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EX-32 - CERTIFICATION OF PERIODIC FINANCIAL REPORT (SECTION 906 CERTIFICATION) - SIERRA BANCORPv229233_ex32.htm
EX-31.2 - CERTIFICATION OF CHIEF FINANCIAL OFFICER (SECTION 302 CERTIFICATION) - SIERRA BANCORPv229233_ex31-2.htm
EX-31.1 - CERTIFICATION OF CHIEF EXECUTIVE OFFICER (SECTION 302 CERTIFICATION) - SIERRA BANCORPv229233_ex31-1.htm
 
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-Q

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

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2011

Commission file number:  000-33063

SIERRA BANCORP
(Exact name of Registrant as specified in its charter)

California
33-0937517
(State of Incorporation)
(IRS Employer Identification No)

86 North Main Street, Porterville, California  93257
(Address of principal executive offices)                  (Zip Code)

(559) 782-4900
(Registrant’s telephone number, including area code)

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

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

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

Common stock, no par value, 14,046,666 shares outstanding as of August 1, 2011

 
 

 
 
FORM 10-Q

Table of Contents
 
Page
Part I - Financial Information
1
 
Item 1. Financial Statements (Unaudited)
1
 
Consolidated Balance Sheets
1
 
Consolidated Statements of Income
2
 
Consolidated Statements of Cash Flows
3
 
Notes to Unaudited Consolidated Financial Statements
4
     
 
Item 2. Management’s Discussion & Analysis of Financial Condition & Results of Operations
12
 
Forward-Looking Statements
12
 
Critical Accounting Policies
12
 
Overview of the Results of Operations and Financial Condition
13
 
Earnings Performance
15
 
Net Interest Income and Net Interest Margin
15
 
Provision for Loan and Lease Losses
19
 
Non-interest Revenue and Operating Expense
20
 
Provision for Income Taxes
23
 
Balance Sheet Analysis
23
 
Earning Assets
23
 
Investments
23
 
Loan Portfolio
25
 
Credit Quality and Nonperforming Assets
27
 
Allowance for Loan and Lease Losses
31
 
Off-Balance Sheet Arrangements
36
 
Other Assets
36
 
Deposits and Interest-Bearing Liabilities
37
 
Deposits
37
 
Other Interest-Bearing Liabilities
38
 
Non-Interest Bearing Liabilities
39
 
Liquidity and Market Risk Management
39
 
Capital Resources
41
     
 
Item 3. Qualitative & Quantitative Disclosures about Market Risk
43
     
 
Item 4. Controls and Procedures
43
     
Part II - Other Information
44
 
Item 1. - Legal Proceedings
44
 
Item 1A. - Risk Factors
44
 
Item 2. - Unregistered Sales of Equity Securities and Use of Proceeds
44
 
Item 3. - Defaults upon Senior Securities
44
 
Item 4. - (Removed and Reserved)
44
 
Item 5. - Other Information
44
 
Item 6. - Exhibits
45
     
Signatures
46

 
 

 

PART I - FINANCIAL INFORMATION
Item 1
SIERRA BANCORP
CONSOLIDATED BALANCE SHEETS
(dollars in thousands)
 
   
June 30, 2011
   
December 31, 2010
 
   
(unaudited)
   
(audited)
 
ASSETS
           
Cash and due from banks
  $ 49,265     $ 42,110  
Interest-bearing deposits in banks
    19,102       325  
Federal Funds Sold
    -       210  
Total Cash & Cash Equivalents
    68,367       42,645  
Investment securities available for sale
    402,736       331,730  
Loans and leases:
               
Loans held for sale
    -       914  
Gross loans and leases
    772,551       804,626  
Allowance for loan and lease losses
    (20,711 )     (21,138 )
Deferred loan and lease fees, net
    229       113  
Net Loans and Leases
    752,069       784,515  
Premises and equipment, net
    20,033       20,190  
Operating leases, net
    547       904  
Foreclosed assets
    18,231       20,691  
Goodwill
    5,544       5,544  
Other assets
    78,372       80,352  
TOTAL ASSETS
  $ 1,345,899     $ 1,286,571  
                 
LIABILITIES AND SHAREHOLDERS' EQUITY
               
LIABILITIES
               
Deposits:
               
Non-interest bearing
  $ 273,684     $ 251,908  
Interest bearing
    842,482       800,366  
Total Deposits
    1,116,166       1,052,274  
Federal funds purchased and repurchase agreements
    3,980       -  
Short-term borrowings
    -       14,650  
Long-term borrowings
    15,000       15,000  
Other liabilities
    14,413       14,122  
Junior subordinated debentures
    30,928       30,928  
TOTAL LIABILITIES
    1,180,487       1,126,974  
SHAREHOLDERS' EQUITY
               
Serial Preferred stock, no par value; 10,000,000 shares authorized; none issued
    -       -  
Common stock, no par value; 24,000,000 shares authorized; 14,046,666 and 13,976,741 shares issued and outstanding at June 30, 2011 and December 31, 2010, respectively
    64,024       63,477  
Additional paid in capital
    1,760       1,652  
Retained earnings
    95,604       93,570  
Accumulated other comprehensive income
    4,024       898  
TOTAL SHAREHOLDERS' EQUITY
    165,412       159,597  
                   
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY
  $ 1,345,899     $ 1,286,571  

The accompanying notes are an integral part of these consolidated financial statements

 
1

 

SIERRA BANCORP
CONSOLIDATED  STATEMENTS OF INCOME
(dollars in thousands, except per share data, unaudited)

   
For the Quarter
   
For the Six Months
 
   
Ended June 30,
   
Ended June 30,
 
   
2011
   
2011
   
2011
   
2011
 
Interest income:
                       
Interest and fees on loans
  $ 11,918     $ 13,495     $ 23,700     $ 27,073  
Interest on investment securities:
                               
Taxable
    2,285       2,043       4,201       4,150  
Tax-exempt
    721       673       1,437       1,318  
Interest on Federal funds sold and interest-bearing deposits
    25       5       33       22  
Total interest income
    14,949       16,216       29,371       32,563  
                                 
Interest expense:
                               
Interest on deposits
    1,125       1,671       2,216       3,329  
Interest on short-term borrowings
    5       55       39       92  
Interest on long-term borrowings
    142       142       282       318  
Interest on manditorily redeemable trust preferred securities
    180       180       361       355  
Total interest expense
    1,452       2,048       2,898       4,094  
                                 
Net Interest Income
    13,497       14,168       26,473       28,469  
                                 
Provision for loan losses
    3,000       3,500       6,600       6,900  
                                 
Net Interest Income after Provision for Loan Losses
    10,497       10,668       19,873       21,569  
                                 
Non-interest revenue:
                               
Service charges on deposit accounts
    2,446       2,887       4,701       5,590  
Other income, net
    1,027       1,102       2,348       2,260  
Total other operating income
    3,473       3,989       7,049       7,850  
                                 
Other operating expense:
                               
Salaries and employee benefits
    5,201       5,151       10,911       10,930  
Occupancy expense
    1,625       1,819       3,200       3,559  
Other
    4,729       4,578       9,146       9,232  
Total other operating expenses
    11,555       11,548       23,257       23,721  
                                 
Income before income taxes
    2,415       3,109       3,665       5,698  
                                 
Provision for income taxes
    231       565       (48 )     814  
                                 
Net Income
  $ 2,184     $ 2,544     $ 3,713     $ 4,884  
                                 
PER SHARE DATA
                               
Book value
  $ 11.78     $ 12.00     $ 11.78     $ 12.00  
Cash dividends
  $ 0.06     $ 0.06     $ 0.12     $ 0.12  
Earnings per share basic
  $ 0.16     $ 0.22     $ 0.27     $ 0.42  
Earnings per share diluted
  $ 0.16     $ 0.22     $ 0.26     $ 0.42  
Average shares outstanding, basic
    14,012,574       11,646,409       13,997,264       11,638,638  
Average shares outstanding, diluted
    14,084,997       11,749,546       14,072,974       11,723,566  

The accompanying notes are an integral part of these consolidated financial statements

 
2

 

SIERRA BANCORP
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands, unaudited)

   
Six Months Ended June 30,
 
   
2011
   
2010
 
Cash flows from operating activities:
           
Net income
  $ 3,713     $ 4,884  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Gain on sales of loans
    (53 )     (37 )
(Gain) loss on disposal of fixed assets
    (12 )     115  
Loss on sale on foreclosed assets
    296       337  
Writedowns on foreclosed assets
    1,305       653  
Share-based compensation expense
    117       68  
Provision for loan losses
    6,600       6,900  
Depreciation and amortization
    1,257       1,535  
Net amortization on securities premiums and discounts
    2,660       1,372  
Increase in unearned net loan fees
    (117 )     (330 )
Increase in cash surrender value of life insurance policies
    (707 )     (506 )
Proceeds from sales of loans
    1,725       932  
Net decrease (increase) in loans held-for-sale
    914       (498 )
Decrease (increase) in interest receivable and other assets
    1,766       (2,004 )
Decrease in other liabilities
    (1,361 )     (572 )
Net decrease in restricted stock, at cost
    670       334  
Deferred income tax (benefit) provision
    (6 )     13  
Excess tax provision (benefit) from equity based compensation
    10       (12 )
Net cash provided by operating activities
    18,777       13,184  
                 
Cash flows from investing activities:
               
Maturities of securities available for sale
    408       4,960  
Proceeds from sales/calls of securities available for sale
    1,275       6,912  
Purchases of securities available for sale
    (104,699 )     (73,005 )
Principal paydowns on securities available for sale
    34,638       33,589  
Decrease in loans receivable, net
    20,543       7,564  
Purchases of premises and equipment, net
    (734 )     (1,185 )
Proceeds from sales of foreclosed assets
    3,434       2,911  
Net cash used in investing activities
    (45,135 )     (18,254 )
                 
Cash flows from financing activities:
               
Increase (decrease) in deposits
    63,892       (33,830 )
Decrease (increase) in borrowed funds
    (14,650 )     21,900  
Increase in fed funds purchased
    3,980       -  
Cash dividends paid
    (1,679 )     (1,397 )
Payments of stock issuance costs
    (23 )     -  
Stock options exercised
    570       225  
Excess tax (benefit) provision from equity based compensation
    (10 )     12  
Net cash provided by (used in) financing activities
    52,080       (13,090 )
                 
Increase (decrease) in cash and due from banks
    25,722       (18,160 )
                 
Cash and Cash Equivalents
               
Beginning of period
    42,645       66,235  
End of period
  $ 68,367     $ 48,075  

The accompanying notes are an integral part of these consolidated financial statements

 
3

 

SIERRA BANCORP
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2011

Note 1 – The Business of Sierra Bancorp

Sierra Bancorp (the “Company”), headquartered in Porterville, California, is a California corporation registered as a bank holding company under the Bank Holding Company Act of 1956, as amended.  The Company was incorporated in November 2000 and acquired all of the outstanding shares of Bank of the Sierra (the “Bank”) in August 2001.  The Company’s principal subsidiary is the Bank, and the Company exists primarily for the purpose of holding the stock of the Bank and of such other subsidiaries it may acquire or establish.  At the present time, the Company’s only other direct subsidiaries are Sierra Statutory Trust II and Sierra Capital Trust III, which were formed in March 2004 and June 2006, respectively, solely to facilitate the issuance of capital trust pass-through securities.  Pursuant to the Financial Accounting Standards Board’s (FASB’s) standard on the consolidation of variable interest entities, these trusts are not reflected on a consolidated basis in the financial statements of the Company.  References herein to the “Company” include Sierra Bancorp and its consolidated subsidiary, the Bank, unless the context indicates otherwise.

The Bank is a California state-chartered bank headquartered in Porterville, California, that offers a full range of retail and commercial banking services to communities in the central and southern sections of the San Joaquin Valley.  Our branch footprint stretches from Fresno on the north to Bakersfield on the south, and on the southern end extends east through the Tehachapi plateau and into the northwestern tip of the Mojave Desert.  The Bank was incorporated in September 1977 and opened for business in January 1978, and in the ensuing years has grown to be the largest independent bank headquartered in the South San Joaquin Valley.  Our growth has primarily been organic, but includes the acquisition of Sierra National Bank in 2000.  We currently operate 25 full service branch offices throughout our geographic footprint, as well as an internet branch which provides the ability to open deposit accounts and submit certain loan applications online.  The Bank’s newest “brick and mortar” branches opened for business in Selma in February 2011 and Farmersville in March 2010.  In January 2011 we closed our first branch ever, in Bakersfield on California Avenue due to lease issues, and we are currently searching for a suitable location to replace that branch.  In addition to our full-service branches, the Bank has an agricultural credit division and an SBA lending unit with staff located at our corporate headquarters, and offsite ATM’s at eight different non-branch locations.  The Bank’s deposit accounts are insured by the Federal Deposit Insurance Corporation (FDIC) up to maximum insurable amounts.

Note 2 – Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in a condensed format, and therefore do not include all of the information and footnotes required by U.S. generally accepted accounting principles (GAAP) for complete financial statements. The information furnished in these interim statements reflects all adjustments that are, in the opinion of management, necessary for a fair statement of the results for such period. Such adjustments are of a normal recurring nature, unless otherwise disclosed in this Form 10-Q. In preparing the accompanying consolidated financial statements, management has taken subsequent events into consideration and recognized them where appropriate. The results of operations in the interim statements are not necessarily indicative of the results that may be expected for any other quarter, or for the full year. Certain amounts reported for 2010 have been reclassified to be consistent with the reporting for 2011. The interim financial information should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, as filed with the Securities and Exchange Commission.

 
4

 

Note 3 – Current Accounting Developments

In June 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2011-05, Comprehensive Income (Topic 220) - Presentation of Comprehensive Income. Current U.S. generally accepted accounting principles allow reporting entities several alternatives for displaying other comprehensive income and its components in financial statements, and ASU 2011-05 is intended to improve the consistency of this reporting issue. The amendments in this ASU require all non-owner changes in stockholders’ equity to be presented either in a single continuous statement of comprehensive income, or in two separate but consecutive statements. In a single continuous statement, the entity is required to present the components of net income and total net income, the components of other comprehensive income and a total for other comprehensive income, along with the total of comprehensive income in that statement. In the two-statement approach, an entity is required to present components of net income and total net income in the statement of net income. The statement of other comprehensive income should immediately follow the statement of net income and include the components of other comprehensive income and a total for other comprehensive income, along with a total for comprehensive income. Furthermore, the entity is required to present, on the face of the financial statements, adjustments for items that are reclassified from other comprehensive income to net income in the statements, where the components of net income and the components of other comprehensive income are presented. The amendments in the ASU do not change the following: 1) items that must be reported in other comprehensive income; 2) when an item of other comprehensive income must be reclassified to net income; 3) the option to present components of other comprehensive income either net of related tax effects or before related tax effects; or, 4) how earnings per share is calculated or presented. The amendments in ASU 2011-05 should be applied retrospectively. For public entities, such as the Company, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Early adoption is permitted. The Company’s adoption of this ASU will impact our presentation of comprehensive income, but not the calculation of such.
 
In May 2011, the FASB issued ASU No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, to substantially converge the fair value measurement and disclosure guidance in U.S. GAAP with International Financial Reporting Standards (“IFRS”). The amended guidance changes several aspects of current fair value measurement guidance, including the following provisions: 1) the application of the concepts of “highest and best use” and “valuation premise”; 2) the introduction of an option to measure groups of offsetting assets and liabilities on a net basis; 3) the incorporation of certain premiums and discounts in fair value measurements; and, 4) the measurement of the fair value of certain instruments classified in shareholders’ equity. In addition, the amended guidance includes several new fair value disclosure requirements, including, among other things, information about valuation techniques and unobservable inputs used in Level 3 fair value measurements and a narrative description of Level 3 measurements’ sensitivity to changes in unobservable inputs. For public entities such as the Company, the provisions of ASU 2011-04 are effective for interim and annual periods beginning after December 15, 2011, and are to be applied prospectively. The implementation of ASU 2011-04 is not expected to change fair value measurements for any of the Company’s assets or liabilities carried at fair value, and thus should not impact the Company’s statements of income and condition.
 
In April 2011, the FASB issued ASU No. 2011-02, Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring, in an effort to improve financial reporting by creating greater consistency in the way GAAP is applied for various types of debt restructurings.  ASU 2011-02 is intended to assist creditors in determining whether a modification of the terms of a loan meets the criteria to be considered a troubled debt restructuring (“TDR”), both for purposes of recording an impairment loss and for disclosure of TDR’s.  In evaluating whether a restructuring constitutes a TDR, a creditor must separately conclude that both of the following exist:  1) the restructuring constitutes a concession; and 2) the debtor is experiencing financial difficulties.  The amendments to Topic 310 clarify the guidance on a creditor’s evaluation of whether it has granted a concession, and likewise clarify the guidance on a creditor’s evaluation of whether a debtor is experiencing financial difficulties.  In addition, the amendments to Topic 310 preclude creditors from using the effective interest rate test in the debtor’s guidance on restructuring of payables (paragraph 470-60-55-10) when evaluating whether a restructuring constitutes a TDR.  For public companies, such as Sierra Bancorp, the new guidance is effective for interim and annual periods beginning on or after June 15, 2011, and applies retrospectively to restructurings occurring on or after the beginning of the fiscal year of adoption.  Early adoption is permitted, and the Company has adopted the provisions of ASU 2011-02 for the reporting period ended June 30, 2011.  There was a total of $552,000 in loan balances that were added to performing TDR’s at June 30, 2011 as a direct result of the Company’s adoption of ASU 2011-02, with only a negligible impact on our allowance for loan and lease losses.

 
5

 

In July 2010, the FASB updated disclosure requirements with respect to the credit quality of financing receivables and the allowance for credit losses.  According to the guidance, there are two levels of detail at which credit information must be presented - the portfolio segment level and class level.  The portfolio segment level is defined as the level where financing receivables are aggregated in developing a company’s systematic method for calculating its allowance for credit losses.  The class level is the second level at which credit information will be presented, and represents the categorization of financing receivables at a slightly less aggregated level than the portfolio segment level.  Companies are required to provide the following disclosures as a result of this update:  A roll-forward of the allowance for credit losses at the portfolio segment level, with the ending balances further categorized according to impairment method along with the balance reported in the related financing receivables at period-end; additional disclosures of nonaccrual and impaired financing receivables by class as of period-end; credit quality and past due/aging information by class as of period-end; information surrounding the nature and extent of loan modifications and troubled-debt restructurings and their effect on the allowance for credit losses during the period; and details on any significant purchases or sales of financing receivables during the period.  The increased period-end disclosure requirements became effective for periods ending on or after December 15, 2010, with the exception of the additional period-end disclosures surrounding troubled-debt restructurings which were deferred in December 2010 and became effective for annual and interim reporting periods ending on or after June 15, 2011.  The increased disclosures for activity within a reporting period become effective for periods beginning on or after June 15, 2011, with retrospective application to January 1, 2011.  The provisions of this FASB update expanded the Company’s current disclosures with respect to our allowance for loan and lease losses and the credit quality of our financing receivables.

In January 2010, the FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements.  This update added disclosure requirements for significant transfers into and out of Levels 1 and 2, clarified existing fair value disclosure requirements about the appropriate level of disaggregation, and clarified that a description of the valuation techniques was required for recurring and nonrecurring Level 2 and 3 fair value measurements.  The Company adopted these provisions of the ASU in preparing the Consolidated Financial Statements commencing with the period ended March 31, 2010.  The adoption of these provisions only affected the disclosure requirements for fair value measurements and as a result had no impact on the Company’s statements of income and condition.  An additional requirement of this ASU is that activity within Level 3, including purchases, sales, issuances, and settlements, be presented on a gross basis rather than as a net number as currently permitted.  This provision of the ASU became effective for the Company’s reporting period ending March 31, 2011.  As this provision only amended the disclosure requirements for fair value measurements, our adoption of it had no impact on the Company’s statements of income and condition.

Note 4 – Supplemental Disclosure of Cash Flow Information

During the six months ended June 30, 2011 and 2010, cash paid for interest due on interest-bearing liabilities was $2.942 million and $4.304 million, respectively.  There was $1.643 million in cash paid for income taxes during the six months ended June 30, 2011, and $5.360 million in cash paid for income taxes during the six months ended June 30, 2010.  Assets totaling $2.948 million and $5.455 million were acquired in settlement of loans for the six months ended June 30, 2011 and June 30, 2010, respectively, and we received $3.268 million in cash from the sale of foreclosed assets during the first half of 2011 relative to $2.911 million during the first half of 2010.  The Company extended $1.381 million in loans to finance the sale of foreclosed assets during the six months ended June 30, 2011, but none during the first six months of 2010.

Note 5 – Share Based Compensation

The 2007 Stock Incentive Plan (the “2007 Plan”) was adopted by the Company in 2007.  Our 1998 Stock Option Plan (the “1998 Plan”) was concurrently terminated, although options to purchase 292,723 shares that were granted prior to the termination of the 1998 Plan were still outstanding as of June 30, 2011 and remain unaffected by the termination.  The 2007 Plan provides for the issuance of both “incentive” and “nonqualified” stock options to officers and employees, and of “nonqualified” stock options to non-employee directors of the Company.  The 2007 Plan also provides for the potential issuance of restricted stock awards to these same classes of eligible participants, on such terms and conditions as are established at the discretion of the Board of Directors or the Compensation Committee.  The total number of shares of the Company’s authorized but unissued stock reserved and available for issuance pursuant to awards under the 2007 Plan was initially 1,500,000 shares, although options have been granted since the inception of the plan and the number remaining available for grant as of June 30, 2011 was 1,040,360.  No restricted stock awards have been issued by the Company.

Pursuant to FASB’s standards on stock compensation, share-based compensation expense is reflected in our income statement for each option granted over the vesting period of such option.  The Company is utilizing the Black-Scholes model to value stock options, and the “multiple option” approach is used to allocate the resulting valuation to actual expense.  Under the multiple option approach, an employee’s options for each vesting period are separately valued and amortized.  This appears to be the preferred method for option grants with multiple vesting periods, which is the case for most options granted by the Company.  A pre-tax charge of $53,000 was reflected in the Company’s income statement during the second quarter of 2011 and $28,000 was charged during the second quarter of 2010, as compensation expense related to outstanding and unvested stock options.  For the first half, these charges amounted to $118,000 in 2011 and $66,000 in 2010.

 
6

 

Note 6 – Earnings Per Share

The computation of earnings per share, as presented in the Consolidated Statements of Income, is based on the weighted average number of shares outstanding during each period.  There were 14,012,574 weighted average shares outstanding during the second quarter of 2011, and 11,646,409 during the second quarter of 2010.  There were 13,997,264 weighted average shares outstanding during the first six months of 2011, and 11,638,638 during the first six months of 2010.

Diluted earnings per share include the effect of the potential issuance of common shares, which for the Company is limited to “in-the-money” shares that would be issued on the exercise of outstanding stock options.  The dilutive effect of options outstanding was calculated using the treasury stock method, excluding anti-dilutive shares and adjusting for unamortized expense and windfall tax benefits.  For the second quarter and first six months of 2011, the dilutive effect of options outstanding calculated under the treasury stock method totaled 72,423 and 75,710, respectively, which were added to basic weighted average shares outstanding for purposes of calculating diluted earnings per share.  Likewise, for the second quarter and first six months of 2010, shares totaling 103,137 and 84,928, respectively, were added to basic weighted average shares outstanding in order to calculate diluted earnings per share.

Note 7 – Comprehensive Income

Comprehensive income includes net income and other comprehensive income. The Company’s only source of other comprehensive income is derived from unrealized gains and losses on available-for-sale investment securities. Reclassification adjustments, resulting from gains or losses on investment securities that were realized and included in net income of the current period that also had been included in other comprehensive income as unrealized holding gains or losses in the period in which they arose, are excluded from comprehensive income of the current period. The Company’s comprehensive income was as follows:

Comprehensive Income
           
(dollars in thousands, unaudited)
 
For the Quarter
   
For the Six Months
 
   
Ended June 30,
   
Ended June 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Net Income
  $ 2,184     $ 2,544     $ 3,713     $ 4,884  
Other comprehensive income:
                               
Unrealized holding gain
    3,450       1,366       5,289       2,550  
Less: reclassification adjustment
    -       -       -       -  
Pre-tax other comprehensive inc/(loss)
    3,450       1,366       5,289       2,550  
Less: tax impact of above
    1,450       574       2,223       1,072  
Net other comprehensive income
    2,000       792       3,066       1,478  
                                 
Comprehensive income
  $ 4,184     $ 3,336     $ 6,779     $ 6,362  

Note 8 – 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, in order to meet the financing needs of its customers.  These financial instruments consist of commitments to extend credit, and standby letters of credit.  They involve, to varying degrees, elements of risk in excess of the amount recognized in the balance sheet.  The Company’s exposure to credit loss in the event of nonperformance by counterparties for commitments to extend credit and letters of credit is represented by the contractual amount of those instruments.  The Company uses the same credit policies in making commitments and issuing letters of credit as it does for making loans included on the balance sheet.  The following financial instruments represent off-balance-sheet credit risk (dollars in thousands):

   
June 30, 2011
   
December 31, 2010
 
Commitments to extend credit
  $ 143,501     $ 142,309  
Standby letters of credit
  $ 11,380     $ 7,761  
Commercial letters of credit
  $ 9,427     $ 9,435  
 
 
7

 

Commitments to extend credit consist primarily of unfunded single-family residential construction loans and home equity lines of credit, and commercial real estate construction loans and commercial revolving lines of credit. Construction loans are established under standard underwriting guidelines and policies and are secured by deeds of trust, with disbursements made over the course of construction. Commercial revolving lines of credit have a high degree of industry diversification. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit are generally unsecured and are issued by the Company to guarantee the performance of a customer to a third party, while commercial letters of credit represent the Company’s commitment to pay a third party on behalf of a customer upon fulfillment of contractual requirements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers.
 
Note 9 – Fair Value Disclosures and Reporting, the Fair Value Option and Fair Value Measurements

FASB’s standards on financial instruments, and on fair value measurements and disclosures, require all entities to disclose the estimated fair value of all financial instruments for which it is practicable to estimate fair values.  In addition to those footnote disclosure requirements, FASB’s standard on investments requires that our debt securities, which are classified as available for sale, and our equity securities that have readily determinable fair values, be measured and reported at fair value in our statement of financial position.  Certain impaired loans are also reported at fair value, as explained in greater detail below, and foreclosed assets are carried at the lower of cost or fair value.  While the fair value option outlined under FASB’s standard on financial instruments permits companies to report certain other financial assets and liabilities at fair value, we have not elected the fair value option for any additional financial assets or liabilities.

Fair value measurements and disclosure standards also establish a framework for measuring fair value.  Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability, in an orderly transaction between market participants on the measurement date.  Further, they establish a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  The standards describe three levels of inputs that may be used to measure fair value:

 
·
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

 
·
Level 2: Significant observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.

 
·
Level 3: Significant unobservable inputs that reflect a company’s own assumptions about the factors that market participants would likely consider in pricing an asset or liability.

Fair value estimates are made at a specific point in time based on relevant market data and information about the financial instruments.  These estimates do not reflect any premium or discount that could result from offering the Company’s entire holdings of a particular financial instrument for sale at one time, nor do they attempt to estimate the value of anticipated future business related to the instruments.  In addition, the tax ramifications related to the realization of unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any estimates.  Because no market exists for a significant portion of the Company’s financial instruments, fair value disclosures are based on judgments regarding current economic conditions, risk characteristics of various financial instruments and other factors.  These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision.  Changes in assumptions could significantly affect the fair values presented.  The following methods and assumptions were used by the Company to estimate the fair value of its financial instruments disclosed at June 30, 2011 and December 31, 2010:

 
·
Cash and cash equivalents and short-term borrowings:  For cash and cash equivalents and short-term borrowings, the carrying amount is estimated to be fair value.

 
8

 

 
·
Investment securities:  The fair values of investment securities are determined by obtaining quoted prices on nationally recognized securities exchanges or by matrix pricing, which is a mathematical technique used widely in the industry to value debt securities by relying on the securities’ relationship to other benchmark quoted securities when quoted prices for the specific securities are not readily available.

 
·
Loans and leases:  For variable-rate loans and leases that re-price frequently with no significant change in credit risk or interest rate spread, fair values are based on carrying values.  Fair values for other loans and leases are estimated by discounting projected cash flows at interest rates being offered at each reporting date for loans and leases with similar terms, to borrowers of comparable creditworthiness.  Fair values of loans held for sale are estimated using quoted market prices for similar loans or the amount that has been committed to purchase the loan.  The carrying amount of accrued interest receivable approximates its fair value.

 
·
Cash surrender value of life insurance policies:  The fair values are based on cash surrender values at each reporting date.

 
·
Investment in, and capital commitments to, limited partnerships:  The fair values of our investments in WNC Institutional Tax Credit Fund Limited Partnerships and any other limited partnerships are estimated using quarterly indications of value provided by the general partner.  The fair values of undisbursed capital commitments are assumed to be the same as their book values.

 
·
Other investments:  Included in other assets are certain long-term investments carried at cost, which approximates their estimated fair value.

 
·
Deposits:  Fair values for demand deposits and other non-maturity deposits are equal to the amount payable on demand at the reporting date, which is the carrying amount.  Fair values for fixed-rate certificates of deposit are estimated using a cash flow analysis, discounted at interest rates being offered at each reporting date by the Bank for certificates with similar remaining maturities.  The carrying amount of accrued interest payable approximates its fair value.

 
·
Short-term borrowings:  The carrying amounts approximate fair values for federal funds purchased, overnight FHLB advances, borrowings under repurchase agreements, and other short-term borrowings maturing within ninety days of the reporting dates.  Fair values of other short-term borrowings are estimated by discounting projected cash flows at the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

 
·
Long-term borrowings:  The fair values of the Company’s long-term borrowings are estimated using projected cash flows discounted at the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

 
·
Subordinated debentures:  The fair values of subordinated debentures are determined based on the current market value for like instruments of a similar maturity and structure.

 
·
Commitments to extend credit and letters of credit:  Commitments to extend credit are primarily for adjustable rate loans.  Commitments to fund fixed rate loans and letters of credit, where such exist, are also at rates which approximate market rates at each reporting date.  Thus, if funded, the carrying amounts would approximate fair values for the newly created financial assets at the funding date.  However, because of the high degree of uncertainty with regard to whether or not these commitments will ultimately be funded, fair values for loan commitments and letters of credit in their current undisbursed state cannot reasonably be estimated, and only notional values are disclosed in the table below.

 
9

 

Estimated fair values for the Company’s financial instruments at June 30, 2011 and December 31, 2010 are as follows:

Fair Value of Financial Instruments
       
(dollars in thousands, unaudited)
 
June 30, 2011
   
December 31, 2010
 
   
Carrying Amount
   
Fair Value
   
Carrying Amount
   
Fair Value
 
Financial assets:
                       
Cash and cash equivalents
    68,367       68,367       42,645       42,645  
Investment securities available for sale
    402,736       402,736       331,730       331,730  
Loans and leases, net
    752,069       780,684       784,515       816,185  
Cash surrender value of life insurance policies
    32,298       32,298       31,591       31,591  
Other investments
    7,691       7,691       8,361       8,361  
Investments in limited partnerships
    10,198       10,198       10,899       10,899  
Accrued interest receivable
    5,695       5,695       5,677       5,677  
                                 
Financial liabilities:
                               
Deposits
    1,116,166       1,117,063       1,052,274       1,052,085  
Repurchase agreements
    3,980       3,980       -       -  
Overnight borrowings
    -       -       9,650       9,650  
Short-term borrowings
    -       -       5,000       5,000  
Long-term borrowings
    15,000       15,529       15,000       15,736  
Subordinated debentures
    30,928       11,651       30,928       11,610  
Limited partnership capital commitment
    392       764       417       417  
Accrued interest payable
    722       722       678       678  
                                 
   
Notional Amount
           
Notional Amount
         
Off-balance-sheet financial instruments:
                               
Commitments to extend credit
    143,501               142,309          
Standby letters of credit   
    11,380               7,761          
Commercial letters of credit
    9,427               9,435          

For each category of financial assets that were actually reported at fair value at June 30, 2011, the Company used the following methods and significant assumptions:

 
·
Investment Securities:  The fair values of trading securities and securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges or by matrix pricing, which is a mathematical technique used widely in the industry to value debt securities by relying on the their relationship to other benchmark quoted securities.

 
·
Loans held for sale:  Since loans designated by the Company as available-for-sale are typically sold shortly after making the decision to sell them, realized gains or losses are usually recognized within the same period and fluctuations in fair values are thus not relevant for reporting purposes.  If available-for-sale loans stay on our books for an extended period of time, the fair value of those loans is determined using quoted secondary-market prices.

 
·
Impaired loans:  Impaired loans carried at fair value are those for which it is probable that the bank will be unable to collect all amounts due (including both interest and principal) according to the original contractual terms of the loan agreement, and for which the carrying value has been written down to the fair value of the loan.  The carrying value is equivalent to the fair value of the collateral, net of expected disposition costs, for collateral-dependent loans, or the present value of anticipated future cash flows for other loans.

 
·
Foreclosed assets: Repossessed real estate (OREO) and other assets are carried at the lower of cost or fair value. Fair value is appraised value less expected selling costs for OREO and some other assets such as mobile homes, and estimated sales proceeds as determined by using reasonably available sources for all other assets. Foreclosed assets for which appraisals can be feasibly obtained are periodically measured for impairment using updated appraisals. Other foreclosed assets are periodically re-evaluated by adjusting expected cash flows and timing of resolution, again using reasonably available sources. If impairment is determined to exist, the book value of a foreclosed asset is immediately written down to its estimated impaired value through the income statement, thus the carrying amount is equal to the fair value and there is no valuation allowance.

 
10

 

Assets reported at fair value on a recurring basis are summarized below:

Fair Value Measurements - Recurring
                   
(dollars in thousands, unaudited)
                       
   
Fair Value Measurements at June 30, 2011, Using
 
   
Level 1
   
Level 2
   
Level 3
   
Total
 
Investment Securities
                       
U.S. Government agencies
  $ -     $ 5,028     $ -     $ 5,028  
Obligations of states and political subdivisions
    -       73,922       -       73,922  
U.S. Government agencies collateralized by mortgage obligations
    -       322,171       -       322,171  
Other Securities
    1,615       -       -       1,615  
Total availabe-for-sale securities
    1,615       401,121       -       402,736  
                                 
Loans Held for Sale
    -       -       -       -  
Total
  $ 1,615     $ 401,121     $ -     $ 402,736  
                                 
   
Fair Value Measurements at December 31, 2010, Using
 
   
Level 1
   
Level 2
   
Level 3
   
Total
 
Investment Securities
                       
U.S. Government agencies
  $ -     $ 5,062     $ -     $ 5,062  
Obligations of states and political subdivisions
    -       70,102       -       70,102  
U.S. Government agencies collateralized by mortgage obligations
    -       255,143       -       255,143  
Other Securities
    1,423       -       -       1,423  
Total availabe-for-sale securities
    1,423       330,307       -       331,730  
                                 
Loans Held for Sale
    914       -       -       914  
Total
  $ 2,337     $ 330,307     $ -     $ 332,644  

Assets for which a nonrecurring change in fair value has been recorded are summarized below:

Fair Value Measurements - Nonrecurring
             
(dollars in thousands, unaudited)
                   
   
Fair Value Measurements at June 30, 2011, Using
 
   
Level 1
   
Level 2
   
Level 3
   
Total
 
Impaired Loans
  $ -     $ 26,312     $ 13,699     $ 40,011  
Foreclosed Assets
  $ -     $ 16,273     $ 1,958     $ 18,231  
                                 
   
Fair Value Measurements at December 31, 2010, Using
 
   
Level 1
   
Level 2
   
Level 3
   
Total
 
Impaired Loans
  $ -     $ 29,482     $ 6,705     $ 36,187  
Foreclosed Assets
  $ -     $ 3,123     $ 17,568     $ 20,691  

The table above only includes impaired loan balances for which a specific reserve has been established or on which a write-down has been taken.  Information on the Company’s total impaired loan balances, and specific loss reserves associated with those balances, is included in Management’s Discussion and Analysis of Financial Condition and Results of Operation, in the “Credit Quality and Nonperforming Assets” and “Allowance for Loan and Lease Losses” sections.

 
11

 

PART I - FINANCIAL INFORMATION
 
ITEM 2
 
MANAGEMENT’S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
 
FORWARD-LOOKING STATEMENTS

This Form 10-Q includes forward-looking statements that involve inherent risks and uncertainties.  Words such as “expects”, “anticipates”, “believes”, “projects”, and “estimates” or variations of such words and similar expressions are intended to identify forward-looking statements.  These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict.  Therefore, actual outcomes and results may differ materially from what is expressed, forecast in, or implied by such forward-looking statements.

A variety of factors could have a material adverse impact on the Company’s financial condition or results of operations, and should be considered when evaluating the potential future financial performance of the Company.  These include, but are not limited to, continued deterioration in economic conditions in the Company’s service areas; risks associated with fluctuations in interest rates; liquidity risks; increases in nonperforming assets and net credit losses that could occur, particularly in times of weak economic conditions or rising interest rates; the Company’s ability to secure buyers for foreclosed properties; the loss in market value of available-for-sale securities that could result if interest rates change substantially or an issuer has real or perceived financial difficulties; the Company’s ability to attract and retain skilled employees; the Company’s ability to successfully deploy new technology; the success of branch expansion; and risks associated with the multitude of current and future laws and regulations to which the Company is and will be subject.

CRITICAL ACCOUNTING POLICIES

The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States.  The financial information and disclosures contained within those statements are significantly impacted by Management’s estimates and judgments, which are based on historical experience and various other assumptions that are believed to be reasonable under current circumstances.  Actual results may differ from those estimates under divergent conditions.

Critical accounting policies are those that involve the most complex and subjective decisions and assessments, and have the greatest potential impact on the Company’s stated results of operations.  In Management’s opinion, the Company’s critical accounting policies deal with the following areas:  the establishment of the Company’s allowance for loan and lease losses, as explained in detail in the “Provision for Loan and Lease Losses” and “Allowance for Loan and Lease Losses” sections of this discussion and analysis; the valuation of impaired loans and foreclosed assets, which is discussed under “Credit Quality and Nonperforming Assets” and “Allowance for Loan and Lease Losses”; income taxes, especially with regard to the ability of the Company to recover deferred tax assets, as discussed in the “Provision for Income Taxes” and “Other Assets” sections of this discussion and analysis; goodwill, which is evaluated annually for impairment based on the fair value of the Company and for which it has been determined that no impairment exists; and equity-based compensation, which is discussed in greater detail in Note 5 to the consolidated financial statements.  Critical accounting areas are evaluated on an ongoing basis to ensure that the Company’s financial statements incorporate the most recent expectations with regard to these areas.

 
12

 

OVERVIEW OF THE RESULTS OF OPERATIONS
AND FINANCIAL CONDITION

RESULTS OF OPERATIONS SUMMARY

Second Quarter 2011 compared to Second Quarter 2010
 
Net income for the quarter ended June 30, 2011 was $2.184 million, representing a decline of $360,000, or 14%, relative to net income of $2.544 million for the quarter ended June 30, 2010.  Basic and diluted earnings per share for the second quarter of 2011 were $0.16, compared to $0.22 basic and diluted earnings per share for the second quarter of 2010.  The Company’s annualized return on average equity was 5.36% and annualized return on average assets was 0.65% for the quarter ended June 30, 2011, compared to a return on equity of 7.36% and return on assets of 0.77% for the quarter ended June 30, 2010.  The primary drivers behind the variance in net income are as follows:

·
Net interest income was down $671,000, or 5%, due to a 27 basis point drop in the Company’s net interest margin, partially offset by a $15 million increase in average interest-earning assets.  Negative factors impacting our net interest margin in the second quarter of 2011 include lower loan yields resulting from increased competition for quality loans, and a shift from average loan balances into lower-yielding investment balances.  These negatives were partially offset by net interest recoveries in the second quarter of 2011, a reduced reliance on interest-bearing liabilities due to growth in average non-interest bearing deposits and equity, and a shift in average balances from non-deposit borrowings and CDARS deposits into lower-cost core deposit categories.

·
The Company’s loan loss provision was reduced by $500,000, or 14%.  Thus far in 2011, our loan loss provision has been utilized to provide specific reserves for impaired loans and to replenish reserves subsequent to loan charge-offs.  Net loans charged off totaled $3.753 million in the second quarter of 2011, including a $1.4 million charge-off associated with a single non-accruing loan for which we had a $1.2 million reserve already established as of year-end 2010.  Net charge-offs were $2.722 million in the second quarter of 2010.

·
Total non-interest revenue declined by $516,000, or 13%, due primarily to a drop in overdraft income resulting from procedural changes implemented pursuant to regulatory guidance.  Another unfavorable variance in non-interest income was the result of a $378,000 increase in costs associated with low-income housing tax credit investments, which are accounted for as a reduction in income.  These unfavorable variances were partially offset by a higher level of debit card interchange income, higher merchant fees, an increase in income on bank-owned life insurance associated with deferred compensation plans, and gains on leased equipment subsequent to the termination of leases.

·
Total operating expense had a negligible variance for the quarterly comparison.  Salaries and benefits increased by only $50,000, or 1%, despite the addition of staff for newer branches and a $120,000 increase in deferred compensation accruals.  Occupancy expense declined by $194,000, or 11%, for the quarter, due mainly to a drop in depreciation expense, lower maintenance/repair costs, and the January 2011 closure of a branch with a relatively costly lease.  Other non-interest expenses increased by an aggregate $151,000, or 3%, due in large part to a $501,000 increase in write-downs on foreclosed assets and an increase in directors deferred fee accruals, which were partially offset by favorable variances in certain other costs including those associated with online deposit accounts and internet banking, marketing expense, FDIC assessments, and sundry losses.

First Half 2011 Compared to First Half 2010

Net income for the first six months of 2011 was $3.713 million, a drop of $1.171 million, or 24%, relative to net income for the first six months of 2010.  Basic and diluted earnings per share were $0.27 and $0.26, respectively, for the first six months of 2011, compared to $0.42 basic and diluted earnings per share for the first six months of 2010.  The Company realized an annualized return on average equity of 4.62% for the first half of 2011 and 7.17% for the first half of 2010, and a return on assets for the same periods of 0.57% and 0.74%, respectively.  The principal reasons for the first half net income variance include the following:

 
13

 

·
Net interest income declined by $1.996 million, due to a 29 basis point net interest margin decline and a $9 million drop in average interest-earning assets.  The drop in our net interest margin for the comparative year-to-date periods was the result of the same circumstances discussed for the quarterly comparison.

·
The Company’s provision for loan losses was $6.6 million in the first half of 2011, which represents a drop of $300,000, or 4%, relative to the first half of 2010.  Net charge-offs increased by $1.3 million, however, due to the charge-off of a pre-established reserve on a non-performing loan that was resolved in the second quarter of 2011.

·
Total non-interest income declined by $801,000, or 10%.  Similar to the quarterly comparison, the largest changes in the components of non-interest income for the half include lower overdraft fee income and higher low-income housing tax credit investment costs, partially offset by an increase in income generated by deferred compensation BOLI, a higher level of debit card interchange fees, and gains realized upon the termination of equipment leases.

·
Total non-interest expense reflects a drop of $464,000, or 2%, for the first half of 2011.  Significant reductions within this category are evident in occupancy expense, marketing costs, internet banking and online account costs, foreclosed asset operating expense, FDIC assessments, and sundry losses.  These reductions were partially offset by a $692,000 increase in write-downs on foreclosed assets, and higher directors deferred fee costs.

·
The Company recorded a negative income tax provision of $48,000 for the first half of 2011, as compared to a provision of $814,000 for the first half of 2011 that resulted in a tax accrual rate of 14%.  The income tax provision was negative for the first half of 2011 due to a high level of tax credits relative to taxable income, as adjusted for the favorable impact of tax-exempt interest income and BOLI income.

FINANCIAL CONDITION SUMMARY

June 30, 2011 relative to December 31, 2010
 
The most significant characteristics of, and changes in, the Company’s balance sheet during the first six months of 2011 are outlined below:

·
The Company’s assets totaled $1.346 billion at June 30, 2011, an increase of $59 million, or 5%, relative to total assets of $1.287 billion at December 31, 2010.  Total assets increased due to growth in investment securities and an increase in cash and balances due from banks, partially offset by lower loan balances.  Gross loan and lease balances declined $33 million, or 4%, due to runoff in the normal course of business, prepayments, transfers to OREO, and charge-offs.  Weak loan demand from quality borrowers and aggressive competition have hindered our ability to counteract this contraction.

·
The $65 million balance of nonperforming assets at June 30, 2011 reflects a decline of $1 million, or 2%, since year-end 2010, and is well below its peak of $78 million reached a year earlier.  In addition to nonperforming assets we had $14.3 million in performing restructured troubled debt (TDR’s) at June 30, 2011, an increase of $2 million, or 15%, relative to year-end 2010.

·
Our allowance for loan and lease losses was $20.7 million as of June 30, 2011, which represents a slight decline relative to the balance at year-end 2010 due primarily to the charge-off of a pre-established specific reserve that was included in the allowance at December 31, 2010.  Even though the allowance for loan and lease losses fell slightly, our allowance as a percentage of total loans increased by 6 basis points, to 2.68% at June 30, 2011 from 2.62% at December 31, 2010, because loan balances fell during the first half of the year.

·
Total deposits increased by $64 million, or 6%.  While $33 million of that growth was in core non-maturity deposits, NOW deposits dropped by $6 million, or 3%, due to runoff in our online-only accounts subsequent to interest rate adjustments.  We also added $15 million in longer-term wholesale-sourced brokered deposits for interest rate risk management purposes, in order to create a more defensive posture for the eventuality of rising interest rates.  Federal Home Loan Bank borrowings were reduced by $15 million during the first six months of the year, but other borrowings increased by $4 million subsequent to a customer’s transfer of $4 million from money market deposits into a non-deposit sweep account.

 
14

 

·
Total capital increased by $6 million, or 4%, to $165 million at June 30, 2011.  Because capital increased and risk-adjusted assets declined, our consolidated total risk-based capital ratio increased to 21.38% at June 30, 2011 from 20.33% at year-end 2010.  Further, our tier one risk-based capital ratio was 20.12% and our tier one leverage ratio was 13.75% at June 30, 2011.

EARNINGS PERFORMANCE

The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earning assets less interest expense on interest-bearing liabilities. The second is non-interest income, which consists mainly of customer service charges and fees but also comes from non-customer sources such as bank-owned life insurance. The majority of the Company’s non-interest expenses are operating costs that relate to providing a full range of banking services to our customers.

NET INTEREST INCOME AND NET INTEREST MARGIN

For the second quarter of 2011 relative to the second quarter of 2010, net interest income declined by $671,000, or 5%.  For the year-to-date comparison, net interest income declined by $1.996 million, or 7%.  The level of net interest income depends on several factors in combination, including growth in earning assets, yields on earning assets, the cost of interest-bearing liabilities, the relative volume of earning assets and interest-bearing liabilities, and the mix of products which comprise the Company’s earning assets, deposits, and other interest-bearing liabilities.  Net interest income can also be impacted by the reversal of interest for loans placed on non-accrual, and by the recovery of interest on loans that have been on non-accrual and are either sold or returned to accrual status.

The following Average Balances and Rates tables show the average balance of each significant balance sheet category, and the amount of interest income or interest expense associated with that category, for the comparative quarters and year-to-date periods.  The tables also show the calculated yields on each major component of the Company’s investment and loan portfolio, the average rates paid on each key segment of the Company’s interest-bearing liabilities, and our net interest margin for the periods noted.

 
15

 

Average Balances and Rates
 
For the Quarter
   
For the Quarter
 
(dollars in thousands, except per share data)
 
Ended June 30, 2011 (1)(2)(3)
   
Ended June 30, 2010 (1)(2)(3)
 
   
Average
   
Income/
   
Average
   
Average
   
Income/
   
Average
 
   
Balance
   
Expense
   
Rate/Yield
   
Balance
   
Expense
   
Rate/Yield
 
 Assets                                    
Investments:
                                   
Federal funds sold/due from time
  $ 36,802     $ 25       0.27 %   $ 10,215     $ 5       0.19 %
Taxable
    312,808       2,285       2.89 %     234,371       2,043       3.45 %
Non-taxable
    73,396       721       5.98 %     67,829       673       6.04 %
Equity
    1,595       -       0.00 %     1,607       -       0.00 %
Total Investments
    424,601       3,031       3.19 %     314,022       2,721       3.88 %
                                                 
Loans and Leases:(4) (5)
                                               
Agricultural
    13,886       179       5.17 %     9,719       122       5.03 %
Commercial
    107,006       1,598       5.99 %     119,237       1,784       6.00 %
Real Estate
    556,509       9,091       6.55 %     623,481       10,285       6.62 %
Consumer
    41,031       946       9.25 %     51,286       1,139       8.91 %
Direct Financing Leases
    7,117       104       5.86 %     11,484       165       5.76 %
Other
    48,459       -       0.00 %     54,702       -       0.00 %
Total Loans and Leases
    774,008       11,918       6.18 %     869,909       13,495       6.22 %
Total Interest Earning Assets (5)
    1,198,609       14,949       5.13 %     1,183,931       16,216       5.62 %
Other Earning Assets
    7,882                       9,196                  
Non-Earning Assets
    133,018                       131,800                  
Total Assets
  $ 1,339,509                     $ 1,324,927                  
                                                 
Liabilities and Shareholders' Equity
                                               
Interest Bearing Deposits:
                                               
NOW
  $ 175,621     $ 205       0.47 %   $ 182,036     $ 530       1.17 %
Savings Accounts
    83,492       50       0.24 %     69,641       41       0.24 %
Money Market
    165,083       192       0.46 %     167,208       245       0.59 %
CDAR's
    49,144       71       0.59 %     78,669       168       0.86 %
Certificates of Deposit<$100,000
    158,083       271       0.69 %     144,702       296       0.82 %
Certificates of Deposit$100,000
    196,870       286       0.58 %     193,209       315       0.65 %
Brokered Deposits
    15,000       50       1.34 %     15,000       76       2.03 %
Total Interest Bearing Deposits
    843,293       1,125       0.54 %     850,465       1,671       0.79 %
Borrowed Funds:
                                               
Federal Funds Purchased
    3       -       0.00 %     -       -       0.00 %
Repurchase Agreements
    1,634       5       1.23 %     -       -       0.00 %
Short Term Borrowings
    1       -       0.00 %     26,676       55       0.83 %
Long Term Borrowings
    15,000       142       3.80 %     15,000       142       3.80 %
TRUPS
    30,928       180       2.33 %     30,928       180       2.33 %
Total Borrowed Funds
    47,566       327       2.76 %     72,604       377       2.08 %
Total Interest Bearing Liabilities
    890,859       1,452       0.65 %     923,069       2,048       0.89 %
Demand Deposits
    269,716                       248,832                  
Other Liabilities
    15,559                       14,454                  
Shareholders' Equity
    163,375                       138,572                  
Total Liabilities and Shareholders' Equity
  $ 1,339,509                     $ 1,324,927                  
                                                 
Interest Income/Interest Earning Assets
                    5.13 %                     5.62 %
Interest Expense/Interest Earning Assets
                    0.48 %                     0.70 %
Net Interest Income and Margin(6)
          $ 13,497       4.65 %           $ 14,168       4.92 %

(1)
Average balances are obtained from the best available daily or monthly data and are net of deferred fees and related direct costs.
(2)
Yields and net interest margin have been computed on a tax equivalent basis utilizing a 35% effective tax rate.
(3)
Annualized
(4)
Net loan costs have been included in the calculation of interest income.  Net loan costs were approximately $145 thousand and $148 thousand for the quarters ended June 30, 2011 and 2010.
 Loans are gross of the allowance for possible loan losses.
(5)
Non-accrual loans have been included in total loans for purposes of total earning assets.
(6)
Represents net interest income as a percentage of average interest-earning assets.

 
16

 

Average Balances and Rates
 
For the Six Months
   
For the Six Months
 
(dollars in thousands, except per share data)
 
Ended June 30, 2011 (1)(2)(3)
   
Ended June 30, 2010 (1)(2)(3)
 
   
Average
   
Income/
   
Average
   
Average
   
Income/
   
Average
 
   
Balance
   
Expense
   
Rate/Yield
   
Balance
   
Expense
   
Rate/Yield
 
Assets                                    
Investments:
                                   
Federal funds sold/due from time
  $ 25,967     $ 33       0.25 %   $ 16,073     $ 22       0.27 %
Taxable
    294,874       4,201       2.83 %     228,162       4,150       3.62 %
Non-taxable
    72,609       1,437       6.06 %     66,064       1,318       6.10 %
Equity
    1,572       -       0.00 %     1,563       -       0.00 %
Total Investments
    395,022       5,671       3.24 %     311,862       5,490       3.95 %
                                                 
Loans and Leases:(4) (5)
                                               
Agricultural
    12,992       331       5.14 %     9,696       242       5.03 %
Commercial
    104,609       3,120       6.01 %     119,181       3,538       5.99 %
Real Estate
    563,054       18,140       6.50 %     625,169       20,693       6.67 %
Consumer
    42,548       1,890       8.96 %     52,990       2,263       8.61 %
Direct Financing Leases
    7,530       219       5.86 %     11,832       337       5.74 %
Other
    49,091       -       0.00 %     53,190       -       0.00 %
Total Loans and Leases
    779,824       23,700       6.13 %     872,058       27,073       6.26 %
Total Interest Earning Assets (5)
    1,174,846       29,371       5.17 %     1,183,920       32,563       5.67 %
Other Earning Assets
    8,114                       9,278                  
Non-Earning Assets
    133,510                       129,758                  
Total Assets
  $ 1,316,470                     $ 1,322,956                  
                                                 
Liabilities and Shareholders' Equity
                                               
Interest Bearing Deposits:
                                               
NOW
  $ 176,358     $ 420       0.48 %   $ 171,352     $ 914       1.08 %
Savings Accounts
    80,852       96       0.24 %     67,378       77       0.23 %
Money Market
    160,811       382       0.48 %     171,248       497       0.59 %
CDAR's
    40,998       125       0.61 %     96,359       431       0.90 %
Certificates of Deposit<$100,000
    159,727       545       0.69 %     144,648       616       0.86 %
Certificates of Deposit$100,000
    194,093       573       0.60 %     193,754       621       0.65 %
Brokered Deposits
    10,939       75       1.38 %     18,083       173       1.93 %
Total Interest Bearing Deposits
    823,778       2,216       0.54 %     862,822       3,329       0.78 %
Borrowed Funds:
                                               
Federal Funds Purchased
    3       -       0.00 %     2       -       0.00 %
Repurchase Agreements
    821       4       0.98 %     -       -       0.00 %
Short Term Borrowings
    2,538       35       2.78 %     18,084       92       1.03 %
Long Term Borrowings
    15,000       282       3.79 %     17,099       318       3.75 %
TRUPS
    30,928       361       2.35 %     30,928       355       2.31 %
Total Borrowed Funds
    49,290       682       2.79 %     66,113       765       2.33 %
Total Interest Bearing Liabilities
    873,068       2,898       0.67 %     928,935       4,094       0.89 %
Demand Deposits
    265,781                       243,251                  
Other Liabilities
    15,524