collateral, and compared that to the carrying amount of the impaired loans. Impaired loans considered to be collateral dependent totaled approximately 99.6% and 99.4% of total impaired loans as of September, 30, 2010 and December 31, 2009, respectively. As of September 30, 2010, the Company has determined that impaired loans with a carrying principal balance of $619 require a reserve of $200 with the remaining $17,476 of impaired loans not requiring a specific reserve allocation as the future anticipated cash flow, including the collateral values, is expected to be sufficient to fully recover all amounts due on these loans. As of December 31, 2009, the Company had determined that impaired loans with a carrying principal balance of $1,353 required a reserve of $451 with the remaining $9,564 of impaired loans not requiring a specific reserve allocation as the future anticipated cash flow, including the collateral values, is expected to be sufficient to fully recover all amounts due on these loans. For the nine months ended September 30, 2010, the Company had loan charge-off’s of $3,038. These charges have been applied against both the allowance for loans losses as well as against the fair value credit adjustment/discount recorded on performing loans acquired through the Merger.

Acquired loans deemed to be impaired at the time of purchase in accordance with Accounting Standard Codification 310-30-30, previously known as Statement of Position (SOP) 03-3, “Accounting for Certain Loans Acquired in a Transfer” are included in the balance of impaired loans. However, these purchased impaired loans have been recorded at their fair value based on anticipated future cash flows at the time of acquisition and are considered to be performing loans as the Company expects to fully collect the new carrying value (i.e. fair value) of the loans.

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

September 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

 

The following table provides activity for the accretable yield of these purchased impaired loans for the three and nine months ended September 30, 2010.

 

     Three Months Ended
September 30, 2010
    Nine Months Ended
September 30, 2010
 

Accretable yield, beginning balance

   $ 1,159      $ 178   

Accretable yield amortized to interest income

     (305     (856

Reclassification from non-accretable difference (1)

     —          1,532   
                

Accretable yield, end of period

   $ 854      $ 854   
                

 

(1) Reclassification from non-accretable difference represents an increase to the estimated cash flows to be collected on the underlying portfolio.

Note 5 - Premises and Equipment

The following table presents premises and equipment as of September 30, 2010 and December 31, 2009:

 

     September 30, 2010     December 31, 2009  

Land

   $ 4,474      $ 5,394   

Building

     13,570        13,684   

Leasehold improvements

     3,827        3,703   

Furniture, fixtures and equipment

     8,208        6,918   

Other

     4,741        3,435   
                

Total premises and equipment

     34,820        33,134   

Accumulated depreciation and amortization

     (5,265     (3,324

Premises and equipment held for sale, net of accumulated depreciation

     (549     —     
                

Total net premises and equipment

   $ 29,006      $ 29,810   
                

During the second quarter of 2010, management had explored the potential sale of a parcel of undeveloped land that was acquired as part of the Merger. As a result, management determined that the recorded cost basis of the land may not be recoverable. Accordingly, the Company determined the estimated fair value of the land to be less than its recorded value, resulting in an impairment charge of $920. Management reviewed the property as of September 31, 2010 and determined no additional impairment had occurred.

Premise and Equipment Held for Sale

During the first quarter of 2010, the Company closed two Tower Bank branches to consolidate banking operations in selected areas. All loans and deposit accounts related to these branches were transferred to existing Tower Bank branches. The Company is currently in the process of selling the land and buildings related to two branches and anticipates the sale of the land and buildings by the end of the first quarter of 2011. The carrying value of the branches is based on the net value of the land and building prior to being reclassified as held for sale. This value is currently less than the estimated fair market value at September 30, 2010. As of September 30, 2010, the carrying value of the land and buildings for these branches are $549.

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

September 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

 

Note 6 - Other Intangibles

Information concerning total amortizable other intangible assets, which consist solely of a core deposit intangible asset, at September 30, 2010 and December 31, 2009 is as follows:

 

     Gross
Carrying
Amount
     Accumulated
Amortization
     Net Carrying
Amount
 

Balance at December 31, 2009

   $ 3,899       $ 532       $ 3,367   

Amortization Expense

     —           496         496   
                          

Balance at September 30, 2010

   $ 3,899       $ 1,028       $ 2,871   
                          

The estimated amortization for the next five years and thereafter is as follows:

 

2010 (October – December)

   $ 160   

2011

     585   

2012

     513   

2013

     444   

2014

     372   

Thereafter

     797   
        
   $ 2,871   
        

Note 7 - Deposits

The following is a summary of deposits at September 30, 2010 and December 31, 2009:

 

     September 30,
2010
     December 31,
2009
 

Non-interest bearing transaction accounts

   $ 125,174       $ 119,116   

Interest checking accounts

     124,106         110,356   

Money market accounts

     604,151         477,292   

Savings accounts

     70,138         87,117   

Time deposits of $100,000 or greater

     145,694         130,938   

Time deposits, other

     286,454         291,650   
                 

Total

   $ 1,355,717       $ 1,216,469   
                 

Brokered deposits totaled $148,250 and $61,114 at September 30, 2010 and December 31, 2009, respectively. Brokered deposits, exclusive of in-market reciprocal brokered deposits, totaled $107,005 and $46,018 at September 30, 2010 and December 31, 2009, respectively.

Note 8 - Borrowings

Federal Home Loan Bank

The Bank has a maximum borrowing capacity under an agreement with the Federal Home Loan Bank (“FHLB”) of approximately $580,289 and $482,024 at September 30, 2010 and December 31, 2009, respectively. The available amount of borrowing capacity for September 30, 2010 and December 31, 2009 was approximately $526,201 and $422,679, respectively. The total outstanding borrowings at September 30, 2010 equaled $54,088, of which $5,000 has a maturity of less than one year and is classified as short-term borrowing. The remaining borrowings of $49,088 have a maturity greater than one year and are classified as long-term debt at September 30, 2010. The average interest rate on FHLB borrowings at September 30, 2010 equaled 3.72%. At September 30, 2010, the unamortized fair value adjustment to FHLB borrowings assumed in the

 

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Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

September 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

Merger totaled $(346). The total outstanding borrowings at December 31, 2009 equaled $59,346, of which, $54,096 have a stated maturity greater than one year and are classified as long-term debt at December 31, 2009. The remaining $5,250 in FHLB borrowings are classified as short-term borrowings at December 31, 2009.

Other Borrowings

On June 12, 2009, the Company issued, to private investors, $9,000 of subordinated notes bearing an annual interest rate of 9.00%. Each note may be redeemed at the Company’s discretion and contains a maturity date of July 1, 2014. Interest only payments are due on a quarterly basis with the unpaid principal balance due at maturity.

On February 5, 2010, the Company issued to private investors an aggregate of $12,000 of subordinated notes bearing an annual interest rate of 9.00%. Each note may be redeemed at the Company’s discretion and contains a maturity date of July 15, 2015. Interest only payments are due on a quarterly basis with the unpaid principal balance due at maturity.

Federal funds are reported on a gross basis. Federal funds sold are stated as assets and federal funds purchased are stated as liabilities. Federal funds purchased are considered short-term borrowings and are subject to restrictions limiting the frequency and terms of advances. Generally, federal funds are purchased or sold for one day periods and bear interest based upon the daily federal funds rate. The Company did not have any federal funds purchased at September 30, 2010 or December 31, 2009.

Capital Lease Obligations

Included in short-term borrowings and long-term debt are two capital lease agreements, which relate to the Lebanon and York branches. Total capital lease obligations related to these leases were $2,693 and $2,729 at September 30, 2010 and December 31, 2009, respectively.

Note 9 - Net Income Per Share and Comprehensive Income

The Company’s basic net income per share is calculated as net income divided by the weighted average number of shares outstanding. For diluted net income per share, net income is divided by the weighted average number of shares outstanding plus the incremental number of shares added as a result of converting common stock equivalents, calculated using the treasury stock method. The Company’s common stock equivalents consist solely of outstanding stock options and restricted stock. The effects of options to issue common stock are excluded from the computation of diluted earnings per share in periods in which the effect would be anti-dilutive.

A reconciliation of the weighted average shares outstanding used to calculate basic net income per share and diluted net income per share follows:

 

     For the Three Months Ended
September 30,
     For the Nine Months Ended
September 30,
 
     2010      2009      2010      2009  

Weighted average shares outstanding (basic)

     7,144,685         5,638,851         7,134,611         4,495,962   

Impact of common stock equivalents

     36         13,441         2,897         6,434   
                                   

Weighted average shares outstanding (diluted)

     7,144,721         5,652,292         7,137,508         4,502,396   
                                   

Common stock equivalents excluded from earnings per share as their effect would have been anti-dilutive

           
     125,846         44,585         94,969         46,981   
                                   

Comprehensive income is defined as the change in equity from transactions and other events from non-owner sources. It includes all changes in equity except those resulting from investments by stockholders and distributions to stockholders. Comprehensive income includes net income and accounting for certain investments in debt and equity securities.

The Company has elected to report its comprehensive income in the statement of changes in stockholders’ equity. The only element of “other comprehensive income” that the Company has is the unrealized gains or losses on available for sale securities.

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

September 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

 

The components of the change in net unrealized gains (losses) on securities are as follows:

 

     For the Nine Months Ended
September 30,
 
     2010     2009  

Gross unrealized holding gains arising during the year

   $ 2,534      $ 654   

Reclassification adjustment for impairment losses recognized in net income

     139        29   

Reclassification adjustment for losses realized in net income

     (287     (185
                

Net unrealized holding gains before taxes

     2,386        498   

Tax effect

     (829     (169
                

Net change

   $ 1,557      $ 329   
                

Note 10 - Financial Instruments with Off-Balance Sheet Risk

The Company 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 letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet.

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

The outstanding financial instruments represent credit risk in the following amounts at September 30, 2010 and December 31, 2009:

 

     September 30, 2010      December 31, 2009  

Commitments to grant loans

   $ 35,368       $ 12,350   

Unfunded commitments under lines of credit

     320,246         267,683   

Letters of credit

     30,494         25,524   

Commitments to extend credit, which include commitments to grant loans and unfunded commitments under lines of credit, are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The Company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation. Collateral held varies but may include personal or commercial real estate, accounts receivable, inventory and equipment.

Outstanding letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank typically requires collateral supporting these letters of credit. Management believes that the proceeds obtained through a liquidation of such collateral would be sufficient to cover the maximum potential amount of future payments required under the corresponding guarantees. The amount of the liability as of September 30, 2010 and December 31, 2009 for guarantees under standby letters of credit issued is not material to the unaudited consolidated financial statements.

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

September 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

 

Note 11 - Stock-Based Compensation

At September 30, 2010, the Company had five equity compensation plans, the 2010 Stock Incentive Plan (the “2010 Plan”), the 2006 Restricted Stock Plan (the “2006 Plan”), the 2007 Stock Incentive Plan (the “2007 Plan”), the 1995 Non-Qualified Stock Option Plan (the “1995 Plan”) and the Stock Option Plan for Outside Directors (the “Director Plan”).

The 2010 Stock Incentive Plan

In May 2010, the shareholders of the Company approved the 2010 Stock Incentive Plan (the “2010 Plan”). The 2010 Plan permits grants of stock options, stock appreciation rights, restricted stock, deferred stock and performance awards (collectively, “Awards”) for up to 400,000 shares of the Company’s common stock to key employees and directors.

In September 2010, awards for 1,050 shares of restricted stock were granted under the 2010 Plan. The fair value of these shares was $20.92 per share based on the closing price at September 28, 2010. These shares have a vesting period of five years. As these shares are considered to have the same rights as common stock shareholders, including voting rights and rights to receive dividends, on the date of issuance, they are included as part of the Company’s basic weighted average shares. At September 30, 2010, 398,950 shares were available for issuance under the 2010 plan.

The following table summarizes the restricted stock issued under the Company’s 2010 Plan at September 30, 2010 and December 31, 2009:

Restricted Stock

 

                          Shares Vested      Unearned Compensation (in 000’s)  

Date of

Issuance

  

Shares
Issued

    

Fair Value
Per Share

    

Expiration
Date

    

September 30,
2010

    

December 31,
2009

    

September 30,
2010

    

December 31,
2009

 

September 28, 2010

     1,050       $ 20.92         N/A         —           —         $ 22       $ —     
                                                  
     1,050               —           —         $ 22       $ —     
                                                  

The 2006 Restricted Stock Plan

During 2006, the shareholders of Graystone approved the 2006 Restricted Stock Plan (the “2006 Plan”), as amended, that provides for the issuance of up to 375,000 shares of restricted stock awards subject to a three year vesting period to key employees and directors. The recipient shall receive all dividends or other distributions and shall have the right to vote with respect to issued but unvested shares. On March 31, 2009, as a result of the Merger, the Company had adopted the provisions of this plan. As of March 31, 2009, the Company had issued all of the available awards under the plan and all of the awards are completely vested as a result of the vesting acceleration in association with the Merger. The Company recognized $0 and $295 of compensation expense during the nine month periods ending September 30, 2010 and 2009, respectively, related to the vesting of the restricted stock awards.

The 2007 Stock Incentive Plan

In May 2007, the shareholders of Graystone approved the 2007 Stock Incentive Plan (the “2007 Plan”). Under the Plan, Graystone may grant incentive stock options, nonqualified stock options, stock appreciation rights, restricted stock, and deferred stock for up to 600,000 shares (shares reflect the 3-for-2 stock split paid September 30, 2007) of Graystone’s common stock to key employees and directors. On March 31, 2009, as a result of the Merger, the Company had adopted the provisions of this plan.

In September 2010, awards for 30,290 shares of restricted stock were granted under the 2007 Plan. The fair value of these shares was $20.92 per share based on the closing price at September 28, 2010. These shares have a vesting period of five years. As these shares are considered to have the same rights as common stock shareholders, including voting rights and rights to receive dividends, on the date of issuance, they are included as part of the Company’s basic weighted average shares.

Subsequent to the Merger and as a result of the conversion factor, the total number of shares authorized to be issued under the 2007 Plan equaled 252,000. At September 30, 2010, 46,365 shares were available for issuance under the 2007 plan.

The following table summarizes the outstanding stock options and restricted stock under the Company’s 2007 Plan at September 30, 2010 and December 31, 2009:

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

September 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

 

Stock Options

 

                  

Expiration Date

   Options Vested      Unearned Compensation (in 000’s)  

Date of

Issuance

  

Options
Issued

    

Exercise
Price

       

September 30,
2010

    

December 31,
2009

    

September 30,
2010

    

December 31,
2009

 

June 26, 2007

     26,145       $ 22.22      

June 26, 2017

     26,145         26,145       $ —         $ —     

January 22, 2008

     1,050       $ 30.96      

January 22, 2018

     1,050         1,050         —           —     

July 17, 2008

     56,700       $ 30.96      

July 17, 2018

     56,700         56,700         —           —     

September 22, 2009

     52,400       $ 26.77      

September 22, 2019

     10,480         —           268         318   

November 24, 2009

     38,000       $ 19.80      

November 24, 2019

     —           —           154         182   
                                                  
     174,295               94,375         83,895       $ 422       $ 500   
                                                  
Restricted Stock                     
                         Shares Vested      Unearned Compensation (in 000’s)  

Date of

Issuance

  

Shares
Issued

    

Fair Value
Per Share

    

Expiration Date

  

September 30,
2010

    

December 31,
2009

    

September 30,
2010

    

December 31,
2009

 

September 28, 2010

     30,290       $ 20.92       N/A      —           —         $ 634       $ —     
                                                  
     30,290               —           —         $ 634       $ —     
                                                  

The stock options normally vest over a three to five year vesting period and will be expensed over the vesting period. As a result of the Merger, all of the outstanding options at March 30, 2009 became fully vested and exercisable. No options issued under this plan have been exercised during the first nine months of 2010. The aggregate intrinsic value of outstanding unvested stock options at September 30, 2010 and December 31, 2009 was $18 and $116, respectively. Options granted resulted in compensation expense of $26 and $78 for the three and nine month periods ended September 30, 2010, respectively. Compensation expense for the three and nine months periods ended September 30, 2009 were $2 and $551, respectively. As of September 30, 2010, a total of 94,375 options have vested with an intrinsic value of $0. These vested options can be exercised at an average price of $28.07 and have an average remaining life of approximately 7.6 years. The fair values of the options awarded under the Plan are estimated on the date of grant using the Black-Scholes valuation methodology.

Upon the closing of the Merger, all of the issued and outstanding stock options originally issued by Graystone converted to options exercisable for Tower common stock. Additionally, all options became fully vested at the time of conversion. As a result and in accordance with U.S. GAAP, the Company revalued the converted options as of the conversion date. The re-valuation of the converted options did not result in any incremental costs to the Company. The table below shows the assumptions utilized by Management to value all stock options:

 

Date of Issuance

   Dividend
Yield
    Expected
Volatility
    Risk Free
Interest Rate
    Estimated
Forfeitures
  Expected
Life
  Issue-Date Fair
Value
 

June 26, 2007

     4.49     32.17     2.31   0.00%   6 years   $ 5.75   

January 22, 2008

     4.49     32.17     2.31   0.00%   6 years   $ 3.70   

July 17, 2008

     4.49     32.17     2.31  

1% – 3

  6.5 years   $ 3.80   

September 22, 2009

     4.00     31.84     3.50   (1)   (2)   $ 6.63   

November 24, 2009

     4.00     32.63     3.39   2.00%   9 years   $ 5.00   

 

(1) Estimated forfeitures for stock options issued to executives are 2.00% while the estimated forfeiture for stock options issued to employees is 5.00%.
(2) Expected life for stock options issued to executives is 9 years while estimated expected life for stock options issued to employees is 7 years.

The dividend yield assumption is based on dividend history and the expectation of future dividend yields. The expected volatility is based on historical volatility using the Company’s own stock price. The risk-free rate is the U.S. Treasury zero-coupon rate commensurate with the expected life of the options on the date of the grant.

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

September 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

 

The 1995 Non-Qualified Stock Option Plan

At September 30, 2010, there were 5,700 options outstanding under the 1995 Plan and the Company recognized $2 and $6 in compensation expense related to the 1995 Plan during the three and nine month period ended September 30, 2010, respectively. There are a total of 27,719 options available to be issued under this plan at September 30, 2010.

The following table summarizes the outstanding non-qualified stock options under the Company’s 1995 Plan at September 30, 2010 and December 31, 2009:

 

                   Expiration
Date
     Options Vested      Unearned Compensation (in 000’s)  

Date of

Issuance

  

Options
Issued

    

Exercise
Price

       

September 30,
2010

    

December 31,
2009

    

September 30,
2010

    

December 31,
2009

 

September 22, 2009

     5,700       $ 26.77         September 22, 2019         1,140         —         $ 29       $ 34   
                                                  
     5,700               1,140         —         $ 29       $ 34   
                                                  

The assumptions utilized by management to calculate the issue date fair value of $6.63 are the same as the assumptions used for shares issued under the 2007 Plan.

The Stock Option Plan for Outside Directors

At September 30, 2010, there were a total of 11,926 options outstanding under the Director Plan. The options outstanding are all fully vested, have a weighted average exercise price of $38.06 per share, and have a weighted average life to maturity of 6.3 years. The Company recognized $0 in compensation expense related to the Director Plan during the nine month period ended September 30, 2010. There are a total of 64,158 options available to be issued under this plan at September 30, 2010.

Note 12 - Fair Value Measurements

Fair value is the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants on the measurement date. The Company determines the fair value of its financial instruments based on the fair value hierarchy. The Company maximizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value. Observable inputs are inputs that market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions that the market participants would use in pricing the asset or liability based on the best information available in the circumstances. Three levels of inputs are used to measure fair value. A financial instrument’s level within the fair value hierarchy is based on the lowest level of input significant to the fair value measurement.

 

Level 1:    Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.
Level 2:    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:    Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported with little or no market activity).

An asset’s or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

September 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

 

For financial assets measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy used at September 30, 2010 and December 31, 20009 are as follows:

 

     September 30,
2010
     Quoted
Prices

(Level  1)
     Significant
Other
Observable
Inputs

(Level 2)
     Significant
Unobservable
Inputs

(Level 3)
 
             

Equity securities

   $ 120       $ —         $ —         $ 120   

U.S Government sponsored agency securities

     27,079         —           27,079         —     

U.S. Government sponsored agency mortgage-backed securities

     11,931         —           11,931         —     

Collateralized mortgage obligations

     74,683         —           74,683         —     

Municipal bonds

     11,341         —           11,341         —     

Municipal bonds – taxable

     10,374         —           10,374         —     

SBA loan pool investments

     9,900         —           9,900         —     

Commercial servicing rights

     451         —           —           451   
                                   
   $ 145,879       $ —         $ 145,308       $ 571   
                                   

 

     December 31,
2009
     Quoted
Prices

(Level  1)
     Significant
Other
Observable
Inputs

(Level 2)
     Significant
Unobservable
Inputs

(Level 3)
 
             

Equity securities

   $ 1,132       $ 300       $ 783       $ 49   

U.S Government sponsored agency securities

     56,384         —           56,384         —     

U.S. Government sponsored agency mortgage-backed securities

     9,116         —           9,116         —     

Collateralized mortgage obligations

     92,485         —           92,485         —     

Municipal bonds

     7,188         —           7,188         —     

Municipal bonds – taxable

     12,910         —           12,910         —     

SBA loan pool investments

     10,638         —           10,638         —     

Commercial servicing rights

     473         —           473         —     
                                   
   $ 190,326       $ 300       $ 189,977       $ 49   
                                   

The valuation technique to measure fair value for the items in the tables above are as follows:

Securities available for sale

As quoted market prices for the investments in securities available for sale held at the Bank, such as government agency bonds, corporate bonds, municipal bonds, etc, are not readily available, a matrix pricing model is used to value these investments. The matrix pricing model takes into consideration yields/prices of securities with similar characteristics, including credit quality, industry, and maturity to determine a fair value measure.

For equity securities held by the Company, management has determined which securities are traded in active markets versus inactive markets. For those securities traded in active markets, management has recorded the securities at quoted market prices. In cases where the securities are deemed to trade in inactive markets, management has adjusted quoted market prices for factors such as indicative bids received from brokers.

Commercial servicing rights

The fair value of commercial servicing rights (“MSRs”) was estimated using Level 3 inputs. MSRs do not trade in an active, open market with readily observable prices. As such, the Company determined the fair value of the MSRs using a projected cash flow model that considers loan rates and maturities, discount rate assumptions, estimated servicing revenue and expenses, and estimated prepayment speeds.

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

September 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

 

The following tables presents reconciliations of the Company’s assets measured at fair value on a recurring basis using unobservable inputs (Level 3) for the three and nine months ended September 30, 2010 and 2009:

 

     For the Three Months September 30,  
2010    Equity Securities     Commercial
Servicing Rights
 

Balance, June 30, 2010

   $ 154      $ 514   

Transfers In from Level 2

     38        —     

Change in fair value

     (72     (63
                

Balance, September 30, 2010

   $ 120      $ 451   
                
2009          Equity Securities  

Balance, June 30, 2009

     $ 257   

Sale of Asset

       (153
          

Balance, September 30, 2009

     $ 104   
          
     For the Nine Months Ended September 30,  
2010    Equity Securities     Commercial
Servicing Rights
 

Balance, December 31, 2009

   $ 49      $ —     

Transfers In from Level 2

     176        473   

Sale of Asset

     (33     —     

Change in fair value

     (72     (22
                

Balance, September 30, 2010

   $ 120      $ 451   
                
2009          Equity Securities  

Balance, December 31, 2008

     $ —     

Purchase through merger

       230   

Transfers In from Level 2

       27   

Sale of Asset

       (153
          

Balance, September 30, 2009

     $ 104   
          

During the Company’s valuation of the investment portfolio performed during the first nine months of 2010, the Company determined one equity security was no longer actively traded on the open market. In the prior year, the fair value of the equity security was determined based on an estimate from limited activity in the open market, determined as Level 2 pricing. As there has been no activity in the current year to determine the fair value price, the Company evaluated the entity’s current financial reports for any going concern or other issues that would affect the entity’s current or future position. Based upon this review, the Company determined the entity does not have any significant issues that would affect the current and future position of the entity. The technique used to determine the price of the equity security required estimates and judgments of management resulting in the classification of the security as a Level 3 security.

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

September 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

 

For financial assets and liabilities measured at fair value on a nonrecurring basis, the fair value measurements by level within the fair value hierarchy used at September 30, 2010 and December 31, 2009 are as follows:

 

     September 30,
2010
     Quoted
Prices
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs

(Level 3)
 

Loans held for sale

   $ 12,851       $ —         $ —         $ 12,851   

Impaired loans

     13,757         —           —           13,757   

Other real estate owned

     879         —           —           879   

Impaired land

     1,000         —           —           1,000   
                                   

Total assets

   $ 28,487       $ —         $ —         $ 28,487   
                                   

 

     December 31,
2009
     Quoted
Prices
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs

(Level 3)
 

Loans held for sale

   $ 8,034       $ —         $ —         $ 8,034   

Impaired loans

     4,718         —           —           4,718   

Other real estate owned

     927         —           —           927   

Loans purchased (1)

     418,747         —           —           418,747   

Core deposit intangible asset (1)

     3,899         —           —           3,899   

Premises and equipment (1)

     22,644         —           —           22,644   
                                   

Total assets

   $ 458,969       $ —         $ —         $ 458,969   
                                   

Time deposits (1)

   $ 160,806       $ —         $ 160,806       $ —     

Borrowings (1)

     69,601         —           69,601         —     
                                   

Total liabilities

   $ 230,407       $ —         $ 230,407       $ —     
                                   
           

(1) – Assets and liabilities are presented at fair value as of the date of the Merger.

The valuation technique to measure fair value for the items in the tables above are as follows:

Loans held for sale

Loan held for sale include residential mortgage loans which are measured at the lower of aggregate cost or fair value. The fair value is measured as the price that secondary market investors were offering for loans with similar characteristics.

Impaired loans

Under U.S GAAP, a loan is classified as impaired when it is possible that the bank will be unable to collect all or part of the loan balance due based on the contractual agreement, including the interest as well as the principal. Based on this guidance, the Company considers all loans placed in non-accrual status as being impaired and subject to an impairment analysis in accordance with ASC 310-10-35. Loans acquired through the Merger that were deemed impaired were recorded using a discounted cash flow model in accordance with ASC 310-30 at the time of acquisition even though the Company considers these loans to be collateral dependent. The carrying amounts of these loans at September 30, 2010 and December 31, 2009 were $4,338 and $6,199, respectively. These loans are not included in the preceding table.

Impaired loans included in the preceding table are those for which the Company has measured impairment based on the fair value of underlying collateral. The balance of impaired loans consists of loans deemed impaired in accordance with the Company’s accounting policy disclosed within its “Critical Accounting Policies.” Fair value is determined primarily

 

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Table of Contents

Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

September 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

based upon independent third party appraisals of the properties. At September 30, 2010, $13,687 of impaired loans were measured using the fair value of underlying collateral and $70 of impaired loans were measured using a discounted cash flow model. At December 31, 2009, $4,650 of impaired loans were measured using the fair value of underlying collateral and $68 of impaired loans were measured using a discounted cash flow model.

Other real estate owned

Other real estate owned consists of eight properties totaling $879 thousand at September 30, 2010 and four properties totaling $927 thousand at December 31, 2009. These properties have been through the foreclosure process and are currently in the process of being sold. These properties are recorded at their lower of cost or fair value less costs to sell.

Impaired land

During the second quarter of 2010, management had explored the potential sale of a parcel of undeveloped land that was acquired as part of the Merger. Based upon the evaluation performed by an independent third party, the Company determined the estimated fair value of the land to be less than its recorded value, resulting in an impairment charge. The Company is currently consulting with third party valuation experts to finalize a determination of fair value for the land.

Loans purchased

In conjunction with the Merger, the loans purchased were recorded at their acquisition date fair value. In order to record the loans at fair value, management made three different types of fair value adjustments. A market rate adjustment was made to adjust for the movement in market interest rates, irrespective of credit adjustments, compared to the stated rates of the acquired loans. A credit adjustment was made on pools of homogeneous loans representing the changes in credit quality of the underlying borrowers from the loan inception to the acquisition date. The credit adjustment on distressed loans represents the portion of the loan balance that has been deemed uncollectible based on management’s expectations of future cash flows for each respective loan.

Core deposit intangible assets

The fair value assigned to the core deposit intangible asset represents the future economic benefit of the potential cost savings from acquiring core deposits in the Merger compared to the cost of obtaining alternative funding such as brokered deposits from market sources. Management utilized an income valuation approach to present value the estimated future cash savings in order to determine the fair value of the intangible asset.

Premises and equipment

Premises and equipment acquired through the Merger has been assigned an acquisition date fair value through the use of independent appraisals and internal discounted cash flow models. Both approaches utilized an income based valuation approach to determine the fair value for the premises and equipment based on the highest and best use concept.

Time deposits

Time deposits acquired through the Merger have been recorded at their acquisition date fair value. In order to derive the fair value, management adjusted the amortized cost basis of the deposits to reflect the current interest rates paid on time deposits at the time of acquisition. The fair value adjustment reflects the movement in interest rates from inception of the deposit to the acquisition date.

Borrowings

Borrowings assumed through the Merger have been recorded at their acquisition date fair value. The fair value adjustment to the carrying value of the borrowings represents the movement in interest rates from the inception of the individual borrowings to the acquisition date.

The following information should not be interpreted as an estimate of the fair value of the entire Company since a fair value calculation is only provided for a limited portion of the Company’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 Company’s disclosures and those of other companies may not be meaningful.

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

September 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

 

The estimated fair values of the Company’s financial instruments were as follows as of September 30, 2010 and December 31, 2009:

 

     September 30, 2010      December 31, 2009  
     Carrying
Amount
     Fair Value      Carrying
Amount
     Fair Value  

Financial assets:

           

Cash, due from banks, and federal funds sold

   $ 46,265       $ 46,265       $ 50,600       $ 50,600   

Securities available for sale

     145,428         145,428         189,853         189,853   

Restricted investment in bank stock

     6,254         6,254         6,254         6,254   

Loans held for sale

     12,851         12,851         8,034         8,034   

Loans

     1,308,820         1,318,397         1,128,576         1,151,368   

Accrued interest receivable

     5,220         5,220         4,974         4,974   

Financial liabilities:

           

Deposits

     1,355,717         1,327,674         1,216,469         1,191,126   

Securities sold under agreements to repurchase

     7,102         7,102         6,892         6,892   

Short-term borrowings

     5,037         5,037         5,292         5,292   

Long-term debt

     72,398         78,815         65,689         69,814   

Accrued interest payable

     1,084         1,084         1,090         1,090   
     Nominal
Amount
     Fair Value      Nominal
Amount
     Fair Value  

Off-balance sheet financial instruments:

           

Commitments to grant loans

     35,368         —           12,350         —     

Unfunded commitments under lines of credit

     320,246         —           267,683         —     

Letters of credit

     30,494         179         25,524         —     

The following methods and assumptions were used to estimate the fair values of the Company’s financial instruments at September 30, 2010 and December 31, 2009.

Cash and cash equivalents (carried at cost)

The carrying amounts reported in the balance sheet for cash and short-term instruments approximate those assets’ fair values.

Restricted investment in bank stock (carried at cost)

The carrying amount of restricted investment in bank stock approximates fair value, and considers the limited marketability of such securities.

Loans held for sale (carried at lower of cost or fair value)

The carrying amounts of loans held for sale approximate their fair value.

Loans (carried at cost)

The fair values of loans are estimated using discounted cash flow analyses, using market rates at the balance sheet date that reflect the credit and interest rate-risk inherent in the loans. Projected future cash flows are calculated based upon contractual maturity or call dates, projected repayments and prepayments of principal. Generally, for variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. This method of estimating fair value does not incorporate the exit price concept of fair value but is a permitted methodology for purposes of this disclosure.

Accrued interest receivable and payable (carried at cost)

The carrying amount of accrued interest receivable and accrued interest payable approximates its fair value.

 

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Tower Bancorp, Inc. and Subsidiary

 

Notes to Unaudited Consolidated Financial Statements

September 30, 2010 (Unaudited)

(Amounts in thousands, except share data)

 

 

Deposits (carried at cost)

The fair values disclosed for demand deposits (e.g., interest and noninterest checking, passbook savings and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market on certificates to a schedule of aggregated expected monthly maturities on time deposits.

Short-term borrowings (carried at cost)

The carrying amounts of short-term borrowings approximate their fair values.

Long-term debt (carried at cost)

Fair values of FHLB advances are estimated using discounted cash flow analysis, based on quoted prices for new FHLB advances with similar credit risk characteristics, terms and remaining maturity. These prices obtained from this active market represent a market value that is deemed to represent the transfer price if the liability were assumed by a third party.

Off-balance sheet financial instruments (disclosed at cost)

Fair values for the Bank’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.

Note 13 - Reclassifications

Certain amounts in the 2009 consolidated financial statements and notes have been reclassified to conform to the 2010 presentation.

 

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

Management’s discussion and analysis of the changes in the consolidated results of operations, financial condition, and cash flows of Tower Bancorp, Inc. and its subsidiary is set forth below for the periods indicated. Unless the context requires otherwise, the terms “Tower,” “we,” “us,” and “our” refer to Tower Bancorp, Inc. and its wholly-owned subsidiary, Graystone Tower Bank. Through Graystone Tower Bank, we provide banking and banking related services to our customers within our principal market areas consisting of Centre, Cumberland, Dauphin, Franklin, Fulton, Lancaster, Lebanon, and York Counties of Pennsylvania and Washington County, Maryland. The following discussion and analysis, the purpose of which is to provide investors and others with information that we believe to be necessary for an understanding of Tower’s financial condition, changes in financial condition, and results of operations, should be read in conjunction with the consolidated financial statements, notes, and other information contained in this report.

FORWARD-LOOKING STATEMENTS

We have made, and may continue to make, certain forward-looking statements in this Report, including information incorporated by reference in this Report. These forward-looking statements are intended to be covered by the safe harbor for forward-looking statements provided by the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not statements of historical fact, and can be identified by the use of forward-looking terminology such as “believe,” “expect,” “may,” “will,” “should,” “project,” “plan,” “seek,” “target,” “intend” or “anticipate” or the negative thereof or comparable terminology. Forward-looking statements include discussions of strategy, financial projections and estimates and their underlying assumptions, statements regarding plans, objectives, expectations or consequences of various transactions, and statements about the future performance, operations, products and services of Tower and our subsidiaries. These forward-looking statements are subject to various assumptions, risks, uncertainties and other factors including, but not limited to, market risk; changes or adverse developments in economic, political, or regulatory conditions; a continuation or worsening of the current disruption in credit and other markets; the effect of competition and interest rates on net interest margin and net interest income; investment strategy and income growth; investment securities gains; declines in the value of securities which may result in charges to earnings; changes in rates of deposit and loan growth; asset quality and the impact on assets from adverse changes in the economy and in credit or other markets and resulting effects on credit risk and asset values; balances of risk-sensitive assets to risk-sensitive liabilities; salaries and employee benefits and other expenses; amortization of intangible assets; capital and liquidity strategies and other financial and business matters for future periods.

Because of the possibility of changes in these assumptions, actual results could differ materially from those contained in any forward-looking statements. We encourage readers of this Report to understand forward-looking statements to be strategic objectives rather than absolute targets of future performance. Forward-looking statements are qualified in their entirety by the risk factors and cautionary statements contained in this Report and speak only as of the date they are made. We do not undertake any obligation to update publicly any forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events except as required by law.

Availability of Information

Our web-site address is www.towerbancorp.com. We make available free of charge, through the Investor Relations section of our web site, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission. We include our web-site address in this Quarterly Report on Form 10-Q as an inactive textual reference only.

Merger and Acquisitions

On March 31, 2009, Tower Bancorp, Inc. completed a merger with Graystone Financial Corp., (“Graystone”) in an all stock transaction valued at approximately $57.9 million (“the Merger”). The Merger, while considered a merger of equals, was accounted for as a reverse acquisition by Graystone Financial Corp. of Tower Bancorp, Inc. using the acquisition method of accounting and, accordingly, the assets and liabilities of Tower Bancorp, Inc. have been recorded at their respective fair values on the date the Merger was completed. The Merger was effected by the issuance of shares of Tower Bancorp, Inc. common stock to Graystone shareholders. Each share of Graystone common stock was exchanged for 0.42 shares of Tower common stock, with any fractional shares as a result of the exchange, paid to Graystone shareholders in cash based on $19.78 per share of Tower common stock.

Pursuant to the Agreement and Plan of Merger, Tower Bancorp, Inc. is the surviving bank holding company and its wholly-owned subsidiary, The First National Bank of Greencastle, merged with and into Graystone’s wholly owned subsidiary, Graystone Bank, with Graystone Bank as the surviving institution, under the name “Graystone Tower Bank” (the “Bank”). The Bank operates as the sole subsidiary of Tower Bancorp, Inc. through two divisions – “Graystone Bank, a division of

 

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Graystone Tower Bank”, consisting of the former Graystone Bank branches, and “Tower Bank, a division of Graystone Tower Bank,” consisting of the former branches of The First National Bank of Greencastle.

On December 27, 2009, Tower Bancorp, Inc. and First Chester County Corporation (“First Chester”) entered into an Agreement and Plan of Merger (the “FCEC Acquisition Agreement”) pursuant to which Tower will acquire First Chester in an all-stock transaction valued at approximately $65 million or $10.22 per share based on the closing price of Tower common stock at the announcement of this acquisition. As described in the FCEC Acquisition Agreement, shareholders of First Chester will receive merger consideration consisting of a number of shares of Tower common stock equal to the exchange ratio, which was 0.453 at the time of the signing of the FCEC Acquisition Agreement. The exchange ratio is subject to upward or downward adjustment based upon the amount of “First Chester Delinquent Loans” (as defined in the FCEC Acquisition Agreement) as of the last business day of the month prior to the date the acquisition is completed. If the closing date of the acquisition had occurred in October 2010, the exchange ratio would have been adjusted to 0.291 based on First Chester Delinquent Loan of $76.2 million calculated as of September 30, 2010, the last business day of the prior month.

As part of the FCEC Acquisition Agreement, Tower’s subsidiary bank, Graystone Tower Bank, agreed to increase its lending facility with First Chester to up to $26 million as well as to purchase up to $100 million of residential mortgage and commercial loans from First National Bank of Chester County (“FNB”) in order for FNB to satisfy the regulatory capital requirements of the Office of the Comptroller of the Currency (the “OCC”). As of September 30, 2010, the Bank loaned $26 million to First Chester, the proceeds of which First Chester contributed to FNB as Tier 1 capital. First Chester pledged 100% of in the capital stock of FNB to Graystone Tower Bank to secure repayment of the loan. The Bank has also purchased approximately $52 million in performing commercial loans from FNB. As of September 30, 2010, the total balance of the loans purchased from First Chester was $49.0 million.

Following the transaction, based on a 0.453 exchange ratio, which was the ratio at the time of the signing of the FCEC Acquisition Agreement, current Tower shareholders would own approximately 71% and First Chester shareholders would own approximately 29% of the combined company’s common stock. The shareholders of both entities must approve the combination.

On March 4, 2010, the FCEC Acquisition Agreement was amended between Tower and First Chester. As part of the amended agreement, First Chester shall use its best efforts to sell at or prior to the effective date of the acquisition, the American Home Bank Division of FNB (“AHB Division”) to one or more purchasers on terms and conditions acceptable to both First Chester and Tower. The AHB Division engages in mortgage-banking activities on a nation-wide basis. Additionally, we extended a $2 million non-revolving line of credit to First Chester, which permits draws from time to time for the sole purpose of contributing additional capital to FNB in the event that, as a result of the attempt to sell the AHB Division, the actual sale thereof, or the effects on FNB of such sale, FNB’s regulatory capital ratios, as reported in FNB’s quarterly call report, fall below the minimum regulatory capital ratios applicable to FNB. Through September 30, 2010, we have not advanced any funds to First Chester under this facility. As of September 30, 2010, First Chester has not sold the AHB Division.

On October 28, 2010, The FCEC Acquisition Agreement was amended between Tower and First Chester. As part of the amended agreement, the closing deadline has been extended from November 20, 2010 to December 31, 2010 and provided increased clarity to the definition of “First Chester Delinquent Loans.”

Results of Operations

Summary of Financial Results

The three month period ending September 30, 2010 and 2009 represents comparable results of operations for the combined entity of Tower Bancorp, Inc. and Graystone Financial Corp. However, for the first nine months of 2010 as compared with the first nine months of 2009, the Merger has still had a significant impact on our results of operations. The operating results reported herein for the first nine months ended September 30, 2010 include the results for the combined entity. However, the results for the nine months ended September 30, 2009 include the historical operating results of Graystone for the entire nine month period and the operating results of Tower only since March 30, 2009, representing the period after consummation of the Merger which was effective before the opening of business on March 31, 2009. Consequently, comparisons of our current results of operation to the nine month ending September, 30 2009 may not be particularly meaningful.

We recognized after-tax net income of approximately $2.5 million or $0.35 per diluted share in the third quarter of 2010, compared to $1.7 million or $0.30 per diluted share in the third quarter of 2009. Net interest income before provision for loan loss increased $3.2 million due to a mix of growth in our loan and investment portfolios coupled with a reduction in the average rate paid on interest bearing liabilities from 2009 to 2010. This increase in net interest income was offset by increases in the provision for loan losses and non-interest expenses of $800 thousand and $2.4 million respectively. The increase in the provision for loan losses is due to our analysis of the risk of loan losses , as well as total net loan charge-offs

 

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of $502 thousand during the third quarter of 2010. The increase in non-interest expense is due to increases in salary and benefit expense, occupancy expense and other operating expense, which increased $1.3 million, $343 thousand and $556, respectively, as compared to the third quarter of 2009. These increases can be attributed to the rapid growth experienced by the Company since the Merger, which resulted in the opening of new branch locations and the addition of personnel within the finance, operations, credit and lending departments in preparation for the pending acquisition of First Chester. Non-interest income increased $1.3 million due to increases in the service charges on deposit accounts, gains on the sale of mortgage loans, gains on sale of other interest earning assets and income from bank owned life insurance which increased $207 thousand, $378 thousand, $322 thousand and $316 thousand, respectively, compared to the third quarter of 2009.

For the first nine months of 2010, we recognized an after-tax net income of $5.6 million or $0.78 per diluted share, compared to after-tax net income of $1.7 million or $0.37 per diluted share for the same period in 2009. The increase in net income included an increase of net interest income after the provision for loan losses of $12.5 million and non-interest income of $2.1 million offset by the increase in non-interest expense of $8.6 million and income tax expense of $2.1 million. Net interest income before loan loss provision increased $13.6 million during the first nine months of 2010 compared to the same period in 2009. In addition to the net interest income contributed by the inclusion of the Tower Bank division’s operations which added $3.6 million, this growth was also driven by organic growth of loans and investments, and the decrease in the average rate paid on interest bearing deposits of 55 basis points. Non-interest income increased by $2.1 million due to increased service charges on deposit accounts, commissions and fees as well as income generated from the bank owned life insurance policies. Non-interest expense, excluding merger related expenses and an impairment charge related to land held for investment, increased by $9.1 million primarily due to increases in compensation costs, occupancy expenses and other operating expenses incurred in order to support our continued growth of assets and deposits and in preparation for the pending acquisition of First Chester, offset by a FDIC special assessment of $580 thousand incurred during the second quarter of 2009. No such assessment was imposed during the same period in 2010.

Quarter Ended September 30, 2010 compared to the Quarter Ended September 30, 2009

Net Interest Income

Our major source of operating revenues is net interest income, which increased $3.2 million or 31.0% to approximately $13.4 million for the third quarter of 2010, as compared to approximately $10.2 million for the same period in 2009. Net interest income as a percentage of net income plus non-interest income was 81.3% for the quarter ended September 30, 2010, compared to 84.9% for the quarter ended September 30, 2009.

Net interest income is the income that remains after deducting, from total income generated by earning assets, the interest expense attributable to the acquisition of the funds required to support earning assets. Income from earning assets includes income from loans, investment securities, and short-term investments. The amount of interest income is dependent upon many factors, including the volume of earning assets, the general level of interest rates, the dynamics of the change in interest rates, and the levels of non-performing loans. The cost of funds varies with the amount of funds necessary to support earning assets, the rates paid to attract and hold deposits, the rates paid on borrowed funds, and the levels of noninterest-bearing demand deposits and equity capital.

We principally utilize in-market deposits to fund loans and investments, while strategically obtaining additional funding from short-term and long-term borrowings when advantageous rates and maturities can be obtained. We use brokered deposits on a limited basis to fund asset growth as demonstrated by the limited use of brokered deposits, which represents approximately 10.9% of total deposits, on our consolidated balance sheet at September 30, 2010 and approximately 5.0% at December 31, 2009. In connection with our growth plans and ongoing focus to improve our net interest spread, we may continue to supplement in-market deposits with brokered deposits and additional short-term and long-term borrowings, including additional borrowings from the Federal Home Loan Bank and federal funds lines with correspondent banks, based upon prevailing economic conditions, deposit availability and pricing, interest rates and other factors at such time.

 

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The following table provides a comparative average balance sheet and net interest income analysis for the three-month period ended September 30, 2010 as compared to the same period in 2009. Interest income and average rates are presented on a fully taxable-equivalent (FTE) basis, using a statutory Federal tax rate of 35% for 2010 and 34% for 2009.

 

     For the Three Months Ended September 30,  
     2010     2009  
     Average           Average     Average           Average  
     Balance     Interest     Rate     Balance     Interest     Rate  
     (dollars in thousands)  

Interest-earning assets:

            

Federal funds sold and other

   $ 16,801      $ 24        0.57   $ 41,029      $ 56        0.54

Investment securities (1)

     175,533        1,071        2.42     81,914        502        2.43

Loans(2)

     1,270,993        17,852        5.57     1,016,395        15,249        5.95
                                                

Total interest-earning assets

     1,463,327        18,947        5.14     1,139,338        15,807        5.50
                                                

Other assets

     137,532            196,758       
                        

Total assets

   $ 1,600,859          $ 1,336,096       
                        

Interest-bearing liabilities:

            

Interest-bearing non-maturity deposits

   $ 794,970        2,138        1.07   $ 604,448        2,719        1.78

Time deposits

     423,415        2,354        2.21     399,902        2,006        1.99

Borrowings

     85,863        1,033        4.77     66,634        795        4.73
                                                

Total interest-bearing liabilities

     1,304,248        5,525        1.68     1,070,984        5,520        2.04
                                                

Noninterest-bearing transaction accounts

     116,974            105,046       

Other liabilities

     13,738            30,293       

Stockholders’ equity

     165,899            129,773       
                        

Total liabilities and stockholders’ equity

   $ 1,600,859          $ 1,336,096       
                        

Net interest spread

         3.46         3.46

Net interest income and interest rate margin FTE

     $ 13,422        3.64     $ 10,287        3.58
                        

Tax equivalent adjustment

       (51         (83  
                        

Net interest income

     $ 13,371          $ 10,204     
                        

Ratio of average interest-earning assets to average interest-bearing liabilities

     112.2         106.4    
                        

 

(1) The average yields for investment securities available for sale are reported on a fully taxable-equivalent basis at a rate of 35% for 2010 and 34% for 2009.
(2) Average loan balances include non-accrual loans.

The following table summarizes the changes in FTE interest income and expense due to changes in average balances (volume) and changes in rates:

 

     Three Months Ended  
   September 30, 2010 vs. September 30, 2009  
     Increase (Decrease) Due to  
     Volume     Rate     Total  
     (in thousands)  

Interest income:

      

Federal funds sold and other

   $ (106   $ 74      $ (32

Investment securities

     642        (73     569   

Loans

     26,486        (23,883     2,603   
                        

Total interest income

   $ 27,022      $ (23,882   $ 3,140   
                        

Interest expense:

      

Interest-bearing non-maturity deposits

   $ 14,869      $ (15,450   $ (581

Time deposits

     122        226        348   

Borrowings

     231        7        238   
                        

Total interest expense

     15,222        (15,217     5   
                        

Net interest income

   $ 11,800      $ (8,665   $ 3,135   
                        

 

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Interest income increased approximately $3.1 million, or 19.9%. This increase was caused by approximately $324.0 million or 28.4% increase in the average balance of interest-earning assets, which resulted in approximately $27.0 million increase to interest income. This increase was partially offset by a 36 basis point reduction in average rates that resulted in a reduction of interest income of approximately $23.9 million.

Interest income on investment securities increased approximately $569 thousand, or 113.5%. The average balance of investments held by the Bank increased from $81.9 million at September 30, 2009 to $175.5 million at September 30, 2010, which resulted in an increase of approximately $642 thousand in interest income. The increase in the average balance of investment securities relates primarily to the addition of securities acquired through the Merger as well as additional debt security investments purchased with excess liquidity. Since March 31, 2009, the Company purchased collateralized mortgage obligation securities, government agency step-up securities, and SBA pooled loan securitizations as well as other debt securities. These investments served as an initial way for management to deploy funds received through deposit growth and capital offerings into interest earning assets other than federal funds sold until the proceeds could be used to fund loan growth. This increase is offset by the reduction in the interest rates earned on securities as compared to prior year resulting in a reduction of 1 basis point on the average rate and a reduction of interest income of $73 thousand.

Average yields on loans decreased 38 basis points or 6.4%, from 5.95% during the third quarter of 2009 to 5.57% during the third quarter of 2010. The Federal Reserve maintained the intended federal funds target rate between 0.08% and 0.25% during both quarters ended September, 30, 2010 and 2009. This rate continues to place downward pressure on the prime rate and all other lending rates, further prolonging the reduced interest rate environment. Fixed rate loans, which represent approximately 23% of total average loans held at September 30, 2010, do not reprice when short-term rates decline. Additionally, the total effect of downward loan repricing on variable rate loans will not coincide with the decrease in the aforementioned rates due to the fact that approximately 87% of our total average variable rate loans at September 30, 2010 contain interest rate floors. Conversely, any benefit associated with an increase in interest rates in the future might not be immediately realized due to the use of interest rate floors. Presumably, an increase in future interest rates would cause repricing in all assets and liabilities linked to variable rate indices; however, as deposit products would experience any increase on a relatively immediate basis, loan products with floors in place would require a rate increase such that the resulting rate earned on the loan would exceed the floor. Refer to Item 3 Quantitative and Qualitative Disclosures About Market Risk for a more detailed discussion of interest rate risk.

Interest expense increased $5 thousand, or 0.1% during the third quarter of 2010 compared to the same period in 2009. This relatively small increase was caused by approximately $233.3 million or 21.8% increase in the average balance of interest-bearing liabilities, which resulted in approximately $15.2 million increase to interest expense. This increase, however, was predominately offset by a 36 basis point reduction in the average rate paid on interest-bearing liabilities, which resulted in a reduction of interest expense of approximately $15.2 million. This reduction in average rates paid on interest-bearing liabilities was the result of lower rates paid on interest-bearing non-maturity deposit accounts and time deposits, which can be attributed to both the low cost deposits acquired through the Merger and management’s efforts to reduce rates paid on deposits while still remaining competitive in our markets.

In future periods, assuming a prolonged flat or declining interest rate environment, we expect an increase in the total amount of net interest income driven by continued growth in average interest-earning assets, the continued use of floors in our variable rate commercial loan portfolio, further migration of assets from federal funds to loans and investments and the continued repricing of a portion of our interest-bearing deposit portfolio into lower rate products. Furthermore, we continue to reduce rates paid on interest-bearing liabilities through reductions during the end of the third quarter to rates paid on deposits. Any significant changes such as movement in interest rates set by the Federal Reserve, changes in the performance of our interest earning assets, the continued repricing of assets, and the inability to move deposit rates in similar increments as earning asset rates may mitigate this benefit in the future. Also, our strategy to extend the duration of our time deposit portfolio during this low interest rate environment may also offset benefits to the margin.

We manage our risk associated with changes in interest rates through the techniques described in this Report under Item 3. Quantitative and Qualitative Disclosures About Market Risk.

Provision for Loan Losses and Allowance for Loan Losses

The provision for loan losses is the expense necessary to maintain the allowance for loan losses at a level adequate to absorb management’s estimate of probable losses in the loan portfolio. Our provision for loan loss is based upon management’s continuous review of the loan portfolio. The purpose of the review is to assess loan quality, identify impaired loans, analyze delinquencies, ascertain risks associated with new loans, evaluate potential charge-offs and recoveries, and assess general economic conditions in the markets we serve.

 

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The following table presents the activity in the allowance for loan losses for the three months ended September 30, 2010 and 2009 (in thousands):

 

     Three months ended  
     September 30,  
     2010     2009  

Balance at beginning of period

   $ 11,619      $ 7,965   

Provision for loan losses

     1,600        800   

Charge-offs

    

Commercial:

       (270

Industrial

     (113     (65

Real estate

     —          (37

Construction

     —       

Consumer:

    

Home equity line

     (65     —     

Other

     (62     (8

Residential mortgage

     (271     (7
                

Total charge-offs

     (511     (387

Recoveries

    

Commercial:

    

Industrial

     6        11   

Real estate

     —          —     

Construction

     —          1   

Consumer:

    

Home equity line

     —          —     

Other

     1        —     

Residential mortgage

     2        —     
                

Total recoveries

     9        12   
                

Net charge-offs

     (502     (375
                

Balance at end of period

   $ 12,717      $ 8,390   
                

We continue to operate in a challenging economic environment. We have increased our allowance for loan loss in accordance with our assessment process, which took into consideration risks related to the overall composition of our loan portfolio, the status of the current economic environment and other qualitative factors, and the results of management’s risk assessment process over delinquent and problem loans. The provision for loan losses for the three months ended September 30, 2010 totaled $1.6 million, an increase of $800 thousand compared to the same period in 2009. The gross loan charge-offs that were applied to the allowance for loan loss during the three months ended September 30, 2010 consisted of 7 commercial industrial loans, 2 consumer home equity lines, 2 other consumer loans and 6 mortgage loans totaling $511 thousand. Net allowance for loan loss charge-offs were 0.16 % of average loans as of the third quarter 2010 on an annualized basis. Our allowance for loan loss as a percentage of loans was 0.96% at September 30, 2010, compared to 0.85% at December 31, 2009.

 

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The following table presents changes in the credit quality adjustment on loans purchased for the three months ended September 30, 2010 and 2009 (in thousands):

 

     Three months ended  
     September 30,  
     2010     2009  

Balance at beginning of period

   $ 1,676      $ 3,639   

Credit fair value adjustment mark

     —          —     

Amortization

     (95     (249

Charge-offs

    

Commercial:

    

Industrial

     (50     (30

Real estate

     —          —     

Construction

     —          —     

Consumer:

    

Home equity line

     (5     (5

Other

     (45     (75

Residential mortgage

     —          (22
                

Total charge-offs

     (100     (132

Recoveries

    

Commercial:

    

Industrial

     8        4   

Real estate

     —          —     

Construction

     —          —     

Consumer:

    

Home equity line

     —          —     

Other

     20        7   

Residential mortgage

     —          2   
                

Total recoveries

     28        13   
                

Net charge-offs

     (72     (119
                

Balance at end of period

   $ 1,509      $ 3,271   
                

The gross loan charge-offs that were applied to the credit quality adjustment on purchased loans for the three months ended September 30, 2010 consisted of 3 commercial industrial, 1 consumer home equity lines, and 10 other consumer loans totaling $100 thousand. Net credit mark charge-offs were 0.02% of average loans as of the third quarter 2010 on an annualized basis.

The total gross loan charge-offs during the three months ended September 30, 2010 consisted of 31 loans totaling $611 thousand. Net total loan charge-offs were 0.18% of average loans as of the third quarter of 2010 on an annualized basis. Our adjusted (Non-GAAP) allowance for loan loss, that is the allowance for loan losses adjusted to include the credit quality adjustment on loans purchased, as a percentage of loans was 1.07% at September 30, 2010, compared to 1.11% at December 31, 2009. See an explanation of the Non-GAAP measures later in this filing on page 46 within Management’s Discussion and Analysis of our loan portfolio performance. Determining the level of the allowance for probable loan loss at any given point in time is difficult, particularly during uncertain economic periods. We must make estimates using assumptions and information that is often subjective and changing rapidly. The review of the loan portfolio is a continuing process in light of a changing economy and the dynamics of the banking and regulatory environment. In our opinion, the allowance for loan loss is adequate to meet probable incurred loan losses at September 30, 2010. There can be no assurance, however, that we will not sustain loan losses in future periods that could be greater than the size of the allowance at September 30, 2010. Management believes that the allowance for loan loss is appropriate based on applicable accounting standards.

Non-Interest Income

In addition to our focus on increasing net interest income through growth of interest-earning assets and expansion in our net interest margin, we remain committed to increasing non-interest income as a way to improve profitability and diversify our sources of revenue.

Non-interest income was approximately $3.1 million and $1.8 million for the three months ended September 30, 2010 and 2009, respectively.

 

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The following table presents the components of non-interest income (in thousands):

 

     September 30,      September 30,     Increase (Decrease)  
   2010      2009     $      %  

Service charges on deposit accounts

   $ 832       $ 625      $ 207         33.1

Other service charges, commissions and fees

     581         566        15         2.7

Gain on sale of mortgage loans originated for sale

     656         334        322         96.4

Gain (loss) on sale of other interest earning assets

     265         (113     378         334.5

Income from bank owned life insurance

     599         283        316         111.7

Other income

     148         115        33         28.7
                            

Total non-interest income

   $ 3,081       $ 1,810      $ 1,271         70.2
                            

The $1.3 million or 70.2% increase in total non-interest income is attributable primarily to the increase in service charges on deposit accounts, gain on sale of mortgage loans originated for sale, gain on sale of other interest earning asset and income from banked owned life insurance. The increase in service charges relates to a 21.8% increase in average deposits compared to third quarter 2009. The increase in the gain on sale of mortgage loans originated was primarily due to the increase in the volume of mortgage loans originated for sale during the third quarter of 2010 compared to the third quarter of 2009. Gain on sale of other interest earning assets increased due to the increase in the sales and calls of debt investment securities during third quarter of 2010 as compared to the third quarter of 2009. Income from bank owned life insurance increased as a result the appreciation in the cash surrender value of life insurance contracts, which was positively impacted by the purchase of $12.0 million in bank owned life insurance during the second quarter 2010.

Non-Interest Expense

The following table presents the components of non-interest expenses (in thousands):

 

     September 30,      September 30,      Increase (Decrease)  
   2010      2009      $     %  

Salaries and employee benefits

   $ 5,554       $ 4,237       $ 1,317        31.1

Occupancy and equipment

     1,805         1,462         343        23.5

Amortization of intangible assets

     160         177         (17     (9.6 )% 

FDIC insurance premiums

     564         409         155        37.9

Advertising and promotion

     231         204         27        13.2

Data processing

     740         627         113        18.0

Professional service fees

     385         305         80        26.2

Other operating expenses

     1,519         963         556        57.7

Merger related expenses

     117         310         (193     (62.3 )% 
                            

Total non-interest expenses

   $ 11,075         8,694       $ 2,381        27.4
                            

Salary and employee benefits increased $1.3 million or 31.1%. Salaries increased by $902 thousand while employee benefits increased by $413 thousand. The increased level of salary expense was driven by personnel costs in connection with our branch expansion during 2009 and the first nine months of 2010. Additionally, we continued to add personnel to our operations, finance, credit, and lending departments to support our balance sheet growth and in preparation for the pending acquisition of First Chester. The Company also incurred approximately $117 thousand related to the adoption of a deferred compensation plan for certain executive officers during the previous quarter. We also incurred general merit increases for all eligible employees between September 30, 2009 and September 30, 2010. These increases were partially offset by a reduction in the bank performance incentive bonus accrual compared to second quarter of 2009 based on the level of achievement of the relative performance metrics within the bonus plan.

Occupancy and equipment expense increased $343 thousand or 23.5%. The increase in occupancy and equipment expense related to the addition of four branch offices during 2009 and 2010 and the lease of the corporate center office space entered into during the third quarter of 2009.

On February 27, 2009, the FDIC announced that it was increasing federal deposit insurance premiums, beginning the second quarter of 2009, for all well managed, well capitalized banks to a range between 12 and 16 cents per $100 of insured deposits on an annual basis. At September 30, 2010, the Bank had approximately $1.1 billion in FDIC-insured deposits compared to $874.3 million at September 30, 2009.

 

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Professional service expenses increased $80 thousand or 26.2% and data processing expense increased $113 thousand or 18.0%. These increases are directly related to increased audit, consulting and legal services, along with increased data processing costs given the rapid growth in the Bank, between September 30, 2009 and September 30, 2010.

Other operating expenses increased $556 thousand or 57.7%. The increase was primarily due to increases in Pennsylvania bank shares taxes, credit reports/appraisal expenses, telephone and postage expense, filing/recording expenses, ATM/Debit card fees, and contribution/donations of $134 thousand, $126 thousand, $118 thousand, $48 thousand, $48 thousand and $45 thousand, respectively.

Income Tax Expense

Income tax expense was $1.3 million and $820 thousand for the three month ended September 30, 2010 and 2009, respectively. Our effective tax rate for the third quarter of 2010 was 33.8%. The effective tax rate was positively impacted by tax free income generated by the purchase of bank owned life insurance, dividends deductions for dividends paid on ESOP shares, and earnings from tax-exempt securities. Our effective tax rate was 32.5% for the three months ended September 30, 2009. The statutory tax rates for 2010 and 2009 were 35.0% and 34.0%, respectively.

Nine Months Ended September 30, 2010 compared to the Nine Months Ended September 30, 2009

Net Interest Income

Net interest income increased $13.6 million or 55.2% to approximately $38.3 million for the first nine months of 2010, as compared to approximately $24.7 million for the same period in 2009. The $13.6 million increase in net interest income includes $3.6 million as a result of the net contribution from interest-earning assets and interest-earning liabilities derived from the Tower division acquired in the Merger, which was not included in the first three months of 2009 results of operations. Excluding the effect of the Merger, net interest income, net of corporate interest expense, increased by $10.0 million or 40.8% over the nine months ended September 30, 2009. Net interest income as a percentage of net interest income plus non-interest income was 83.5% for the nine month ended September 30, 2010, compared to 81.9% for the same period in 2009.

 

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The following table provides a comparative average balance sheet and net interest income analysis for the nine month period ended September 30, 2010 as compared to the same period in 2009. Interest income and average rates are presented on a fully taxable-equivalent (FTE) basis, using a Federal tax rate of 35% for 2010 and 34% for 2009.

 

     For the Nine Months Ended September 30,  
     2010     2009  
     Average           Average     Average           Average  
     Balance     Interest     Rate     Balance     Interest     Rate  
     (dollars in thousands)  

Interest-earning assets:

            

Federal funds sold and other

   $ 20,010      $ 98        0.65   $ 34,766      $ 83        0.32

Investment securities (1)

     181,018        3,358        2.48     50,043        1,058        2.83

Loans(2)

     1,202,259        51,632        5.74     874,933        38,789        5.93
                                                

Total interest-earning assets

     1,403,287        55,088        5.25     959,742        39,930        5.56
                                                

Other assets

     150,828            115,709       
                        

Total assets

   $ 1,554,115          $ 1,075,451       
                        

Interest-bearing liabilities:

            

Interest-bearing non-maturity deposits

   $ 749,017        6,470        1.15   $ 454,106        5,560        1.64

Time deposits

     425,697        7,175        2.25     353,136        7,822        2.96

Borrowings

     85,691        2,985        4.66     62,363        1,734        3.72
                                                

Total interest-bearing liabilities

     1,260,405        16,630        1.77     869,605        15,116        2.32
                                                

Noninterest-bearing transaction accounts

     114,534            79,974       

Other liabilities

     14,138            27,365       

Stockholders’ equity

     165,038            98,507       
                        

Total liabilities and stockholders’ equity

   $ 1,554,115          $ 1,075,451       
                        

Net interest spread

         3.48         3.24

Net interest income and interest rate margin FTE

     $ 38,458        3.66     $ 24,814        3.46
                        

Tax equivalent adjustment

       (135         (123  
                        

Net interest income

     $ 38,323          $ 24,691     
                        

Ratio of average interest-earning assets to average interest-bearing liabilities

     111.3         110.4    
                        

 

(1) The average yields for investment securities available for sale are reported on a fully taxable-equivalent basis at a rate of 35% for 2010 and 34% for 2009.
(2) Average loan balances include non-accrual loans.

The following table summarizes the changes in FTE interest income and expense due to changes in average balances (volume) and changes in rates:

 

     Nine Months Ended  
   September 30, 2010 vs. September 30, 2009  
     Increase (Decrease) Due to  
     Volume     Rate     Total  
     (in thousands)  

Interest income:

      

Federal funds sold

   $ (85   $ 100      $ 15   

Investment securities

     2,640        (340     2,300   

Loans

     15,858        (3,015     12,843   
                        

Total interest income

   $ 18,413      $ (3,255   $ 15,158   
                        

Interest expense:

      

Interest-bearing non-maturity deposits

   $ 4,654      $ (3,744   $ 910   

Time deposits

     2,791        (3,438     (647

Borrowings

     746        505        1,251   
                        

Total interest expense

     8,191        (6,677     1,514   
                        

Net interest income

   $ 10,222      $ 3,422      $ 13,644   
                        

 

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Interest income increased approximately $15.2 million, or 38.0%. This increase was caused by approximately $443.5 million or 46.2% increase in the average balance of interest-earning assets, which resulted in approximately $18.4 million increase to interest income. This increase was partially offset by a 31 basis point reduction in average rates that resulted in a reduction of interest income of approximately $3.3 million.

Interest income on investment securities increased approximately $2.3 million, or 217.4%. The average balance of investments held by the Bank increased from $50.0 million at September 30, 2009 to $181.0 million at September 30, 2010, which resulted in an increase of approximately $2.6 million in interest income. The increase in the average balance of investment securities relates primarily to the addition of securities acquired through the Merger as well as additional investments purchased with excess liquidity. Since March 31, 2009, the Company purchased collateralized mortgage obligation securities, government agency step-up securities, and SBA pooled loan securitizations as well as other debt securities. These investments served as an initial way for management to deploy funds received through deposit growth and capital offerings into interest earning assets other than federal funds sold until the proceeds could be used to fund loan growth. This increase is offset by the reduction in the interest rates earned on securities as compared to prior year resulting in a reduction of 35 basis points on the average rate and a reduction of interest income of $340 thousand.

Average yields on loans decreased 19 basis points from 5.93% during the first nine months of 2009 to 5.74% during the first nine months of 2010. The Federal Reserve maintained the intended federal funds target rate between 0.08% and 0.25% during September, 30, 2010 and 2009. This rate continues to place downward pressure on the prime rate and all other lending rates, further prolonging the reduced interest rate environment. Fixed rate loans, which represent approximately 24% of total average loans held at September 30, 2010, and do not reprice when short-term rates decline. Additionally, the total effect of downward loan repricing on variable rate loans will not coincide with the decrease in the aforementioned rates due to the fact that approximately 88% of our total average variable rate loans at September 30, 2010 contain interest rate floors. Any benefit associated with an increase in interest rates in the future might not be immediately realized due to the use of interest rate floors. Presumably, an increase in future interest rates would cause repricing in all assets and liabilities linked to variable rate indices; however, as deposit products would experience any increase on a relatively immediate basis, loan products with floors in place would require a rate increase such that the resulting rate earned on the loan would exceed the floor. Refer to Item 3 Quantitative and Qualitative Disclosures About Market Risk for a more detailed discussion of interest rate risk.

Interest expense increased $1.5 million, or 10.0% during the nine months ended September 30, 2010 compared to the same period in 2009. This increase was caused by approximately $390.8 million or 44.9% increase in the average balance of interest-bearing liabilities, which resulted in approximately $8.2 million increase to interest expense. This increase was predominately offset by a 56 basis point reduction in the average rate paid on interest-bearing liabilities, which resulted in a reduction of interest expense of approximately $6.7 million. This reduction in average rates paid on interest-bearing liabilities was the result of lower rates paid on interest-bearing non-maturity deposit accounts, time deposits, and borrowings.

In future periods, we expect an increase in the total amount of net interest income driven by continued growth in average interest-earning assets, the continued use of floors in our variable rate commercial loan portfolio, further migration of assets from federal funds to loans and investments, and the continued repricing of our interest-bearing deposit portfolio into lower rate products. Any significant changes such as movement in interest rates set by the Federal Reserve, changes in the performance of our interest earning assets, the continued repricing of assets, and the inability to move deposit rates in similar increments as earning asset rates may mitigate this benefit in the future.

We manage our risk associated with changes in interest rates through the techniques described in this Report under Item 3. Quantitative and Qualitative Disclosures About Market Risk.

Provision for Loan Losses and Allowance for Loan Losses

The provision for loan losses is the expense necessary to maintain the allowance for loan losses at a level adequate to absorb management’s estimate of probable losses in the loan portfolio. Our provision for loan loss is based upon management’s continuous review of the loan portfolio. The purpose of the review is to assess loan quality, identify impaired loans, analyze delinquencies, ascertain risks associated with new loans, evaluate potential charge-offs and recoveries, and assess general economic conditions in the markets we serve.

 

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The following table presents the activity in the allowance for loan losses for the nine months ended September 30, 2010 and 2009 (in thousands):

 

     Nine months ended
September 30,
 
     2010     2009  

Balance at beginning of period

   $ 9,695      $ 6,017   

Provision for loan losses

     4,950        3,816   

Charge-offs

    

Commercial:

    

Industrial

     (915     (1,102

Real estate

     (266     (65

Construction

     —          (150

Consumer:

    

Home equity line

     (265     (7

Other

     (291     (148

Residential mortgage

     (271     (7
                

Total charge-offs

     (2,008     (1,479

Recoveries

    

Commercial:

    

Industrial

     75        28   

Real estate

     —          —     

Construction

     2        1   

Consumer:

    

Home equity line

     —          7   

Other

     1        —     

Residential mortgage

     2        —     
                

Total recoveries

     80        36   
                

Net charge-offs

     (1,928     (1,443
                

Balance at end of period

   $ 12,717      $ 8,390   
                

We continue to operate in a challenging economic environment. We have increased our allowance for loan loss in accordance with our assessment process, which took into consideration risks related to the overall composition of our loan portfolio, the status of the current economic environment and other qualitative factors, and the results of management’s risk assessment process over delinquent and problem loans. The provision for loan losses for the nine months ended September 30, 2010 totaled $5.0 million, an increase of approximately $1.1 million compared to the same period in 2009. The gross loan charge-offs that were applied to the allowance for loan loss during the nine months ended September 30, 2010 consisted of 15 commercial industrial loans, 2 commercial real estate loans, 1 commercial construction loan, 3 consumer home equity lines, 10 other consumer loans and 6 mortgage loan totaling $2.0 million. Net allowance for loan loss charge-offs were 0.21% of average loans for the first nine months of 2010 on an annualized basis. Our allowance for loan loss as a percentage of loans was 0.96% at September 30, 2010, compared to 0.85% at December 31, 2009.

 

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The following table presents changes in the credit quality adjustment on loans purchased for the nine months ended September 30, 2010 and 2009 (in thousands):

 

     Nine months ended  
     September 30,  
     2010     2009  

Balance at beginning of period

   $ 2,942      $ —     

Credit fair value adjustment Mark

     —          4,044   

Amortization

     (495     (520

Charge-offs

    

Commercial:

    

Industrial

     (377     (30

Real estate

     (160     —     

Construction

     —          —     

Consumer:

    

Home equity line

     (19     (5

Other

     (210     (156

Residential mortgage

     (263     (75
                

Total charge-offs

     (1,029     (266

Recoveries

    

Commercial:

    

Industrial

     27        4   

Real estate

     —          —     

Construction

     —          —     

Consumer:

    

Home equity line

     1        —     

Other

     61        7   

Residential mortgage

     2        2   
                

Total recoveries

     91        13   
                

Net charge-offs

     (938     (253
                

Balance at end of period

   $ 1,509      $ 3,271   
                

The gross loan charge-offs that were applied to the credit quality adjustment on purchased loans for the nine months ended September 30, 2010 consisted of 11 commercial industrial loans, 1 commercial real estate loan, 4 consumer home equity lines, 33 other consumer loans and 5 residential mortgage loans totaling $1.0 million. Net credit mark charge-offs were 0.11% of average loans for the first nine months of 2010 on an annualized basis.

The total gross loan charge-offs during the nine months ended September 30, 2010 consisted of 91 loans totaling $3.0 million. Net total charge-offs were 0.32% of average loans for the first nine months of 2010 on an annualized basis. Our adjusted (Non-GAAP) allowance for loan losses, that is the allowance for loan losses adjusted to include the credit quality adjustment on loans purchased, as a percentage of loans was 1.07% at September 30, 2010, compared to 1.11% at December 31, 2009. See an explanation of this Non-GAAP measure later in this filing on page 46 within Management’s Discussion and Analysis of our loan portfolio performance. Determining the level of the allowance for probable loan loss at any given point in time is difficult, particularly during uncertain economic periods. We must make estimates using assumptions and information that is often subjective and changing rapidly. The review of the loan portfolio is a continuing process in light of a changing economy and the dynamics of the banking and regulatory environment. In our opinion, the allowance for loan loss is adequate to meet probable incurred loan losses at September 30, 2010. There can be no assurance, however, that we will not sustain loan losses in future periods that could be greater than the size of the allowance at September 30, 2010. Management believes that the allowance for loan loss is appropriate based on applicable accounting standards.

Non-Interest Income

In addition to our focus on increasing net interest income through growth of interest-earning assets and expansion in our net interest spread, we remain committed to increasing non-interest income as a way to improve profitability and diversify our sources of revenue.

Non-interest income was approximately $7.6 million and $5.5 million for the nine months ended September 30, 2010 and 2010, respectively.

 

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The following table presents the components of non-interest income (in thousands):

 

     September 30,      September 30,      Increase (Decrease)  
   2010      2009      $      %  

Service charges on deposit accounts

   $ 2,377       $ 1,506       $ 871         57.8

Other service charges, commissions and fees

     1,788         1,475         313         21.2

Gain on sale of mortgage loans originated for sale

     1,250         1,182         68         5.8

Gain on sale of other interest earning assets

     260         156         104         66.7

Income from bank owned life insurance

     1,390         725         665         91.7

Other income

     512         431         81         18.8
                             

Total non-interest income

   $ 7,577       $ 5,475       $ 2,102         38.4
                             

The $2.1 million or 38.4% increase in total non-interest income is attributable to increases in service charges on deposit accounts, other service charges and fees, and income recognized on the cash surrender value of bank owned life insurance. The increase in services charges on deposit accounts and other services charges is due 45.5% increase in average deposits from third quarter 2009. Income from bank owned life insurance increased as a result of appreciation in the cash surrender value of life insurance contracts acquired through the Merger and purchased during the second quarter 2010, as that income would not have been present in the results of operations for the same period of 2009.

Non-Interest Expense

Non-interest expense was approximately $32.7 million and $24.1 million for the nine months ended September 30, 2010 and 2009, respectively. Excluding the effects of merger related expenses and a $920 thousand impairment charge taken on land held for investment, non-interest expense for the nine months ending September 30, 2010 would have totaled approximately $31.5 million, up approximately $9.1 million or 40.6% from $22.4 million for the same period 2009.

The following table presents the components of non-interest expenses (in thousands):

 

     September 30,      September 30,      Increase (Decrease)  
     2010      2009      $     %  

Salaries and employee benefits

   $ 15,996       $ 11,523       $ 4,473        38.8

Occupancy and equipment

     5,236         3,664         1,572        42.9

Amortization of intangible assets

     496         354         142        40.1

FDIC insurance premiums

     1,500         1,320         180        13.6

Advertising and promotion

     740         422         318        75.4

Data processing

     1,894         1,414         480        33.9

Professional service fees

     1,197         843         354        42.0

Impairment on fixed assets

     920         —           920        n/a   

Other operating expenses

     4,436         2,858         1,578        55.2

Merger related expenses

     304         1,722         (1,418     (82.3 )% 
                            

Total non-interest expenses

   $ 32,719       $ 24,120       $ 8,599        35.7
                            

Salary and employee benefits increased $4.5 million or 38.8%. Salaries increased by $3.0 million while employee benefits increased by $1.5 million. Salaries and employee benefits directly related to the Tower Bank Division branches acquired in the Merger contributed approximately $1.1 million to the increase in salary and benefit expenses for the first nine months of 2010. Additionally, we continued to add additional personnel to our operations, finance, credit, and lending departments to support our balance sheet growth and in preparation for the pending acquisition of First Chester. The Company also incurred $351 thousand related to the adoption of a deferred compensation plan for certain executive officers during 2010. We also incurred general merit increases for all eligible employees between September 30, 2009 and September 30, 2010. These increases were partially offset by a reduction in the bank performance incentive bonus accrual compared to third quarter of 2009 based on the level of achievement of the relative performance metrics within the bonus plan.

Occupancy and equipment expense increased $1.6 million or 42.9%. The increase was partially related to the additional expense attributable to the Tower Bank division’s branches which contributed $579 thousand to occupancy and equipment expense. The remaining building and equipment expense increase related to the addition of four branch offices during 2009 and the first nine months of 2010 and the lease of the corporate center office space during the third quarter of 2009.

 

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On February 27, 2009, the FDIC announced that it was increasing federal deposit insurance premiums, beginning the second quarter of 2009, for all well managed, well capitalized banks to a range between 12 and 16 cents per $100 of insured deposits on an annual basis. At September 30, 2010, we had approximately $1.1 billion in FDIC-insured deposits compared to $874.3 million at September 30, 2009. During the second quarter of 2009, the FDIC imposed a special assessment on all FDIC-insured banks based in the total assets and Tier I capital as of June 30, 2009. At June 30, 2009, the Company recorded an estimated expense for the special assessment of $580 thousand. No special assessment fees were recognized during the first nine months of 2010.

Advertising and promotion expenses increased $318 thousand or 75.4%. The increase in advertising and promotions relates to the Company’s increased advertising costs due to branch openings since prior year, our promotion of new loan and deposit products, and increases in costs related to our checking account rewards program.

Professional service expenses increased $354 thousand or 42.0% and data processing expense increased $480 thousand or 33.9%. These increases are directly related to increased audit, consulting and legal services, along with increased data processing costs given the rapid growth in the Bank, between September 30, 2009 and September 30, 2010.

The impairment of fixed asset expense relates to undeveloped land that was acquired as part of the Merger. The impairment charge was based on a significant drop in the fair value of the land between the time of the Merger, March 31, 2009 and September 30, 2010. The Company owns other no undeveloped land as of September 30, 2010.

Other operating expenses increased $1.6 million or 55.2%. The portion of the increase that can be attributed directly to the Tower Bank branches equaled $113 thousand for the nine months ended September 30, 2010. The remaining increase was primarily due to increases in Pennsylvania bank shares taxes, credit report and appraisal fees, ATM/Debit fees, filing/recording expenses, contributions/donations, internal meeting expenses, and other than temporary impairment losses of $412 thousand, $201 thousand, $99 thousand, $65 thousand, $63 thousand, $64 thousand and $70 thousand, respectively, offset by decline in other expenses related to the early retirement of debt of $119 thousand during the second quarter 2009.

Income Tax Expense

Income tax expense was $2.6 million for the nine months ended September 30, 2010. For the nine month ended September 30, 2009, the income tax benefit was $577 thousand. Our effective tax rate for the six months ended September 30, 2010 was 32.2%. The effective tax rate was positively impacted by tax free income generated by the purchase of bank owned life insurance, dividend deductions for dividends paid on ESOP shares and earnings from tax-exempt securities. Our effective tax rate was 25.9% for the nine months ended September 30, 2009. The statutory tax rates for 2010 and 2009 were 35.0% and 34.0%, respectively.

Financial Condition

Total Assets

Total assets increased by $148.3 million, or 10.1%, from December 31, 2009 to September 30, 2010. The increase is primarily due to the increase in net loans of $180.2 million, offset by the decline in cash and equivalent of $4.3 million and securities held for sale of $44.4 million.

Loans, net

Our gross loan balance grew by $183.2 million, or 16.1%, to $1.32 billion as of September 30, 2010. During the first nine months of 2010, new loan originations totaled $268.3 million. These new loans were offset by a net decrease in existing loan balances of $81.7 million. The net decrease in existing loan balances during the first nine months included the net decrease of approximately $14.7 million of mortgages previously held in the Company’s loan portfolio. Management believes that there continues to be opportunities to bring quality existing credits into our bank from our competitors, coupled with demand for commercial and consumer loans to credit qualified businesses and individuals within the Company’s market areas, which management anticipates will result in additional loan growth.

 

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See the table below for a detail of the loan balances, net of unearned income and allowance for loan losses at September 30, 2010 and the changes from December 31, 2009:

 

     September 30,     December 31,     Increase/(Decrease)  
     2010     2009     $     %  
     (dollars in thousands)  
Commercial:         

Industrial

   $ 707,114      $ 599,708      $ 107,406        17.9

Real estate

     179,064        159,948        19,116        12.0

Construction

     138,863        102,017        36,846        36.1

Consumer & other

        

Home equity lines

     85,921        49,239        36,682        74.5

Other

     34,100        36,271        (2,171     (6.0 )% 

Residential mortgage

     176,555        191,277        (14,722     (7.7 )% 
                          

Total Loans

     1,321,617        1,138,460        183,157        16.1

Deferred costs (fees)

     (80     (189     109        (57.7 )% 

Allowance for loan losses

     (12,717     (9,695     (3,022     31.2
                          

Net Loans

   $ 1,308,820      $ 1,128,576      $ 180,244        16.0
                          

The commercial loan portfolio continues to be the largest component of our loan portfolio, representing 77.5% and 75.7% of total loans at September 30, 2010 and December 31, 2009, respectively. In addition, we have $104.8 million in loan participations without recourse sold to unaffiliated banks through September 30, 2010, where we maintain the servicing rights with these relationships. Currently, the bank is participating in 33 loans purchased from unaffiliated banks. The total outstanding balance of these loans is $66.5 million. These participations include 16 loans purchased from First National Bank of Chester County at 98.5% of par. The net purchase price of these loans was $51.7 million. The borrowers on all these loans are in-market customers and the Company has not experienced any losses due to nonperformance. During the first nine months of 2010, one of these purchased loans was fully paid off. Currently, the carrying balance of the remaining purchased loans from First National Bank of Chester County is $49.0 million.

Additionally, we have not participated in any shared national credit programs and we do not have any shared national credits in our loan portfolio. We expect continued loan growth in the future, as we focus on serving the credit needs of our market areas, while exercising prudent underwriting standards considering the economic uncertainties that are expected to continue.

The following is a summary of our lending activities based on our current loan portfolio

Lending Activities

Our principal lending activity has been the origination of business and commercial real estate loans, commercial and industrial loans, and personal consumer loans to customers located within our primary market areas. We generally release the servicing rights on residential mortgage loans that we sell which results in additional gains on sale. We also originate and retain in our lending portfolio various types of home equity and consumer loan products.

Commercial Lending

Our commercial loan portfolio includes business term loans and lines of credit issued to small and medium size companies in our market areas, some of which are secured in part by additional owner occupied real estate. Additionally, we make secured and unsecured commercial loans and extend lines of credit for the purpose of financing equipment purchases, inventory, business expansion, working capital, and other general business purposes. The terms of these loans generally range from less than 1 year to 7 years with a maximum term to not exceed 10 years, carrying a fixed interest rate or a variable interest rate indexed to LIBOR or our prime rate. It is our standard practice to issue lines of credit due on demand, accruing interest at a variable interest rate indexed to either LIBOR or our prime rate.

We originate commercial real estate loans secured predominantly by first liens on apartment complexes, office buildings, lodging facilities and industrial and warehouse properties. The maximum term that we offer for commercial real estate loans is generally not more than 10 years, with a payment schedule based on not more than a 25-year amortization schedule and a maximum loan-to-value of 80%. Our current policy with regard to these loans is to minimize our risk by emphasizing diversification of these property types.

Additionally, we offer construction and land development financing secured by the corresponding real estate and other collateral as necessary to meet our underwriting standards. Terms for construction and land development financing vary based on the depth of the project usually requiring a maximum loan-to-value ratio of 65% to 80% and a term typically ranging from 12 to 36 months. The construction/development loan application process includes the same criteria which are required for our permanent commercial mortgage loans, as well as a submission of completed plans, specifications, and cost estimates related to the proposed construction. We use these items as an additional basis to determine the appraised value of

 

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the subject property. The appraisal is an important component because construction loans involve additional risks related to advancing loan funds upon the security of the project under construction, which is of uncertain value prior to the completion of construction and subsequent pro-forma lease-up. Additional underwriting considerations for these projects include but are not limited to, market analysis, the borrower’s debt service capacity during the project, environmental evaluations, and pre-sale activity.

Residential Real Estate Lending

The majority of the residential mortgage loans on our balance sheet have been acquired through the Merger. We originate mortgage loans through our subsidiary, Graystone Mortgage, LLC, to enable our customers to finance residential real estate, both owner occupied and non-owner occupied, in our primary market areas. We generally offer traditional fixed-rate and adjustable-rate mortgage (“ARM”) products, with monthly payment options, that have maturities up to 30 years, and maximum loan amounts generally up to $750 thousand.

We generally sell newly originated conventional 15 to 30 year fixed-rate loans as well as FHA and VA loans in the secondary market to wholesale lenders. Our LTV requirements for residential real estate loans vary depending on the secondary market investor. Loans with LTVs in excess of 80% are required to carry private mortgage insurance. We generally originate loans that meet accepted secondary market underwriting standards.

Home Equity Lending

We offer fixed-rate, fixed-term, monthly home equity loans, and prime-based home equity lines of credit (“HELOCs”) in our market areas. We offer both fixed-rate and floating-rate home equity products in amounts up to 85% of the appraised value of the property (including the first mortgage) with a maximum loan amount generally up to $1 million. We offer monthly fixed-rate home equity loans and HELOCs with repayment terms generally up to 15 years. The minimum line of credit is $10 thousand and the maximum generally up to $1 million with exceptions as approved.

Consumer Loans

We offer a variety of fixed-rate installment and variable rate line-of-credit consumer loans, including direct automobile loans as well as personal secured and unsecured loans. Terms of these loans range from 6 months to 72 months and generally do not exceed $50 thousand. Secured loans are collateralized by vehicles, savings accounts, or certificates of deposit. We only approve unsecured loans for our more creditworthy customers.

 

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Loan Portfolio Performance

The table below sets forth, for the periods indicated, information with respect to our non-accrual loans, accruing loans greater than 90 days past due, total nonperforming loans, other real estate owned, total nonperforming assets, and selected asset quality ratios.

 

     September 31,     December 31,  
     2010     2009  
     (dollars in thousands)  

Total loans outstanding, net of unearned income

   $ 1,334,388      $ 1,146,305   

Daily average balance of loans

     1,202,259        909,476   

Non-accrual loans

   $ 13,757      $ 4,718   

Accruing loans greater than 90 days past due

     1,529        2,106   
                

Total non-performing loans

     15,286        6,824   

Other real estate owned

     879        927   
                

Total non-performing assets

     16,165        7,751   

Allowance for loan losses

     12,717        9,695   

Credit fair value adjustment on loans purchased

     1,509        2,942   
                

Adjusted (Non-GAAP) allowance for loan losses

   $ 14,226      $ 12,637   

Non-accrual loans to total loans(1)

     1.04     0.41

Non-performing assets to total assets

     1.00     0.53

Non-performing loans to total loans(1)

     1.15     0.60

Allowance for loan losses to total loans(1)

     0.96     0.85

Adjusted (Non-GAAP) allowance for loan losses to total loans(1)

     1.07     1.11

Allowance for loan losses to non-performing loans

     83.19     142.07

Adjusted (Non-GAAP) allowance for loan losses to non-performing loans

     93.07     185.18

 

(1) Total loans balance excludes purchased impaired loans accounted for under SOP 03-3 acquired as part of the merger between Tower Bancorp Inc. and Graystone Financial Corp. The total balance of these loans is $6,470 as of September 30, 2010, $6,200 as of December 31, 2009.

GAAP requires that expected credit losses associated with loans obtained in an acquisition be reflected at fair value as of each respective acquisition date and prohibits the carryover of the acquired entity’s allowance for loan losses. Accordingly, the Company’s management believes that presentation of the adjusted (Non-GAAP) allowance for loan losses, consisting of the allowance for loan losses plus the credit fair value adjustment on loans purchased in merger transactions, is useful for investors to understand the complete allowance that is recorded as a representation of future expected losses over the Company’s loan portfolio

The accounting estimates for loan losses are subject to changing economic conditions. At September 30, 2010, the non-accrual loans totaled $13.8 million compared to $4.7 million at December 31, 2009. Of the $13.8 million of total non-accrual loans at September 30, 2010, $11.6 million or 84.1% related to commercial loans, $124 thousand or 0.9% to consumer loans and $2.1 million or 15.0% to residential mortgage loans. When analyzing the non-accrual loans on an individual basis, the increase included one commercial relationship filing for Chapter 11 bankruptcy protection during the first quarter of 2010. The total loan relationship to this customer is $5.0 million as of September 30, 2010.

As of September 30, 2010, we had total impaired loans of $18.1 million. Included in impaired loans are loans on which management has stopped accruing interest in accordance with our loan accounting policy and impaired loans purchased as a result of the Merger. Management discontinues the accrual of interest on a loan 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 is currently performing. The impaired loan balance includes $4.3 million of impaired loans acquired as part of the Merger, which were recorded at their individual fair values at the time of Merger as determined based on management’s estimate of future cash flows. For the remaining impaired loans, management performed an evaluation of the anticipated cash flow from the sale of collateral to determine that the value of the collateral exceeded the carrying amount of the loan. Based

 

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on these evaluations, management has determined that a reserve of $200 thousand is required against the impaired loans at September 30, 2010.

Management has performed a detailed review of the non-performing loans and of their related collateral and believes the allowance for loan losses remains adequate for the level of risk inherent in the loan portfolio. It is our policy that non-performing loans will remain classified as non-performing until such time that the loan becomes current on all principal and interest payments and remains current for a period of six months. For loans where the original terms have been modified, we would not consider the modified loan to be performing until the borrower demonstrates their performance under the modified terms for a period of at least six months.

During 2009 and the first nine months of 2010, the banking industry experienced increasing defaults in mortgage loans coupled with decreasing values of real estate values as a result of an economic downturn. In addition, the prolonged economic downturn present throughout 2009 and continuing into 2010 has resulted in increased delinquencies in our loan portfolio. Through our loan approval process and diligent loan monitoring, we have experienced a relatively low percentage of non-performing loans when compared to the total amount of loans.

Other real estate owned consists of eight properties totaling $879 thousand at September 30, 2010. These properties have been through the foreclosure process and are currently in the process of being sold. These properties are recorded at their lower of cost or fair value less costs to sell.

Securities Available for Sale

The following table presents the amortized cost and fair value of investment securities for the September 30, 2010 and December 31, 2009 in thousands.

 

     September 30, 2010      December 31, 2009  
     Amortized
Cost
     Fair Value      Amortized
Cost
     Fair Value  

Equity securities

   $ 120       $ 120       $ 1,156       $ 1,132   

U.S. Government sponsored agency securities

     27,040         27,079         56,437         56,384   

U.S. Government sponsored agency mortgage backed securities

     11,830         11,931         9,109         9,116   

Collateralized mortgage obligations

     73,626         74,683         93,058         92,485   

Municipal bonds

     10,929         11,341         7,093         7,188   

Municipal bonds – taxable

     10,360         10,374         12,917         12,910   

SBA loan pool investments

     9,765         9,900         10,710         10,638   
                                   

Total securities available for sale

   $ 143,670       $ 145,428       $ 190,480       $ 189,853   
                                   

At September 30, 2010, total available for sale securities were $145.4 million, a decrease of $44.4 million from total available for sale securities of $189.9 million at December 31, 2009. During the first nine months of 2010, the Bank purchased $73.8 million in securities, offset by the net sales, calls, pay downs and maturities of $119.6 million and a net increase in market value of securities of $1.6 million. Proceeds from the sale and maturity of securities were used as a source of funding for new loans during the quarter. Since March 31, 2009, we have purchased debt securities and sold various debt and equity securities to realign the holdings within the investment portfolio to our overall investment strategy.

Bank-owned Life Insurance

At September 30, 2010, the total cash surrender value of the bank-owned life insurance (“BOLI”) was $37.9 million. The Company purchased $12.0 million of BOLI during the second quarter of 2010. The BOLI was purchased as a means to offset a portion of current and future employee benefit costs. The Bank’s deposits and proceeds from the sale of investment securities were used to fund the BOLI. Earnings from the BOLI are recognized as other income and are treated as tax-free earnings. The BOLI is profitable from the appreciation of the cash surrender value of the pool of insurance, and its tax advantage to the Company.

Deposits

Total deposits at September 30, 2010 were $1.36 billion, an increase of $139.2 million from total deposits of $1.22 billion at December 31, 2009.

 

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The table below displays the increases in deposits by type at September 30, 2010 as compared to December 31, 2009. All dollar amounts are in thousands.

 

     September 30, 2010     December 31, 2009     Increase/Decrease  
     Amount      %     Amount      %     Amount     %  

Noninterest-bearing transaction accounts

   $ 125,174         9.2   $ 119,116         9.8   $ 6,058        5.1

Interest checking accounts

     124,106         9.2     110,356         9.0     13,750        12.5

Money market accounts

     604,151         44.6     477,292         39.2     126,859        26.6

Savings accounts

     70,138         5.2     87,117         7.2     (16,979     (19.5 )% 

Time deposits of $100,000 or greater

     145,694         10.7     130,938         10.8     14,756        11.3

Time deposits, other

     286,454         21.1     291,650         24.0     (5,196     (1.8 )% 
                                            

Total deposits

   $ 1,355,717         100.0   $ 1,216,469         100.0   $ 139,248        11.4
                                            

The Company continues to manage the size, mix, and cost of the deposit portfolio with the goal of lowering current deposit costs and positioning the cost of the portfolio in the future. In-market non-maturity deposits have increased by $129.7 million between December 31, 2009 and September 30, 2010. In-market time deposits increased $9.6 million between December 31, 2009 and September 30, 2010. The Company realized a decrease of 19 basis points in the three-month weighted average rate of in-market deposits between December 31, 2009 and September 30, 2010.

The Company has used various brokered deposit products as tools to manage deposit costs, interest rate risk, and the mix of deposits. The money market accounts include $68.9 million and $23.1 million of brokered money market deposits at September 30, 2010 and December 31, 2009, respectively. The brokered money market products are indexed to the one-month LIBOR and provide an effective funding source for LIBOR-indexed lending. The time deposits include $79.4 million and $38.0 million of brokered certificates of deposit at September 30, 2010 and December 31, 2009, respectively. The total brokered time deposits include reciprocal brokered time deposits of $41.2 million and $15.0 million at September 30, 2010 and December 31, 2009, respectively. Overall, total brokered deposits increased to $148.3 million or approximately 10.9 % of our total deposits at September 30, 2010 as compared to $61.1 million or 5.0% of total deposits at December 31, 2009. Total brokered deposits, exclusive of reciprocal deposits, represented 7.9% and 3.8% of total deposits, respectively at September 30, 2010 and December 31, 2009. Though brokered deposits exclusive of reciprocal deposits are currently less than 10.0% of total deposit, any significant unforeseen changes to the deposit portfolio could cause the brokered deposits to exceed 10.0%, exposing the Company to additional FDIC assessment fees.

Money market deposits at September 30, 2010 increased by $126.9 million or 26.6% from December 31, 2009 as a result of an increase in in-market growth of $81.1 million and brokered money market deposits of $45.8 million. Time deposit balances at September 30, 2010 increased by $9.7 million or 2.3% from December 31, 2010. This net decrease reflected a decrease of $31.6 million of in-market time deposits and an increase of $41.3 million of out-of-market brokered deposits. The Company realized a decrease of 22 basis points in the three-month weighted average rate of time deposits between December 31, 2009 and September 30, 2010. Time deposits represent 31.9% of total deposits at September 30, 2010 compared to 34.8% of total deposits at December 31, 2009.

During the third quarter of 2010, the Company reduced the interest rate paid on certain savings products to better align the pricing strategies of non-maturity deposit products. As a result of the pricing changes, a portion of the balances in the savings product shifted to the money market products.

The average balances and weighted average rates paid on deposits for the first nine months of 2010 and 2009 are presented in the table below (dollars in thousands):

 

     September 30, 2010     September 30, 2009     Increase/(Decrease) in
average balance
 
     Average
Balance
     Average
Rate
    Average
Balance
     Average
Rate
    $     %  

Noninterest-bearing transaction accounts

   $ 114,534         N/A      $ 79,974         N/A      $ 34,560        43.2

Interest checking accounts

     114,829         0.43     57,901         0.61     56,928        98.3

Money market accounts

     551,394         1.40     308,719         1.81     242,675        78.6

Savings accounts

     82,794         0.52     87,486         1.71     (4,692     (5.4 )% 

Time deposits

     425,697         2.25     353,136         2.96     72,561        20.5
                                

Total

   $ 1,289,248         1.42   $ 887,216         1.97   $ 402,032        45.3
                                

As reflected above, we have decreased the average rate on our total deposits by 55 basis points between the first nine months of 2010 and the first nine months of 2009. Although we operate in a very competitive environment for deposits, we have been able to grow our deposits from an average of $887.2 million to $1.29 billion between the nine months ended September 30, 2009 and the nine months ended September 30, 2010 as a result of acquisition-related growth, organic growth and the strategic use of brokered deposits.

 

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Short-Term Borrowings and Long-Term Debt

Short-term borrowings decreased by $255 thousand to $5.0 million at September 30, 2010 from $5.3 million at December 31, 2009. The decrease in short-term borrowings was due to the maturity of FHLB advances of $5.3 million during the third quarter of 2010 offset by the reclassification of FHLB advances from long-term debt to short-term borrowing of $5.0 million. At December 31, 2009 and September 30, 2010, short-term borrowings consisted of advances from the Federal Home Loan Bank of Pittsburgh and current obligations under capital leases. Advances from the Federal Home Loan Bank of Pittsburgh totaled $5.0 million and $5.3 million as of September 30, 2010 and December 31, 2009, respectively. The current obligation under capital leases was $37 thousand and $42 thousand as of September 30, 2010 and December 31, 2009, respectively.

Long-term debt increased by $6.7 million to $72.4 million at September 30, 2010 compared to $65.7 million at December 31, 2009. The increase in long-term debt was caused by the issuance of $12.0 million in subordinated debt during February of 2010 bearing interest at a 9.0% annual interest rate with a term of 65 months offset about the reclassification of FHLB Advances to short-term borrowings. At September 30, 2010, long-term debt consisted of $48.8 million in advances from the FHLB that had a maturity of greater than one year, $21.0 million of subordinated debt and $2.7 million in obligations under capital leases. The total average rate incurred on borrowings and securities sold under agreement to repurchase during the first nine months of 2010 was 4.66% compared to an average rate of 3.72% during the first nine months of 2009.

Stockholders’ Equity and Capital Adequacy

Total stockholders’ equity increased $1.9 million or 1.2%, from $163.9 million at December 31, 2009 to $165.8 million at September 30, 2010. The increase of $1.9 million was due to equity proceeds received from the Dividend Reinvestment and Stock Purchase Plans and an increase in accumulated other comprehensive income offset by the increase in accumulated deficit. The increase in accumulated comprehensive income is attributed to the unrealized gains on available for sale securities of $1.6 million, net of tax. The change in accumulated deficit is due to dividends declared of $6.0 million to our shareholders offset by net income of $5.6 million.

The Company is subject to various regulatory capital requirements administered by banking regulators. Failure to meet minimum capital requirements can initiate certain actions by regulators that could have a material effect on our consolidated financial statements. The regulations require that banks maintain minimum amounts and ratios of total and Tier I capital (as defined in the regulations) to risk weighted assets (as defined), and Tier I capital to average assets (as defined). As of September 30, 2010, the Company and the Bank met the minimum requirements. In addition, capital ratios of the Company and the Bank exceeded the amounts required to be considered “well capitalized” as defined in the regulations.

On June 12, 2009, the Company issued, to private investors, $9.0 million of subordinated notes bearing an annual interest rate of 9.00%. On February 5, 2010, the Company issued an additional $12.0 million in subordinated notes bearing annual interest of 9.00%. Each note may be redeemed at the Company’s discretion and contains a maturity date of July 1, 2014 for notes issued in June 2009 and July 1, 2015 for notes issued in February 2010. The Company has contributed $17.0 million of the net proceeds of $21.0 million from the sale of the notes to Graystone Tower Bank, the Company’s wholly-owned subsidiary, as Tier 1 capital to support the Bank’s continued growth, including ongoing lending activities in its local markets. The notes are intended to qualify as Tier 2 capital at Tower Bancorp, Inc, for regulatory purposes, to the extent permitted. In accordance with applicable regulatory treatment one-fifth of the original principal amount of the notes will be excluded each year from Tier 2 capital during the last five years prior to maturity.

The following table summarizes Graystone Tower Bank and Tower Bancorp, Inc.’s regulatory capital ratios in comparison to regulatory requirements:

 

Graystone Tower Bank    September 30,
2010
    December 31,
2009
    Minimum Capital
Adequacy
 

Total Capital (to Risk Weighted Assets)

     13.16     14.43     8.00

Tier I Capital (to Risk Weighted Assets)

     12.22     13.58     4.00

Tier I Capital (to Average Assets)

     10.38     11.13     4.00
Tower Bancorp, Inc.    September 30,
2010
    December 31,
2009
    Minimum Capital
Adequacy
 

Total Capital (to Risk Weighted Assets)

     13.18     14.53     8.00

Tier I Capital (to Risk Weighted Assets)

     11.12     13.05     4.00

Tier I Capital (to Average Assets)

     9.45     10.70     4.00

Management believes, as of September 30, 2010, that the Company and the Bank met all capital adequacy requirements to which it is subject.

The Bank is subject to certain restrictions on the amount of dividends that it may declare due to regulatory considerations. The Pennsylvania Banking Code provides that cash dividends may be declared and paid only out of accumulated net earnings. As a result of the Merger, $24.4 million of accumulated earnings related to the pre-merger retained earnings of the

 

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Company, were transferred and reclassified into additional paid-in capital. Based on the approval from the Pennsylvania Department of Banking, this amount is available for cash dividends and may be declared and paid in future periods. The current balance of retained earnings available for payment of dividends equals $24.8 million at September 30, 2010. During the first nine months of 2010, the Company declared a dividend of $0.84 per share which totaled $6.0 million.

During the second quarter of 2009, the Board of Directors approved a Dividend Reinvestment and Stock Purchase Plan (“Plan”) to provide our shareholders with the opportunity to use cash dividends, as well as optional cash payments up to $50,000 per quarter, to purchase additional shares of Company common stock. The Company has reserved 1,000,000 shares of common stock, no par value, for issuance under the Plan. At the discretion of the Company, shares may be purchased under the Plan directly from the Company or in open market purchases from others by the plan agent. The purchase price for shares purchased from the Company with reinvested dividends is 95% of the fair market value of the Company’s common stock on the investment date. The purchase price for shares purchased with voluntary cash payments or any open market purchases is 100% of the fair market value of the Company’s common stock on the investment date. During the first nine months of 2010, approximately $533 thousand in capital has been raised under the Plan. As of September 30, 2010, the Plan has raised approximately $937 thousand since plan inception.

Also during the second quarter of 2009, the Company’s Board of Directors and shareholders approved an Employee Stock Purchase Plan (“Employee Plan”) to provide our employees with the opportunity to purchase shares of Company common stock directly from the Company. The purchase price for shares purchased under the Employee Plan is 95% of the fair market value of the Company’s common stock on the purchase date. During the first nine months of 2010, approximately $97 thousand in capital has been raised under the Employee Plan. As of September 30, 2010, the Employee Plan has raised approximately $162 thousand since plan inception.

In connection with the Emergency Economic Stabilization Act of 2009 and the Troubled Asset Recovery Program (TARP), the U.S. Department of the Treasury (UST) has initiated a Capital Purchase Program. Through this program, qualifying financial institutions are eligible to participate in the sale of senior preferred stock to the UST in an amount not less than 1% of total risk-weighted assets and not more than 3% of total risk-weighted assets. The senior preferred stock will pay cumulative dividends at a rate of 5% per year for the first five years and 9% thereafter. The UST would also receive warrants to purchase a number of shares of common stock of the financial institution having an aggregate market value equal to 15% of the senior preferred stock on the date of the investment, subject to certain reductions.

In January 2009, Graystone received preliminary approval from the U.S. Treasury Department for the placement of up to $17.3 million in senior preferred stock. In March 2009, Graystone announced that it would not be participating in the U.S. Treasury Department’s Troubled Asset Relief Program Capital Purchase Program. The Company did not apply to participate in the Capital Purchase Program.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Our exposure to market risk principally includes liquidity risk, interest rate risk, and market price risk which are discussed below.

Liquidity Risk

We manage our liquidity position on a daily basis as part of the daily settlement function and continuously as part of the formal asset liability management process. Our liquidity is maintained by managing several variables including, but not limited to:

 

   

Pricing and dollar amount of core deposit products;

 

   

Pricing and dollar amount of in-market time deposits;

 

   

Growth rate of the loan portfolio (including the sale of loans on a participation basis);

 

   

Purchase and sale of federal funds;

 

   

Purchase and sale of investment securities;

 

   

Use of wholesale funding such as brokered deposits; and

 

   

Use of borrowing capacity at the FHLB.

Management maintains a detailed liquidity contingency plan designed to respond to an overall decline in the condition of the banking industry or a problem specific to the Company. On a quarterly basis, the Asset Liability Committee (“ALCO”) of the board of directors reviews a comprehensive liquidity analysis along with any changes to the liquidity contingency plan.

 

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As of September 30, 2010, we had a maximum borrowing capacity at the Federal Home Loan Bank of Pittsburgh (“FHLB”) of $580.3 million of which $54.1 million (exclusive of the unamortized fair value adjustment to FHLB borrowings assumed in the Merger) was used in the form of borrowings. Accordingly, we had unused borrowing capacity of $526.2 million at the FHLB. Based on the FHLB capital stock owned by the Bank as of September 30, 2010 and the capital stock requirements of the FHLB that became effective July 1, 2010, we can access approximately $24.4 million of funding without the need to purchase additional FHLB stock. As of September 30, 2010, we had federal funds lines availability (committed and discretionary) at five correspondent banks totaling $55.5 million. There were no funds drawn upon these facilities as of September 30, 2010.

We participate in obtaining wholesale funding sources in addition to core demand deposits as described above. As of September 30, 2010 and December 31, 2009, total brokered deposits, excluding CDARS, represented 7.9% and 3.8%, respectively, of total deposits. Brokered deposits, exclusive of CDARS, are generally comprised of money market accounts that are indexed to one-month LIBOR and time deposits. We have issued brokered time deposits, exclusive of CDARS, in maturities beyond four years as a means of extending the composite maturity structure of the time deposit portfolio.

At September 30, 2010, liquid assets (defined as cash and cash equivalents, loans held for sale, and securities available for sale exclusive of securities pledged as collateral or used in connection with customer repurchase agreements) totaled approximately $140.8 million or 10.4% of total deposits. This compares to $204.3 million, or 16.8%, of total deposits, at December 31, 2009.

Management is of the opinion that its liquidity position at September 30, 2010, is adequate to respond to fluctuations “on” and “off” balance sheet. In addition, management knows of no trends, demands, commitments, events or uncertainties that may result in, or that are reasonably likely to result in our inability to meet anticipated or unexpected liquidity needs.

Interest Rate Risk

We actively manage our interest rate sensitivity position. Interest rate sensitivity is the matching or mismatching of the repricing and rate structure of the interest-bearing assets and liabilities. Our primary objectives of interest rate risk management are to neutralize adverse impacts to net interest income arising from interest rate movements and to attain sustainable growth in net interest income. The Management Asset Liability Committee (“MALCO”) is primarily responsible for developing and implementing asset liability management strategies in accordance with the Asset and Liability Management Policy and Procedures (the “ALCO Policy”) approved by the board of directors. The MALCO generally meets on a monthly basis and is comprised of members of our senior management team. The ALCO of the board of directors meets on a quarterly basis to review the guidelines established by MALCO and the results of our interest rate risk analysis.

We manage interest rate sensitivity by changing the volume, mix, pricing and repricing characteristics of our assets and liabilities. We have not entered into separate derivative contracts such as interest rate swaps, caps, and floors.

 

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The interest rate characteristics and interest repricing characteristics of the loan portfolio at September 30, 2010 are set forth in the tables below. Adjustable-rate loans represent loans that are currently in a fixed-rate, but are subject to repricing to either a fixed or variable rate at the related next repricing date.

 

Interest Rate

Characteristic

   Percentage
of Portfolio
 

Fixed-rate loans

     22.9

Adjustable-rate loans

     32.7

Variable-rate loans

     44.4
        

Total

     100.0
        

Repricing

Structure

   Percentage
of Portfolio
 

One month or less

     41.4

Two to six months

     7.8

Six to twelve months

     6.1

One to two years

     6.2

Two to three years

     11.4

Three to five years

     15.7

Greater than five years

     11.4
        
     100.0
        

As of September 30, 2010, the loan portfolio contained $592.5 million of loans in the variable-rate interest mode. Of these loans, 85.8% had interest rate floors. The majority of these loans are indexed to prime, 1-Month LIBOR, and 3-Month LIBOR (i.e. the index plus a spread). While the interest rate floors provide the Company with interest rate protection given that the prime rate and LIBOR rates, plus the applicable spread, are substantially below these floors, these loans will not generate incremental income in an upward rising environment until the floors have been surpassed. The compression on net interest margin related to these relationships will be influenced by a number of variables including, but not limited to, the volatility of the respective indices, the speed at which rates rise, and the interest rate sensitivity of deposit costs. To date, we have elected to manage this risk without the use of separate derivative contracts.

As of September 30, 2010, the loan portfolio contained $168.7 million of loans that are indexed to the one-year Treasury rate (i.e. the index plus a spread). Approximately $90.0 million of these loans are scheduled to reprice over the next twelve months. The loans that will reprice over the next twelve months have a current weighted average interest rate of approximately 4.32%. In the current rate environment, these loans will reprice to new rates that are below the current contractual rates thereby putting pressure on net interest margin. In the event that the one-year Treasury rate rises, the loss of interest income from repricing will be lessened. We have been actively encouraging customers to refinance these loans into fixed-rate loans through our mortgage company subsidiary as a means of locking in historically low interest rates. Since December 31, 2009, the mortgage loan portfolio that is indexed to the one-year Treasury rate has been reduced by $18.3 million. We expect to continue this strategy and other initiatives to manage this interest rate risk. Furthermore, we expect that newly originated mortgage loan volume will principally be underwritten and sold into the secondary market through our mortgage subsidiary. To date, we have elected to manage this risk without the use of separate derivative contracts.

During the nine months ended September 30, 2010, the Company adjusted the composition of the loan portfolio to include a higher percentage of variable rate loans. As of September 30, 2010 and December 31, 2009, the percentage loans classified as variable rate was 44.4% and 34.6%, respectively. The shift to more asset-sensitive loans has been intentional and is related to the Company’s management of interest rate risk across time.

As of September 30, 2010, we reported deposit liabilities of approximately $1.36 billion and securities sold under agreements to repurchase of approximately $7.1 million. Comparatively, we reported deposit liabilities of approximately $1.22 billion and securities sold under repurchase agreements of approximately $6.9 million at December 31, 2009.

 

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The maturity structure of the time deposit portfolio as of September 30, 2010, is summarized below.

 

Certificates of Deposit

Maturity Structure

   Dollars
(millions)
     Percentage  

One months or less

   $ 24.3         5.6

Over one month through one year

     135.1         31.3

Over one year through two years

     76.9         17.8

Over two years

     195.8         45.3
                 

Total

   $ 432.1         100.0
                 

As noted above, approximately $159.4 million of time deposits will mature over the next year. Given existing market conditions, we expect to retain a significant portion of the maturing time deposit portfolio in the form of new time deposits or money market accounts at interest rates that are generally comparable to the current rates of the time deposits maturing over the next year except for that portion of the time deposit portfolio that we target for longer maturities. We are actively seeking to extend the weighted average life of the time deposit portfolio which may result in renewing a portion of the time deposit portfolio at rates that are higher than the rates of time deposits maturing over the next year.

We use several tools to assess and measure its interest rate risk including interest rate simulation analysis that is prepared on a quarterly basis. Each analysis is largely dependent on many assumptions and variables with past behaviors that may not prove to be effective predictors of future outcomes. These assumptions are reviewed on at least a quarterly basis.

Gap Analysis

We use gap analysis to compare the relationship of assets that are expected to reprice during a specific time frame (“Rate Sensitive Assets” or “RSA”) as compared to liabilities that are scheduled to reprice during an identical time period (“Rate Sensitive Liabilities” or “RSL”). When the ratio is greater than one, RSA exceed RSL and potentially exposes the bank to a risk of a decline in interest rates by virtue of a larger amount of assets repricing at lower interest rates than rate sensitive liabilities. The converse would be true of a RSA/RSL ratio less than 1.0. While gap analysis can be useful in evaluating the relationship of RSA to RSL, it does not capture other critical interest rate risk variables such as the extent of change that will take place when a RSA or RSL reprices, prepayment considerations, and other factors. Under the ALCO Policy, the interest rate simulation report measures the ratio of rate sensitive assets to rate sensitive liabilities at a one-year time frame. The ALCO Policy has established an acceptable relationship of RSA to RSL to a range of 80% to 120%.

We use the following methodology in computing repricing gap. This methodology is noteworthy given the current interest rate environment. First, we classify variable-rate loans with current interest rates below loan floors as rate sensitive assets. As of September 30, 2010, we have $592.5 million of loans that are currently in the variable rate mode with interest rates indexed to the prime rate, the one-month LIBOR, and the three-month that are subject to contractual floors. The majority of these loans have current interest rates determined by the contractual floors. To the extent that these loans will not reprice until the floor have been pierced (approximately 175 basis points), these loans are technically not rate sensitive. However, for purposes of computing repricing gap, we have treated these loans as rate-sensitive to capture their behavior in more traditional interest rate environments. Second, we have classified all interest-bearing non-maturity deposits as repricing immediately. We believe that this methodology is more conservative in comparison to other methodologies that assume non-maturity deposits reprice across time. We recognize that this methodology has the potential to highlight the inherent weaknesses of repricing gap analysis. For this reason, we emphasize the metrics of net interest income at risk and economic value of equity at risk when evaluating interest rate risk.

At September 30, 2010, our balance sheet was liability sensitive with a cumulative gap ratio at one year of approximately 97.5%. The gap ratio is within policy guidelines. In large part, the liability sensitive position of the balance sheet is due to the increase in transaction, and money market in the deposit portfolio. This is an intentional strategy designed to strengthen on-balance sheet liquidity, acquire lower cost in-market deposits, and address consumer demand for FDIC-insured liquid deposits. Management believes the interest rate sensitivity of the Company’s non-maturity deposit portfolio is less than that of the general market. Accordingly, the lower level of interest rate sensitivity will partially mitigate the general effects of liability sensitivity. As of September 30, 2010, 91.9% of deposits were originated within markets we serve. The table below summarizes the repricing gap of the Company as of September 30, 2010.

 

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Repricing Gap Report as of September 30, 2010 (in thousands)

 
    1 to 3
Months
    3 to 6
Months
    6 -12
Months
    12 to 24
Months
    24 to 36
Months
    36 to 60
Months
    Greater
than 60
Months
    Non-rate
sensitive
    Total  

Assets

                 

Cash, due from banks, and Federal funds sold

  $ 17,831      $ —        $ —        $ —        $ —        $ —        $ —        $ 28,434      $ 46,265   

Securities available for sale

    28,031        28,490        29,058        27,251        9,007        5,157        24,568        120      $ 151,682   

Loans

    640,437        74,594        126,726        151,915        147,299        126,941        53,759        —        $ 1,321,671   

Other Assets

    —          —          —          —          —          —          —          99,225      $ 99,225   
                                                                       

Total Assets

  $ 686,299      $ 103,084      $ 155,784      $ 179,166      $ 156,306      $ 132,098      $ 78,327      $ 127,779      $ 1,618,843   
                                                                       

Liabilities

                 

Non-interest bearing deposits

  $ —        $ —        $ —        $ —        $ —        $ —        $ —        $ 125,174      $ 125,174   

Interest-bearing transaction and savings deposits

    798,395        —          —          —          —          —          —          —        $ 798,395   

Time deposits

    58,824        46,854        53,500        76,854        21,238        164,607        10,271        —        $ 432,148   
                                                                       

Total deposits

    857,219        46,854        53,500        76,854        21,238        164,607        10,271        125,174      $ 1,355,717   

Borrowings, including repurchase agreements

    7,126        24        5,050        106        5,115        31,263        35,853        —        $ 84,537   

Other Liabilities

    —          —          —          —          —          —          —          12,793      $ 12,793   
                                                                       

Total Liabilities

  $ 864,345      $ 46,878      $ 58,550      $ 76,960      $ 26,353      $ 195,870      $ 46,124      $ 137,967      $ 1,453,047   
                                                                       

Equity

    —          —          —          —          —          —          —          165,796        165,796   
                                                                       

Total Liabilities and Equity

  $ 864,345      $ 46,878      $ 58,550      $ 76,960      $ 26,353      $ 195,870      $ 46,124      $ 303,763      $ 1,618,843   
                                                                       

Period Repricing Gap

    (178,046     56,206        97,234        102,206        129,953        (63,772     (32,203     (10,188     165,796   

Period Repricing Gap Percentage

    79.4     219.9     266.1     232.8     593.1     67.4     169.8     92.6     111.4

Cumulative Repricing Gap Percentage

    79.4     86.6     97.5     107.4     119.3     111.3     113.4     158.4     111.4

Net Interest Income at Risk

We assess the percentage change in net interest income assuming interest rate shocks (upward and downward) of 100, 200, and 300 basis points. Given the current rate environment, we limited the downward shock to 100 basis points, but included an upward shock of 400 basis points. This analysis captures the timing of the repricing of RSA and RSL as well as the degree of change (“beta”) in the interest rates of particular asset and liability products that occurs as interest rates move upward or downward. Under the Asset and Liability Management Policy and Procedures, the interest rate simulation report measures the percentage change in net interest income for one year assuming interest rate shocks of 100, 200, and 300 basis points. The ALCO Policy has established an acceptable negative percentage change in net interest income under 100, 200, and 300 basis point shocks of 20%.

The table below summarizes the Net Interest Income at Risk modeling results as of September 30, 2010.

 

     Actual     Policy  

Net Interest Income: Up 100 Bps (%)

     (0.30 )%      20.0

Net Interest Income: Up 200 Bps (%)

     2.34     20.0

Net Interest Income: Up 300 Bps (%)

     6.17     20.0

Net Interest Income: Up 400 Bps (%)

     10.44     20.0

Net Interest Income: Down 100 Bps (%)

     (1.52 )%      20.0

Economic Value of Equity at Risk

We assess the present value of cash inflows of cash, investments, loans, bank-owned life insurance policies, when applicable, netted against the present value of cash outflows from deposits, repurchase agreements, borrowings, and other interest-bearing liabilities, all discounted to a measurement date. This measure is expressed as the percentage change in the present value of such cash flows when interest rates are shocked (upward and downward) at 100, 200, and 300 basis points. Under the Asset and Liability Management Policy and Procedures, the interest rate simulation reports measures the percentage change in economic value of equity at risk assuming interest rate shocks of 100, 200, and 300 basis points. Given the current rate environment, we limited the downward shock to 100 basis points, but included an upward shock of 400 basis points. The ALCO Policy has established an acceptable negative percentage change in economic value of equity at risk under 100, 200, and 300 basis point shocks of 20%.

 

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The table below summarizes the Economic Value of Equity at Risk as of September 30, 2010.

 

     Actual     Policy  

Economic Value of Equity: Up 100 Bps (%)

     (6.32 )%      20.0

Economic Value of Equity: Up 200 Bps (%)

     (7.48 )%      20.0

Economic Value of Equity: Up 300 Bps (%)

     (4.22 )%      20.0

Economic Value of Equity: Up 400 Bps (%)

     0.23     N/A   

Economic Value of Equity: Down 100 Bps (%)

     12.33     20.0

Market Price Risk

As of September 30, 2010, our investment portfolio had a market value of approximately $151.7 million. The investment portfolio is comprised of two separate components each of which is managed pursuant to a board approved investment policy. At the holding company level, we have a portfolio of equity securities of financial institutions (the “Equity Portfolio”) with a market value of approximately $120 thousand. At the bank level, the Bank has a portfolio with a market value of approximately $151.6 million comprised of debt securities summarized below and certain restricted investments related to business relationships with the Federal Home Loan Bank of Pittsburgh and a correspondent bank. As of December 31, 2009, we had an investment portfolio with a market value of approximately $196.1 million of which $195.0 million was that was held at the bank level and $1.1 million was held at the holding company level.

The investment portfolio held by the Bank decreased $43.4 million during the first nine months of 2010. The decrease was related to $65.9 million of U.S. Government Agency step-up bonds that were called; replacing assets that matured, prepaid, or called; a modest increase in municipal securities; and an increase in the market value of the portfolio as a result of lower interest rates. The maturities and cash flows from these investments have been structured to coincide with the lending activities of the bank. For example, the weighted average life of the bank investment portfolio is 3.0 years. The weighted average life of the bank investment portfolio has extended 0.30 years between December 31, 2009 and September 30, 2010. This extension is largely related to the redemption of investments that were designed to return cash flow to provide a source of funding for the Company’s lending activity in 2010. We believe that the off balance sheet liquidity sources of the bank and the ability to raise in-market deposits at reasonable prices adequately mitigates the cash flow variability of the investment portfolio.

The securities available for sale in the bank portfolio at September 30, 2010 consisted of U.S. Government agency securities, U.S. Government agency mortgage-backed securities; Government National Mortgage Association collateralized mortgage obligations, Small Business Administration loan pools, and municipal bonds. The Government National Mortgage Association collateralized mortgage obligations and Small Business Administration loan pool securities are secured by the full, faith, credit and taxing power of the United States of America and carry a zero risk weighting for regulatory capital purposes.

 

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Debt security market price risk is the risk that changes in the values of debt security investments could have a material impact on our financial position or results of operations. The table below summarizes the effective maturity structure of the portfolio as of September 30, 2010.

 

     Within 1 year     After 1 year but
within 5 years
    After 5 years but
within 10 years
    After 10 years     Total  
     (dollars in thousands)  
     Fair
Value
     W/A
Yield
    Fair
Value
     W/A
Yield
    Fair
Value
     W/A
Yield
    Fair
Value
     W/A
Yield
    Fair
Value
     W/A
Yield
 

U.S Government agency obligations

   $ 5,000         1.00   $ 17,073         1.48   $ 5,006         2.23   $ —           —        $ 27,079         1.53

State and municipal obligations

     693         3.19     3,981         3.66     6,939         4.31     10,102         4.92     21,715         4.45

Asset-backed securities (1)

     —           —          —           —          —           —          —           —          96,514         2.75

Other securities (2)

     —           —          —           —          —           —          —           —          6,254         0.00
                                                       

Graystone Tower Bank Portfolio

   $ 5,693         $ 21,054         $ 11,945         $ 10,102         $ 151,562         2.77
                                                       

Holding company equity investments

                       $ 120      
                               

Total investment securities

                       $ 151,682      
                               

 

(1): Mortgage-backed securities include agency mortgage-backed securities; Government National Mortgage Association collateralized mortgage obligations, and Small Business Administration loan pools.
(2): Equity investments in business relationship banks such as the Federal Home Loan Bank and correspondent banks.

Equity market price risk is the risk that changes in the values of equity investments could have a material impact on our financial position or results of operations. The Equity Portfolio was acquired as a result of the Merger. As of September 30, 2010, the equity portfolio was comprised of three different equity securities of financial institutions with a market value of $120 thousand. During the third quarter of 2010, the investment portfolio at the holding company level decreased by $238 thousand as a result of selling one equity position and recognizing other-than-temporary-impairment charges of approximately $70 thousand. The total asset sizes of the financial institutions remaining in the portfolio range from approximately $125 million to financial institutions with assets of approximately $485 million. The remaining three financial institutions held in our portfolio are located in the mid-Atlantic region.

 

Item 4. Controls and Procedures.

We maintain a system of controls and procedures designed to ensure that information required to be disclosed by us in reports that we file with the Securities and Exchange Commission (the “Commission”) is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms. Tower’s Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of our disclosure controls and procedures as of September 30, 2010. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting management to information required to be included in our periodic Securities and Exchange Commission filings.

As disclosed in management’s report on internal control over financial reporting, filed in Tower’s Form 10-K for the year ended December 31, 2009, in connection with Tower’s reverse merger with Graystone Financial Corp., Tower’s internal control structure was converted to the former control structure of Graystone Financial Corp. during 2009; however, because of the timing of the new internal control implementation, it was not practical for management to evaluate the effectiveness of internal control over financial reporting in a manner that would prove meaningful. Tower is continuing to execute its internal audit program under the direction of the Audit Committee of the Board of Directors and will be in a position to report on the effectiveness of internal control over financial reporting within the annual report for 2010.

During the quarter ended September 30, 2010, in connection with the execution of the internal audit program with the support of a third-party service provider, Tower continued implementing or changing key procedures, systems, and personnel throughout the organization. The merger with Graystone Financial Corp. also provided for the enhancement of certain management and administrative personnel and staffing, as well as the implementation of certain credit administration, loan review, lending and other control policies and procedures throughout the entire Tower organization. Management believes that these changes will significantly remediate the material weaknesses related to credit administration and documentation identified in Management’s Report on Internal Control over Financial Reporting, as filed with Tower’s annual report on Form 10-K for the year ended December 31, 2008.

 

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Other than the foregoing, there were no changes in Tower’s internal control over financial reporting during the third quarter of 2010 that materially affected, or are reasonably likely to materially affect, Tower’s internal control over financial reporting.

PART II – OTHER INFORMATION

 

Item 1. Legal Proceedings.

Tower is an occasional party to legal actions arising in the ordinary course of its business. In the opinion of Tower’s management, Tower has adequate legal defenses and/or insurance coverage respecting any and each of these actions and does not believe that they will materially affect Tower’s operations or financial position.

 

Item 1A. Risk Factors.

There have been no material changes from the risk factors as disclosed in Tower’s Annual Report on Form 10-K for the year ended December 31, 2009, except for the following risk factors, which have been amended or added since December 31, 2009.

Legislative and regulatory actions taken now or in the future may significantly affect our financial condition, results of operations, liquidity or stock price.

Current economic conditions, particularly in the financial markets, have resulted in government regulatory agencies and political bodies placing increased focus and scrutiny on the financial services industry. The U.S. Government has intervened on an unprecedented scale, enacting and implementing numerous programs and actions targeted at the financial markets generally and the financial services industry in particular.

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act, or the Dodd-Frank Act, was signed into law. The Dodd-Frank Act will implement significant changes to the U.S. financial system, including among others, (i) the creation of a new Bureau of Consumer Financial Protection with supervisory authority, including the power to conduct examinations and take enforcement actions with respect to financial institutions with assets of $10 billion or more, (ii) the creation of a Financial Stability Oversight Council with authority to identify institutions and practices that might pose a systemic risk, (iii) provisions affecting corporate governance and executive compensation of all companies subject to the reporting requirements of the Securities and Exchange Act of 1934, as amended, (iv) a provision that would broaden the base for FDIC insurance assessments, and (v) a provision that would require bank regulators to set minimum capital levels for bank holding companies that are as strong as those required for their insured depository subsidiaries, subject to a grandfather clause for holding companies with less than $15 billion in assets as of December 31, 2009.

The Dodd-Frank Act contains numerous other provisions affecting financial institutions of all types, many of which may have an impact on our operating environment in substantial and unpredictable ways. While some of the Dodd-Frank Act’s provisions will be effective immediately, many are to be implemented by rules promulgated within six to 18 months of signing.

The Dodd-Frank Act and the regulations to be adopted thereunder are expected to subject us and other financial institutions to additional restrictions, oversight and costs that may have an adverse impact on its business, financial condition, results of operations or the price of our common stock. The Dodd-Frank Act substantially increases regulation of the financial services industry and imposes restrictions on the operations and general ability of firms within the industry to conduct business consistent with historical practices. However, the ultimate effect of the Dodd-Frank Act on the financial services industry in general, and our organization in particular, is uncertain at this time.

Federal and state regulatory agencies also frequently adopt changes to their regulations or change the manner in which existing regulations are applied or enforced. We cannot predict the substance or impact of the Dodd-Frank Act or other pending or future legislation, regulation or the application thereof. Compliance with such current and potential regulation and scrutiny may significantly increase our costs, impede the efficiency of our internal business processes, require us to increase our regulatory capital and limit our ability to pursue business opportunities in an efficient manner.

 

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Risks Related to the Proposed Acquisition of First Chester County Corporation

Regulatory approvals already received may expire, be revoked or be amended to impose conditions that are not presently anticipated or cannot be met.

Before the transactions contemplated in the acquisition agreement with First Chester County Corporation, including the acquisition, may be completed, various approvals or consents must be obtained from various bank regulatory and other authorities, including the Federal Reserve, the FDIC and the Pennsylvania Department of Banking. These governmental entities may impose conditions on the completion of the acquisition or require changes to the terms of the acquisition agreement. Further, such approvals are subject to expiration if the transaction is not consummated within the time period provided in the approval.

Although all requisite bank regulatory approvals have been received, these approvals are subject to modification or revocation by issuing authorities prior to completion of the acquisition. Although we do not currently expect that any approvals will be revoked or modified to impose conditions on the acquisition or changes to the acquisition agreement, there can be no assurance that they will not be, and such conditions or changes could have the effect of delaying completion of the transactions contemplated in the acquisition agreement or imposing additional costs on or limiting our revenues, any of which might have a material adverse effect on us following the acquisition. We may be required to request an extension of the expiration date for one or more approvals. There can be no assurance as to whether any requests for an extension of any expiration date of any regulatory approval will be received, the timing of those extensions, or whether any conditions will be imposed.

First Chester’s banking subsidiary, the First National Bank of Chester County (“FNB”) is currently subject to a Memorandum of Understanding between its board of directors and the Office of the Comptroller of the Currency, the failure to comply with which could result in additional enforcement action.

On October 16, 2009, the Board of Directors of FNB entered into a Memorandum of Understanding, or MOU, with the OCC, which focused, among other things, on FNB’s need to: (i) develop a comprehensive three-year capital plan; (ii) take action to protect criticized assets and adopt and implement a program to eliminate the basis of criticism of such assets; (iii) establish an effective program that provides for early problem loan identification and a formal plan to proactively manage those assets; (iv) review the adequacy of the bank’s information technology activities and Bank Secrecy Act compliance and approve written programs of policies and procedures to provide for compliance; and (v) establish a Compliance Committee of the board of directors to monitor and coordinate the bank’s adherence to the provisions of the MOU.

Additionally, in early November 2009, the OCC notified FNB that it had established individual minimum capital ratios, or IMCRs, requiring FNB to achieve, by December 31, 2009, a Tier 1 leverage capital ratio of at least 8% of adjusted total assets, a Tier 1 risk-based capital ratio of at least 10% and a total risk-based capital ratio of at least 12%, each of which exceeded the well-capitalized ratios generally applicable to banks under then-current regulations. Tower, individually and through our subsidiary Graystone Tower Bank, has taken certain actions to assist FNB in achieving and maintaining capital ratios consistent with the IMCRs, including: (i) extending a $26 million loan to First Chester, the proceeds of which were contributed to FNB as Tier 1 capital, and which loan is secured by the stock of FNB; and (ii) purchasing from FNB $52.5 million in participations in performing commercial loans at a 1.5% discount.

Despite these efforts, FNB subsequently reported that, as of December 31, 2009, FNB was not in compliance with the leverage capital ratio and the total risk-based capital ratio, and as of March 31, 2010, FNB was not in compliance with the Tier 1 leverage capital ratio established by the IMCRs. As of September 30, 2010, FNB had achieved compliance with the IMCRs.

On August 27, 2010, the board of directors of FNB entered into a formal written agreement with the OCC, which supersedes and replaces the MOU. The formal agreement requires that the board of directors of FNB ensure that FNB takes those actions identified in the MOU (described above), and, in some cases, augments those requirements, such as establishing a written program regarding criticized assets of $750,000 or above, rather than the $1,000,000 threshold referenced in the MOU. In addition, the formal agreement adds a number of new requirements, requiring FNB to: (i) ensure FNB has adequate and competent senior management; (ii) develop and implement a written profit plan to improve and sustain the earnings of FNB; (iii) develop and implement a written program to improve loan portfolio management; (iv) review the methodology for FNB’s allowance for loan and lease losses and establish a program providing for the maintaining of an adequate allowance; and (v) adopt and implement a written interest rate risk policy. Unlike the MOU, the formal agreement is a form of formal enforcement action enforceable by the OCC through several means, including injunctions and the assessment of civil money penalties against FNB, its board of directors and/or its management.

There can be no assurance that the OCC will not take adverse action in the future. If the condition of FNB continues to deteriorate, Tower may lose all or a portion of the funds it invested in First Chester and/or FNB in order to assist it in achieving and maintaining “well-capitalized” status.

 

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If the acquisition agreement is terminated, the loans between First Chester and us, which were designed to alleviate regulatory pressure on FNB, may not have their intended result.

In early November 2009, the OCC imposed IMCRs on FNB requiring it to increase its regulatory capital ratios. To enable FNB to achieve and maintain capital ratios consistent with the IMCRs, we, through Graystone Tower Bank, loaned $26 million to First Chester, the proceeds of which were contributed to FNB as Tier 1 capital. Additionally, we extended a $2 million non-revolving line of credit to First Chester, which permits draws from time to time for the sole purpose of contributing additional capital to FNB in the event that, as a result of the attempt to sell the AHB Division, the actual sale thereof, or the effects on FNB of such sale, FNB’s regulatory capital ratios, as reported in FNB’s quarterly call report, fall below the minimum regulatory capital ratios applicable to FNB as established by the IMCRs. Both loans are secured by a pledge of all of the stock of FNB. If the acquisition agreement is terminated constituting an event of default under the loan agreements, First Chester will have to immediately repay the full amount of the loans to us. If First Chester cannot repay the loans, we could, with prior regulatory approval, foreclose on the stock of FNB under the pledge security agreement. There can be no assurance that First Chester will be able to raise funds sufficient to repay the loans from us if the acquisition agreement is terminated or that we would receive the requisite regulatory approval in order to foreclose on the FNB stock. If the acquisition agreement is terminated, we could lose all or a portion of the funds loaned to First Chester.

There are numerous conditions to the acquisition and the acquisition may not be completed.

The acquisition agreement is subject to a number of conditions which must be fulfilled or, to the extent permissible, waived in order to close. Those conditions include: receipt of approval from both First Chester’s and our shareholders, receipt of regulatory approval, the continued accuracy of certain representations and warranties by both parties and the performance by both parties of certain covenants and agreements. In particular, it is a condition to our obligation to close the acquisition that: (i) First Chester delinquent loans, as defined in the acquisition agreement, not exceed $90 million as of the last day of the month prior to the closing date; and (ii) FNB shall have received written confirmation from the OCC of the termination of the MOU, such termination to be effective as of or prior to the effective time of the acquisition. The failure of any of the foregoing conditions would allow us to refuse to consummate the acquisition.

Additionally, either party may terminate the acquisition agreement if the acquisition has not been completed on or before December 31, 2010.

There can be no assurance that the conditions to closing the acquisition will be fulfilled or waived or that the acquisition will be completed.

There is substantial doubt about First Chester’s ability to continue as a going concern

Due to First Chester’s financial results, FNB’s failure to comply with the IMCRs as of December 31, 2009 and March 31, 2010, the substantial uncertainty throughout the U.S. banking industry and other matters, there is substantial doubt about its ability to continue as a going concern. Continued operations of First Chester depend on FNB’s ability to comply with the terms of the MOU, the IMCRs and the closing of the acquisition. As of December 31, 2009 and March 31, 2010, FNB met the IMCR threshold for Tier 1 risk-based capital, but was below the IMCR thresholds for Tier 1 leverage and total risk-based capital. As of September 30, 2010, FNB had achieved compliance with the IMCRs.

If First Chester is unable to continue as a going concern, we could lose some, if not all, of our investment in First Chester, and the acquisition may not be consummated. In addition, First Chester’s customers, employees, vendors, correspondent institutions, and others with whom it does business may react negatively to the substantial doubt about its ability to continue as a going concern. This negative reaction may lead to heightened concerns regarding First Chester’s financial condition that could result in a significant loss in deposits and customer relationships, key employees, vendor relationships and First Chester’s ability to do business with correspondent institutions upon which it relies. Any negative trends or deterioration prior to the acquisition could have an adverse impact on us post-acquisition.

First Chester’s asset quality and/or overall financial condition may continue to deteriorate prior to completion of the acquisition.

Should the asset quality at First Chester deteriorate further, such deterioration may have an adverse effect on First Chester’s financial and capital positions and, upon completion of the acquisition, our financial and capital positions. Additionally, any further deterioration in First Chester’s overall financial condition prior to completion of the acquisition could have an adverse impact on us post-acquisition.

 

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First Chester may be unsuccessful in selling its AHB Division prior to completion of the acquisition, which could result in additional costs to us associated with selling or discontinuing the AHB Division’s mortgage-banking activities, or First Chester may be required to retain contingent liabilities in connection with a sale of the AHB Division which may be deemed material to us.

First Chester, through the American Home Bank Division of FNB (the “AHB Division”), engages in mortgage-banking activities on a nationwide basis. The acquisition agreement requires that First Chester use its best efforts, and shall cause FNB to use its best efforts, to sell, at or prior to the effective time of the acquisition, the AHB Division to one or more purchasers on terms and conditions acceptable to First Chester and us. There can be no assurance that First Chester will be successful in selling the AHB Division prior to the acquisition, and as of the date of this document no agreement of sale has been executed. Additionally, it is possible that, in connection with a sale of the AHB Division, First Chester may be required to retain contingent liabilities not assumed by the purchaser, which liabilities may be material to First Chester or, after the acquisition, to us. If the sale does not occur prior to the acquisition, we intend to sell or discontinue the mortgage-banking operations associated with the AHB Division in an orderly fashion upon completing the acquisition. Selling or discontinuing such activities after the acquisition may result in significant additional, unanticipated costs to us.

The potential costs associated with selling or discontinuing the mortgage-banking operations associated with the AHB Division, as well as the realization of any material contingent liabilities required to be retained by First Chester and, after the acquisition, by us in connection with a sale of the AHB Division, could have a material impact on our results of operations. In addition, we may not be able to maintain or retain licenses, permits, authorizations or approvals currently held by First Chester or FNB related to the AHB Division, which could further increase costs of discontinuing the mortgage-banking operations.

First Chester holds certain intangible assets that could be classified as impaired in the future. If these assets are considered to be either partially or fully impaired in the future, First Chester’s earnings and the book value of these assets, which would be acquired by us if the acquisition is consummated, would decrease.

Pursuant to FASB ASC Topic 350, “Intangibles-Goodwill and Other,” First Chester is required to test its goodwill and core deposit intangible assets for impairment on a periodic basis. The impairment testing process considers a variety of factors, including the current market price of its common shares, the estimated net present value of its assets and liabilities, and information concerning the terminal valuation of similarly situated depository institutions. The market price of First Chester common shares was below their book value as of December 31, 2009. If the duration of this decline in the market value of First Chester common shares and the decline in the market prices of the common shares of similarly situated insured depository institutions persists during future reporting periods, or if the severity of the decline increases, it is possible that future impairment testing could result in a partial or full impairment of the value of First Chester’s goodwill or core deposit intangibles, or both. If an impairment determination is made in a future reporting period, First Chester’s earnings and the book value of these intangible assets, which would be acquired by us if the acquisition is consummated, will be reduced by the amount of the impairment.

The pending acquisition of First Chester may distract our management from their other responsibilities.

The pending acquisition of First Chester could cause our management to focus their time and energies on matters related to the acquisition that otherwise would be directed to our business and operations. Any such distraction on the part of management, if significant, could affect management’s ability to service existing business and develop new business and otherwise adversely affect us following the acquisition.

 

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

None.

 

Item 3. Defaults Upon Senior Securities.

None.

 

Item 4. (Removed and Reserved).

None

 

Item 5. Other Information.

None

 

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Item 6. Exhibits.

 

Exhibit No.

  

Description

  2.1

   Agreement and Plan of Merger by and between First Chester County Corporation and Tower Bancorp, Inc., dated as of December 27, 2009 (Incorporated by reference to Exhibit 2.1 to Registrant’s Current Report on Form 8-K filed December 28, 2009)

  2.2

   First Amendment to Agreement and Plan of Merger by and between Tower Bancorp, Inc. and First Chester County Corporation, dated March 4, 2010 (Incorporated by reference to Exhibit 10.1 to Registrant’s Current Report on Form 8-K filed on March 9, 2010)

  2.3

   Form of Bank Plan of Merger by and between Graystone Tower Bank and First National Bank of Chester County (Included as Exhibit F to the First Amendment to Agreement and Plan of Merger filed herewith as Exhibit 2.2)

  2.4

   Second Amendment to Agreement and Plan of Merger by and between Tower Bancorp, Inc. and First Chester County Corporation dated as of August 25, 2010 (Incorporated by reference to Exhibit 2.1 to Registrant’s Current Report on Form 8-K filed on August 26, 2010)

  2.5

   Third Amendment to Agreement and Plan of Merger by and between Tower Bancorp, Inc. and First Chester County Corporation dated as of October 28, 2010 (Incorporated by reference to Exhibit 2.1 to Registrant’s Current Report on Form 8-K filed on November 2, 2010)

  3.1

   Amended and Restated Articles of Incorporation (Incorporated by reference to Exhibit 3.1 to Registrant’s Current Report on Form 8-K filed on September 24, 2009)

  3.2

   Bylaws of Tower Bancorp, Inc. (Incorporated by reference to Exhibit 3.1 to Registrant’s Current Report on Form 8-K filed on July 27, 2010)

  4.1

   Form of Subordinated Note due July 1, 2014 (Incorporated by reference to Exhibit 4.1 to Registrant’s Current Report on Form 8-K filed on June 12, 2009)

  4.2

   Form of Subordinated Note Due July 1, 2015 (Incorporated by reference to Exhibit 4.1 to Registrant’s Current Report on Form 8-K filed on February 8, 2010)

10.1

   Amendment to Limited Waiver dated July 26, 2010, relating to Loan Agreement between First Chester County Corporation and Graystone Tower Bank dated November 20, 2010, as amended (Incorporated by reference to Exhibit 10.1 to Registrant’s Current Report on Form 8-K filed on July 27, 2010)

10.2

   Form of Restricted Stock Agreement under the 2007 Stock Incentive Plan

10.3

   Form of Restricted Stock Agreement under the Tower Bancorp, Inc. 2010 Stock Incentive Plan

10.4

   Letter Agreement between Graystone Tower Bank and First Chester County Corporation dated October 28, 2010 (Incorporated by reference to Exhibit 10.1 to Registrant’s Current Report on Form 8-K filed November 2, 2010)

10.5

   Letter Agreement between Tower Bancorp, Inc. and First Chester County Corporation dated October 28, 2010 (Incorporated by reference to Exhibit 10.2 to Registrant’s Current Report on Form 8-K filed November 2, 2010)

31.1

   Certification of President and Chief Executive Officer of Tower Bancorp, Inc. Pursuant to Securities and Exchange Commission Rule 13a-14(a) / 15d-14(a)

31.2

   Certification of Chief Financial Officer of Tower Bancorp, Inc. Pursuant to Securities and Exchange Commission Rule 13a-14(a) / 15d-14(a)

 

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32.1

   Certification of President and Chief Executive Officer of Tower Bancorp, Inc. Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Furnished, not filed)

32.2

   Certification of Chief Financial Officer of Tower Bancorp, Inc. Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Furnished, not filed)

 

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SIGNATURES

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

 

  TOWER BANCORP, INC.
  (Registrant)
Date: November 9, 2010   By:  

/s/ Andrew S. Samuel

  Andrew S. Samuel
  President and Chief Executive Officer
Date: November 9, 2010   By:  

/s/ Mark S. Merrill

  Mark S. Merrill
  Executive Vice President and Chief Financial Officer

 

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EXHIBIT INDEX

 

Exhibit No.

  

Description

  2.1

   Agreement and Plan of Merger by and between First Chester County Corporation and Tower Bancorp, Inc., dated as of December 27, 2009 (Incorporated by reference to Exhibit 2.1 to Registrant’s Current Report on Form 8-K filed December 28, 2009)

  2.2

   First Amendment to Agreement and Plan of Merger by and between Tower Bancorp, Inc. and First Chester County Corporation, dated March 4, 2010 (Incorporated by reference to Exhibit 10.1 to Registrant’s Current Report on Form 8-K filed on March 9, 2010)

  2.3

   Form of Bank Plan of Merger by and between Graystone Tower Bank and First National Bank of Chester County (Included as Exhibit F to the First Amendment to Agreement and Plan of Merger filed herewith as Exhibit 2.2)

  2.4

   Second Amendment to Agreement and Plan of Merger by and between Tower Bancorp, Inc. and First Chester County Corporation dated as of August 25, 2010 (Incorporated by reference to Exhibit 2.1 to Registrant’s Current Report on Form 8-K filed on August 26, 2010)

  2.5

   Third Amendment to Agreement and Plan of Merger by and between Tower Bancorp, Inc. and First Chester County Corporation dated as of October 28, 2010 (Incorporated by reference to Exhibit 2.1 to Registrant’s Current Report on Form 8-K filed on November 2, 2010)

  3.1

   Amended and Restated Articles of Incorporation (Incorporated by reference to Exhibit 3.1 to Registrant’s Current Report on Form 8-K filed on September 24, 2009)

  3.2

   Bylaws of Tower Bancorp, Inc. (Incorporated by reference to Exhibit 3.1 to Registrant’s Current Report on Form 8-K filed on July 27, 2010)

  4.1

   Form of Subordinated Note due July 1, 2014 (Incorporated by reference to Exhibit 4.1 to Registrant’s Current Report on Form 8-K filed on June 12, 2009)

  4.2

   Form of Subordinated Note Due July 1, 2015 (Incorporated by reference to Exhibit 4.1 to Registrant’s Current Report on Form 8-K filed on February 8, 2010)

10.1

   Amendment to Limited Waiver dated July 26, 2010, relating to Loan Agreement between First Chester County Corporation and Graystone Tower Bank dated November 20, 2010, as amended (Incorporated by reference to Exhibit 10.1 to Registrant’s Current Report on Form 8-K filed on July 27, 2010)

10.2

   Form of Restricted Stock Agreement under the 2007 Stock Incentive Plan

10.3

   Form of Restricted Stock Agreement under the Tower Bancorp, Inc. 2010 Stock Incentive Plan

10.4

   Letter Agreement between Graystone Tower Bank and First Chester County Corporation dated October 28, 2010 (Incorporated by reference to Exhibit 10.1 to Registrant’s Current Report on Form 8-K filed November 2, 2010)

10.5

   Letter Agreement between Tower Bancorp, Inc. and First Chester County Corporation dated October 28, 2010 (Incorporated by reference to Exhibit 10.2 to Registrant’s Current Report on Form 8-K filed November 2, 2010)

31.1

   Certification of President and Chief Executive Officer of Tower Bancorp, Inc. Pursuant to Securities and Exchange Commission Rule 13a-14(a) / 15d-14(a)

31.2

   Certification of Chief Financial Officer of Tower Bancorp, Inc. Pursuant to Securities and Exchange Commission Rule 13a-14(a) / 15d-14(a)

 

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32.1

   Certification of President and Chief Executive Officer of Tower Bancorp, Inc. Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Furnished, not filed)

32.2

   Certification of Chief Financial Officer of Tower Bancorp, Inc. Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Furnished, not filed)

 

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